HSBC’s $1.59 million contingent income notes on biotech, health ETFs to offer higher yield

By Emma Trincal

New York, March 6 – HSBC USA Inc. priced $1.59 million of autocallable contingent income barrier notes due March 1, 2021 linked to the SPDR S&P Biotech exchange-traded fund and the Health Care Select Sector SPDR fund are designed for income-seeking investors. But buysiders had distinct views on the risk-reward profile of the worst-of notes linked to the two health care funds.

If each asset closes at or above its coupon trigger, 70% of its initial price, on a quarterly observation date, the notes will pay a contingent coupon that quarter at an annual rate of 8%, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par plus the contingent coupon if each asset closes at or above its initial price on any quarterly observation date after six months.

The payout at maturity will be par plus the contingent coupon unless any asset finishes below the 70% barrier level, in which case investors will lose 1% for each 1% decline of the worst performing asset from its initial price.

Volatility

Tom Balcom, founder of 1650 Wealth Management, said the notes were designed to generate income. In his view the downside protection was not negligible.

“It’s a worst-of, but the funds are not overly volatile,” he said.

The Health Care Select Sector fund is the least volatile of the two. It comprises blue chip stocks such as Johnson & Johnson, UnitedHealth Group Inc. and Pfizer Inc.

The fund’s implied volatility is 16%.

The other fund is more speculative as its components are stocks of smaller biotechnology firms, which may “move up and down a lot more,” he said.

The top holdings of the SPDR S&P Biotech ETF are Bioverativ Inc., Array BioPharma Inc. and Loxo Oncology Inc.

The volatility of this ETF is 26%.

“I’ve seen more volatile sector funds that this one.”

Correlation

The two funds however are less correlated than one would expect given that both funds are in the same sector, noticed Balcom.

The coefficient of correlation between the two is 0.63.

Less or inversely correlated assets increases the odds of breaching the barrier in a worst-of.

But Balcom said the 70% barrier was taking care of a significant part of the risk.

“I’m not saying it’s a conservative investment of course but 30% over three years definitely helps protect the client,” he said.

The Health Care Select Sector SPDR fund closed at $84.28 per share on Tuesday. The 52-week high is $92 and the low is at $72.

“The price is pretty much mid-point. If it stays in that range you can earn a nice income,” he said.

Dividends

Balcom underlined another benefit: the opportunity cost of not receiving dividend payments was modest.

“You’re not giving up much dividends compared to someone investing in the ETFs directly,” he said.

The dividend yield for the SPDR S&P Biotech ETF and the Health Care Select Sector fund are 0.22% and 1.57%, respectively.

Six-month no call

Reinvestment risk is another consideration for investors buying autocallable notes. Autocalls have the greatest probability of a call on the first observation date. In that regard, the six-month call protection was an advantage, he noted.

“You know you won’t be called at 2% after three months. Chances are it’s going to be 4% after six, which is better for investors,” he said.

Overall, Balcom said the notes could be used as an income substitute.

“High-yield bonds don’t pay as much and you have the interest rate risk,” he said.

“As long as investors understand the risk associated with equity exposure and the mechanics of a worst-of, it’s a nice way to generate income in a portfolio.”

Possible, best scenarios

Donald McCoy, financial adviser at Planners Financial Services, expressed a very different point of view.

“I just don’t know why anyone would buy this,” he said.

“Most likely you’ll get called after six months and you just made 4%. But to get there you take the full downside risk because it is possible to lose 100% of your money.”

The best-case scenario, he added, is the “unlikely situation in which the worst-performing ETF hovers below the original strike price for the entire period while staying above the barrier,” he said.

“But what’s the likelihood of that?”

Risk-adjusted return

McCoy said the risk at maturity was high compared to the possible reward of the investment.

“The most you can make is three years worth of coupons. By the way it’s not likely to happen. But let’s assume you get your maximum return of 24%.

“On the other hand, say you never get called, you are in a risky spot at maturity. If you lose it’s going to be at least 30% of your principal. Meanwhile you can’t get more than 24%. You can lose everything but your upside is capped.

“I don’t think I like that risk-reward profile,” he said.

Big mover

A final concern was the volatility of the biotechnology fund, which McCoy said could easily cause the barrier to be breached.

“These two health care funds are in two different sub-sectors and one of them is prone to dramatic moves.”

The SPDR S&P Biotech ETF for instance lost 47% between July 2015 and February 2016.

“It’s a deal with a lot of moving parts. I know that people are desperate for yield. But you’re taking significant risks for that with a three-year lockup period, no guarantee of getting the full income stream and at the end you could take a tumble and get nothing,” he said.

HSBC Securities (USA) Inc. is the agent.

The notes (Cusip: 40435FUD7) settled on Feb. 28

The fee is 2.25%

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