HSBC’s leveraged notes linked to index basket have ‘surprisingly good structure,’ adviser says

By Emma Trincal

New York, June 18 – HSBC USA Inc.’s 0% Leveraged Index Return Notes with a maturity of about two years linked to a basket of unequally weighted indexes caught financial advisers’ attention for its uncapped and leveraged exposure combined with a hard buffer priced over a short-term tenor.

The basket components are the Euro Stoxx 50 index with a 40% weight, the FTSE 100 index with a 20% weight, the Nikkei Stock Average index with a 20% weight, the Swiss Market index with a 7.5% weight, the S&P/ASX 200 index with a 7.5% weight and the Hang Seng index with a 5% weight, according to an FWP filing with the Securities and Exchange Commission.

If the basket return is positive, the payout at maturity will be par plus 115% to 135% of the basket return, with the exact participation rate to be set at pricing.

If the basket falls by up to 10%, the payout will be par. Investors will lose 1% for each 1% basket decline beyond 10%.

Value play

Steven Foldes, vice-chairman of Evensky & Katz/Foldes Financial Wealth Management, said the benefits of the notes offset its downside, which is the non-payment of relatively high dividends.

His assessment of the underlying asset class was positive.

“This is tied to a basket of international indices representative of a foreign developed exposure with the exception of a small allocation to China, which only has a 5% weight,” he said.

Value was an important factor.

“International benchmarks have much cheaper multiples compared to the U.S. There is a reason for that: Europe’s growth hasn’t been as strong as in the U.S. But these things tend to work themselves out. If you are a value buyer, as we are, buying at these lower prices adds value with potential higher returns,” he said.

Terms

Foldes said he also liked the structure of the product.

“It’s a short-term note, which we like. Two years is healthy,” he said.

“1.25 times leverage, assuming it’s the midpoint of the range, is very nice. Having no cap is important. If the market really takes off, you have full leveraged upside participation.

“And if things turn sour, you have that 10% hard buffer.”

Two years, uncapped

What was also particularly appealing to Foldes was the ability to eliminate the cap over a short tenor without compromising the other terms.

“We don’t know what’s going to happen in two years, but the idea of having a 10% buffer for a relatively short note that covers a broad developed market exposure is quite attractive, especially with a bank that has such a good credit, better than U.S. banks at this point,” he said.

The U.S. bank with the tightest credit spreads is currently Wells Fargo. It shows five-year credit default swaps of 48 basis points, according to Markit, versus 32 bps for HSBC.

Dividends

The trade-off lies in the dividends as several of the index components pay high dividends, especially in Europe.

The Euro Stoxx 50 index yields 3%.

“You’re giving up approximately 3%, but it’s the cost of doing business. We understand that. For that you’re getting a number of good things. You’re getting a hard buffer, not a barrier. You’re getting the leverage, and there is no cap, which is also very positive.”

Break even

Assuming an unpaid dividend of 5% for the two years and a leverage multiple of 1.25, investors would make up for the loss of dividends with a 10% annualized return.

“That’s the historical average,” he said.

“If you get the historical return over the next two years, it’s a wash.

“I don’t see a lot of things not to like with this deal other than not getting the dividends, but you’re fairly compensated for it.

“All and all, it’s quite an attractive note. Something to think about.”

Structure

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that the structure and the underlying may not be his first choice, but he still liked the notes.

“The terms that are laid out are good. All those indexes are somewhat volatile, but by combining them in a basket, you remove a lot of the volatility,” he said.

From the structure standpoint, Kalscheur said that BofA Merrill Lynch, the agent for the deal, had done a “pretty good job.”

“HSBC is a very good credit. The leverage is good. Not great but good. The 1.15x to 1.35x is a pretty wide range. It will depend how they will price it. But I like the leverage with the uncapped return. The uncapped is important to me,” he said.

“And of course you have a real buffer. Not a cliff, but a hard buffer.

“All those terms put together make for a pretty nice deal. Usually, Merrill Lynch has higher fees, and you don’t necessarily get terms like these. I have to say, this is a surprisingly good structure.”

Euro-centric basket

Kalscheur did not like the underlying as much as the terms, however.

“You have to be a fan of international equity. Two-thirds of your basket is in Europe. The Euro Stoxx 50 is not our favorite benchmark,” he said.

However, he recognized the pricing advantage of European indexes.

“I usually extend duration to five years rather than two so I can get better terms. Here, they priced the deal with pretty decent terms on a two-year because we’re talking about the Euro Stoxx. Most European indexes are going to have much higher yields than their domestic equivalent,” he said.

Buffer efficiency

While not very bullish on Europe, Kalscheur kept some back testing data on the Euro Stoxx 50 index dating back from 2002. As a rule, he runs rolling data to get a sense of the probabilities of return outcomes on a specific underlying as part of his due diligence process prior to buying a note.

“Here I will only look at the Euro Stoxx, having no data on the other components,” he said.

He found that over two-year rolling periods since 2002, the Euro Stoxx 50 dropped 10% or less 11.3% of the time. The benchmark posted negative returns 37.6% of the time. The difference between those two scenarios revealed a 26.3% probability of losing some money despite the buffer even though the losses will be cushioned at a rate of 10%.

“It’s about a quarter of the time that you would lose some money. But it’s a big enough buffer even on a short-term period of time that it more than compensates for the loss of dividends.

“It’s a pretty good offering.”

The notes will price in June and settle in July.

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