HSBC’s autocallables linked to ETFs have high contingent coupon, present variety of risks

By Emma Trincal

New York, Aug. 6 – HSBC USA Inc.’s autocallable contingent income barrier notes due Aug. 14, 2026 linked to the least performing of the iShares MSCI EAFE exchange-traded fund, the iShares FTSE China Large-Cap exchange-traded fund and the S&P Midcap 400 ETF trust offer an attractive potential return, but the risks are many and perhaps hard to model, financial advisers said.

This is partly due to a long tenor, three underlying ETFs and an automatic call that may kick in 25 times during the life of the notes.

The notes will pay a contingent quarterly coupon at an annual rate of 9% if each ETF closes at or above its 70% coupon barrier on the observation date for that quarter, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par plus the contingent coupon if each ETF closes at or above its initial share price on any quarterly call observation date after one year.

The payout at maturity will be par unless any ETF finishes below its 70% trigger level, in which case investors will be fully exposed to the losses of the worst-performing ETF.

Market risk

The barrier at maturity means that in theory, investors could lose up to their entire investment. But market risk was not a real concern, according to financial advisers.

“Seven years greatly reduces the odds of losing money at the end,” said Tom Balcom, founder of 1650 Wealth Management.

“There is plenty of time in seven years for the market to crash and recover, especially with a 70% barrier.”

Donald McCoy, financial adviser at Planners Financial Services, held a similar view based on historical performance and probabilities.

“Over seven-year rolling periods, the probabilities are fairly low that any of these three indexes would be down more than 30%,” he said.

Holding period

More of a drawback was the uncertainty over the length of the investment and the possibility of holding the notes over a long period of time.

“The credit risk is not a big deal for me, even for seven years. HSBC credit is good. It’s the lack of liquidity for that long holding period that I find unappealing,” said Balcom.

“Seven years is a long duration. It’s longer than what most people want to hold a note for.”

Investors do not know if their exposure to the market will be for a short or long period of time, unlike most autocalls, which are usually shorter than three years.

“Sure, it’s callable, and I’m sure that’s how it’s sold by advisers – as something that’s going to be called much sooner. Still, you don’t know if or when you’re going to get called,” Balcom said.

High return

However, for investors who do not mind longer-dated notes and who expect flat returns, the contingent coupon of the note was the best part of the deal.

“What’s appealing is the yield,” Balcom said.

“When the 10-year Treasury yields 1.75%, being able to get 9% on a seven-year note is attractive. Of course it’s more risk. But you’re getting paid for it.

“I still wouldn’t buy it because it’s too long for us. But other than that, 9% is a juicy return.”

Entry point

Monday’s market sell-off could make the notes even more attractive for bargain hunters, he said.

Stocks plunged on Monday amid an escalation in the U.S./China trade war, pushing the Dow Jones industrial average down 767 points. With the deal pricing this Friday, investors may get access to favorable prices, he said.

The prospectus was filed with the SEC on July 30. Four trading days later, the iShares FTSE China Large-Cap ETF dropped 8.1%, the S&P Midcap 400 ETF trust fell by 6.3% and the iShares MSCI EAFE ETF was 4.3% lower.

Coupon risk

One aspect of the deal to consider is the fact that the coupon is contingent upon the return of the worst of three assets.

“Basically you run the risk of not getting paid,” said McCoy.

The risk is increased by the low correlation between the three funds and the fact that all three need to be above the coupon barrier level in order for investors to receive their coupon.

McCoy said he would pay attention to the iShares FTSE China Large-Cap ETF first.

“Worst-case scenario, the Chinese index drops 50% on the first quarter and you don’t get paid. You may not get paid for a while. I’m focusing on the Chinese ETF because it is the most volatile of the three. It could show returns that can be very negative,” he said.

Call risk

But the more probable scenario remained an automatic call as early as a year. While many autocall buyers welcome the early redemption, others may view it as a negative outcome.

“The most likely event is you get cashed out right on the first call date,” said McCoy.

“All of a sudden the U.S. and China agree to reduce their rhetoric. All three indexes take off. You get paid. You’re done,” he said.

The noteholders would get 9%, but they may be missing a strong rally.

“That’s just the upside risk. But you also have to decide what you’re going to do with the money,” he added, pointing to the reinvestment risk.

The prospectus defined it as when investors following a call would not be able to reinvest the proceeds at a comparable return for a similar level of risk.

“You have to have a plan B when you buy this type of note.”

HSBC Securities (USA) Inc. is the agent.

The notes will price Friday.

The Cusip number is 40435UUU6.

© 2015 Prospect News.
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