HSBC’s barrier leveraged notes offer uncapped bet on utilities, financial sector

By Emma Trincal

New York, July 13 – HSBC USA Inc.’s 0% barrier enhanced participation notes due July 31, 2025 linked to the least performing of the Utilities Select Sector SPDR fund and the Financial Select Sector SPDR fund offer uncapped leveraged exposure to the worst of two defensive sectors. While advisers said some of the terms are appealing, they expressed more concern with the worst-of payout and the choice of the underlying funds.

If the return of each exchange-traded fund is positive, the payout at maturity will be par plus at least 250% of the least-performing ETF’s return, according to an FWP filing with the Securities and Exchange Commission.

The exact participation rate will be set at pricing.

If the return of the least-performing ETF is less than or equal to zero but greater than or equal to negative 40%, the payout will be par.

If the return of either ETF is less than 60% of its initial level, investors will lose 1% for every 1% that the least-performing fund declines from its initial level.

Not a core allocation

“The structure is pretty enticing,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“Unfortunately, I wouldn’t use sector bets for my core portfolio. This is a personal bias that I have, and my partners have it too.”

He explained why.

“We made a couple of sector bets in 2000 that went against us. Obviously, it was tech. It soured us on sector bets.”

Conscious bias

Kunhardt acknowledged that his approach is a bias.

“One of the things you have to be cognizant as an adviser is the biases that you have because they will impact your investment decisions and ultimately your returns.

“But we have paid a price with tech stocks in the past. Since then, the firm as a whole has maintained exposure to well-diversified markets and broad asset classes. We just don’t play single stocks and sectors.”

Terms are good

Kunhardt said that he otherwise liked the structure.

“You get a lot of leverage. The downside protection is 40%. That’s compelling over five years especially for those two sectors.

“By and large utilities is not that volatile nor is the financial sector although at times of dislocation as we are right now, the financial sector can hiccup pretty significantly.

“Still, having a 40% barrier is enticing.”

Core, satellite

Kunhardt explained that the notes would not fit in his asset allocation model, which was the main reason he would not consider buying the product.

Along with many financial advisers, Kunhardt adopted an allocation approach in which his investments are divided into core and satellite.

The “core” portfolio represents the bulk of the assets. It includes passive investments and indexes of major asset classes.

The “satellite” strategy, on the other hand, is more active and designed to generate alpha.

“This note couldn’t be part of my core. Could it be part of my satellite strategy? In theory, yes. Absolutely. Except that it’s a little bit too long for that,” he said, adding that he would not want to hold any “satellite investment” for five years.

“Your satellite investments constantly move around. You must be nimble for these types of positions.

“As we know, structured notes are not very liquid. You’re pretty much stuck in it or you may have to take a loss if you even find someone to bid on it.”

No match

He concluded that the notes simply would not help him as an asset allocator.

“It couldn’t be in my core since it’s a sector bet nor could it be in my satellite due to its long maturity.

“Oh, and one other thing: I don’t like worst-of.”

Those limitations could be frustrating even for a portfolio manager.

“The structure is really compelling. I like the notes.

“But it just doesn’t work,” he said.

“Sometimes your biases get in the way.”

Unknown underlier

For Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, the problem with the notes was the non-distribution of dividends from the underlying funds known for their income potential.

“Usually people invest in financials and utilities for the dividends. And as a note investor, you’re not getting that” he said.

The Utilities Select Sector SPDR ETF yields 3.5%, which over five years makes for a solid income-based return on a compounded basis, he said.

The Financial Select Sector SPDR fund has a 2.6% dividend yield, which is lower but still higher than the S&P 500 index at 1.8%.

Muted gains ahead

He evaluated the value of the 40% contingent protection based on the tenor and the uncertainty associated with the worst-of exposure.

“If we’re going to be in a recession, which at some point is inevitable, utilities should hold up a little bit better, but anything is possible in five years,” he said.

If the economy is expanding, the financial sector “will do well” and utilities “will be lagging,” he added.

Missing yield

“You don’t know what your exposure is until maturity,” he said.

“The leverage is nice but you’re getting the lesser of the two.”

In a down market, both funds could have low price returns. Even with a high participation rate, investors may underperform the funds as the notes suppress dividend distribution, he argued.

“The upside is going to be limited if we go through a period of stagnation, which we may already be in.

“In the past people were buying dividend stocks for safety. The price doesn’t move that much, and the dividend provides some downside protection.

“Without the income, I’m not sure why would anyone be looking at this.”

HSBC Securities (USA) Inc. is the underwriter.

The notes will price on July 28.

The Cusip number is 40438CQG9.

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