HSBC’s notes tied to five stocks with 5.5% potential coupon target conservative income seekers

By Emma Trincal

New York, July 13 – HSBC USA Inc.’s income plus notes due July 31, 2023 linked to five common stocks give investors a low guaranteed coupon plus a chance to get more based on the performance of an underlying equity basket. The product, which provides full principal protection, is designed for risk-averse investors in search of yield, sources said.

The reference stocks are Bristol-Myers Squibb Co., Ford Motor Co., McDonald’s Corp., Philip Morris International Inc. and Wal-Mart Stores, Inc., according to an FWP filing with the Securities and Exchange Commission.

Interest is payable annually. The interest rate will be 1% plus (a) 4.5% if each basket stock closes at or above its initial share price on the valuation date for that year or (b) 0% otherwise.

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

Pricing

“It’s a seven-year paper, but if you want the full principal protection, you have to accept a longer term,” said a market participant.

Getting an additional 4.5% coupon a year if all five stocks close at or above their initial share prices on the observation date is what makes the structure compelling for yield-seekers, he said.

“Honestly 1% is not very exciting. Why would you need 1%? The whole idea is to get 5.5% a year,” he said.

The five basket components show little correlation to one another, he noted. Each company belongs to a distinct industry: pharmaceuticals, automotive, restaurants, tobacco and consumer staples.

“There’s a reason why they picked those stocks. They’re not correlated, and that helps pricing,” the market participant said.

“If the shares go in different directions, one stock drops below zero and you get the lower coupon. The low correlation is what gives you the higher coupon. It’s a risk and you get compensated for it.”

The notes, however, are designed for conservative investors. The structure has the objective of maximizing income while limiting risk as much as possible, he said.

Investors may not earn the 4.5% extra coupon, but they are protected against market declines, he noted.

Exposure to credit risk but not to market risk is a characteristic the notes share with the corporate debt from the same issuer.

Risk/reward

The market participant compared the two types of securities.

He noted that the seven-year swap rate was at 116 basis points and that the credit spread of HSBC was at 112 bps.

Investors buying a seven-year plain-vanilla HSBC note would receive the swap and the spread, which would be the equivalent of a 2.28% yield, he said.

In comparison, investors in the notes as far as a guaranteed coupon only receive 1%.

The difference between the fixed interest rate on the corporate debt and the fixed rate paid by the structured note represents the risk, or 1.28%.

“You’re risking 1.28% in order to get 4.5%. That’s a one-to-3.5 risk/reward.”

Asked whether the deal is fairly priced, this market participant said that “I’m sure it is” but that he “personally would have asked for a little bit more.”

In his view, the 1% guaranteed coupon does not add much value.

“I could do without it. It’s just psychological.”

Instead, he would have opted for a higher variable coupon.

Homework

An industry source reached a similar conclusion: the product is well-priced, but he would venture into a higher-risk investment.

“Those deals have been around for a while. It’s sometimes called a high/low coupon,” he said.

“The minimum coupon is not necessarily irrelevant. It depends on where you live. One percent in Europe is a pretty high return,” he said.

The low correlation between the five stocks, he said, generates some of the premium necessary for the pricing of the variable coupon.

Any investor in the notes should compare its potential rewards with the regular HSBC corporate bond, he added.

“Whether you buy this note or a straight bullet, you take the HSBC credit risk,” he said.

“What you need to figure out is, what are my chances of getting this better coupon? How often do I need to get it if I want to outperform HSBC paper? And what’s the percentage of the time I need to get the 4.5% in order to make up for what I’m giving up by choosing this note?”

Calculated risk

Both the notes and the corporate debt offer investors protection against market risk.

“A lot of people like the full principal protection. Some entities can only invest in principal-protected notes. It’s in their bylaws,” this source said.

“Personally I wouldn’t be a buyer of this. I would be willing to take more risk for more return,” he said.

He would prefer instead structured notes delivering a higher yield when the underlying closes above a low coupon barrier. The underlying could be one index or the worst performing of several. The final barrier would be extremely low, and the indexes ideally would be well-correlated in order to mitigate the risk of a barrier breach.

“We’ve done one like that on the Russell and the S&P. The coupon barrier was at 70%. That means one of the indexes would have to drop at least 30% to miss the coupon, which is unlikely,” he said.

The correlation between the Russell 2000 and the S&P 500 is “great,” he said based on historical data his firm examined since 1981.

During that time, which covered the high-tech bubble and the 2008 financial crisis, any five-year rolling period showed that the coupon would have been paid 96% of the time, he said.

At maturity, investors received their money back if the final level was above 50% of the initial level.

“It’s a principal-at-risk product, but in reality, it’s almost like having full protection. You’re never going to have on any five-year rolling period any index down 50%.

“Personally, I prefer those structures. They’re not as safe as a full principal-protected note, but they’re a little bit more predictable.”

HSBC Securities (USA) Inc. is the agent.

The notes will price on July 26.

The Cusip number is 40433UQC3.

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