HSBC’s buffered leveraged notes tied to Hang Seng China would be better deal on A-shares

By Emma Trincal

New York, Feb. 1 – HSBC USA Inc.’s 0% buffered return enhanced notes due Feb. 3, 2021 linked to the Hang Seng China Enterprises index feature attractive terms for investors bullish on China, but the selection of the index and length of the tenor may not be optimal, according to a contrarian portfolio manager.

If the index closes at or above its initial value, the payout at maturity will be par plus 2 times any gain with the payout capped at par plus 29.4%, according to an FWP filing with the Securities and Exchange Commission.

If the index declines by up to 20%, the payout will be par. Investors will lose 1.25% for each 1% loss beyond 20%.

H versus A

The HSCEI is comprised of the “H-shares,” which are Hong Kong listed shares of companies based in Mainland China.

The alternate exposure to China is through the China A-share market, which consists of Chinese domestic stocks trading on the Shanghai exchange.

Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments, prefers the A-shares.

“The A-shares are much more depressed from their high from a year ago than the H-shares. You get much better value from the A-shares than the H-Shares. Too bad they picked the Hang Seng as the underlying, he said.

Two Harvest funds

Kaplan gets direct exposure to the A-shares market through two exchange-traded funds. A structured note tied to any of those two funds would have been more appealing, he said.

The first ETF is the Xtrackers Harvest CSI 300 China A-Shares ETF, which is listed on the Nasdaq under the symbol “ASHR.” This fund tracks the performance of the 300 largest companies in the China A-share market.

The second fund, which is more volatile as it consists of the A-shares of Chinese small-cap stocks, is the Xtrackers Harvest CSI 500 China A-Shares Small Cap ETF.” It is listed on the Nasdaq under the symbol “ASHS.”

Where value is

“I particularly like the ASHS,” he said.

Kaplan, who is a value and contrarian investor, said the price is attractive. The share price of the fund has plummeted 37% from its previous peak back in September 2017, he noted.

“Compare that to the Hang Seng, which is down 19% from its high. That’s a big decline, but the small-cap A-shares ETF has dropped twice as much,” he said.

“You get a better bargain on the Shanghai market than you will get in the Hong Kong market. I don’t really know why. It has nothing to do with fundamentals. I guess it’s just sentiment.

“You see much higher highs and much bigger drops because A-shares trade in a local market. People save much more in China than here. It’s more of a retail market and investors get more excited. When the market rallies they jump aboard. When prices fall, they start to panic. This is why every few years you see these huge rallies followed by huge sell-offs... and the cycle repeats itself.

“In the Hong Kong market for whatever reason, investors tend to be less emotional.”

Low P/E

Investing in the Hang Seng through a structured note provides more value than a similar investment in the S&P 500 index. But the A-shares offer a much deeper discount.

“You’re not getting as much of a bargain,” he said.

The Hang Seng China Enterprises index has a P/E of 13 compared to 20.76 for the S&P 500 index. But the P/E for A-shares of Chinese small-cap stocks is at about 8.

Dynamic reaction

As the A-shares market is both cheaper and more volatile, it will resonate more with global macroeconomic events.

Kaplan pointed to the trade talks between the United States and China.

“If they get to a deal, it’s going to have a very positive impact on the domestic market in China,” he said.

Kaplan said he believes a deal can be made.

“It will probably happen because Trump wants to be able to say – I’m the greatest dealmaker – even if the deal doesn’t mean much. The Chinese are also probably eager to save face,” he said.

“If we have a deal, the gains on the Hang Seng will be muted in comparison to the impact it will have on the A-Shares market,” he said.

One major reason is simply because the P/E of the H-Shares is already so much higher.

Political clouds

The notes presented another drawback for this portfolio manager: the two-year maturity.

“In two years we’ll have headwinds on the political front. We’ll be in the midst of the 2020 campaign, which will bring its share of uncertainty and volatility,” he said.

Kaplan also expects a recession in the U.S. around that time.

“I just would stay away from 2020,” he said.

Despite those shortcomings, Kaplan said the notes offered an attractive structure.

“They did a good job with the upside. I like the two-times leverage. Obviously, I’d rather not have a cap, but this is a reasonable cap,” he said.

“The 20% buffer on the downside even though it’s geared is very favorable too.”

“I’m bullish on China. It’s good to see notes on this asset class.

“If they had just picked the A-shares market and made it a one-year or even a three-year, I would have been much more excited about it.”

The placement agents are JPMorgan Chase Bank, NA and J.P. Morgan Securities LLC.

The notes will settle on Wednesday.

The Cusip number is 40435UGB4.

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