HSBC’s dual directional notes on Dow, Nasdaq, Russell offer uncapped leverage, hard buffer

By Emma Trincal

New York, March 17 – HSBC USA Inc.’s 0% dual directional buffered notes due March 20, 2023 linked to the least performing of the Dow Jones industrial average, the Nasdaq-100 index and the Russell 2000 index caught advisors’ attention for some compelling aspects in the structure both on the upside and the downside.

The payout at maturity will be par plus 120% of the lesser-performing index’s gain, according to an FWP filing with the Securities and Exchange Commission.

If the lesser-performing index falls by up to 20%, the payout will be par plus the absolute value of this index’s return. Investors will lose 1% for every 1% decline of the lesser-performing index’s return beyond the buffer.

Issuer

“That’s a very intriguing note,” said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

The downside structure was his favorite part. But he liked the overall product too.

“First we’re comfortable with HSBC. It’s a high-quality issuer,” he said.

The credit default swaps rates for the bank are 106 basis points, according to Markit. It is tighter than the large U.S. banks, whose spreads range from 130 bps for JPMorgan to 162 bps for Goldman Sachs.

Correlation

The inclusion of three underlying indexes in a worst-of is something Kalscheur has not been eager to use before.

“We usually stick to two only. But I can see why you could have those three in a note. They’re all well-known, understandable U.S. equity indices,” he said.

Despite the high correlation between the three assets, this financial adviser was a little bit cautious.

“You can still see divergences of those three in the last couple of years. While they’re all U.S. they may act fairly differently, especially small-cap versus large-cap. The Dow is also going to behave differently from the tech-heavy Nasdaq,” he said.

Three-year term

The three-year tenor was slightly on the short end for Kalscheur’s preferred maturities as he encourages his clients to invest for the long term, especially when the market is going through panic selling mode as has been the case over the past few weeks in reaction to the coronavirus pandemic.

“For us, three-year is short term. But to tell you the truth, they’re giving you some really good terms for a three-year. I was a little bit surprised that you could get leverage and unlimited upside over that period.

“The leverage will make up for the loss of dividends. And if it takes off, you’re in good shape,” he said.

Downside

But what Kalscheur liked best in the structure was the downside payout, which combines absolute return and buffered protection.

“The absolute return buffer...we really like these.”

Most absolute return notes, he added, offer a barrier, not a buffer.

“If the market is down, you at least have something that has the potential of being up.”

It would be a mistake however for investors to expect an unlikely price decline near the minus 20% threshold, for instance a 19% drop.

Necessary buffer

“The window of opportunity is too narrow. Statistically it’s not likely to happen,” he said.

“Investors can’t buy an absolute return in the hope of getting a high return on the downside.”

Using data he has on the S&P 500 index for over the past 30 years, he found that the index has been down 20% or more less than 10% of the time over a three-year rolling period.

“It’s much more likely that it’s going to be up,” he said.

“And yet, it’s good to have it, especially the buffer because it’s not unusual in a bear market to have a downdraft followed by a recovery and then another downdraft in a three-year period.”

Overall, the structure presented many positive aspects.

“You’re uncapped on the upside with leverage. You have a 20% buffer with absolute return.

“It’s the best of both worlds.”

Finally, the notes, which priced Tuesday, should benefit from the market’s tumble.

“We are in a better going-forward position than just a month ago,” he said.

Shorter would be better

Steven Foldes, vice-chairman at Evensky & Katz / Foldes Financial Wealth Management, also liked the note but would make some changes to the structure by reducing the tenor and downside protection for more leverage.

His view is more bullish given the current market disruption.

“We really like the use of three asset classes that are highly correlated to each other,” he said.

“You don’t want worst-of based on very different asset classes, and those are very similar.

“We also like very much having the leverage with no cap.”

One possible change in his view would be to reduce the duration from three to two years.

“For those investors who are concerned about the downside risk three years from now, which I don’t think they should be, this is an attractive note.

“If there is a significant decline three years from now of less than 20%, you get the absolute return plus you have a buffer if it drops more.

“For investors worried about the coronavirus, which clearly will be over in three years, this is a compelling note.”

Foldes thinks the market will recover much sooner.

“I think life will get back to normal sooner than that. It’s a matter of getting a vaccine, which we should have in one year or 18 months from now,” he said.

Restructuring the note

Foldes said he would negotiate terms that better fit his outlook by giving up the defensive parts of the product.

“I would prefer to have a shorter note with more leverage rather than a buffer because I don’t think we will need a buffer. For the same reason, I don’t think we need to get a return on the downside, so I would eliminate the absolute return as well.

“If I was redoing the note, I would keep the underlying assets and the uncapped upside.

“But I would reduce the length of the notes...maybe to two years.

“I would increase the leverage and do away with the buffer and the absolute return.

“Having said that this note would be appropriate for someone a little bit more pessimistic who thinks the current crisis is a long-term situation.”

HSBC Securities (USA) Inc. is the agent.

The notes will settle on March 20.

The Cusip number is 40438CBZ3.

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