HSBC’s $770,000 digital plus notes on three ETFs offer absolute return, uncapped upside

By Emma Trincal

New York, April 13 – HSBC USA Inc.’s $770,000 of 0% dual directional digital plus securities due April 14, 2026 linked to the least performing of the of iShares MSCI EAFE exchange-traded fund, the iShares MSCI Emerging Markets ETF and the iShares Russell 2000 Value ETF provide advantageous features for investors seeking to beat the market both on the upside and the downside. But high valuations are a concern for some.

If the least performing ETF finishes at or above its initial value, the payout at maturity will be par plus the greater of the return of the least performing ETF and 52%, according to a 424B2 filing with the Securities and Exchange Commission.

If the least performing ETF finishes below its initial value but at or above its barrier value, 70% of its initial value, the payout will be par plus the absolute value of the return of the least performing ETF.

If the least performing ETF finishes below its barrier value, investors will receive a number of shares of the least performing ETF equal to $1,000 divided by the initial value of that ETF.

Overbought

Billions have flowed into global equity funds and value assets, pushing up prices at unsustainable heights, said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

“You’re really starting at extremely high levels, and that’s not a good thing,” he said.

“The emerging markets one may be a little bit less overbought, but it’s still quite high because it’s overweight China and India, which are both at super high points.”

The two countries combined represent nearly half of the fund’s portfolio, according to iShares’ website. China alone showed a 37.7% weighting.

All three ETFs have been on a bullish momentum.

The Emerging Markets ETF rose 48% in the past year. In February, the fund hit a 13-year high.

The iShares MSCI EAFE ETF has also climbed, up 40% in the past 12 months. On Friday, the share priced notched a new record, its highest level since May 2008.

“The Value ETF has been going way up in recent months too,” Kaplan noted.

The iShares Russell 2000 Value ETF set an all-time high in March and has surged 84% in the past year.

“People are buying aggressively. You don’t really have any bargain on any of those three indices. That would to me be my main concern,” he said.

Bear scenario

The portfolio manager admitted that the upside was “quite generous” with the minimum return of 52% offered even if the worst-of fails to go up and finishes flat.

But the risk versus reward was not in favor of investors, he noted.

“Five years might seem like plenty of time for markets to recover, but it depends what type of market you’re talking about. If you get big price drops in the coming two or three years, which is what I expect, the question is: how much of a rebound do you need? You’ll need a big rebound,” he said.

“If one index drops 60%, it has to rise 75% to go back to the 70% barrier level you need to break even.”

A 60% price decline in any of these underliers is not far stretched in the current market, he said.

“Valuations are at extreme levels. The market is overbought. You’ve seen such drawbacks during previous bear markets. Just look at the years that followed the crash of 2000 and the peak of 2007.”

The iShares MSCI EAFE peaked on Oct. 31, 2007. Exactly five years later, the share price was down 39% from that level.

“In a market that carries so much risk, I would be more concerned about the downside protection,” he said.

“Just because it’s a five-year doesn’t mean it’s a good time to buy at those levels.”

Benefit of time

Tom Balcom, founder of 1650 Wealth Management, was encouraged by the length of the holding period.

“Over five years, the probability of being down 30% is pretty low, I think. Of course, it could happen, especially with a worst-of. But over that long period of time, the odds of breaching the barrier are pretty slim in my view,” he said.

If the underlying finishes negative but above the barrier, investors benefit from the absolute return.

“That’s a good way to generate alpha,” he said.

Balcom liked the upside potential as well.

“As long as it’s not negative at the end, you’ll get at least 8% per year compounded. That’s a great opportunity to outperform if the market is flat. If it is not, if it rises more than 52%, you’re not capped. You’re long the worst-of.”

Asset allocation

The notes offered another advantage for advisers: some flexibility in allocating the notes in the portfolio.

“With that type of return, you could use it either as high-yield replacement or as equity replacement. You have the choice, really. It depends on how the adviser looks at it,” he said.

“The 8% minimum gain makes it suitable for a piece of your equity bucket especially since you don’t have a cap.

“But it could also qualify as high-yield replacement. With a five-year duration, even if there’s a pullback, you still have a healthy safety net.

“I like it.”

HSBC Securities (USA) Inc. is the agent.

The notes priced on Friday and will settle on Wednesday.

The Cusip number is 40428HQC9.

The fee is 0.25%.

© 2015 Prospect News.
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