HSBC’s dual directional barrier notes tied to S&P, Russell can barely hide the bear

By Emma Trincal

New York. Nov. 7 – HSBC USA Inc.’s 0% dual directional barrier securities due Nov. 20, 2020 linked to the lesser performing of the S&P 500 index and the Russell 2000 index showed more directionality than their name implies, sources said. Looking closer, they found in the structure some of the characteristics of a bear note albeit a non-typical one.

If each index finishes at or above its initial value, the payout at maturity will be par plus the return of the lesser performing index, capped at par plus 15.5%, according to an FWP filing with the Securities and Exchange Commission.

If the lesser performing index declines but finishes at or above its trigger value, 66% of its initial value, the payout will be par plus the absolute return of the lesser performing index.

Otherwise, the notes offer full exposure to the decline of the lesser performing index.

Knock-out

“This is very interesting. I like it,” said Elliot Noma, founder of Garrett Asset Management.

“It’s a delta one strategy on both sides. But you can make up to 34% on the downside while your potential gain on the upside is half of that. Obviously, there is a strong bearish bias.

“You’re willing to take the dispersion between the two indices but you have to pay for it. You’re paying for it with this knock-out on the downside. Once you hit this barrier, you’re long the minimum index.”

The term “knock out” refers to the barrier option at 66%, which ceases to exist once the underlying price hits this level.

“It’s a bet on volatility but a specific bet. You want volatility both ways, but not too much since you don’t want the full downside exposure,” he said.

Up and down

“On the upside, it’s a bull spread on the underlying. You’re simply giving up any return above the cap.”

In this note, the long call position would be at the initial price or at the “at-the money” strike. The higher strike for the short call position would be the 15.5% cap above which investors give up any additional return.

As with any barrier notes, the risk was to be “knocked out,” he said.

“But 34% is a pretty major crash.

“My guess is that this note must have been done for a client with a very specific view.

“Perhaps the view is that this bull market has run its course and that we’re about to have a major pullback and if we don’t the market performance will be sluggish for the next two years.

“It’s definitely not a bullish note with 15.5% over two years. They’re not zooming upwards.”

Skewed

In general dual directional notes offer more even ranges of return between the upside and the downside, which is why sources considered the product a hybrid between a dual directional bet and a bear note.

As investors can gain twice more from a market drop than a rally, the notes are more of a directional bet on the downside than a neutral play, Noma noted.

Bear or bear-like notes are often sought after as an alternative to a hedge. Buying protection through options has a cost, which not every investor is willing to pay for.

Tricky hedge

“This deal sort of fits into the category of a bear note although it’s a bit different. We get occasional requests for bear notes,” he said.

“When clients want to use bear notes to express a negative outlook, as a directional play, it’s absolutely fine. That’s what they’re for.

“But if they want to use them as a hedge, I don’t think it’s the best use. There are other alternatives in the options market, which are more cost-effective and require less capital.”

Buying a put option for instance may be costly as a type of insurance. If the bearish forecast turns out to be wrong, investors lose the entire premium they spent on the put option.

“You could lose 100% of your principal. But by principal, I’m talking about the premium you paid for the option. It’s a much smaller amount of money. Certainly not like the principal of your notes being tied up for two years.”

Still works both ways

The product however is distinct from a pure bear play where investors only win if the market is down and end up losing if it’s up. That’s when the dual directional feature comes into play, sources noted.

With HSBC notes, investors are guaranteed a positive return in either direction except when the barrier is breached.

As a result, investors should rule out the notes as a defensive strategy.

“You have sold a deep insurance with a knock-out. You’re not buying any insurance. Your protection can go away in a very volatile scenario. There is no hedge,” Noma said.

But for investors with a bearish outlook willing to gain from both sides of the market, the product was attractive.

“I sort of like it. The knock-out is very, very deep. A 34% drop in two years, that’s a big bear. If you think the market will be volatile but within realistic limits, it’s a reasonable thing.”

HSBC Securities (USA) Inc. is the agent.

The notes will price on Nov. 15.

The Cusip number is 40435UAE4.

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