HSBC's income notes linked to 20 stocks offer rare structure, but upside is too limited

By Emma Trincal

New York, June 3 - HSBC USA Inc.'s income notes due June 2020 linked to a basket of 20 common stocks feature an unusual binary coupon that will be either a minimum rate or a maximum rate depending on some price conditions to be met by the underlying basket.

But sources said the structure is too complex and the return too limited even in the best-case scenario. They concluded that a note with a fixed, guaranteed coupon offers a more appealing risk-reward trade-off.

Two coupons

The notes will pay interest at a minimum rate of 1% per year, according to an FWP filing with the Securities and Exchange Commission.

If, however, at least 14 of the 20 basket stocks have not decreased in value from the pricing date as measured on a coupon determination date, the notes will pay interest at a maximum rate of 5.5% to 6.5% per year. The exact maximum rate will be set at pricing.

The underlying companies are AbbVie Inc., Amazon.com, Inc., BHP Billiton Ltd., Walt Disney Co., Ensco plc, Eaton Corp. plc, Ford Motor Co., Facebook, Inc., Fortinet, Inc., Helmerich & Payne, Inc., JPMorgan Chase & Co., Kraft Foods Group, Inc., Och-Ziff Capital Management Group LLC, Philip Morris International Inc., PPL Corp., Spectra Energy Corp, Sempra Energy, Texas Instruments Inc., Under Armour, Inc. and Verizon Communications Inc.

"This type of income structure looks sort of new," said Tom Balcom, founder of 1650 Wealth Management.

"I haven't seen it before, but I'm not sure it's going to be a hit."

Moving parts

One of his main objections to the product is what he perceives as complexity.

"There are too many moving parts there," he said.

"In general, I am not a big fan of income notes. There is too much going on.

"This one in particular would take even more time to explain to a client. You have 20 different stocks. You have the different scenarios: If the market is down and less than 14 stocks are down, you get 1%. If at least 14 stocks are up, you get 6%. There are a lot of ifs."

Don McCoy, financial adviser at Planners Financial Services, agreed, pointing to the need to study the underlying stocks.

"It does seem a bit too complex for its own good," he said.

"You've got 20 stocks. It doesn't matter which one goes up.

"Yet you have to drill down at each of the 20 stocks to see what the odds are. You don't want to buy into stocks that are overvalued, otherwise the odds of getting only 1% are greater.

"So you have to do the research as if you were buying the shares. But you're not investing in the 20 companies. We're betting on it.

"I wouldn't say that it's complex. But it's overly detailed.

"You have to track this basket, which is a lot more work than tracking the S&P or the Russell 2000.

"You have to have 70% of the stocks either flat or up to get the higher coupon. From my perspective, it's a good bet. You have a pretty good chance of winning.

"But it's a bet. It's like putting a chip down on a basket of 20 stocks to get either 1% or 6%.

"I see this more like gambling than investing. You're sitting down at the table, gambling on red or black."

Insufficient upside

Balcom said the risk-reward of the notes is not attractive enough to lure him away from fixed-income securities paying less but offering a guaranteed coupon.

"The 10-year Treasury yield is ... 2.57%. If there is a pullback in the market, this note will only give you 1%. There's not much yield in there," he said.

Because the notes are designed for income but linked to equity, clients may have the wrong expectations, he added.

"With those two types of coupons, you increase the odds of making the client unhappy," he said.

"If 13 stocks are up in the basket and clients only get 1%, they are not going to like it. They will say, 'I could have bought Treasuries.' So it's definitely not for equity replacement unless you are bearish.

"Now imagine that the market is up 20% and that 14 of the stocks are up. You get the best coupon, you get 6%. But your clients, seeing how much they underperform the market, are not going to be happy either.

"I'm not really sure what someone would be trying to accomplish in buying that. It's complicated. Too many things can go wrong."

Two coupons versus one

McCoy also said that the upside is not enough to compel investors to abandon a plain-vanilla interest-bearing bond.

"I'm not sure what function this product serves in a portfolio," he said.

"If you're looking for income, the upside is 6%, the downside is 1%.

"I can get 2.6% guaranteed.

"While it's not such a high barrier to achieve to get the 6%, you still have to have at least 70% of your holding that are not down in price."

When mentioning the 2.6% yield, McCoy referred to the 10-year Treasury.

Balcom offered an example in which the basket performs best half of the time.

"It's unlikely that 14 stocks will be up year after year for six years. So take a hypothetical 50/50 scenario, which is a reasonably optimistic expectation. For three years you get the high coupon of 6%. The rest of the time, it's only 1%. This gives you on average a 3.5% yield," he said.

"If you had invested in Treasuries instead, you would have received 2.6%.

"What you get from the notes is not even one point over Treasuries. Between the 2.6% guaranteed coupon and a 3.5% potential coupon, which one do you want to take? I'd rather have the 2.6% Treasury or the HSBC paper."

The six-year HSBC corporate bond offers a 2.6% yield to maturity.

Focusing on the worst-case scenario, McCoy had a similar approach: "If you compare it with a guaranteed coupon, the 2.6% HSBC paper for instance, you can say that 2.6% is not 6%. But it's better than 1%. Here, the most you're guaranteed is 1%."

Alternatives

Alternatives to this payout would be either the same structure but with a higher maximum coupon or other income strategies, those advisers said.

"If the investor is reaching for yield and takes that type of exposure, they should get a juicier coupon," Balcom said.

"Here, the best you can get is 6%. Make it 10% because if the stocks pull back, your clients are not going to be impressed with 1% and that's your risk."

Investors could also look at other instruments.

"There are so many other ways to get income," Balcom added.

"You can do a 3% bond fund or a 2.6% 10-year Treasury. Why play these games? If your purpose is to get income, there are better ways to spend your money and your time."

McCoy suggested annuities as an alternative.

"I think you can find a product with a better upside and not too much more risk. Here, you're capped at 6%," he said.

"Maybe you can get better upside with other products in taking a little bit more risk, for instance an equity-indexed annuity.

"I would easily get rid of the 1% minimum in order to get a much higher upside."

The payout at maturity will be par plus the final coupon.

BofA Merrill Lynch is the agent.

The notes will price and settle in June.

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