HSBC’s barrier notes linked to Dow, Russell 2000 offer deep barrier, unlimited potential gains

By Emma Trincal

New York, Feb. 7 – HSBC USA Inc.’s 0% barrier enhanced participation notes due Feb. 28, 2024 linked to the lesser performing of the Dow Jones industrial average and the Russell 2000 index present the double advantage of solid downside protection and uncapped leveraged return. But the cost for those features is exposure to the worst-performing index and a relatively long tenor, advisers said.

If each index finishes at or above its initial level, the payout at maturity will be par plus at least 145% of the gain of the worst-performing index, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if each index falls by no more than 50% and will be fully exposed to the losses of the worst-performing index if it finishes below the 50% barrier level.

Plain vanilla

One adviser first noted the simplicity of the structure.

“I do tend to lean toward non-complex notes. When you start adding absolute return components it gets confusing, whereas this one is easy to understand. There isn’t any uncertainty other than not knowing where we are at the date of maturity,” said Steve Doucette, financial adviser at Proctor Financial.

The 50% barrier was attractive but, in his opinion, mostly from a psychological standpoint.

“What are the odds that in five years you’re even going to need protection?

“If it’s down that much, you get bigger things to worry about.

“It’s really there to bring you peace of mind.”

The five-year duration could work to the advantage of a client in the event of a market downturn, which most investors expect will occur during the life of the notes.

“It gives you time to go through a bear market, go all the way down and back up,” he said.

“I like the no-cap. I would hate having my upside limited over such a long period of time.”

Trade-off

One possible improvement would be to add more leverage even at the expense of the downside protection.

“I’d be interested to see how much I would have to give up on the downside in order to get 1.6, 1.7 or 1.8 times the upside. Would I have to give up five percent? Ten percent or fifteen percent? It’s something I’d be curious to know,” he said.

This adviser did not consider the worst-of feature to add a significant level of risk given the parallel fluctuations of both indexes. The coefficient of correlation between the two U.S. benchmarks is 0.92 with 1 being perfect correlation.

“Theoretically the small-cap index should outperform if you’re bullish. You’re only getting to participate in the Dow Jones return,” he said.

“But that’s fine. This is a note you can use in a diversified portfolio as a large-cap substitute.”

Too long

Jeff Pietsch, head of capital markets at the Institute for Wealth Management, said he liked the terms but not the tenor.

“Five years is a long period time,” he noted.

“We know that we’re late in the cycle of this economic expansion. If we do have a more substantial market decline than last fall, we would anticipate it to be midway of the term of this note.”

“I would much rather have a two- or three-year note and then roll it over than going so far out given the fact that the haircut of the issuer is so high.”

He was referring to the 3.75% commission disclosed in the prospectus.

“We look for 30 to 40 bps per annum. This is about double our target cost,” he said.

“It seems expensive.”

One up, one down

The worst-of payout did not offer many surprises, but it made the risk management process more challenging.

“The beta of the Russell is substantially higher. That beta could be harmful to the downside or be beneficial to the upside,” he said.

Since the exposure is only to the worst-performing index, he reached the following conclusion: “Your upside index is likely going to be the Dow. Your downside index is probably going to be the Russell.

“This creates some sort of shift in your risk/return profile, and that’s a concern. It just complicates the analysis.”

Terms, cost

The terms of the structure, however, were attractive.

“The leverage with no cap is always a good thing. A 50% barrier is also a good thing to have. Anyone looking at a note has that downside concern. The lower the barrier, the better, especially since it’s not a hard protection like a buffer,” he said.

The notes may be more appropriate for a long-term investor or adviser.

“This could be for someone who wants to hold and forget instead of constantly rolling over,” he said.

“I do like the leverage, the no-cap.

“It looks good. It’s just too long for us and a bit too rich too.”

HSBC Securities (USA) Inc. is the agent.

The notes (Cusip: 40435UFS8) will price on Feb. 25.

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