HSBC’s autocallable notes linked to indexes offer interest-rate-risk mitigation, equity hedge

By Emma Trincal

New York, Sept. 18 – HSBC USA Inc.’s 0% autocallable notes due Sept. 28, 2017 linked to equal weights of the S&P 500 index and the iShares MSCI Emerging Markets exchange-traded fund may be used in a fixed-income bucket or equity portion of a portfolio, depending on what an adviser is trying to hedge, according to two buysiders.

The notes will be called at par plus the 7% annualized call premium if the basket closes at or above its initial level on any annual call observation date beginning on Sept. 25, 2015, according to an FWP filing with the Securities and Exchange Commission.

If the notes are not called and the basket finishes at or above its 90% buffer level, the payout at maturity will be par. Investors will be exposed to any losses beyond the buffer.

Fixed-income replacement

Steve Doucette, financial adviser at Proctor Financial, said he often uses autocallable notes as an income substitute.

Investors in the notes are not immune from equity market risk, and the coupon is not guaranteed. But the main advantage for a fixed-income portfolio is that they “eliminate” interest-rate risk, he said.

“I like this one as an income substitute,” he said.

“The probability that you might get called in the next three years is pretty good. You still have the cumulative coupon going out into three years, so if you miss year one, you can catch up and get 14% on the second call date [or] 21% at maturity. Nobody is going to complain about a 7% a year return even though the market has delivered more than that lately. And if your timing is bad, you have a 10% protection at the end, at maturity.”

Doucette said he is aware of the market correction risk when investing in those notes for income. However, several factors have to be taken into consideration as they offset some of the risk.

Interest-rate risk mitigation

“As an income substitute, it’s a little bit risky if the market takes a hit,” he said.

“It’s not a fixed-income instrument since you’re exposed to an equity basket. If it’s down, you would be long the basket less 10%.

“In 2008, we saw both the bond and the stock markets drop by more than 30%, but that was the financial crisis. You could still have a 10% to 30% correction in equity though.

“The nicest thing about the notes is that it’s not interest-rate-sensitive. Even though you have the 10% buffer, if the market is down 37%, you’re still down 27%. You have the basket exposure less the buffer, but you’re still long the basket, no way around it.

“So it’s a risk, but it’s a reasonable risk. You can get hit in a market decline, but you’re not exposed to interest-rate risk, which is important particularly when you’re hearing all the chatter about the Fed raising interest rates next year, which would push down bond prices as interest rates would increase.

“You’re eliminating the interest-rate risk. You’re still exposed to equity-market risk, but we don’t know when and how much of a correction we’ll have.

“What we know though is that when rates rise, bond prices go down and your principal in your bond portfolio is sure to take a hit. This eliminates that problem.”

Doucette said he has been using autocallables “for a while” as a way to hedge against interest-rate risk.

“We collect the coupon, we’re replacing some fixed-income portion of our portfolio, and we’re eliminating interest-rate risk. Most are structured with some sort of protection like this one with a buffer or with a low barrier,” he said.

Range-bound play

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said the notes fit in an equity bucket due to the exposure to the market. However, the limited return is acceptable in a market trading sideways, which he expects will be the case given the recent new highs in the U.S. stock market.

“It’s an interesting structure. I would have to do a lot more study on the indices to determine my position in the portfolio,” he said.

“While we’re optimistic on both indices, valuations on the S&P are getting to be a bit high. It’s conceivable to see a correction ahead of us, but I wouldn’t anticipate it to be more than 10%.

“There is a good probability that these notes will be called prior to maturity. You would have to see the market down on each of the call dates for three years [in order not to get called]. I don’t anticipate that. So it’s interesting.”

Investors may not expect more than 7% per year in return, which effectively caps the upside, he noted.

“But given the relatively high value of the market at this time, I don’t expect that we will have a return much higher than that. In addition, since the market has been hitting new highs, it’s nice to have the downside protection, especially delivered with a buffer. The structure of the notes works if the underlying trades in a range. I think it’s priced in the range of what we’re anticipating to see in the market,” he said.

“With these types of indices, you would expect to have a negative to flat return in a short period of time. I would not use this product as a bond replacement. I see it more like a bit of a hedge against a long-only position.”

The notes (Cusip: 40433BNS3) are expected to price Sept. 25 and settle Sept. 30.

HSBC Securities (USA) Inc. will be the agent.

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