HSBC's $2 million autocallable floaters linked to indexes offer high yield, worst-of payout

By Emma Trincal

New York, June 13 - HSBC USA Inc.'s recent autocallable yield notes linked to three indexes combined an autocallable feature with a floating rate. The attractive income-based product removed interest rate risk, but the trade-off was increased market downside risk, which, sources said, investors should carefully consider.

HSBC priced $2 million of autocallable yield notes due June 14, 2018 linked to the S&P 500 index, the Euro Stoxx 50 index and the Nikkei 225 index, according to a 424B2 filing with the Securities and Exchange Commission.

The notes pay an interest rate equal to Libor plus a spread of 475 basis points. Interest is payable quarterly.

The notes will be called at par if each underlying index closes at or above its initial level on any annual call observation date.

A trigger event occurs if any underlying index closes below its trigger level, 50% of its initial level, during the life of the notes.

If the notes are not called, the payout at maturity will be par unless a trigger event has occurred and the return of the least-performing index is negative, in which case investors will be fully exposed to any losses of the least-performing index.

Worst-of, worst scenario

Jim Delaney, portfolio manager at Market Strategies Management, said that the securities offered an attractive yield, especially in an environment characterized by low interest rates and the likelihood of higher rates coming up.

"The notes have to be evaluated on the coupon level, which is the return that you get. You're getting Libor plus 4.75%.

"That 4.75% spread is a tremendous yield in this environment, and on top of that, it's floating, which is very attractive since we know that rates are not going down.

"The happiest conclusion is to get called.

"The worst-case scenario is if you're not called and get exposed to the worst performer. That's why you must evaluate the risks."

The credit risk involved in holding the notes for five years was minimal, according to Delaney.

"HSBC is one of the largest institutions in the world," he said.

The most pressing risk was the occurrence of a trigger event, which could happen anytime and be caused by any and even only one of the three underlying indexes.

"You may not be called. You have to be ready for the trigger event to occur," he said.

"I think the 50% downside risk on the S&P is very limited. The risk on the Euro Stoxx is a little bit greater but not that much. A 50% downside is possible, but unlikely.

"The Nikkei is the wildcard. The Nikkei just closed [Thursday] 20% below its peak of last month. Today, Tokyo is in bear market territory.

"On the other hand, the Nikkei is already down 20% and the note has not been issued yet. So a 50% decline on the Japanese benchmark is also a low probability event. But it's still in the cards. It might not be a lot of cards, but it's still a possibility. It's just a very volatile index."

Tail risk

For any of the three indexes to drop by more than 50%, the world would have to go through another major crash, he said.

"I don't think we're going to get the kind of equity growth that we've seen over the past three or four years," he added.

"The growth in March 2009 was explosive because we were down in a hole.

"On the other hand, I don't think we're going to see that kind of downside move of 50% or more anytime soon.

"One factor that helps here is the five-year period. It reduces the odds of such a strong decline.

"I don't think any of the indexes are going to be down by more than 50%. You would need to get another 2008 for that to happen. In 2008, it was 60% down and it was almost the end of the world. I don't see this happening again within the next five years."

Once investors feel comfortable with the downside market risk, the yield offered may be appealing for investors looking for income.

"You're getting a yield that's likely to be over 5%. In this low-yield environment, it's probably not a bad return," he said.

As of now, the coupon, which is the spread plus Libor, would be 5.02%. Libor is 0.27%.

"If you're looking for an above-average yield, I don't think this is a bad play," he said.

Kirk Chisholm, principal and wealth manager of NUA Advisors, said that he was not comfortable with the structure and the terms of the security.

"It's not something I would want to explain to a client. It's way too complicated. And on top of that, I just don't like the risk return trade-off," he said.

Risk versus reward

"My biggest problem with the structure is that your entire upside is capped at the Libor plus 4.75% rate," Chisholm said.

"Meanwhile, you're totally exposed to the downside. You probably won't lose 100%, but if you had another 2008, you could be down a lot. Five years is way too long in this kind of environment. You have three underlying indexes, which is hard to model on a five-year term.

"I don't think these indexes would be down 50%. The one that's most likely to be the worst though would be the S&P 500 because the others are already starting from a lower point.

"Even if the probability of the trigger event to happen is low, I still don't like the risk reward on the table for this.

"If the trigger does happen, you have no protection against this tail risk. Things could be pretty bad. I wouldn't want to lose 50% or 60% of my capital while my return is capped at 5%."

Floating benefits

Another characteristic of the notes, its floating rate, is appealing for some but may actually generate additional risks, he explained.

"The floating rate is a plus only for those who believe that rates are going to rise," he said.

"I know that the sentiment on the Street is that rates are going to go much higher. I don't know if I agree.

"We've had 515 rate cuts since 2007 around the world. Everybody's keeping rates very, very low. They may go up at some point. But until they start to go up, I can't assume that it's going to happen.

"In fact, I believe that we are going to have lower rates a lot longer than what people think.

"The Federal Reserve is in full control of rates, and based on the amount of money they're printing, rates should stay low for a while. Even if Libor starts to go up, it still has a long way to go. And even if rates were to go up that much, it would be damaging to the economy and your downside risk would be higher."

The floating rate benefits the investor looking for higher yields in a rising rates environment, he explained. But such benefit in this context may be offset by the increased likelihood of a trigger event.

"From a rational standpoint, if rates start to increase, up to a certain level it would be fine. But once it starts to creep up a lot higher, it would have a negative impact on the economy, putting downward pressure on stocks," he said.

The notes (Cusip: 40432XGA3) priced on June 11.

HSBC Securities (USA) Inc. was the agent.

© 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.