HSBC’s autocallables tied to Russell 2000, S&P 500 allow for fixed rate with American barrier

By Emma Trincal

New York, May 5 – HSBC USA Inc.’s autocallable yield notes due Aug. 31, 2018 linked to the S&P 500 index and the Russell 2000 index feature some risky elements in the structure but those allow the issuer to offer fixed monthly coupon payments, said Suzi Hampson, structured products analyst at Future Value Consultants.

“The notes are not as risky as they appear to be,” she said.

The interest rate will be at least 6.25% per year, according to an FWP filing with the Securities and Exchange Commission.

After six months, the notes will be called at par if each index closes at or above its initial level on any quarterly call observation date.

The payout at maturity will be par unless either index closes below its trigger level, 70% of its initial level, on any day during the life of the notes and the return of the lesser-performing index is negative, in which case investors will lose 1% for every 1% that the lesser-performing index finishes below its initial level.

Any day

“A guaranteed coupon is something many investors want. But it’s hard to price. In order to do that you have to add some risky elements,” Hampson said.

She cited the worst-of, which is “common,” but more importantly the American barrier. That second piece is less often used, she noted.

A barrier or option is known to be “American” when it can be triggered (or exercised) prior to the maturity of the notes or before the expiration of the option contract. The barrier in these notes is American since it can be triggered anytime.

“Rather than just looking at the performance at maturity you take into account any trading day to see if either the S&P or the Russell has been below the barrier. If so, you will be looking at the worst performer at the end to determine how much principal you’re going to get back,” she said.

As long as the barrier is never breached investors will get the 6.25% annual coupon, which is 8% over 15 months.

But investors will be more likely to be called on any of the three call dates following the initial six-month non-callable period, she said.

Maturity scenarios

Future Value Consultants produces stress-test reports on structured notes with several sections.

One of the most comprehensive sections is the scorecard: a Monte Carlo simulation based on different mutually exclusive outcomes of product performance. For this product, the notes are either called or they reach maturity. A simulation is run for each of the call points describing the probability of occurrence and the average payoff for each.

Under the assumption that the notes reach maturity, Hampson described the three possible outcomes.

In the first and best one, “full capital return,” investors receive par plus the entire coupon payment.

“This happens when the 70% barrier was never breached or if it was, both indexes end up above their initial level,” she explained.

The probability for this outcome is 17.23%. The average payoff is par plus the total amount of payable coupon over 15 months or 107.8%.

The second outcome called “capital loss but total return above capital,” would be extremely unlikely and only applies to income products.

“That’s when investors should have lost some principal but won’t. They’ve got the entire 8% coupon, which will offset the losses,” she explained.

This outcome will occur when the barrier is breached at some point and the worst index finishes down but not by more than 8%, she said.

“You have to first not get called, and then you have to breach and finally the worst index has to finish between 92% and 100%,” she said.

“Needless to say the odds for such outcome are small.”

The table shows a 0.52% probability.

Negative outcome

The third and worst scenario named “total return loss,” is the one in which investors will lose some principal. Its probability is 14.40% or slightly lower than the optimal outcome, according to the scorecard.

Hampson compared the risk profiles of American versus European barriers as she commented on this third scenario.

European barriers, unlike American, are observed at maturity. The chances of breaching, all things remaining equal, are lower. Most issuers use European barriers when structuring products.

“American barriers are not common. They’re more risky but give you more leeway in pricing,” she said.

While the increased risk is due to the greater chance of a breach given the frequency of observation points, the amount of losses may not be greater, she noted.

Loss recovery

The scorecard indeed indicates that the average loss in the total return loss scenario is 26.60%.

“Twenty six percent is close but distinct from 30%. If you had a 70% European barrier here you would know that you’re going to lose at least 30%,” she said.

That is because the European barrier can only be breached at maturity. When it happens, investors by definition lose at least 30% or more.

“Your average loss here is similar but lower. Your chances of big losses are still there. But because the barrier can be triggered any day, your loss is going to be less than 30%.”

She explained why.

“Your average is skewed by the small losses which happen when the index breaches the barrier but recovers some but not to the initial level,” she said.

Call most likely

Investors will hold the notes until maturity about a third of the time, or 32.15% of the time. The figure is simply the sum of all the probabilities associated with the three outcomes previously reviewed.

In contrast noteholders have a 67.85% chance of being called, with a greater chance (48%) to be called on the first call date, after six months, according to the scorecard.

“This note gives you a pretty reasonable chance of calling,” she said.

“Although on the face of it it looks quite risky – you have the worst-of, the American barrier – there are elements in the structure, for instance the high correlation between the indexes and the high chances of calling, which somewhat reduce the risk.”

“The structure is quite common, but they added the less common American barrier as well as the worst-of so that they could price the fixed rate. Overall it works out in a way that doesn’t add a huge amount of risk,” she said.

HSBC Securities (USA) Inc. is the underwriter.

The notes will price on May 25.

The Cusip number is 40433U4P8.

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