HSBC’s dual directional notes on S&P 500, Russell 2000 reduce absolute gains, boost protection

By Emma Trincal

New York, Jan. 12 – HSBC USA Inc.’s price 0% dual directional barrier notes due Jan. 22, 2019 linked to the worse performing of the S&P 500 index and the Russell 2000 index represent one of the most recent examples of a trendy way to structure absolute return notes with more protection, sources said.

Payout at maturity will be par plus 110% of any gain by the lesser performing index, up to a maximum return of 40%, according to an FWP filed with the Securities and Exchange Commission.

Investors will receive par plus 0.5 times the absolute value of the lesser performing index’s return if the worst index falls by up to 40%. If either of the indexes finish below 60% of their initial levels, investors will be exposed to the decline of the least performing index.

The 0.5 factor

What is relatively new is the idea of offering investors 50% of the absolute value of the underlier’s price decline rather than 100%, said Tom Balcom, founder of 1650 Wealth Management. He added that he recently “did” a similar deal as a reverse inquiry for his clients. BNP Paribas won the bid and issued the notes (Cusip: 05579TKV7), pricing the deal on Friday. It was a three-year product linked to the S&P 500 index. As with the HSBC structure, the downside participation in the absolute return was also 50%. The upside was two-times leveraged up to a 42.5% cap. The contingent protection was 20%.

A trend

“In our case we wanted more leverage. The HSBC deal is more defensive,” he said.

“Whether people use the 50% downside participation to increase the upside or lower the barrier depends on the market. Right now, in this type of environment, a lot of people want more protection.”

As previously reported, BNP Paribas announced last week the pricing of a very similar structure also based on the 50% participation in the absolute return. It was a four-year uncapped note with a one-to-one upside exposure to the S&P 500 index. The downside barrier was quoted in a range giving an approximate average of 40% protection.

“Reducing the downside participation in those dual directional notes can do a lot for investors. In our case we wanted more upside. It’s nice to have it and at the same time, to be able to monetize a loss. Telling your client the market is down 20% but you’re up 10% is nice. We like the idea,” he said.

The “idea” is getting traction as the market is becoming increasingly volatile, he predicted.

“We’ll see more of that,” he said.

“The HSBC is very similar. Everyone copies each other if it’s a good idea. These are registered notes most of the time. It’s easy to see what other people are doing.”

Worst of

Some of the terms of the HSBC structure were unique, however, he said, pointing to the 60% barrier and the worst-of payout.

“This one has a 40% downside protection. It’s a very solid barrier,” he said.

“It’s a worst-of, so the odds of breaching the barrier are greater.

“But the S&P 500 and the Russell are highly correlated, which is good.”

The size of the contingent protection lessened the additional risk carried by the worst-of, he said.

“It’s a lot of protection. If we breach this in three years we’ll have worse problems to worry about.”

Best of

As long as the worst-performing index does not breach the barrier, the worst-of could actually better the terms, he said.

“In a way, it’s helpful in a down market. If the S&P is down 10% and the Russell is down 30%, you’ll get 15%. You get half the worst return, which means you’ll get more return in absolute terms. That could work to your advantage. In that way it’s a bearish note too.”

While the worst-of feature probably contributed the attractive barrier pricing, Balcom said he would have not used two underliers.

“Personally I’d rather do it on one index individually. It’s just much easier. If you have small-cap allocation, do a small-cap note; if you have large-cap, do a large-cap note,” he said.

“We like to keep it simple for our clients. I don’t like complicated.”

Prior to last week’s deal with BNP Paribas, Balcom said he bought similar structures (0.50% of a positive return for each 1% of the underlying decline over a barrier) first with BNP Paribas for the first time in October followed with Morgan Stanley in November.

Bear lurking

Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments, said that dual directional notes can be attractive in some cases. But the 40% contingent protection offered by HSBC on the basis of a worst of payout presented too much risk given the currently high market valuation.

“What concerns me is the level of protection and the term,” said Jon Kaplan.

“In 2019, the market could have rebounded. But we could still be pretty low. When you consider current market valuations and the high probability of a pullback, 40% is not really going to protect you. In the last two bear markets of 2000-02 and 2007-09, the market fell more than 40%.”

During the most recent financial crisis bear market the Russell 2000 index fell 60% and the S&P 500 index, dropped 57%, he noted.

Overpriced market

“The markets have done it twice in the last 16 years. There could be a third time and the next time could actually be worse. This bull market has been one of the longest one and we’re probably at a peak.

“A big drop would require a big bounce. We may not have enough time for that in three years.

“I wouldn’t want to take that risk. A 40% downside is not enough.

“If you had a five year it might be somewhat better although it wouldn’t be ideal either because we’re not starting off at a bargain.

“I would be more comfortable doing it a year after a significant bear market. In 2009 or even in 2010 or 2011, we were recovering but we were not totally up. Right now, the market is too rich.”

HSBC Securities (USA) Inc. is the agent.

The notes (Cusip: 40433UGG5) will price on Friday and settle on Jan. 21.

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