HSBC’s income plus notes linked to stocks come with 8% potential coupon, opportunity costs

By Emma Trincal

New York, June 25 – HSBC USA Inc.’s income plus notes due Aug. 1, 2022 linked to a basket of five common stocks offer an unusual structure for conservative, income-seeking investors who can benefit from principal protection and a small guaranteed coupon while potentially getting a higher performance-based interest rate, sources said.

But the worst-of structure of the variable rate, the yields paid by the stocks used in the underlying basket and the current market environment represent challenges and opportunity costs, they added.

The underlying companies are Ford Motor Co., International Business Machines Corp., UnitedHealth Group Inc., Verizon Communications Inc. and Walgreens Boots Alliance, Inc., according to an FWP filing with the Securities and Exchange Commission.

Interest is payable annually. Interest will be 1%, the minimum coupon, plus 7% if each basket stock closes at or above its initial share price on the valuation date for that year.

The payout at maturity will be par plus the last coupon payment.

Single stock risk

Steve Doucette, financial adviser at Proctor Financial, emphasized the “single stock risk” of the investment, saying that one stock may not follow the general market direction due to reasons inherent to the company itself.

“The scariest thing is that you’re exposing yourself to a single stock risk. These are nice blue chips with decent dividends, but anything can happen with just one company,” he said.

Investors obtain the higher coupon if the prices of all the reference stocks increase or stay flat on each annual valuation date, according to the prospectus. This condition means that the underlying is not a traditional underlying basket, he observed.

“The return is not linked to the average performance of the basket but to one condition: they all need to be up,” he said.

“If one stock only goes down, you’re only collecting 1% and you’re giving up the dividends. That’s an opportunity cost.”

An equity investor who owns the five stocks would get an average dividend yield of more than 3%.

The reference stocks have the following dividend yields: Verizon, 4.6%; Ford, 4.0%; IBM, 3.1%; Walgreens Boots Alliance, 2.0%; and UnitedHealth, 1.7%.

“The worst-case scenario is if you collect only 1%. I guess you’re still doing better than money markets,” he said.

“Somebody with a bunch of cash who doesn’t want to invest may find it to be a safe way to put money somewhere.

“But we do expect interest rates to rise, and that’s another opportunity cost.”

Outcome scenarios

The odds of the most attractive outcome, receiving the 1% guaranteed coupon and the 7% variable coupon, are difficult to estimate.

“What are the odds of getting 8% coupon and how many times? It’s a seven-year. The market could go down then back up, or it could run and crash at the end. It’s hard to tell, but it may not be impossible to collect the coupon during two to three years out of the seven,” he said.

“Still, the single stock risk is huge. One bad decision from a company, one bad strategic plan and the 8% is out.

“It’s a worst-of, and all five stocks have to be up. That means you have a better shot at getting the coupon if there is correlation between the stocks.”

The stocks are from different sectors, he noted, but that does not automatically mean more risk.

“I don’t know if different sectors necessarily mean less correlation. What I see is that all five names are large-cap U.S. stocks. That’s correlation. I would have to look at it. It’s hard to say what are the odds,” he said.

“I would look at market cycles. Correlation goes to one in a bad market, and you definitely don’t want that. If you have several years of that, you miss the opportunity of collecting the 8%. You’re stuck with just 1% in what’s anticipated to be a rising interest rate environment.

“You’re giving up a lot of opportunities. All that might make some people happy. But I don’t think a savvy investor would necessarily be happy.”

Non-callable

The notes are not autocallable, which he said is a disadvantage.

“You’re stuck for seven years. An autocall is kind of nice, especially when the coupon is cumulative. This one is not an autocall. There are a lot of moving parts,” he said.

In order to consider the investment, Doucette said that some terms would have to be negotiated and altered.

“To define how much yield I get, give me for instance not the worst of but the basket return,” he said.

Doucette said he might “revisit” the underlying as an alternative.

“I’ll keep the same terms but with broader indices. That way I am not exposed to the risk of one single stock.”

Worst of

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said the trigger for the variable coupon is problematic.

“In theory it sounds interesting. The challenge in terms of the 1% minimum is the rising rates environment. You can buy a Treasury at 2.3% if you’re just concerned about yield,” he said.

“I like the idea of an upside kicker, but I don’t like that it’s based on five different stocks and all of them having to be positive.

“Like any structure, the more moving parts, the more challenging it is to determine the expected outcome.

“I do like the fact that it’s principal-protected. But I would probably pass on it because of the multiple parts – and that is five different underlying securities having to do the same thing.”

Equity alternative

For Medeiros, the structure employed is an hybrid representing some of the disadvantages of both fixed income and equity.

“If you own the stocks, you have good dividends and potential upside, whereas this is between the lines of yield play versus yield enhancement play,” he said.

“I would prefer to own the underlier to capture the dividends and get the best upside that comes from equity.

“I wouldn’t have the principal guarantee, that’s true. But I would probably implement some option strategy to get some protection.”

HSBC Securities (USA) Inc. is the agent.

The notes will price on July 28 and settle on July 31.

The Cusip number is 40433B2S6.

© 2015 Prospect News.
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