HSBC’s contingent income notes tied to Metals and Mining ETF seen as viable income alternative

By Emma Trincal

New York, May 26 – HSBC USA Inc.’s contingent income barrier notes due June 2022 linked to the SPDR S&P Metals and Mining exchange-traded fund offer yield-seeking investors a realistic income strategy as the structure offsets some of the risks associated with the highly volatile underlying fund, sources said.

The notes will pay a contingent quarterly payment at an annual rate of 7% if the fund closes at or above the 50% downside threshold level on a determination date for that quarter, according to an FWP filed with the Securities and Exchange Commission.

The payout at maturity will be par plus the contingent coupon unless the fund finishes below the 50% trigger level, in which case investors will be fully exposed to any losses.

Investors in the nots should be looking for income and believe the underlying fund will not drop significantly in price, according to the prospectus.

As long as the ETF price does not breach the 50% barrier level, investors will receive the coupon, which is 1.75% per quarter.

Homework required

“You have to do some research and look at the highs and lows to get an idea of the risk,” said Steve Doucette, financial adviser at Proctor Financial.

“I would do some fundamental research first. But you need to look at prices too.

“This is a volatile thing. We know there’s been a commodities slowdown.”

The fund tracks the performance of the metals and mining segments of the U.S. equity market as measured by the S&P Metals & Mining Select industry index. The ETF is listed on the NYSE Arca under the symbol “XME.”

The share price of the fund is down 68% over the past five years and has dropped 20% in the past 12 months. But prices have climbed 45% year to date.

Metals are here to stay

“It has dropped a lot. It tends to overshoot on the downside. But I can’t imagine metals and mining disappearing. All these things are in use every day from manufacturing facilities to medical equipment. How do you eliminate it?” he said.

“I could see more risk with energy. You can find alternatives to oil and gas that are going to be knocking the whole energy out. But not metals,” he said.

The fund’s volatility could be a concern however.

The SPDR S&P Metals and Mining ETF has a 42% implied volatility versus 10.63% for the S&P 500 index, according to iVolatility.com.

However both the fund’s current share price and the 50% barrier are “significantly” low, he said, making the risk-adjusted profile of the notes attractive despite the volatile underlying.

Safeguards

The barrier size increases the likelihood of collecting the 1.75% quarterly coupon. It also limits the risk of principal loss at maturity.

“If you overlay your fundamental analysis with technical analysis, it looks pretty good.

“It’s been down 70% in five years already. Your chances of collecting the coupon are pretty high.

“And six years from now, the odds of breaching the 50% barrier are slim.

“As a fixed-income alternative, it looks like a reasonable option.”

Income play

Matthew Bradbard, director of RCM Alternatives, a managed futures brokerage, said the notes offered income investors a better proposition than fixed-income instruments although he prefers allocating to commodities directly.

Investors in the notes are willing to lock in their money for six years to collect a 7% coupon, he explained.

They are not looking to participate in the upside.

“All they care about is not getting a 50% drop,” he said.

Correlations

From a technical standpoint, Bradbard said this reasoning made sense as the “entry point” today was at a historical low level since the financial crisis.

The fund peaked in June 2008 at 100 then hit a 25 low in February 2009. The next high was in April 2011 at 75. Today the share price is as low as 22.

“If I look at the prices of the metals themselves, it reflects the ETF. They’re pretty correlated. They move in the same direction. But the volatility levels are different,” he said.

“Interestingly XME is more volatile than gold and copper in terms of percentage moves. Silver is the exception on the upside. It appreciated more but didn’t fall as much as XME.”

Bond substitute

Bradbard said that as a commodity asset allocator, he prefers to trade the commodities themselves.

“As opposed to an agriculture basket, I’d rather trade wheat or cotton directly,” he said.

While his investment style differs from what a note holder would be looking for in the notes, he said the product made sense.

“A lot of people are looking for alternatives for fixed-income. That’s why we see private equity, crowdfunding getting a lot of traction. It’s not our business but people are doing it for the same reasons they would be doing this note.”

For investors satisfied with just earning the coupon, the notes offer a structure that limits the risk associated with the fast-moving fund, he added.

“The current price at 22 is not as good as January when it was trading at 14. But it’s pretty low compared to the high of June 2008.

“We’re close to the bottom rather than the top.

“This XME has seen pretty significant depreciation already. To lose 50% from now, it would have to go to 11.

“I don’t know what needs to happen for this to go to 11. I don’t see it happening actually.”

Dollar rally priced in

Bradbard explained the strong rally in the ETF year to date as a result of the U.S. dollar. A trend reversal – or a long-lasting dollar rally – would represent a risk for investors in the HSBC product given the inverse relationship between commodity prices and the dollar, he said, adding that such risk was limited.

“XME soared this year due to the weak dollar. The dollar has strengthened in the past month but it’s still down on the year,” he said.

The inverse relationship continues to be evidenced by the recent dollar appreciation. Since the beginning of May, when the rise began, the fund price has dropped 12%.

Bradbard said he does not believe the trend will last.

“The Fed has already telegraphed that they’ll raise rates so the dollar rise is going to be contained, not huge. We’ll probably get one or two hikes this year. We’ll see a little bit of cooling in metals but not much. The Fed move is already priced in,” he said.

“The whole point is that we’re 80% lower than the peak.

“You’re buying low. If your goal is not to lose more than 50%, it seems like a good entry.”

Bradbard however was not convinced that the risk-reward of the notes was best.

“It’s a better income strategy than buying treasuries or CDs. But it’s not as good as looking at other alternative investments away from fixed-income,” he said.

“Managed futures offer a good portfolio diversification. You get non-correlated returns going long and short.”

While his investment style is risky, risk can be actively managed.

“I’m firing a manager way before they lose 50%,” he said.

HSBC Securities (USA) Inc. is the agent.

The notes will price in May and settle in June.

The Cusip number is 40433UPK6.

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