HSBC’s callable income notes on S&P, Russell, Gold ETF seen as risky despite low barrier

By Emma Trincal

New York, Sept. 9 – HSBC USA Inc.’s callable contingent income barrier notes due Dec. 15, 2022 linked to the least performing of the S&P 500 index, the Russell 2000 index and the VanEck Vectors Gold Miners exchange-traded fund could lead to severe losses despite a large barrier, advisers said, each pointing to a specific underlying as the most likely to cause a breach at maturity.

Each month, the notes will pay a contingent coupon at an annualized rate of at least 12% if each asset closes at or above its coupon trigger level, 65% of its initial level, on the observation date for that period, according to an FWP filing with the Securities and Exchange Commission.

The exact contingent coupon rate will be determined at pricing.

The notes will be callable at par on any quarterly coupon payment date on or after March 15, 2022.

The payout at maturity will be par plus the final coupon unless any asset finishes below its 65% barrier level, in which case investors will be fully exposed to the decline of the lowest performing asset.

Small cap risk

Steve Doucette, financial adviser at Proctor Financial, said the worst-of was “not a problem.” But one of the underlying assets was a too risky, in his view.

“My biggest concern is the Russell. If we get a pullback, small caps would be hit pretty hard. The S&P is not so much of an issue. Large caps don’t drop that much,” he said.

“And if things get ugly, gold miners will do well.”

That’s in part because the equity fund is highly correlated with gold prices, he said, adding that gold is often used as a defensive asset.

“I think it’s much less likely for the gold miners to drop 35% than it is for the Russell,” he said.

Call it

Not using the typical automatic call but rather an issuer call likely improved the terms of the product.

For Doucette, there was no real downside to having a discretionary call.

“It’s fine with me. It’s a 15 month and you have a six-month no-call. Also, the best scenario is to get out so you can take the risk off the table. No more market risk, just reinvestment risk and that’s OK,” he said.

The worst-case scenario is “getting caught” in a downturn at maturity, he said.

“The Russell drops 36%, you didn’t collect many coupons along the way or even if you did, you still get hit with a hefty loss,” he said.

High return

The coupon size was attractive, he noted.

“12% is pretty rich, especially when you look at future return expectations as we get to the peak of the market,” he said.

“But do you want to take the risk of the Russell?

“If you lose, you’re going to lose at least 35% of principal. You may collect three quarters worth of coupon, but you still run the risk of losing a considerable amount of money.”

The coupon caps the upside, but Doucette said the risk of underperforming the market was not central.

“Of course, the index could be up a lot more than 12%. But I doubt many investors would complain over a 12% return,” he said.

Asset allocation

In fact, given the return and the amount of risk associated with it, the notes may be better used in an equity allocation, he said.

“We usually look at these as fixed-income substitute, but this might be an equity substitute.

“You plug this in an equity allocation and hope to get as much coupon payments as possible.

“In any portfolio, you already have exposure to the Russell anyway. You just add a protection level.

“You take some of your small-cap exposure, put it into a note where you know you’re going to collect a coupon.”

However, there may be better equity replacement strategies than this one, he said.

“The risk-reward is really equity here. So, I guess yes you can use it as an equity substitute. But it’s still income. If I need an equity substitute, I’d rather use a growth note with a barrier or a buffer and leverage,” he said.

Volatile gold miners

Matt Medeiros, president and chief executive of the Institute for Wealth Management, focused on the ETF.

“It’s an interesting note. But my first concern is with the gold miners. It’s a much more volatile underlier than the two indices,” he said.

The ETF has an implied volatility of 32% versus 26.4% for the Russell 2000 index and 18.8% for the S&P 500 index.

The risks associated with low correlations between the underliers in a worst-of were not Medeiros’ main concern.

The VanEck Vectors Gold Miners fund has a low correlation with the Russell 2000 index, with a 0.44 coefficient of correlation. The fund’s correlation with the S&P 500 index at 0.58 is also low.

“Volatility remains the problem here in my opinion, not dispersion risk,” he said.

“We have historical measurements of volatility. Sometimes non-correlated assets can also become highly correlated over a short period of time.”

The gold miners fund may not even hold well in a market pullback, he noted.

“When there is selling, people are more inclined to buy gold than gold miners.”

Big decline

Medeiros pointed to the tendency for the miners ETF to drop sharply in down markets.

For instance, during the Covid-induced bear market of February and March of last year, the ETF dropped 49.2% in 20 days versus 35% for the S&P 500 index.

“While 35% looks like a sound protection, it could easily be breached in a bear market. There is too much risk in using such a volatile asset,” he said.

“This note doesn’t strike me as a must-have.”

HSBC Securities (USA) Inc. is the agent.

The notes will price on Friday and settle on Sept. 15.

The Cusip number is 40439JMG7.

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