HSBC's knock-out buffer notes tied to Euro Stoxx trade longer tenor for more appealing terms

By Emma Trincal

New York, Oct. 17 - In order to provide better terms, issuers are increasingly bringing to market longer-dated products, sources said, noting that HSBC USA Inc.'s 0% knock-out buffer notes due Oct. 23, 2018 linked to the Euro Stoxx 50 index were a case in point.

"We've seen recently products with extended durations and no caps. I guess issuers can price a decent downside protection with unlimited returns. It's a way to balance out the overall structure," said Steve Doucette, financial adviser at Proctor Financial.

The payout at maturity for the notes will be par plus 157% of any index gain. Investors will receive par if the index falls by up to 40% and will be fully exposed to the decline if it drops below the 60% trigger level, according to a 424B2 filing with the Securities and Exchange Commission.

"This is a very interesting offering from my perspective," said Matt Medeiros, president and chief executive of the Institute for Wealth Management.

"With the market somewhat stabilizing, issuers are more comfortable going longer term."

The five-year duration gives the notes the double advantage of providing a downside contingent protection of 40% while offering upside leveraged participation with no limitation, sources said.

"I absolutely like the fact that it has no cap," Medeiros said.

"We are seeing these no caps, but we are taking out duration, and you can only go so long. The five-year term is the only thing I would want to revisit," Doucette said.

Short and sweet

Doucette said that getting a note shorter than five years would involve either accepting less leverage or some sort of maximum return. Keeping the notes uncapped is his main focus, he said.

"It would be interesting to see what the impact would be on leverage. If you could get a shorter term, you might be able to still get some decent leverage," he said.

Getting a shorter-term product is also important in terms of pricing as investors may want to redeem early, he explained.

"We like to stay shorter because the closer to maturity, the more realistic the value is. Theoretically, the embedded option is easier to value when you're closer to maturity. If you're in the money, it's easy to price," he said.

"Anybody who is active in this market wants to know what the current value is in relation to a particular market scenario.

"I would really want to see if you maintain what the impact of a shorter duration would be on the leverage if you were to keep the uncapped return.

"For instance, if you were to shorten the notes from a five-year to a two-year note and still have no cap on the upside, would you get a leverage of 1.3 instead of 1.57? I would have to take a closer look."

For some investors, sacrificing the leverage may be the solution in order to keep the protection as well as the uncapped component while making the duration shorter. Doucette said this would not be the option for him.

"It wouldn't be worth getting the pure index. It wouldn't make sense unless all you want at that point is the protection. You would have to be slightly bearish for that," he said.

"Alternatively, you may be able to keep the five-year [term] and sneak out a little bit more leverage rather than shortening the term. You have to look at all the moving parts."

Good entry point

Other investors said that the longer term is not necessarily a negative, especially if the underlying asset class offers attractive valuations.

"The entry point for the European stock market is very attractive at this point relative to the term of this note. A five-year note in this asset class is appropriate in my opinion," Medeiros said.

"It appears to me that the buffer is rather generous. I see probably less risk in the Euro Stoxx market now than there was a year or so ago.

"Relative to where prices are today, hitting that buffer seems unlikely."

Medeiros said that growth in the euro zone will be "gradual," which is why a longer investment horizon would be appropriate.

"I'm optimistic for Europe over the next five years. I am not bullish today. Growth is going to be gradual. Trying to time the market in this asset class would be a challenge," he said.

"If you do some back testing, if you look at the probabilities over a five-year period with this asset class, the probability of being underwater with this type of buffer is unlikely, and it's even less likely based on what the prices are today."

Finally, a longer duration in some cases enables investors to reduce some of the risks associated with short-term trades, he noted.

"Coming up with products that are more short-term in duration can represent a behavioral challenge," he said.

"Investors when they go short-term start to think short-term; and the more short-term you're thinking, the more risk you are taking.

"If you make short-term decisions, you're relying on market-timing. You're not allowing the investment to go through the whole market cycle.

"This is why I'm comfortable with the five-year term here, especially for this asset class."

HSBC Securities (USA) Inc. is the underwriter with J.P. Morgan Securities LLC as placement agent.

The notes were expected to price Friday and settle Wednesday.

The Cusip number is 40432XML2.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.