HSBC’s leveraged uncapped notes tied to S&P 500 show buffer/dividend trade off

By Emma Trincal

New York, June 20 – HSBC USA Inc.’s 0% leveraged buffered uncapped market participation securities due June 30, 2022 tied to the S&P 500 index offer a solid buffer and uncapped upside, but the longer tenor increases the opportunity cost associated with the non-payment of dividends, buysiders said.

The tradeoff may or may not be attractive depending on advisers’ perception of the market risk.

The payout at maturity will be par plus at least 110% of any index gain, according to a 424B2 filing with the Securities and Exchange Commission.

The exact upside participation rate will be set at pricing.

Investors will receive par if the index falls by up to 25% and will lose 1% for each 1% decline beyond 25%.

Credit, leverage

“That’s a great note,” said Jerry Verseput, president of Veripax Financial Management.

“It’s a five year. But we like long-term notes.

“I’m not worried about HSBC credit risk. They’re one of the top five credit-rated large global banks.”

Verseput said he always compares a structured note with the common equity alternative, which here would be the index fund.

“What’s the difference? Essentially I’m going to miss out on the dividend,” he said.

The S&P 500 index yields 1.87%.

“The leverage is kind of low, so it might not help me much offsetting that cost.”

Buffer

But rather than looking just at gains or upside opportunity costs, Verseput said he focuses more on the risk-adjusted return.

“For the first 25% drop in the index I don’t lose any money. That to me is worth giving up a little bit of dividends,” he said.

“This allows you to have some upside exposure if the index goes up with a real tangible downside protection.”

For Verseput, the 25% buffer could become useful based on backtesting.

“I don’t have the data on the S&P. But I know that for the Russell 2000, the worst five year rolling return was a negative 43%,” he said.

Not really illiquid

Verseput likes to extend maturities in order to offer his clients better terms. When a note has a successful track record he may even sell it on the secondary market. For this reason, he does not believe that a note maturing in five years will necessarily be held during that entire period of time.

This approach allows him to feel comfortable extending the term sometimes even further.

Six year even better

“I would get a big boost on that note by going from five year to six years in terms of leverage or downside protection,” he said.

“Just statistically, if you give them another year to hedge, that reduces the risk. I’ve seen that break between five and six year and it’s pretty substantial.

“Unfortunately I’ve found that clients are more comfortable with five year than six year. That’s just an emotional thing. People like simple or round numbers.”

Later, if the notes were to perform well due to the appreciation of the underlying index, Verseput would consider selling them.

“If the market is up 5% now this note has a 30% buffer. You would expect to pay more,” he said.

The reverse of course is also true: a 10% decline in the market down the road would virtually lower the size of the buffer and therefore reduce the value of the notes as well, he explained.

Some good points

Steve Foldes, vice-chairman at Evensky & Katz / Foldes Financial Wealth Management, had a different point of view in part because he avoids long tenors but also because he thought the product did not add any value.

“It’s a bad tradeoff,” he said.

But he first began by stressing a couple of positive points.

“A leveraged note with no cap is always good. We like that,” he said.

“And secondly, we have no problem with HSBC credit. In fact, it is superior to American banks at this time with respect to CDS spreads.”

HSBC’s five-year credit default swaps (CDS) rates are 40 basis points, according to Markit. In comparison, all large U.S. banks see their spreads ranging from the 50’s to the 70’s bps. Goldman Sachs for instance has spreads of 70 bps. The tightest spreads are seen with Wells Fargo at 43 bps.

Expensive protection

Aside from those positive aspects of the product, Foldes said he would not buy the notes.

The first reason was the five-year term. “It’s too long for us. It’s a non-starter,” he said.

The second reason was “paying dearly” for the protection.

“We don’t believe you need a 25% buffer on the S&P on a five year. Five year is a long time. It’s unlikely that you would see over that period of time the S&P down 25%,” he said.

“There is protection but it is almost illusory because of the very unlikely event that a large index like the S&P would be down so significantly.”

No dividends

So while the size of the buffer may appear attractive for investors “with a very negative view” on the market, to Foldes, the feature was just a cost that limited the value of the other terms in the product.

“Twenty five percent is a big buffer and that big buffer is expensive,” he said.

For investors, one serious negative impact was to forgo dividends over that relatively long timeframe.

“You’re paying too much for this note because you’re not getting approximately 10% in dividends on a compounded basis,” he said.

“That’s a lot to give up and the leverage doesn’t really make up for it.”

The break-even at which the positive effect of the leverage would offset the cost of losing the dividend would depend on the index performance.

“You would need the S&P to go up pretty significantly to be able to recoup,” he said.

Do it again

If Foldes was to “reconstruct” the product and negotiate the terms with the issuer he would ask for a shorter term, a higher leverage factor and a much smaller buffer.

“I know that issuers on the desk are struggling with record low levels of volatility. To sweeten things up they give you a buffer, which I call illusory because it’s unlikely to be helpful. This option is probably very cheap on a five year. But for the investor it’s not so exciting,” he said.

HSBC Securities (USA) Inc. is the agent.

The notes will price on Friday.

The Cusip number is 40433U6W1.

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