HSBC’s contingent income autocallables linked to U.S. Steel show poor risk-adjusted return

By Emma Trincal

New York, June 2 – HSBC USA Inc. plans to price contingent income autocallable securities due Dec. 7, 2017 linked to the common stock of United States Steel Corp. The notes may expose investors to more risk than they are getting paid for despite an eye-catching contingent coupon rate, said Tim Mortimer, managing director at Future Value Consultants.

If U.S. Steel shares close at or above the downside threshold level, 65% of the initial share price, on a monthly determination date, the notes will pay a contingent payment that month at an annualized rate of at least 16%, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par of $10 plus the contingent coupon if U.S. Steel shares close at or above the initial share price on any monthly determination date other than the final determination date.

If the final share price is greater than or equal to the downside threshold level, the payout at maturity will be par plus the final contingent coupon. Otherwise, investors will lose 1% for every 1% that the final share price is less than the initial share price.

Big loser

The share price may appeal to investors seeking bargains given the stock’s recent sell-off. The implied volatility of the stock – in the 50s – explains how the issuer was able to offer the double-digit interest rate, he said.

“The stock fell 50% in the past three months,” he noted.

“Maybe it’s a sector issue or an operational issue. Maybe it’s a Trump-related thing with concerns around global trade agreements. I’m not sure exactly why, but it’s a pretty dramatic drop.

“The options have a very high implied volatility, and that’s how investors can obtain a 16% coupon versus a 10% or 12%.

“Maybe it’s good timing too. Investors may think it has already gone down so much ... it’s likely to go up now.”

For some investors, the drastic price decline helps when buying a product that offers no downside protection.

First call

On a monthly basis investors can expect a 1.33% coupon if the index is above the 65% barrier. As with all autocallable structures, the probability of being called on the first call date is the greatest, he said.

Future Value Consultants offer for its clients – issuers and distributors – stress test reports on structured products. Each report contains a total of 29 tables, which clients choose from at their own convenience.

The product-specific tests table of the report shows that investors have a 48.09% chance of an autocall event after just one month.

“While the coupon is pretty high, you also have a great probability of only getting 1.33% as opposed to 8%, which is the maximum you can get over the six-month duration,” he said.

When the tenor is short and the frequency of the call observation dates is high, investors always run the risk of receiving only a small fraction of the annual coupon. Having a no-call feature often helps but would not be an option on such a short tenor, he explained.

The short duration is also an obstacle to the inclusion of a barrier or buffer.

“The very short maturity and high volatility wouldn’t help the protection or would make it too expensive,” he said.

“If it fails to get called six times, you’re likely to be very far down anyway ... therefore no protection could really help.”

Capital performance

Another table included in the stress test report, the capital performance tests table, shows the probability of three different outcomes: return more than capital, return exactly capital and return less than capital.

“Getting more than your capital is basically the same as being called,” he said. There is a 77.75% chance for this event to happen.

The second outcome, getting the principal back at maturity with no payment, is impossible, hence there is a zero probability associated with this event.

Finally the “return less than capital” outcome represents a scenario in which investors have not been called and lose money at maturity. There is a 22.25% chance for this worst-case scenario to materialize, according to the capital performance tests table.

Such outcome would generate an average loss of 26.4%.

Due diligence

“Here is what investors need to consider before buying the notes: do you really want a product that will finish in one month and pay you only 1.33% for all that risk and aggravation?” he said.

“Half of the time you’ll get called on the first month with a meager 1.33%. Meanwhile, a fifth of the time you’re losing over a quarter of your money!”

He was referring to the 48.09% probability of a call on the first call date along with the 22.25% chance of losing principal, which corresponds to an average loss of 26.4%, according to the data.

“If it was a stress-test run for one of our clients, you would expect the client to think very carefully before issuing the product or distributing it,” he said.

“Someone should be looking at this risk-return profile. It doesn’t really support well the case for issuing these notes.”

HSBC Securities (USA) Inc. is the agent. Morgan Stanley Smith Barney LLC is handling distribution.

The notes are expected to settle on Wednesday.

The Cusip number is 40435D425.

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