HSBC's trigger notes linked to Vanguard FTSE EM fund use ETF 'in transition' for first time

By Emma Trincal

New York, March 11 - HSBC USA Inc.'s 0% trigger performance securities due March 29, 2018 linked to the Vanguard FTSE Emerging Markets exchange-traded fund give investors exposure to a remodeled fund for the first time and use a growingly popular structure offering uncapped leverage over a longer investment period, according to sources and data compiled by Prospect News.

First use of ETF

It is the first note to be linked to the Vanguard FTSE Emerging Markets ETF, according to data compiled by Prospect News.

Historically, the Vanguard ETF tracked the performance of the MSCI Emerging Markets index. Starting in January though, it began a two-step transition process to instead track the performance of the FTSE Emerging Markets index. The process is expected to be complete in July.

One of the main differences between the two target indexes is that the FTSE methodology does not consider South Korea as an emerging market (it classifies this country as a developed market), while the prior MSCI benchmark index does. The result is that investors in the FTSE index fund - and as a result, in the upcoming notes - will have no exposure to South Korea after a transition period, according to an FWP filing with the Securities and Exchange Commission.

The Vanguard FTSE Emerging Markets ETF has changed its name - it used to be the Vanguard Emerging Markets Stock index fund - but it remains listed on the NYSE Arca under the ticker symbol "VWO."

The payout at maturity will be par plus 120% to 130% of any ETF gain, with the exact participation rate to be set at pricing, according to the prospectus.

Investors will receive par if the ETF falls by up to 25% and will be fully exposed to losses if the ETF falls below the 75% trigger level.

"It's interesting that some countries, like South Korea and also Israel, are considered by some developed countries and by others emerging markets," said Carl Kunhardt, wealth adviser at Quest Capital Management.

"If you're trying to find out what an emerging market country really is, it's not defined anywhere.

"Curiously, the CIA World Factbook is where many indexes pool their information from.

"It's amazing the amount of information the CIA captures. They don't define what an emerging market is, but they do categorize it."

While not new, the structure employed in the "trigger performance" notes is part of a recent trend in the structured products market, he noted.

The development is characterized by the inclusion of a modest leverage factor and no cap on the upside in addition to an usually low downside barrier. The tradeoff is the extension of the duration, he said.

Not so long

"Issuers have been coming up with longer notes. I think that's the only way they can price this," he said.

"I kind of like it. I'm not really finding anything not to like other than the lack of liquidity.

"But five years is not terribly long. We buy bonds all the time with a five-year duration.

"I can't fathom that we would go five years with no growth."

Kunhardt added that the probability of a late correction as the notes near maturity could reverse all the gains.

"Sure, that's a risk. But you take that chance with anything," he said.

Kunhardt said that on the other hand, long-term products offer other advantages: they reduce the risk of panic selling in down markets.

"A lot of times, it's easier for an adviser to use long-term-maturity notes because it's an additional hurdle to stop the clients from doing something stupid. If they know they can't sell, they won't sell at the worst possible time," he said.

Kunhardt said that he usually does not like leveraged notes, especially when they are capped.

"But that's not the case here. You have some leverage, not a huge leverage ... let's call it 1.25 to slip in the middle. But since there's no cap, they're giving you enough of an impetus there on the upside," he said.

"This is a bull investment even with the barrier. Anything with leverage is bullish."

Additionally, Kunhardt said that he liked the downside protection and the cost of the investment.

"The 25% buffer is pretty substantial. The 3.5% fee is not bad," he said.

Pricing trend

Kunhardt said that he has seen longer-term notes more often recently.

"I am seeing a lot of those longer-dated maturities with this uncapped, substantial barrier feature. It looks like a trend to me," he said.

"I've noticed longer products across all the issuers, and I think this is how they can price it. In the current interest rate environment, the cost of these hedges is pretty high and it's squeezing their margins. They have to make some adjustments, otherwise it's not going to be profitable, and if it's not profitable, they're not going to create notes, why would they?

"Instead of getting rid of the downside protection entirely, they give you a barrier instead of a buffer with less leverage and they extend the term.

"If you can tolerate the longer maturity, it makes sense for the investor too."

Tenor shortcoming

Scott Cramer, president of Cramer & Rauchegger, Inc., said that he didn't like the five-year tenor, adding that the terms of the product did not offer enough benefits to offset the liquidity risk.

"My initial reaction was 'Good news, you're getting a 25% downside protection and a 20% premium on the upside.' At first it looked like it was not bad compared to other leveraged notes because you have this unlimited upside," he said.

"But you really have to compare it to the actual ETF. When you do, you realize that the risk is pretty high over five years.

"I don't think that the 20% leverage is worth taking the 25% risk in it. If it was a buffer, fine. But [a] five year is a long-term product. Anything can happen.

"Any time you go from one point in time to another without being able to get out, if the index is down 26% on maturity day, you're stuck. You have more downside risk than most people realize."

Cramer said that the positive terms of the deal were not sufficient to offset the drawbacks.

"In order for me to be comfortable investing in this index over that long period of time, I would need a deeper barrier, a 50% barrier for instance would make a difference. Or I would need more leverage or a buffer instead of a barrier, probably a combination of those things, something that would make a difference with a direct investment in the ETF," he said.

"When you look at the emerging market index, by its very nature, it is very volatile. You have so many of those countries that have so much political risk and could have a meltdown any time.

"The problem with this note is simple: it's a five year."

HSBC Securities (USA) Inc. and UBS Financial Services Inc. are the agents.

The notes will price March 25 and settle March 28.

The Cusip number is 40433T125.

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