HSBC's six-year averaging notes linked to S&P 500 Low Volatility may reduce return

By Emma Trincal

New York, Sept. 10 - HSBC USA Inc.'s 0% averaging notes due Sept. 28, 2018 linked to the S&P 500 Low Volatility index offer investors exposure to a low-volatility equity strategy with full principal protection.

But some sources questioned the benefit of using a low-volatility benchmark in a capital-guaranteed wrapper in combination with a quarterly averaging payoff calculation.

The quarterly averaging method used in the product to calculate the payoff may reduce volatility but could also reduce the return on the notes compared to point-to-point products, the prospectus warned.

The payout at maturity will be par plus any increase in the average closing level of the index. If the average closing level of the index falls, the payout will be par, according to a 424B2 filing with the Securities and Exchange Commission.

The calculation is based on the average closing level of the index on 24 quarterly observation dates over the six-year term of the notes.

The S&P 500 Low Volatility index measures the performance of the 100 least volatile stocks in the S&P 500. It is designed to serve as a benchmark for low-volatility U.S. equity strategies. Constituents are weighted relative to the inverse of their corresponding volatility, with the least volatile stocks receiving the highest weights.

Investors seek low-volatility strategies in order to reduce downside risk while remaining exposed to equities, sources said.

The risk versus reward of the index is very attractive in bear markets, as illustrated by the prospectus, which showed a table comparing the annual returns of the S&P 500 Low Volatility index with those of the S&P 500.

In the 2008 bear market, for instance, the S&P 500 Low Volatility index lost 23.61% but the S&P 500 suffered much heavier losses, down 38.49%. On the other hand, when the market rallied the next year, the S&P 500 was up 23.45% and the S&P 500 Low Volatility index was up 15.52%, lagging the benchmark but still showing robust growth. For this reason, the low-volatility index is often used as a hedging tool, a structurer said.

Skittish buyers

The use of a principal-protected wrapper is, in the structurer's view, driven by investor demand.

"The S&P Low Volatility just picks the lowest volatility stocks of the S&P. It certainly doesn't mean that you could not experience some sort of major downside. It will tend to do better on a downside market. You may just lose less than if you were invested in the S&P 500. But you can still lose money," he said.

This structurer said that for some conservative investors, the reduced volatility of the underlying index is not enough to satisfy a desire for safety.

"At the end of the day, people are still going to want principal protection. When investors are scared, as they are now, they are going to ask for principal-protected notes rather than a risk product with a buffer or a knock-out barrier," he said.

"People are still skittish about what's going on in Europe. With Greece still making headlines, people are fearful of being fully at risk on the downside.

"It's probably a note designed for retail investors. Private banks have not liked principal-protected notes or CDs. They're more into asset allocation or minimizing risk. They're not focusing as much on principal protection as retail investors do."

Invisible cap

This structurer said that investors should understand the payoff method and be cautious before concluding that there is no cap.

"It's uncapped, but it's really capped because of the quarterly averaging. In the six years you'll be averaging from the lower quarter to the higher quarter, you'll be somewhere in the middle. Technically it's uncapped. But because you're not really experiencing the full upside, you are capped," he said.

The structural advantage of the quarterly averaging feature is that the option used to structure it is cheaper than a point-to-point payoff, he said.

"A low-volatility underlying would have actually made the option more expensive. So what they did here is that they made the low-volatility index option cheaper by using the quarterly averaging," he said.

And that is precisely what Scott Cramer, president of Cramer & Rauchegger, Inc., said he is not comfortable with.

"I don't like averaging products. For a quarterly averaging product to make money you would need the index to go up significantly over a long period of time. It's very different from an annual reset for instance," Cramer said.

In a hypothetical example in the prospectus, the initial index level is 4,000, and the final level is 5,440 at the end of the sixth year.

The example lists 24 different closing levels for each quarter during the term. The average closing level in the example is 4,750. That level compared to the initial level gives the noteholder a return of 18.75%. By contrast, a normal point-to-point calculation would generate a 36% rate of return.

"This example illustrates my point," said Cramer. "You should get about half of the actual return if it goes up linearly.

"I'm not saying that's horrible, but when you get these long-term averages, that's what happens. I just think it's a bad deal.

"If they did an annual reset, averaging each year, locking in that gain or that loss, then fine. But when you start averaging, it will really lower the ending points. They're really cutting down the costs of the options."

Cramer agreed with the structurer that quarterly averaging could dampen the returns over time.

"It is a cap. They are limiting your participation rate," Cramer said.

"I've done calculations on these. If you take a line upward on a 45-degree angle, you'll get half. If it's a downward line with a 45-degree angle, you'll get zero.

"The only time you'll make money is if you go up for three years then down for three years, in that order, then you'll make money versus the index that will be flat point to point. But what are the odds of having that type of sequence? Most often, it works somewhere in the middle. You're likely to give up a big chunk of the upside. With this deal you're giving up the upside for the principal protection."

Cramer added that for that reason, he does not understand the point of combining a low-volatility index with this type of averaging payoff.

"Averaging is a way to smooth out the volatility. Using this type of low-volatility benchmark is a way to smooth out the volatility of your equity portfolio as well. So it doesn't make much sense to me to use them both in the same deal. I guess that's why the option is cheap enough," he said.

HSBC Securities (USA) Inc. is the agent.

The notes will price Sept. 25 and settle Sept. 28.

The Cusip number is 4042K14W0.

© 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.