HSBC’s six-year autocallable step-up notes linked to S&P 500 seen as covered call alternative

By Emma Trincal

New York, Nov. 22 – HSBC USA Inc.’s autocallable market-linked step-up notes due November 2022 linked to the S&P 500 index offer investors a potential early redemption with a call premium, but the stated maturity remains too long, advisers said.

The notes will be called at an annual call premium of 4.5% to 5.5% if the index closes at or above its initial level on any of the five annual observation dates, according to an FWP filing with the Securities and Exchange Commission.

The exact call premium will be set at pricing.

If the index finishes above the step-up level – 135% of the initial level – the payout at maturity will be par of $10 plus the index gain.

If the index is unchanged or gains by up to the step-up level, the payout will be par plus the step-up payment of 35%.

Investors will receive par if the index declines by up to 30% and will lose 1% for each 1% decline beyond 30% if the index finishes below 70% of its initial level.

Term

“This is effectively a six-year covered call on the S&P 500,” said Kirk Chisholm, wealth manager and principal at Innovative Advisory Group.

“Six years is way too long to be considering that strategy.”

However, investors could be called as early as a year after issuance, and the observation for the call is established five years in a row, increasing the odds of a much shorter duration than six years, he noted.

“But that’s not necessarily a good thing. It caps you along the way. You can’t make more than 5% a year,” he said, assuming the final premium would be at mid-point between 4.5% and 5.5%.

“If you get called after one year, it’s some covered-call like trade that has removed the benefit of a covered call.

“The seller of a call gets to keep the premium and all of it on day one. But you don’t.”

Buffered, not winner

This was particularly an issue for him on the downside. If the underlying index closes down 20% at maturity, the decline is within the range of protection and investors in the notes get their money back but make no gain. The seller of a call would get to keep his entire premium.

“A premium offsets your decline. It’s down 20%, you have a 30% premium ... you make 10%. Anything above your breakeven you make money. The notes don’t do that. The buffer absorbs your losses, but there is no money left for you if the index is down,” he said.

Another disadvantage of the notes versus the option strategy is the lack of liquidity.

“There’s much less liquidity with the note. An exchange-listed option, particularly on the S&P, is liquid. You can always sell it,” he said.

Volatility

Jonathan Tiemann, president of Tiemann Investment Advisors, said the note is a short-volatility play.

“If the index moves up a little, you get a little gain but probably less gain than you would have had if the index was volatile and had gone up a lot,” he said.

“Until the very end, if you make it to maturity, you will always get at least the index.

“But what you’re giving up for this is the dividend, as always, [and] the liquidity, and you’re taking the credit risk. All these things are always the same.

“You’re selling a call on each of those observations, and if you get past all of them, you get a final reward. After the fifth date, if it hasn’t been called away from you, you’re golden basically, assuming the index is up. It’s as if you sold all these calls and they expired worthless, and you can pocket the premium.”

Low conviction

Tiemann said his main objection is the duration of the notes.

“I really don’t like the six-year tenor. But that’s just my personal preference,” he said.

The note is similar to a “series of call options” that may leave investors with a 5% return in one year.

“If the market has any big run up, you’re likely to be called away somewhere along the way.”

Investors buying the notes may be driven by a rationale that is not uncommon among investors, he said.

“You have to not like the market for the next six years, but you still don’t want to be out of it.

“It’s not a bad note. It’s just not for someone who is very bullish.”

BofA Merrill Lynch is the agent.

The notes will price in November and settle in December.

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