HSBC’s $1 million buffered uncapped notes with lock-in floor on S&P may be a game-changer

By Emma Trincal

New York, Oct. 17 – How to combine full downside-protection, absolute return, uncapped participation, tax efficiency and high water mark payouts in one structure? Ask HSBC.

Amid last Thursday’s selloff, the issuer priced a deal, which may appeal to other firms.

Very novel, the structure brings buffers to a new dynamic by knocking them out and upping the protection to 100%. The structure however is relatively complex.

“It’s been a work in progress for a good couple of years,” said a market participant familiar with the deal.

“The main concept is to find a way to outperform through different market cycles.”

HSBC USA Inc. priced $1 million of 0% Buffered Uncapped Market Participation Securities with lock-in floor due Jan. 16, 2024 linked to the S&P 500 index, according to a 424B2 filed with the Securities and Exchange Commission.

Lock-in or not

The payout varies depending on whether a “lock-in” event happens or not.

The lock-in occurs when the index measured from its initial level increases by at least the lock-in floor, which is 15%, on any of the five annual observation dates.

If there is no lock-in, investors get one-to-one upside with no cap and a 15% geared buffer on the downside, or a loss of 1.1765% for each 1% below the 15% buffer level.

Things get better and at the same time more complicated when the lock-in event occurs.

The first thing the lock-in does when it occurs is to guarantee full protection on the downside, effectively “knocking out” the buffer.

The second thing is to offer the greater of the one-to-one index return or a step return.

The step return is the highest percentage change on any of the five annual observations rounded down to the nearest sum of 15% and a multiple of 10%, or steps of 15%, 25%, 35% etc.

Trailing stop

“My first comment is that it makes sense based on a simple observation. A lot of buffered notes have appreciated 60%, 70%. No one wants to see the market fall just to get a buffer,” the market participant said.

“The original idea was some kind of a trailing buffer, a buffer that would move up through time.

“When you’re up at some point so far away from the buffer, you want to play the upside. You want to lock in that level until maturity.”

The prospectus for the new notes illustrates his point using several examples of payouts under the lock-in event scenario.

First example: the index finishes up 41% and the highest gain on any annual observation date is 39%. The step return will be 15% plus 20%, or 35%, which is the nearest rounded down from 39%. Since the index performed better than the step return, investors will receive 41%.

Assuming the same 35% step return, a second example assumed that the S&P 500 fell 22% at the end of the term. In that example, investors would receive the 35% step return since it is higher than the underlying performance.

Navigating market cycles

The “lock-in” could be particularly useful in the event of a recession or a bear market because investors could still claim the lock-in gains.

The following hypothetical scenario illustrates the defensive trait of the structure in a down cycle.

Assuming a step return of 35% and a drop in the index at maturity of 30%, investors would be spared the 30% loss, gaining 35% and beating the market by 65 percentage points.

“The idea was to make a principal-protected note at a higher lock-in level. It’s better than having one of those buffers that shift higher as the underlying increases. It’s better because it knocks out the buffer,” the market participant said.

“Your entire principal now is guaranteed and you get at last the 15% lock-in level. You’re playing for more.”

Long-term gains

Some high-net worth investors however often complain about being subject to ordinary income taxes, a downside of the bond-like quality of zero-coupon notes.

The HSBC product overcomes this problem by offering investors long-term capital gains.

That’s because the principal-protection itself is not guaranteed. If a lock-in event does not occur, the “principal-at-risk” status of the product will be intact and with it, the capital gains tax treatment.

No high water

The notes under the lock-in scenario, also offer similarities with high water mark products, but here again the differences are notable.

High water mark products give investors the highest closing level of the index during the life of the notes.

But the high water mark also caps the upside.

“If the high water mark is 90% and the index finishes up 150%, you’re capped at the high water mark. Here you get 150%,” the market participant said.

On the other hand, the lock-in is observed only five times during the life of the notes, while observations for a high water mark deals of a comparable tenor may be as frequent as monthly, according to data compiled by Prospect News.

No twin-win

Another “sister” structure, if the lock-in event occurs, would be absolute return products, also known as “twin-win.”

That’s because in both cases, profits can be made if the market is down.

But the market participant pointed to an important difference: the barrier breach and the heavy losses it entails.

“With this note, you’re getting your principal back plus at least 15% across the board whether the index finishes up or down as long as you lock in once.”

Back testing

This begs the question of whether or not it is easy to “lock in.”

Since the 15% required increase is measured from the initial level, it should become easier as time goes on. But market cycles along with the length and depth of bear markets will determine the outcome.

The designers of the notes conducted back testing going back to 1957. The results showed a very high frequency of lock-in events.

Using rolling 63-month periods, which correspond to the 5.25-year tenor of the notes, the test revealed that the lock-in occurred 93% of the time. Within the 7% frequency showing the absence of any lock-in, losses at maturity only occurred 2.4% of the time.

“This is a note that starts as an equity product with downside risk but once you lock in, it knocks out the buffer and gives you full downside protection,” the market participant said.

“Your upside is not capped. The only requirement is to get the lock-in but the odds are in your favor statistically speaking.”

HSBC did a “small trade,” he added, predicting that other issuers will soon follow suit with larger sizes.

HSBC Securities (USA) Inc. is the agent.

The Cusip is 40435F5J2.

© 2015 Prospect News.
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