HSBC’s 6.5%-7.5% autocallable yield notes linked to Schlumberger designed for pure income play

By Emma Trincal

New York, Aug. 8 – HSBC USA Inc.’s 6.5% to 7.5% autocallable yield notes due Aug. 13, 2015 linked to the common stock of Schlumberger Ltd. offer investors a guaranteed coupon, but principal is at risk and the autocallable feature may trigger early redemption, said Tim Mortimer, managing director at Future Value Consultants.

Interest is payable monthly. The exact rate will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par if the stock closes at or above its initial level on any quarterly call date beginning Feb. 13, 2015.

A trigger event will occur if the shares close below the 80% trigger level on any day during the life of the notes.

The payout at maturity will be par unless a trigger event has occurred and the stock finishes below its initial level, in which case investors will be exposed to the stock’s decline.

Not a phoenix

This type of product fits into the category of “review reverse convertible” products, according to Future Value Consultants’ terminology.

These notes offer a fixed coupon, but the maturity is variable because the notes can be terminated early if the call is triggered, he said.

“This is a hybrid product between an autocallable and a reverse convertible,” he said.

“You get the 7% coupon paid monthly, and there is an autocallable feature if the price is above its starting level on a quarterly basis.”

The notes also differ from another type of autocallable called “trigger phoenix autocallable,” he noted.

The “phoenix” type, he explained, adds another level of uncertainty: the coupon is contingent upon the price closing above a coupon barrier, which is usually distinct from the call trigger. With those products, the payment of the coupon does not necessarily mean that the notes are being called. In addition, investors may not receive any payment.

“The difference between this and the phoenix autocallable is that you’re definitely getting the income. With the phoenix structure, your coupon is not guaranteed. It is contingent upon the underlying price closing above a certain barrier level, usually below the initial price,” he said.

“With a reverse convertible note like this one, which offers a fixed interest rate, your return is usually lower than when you are being offered a coupon that may or may not get paid.”

Investors need to assess the value of a coupon not just based on its amount but also on the probability of receiving payment.

Fixed coupon

When a bank has to price a contingent coupon product, it will use the reverse convertible as a reference for pricing, he explained.

“First the bank will calculate for the investor the chances of being paid if the product is still alive at maturity. It will then take the coupon offered without condition in a plain reverse convertible trade like this one and divide its value by the probability. This formula will give the issuer an idea of how to price the contingent coupon,” he said.

He offered the following example: “Take a structure like this one, say the issuer offers a 7% fixed coupon and they put a pretty low barrier. You have a 50% chance of getting the coupon. In that case, they would offer double the coupon, or 14% on a contingency basis. If you have a 50% chance of getting paid 14%, that’s essentially the equivalent of having a 100% chance of getting paid 7%.

“If the outcome of getting your income is uncertain, the calculation of the coupon will be based on the likelihood of getting it. Since it’s never a certainty, the issuer is going to inflate the headline rate in a phoenix type of deal.

“This is why the 7% doesn’t seem like a lot, but that’s because you don’t have the risk associated with the contingency. Investors need to keep that in mind when comparing autocallables.

“The 7% coupon is still high compared to the risk-free rate. You’re actually getting a lot in excess of it.”

Income play

Compared to a traditional reverse convertible, which often tends to be shorter in duration, these notes do not offer a fixed duration since they are autocallables.

“It’s a hybrid because you have the fixed coupon but you also have the autocall,” he said.

“The length of the notes is unknown. It depends on whether the product is going to get called or not. But you know that you’ll get paid as long as the product is in force.”

Investors in the notes do not participate in any appreciation in the underlying stock. As such, the payout is designed for income investors.

“Someone buying this product would do it for the coupon. It’s definitely geared toward income-seeking investors,” he said.

“But those income investors would tend to be slightly more conservative than others who are willing to accept the contingent coupon for a higher yield. The potential buyers of this product want a fixed coupon without any conditions. In exchange, they are willing to put their principal at risk.”

The contingent protection is offered through an American barrier, which is a type of option observable any day during the life of the notes, as opposed to a European barrier, which would be observed only at maturity.

“This barrier type is slightly more risky. Having the fixed coupon of 7% could in theory add a little bit of a cushion against losses, but this is not going to be relevant on a one-year trade. The protection would be much more meaningful on a three-year,” he said.

Risk score

Future Value Consultants in its reports assesses risk, return and price using a variety of proprietary scores in order to compare a product with others.

The research firm measures risk with its riskmap, which scores the risk on a scale of zero to 10 with 10 as the highest level of risk possible. The riskmap is the sum of two risk components: market risk and credit risk.

The market riskmap of the notes is 2.76 versus an average score of 3.45 for products of the same type.

“The market risk is lower. Although the barrier is observed any day, the 80% level is quite good for a one-year. In addition, the volatility of the stock is not especially high at 25%,” he said.

The credit riskmap is 0.35, compared with 0.29 for the average in the category.

“The credit risk on a one-year is not significant. It’s slightly higher, but it’s only a marginal difference compared to the product type,” he said.

Return, price scores

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using the best market scenario from five assumptions: neutral assumption, bull and bear markets and high- and low-volatility.

The notes have a 6.22 return score. The average for the product type is 6.04.

Future Value Consultants also rates the value of a deal using its price score, which assesses the value on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The average price score for review reverse convertible products is 6.27. The notes show a slightly better result with a 6.48 score.

Mortimer said that return score and price score are intertwined and should be analyzed together.

“Compared to the average of the same product type, the return score and the price score are slightly ahead,” he noted.

“You’re not finding a whole lot of difference with the average because most of these products will have a similar construction, which is quite basic. There aren’t that many variables from one product to the other, not many moving pieces. It’s a pretty standard product type, so you would expect the value to be high and consistent between products, which it is.

“Pricing is better than average. Since it’s a simple structure, if you spend more money into it, it’s going to have a positive impact on both pricing and return. Both scores are slightly ahead of average. We could say it’s moderately good.”

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The product has an overall score of 6.35 versus 6.16 for the average of the same product type.

“The product does what it’s designed to do. It delivers a competitive yield. In exchange, principal is at risk and investors can lose their entire investment. You are not going to get a 7% return without taking on some risk,” he said.

“When one gets these types of coupons in today’s low-yield environment, one has to take some risk, and that’s what the product offers: an above-average interest rate, but it’s not risk free.”

HSBC Securities (USA) Inc. is the agent.

The notes were expected to price Friday and will settle Wednesday.

The Cusip number is 40433BKY3.

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