HSBC’s capped gears on Energy Select Sector offer potential for gains in down sector

By Emma Trincal

New York, Feb. 15 – HSBC USA Inc.’s 0% capped gears due April 20, 2020 linked to the Energy Select Sector SPDR fund give investors a chance to monetize the rebound taking place in the energy sector of the S&P 500 index even though a lot of the recovery has already taken place, a contrarian investor said.

If the fund finishes above its initial level, the payout at maturity will be par plus 3 times the gain, up to a maximum return of 29% to 29.5%, according to an FWP filing with the Securities and Exchange Commission.

If the index return is negative, investors will lose 1% for each 1% decline.

One of the first attractive aspects of the deal was the single underlier.

“At least this is one underlier only. It’s not energy versus gold or any kind of worst-of. If you’re focusing on the energy sector, you get leveraged exposure,” said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

“It’s probably a good idea.”

Sister fund

Energy stocks were one of the hardest hit last year due to a sharp decline in crude oil prices in the last quarter, he said.

But the correlation between oil and energy stocks is not perfect.

“I would compare the XLE with another one I like, which is more volatile,” he said.

“XLE” is the ticker for the Energy Select Sector SPDR ETF, which is listed on the Nasdaq.

The “other” fund was the SPDR S&P Oil & Gas Equipment & Services ETF. It trades on the NYSE Arca under the symbol “XES.”

“Last year, the XES fell the most. From its high to its low, it was down 57.5%. The XLE on the other hand fell a lot but not quite as much. It lost 31%,” he said.

Big stocks, slow movers

Oil prices could not explain the discrepancy. Kaplan pointed to the market-capitalization of the constituents in both funds as the explanation.

“The reason the underlying in this note didn’t fall quite as badly is because it is made of huge companies,” he said.

The two top holdings are Exxon Mobil Corp. and Chevron Corp. The top constituents in the SPDR S&P Oil & Gas Equipment & Services fund are Weatherford International plc and Rowan Cos. plc.

“XLE is more correlated to the S&P than it is to oil prices. This is because those are very large companies. They just don’t move up or down as much as smaller companies such as those in the XES,” he said.

If size matters, concentration does too. Combined Exxon and Chevron represent 42% of the fund’s portfolio.

Those characteristics make the Energy Select Sector SPDR a relatively good underlying candidate in a highly leveraged structure.

“You’re getting a much less volatile fund with XLE,” he said.

“That’s why XES dropped 60% last year while XLE fell by a third.”

The implied volatility of “XLE” is 20% versus 30% for XES.

Correlation with oil

By choosing an underlying fund made of very large companies, the issuer also reduces the correlation to oil prices.

“It’s not where you are in the world that will determine the correlation with oil. It’s the size of the company that’s going to be a factor,” he said.

“Exxon doesn’t trade in lockstep with oil, so it benefits less from higher prices but will get hurt much less from lower oil prices.”

“The notes are effectively linked to one of the least volatile funds in the energy sector. It behaves more like the S&P.”

These characteristics happened to “work” with the structure.

One-to-one downside

“I’m not too concerned about having no downside protection because you’re not playing the sector on a very volatile energy fund like XES,” he said.

“Big companies during a bear market tend to fall less in percentage.

Current valuations also helped.

“The fund dropped a lot in December. Even though a lot of the rebound has already been taking place – my guess is we’re halfway through – we’re still far from the October levels,” he said.

“If the notes had priced around Christmas, it would have been much better of course.”

Upside

On the upside, the fund’s returns may be modest.

“I like the 29% cap over 14 months. It’s very reasonable. I also like the three-to-one leverage on the upside. Having a lot of leverage is a very helpful feature when something isn’t moving up a lot,” he said.

The share price of the Energy Select Sector SPDR fund closed at $65 on Thursday.

“You only need to be up 10% at maturity. A gain of 10% from the current price would bring you to somewhere around $71.

“It’s less than the highs of many of the recent years. You don’t have to set a new record high or see anything spectacular. You just need the share price to rebound.

“At least there is a reasonable possibility to make money,” he said.

Timing

The timeframe for the trade was “reasonably good,” he said, although “not perfect.”

Kaplan sees next year as potentially “bad” for the stock market.

“In 2016 the election of Donald Trump was completely unexpected. People didn’t think he had a chance.

There was no time to fret about it. Next year will give everybody plenty of time to talk and worry about it in advance. Volatility will be pretty high, “he said.

“I’m glad it’s not maturing around the elections, but it’s still going to mature in an election year.

“I would have picked the end of January or February rather than April.

“But you’re still ahead of the game. It’s still better than an 18-month or a two-year.”

In conclusion, Kaplan said the notes were valuable.

“I generally like it. It’s a reasonable timeframe. They picked a sector that has gone down more than the others, with very low P/E ratios. I think it’s got potential for profits given the high leverage.”

HSBC Securities (USA) Inc. and UBS Financial Services Inc. are the agents.

The notes will settle on Tuesday.

The Cusip number is 40436A321.

© 2015 Prospect News.
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