HSBC’s $57.4 million notes linked to basket of 19 stocks raise issues of value among RIAs

By Emma Trincal

New York, May 28 – The size of HSBC USA Inc.’s $57.4 million of 0% notes due June 8, 2016 linked to a basket of stocks caught the attention of registered investment advisers given that no equity research powerhouse or stock-picking strategy was used in the prospectus to brand the basket.

And RIAs who like barriers, buffers and leverage saw no particular value in the tracker-type structure of the product.

Investors participate in the appreciation or depreciation of the basket at a rate of 99.55%, which is the adjustment factor, according to a 424B2 filing with the Securities and Exchange Commission. As a result, they need to see an increase of 0.45% in the basket value to avoid losing principal.

The return is calculated at the end using an averaging method: for each stock, the final share price will be the average of its closing share prices on May 27, 2016, May 31, 2016, June 1, 2016, June 2, 2016 and June 3, 2016.

Adjustment factor

The first objections expressed by the RIAs was the lack of optionality and the adjustment factor.

“You have that 50 basis points to pay, so it’s not even one-to-one. Right there, you know you’re going to underperform the basket on the downside and on the upside,” said Steve Doucette, financial adviser at Proctor Financial.

“I have no idea who bought it.”

He noted that if one client bought the whole issue, the 45 bps fee would total $258,300.

“If you know you like the stocks, you could buy them in a block trade,” he said.

“Chances are it’s for JPMorgan clients, so I don’t really see why you can’t buy all these stocks and hold them for a $100 commission. I don’t get it.”

J.P. Morgan Securities LLC was the agent on the deal, according to the prospectus.

19 stocks

The equally weighted basket includes the following 19 stocks: Actavis plc, Akorn, Inc., Anadarko Petroleum Corp., BioMarin Pharmaceutical Inc., Endo International plc, FireEye, Inc., First Republic Bank, Jarden Corp., Jazz Pharmaceuticals plc, Lions Gate Entertainment Corp., Pioneer Natural Resources Co., Rite Aid Corp., Tableau Software, Inc., Time Warner Cable Inc., Valeant Pharmaceuticals International, Inc., Viacom Inc., Workday, Inc. and YUM! Brands, Inc.

The majority of the components belong to the health-care sector with 37% of the total in seven stocks. Technology and services combined make for nearly a third, and energy accounts for more than 10% of the allocation.

Pharma

Doucette said some names may already be overbought.

“It’s mostly a basket of pharmaceuticals and biotech stocks,” he said.

“If you look, biotech has been going nuts in the last five years. It’s one of the top-performing sectors. Do I want to be in these stocks without leverage if I’m a bull? And if I’m a bear, do I want to buy with no protection?”

Doucette said the notes may have been designed for a client who knew and liked the stocks, seeking exposure to the basket in a note format.

“But why lock it up in a note? I guess getting the five-day averaging is a good thing. That’s the big advantage because it eliminates some of the volatility,” he said.

“It may be easier for some people to do it in a note. But from my perspective, I am not sure why I would be paying the fees except for the averaging at the end.”

Interesting allocation

Matt Medeiros, president and chief executive officer of the Institute for Wealth Management, offered a similar viewpoint.

“The underlying allocation is interesting. I like the fact that it’s heavily weighted in technology and biotechnology. It’s in line with the sectors we are looking at,” he said.

“But I’m not sure why I would purchase it for the fee associated with it without downside protection or upside enhancement.

“For that you’re paying – and if I understand it right, it’s 1.5% for a year. I’m not sure it equates to less than the transaction costs of buying the basket yourself.”

The prospectus listed the commissions as 1%.

“And you’re taking on additional risk with credit risk. I don’t know. I’m not really seeing an advantage that would entice me to take credit risk and liquidity risk to purchase these particular securities.”

Marc Gerstein, research consultant at Portfolio 123, also had a negative view.

“It’s really a [unit investment trust]. My question is, what’s the point?” he said.

“Do we even know what’s the rationale, the methodology behind this basket? What’s the basis for these picks?

“It’s one thing to buy a note on a Raymond James basket, what they selected as their top buys. You have a basis for valuing your basket. You may like Raymond James or you may not, but you know what you’re buying.”

The prospectus did not state who did the research or how it was done.

“You should make your own investigation into each basket component,” said the offering document.

Strong performance

A look at the average performance of all 19 stocks showed an 18.15% return year to date as of Thursday’s close. The last-12-month average return for the basket was 31.70%.

In comparison, the S&P 500 index has only gained 3% this year. It’s up 11.60% for the past 12 months.

“You know this deal is probably based on some proprietary research, some list somewhere. It could be JPMorgan’s research or HSBC or even someone else,” a market participant said.

“For someone who values the research, then it makes sense. In absence of that, I agree, there’s no reason to do this.

“But I really think the buyers of the notes have some idea of who picked the stocks, they think, ‘Hey, those guys are really smart. Their picks beat the market. The notes have some value.’ That’s what’s behind that kind of trade.”

He noted that some investors, especially retail investors, may want to have access to the portfolio in one instrument.

“It’s a lot easier than owning all the shares. A lot of people like that,” he said.

But he agreed that cost-efficiency may be debatable.

“You’re paying 1.5% versus the trading commissions for buying stocks. Is it cheaper? Fair enough,” he said.

“But you really have people who overlook the 45 bps and the upfront fee. It’s kind of the old school. They’re willing to pay higher commissions for their convenience.”

HSBC Securities (USA) Inc. was the underwriter.

The notes (Cusip: 40433BW79) priced on May 22.

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