HSBC’s market-linked step-up notes on Stoxx Europe 600 Banks index offer inflation hedge

By Emma Trincal

New York, June 11 – HSBC USA Inc.’s 0% market-linked step-up notes due June 2023 linked to the Stoxx Europe 600 Banks index offer an unusual bet on a return of inflation, said Clemens Kownatzki, finance professor at Pepperdine University. In addition, the structure can accommodate different types of bullish views.

If the index finishes at or above its initial level, the payout at maturity will be par of $10 plus the greater of the step-up payment and the index return, according to an FWP filing with the Securities and Exchange Commission.

The step-up payment is expected to be 23.5% to 27.5% and will be set at pricing.

“The step-up gives you a pretty high return if the index is up, regardless of how much, and you’re not capped above that. That seems attractive,” he said.

“It’s a short-term note. The underlying index doesn’t pay huge dividends. So how do they price it? They had to get rid of the downside protection,” he said.

The yield for this underlying index is 0.7%, which is relatively low.

The SPDR S&P Bank ETF, which focuses on U.S. banks, yields 2.17%.

“This difference is due to the spread between U.S. and European rates. The Germany 10-year Bond yield is negative. Interest rates in Europe are well below U.S. rates,” he said.

Inflation strategy

For Kownatzki, the notes offered a play on inflation.

“Banks will profit from higher rates,” he said.

“Their margins increase when long-term rates rise since they tend to make loans on long durations.”

As inflation erodes the value of fixed-income securities, investors sell bonds, which pushes yields higher.

CPI warning

In the United States, the presence of inflation is hard to dismiss, he said.

The Consumer Price Index jumped 5% year over year in May, its biggest 12-month increase since a 5.4% rise in August 2008, according to data released by the Department of Labor on Thursday.

“Inflation expectations have gone up. It’s a little bit more muted in Europe,” he said.

“The Fed has downplayed inflation concerns. There is a debate here in the U.S. between those who think inflation is temporary, as the Fed suggested, and those who see it as a real problem.”

Subdued reactions

The bond market’s interpretation seems to lean toward a temporary inflation, he said. The 10-year Treasury spiked at the end of March but has dropped more than 30 basis points since.

“Perhaps it’s the recent job report, which missed expectations. Without a strong report, inflation fears eased up,” he said.

“Or perhaps the market takes the Fed’s comments seriously. It’s hard to tell.”

The stock market has been more sensitive to inflation signals without being overly rattled by it. After all, the S&P 500 index on Thursday notched a new record high on the day of the CPI data release.

“You may wish to have the safety of the Treasury market, but the 10-year rate is low. On the other hand, there is some risk in the equity market, but look at the last decade. It goes up and up, and every time you have a correction people buy on the dip,” he said.

“We are all forced to continue to buy stocks because there is no alternative in terms of risk return. You’re pushed into risky investments.”

Europe

In Europe post-pandemic inflationary pressures can also be felt.

“While Europe's rates are clearly lower than the U.S., inflation is also creeping up there,” he said.

European Union annual inflation was 2% in April, up from 1.7% in March. A year earlier, the rate was 0.7%, according to Eurostat, the statistical office of the European Union.

“The notes rely on the view that inflation is not going to explode in the short term. Banks’ profits will rise, but the rally may be muted in Europe,” he said.

“If that’s the case, you get a decent bump above the initial level. It’s nice to get a double-digit return at this stage of the bull market cycle.

“If you’re wrong, if European bank stocks are flying, you’re not missing the upside. That’s not why you would buy the notes, but it’s a good outcome if you’re wrong.”

Bear put spread

The tradeoff however is the full downside risk exposure.

“I would hedge it,” he said.

“If you outperform with the step-up at maturity, your excess return may help you pay for that hedge.”

A hedge typically requires a cash outlay. In order to reduce the cost, Kownatzki would use a bear put spread.

A bear put spread consists of buying one put for protection and selling another put with the same expiration, but at a lower strike price to reduce the cost of the trade. The entire cost is not totally offset since the premium received on the lower strike put is lower than the cost of purchasing the higher strike put.

The strategy offers the advantage of limiting the loss to the net cost of the position. The trade loses money when the underlying finishes above the initial price.

Diversification, recovery

Risk mitigation can also be found in the underlying, he said, pointing to a diversified index of 45 stocks in different European countries.

“I don’t see a huge risk in the banking sector like the type of risk we encountered in 2008,” he said.

Some of the European banks during the sovereign debt crisis were exposed to Greece, but the stress of those years seems to have somewhat subsided.

“The perceived risk around Greece has greatly diminished. Notice the tight spread, around 1%, between Greece government bonds and German bunds.

“Banks’ balance sheets are much better than what they used to be, and that’s true not just in the U.S. but in Europe too. I don’t see a huge risk exposure over two years.”

While Kownatzki does not have any specific view on the banking sector, he liked the note for the structure.

“I would prefer to see some downside protection built into the note.

“But I like the step up a lot. In a slow market, you get a very compelling return and the odds of achieving it are fairly high.”

Investors will lose 1% for each 1% decline of the index from its initial level.

BofA Securities, Inc. is the agent.

The notes will price in June and settle in July.

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