HSBC’s trigger gears tied to S&P 500 show trade off of long tenor versus deep protection

By Emma Trincal

New York, Dec. 16 – HSBC USA Inc.’s 0% trigger gears due Dec. 31, 2026 linked to the S&P 500 index, offer deeply protected exposure to the U.S. markets without sacrificing the upside, said Tim Mortimer, managing director at Future Value Consultants. In exchange, investors are locked in to a 10-year investment.

The payout at maturity will be par of $10 plus 1.45 to 1.65 times any index gain, with the exact upside leverage to be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 50% and will be fully exposed to any losses if the index finishes below the 50% trigger level.

“It’s a 10-year, a very long time for U.S. products,” he said.

“At the same time, the S&P 500 is at all-time highs. By pricing the notes over a longer period of time, you can offer a more attractive structure.

“Rates are low. Extending the maturity improves product terms.”

He mentioned the “healthy” participation of 150%, the uncapped upside and the “deep” barrier as compelling terms.

Barrier and cost

“The S&P would have to be less than half its value in 10 years before you can lose money on this note,” he said.

The chances of hitting the barrier threshold over that long time period are low on a statistical basis, he noted.

A higher barrier of 70% may have cost much less without adding too much risk over that 10-year term.

“Perhaps you’re spending too much on the protection based on historical returns. But if investors want adequate protection, telling them they won’t lose money unless the underlying is down by half is likely to resonate with them, at least more than if you were to tell them they have up to 30%,” he said.

“Retail products are always based on a tradeoff between the asset class’ expected return and what investors want to rely on in terms of protection.

“With this 50% barrier you’re not fully capital protected, but the chances of breaking the barrier are slim.”

Tradeoff

Long maturities however can erode returns.

“When you do a 10-year, you’re looking at losing a significant amount of dividends compared to holding it in ETFs. You’re also not getting paid any interest. It’s something to keep in mind. In exchange though, you get a nice deep barrier and a reasonable participation.”

Scoring products

Future Value Consultants in its research assesses risk, return and price using a variety of proprietary scores in order to compare a product with others.

Future Value Consultants rates the risk with its riskmap, which scales the risk from zero to 10 with 10 the highest level of risk possible. This rating is the sum of two riskmap components – market risk and credit risk, both calculated on the same scale.

Market risk

The HSBC notes have a 2.67 market riskmap versus an average of 1.59 for the same product type, according to Future Value Consultants’ research report. The product type is leveraged return.

The high market riskmap may surprise. On an historical basis, the chances of the S&P 500 breaking the 50% strike in 10-years are small. But Mortimer said one had to look at the risk from a different angle.

“From a pricing perspective there will be [more] time to breach the barrier in 10 years than in six months,” he said.

In that sense, the firm’s model prices time as an additional market risk factor.

Nevertheless, investors were likely to be attracted to the notes for the protection.

“People don’t always do what’s the most logical, rational. A 50% barrier on a 10-year note may end up costing you more. It is expensive. But if it was not there, you would have too many angry investors. Clearly it was designed to provide peace of mind,” he said.

On the credit risk side, the long maturity undoubtedly elevates the credit riskmap to 1.08, compared to the 0.37 average for same products, the report showed.

Investors are subject to more credit risk when the exposure lasts longer.

Adding the two risk components gives a 3.75 riskmap, which is more than the average of 1.96 for similar products.

Return score

Future Value Consultants measures the risk-adjusted return of each product with its return score. It uses the same zero to 10 scale.

The return score is 9.35 versus an average of 7.42 for similar products and 6.68 for all products.

“It’s quite high. It’s quite bullish. You don’t have a cap and the long investment horizon increases the potential return,” he said.

Value

The value of a product is determined by Future Value Consultants’ price score. A higher price score means more value.

The rating takes into account the fees on an annualized basis. As a result, longer maturities should compress the price score as there is more time to spread the cost over the life of the notes.

Despite this time advantage the price score of 6.73 was disappointing compared to the average of 8.80 for leveraged return notes.

“The price score is a little bit down,” he said.

“It’s because the 10-year index is less liquid than shorter terms so the volatility in the option pricing will get a little bit more expensive. You’re running into the issue of less liquidity.”

Overview

Future Value Consultants rates the overall value of each product with its overall score. This metrics is the sum of the price score and return score.

The notes have an overall score of 8.04, which is higher than the average for all products of 7.02 and comparable to the same product type overall score of 8.11.

“The price score is low but you have this really good return score with the long-term potential,” he said.

“It’s a fairly good product.

You’re investing long term. You have a long-term hedge against the downside. You’ve got good prospects on the upside. No cap. The protection gives you 50%.

“Ten year notes like this one are rather unusual in the U.S. This one certainly offers good terms if you’re willing to hold your investment for a long period of time.”

UBS Financial Services Inc. and HSBC Securities (USA) Inc. are the underwriters.

The notes will price on Dec. 27 and settle on Dec. 30.

The Cusip number is 40435B171.

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