HSBC, Morgan Stanley 10-year notes tied to S&P have eye-catching buffers but face objections

By Emma Trincal

New York, Dec. 5 - Issuers are readying longer-dated notes with uncapped and leveraged upside as well as eye-catching buffers or barriers in an effort to lure buy-and-hold conservative investors, but financial advisers said that the long holding period may be a deterrent.

Two issuers have announced plans to offer 10-year leveraged and uncapped notes with 50% downside protection. Both deals use the S&P 500 index as the underlying index, but the types of protection are different.

Two offerings

The first deal is HSBC USA Inc.'s 0% trigger performance securities due Dec. 29, 2023 linked to the S&P 500. The payout at maturity will be par of $10 plus 145% to 165% of any index gain, with the exact participation rate to be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

The downside protection of 50% is offered through a barrier: Investors will receive par if the index falls by up to 50% and will be fully exposed to losses if the index finishes below the 50% trigger level.

In the second example, Morgan Stanley will price 0% buffered Performance Leveraged Upside Securities due Dec. 26, 2023 linked to the S&P 500.

The payout at maturity will be par of $10 plus 170% of any index gain, according to an FWP filing with the SEC.

This time, a 50% buffer is provided for the downside protection. However, investors can still lose 100% of their principal as any index decline beyond the buffer is multiplied by a downside factor of two. Investors will lose 2% for each 1% drop beyond 50%.

Too long

Steve Doucette, financial adviser at Proctor Financial, said the appealing downside protection would not be enough to entice him to invest for such a long period of time.

"It's amazing that they could tie [up] your money for 10 years. You're much better off buying the index," he said.

"After 10 years, if you're worried about the market being down 50%, why do you even buy a leveraged upside note? And it's not like you're getting a lot of leverage on the upside. Why give up leverage to get a protection?

"To me, this is a little weird. You have absolutely no view, or you're excessively pessimistic."

Doucette said that the Morgan Stanley notes offer a better downside protection via the 50% buffer than the HSBC product. For instance, a 60% drop in the index would cause investors in the buffered notes to lose 20% versus a 60% loss with the other product.

But what makes the Morgan Stanley product "better" in his view is simply the amount of upside leverage. It has a 1.7 times leverage factor instead of 1.45 times to 1.65 times for the HSBC product.

"It's a bit better because they have the higher leverage. But Morgan Stanley can do that because their credit is lower than HSBC," he said.

Tax treatment

"You're looking for a high protection level, you're adding a little bit of leverage, and you're going 10 years out," he said.

"That wouldn't be for us. We never go 10 years. We don't even do 100% downside protection because of the ordinary income tax treatment."

Even for principal-at-risk notes, the taxation can be a "gray area," he said.

Despite the potential for full loss of principal, the Internal Revenue Service may "recharacterize" long-term capital gains as ordinary income, according to the Morgan Stanley prospectus. In such case, investors would be "required to accrue into income original issue discount on the buffered PLUS every year at a 'comparable yield' determined at the time of issuance and recognize all income and gain in respect of the buffered PLUS as ordinary income," the prospectus said in its risk factors section.

Doucette said that tax consequences need to be evaluated cautiously given the uncertainty of the treatment reflected in the prospectus in general.

"It's not clear how they're going to tax your note. I would be surprised if they considered your gains as [an] interest payment, but if they did, if you ended up getting ordinary income, that would be another reason to stay away from these products," he said.

Credit risk

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said his main concern is credit risk.

Investors depend on the issuer's ability to repay principal and the payment at maturity after 10 years, according to the filings. In addition, changes in the ratings or credit spreads of the issuer can adversely impact the market value of the notes.

"I'm not much of a fan of the 10-year term. When you introduce the 10-year, you're really introducing new risk factors, especially credit risk. The longer the term, the greater the credit risk. Some issuers are more creditworthy than others, but a long duration is going to add more risk no matter what. So I wouldn't do 10-year on a note because of that.

"The only way I'd look at a 10-year would be if it was associated with an FDIC-type of insurance," he said, referring to certificates of deposit, which are insured by the Federal Deposit Insurance Corp.

The HSBC notes (Cusip: 40434B685) are expected to price Dec. 26 and settle Dec. 31. HSBC Securities (USA) Inc. is the underwriter with UBS Financial Services Inc. as agent.

The Morgan Stanley notes (Cusip: 61761JNB1) are set to price Dec. 20 and settle Dec. 26. Morgan Stanley & Co. LLC is the agent.

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