HSBC’s autocallable step-up notes tied to MSCI Emerging Markets to offer double-digit premium

By Emma Trincal

New York, Oct. 28 – HSBC USA Inc.’s 0% autocallable market-linked step-up notes due November 2022 linked to the MSCI Emerging Markets index offer a double-digit call premium in a flat or up market but no downside protection, making the notes inadequate for highly bullish or conservative investors alike given the underlying volatility, sources said.

The notes will be automatically called at par of $10 plus a call premium if the index closes at or above the initial index level on either annual observation date, according to an FWP filing with the Securities and Exchange Commission.

The call premium is expected to be 10.5% to 11.5% per year and will be set at pricing.

If the notes are not called and the final index level is greater than the step-up value, 130% of the initial index level, the payout at maturity will be par plus the index return.

If the final index level is greater than or equal to the initial index level but less than or equal to the step-up value, the payout will be par plus the step-up payment, 30%.

If the final index level is less than the initial index level, investors will have one-to-one exposure to the decline.

China

“I’ve got mixed feelings about this payout,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“To some extent, it is a China play. It’s a bet on the resolution of the China/U.S. trade war to the extent that China is such a big component of the index.”

Chinese stocks represent nearly a third of the index portfolio.

“There is no downside protection, but we’re underweight emerging markets. Our target is usually 5% of the portfolio, and we’re at 1%. So it’s not going to move the needle anyway,” he said.

“If the index is down, you’re not worst off than if you held the position long.

“And you’d be slightly better off on the upside because you get an easier opportunity to capture an 11% annual return. If the index is flat you get 11%.”

Downside risk

The automatic call was a favorable outcome, and the fact that the call premium may be cumulated on year two and shift to a 30% step payment at maturity was another benefit.

In the absence of a call, however, investors are exposed to more risk, he said.

“If you don’t get called, you’re kind of stuck waiting for that third year. You can’t really bail on it. It’s not a liquid investment. There is no secondary if the outcome is really negative,” he said.

But he downplayed the extent of the risk.

“My personal feeling is that you’re not going to be down for three years. I don’t think you’re going to get locked in. You’re going to get called on that first or second year.

“So I guess it’s an attractive way to get exposure to emerging markets. At least it gives you an opportunity for an 11% annual return if the market doesn’t drop.”

Passive and small

Any investor considering the notes would have to be only mildly bullish or neutral on emerging markets.

Kunhardt said he is “agnostic” on the notes.

“Emerging markets are very inefficient. It’s one of the few asset classes where I prefer to use active management. I’d rather not go the passive route, which is what you do with a note.”

On the other hand, sizing the exposure is another way to manage the risk, and it can be done “passively,” he said.

“If I’m negative on emerging markets, I won’t hold the asset class to begin with. My allocation will be zero, or I would cut my exposure to the bare minimum, which is what I’ve just done.”

Given his small allocation to the asset class, Kunhardt said he would be willing to take a chance.

“I may do it anyway because all I have to do is be flat to get 11%,” he said.

“If you control your risk exposure, it’s not necessarily a bad bet.”

De facto cap

Steven Foldes, vice-chairman of Evensky & Katz/Foldes Financial Wealth Management, said he did not like the risk/reward profile of the notes.

“We don’t have a problem with HSBC. HSBC is a very strong financial institution,” he said.

“But we don’t like the asymmetrical payout. We think the upside is very much capped to the call premium even if you have unlimited upside at maturity.”

In his view, the automatic call was very likely to be triggered on either the first or second call date.

If not, the odds of getting any gain above the 30% step payment were slim.

“Technically it’s uncapped. But to get the uncapped return you cannot be called for two years and on year three, things suddenly have to take off. We think it’s illusory.”

Perhaps the real issue with the note was the mismatch between a structure designed for a sideways market and an underlying that tends to display wide price fluctuations.

“Emerging markets is a very volatile asset class,” he said.

In 2018, the index dropped 15%. But it was up 37.5% in the previous year, he noted.

Uncapped alternative

“We don’t love investing in a note that gives you a potential fixed return of 11% when the asset class can be up more than three times that like in 2017,” Foldes said.

He also pointed to the downside risk.

“If we have a lousy year, you’ll suffer the full loss and you won’t have time to recoup. You’ll have to wait and hope that it goes back at par, which it might or might not do,” he said.

“So you could get a significant loss or you may miss a substantial year and all you get is 11%.”

Foldes said a better alternative was to use an “uncapped digital” note, one without any autocallable feature.

He pointed to a Morgan Stanley Finance LLC jump securities issue tied to the iShares MSCI Emerging Markets exchange-traded fund, which he bought in December. The 14-month note pays a 16% digital coupon at maturity if the underlying is at or above its initial level and offers one-to-one participation in the gain if the price climbs above 16%.

“The downside exposure is the same. No protection,” he said.

“But at least you can fully participate in a bull market. Your upside is not limited by the likelihood of getting called with a premium lower than the market.”

BofA Securities Inc. is the agent.

The notes will price in November and settle in December.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.