Advisers see averaging, tax treatment as drawbacks in HSBC's $2.75 million notes tied to S&P

By Emma Trincal

New York, July 22 - The averaging payout and the tax treatment of HSBC USA Inc.'s $2.75 million of 0% averaging notes due July 23, 2018 linked to the S&P 500 index were seen as major negatives by two financial advisers.

The payout at maturity will be par plus 95% of any index gain, according to a 424B2 filing with the Securities and Exchange Commission.

If the index falls, investors will receive par.

The index's final level will be the average of its closing levels on the 10 semiannual observation dates.

Immaterial averaging

"Instead of getting a point-to-point payout, you're getting the averaging of several dates. It's going to dampen your return," said Carl Kunhardt, wealth adviser at Quest Capital Management.

"Instead of getting 95% of the gains, you're probably getting less. The product is principal-protected, so the averaging is immaterial. It would only help with a capital-at-risk product since it may lower the amount of losses. But on the upside, the benefit of averaging becomes moot. You're not gaining anything from it. In fact, they're taking returns from you. To begin with you get less than 100% upside participation, and then the averaging lowers your actual return."

Kunhardt said that the impact of averaging would need to be evaluated but that he was convinced that it would not be beneficial to someone buying a principal-protected note.

"You have to pay the principal protection somehow. But it's misleading to say that you get 95% when in reality you get less. How much less I don't know, but it's going to be less than 95%," he said.

"They're adding complexity, and they are not doing it to help you. You would have to model the averaging to measure its real effect on your return. But I suspect it leaves you with less return, not more."

But other aspects of the notes were more appealing, in particular for a principal-protected structure, a product category that is difficult to price in today's environment and less and less common, he noted.

"It's still an attractive note. The 25 basis points fee is incredibly cheap. It's a five-year, but principal-protection notes these days are hard to come by in less than five years. Most often you're going to get a six- or seven-year," he said.

"They're giving you 95% of the upside. As I said, it's going to be less with the averaging. But even if it's just going to be 80%, let's assume the index averages 10%, you're still in good shape."

Phantom income

However, Kunhardt said he would have never considered the notes due to the way principal-protected notes are being taxed.

According to the prospectus, it is "reasonable" to treat the notes as "contingent payment debt instruments," and as such, "a U.S. holder will be required to include original issue discount ("OID") in gross income each year, even though no payments will be made on the notes until maturity."

"I'm not comfortable with the taxation of this product. If you have to pay income tax on the notes each year, that's not a great thing. In fact, it wouldn't work for us," he said.

Steven Foldes, president and chief executive of Foldes Financial Management LLC, shared similar concerns regarding the averaging and the taxation.

The averaging, he said, could be a source of "disappointment" for clients.

"It is a little bit of a trick. When our clients do these kinds of index-linked notes they expect to get very much of the same return as the underlying. Any final return that differs a lot from the benchmark would be a big disappointment for them. I would have to see a study about the impact of averaging on returns. But chances are you would get a different return. For that reason, I wouldn't want to do the averaging. It becomes difficult to explain to a client the results of the semiannual averaging," he said.

Buffer preferred

"Then there's the tax issue," he added, as "principal-protected notes provide ordinary income, not capital gains."

"That's a big negative, especially if you're looking at a five-year situation. You'll be paying not 20% in capital gains but potentially 40% or slightly more, which is twice as much in taxes.

"Not only [do] you pay more in taxes, but you often have to pay a phantom income each year even though you're not getting your return until maturity. It gets pretty ugly very early on.

"We almost never enter into a note for our clients when there is ordinary income. We prefer capital gains."

Pricing of the notes on the secondary market was also an important question to discuss directly with the issuer, he said.

"There's always this pricing issue, which is very important for us," he said.

"One question to ask the issuer would be: How close to the S&P performance would the issuer price the notes in the event an investor wishes to exit early?"

Foldes said that he was not comfortable with the principal-protection structure used for the notes.

"We would much prefer not having the principal protection but a good buffer instead, something around 30% to 35% downside protection," he said.

"That way, we would get capital gains treatment as opposed to ordinary income. We wouldn't have the OID, phantom income issue.

"The duration is awfully long for those notes. We would want the upside to be a multiple of the S&P. By getting rid of the full principal protection, you would be freeing money to buy the options that would give you the leverage even on a shorter duration.

"I would expect some leverage, maybe with a cap as long as it's an attractive cap and not such a long tenor.

"Overall, the averaging issue and the bad tax treatment would be serious obstacles for us.

"Having to pay taxes on a phantom income is not a happy situation at all.

"You only get 95% of the upside, and there's no leverage. In addition, the averaging is likely to confuse the client.

"There's one good thing though - and that's the fee. A 25 basis points fee is compelling."

The notes (Cusip: 40432XHX2) priced July 18.

HSBC Securities (USA) Inc. was the agent.

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