HSBC’s leveraged notes linked to S&P 500 Low Volatility are built for lower risk, analyst says

By Emma Trincal

New York, June 27 – HSBC USA Inc.’s 0% leveraged buffered uncapped market participation securities due June 26, 2019 linked to the PowerShares S&P 500 Low Volatility Portfolio exchange-traded fund offer two layers of safety: a large buffer and a less volatile underlying, said Tim Mortimer, managing director at Future Value Consultants.

The upside is slightly leveraged at a factor of 1.1 and uncapped.

The downside includes a 20% buffer. It’s only beyond the buffer that investors would lose money on a one-to-one basis.

“The 20% downside protection represents quite a wide buffer. You should expect to reduce the risk quite significantly on a five-year,” Mortimer said.

“The underlying fund by definition reduces the level of volatility, which will also have an impact on risk, or more specifically market risk.”

Cost

The fund tracks the S&P 500 Low Volatility Portfolio index. This index measures the performance of the 100 least-volatile stocks in the S&P 500 index.

Mortimer explained that when there is control of the volatility of an underlier, the cost of leverage is reduced because the call options are less expensive to buy. On the other hand, the lower premium on the options does not help the downside, which is built around the sale of a put.

“Your upside should be cheap, and you may wonder why they’re only giving you 110% in upside participation. Well, they had to pay for the buffer,” he said.

“Although the options are cheap, you don’t raise much premium by selling the put either. The way they were able to price a 20% buffer is by having investors give up dividends over a five-year stretch and taking on credit risk.

“HSBC has a high credit spread. You get the funding spread and the loss of dividends to pay for the buffer.”

Less risk

The notes showed a low level of risk as measured by riskmap, a Future Value Consultants score that measures risk on a scale of zero to 10 with 10 being the maximum risk level.

The riskmap is the sum of the market riskmap and the credit riskmap measured on the same scale.

The market riskmap for the product is 1.11, compared with a 2.72 average score for leveraged return products. The credit risk at 0.94 is higher than the 0.59 average.

The overall riskmap at 2.05 is significantly less than the 3.32 average, he noted.

“We have limited risk. It’s a combination of the buffer, a five-year term and the low volatility,” he said.

Longer-term products tend to be less risky because “the risk of the underlying is never linear,” he added.

The notes are slightly different from the majority of leveraged notes because of the unusual underlier, he noted.

“It’s an interesting index,” he said.

“In the U.K. we have something similar. FTSE launched an index made of some of its less-volatile stocks. It’s the same idea.

“It’s interesting to note that putting together an index made of the 100 less-volatile stocks of the S&P is not the same as putting together a fund with the lowest volatility, in which case you would take into account correlations, not just volatility.

“But the main result of using the S&P Low Volatility is to reduce risk, and it works in that the notes show a lot less market risk than their peers.”

The beta for the PowerShares S&P 500 Low Volatility Portfolio ETF is half that of the S&P 500 index, he said.

The three-year standard deviation of the fund is 9% versus 12% for the S&P.

While attractive for its reduced risk, the product disappoints in terms of pricing and return potential.

Disappointing risk-reward

The risk-adjusted return of any given note is assessed by Future Value Consultants’ 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, which would be the bullish one for this product.

The notes have a return score of 6.29, according to the research report. The average in this category of product is higher at 7.77.

“It’s a bit down. The reason is that with long-term uncapped structures like that, you run the model based on a bullish scenario. You would expect the bull assumption to provide the best returns. But this one is a low volatility, which dampens the return potential. That’s why you can’t expect a high return even under the most aggressive scenario. All those scores are based on a comparison with similar products, which will be tied to more volatile indexes, starting with the S&P,” he explained.

Dividends and leverage

The leverage factor of 1.1 is not very high, he noted.

“It would take a lot of index growth to offset what you’re not earning in dividends,” he said.

Assuming a dividend yield of 2%, investors give up 10% in dividends over the five-year term.

“You get 10% participation on the upside, but you lose 10% in dividends. The index would have to double for you to get your dividend back,” he said.

While the upside is uncapped, the weak leverage combined with a less volatile underlier does not make for an attractive upside potential.

“The true value of this structure is the buffer,” he said.

Price, overall scores

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 6.19 price score for the product lags the average at 7.56, according to the research report.

“The price score is not as high as average,” he said.

“Whenever you have a non-standard index, the options are not as liquid as on the S&P or the Euro Stoxx. You would expect the price score to be lower, which is what’s happening here.

“Why an issuer would go through the trouble of putting together a note that may not price as well as one on the S&P? Because they need to do something different for the investor.

“If you want to buy a note on the S&P, there are a lot of choices to choose from, there are many payouts, different types of structures. But ultimately it’s an S&P type of product, and investors will have a high concentration of the S&P in their portfolio.

“If you do something a bit different, you would expect to pay a little bit more.”

The overall score of the product is 6.24, compared with 7.66 for the average leveraged return note.

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

“Someone who wants a less-volatile underlying with the inclusion of that buffer would be quite risk averse. It would take a lot for a low-volatility index to drop by more than 20%,” he said.

“But if it falls 10%, 20%, you will be happy that you had the hard buffer.”

The notes (Cusip: 40433BDZ8) priced on June 23 for $517,000.

HSBC Securities (USA) Inc. was the agent.

The fee was 3.7%.

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