HSBC’s $18.94 million notes tied to 20 stocks offer worst of-like payout for income investors

By Emma Trincal

New York, June 25 – HSBC USA Inc.’s $18.94 million of income notes due June 26, 2020 linked to a basket of stocks offer an unusual income-oriented structure with guaranteed principal and guaranteed minimum coupon but a low probability of earning some extra yield, sources said.

Each year, the notes will pay a 5.56% coupon if at least 14 of the 20 basket stocks have not decreased in value from the pricing date as measured on the coupon determination date for that year. Otherwise, the coupon for that year will be 1%, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus the final coupon.

Worst-of type

“I’ve seen a few of those come out in Europe,” a sellsider said.

“If six are down, you get the higher coupon. If seven are down, you don’t. It’s sort of a worst-of with no downside risk.”

The underlying companies are AbbVie Inc., Amazon.com, Inc., BHP Billiton Ltd., Walt Disney Co., Ensco plc, Eaton Corp. plc, Ford Motor Co., Facebook, Inc., Fortinet, Inc., Helmerich & Payne, Inc., JPMorgan Chase & Co., Kraft Foods Group, Inc., Och-Ziff Capital Management Group LLC, Philip Morris International Inc., PPL Corp., Spectra Energy Corp, Sempra Energy, Texas Instruments Inc., Under Armour, Inc. and Verizon Communications Inc.

“We used to price some of these, which are a variation of worst-of trades. You pick up the entire coupon if a given number of stocks are above the barrier. If for any reason some are below the barrier, you don’t get anything. This one at least lets you keep a small coupon of 1%,” an industry source said.

“The idea behind this product is to play a little bit with luck,” he added.

“You have 14 chances out of 20 to get the higher coupon. But remember it’s a capital-guaranteed note. You could never obtain the full protection on a six-year by simply linking your basket return to the notes. It just would not happen.

“With low interest rates, the issuer has to be a little bit more creative. They use an exotic option to deliver a potential income that is enticing even if ultimately, a lot of it has to do with luck.”

Correlation play

As a variation on a worst-of payout, this type of structure is long correlation, a structurer said. The higher the correlation between the basket components, the greater the risk to the investor and the higher the coupon, he explained.

“This basket deal is a correlation play. But the odds are not necessarily in your favor,” he said.

The basket includes stocks in different sectors offering some diversification, hence less correlation between the stocks. But within some sectors such as energy, technology or consumer goods for instance, the concentration is relatively high.

The basket includes five energy stocks (Ensco, Sempra Energy, PPL, Spectra Energy and Helmerich & Payne), or a 25% weighting. BHP Billiton, in the basic materials sector, is closely correlated to energy.

Facebook, Fortinet, Verizon and Texas Instruments are all part of the same sector (technology), and Under Armour, Kraft, Ford and Philip Morris are consumer goods stocks.

“This is not a product that I like,” the structurer said.

“In order to get the higher coupon, you have to have 14 stocks out of 20 that don’t go down in price. If more than six drop in price, you only get 1%. Right there, the probabilities of getting the lowest coupon are fairly high. It’s probably even higher once you look at the correlations between the basket constituents.”

This structurer said that a traditional worst-of note may be more attractive.

“I’d much rather see a product tied to two or three assets on a worst-of basis. We’ve done a 24- to 26-month with a 60% American barrier offering a 4% coupon as long as the S&P, the Euro Stoxx and the SMI index never dropped below the 60% barrier. You could also be called at a 90% level, in which case you got par plus your coupon,” he said.

“That type of deal is much more interesting.”

Juicy dividends

As with all structured notes, investors have to forego dividends they would receive if they were long the stocks. Depending on the basket components, the non-payment of dividend may represent a high opportunity cost, this structurer added.

“You probably have companies out there that pay high dividends, which you’re not entitled to,” he said.

“The forward, or growth price of the underlying discounting dividends, I guess must be quite low.

“You lose on high dividend potential in the hope of getting the higher coupon. And your chances of receiving only 1% in coupon are extremely high.”

The stock with the highest dividend is Och-Ziff with a 6.7% yield. Ensco has a 5.4% dividend yield. PPL and Verizon each pay a dividend rate of 4.3%. The average yield for the basket is 2.75%, or nearly a point above the S&P 500 index, which has a 1.8% yield.

Wise gambling

“Look, it’s not perfect, but it’s a way to put together a principal protection structure, which given interest rates is pretty expensive to price right [now] on anything, especially if you want to keep it to a six-year term,” the industry source said.

“This is for an investor willing to bet that roughly a third of the basket is not going to fall in price. The probability of being right on this is probably pretty low. But the risk of losing principal is limited to a credit event.”

The sellsider agreed that for some investors seeking income, the structure may be attractive.

“As long as the investor is comfortable with the trade-off and knows the odds of getting more are slim, this may make sense for some people,” he said.

“This sort of structure is a form of gambling. You have no way of running an analysis on the basket and predict how many of the stocks will go down in price. You can’t really have a firm belief on it.

“But if you’re willing to live with 1% in return for the potential of getting a coupon much above market rates, why not? It’s not for conservative clients. You’re taking a risk, but considering that you get your principal back, it’s not a bad payoff.”

The notes (Cusip: 40434C519) priced June 16.

BofA Merrill Lynch was the agent.

The fee was 2.5%.

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