HSBC’s three- and five-year uncapped buffered notes on S&P lack critical leverage, sources say

By Emma Trincal

New York, April 16 – HSBC USA Inc. plans to price two nearly identical issues of notes linked to the S&P 500 index. Both provide one-to-one uncapped exposure to any index gain and a buffer on the downside. Only the tenors and buffer sizes vary.

HSBC’s 0% buffered uncapped market participation securities due May 3, 2022 offer a 10% buffer, and its five-year notes maturing on April 30, 2024 have a 20% buffer, according to FWP filings with the Securities and Exchange Commission

“The no-leverage jumps out at me, especially on a five-year,” said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

“I realize there’s no cap, but we see plenty of five-year deals on the S&P with no cap and you still get leverage.”

He said he recently spotted a five-year note tied to the S&P 500 from another issuer with 1.22 times leverage, no cap and a 20% buffer.

Dividend “loss”

When leverage is eliminated over longer periods of time, investors incur a greater opportunity cost from not receiving the dividends, he noted.

Assuming a 2% dividend yield on the S&P 500 for illustration purposes (the actual yield is 1.7%), investors in the notes would forgo the equivalent of 10% over the life of the notes without taking into account compounding, he said.

Trade-off

“On its face, you’re really trading a guaranteed 10% loss of dividends on the upside for the benefit of a buffer on the downside that you may or may not use,” he said.

“Since you’re losing 10% on the upside for 20% on the downside, you could argue that you’re trading off two-to-one. That looks good. Well, not necessarily. ...”

He explained that the “net” buffer size compared to owning the index fund outright was only 10% since the unpaid dividends would be the equivalent of a 10% cushion.

More importantly, the probabilities associated with the two events in the trade-off varied greatly.

“You’re definitely going to lose 10% of the upside for the chance of making the buffer work for you.”

In probabilities terms, the trade-off was the equivalent of foregoing 10% in dividend returns 100% of the time for a much less likely negative scenario.

“The market just doesn’t go down over a five-year period very often,” he said.

“When it does, it happens maybe 20% of the time at the most.”

Probabilities of losses

Based on market data he collected on the S&P 500 since 1950, Kalscheur found that the probabilities of the S&P 500 finishing negative over a three-year and five-year rolling period were very similar. Both were in a 16% to 18% range.

The difference between the two timeframes was in the average amount of losses.

“Even though your overall chances of losing money are pretty much the same over three years and five years, the probabilities of losing 20% or 30% of your investment are more prevalent on the three-year than on the five-year,” he said.

Overall though, Kalscheur was not unhappy having the downside protection in either case.

“Is it worth giving up 10% to maximize the chance that the buffer could help you? I would say in and of itself, it’s not a deal breaker for us.

“We wouldn’t be talking structured products if we didn’t have the downside protection. We buy them for that reason.”

Not competitive

If he had to choose between the two offerings, he would opt for the five-year note because he likes to diminish his downside risk as much as possible.

However, neither note was satisfying when it came to the upside, he added.

“We like the no-cap. We like the buffers. But having no leverage is not an option for us. On a five-year, those terms are just not competitive with what the market is showing right now.”

Bullish with time

Steven Foldes, vice-chairman of Evensky & Katz/Foldes Financial Wealth Management, expressed a similar view only slightly more bullish as he did not assess much value to the buffers associated with longer durations.

“Anytime I buy a note, I know that the likelihood of a loss over a longer period diminishes,” he said.

“So whether I see a three-year with a 10% buffer or a five-year with a 20% buffer, in both cases, my reaction is that the protection is unnecessary. Money could have been better spent elsewhere.

“The longer you go out, on a three-year, five-year, the less you need a buffer.”

It would be different for shorter-dated products.

“On a one-year or an 18-month, a buffer does make sense,” he said.

Foldes’ view derived from historical data showing that the market is more likely to show positive returns over longer periods of time.

If he was to contemplate buying either of those notes, he would change the terms and replace the buffer with some leverage.

The uncapped exposure would be maintained.

But without any return enhancement, he would have no interest in those offerings.

“I don’t like those notes because the likelihood of the market being positive after three or five years is great.

“I’d rather make a bullish bet, lever the upside as opposed to having a buffer, which I’m probably not going to need anyway.”

HSBC Securities (USA) Inc. is the agent.

The five-year notes (Cusip: 40435UKJ2) will price on April 25.

The three-year notes (Cusip: 40435UKK9) will price on April 30.

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