HSBC's buffered notes tied to S&P 500 Low Volatility ETF seen as strong hedge, defensive play

By Emma Trincal

New York, May 5 - HSBC USA Inc.'s 0% leveraged buffered uncapped market participation securities due May 28, 2019 linked to the PowerShares S&P 500 Low Volatility Portfolio exchange-traded fund should appeal to conservative or defensive investors given the two means of protection offered in the structure: the buffer and the underlying, buysiders said.

If the ETF return is positive, the payout at maturity will be par plus at least 110% of the ETF return. The exact upside participation rate will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the ETF declines by 20% or less and will lose 1% for every 1% that it declines beyond 20%.

Low beta, smart beta

The first protective aspect of the structure itself is the underlying, sources said.

The ETF tracks the S&P 500 Low Volatility index, which is designed to serve as a benchmark for low-volatility strategies in the U.S. stock market. The index, which is rebalanced quarterly, measures the performance of the 100 least-volatile stocks in the S&P 500.

"It's a very nice note. I love low-volatility offerings," said Carl Kunhardt, wealth adviser at Quest Capital Management.

"I don't use that underlying. I use the iShares [MSCI USA Minimum Volatility ETF], only because I have more experience with them and it has worked well for me. But these are very similar strategies.

"What's more important than the fund itself is the index the ETF is designed to replicate. I like this index. It's what is called smart beta. It's a good fund to have exposure to for any investor."

Kunhardt said that he likes the idea of "fundamental" indexing.

"This is not a black box. Someone is making a determination of what these 100 stocks are every quarter. It's perfectly transparent," he said.

"Pimco has a couple of funds using the same concept. The strategy has not been in favor until lately."

Defensive index

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that he likes the "defensive" nature of the S&P 500 Low Volatility index.

"This is right up our alley. It's a clean and straightforward structure with a strong issuer," Kalscheur said.

"One of the drawbacks [of this deal] is that the S&P 500 Low Volatility index pays 2.48% in dividends versus 1.86% for the S&P. That's a little bit more than 60 basis points of income that you're giving up with this particular offering compared to a standard S&P-based product," he noted, adding that the higher yield is partly due to the 25% weighting in utilities.

"But in exchange, you're getting a very defensive index. Last year, it trailed the S&P terribly. But so far this year, the Low Volatility index is up 4% versus 2.8% for the S&P.

"You're getting a more defensive index. For that you're giving up part of the yield, but it's partly offset by the leverage.

"You are going to trail in an up market. If the S&P 500 is up 10%, you might only get 7.5%, which would be 8.25% with the leverage.

"But the downside protection is extremely good, and that's what makes this note very attractive," he said.

The Low Volatility index tends to outperform the S&P 500 in periods of market decline. But investors will likely underperform the S&P 500 in bull markets.

Buffer

"Not only do you have the more conservative index, but the 20% hard-and-fast buffer. And it's not geared. That's what I call a very conservative play," Kalscheur noted.

"If the index is down 20%, you're down zero. If it's down 30%, you're only down 10%."

Kalscheur considered the 0.85 beta of the S&P 500 Low Volatility index and added, "A market decline of 30% statistically speaking should only result in a decline of roughly 25%. So you're actually getting an extra 5% from the low-volatility strategy itself.

"Put together those two features, the low beta and the buffer, and if the S&P drops 30%, you're down only 5%.

"In bad markets like in 2008-09, you might be down, but you would be down in the single digits as opposed to down 30% or 40%. That's a big difference."

Upside risk

Kunhardt said the underlying low-beta strategy does not make the note necessarily risk-free. Investors could underperform the market in a bullish scenario, for instance.

"I wouldn't call it a defensive play because you have to look at your performance on a relative basis. If the market rallies a lot, you have to expect to underperform the full-cap-weighted index," Kunhardt said.

"The reason you would underperform in a strong bull market is simply because volatility is not just on the downside. It's on both sides of zero. So if you limit your universe to stocks [with] a low beta, which is what this index does, you're reducing volatility on the upside just as much as on the downside."

This in part explains why the issuer was able to price the notes without a cap, he added.

"Most funds tend to have more upside capture if they're any good. If you're giving up volatility, you don't need a cap because you are likely not to go up that much," he said.

But for investors unsure about the future direction of the market, the notes would provide a hedge, he explained.

"It's useful to be able to protect your portfolio without necessarily having a bearish outlook. This is precisely a non-bearish strategy that enables you to hedge the potential downside. You're still exposed to the S&P; you're not getting away from that. But you can navigate the rough waters ahead if the market goes down," he said.

Safer equity allocation

For Kalscheur, the product could be useful for conservative investors who need the equity returns and more diversification from fixed income.

"I like this index particularly for these clients who are nervous about stocks but still need some equity exposure because, as it's often reported in the press, cash is paying nothing and bonds have inherent interest rate risk," Kalscheur said.

"I am talking about the 75-year-old retiree who needs income and protection. Is he going to invest in a 2.6% Treasury or should he choose this low-volatility index note that has upside potential and a huge downside protection?

"If the market takes off, you are giving up on the dividends, but you are compensated for that.

"I see this offering as ideal for investors who may have lost money in the past and are wary about going back into stocks. This is a good way to regain exposure and to diversify away from bonds.

"If you're going to be all-equity, this is as conservative as you can go."

Double dipping

Perhaps the weakness of the structure for some would be that it is overly protective, added Kalscheur.

"It's almost too defensive," he said.

"If I wanted to play devil's advocate I could say that between the low-beta index and the buffer, you're kind of double dipping on the downside. It's more like a 25% buffer that you're getting given the inherent defensive nature of the underlying.

"You could consider doing something similar maybe with a 10% buffer and two-times leverage for instance. Would that be more interesting? I don't know.

"I think the way they put it together is very suitable for someone looking to be in equity but too skittish to do it with a traditional equity-linked note, someone who really needs a defensive structure while being able to avoid all the issues associated with CDs and bonds."

For Kunhardt, protection is never too much.

"It's always good to have some solid downside protection no matter what. If the market goes through a correction, you'll be glad that you had a buffer," he said.

"In this environment, you'd be foolish not to hedge your portfolio.

"Some protection is in order right now."

Finally, the fee, potentially up to 3.75%, was deemed "reasonable" by Kalscheur.

"It's 75 basis points a year. I'd like to see it close to 50 bps, but I can live with 75. It's not a deal breaker. We would still consider it," he said.

HSBC Securities (USA) Inc. is the agent.

The notes will price May 22 and settle May 28.

The Cusip number is 40433BAW8.

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