HSBC’s $1.13 million of autocalls with memory on indexes offer high yield, dispersion risk

By Emma Trincal

New York, April 26 – HSBC USA Inc.’s $1.13 million of 0% autocallable barrier notes with step-up premium due April 27, 2026 linked to the lesser performing of the Euro Stoxx 50 index and the Russell 2000 index give investors a mid-double-digit call premium in part because of the low correlation between the two underlying indexes, a market participant said.

The notes will be called at par plus a call premium if each index closes at or above its initial level on any annual observation date. The premium is 15.3% per year, according to an 424B2 filing with the Securities and Exchange Commission.

If the notes are not called, meaning all indexes have finished below their initial levels, the payout will be par unless any index has finished below its 70% barrier level, in which case investors will lose 1% for each 1% decline of the least-performing index from its initial level.

Good pricing

One yield-enhancing factor was the use of a worst-of.

“Investors will always prefer notes on one index but if you want to get double-digit returns on your coupon or call premium, then you typically need to use two or three indices. That’s what they did,” he said.

The choice of the underlying was also key.

“They picked one domestic index and one European index. They’re also using small-cap versus large-cap.

“This gives you a structure that prices relatively well with a substantial call premium,” he said.

He summarized the factors which contributed to high call premium.

“First, the exposure is to two different markets. That helps.”

He was referring to the increased dispersion of returns between the two asset classes.

The five-year coefficient of correlation between the Russell 2000 and the Euro Stoxx 50 is 0.786.

“It’s not a strong correlation,” he noted. In comparison, the Dow Jones industrial average and the S&P 500 index show a coefficient of correlation of 0.963. The low correlation between the Russell 2000 and the Euro Stoxx 50 is an additional source of premium, he said.

“Second factor: volatility is higher today. That helps too.

“Finally, Europe has underperformed the U.S. for some time, which led to some correlation divergence in the recent years. That also helps with the pricing,” he said.

Snowball versus Phoenix

The notes offer several benefits to investors, he said, pointing first to the “well-known and well-diversified” underlying indexes.

The 70% barrier was “pretty substantial for these broad-based indices,” he said, while the call premium was “quite high.”

The structure of the notes is known as “snowball” in the industry jargon. Snowballs allow investors to get paid upon the automatic call and to collect a cumulative premium. If a premium is missed out, it can be obtained later when the notes get called. Investors will then collect the sum of all unpaid call premium, a feature known as memory.

“This snowball, any snowball is very different from the usual coupon structure,” he said.

“It’s harder to get paid here because you need the market to go up. That’s the downside of a snowball. With the coupon note, you can still receive your income if the market is negative providing that it’s above the barrier.”

But the higher call trigger at 100% of the initial price also provides notable advantages, he noted.

“You get a higher payout. You get the memory feature. And it’s more efficient from a tax standpoint,” he said.

Tax treatment

The notes are treated as long-term capital gain or loss for tax purposes upon early redemption or at maturity as long as the note has been held for more than one year, the prospectus stated.

Since the first call date is on April 24, 2023, or 367 days after the trade date (April 22), the noteholders will avoid the less favorable ordinary income tax treatment, he said.

Typical autocallables, often named “Phoenix autocallables,” are similar to pure income products because investors can collect the coupon while still holding the notes. Those contingent (or fixed) coupons are usually taxed as ordinary income.

But snowballs such as this note can offer the preferable capital gains tax treatment due to the payout. That’s because investors get paid either upon the call or at maturity not as they hold and continue to hold the securities.

“This note is much more tax efficient than the coupon structure,” he noted.

Long-dated note

Jonathan Tiemann, president of Tiemann Investment Advisors, admitted that the call premium was attractive. But he did not like the structure of the product.

“The risk profile of this note makes me a little bit uncomfortable,” he said.

One positive outcome would be a call after one or two years, allowing investors to capture the 15% annualized return.

“That’s really not a bad return,” he said.

But in the absence of a call the risk increases significantly.

“Suppose the notes are not called three years in a row. At maturity, you have three possible outcomes: you receive a 61% cumulative premium, you get nothing but your money back or you take a loss of at least 30%.

“The idea of getting the 61% premium at maturity is a bit of a stretch. If you’ve been negative three years in a row, what are the odds that you’ll finish positive on the fourth year?” he said.

Tiemann said his main concern was the long tenor.

“I don’t really like the four-year holding period with the ensuing credit risk exposure and limited liquidity,” he said.

Whether the notes get called or not, he saw disadvantages in both scenarios.

“It’s nice to get called with 15%. But I don’t like the early redemption idea. I don’t like the reinvestment risk after one year.

“Perhaps the worst scenario is to be stuck with the notes for four years. You don’t get called on year one, you don’t get called on year two. As you get closer to year four, your chances of losing money increase. I’m not too excited about that scenario either,” he said. “In fact, it’s the most adverse scenario.”

HSBC Securities (USA) Inc. is the agent.

The notes will settle on Wednesday.

The Cusip number is 40439JT47.

The fee is 0%.

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