HSBC’s series of buffered market participation notes on sector ETFs play defense only

By Emma Trincal

New York, June 26 – HSBC USA Inc. is readying series of buffered market participation securities due Oct. 17, 2019 tied to sector funds, which focus on a defensive approach as the payout in a positive scenario offers no particular appeal. The main benefit of the notes is the buffer.

The deals carry a 15-month maturity. Investors will get one-to-one exposure to any positive return of the relevant ETF subject to a cap, which varies based on the underlying fund, according to an FWP filing with the Securities and Exchange Commission.

The downside is protected by a 10% buffer.

Tech, finance, miners

One series is based on the Technology Select Sector SPDR fund, which is listed on the Arca NYSE under the ticker “XLK”.

Another is linked to the Financial Select Sector SPDR fund, which is listed under the ticker “XLF”.

The Market Vectors Gold Miners ETF is the underlying for the third offering. This fund is listed under the ticker “GDX.”

The maximum return will be 10.75% for the technology-based notes, 11% for the financial sector-linked product and 17% for the product tied to the gold miners fund.

Sideways view

“I guess if you’re thinking the market is going to go sideways, the buffer is giving you some protection...it might work. To me though, that’s not enough to get excited,” said Clemens Kownatzki, independent currency and options trader.

“When you look at technology we’ve been nine years into a bull market. We know we’re due for some kind of retracement and we haven’t seen it yet. Is 10% protection going to be enough? I doubt it.”

On the other hand, for those who remain bullish on the sector, the cap of 10.75% over 15-month, which is about 8.5% a year may be a strong negative, he noted.

“I don’t believe that tech stocks will be affected as much as the manufacturing, industrial sector in a trade war. You could have more upside. Therefore, you may be capped out too low.”

Defense only

The “upside risk” could be even greater with the financial sector.

“This is not a sector that should suffer too much from a trade war. It’s also a sector that is going to benefit a lot from a rising rate environment,” he said.

“If you’re bullish again you’re capping yourself too low at less than 9% a year.

“And if you don’t believe the market is going to be up, why should you be in the market?”

He reasoned that the strength of the notes relied too much on the protection, adding that such protection can be created with options for less.

For instance, he suggested to sell a put option 10% below the initial price and getting paid a premium for the short position. The strategy is bullish but investors can add the premium to their bottom line.

Dividends

Another disappointing aspect of the payout was the non-payment of dividends. While this is the case with most notes, the leverage typically helps offset the cost of foregoing those returns.

“To be fair none of those ETFs pay huge dividends. GDX has a yield of only 0.8%. The highest one is XLF at 1.58%,” he said.

Tradeoff

Overall this investor said that he needs to see a “tradeoff” in order to invest in a note.

“I don’t mind having a cap if I have some leverage or more protection. Give me 20%, 30% buffer and I would understand the tradeoff. But I don’t see any here.”

His view on the gold miners deal was the same.

“If I want to be long GDX, I can just buy the ETF. I can create some protection being long a put. I don’t see any reason to buy the notes.”

Covered call

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, expressed similar doubts.

“OK, basically you can’t go below 10%, you can’t go above 10% or 11%. It’s a covered call. Except that you’re not making money on the downside as you would with a covered call,” he said.

In a covered call strategy, the investor would own the ETF and write a call option on it at a strike price, which in this case would be the equivalent of the cap.

The strategy prevents the investor from making money above the cap (or strike). If the price of the fund rises above it, the investor must sell at the strike price. But in exchange for risking losing gains above the call strike, the investor is paid a premium.

Premium versus buffer

In turn, the investor can use the premium as “cushion” to reduce the downside risk. The strategy offers an additional benefit: it allows the investor to keep the difference between the paid premium and the price decline.

Chisholm offered an example.

“Say you put on a covered call. The stock price is at $100. You’re getting $10 in premium for selling the call. If the stock price goes nowhere, you keep your 10%. If it goes up 20% you get 10%. If it goes down to 90% you lose nothing. But if it goes down to 95%, you make 5%.”

“With the notes, you don’t make any money. You just get your money back,” he said.

Learning curve

One argument in favor of a structured note is the simplicity of the payout, the small minimum denomination and the ease of monitoring the investment. But Chisholm refuted these arguments.

“If you can get the same outcome leaving less money on the table why wouldn’t you use the option strategy in this case?

“If the answer is because you don’t understand options, then I would say don’t buy structured notes.

“Structured notes are not for ma-and-pa investors. They are derivatives strategies. If a client doesn’t understand an investment they shouldn’t invest in it.

“That’s how they lose money and blame other people for it.”

HSBC Securities (USA) Inc. is the agent for the three upcoming deals.

The offerings will all price on July 12 and settle on July 17.

The Cusip number for the “technology” notes is 40435FH42

The Cusip number for the notes linked to the financial sector ETF is 40435FH59.

The Cusip for the third offering based on gold miners is 40435FH67.

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