HSBC’s $2 million Stars linked to Russell 2000 offer aggressive call premium, no protection

By Emma Trincal

New York, Sept. 13 – HSBC USA Inc.’s $2 million 0% Strategic Accelerated Redemption Securities due Sept. 12, 2022 linked to the Russell 2000 index pay a high call premium for income-seeking investors, but if the notes are not called, investors will lose money at maturity, sources said.

The notes will be called at par of $10 plus a call premium of 9.35% per year if the index closes at or above its initial level on any annual review date, according to a 424B2 filing with the Securities and Exchange Commission.

If the notes are not called, investors will be exposed to the index’s decline.

“It’s a yield play, and it’s a pretty juicy yield,” said Tom Balcom, founder of 1650 Wealth Management.

The tenor may be six years, but investors have five annual opportunities to be called and to pocket a 9.35% return per annum, he said, which could shorten the duration.

“I don’t think any adviser or investor is going to be upset to be called with nearly 10% in annual return,” he said.

Catching up

The structure provides a cumulative call premium payment, according to the prospectus, which Balcom said is “a bonus” for investors.

For instance, if the autocall is triggered on the second annual observation date, investors will be entitled to two years’ worth of premium, or 18.7%, even though they missed the first payment date.

If the notes have not been called for five years, investors will receive a final return of 56.1% at maturity under the condition that the index level is not down.

Risk/return

Balcom said the notes are capped at the call premium amount, making the investment less suitable for an “overly bullish” investor.

But for mildly bullish and income investors, the product offers a “nice” risk/return given the size of the premium.

One of the main risks for investors, he said, is to never see the notes called automatically.

In this scenario, the index would be negative at maturity, with up to 100% of the principal at risk.

“But for this to happen, the Russell six years in a row would have to be negative on the observation date,” he said.

“There is a very low probability of this happening. Can it happen? Yes, but it’s unlikely.”

Another risk would be to see the index performing better than 9.35% per annum over the six-year term.

“But that’s a bull’s concern. If you’re a bull, you don’t buy these notes. This is for income,” he said.

Risks

The accumulation of payments is a risk-reducing factor, he stressed. If the notes were called, investors would receive full payment for the entire period preceding the call.

“Even if you haven’t been called three years in a row, if you get called on year four, it doesn’t matter. You get 37%,” he said,

“This limits your risk of sitting there with no payment for six years. You can cumulate previous missed coupons.”

The downside risk, however, should not be ignored since the product does not provide any buffer or barrier, he noted.

“Your risk is limited by the repeated opportunity to get called, but if it doesn’t happen, you can lose money,” he said.

“The only bad scenario would have to be a severe bear market, but it would have to be a long-lasting bear cycle.”

Slippery slope

Steven Jon Kaplan, founder and portfolio manager of TrueContrarian Investments, argued that the bear market scenario is not far-stretched.

“The big risk is the actual valuation of the Russell 2000,” he said.

The index hit an all-time high in June of last year but has not shown new highs since, he noted.

“This happens typically when a bear market begins.

“You can certainly imagine the possibility of a big drop in 2018 or 2019. The index starts to come back, but it doesn’t make it all the way back when you get to maturity.”

In this situation, which would be based on the assumption that the index never closes at or above its initial price on any of the six observation dates, investors would lose money at maturity and would not have collected any premium.

Kaplan said this scenario is possible depending on the timing and intensity of the bear market, which he said is showing “dangerous signs” of happening.

Big drop, no gains

“We were at a high last year. We haven’t gone anywhere since. We have a lot to go down. The Russell could drop 60% from now. It can happen if you look at prices from top to bottom,” he said.

“You can have six years in a row, if the index drops that much you’re not going to get back.”

Kaplan said investors are at risk of losing some of their capital. They could in that case miss all payments.

“This investment is not just risky. It could also be a waste if you never get called because it means you won’t get any premium for six years.”

Kaplan instead recommended buying “very boring” fixed-income instruments, which pay less income but are predictable.

Specifically, he said he would choose Treasury products designed to hedge against inflation, such as Treasury Inflation-Protected Securities and I Bonds.

BofA Merrill Lynch was the agent.

The notes (Cusip: 40435B841) priced in Sept. 2.

The fee was 2%.

© 2015 Prospect News.
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