HSBC’s contingent income autocalls on Seagate offer attractive pricing due to negative forward

By Emma Trincal

New York, Feb. 21 – HSBC USA Inc.’s contingent income autocallable securities due Feb. 24, 2023 linked to the common stock of Seagate Technology plc offer compelling pricing due in part to the high-dividend underlying stock, said Suzi Hampson, head of research at Future Value Consultants.

If the shares close at or above the downside threshold level, 60% of the initial share price, on a quarterly determination date, the notes will pay a contingent payment that quarter at an annualized rate of 10%, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par of $10 plus the contingent coupon if the shares close at or above the initial share price on any of the first 11 quarterly determination dates.

If the final share price is greater than or equal to the downside threshold level, the payout at maturity will be par plus the final contingent coupon. Otherwise, investors will lose 1% for every 1% that the final share price is less than the initial share price.

Negative forward

“This product offers relatively attractive terms in part due to the high-dividend yield of the stock,” said Hampson.

“Of course, many other factors play out as well. But the dividend is an important factor.”

Seagate Technology carries a 3.4% dividend yield.

“The dividend is higher than the risk-free rate. It will give us a negative forward, which enhances pricing,” she said.

The forward is the risk-free rate minus the dividend. With the risk-free rate at 1.40%, the forward is minus 2%.

Hampson explained how this information is used by her firm to price, assess the value and run stress testing reports on structured notes.

Stress testing

To conduct its stress testing analysis, Future Value Consultants runs a Monte-Carlo simulation using market and implied data, including risk-free rate, issuer credit spread, deposit rate, dividend yield and volatility.

The model is based on five distribution assumption sets.

One of them is the neutral scenario, which is the basis of the simulation in all reports. It reflects standard pricing and is based on the risk-free rate, dividends and volatility of the underlying.

“The minus 2% forward rate will be the growth rate of the underlying stock under the neutral scenario,” she said.

The other four market scenarios, which are designed to represent more realistic market regimes are – bull, bear, more volatile and less volatile.

Neutral is not real

Showing an underlying asset with a negative growth rate may seem counterintuitive when investors buy structured notes in the hope of profiting from the underlying price appreciation.

Hampson explained how it could happen.

“The neutral is not a market scenario; it does not seek to predict anything. It’s just a formula used in the options pricing model, which will affect the product terms and the value of this product,” she said.

“It’s really the bull assumption that reflects the most what buyers are expecting from the product. You wouldn’t invest in equity if you had a neutral outlook. The bull is more aligned with the analysis on equity.”

Options pricing

On the other hand, the minus 2% growth rate under the neutral scenario explained how the issuer may offer better terms.

“The negative forward makes it less likely for the stock to be above initial price, in other words, you’re less likely to kick out.

“Since your chances of being above 100 are lower, the cost of the options will be cheaper.”

The options pricing model reflects the current interest rate environment.

“Rates are so low,” she said.

“Imagine for instance a very different market with high interest rates and let’s assume there are no dividends for that stock.”

She picked a hypothetical risk-free rate of 5% with the dividend yield of the stock at 0%. Applying the forward formula would generate a 5% growth rate.

“It would make the call much more likely and therefore the terms may not be as attractive,” she said.

Choosing the asset

There’s a variety of reasons for choosing a particular underlying, she explained.

“It could be a sector play; it could be to generate a high coupon by selling the implied volatility; sometimes it’s simply a stock or index people want exposure to with a different risk-reward profile,” she said.

In some cases, using an underlying with a high dividend yield can pay off.

“It enables the issuer to put together products that are much more attractive because pricing is much easier.”

Call on first date

Hampson analyzed some of the probabilities of outcomes from a report she ran on this product. She picked one of the 29 tables available in each report, which is called “product specific tests.”

This set of specific tests includes probability of barrier breach, probabilities of calls at 11 call points, probabilities of coupon payments on the 12 payment dates and the probability of no call occurring. The results are shown for the five different scenarios.

As always, the probability of a call at point one is the highest. The table showed a 47.47% probability under the neutral assumption.

“These probabilities change a lot depending on your market assumption,” she said.

Naturally, the chances increase in the bull market with a 51.16% probability for this outcome and fall to 43.37% under the bear assumption.

Markets matter

“It’s interesting to note that if you change the market scenario, not only will the probabilities change but also their ranking,” she said.

She offered an example. Under the neutral scenario, the second most likely outcome is the barrier breach with a probability of 14.40%. However, under the bull assumption, the second most likely event is a call at point 2, which will happen 13.04% of the time versus 9.07% for the barrier breach.

“The change in the order of probabilities represents quite a big shift,” she said.

“But one thing remains always the same with any autocall regardless of the market scenario: the most likely outcome will always be call at point 1.”

No call

Another outcome – “no call occurs” – is associated with a 21.49% probability in the neutral scenario.

This represents the situation in which the stock finishes negative.

That bucket can be divided into two separate ones. First, the barrier breach, which happens 14.40% of the time.

Second, a price drop above the barrier threshold, which guarantees the protection. This second outcome has a probability measured by the difference between the probability of a negative final closing price and the probability of a barrier breach. It results in a 7.09% probability.

Barrier barometer

“7% of the time, you will finish between 100% and 60%. You get your principal back and lose nothing,” she said.

This probability gives an idea of the value of the downside protection.

“It may not seem like this barrier is going to be of use a lot, but it’s still helpful some of the time.

“If the value of the protection was much higher, you wouldn’t get that kind of return,” she said.

Cushions

Another risk mitigating factor if the notes are not called is the likelihood of collecting more than one coupon payment during the life of the notes.

It’s only 0.05% of the time that investors will not receive any coupon payment, according to the table.

The most likely outcome goes to “one coupon paid,” which will occur 48.23% of the time.

As the number of coupon payments increase the probabilities progressively decline down to a 2% chance of getting 12 payments.

“Even if you lose some principal, it’s likely that you will collect some coupons throughout the life of the product. It may soften some of the blow,” she said.

As with any product tied to a single stock, there should be further analysis into the underlying.

“Investors should be familiar with the stock and have some kind of a view,” she said.

This autocall product could be used as an alternative to a direct investment in the stock.

“You get a protection built in to the structure and give up the full growth potential of the stock and dividend payments.

“It’s still risky, but less risky than buying the shares outright, where you would have full exposure to the downside.”

HSBC Securities (USA) Inc. is the agent. Morgan Stanley Wealth Management is a dealer.

The notes will settle on Wednesday.

The Cusip number is 40438G854.

© 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.