HSBC’s trigger performance notes tied to S&P 500 seen as low risk due to barrier, tenor

By Emma Trincal

New York, Jan. 5 – HSBC USA Inc.’s 0% trigger performance securities due Jan. 31, 2020 linked to the S&P 500 index appealed to advisers who said the conservative barrier and five-year tenor would enable investors to reduce market risk.

The payout at maturity will be par of $10 plus 102% to 112% of any index gain, according to an FWP filing with the Securities and Exchange Commission.

If the index finishes at or above the trigger level, 60% of the initial level, the payout will be par.

Otherwise, investors will be fully exposed to any losses.

Defensive barrier

“It’s a pretty plain-vanilla note that’s got a lot of what I like to see: it’s simple, straightforward, there is minimum leverage and no leverage on the downside and it’s linked to a well-known index,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“The 60% trigger makes for a fairly generous barrier when you think about it because the odds of the S&P 500 being down 40% in five years are pretty nil.

“Even if you take the 2008 scenario, an exceptionally severe bear market with a 37% decline, let’s say if the S&P 500 was down 40% on one of the years, you’d still be in the teens because the gains scored during the other years would compound.

“Going down 40% in five years is a pretty big hurdle.”

Kunhardt said the barrier was conservative due to its size – a 40% contingent protection – but also because it was observed once and at the end.

The investment horizon was also seen as a positive.

“The five-year term works to your benefit here since there is no cap and you have such a low barrier,” he said.

“It’s point to point, so really only two points matter: now and at maturity. The long-term reduces the risk because, even if the market corrects, you’re not going to have a down cycle for five years. The gains accumulated while holding the notes will play in your favor.”

Market cycles

However, the sequence of the returns will be important, he noted.

“If we have a bear market early on, it will be harder to recover. A couple of really bad returns in the first two years and that’s when you flirt with that barrier,” he added.

This scenario is not impossible, but Kunhardt, who is bullish, said it was unlikely.

“All asset classes except real estate are up. It stands to reason that we are due for a correction. But I see a 10% correction, not a 20% bear market sustained for a period of time. I don’t see that in the cards.”

A more likely negative outcome would be a neutral scenario.

“If there is a down market you could end up negative but above the barrier, in which case you get your principal back. It’s not a loss. It’s an opportunity cost.”

The longer term, while it might reduce market risk, has the opposite effect on credit risk. But Kunhardt said he was comfortable with the issuer’s credit quality.

“Five-year is a reasonable timeframe but you could legitimately be worried about credit risk since this is an unsecured obligation. But HSBC takes care of the credit quality concerns.”

HSBC USA Inc. is rated A+ by Standard & Poor’s.

“You can always worry all you want about a bear market – I don’t – but meanwhile you have to invest your money somewhere. This product gives me exposure to an asset class that I’m going to invest in anyway. Since I have the protection below me, it’s a better place to be than being long the index.”

Sweet spot

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that the nature of the barrier gave him some confidence.

“You have this 40% soft protection. It’s a barrier and I’d much rather have a buffer. But I would take comfort with the amount of protection,” he said.

Since 1990, the probability of any five-year trailing period showing a decline in excess of 40% has been less than 1%, he noted.

“If the barrier was not observed at maturity but on any trading day, I would be more hesitant. But here, to know that 99% of the time I am not going to breach this barrier over the five-year makes me feel much more confident when I talk about this to my clients.”

Kalscheur said that equity notes with longer maturities represent a “sweet spot” for him.

“For a lot of people, five years would be way too long. We have the opposite view. For us, it’s a sweet spot. We want our investors to invest for the long haul. So three to seven years is ideal for us, preferably three to five years,” he said.

“Is five years really less risky than two and a half years? It would be interesting to find out. But you’re definitely going to get better terms on a five-year note than on a shorter-term product and that’s one of the reasons we like it better.”

Tight spreads

Kalscheur agreed that the issuer’s creditworthiness addressed credit risk concerns.

“HSBC is a pretty good issuer. We’ve used them before and we like it a lot. Their credit spreads are tighter than Wells Fargo, which is probably the best credit among U.S. banks,” he said.

Wells Fargo’s five-year credit default swap spreads were at 47 basis points on Dec. 19, according to Markit. All other major U.S. banks have wider spreads, ranging from 62 bps for JP Morgan to 85 bps for Goldman Sachs. In comparison, HSBC shows spreads of 41 bps.

Kalscheur said he also liked the note for the upside.

“It’s good to have no cap, especially on a five-year note,” he said.

“You have the point-to-point and that’s key. For a five-year uncapped, the leverage is a bit soft. We’ve been able to get 1.1 to 1.15 for that timeframe. But it’s close enough. Besides, as soon as you hit 1.5 times, they’re going to cap.

“In general, everything is better than 100% participation and I’d much rather have small leverage than a cap.”

The win test

Kalscheur said the structure passed his “two-out-of-three-times” test, one method he uses to find out if the product is worth being shown to his clients.

“This note works for me. It wins two out of three times, so I’m comfortable with it,” he said.

“If the market decides to run, you’re uncapped. You win from that standpoint.

“If it’s flat you’ve lost a little on dividends but at least you have the leverage.

“If it’s down, you have the protection.

“I win on the upside, I win on the downside, I break even in the middle.

“Overall I really like it. Our more conservative clients wouldn’t do it because they want buffers. But it will be on our consideration list at the end of the month.”

UBS Financial Services Inc. and HSBC Securities (USA) Inc. are the agents.

The notes will price on Jan. 27 and settle on Jan. 30. The exact participation rate will be set at pricing.

The Cusip number is 40434F637.

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