HSBC's 0% averaging notes linked to S&P 500 index offer high value, full principal protection

By Emma Trincal

New York, Dec. 20 - HSBC USA Inc.'s 5.5-year 0% averaging notes linked to the S&P 500 index enable investors to get better terms, such as uncapped upside and shorter duration, through the use of a different payout calculation technique, said structured products analyst Suzi Hampson at Future Value Consultants.

The final index level will be the average of its closing levels on the 26th calendar day of each March, June, September and December from March 26, 2014 up to and including June 29, 2019, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is positive, investors will receive par plus the index return. If the index return is less than or equal to zero, the payout will be par.

Quarterly averaging

"This is a bit more than five years, which is very short compared to most principal-protected notes. As with the majority of such products, you get upside participation, in this case without a cap, plus 100% principal protection," she said.

"You forego the dividends. Fair enough if you compare it to a pure tracker, which has no downside protection."

What makes this product different from most principal-protected products is the use of quarterly averaging throughout the product term, she said.

"Instead of looking at the index performance point-to-point, they average up the index return of each quarter," she said.

This kind of method lowers the volatility of the returns, she explained.

"It may dampen the return, especially if the market is up. On the other hand, it may also cut your losses slightly in a down market. But you don't really need to lower the volatility of your index if you're going to have full principal protection at the end," she said.

"So compared with the point-to-point payout, the quarterly averaging doesn't really work in your favor for that type of structure.

"This is why this technique is less expensive for the issuer. They're able to buy the options at a lower cost, which is why investors can get better terms. The five-and-a-half-[year] maturity is much better than most principal-protected notes running from six or seven years and even longer in the U.S. And you do not have any limitation on the upside, which is also a great advantage."

The averaging payout calculation applied to a principal-protected note is not very common.

"We see the tactic used from time to time but not often. We see it more in the U.K.," she said.

The additional complexity is one of the disadvantages, she said, as investors understand better the concept of a point-to-point return.

"Looking at the performance on a quarterly basis for five-and-a-half years makes the return more difficult to predict. It's a more complex concept, which may not be easily grasped by the retail kind of investor," she said.

Future Value Consultants assesses the risk, risk-reward profile and value of each product it rates with several scores it developed. Those ratings are used to compare a product to similar ones. In this case, the product type for the report is principal-protected.

Riskmap

The riskmap is Future Value Consultants' measure on a scale of zero to 10 of the risk associated with a product with 10 as the highest level of risk possible. It is the sum of two risk components: market risk and credit risk.

At 0.35, the market riskmap of the product is much less than the 1.37 average score for products of the same type.

Hampson explained that the market risk measures potential losses against the risk-free rates. It explains why the market risk of this principal-protected product is not equal to zero.

"Even though you may not lose principal at maturity, you're still exposed to the risk of getting less in return than cash," she said.

On the credit risk side, the notes show a low risk profile with a 0.89 credit riskmap versus 1.19 for the average of principal-protected products. She attributed this score to the creditworthiness of the issuer.

As a result of the two low riskmap components, the notes have a riskmap of 1.24, which is lower than the 2.56 average for products of the same type.

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

With this type of structure, the bullish assumption is the optimal one, she said.

The notes have an 8.66 return score versus an average of 8.22 for the category.

"It's slightly higher than the average for the same product type. We're comparing this product with other principal-protected notes that may have a cap. This one doesn't, which may explain the difference," she said.

"So even though we've got the averaging, which will dampen the returns, we do have more upside potential due to the absence of a cap.

"We're using the bullish scenario to calculate the return score. This market assumption gives you quite a good chance of positive returns given the long duration and the absence of a cap.

"Obviously, the low risk profile is also a factor since we're looking at the risk-adjusted return."

High value

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The notes carry a 9.98 price score, compared with 9.45 for the average of the same product type.

"It's very high, nearly at 10. Obviously, it's hard to get much better than that," she said.

One factor is the averaging, which is taken into account in the scoring of the pricing. Another reason has to do with the length of time. Longer-dated products price better as the firm measures fees on an annualized basis, she said.

"Principal-protected notes have been difficult to create. When rates are low, there isn't much money available to buy the call option. Issuers have to find some way to offer attractive terms," she said.

"Investors don't want participation rates to be lower than 100%. It sounds very unappealing.

"What has been done the most was either capping the return or extending the duration. But you can really end up with very long maturities.

"Then you have the averaging technique, which they're using here. It's another way to lower the price of the options and make the terms work for the investors."

The last Future Value Consultants score is the overall score. It reflects on a scale of zero to 10 the firm's general opinion on the quality of a deal. It is simply the average of the price score and the return score.

Given the high return score and the very elevated price score, the notes end up with a "very attractive" overall score, she said.

The 9.32 overall score exceeds the average in this product type by half a point, the report showed.

HSBC Securities (USA) Inc. is the agent.

The notes are expected to price Thursday and settle Dec. 31.

The Cusip number is 40432XQU8.

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