HSBC’s income notes on indexes, gold ETF boost yield with call, American barrier, correlations

By Emma Trincal

New York, June 1 – HSBC USA Inc.’s callable contingent income barrier notes due Sept. 5, 2023 linked to the least performing of the Nasdaq-100 index, the Russell 2000 index and the VanEck Vectors Gold Miners ETF via a combination of riskier features provide an eye-catching coupon, sources said. While the return is commensurate with the risk, according to one source, the structure is too complex to sell, another one said.

The notes will pay a contingent monthly coupon at an annual rate of 21% if each underlying asset closes at or above its trigger level, 65% of its initial level, on the observation date for that period, according to an FWP filing with the Securities and Exchange Commission.

The notes will be callable at par on any quarterly call observation date after six months.

The payout at maturity will be par plus the final coupon unless any asset closes below its 65% trigger level on any day during the life of the notes or if all indexes finish above their initial levels. Otherwise, investors will be fully exposed to the decline of the lowest performing asset from its initial level.

Low correlations

“21% is a very high coupon. But there are a lot of moving parts in this note,” said Tom Balcom, founder of 1650 Wealth Management.

“Gold stocks, tech stocks, small-cap...You really have to have a view on those three uncorrelated assets. I doubt they’re moving in the same direction and that’s the correlation risk you need to explain to a client,” he said.

The coefficient of correlation between the Nasdaq-100 and the Russell 2000 indexes is 0.93 with 1 representing a perfect correlation. In contrast, equity fund VanEck Vectors Gold miners has a correlation of 0.18 with the Russell 2000. Its correlation with the Nasdaq-100 is only 0.09.

“Even if a 35% drop is a low-probability event, I still have to explain the risk you take in a worst-of with low correlations.”

American style, issuer call

Another stumbling block was the principal repayment barrier at maturity, which may be breached any day during the 15-month term. Such barriers are built on so-called “American options” and contrast with the less risky “European barriers” observed point to point which investors in structured notes are accustomed to.

“I hate to tell my clients: this is an American option. You could finish down 20% and you’re still going to lose 20% because at some point down the road, one of the underlying breached the 65% barrier even though you’re not breaching at maturity. It’s not a pleasant surprise and you have to explain the difference between American and European options.”

The issuer call was not something this adviser recommends to his clients despite the fact that the feature can boost the yield.

“We stick with autocalls because we want more certainty. With the autocall, you know when it happens and why. I like to remove as much uncertainty from the equation as possible,” he said.

For nerds only

“I’m not a big fan of too many variables. Clients are usually not very sophisticated, and they need to understand what they’re buying.

“You have the gold miners versus the Nasdaq and Russell 2000. You also have the barrier, the contingency of the coupon, the issuer call... Tell your clients all those details and all of a sudden, their eyes glaze over,” he said.

The structure may be a better fit for more advanced investors.

“It’s designed for sophisticated clients. It could be a note for the nerdy type of investor, the propeller-head.

“Clients want the best terms possible. Some of these issuers create those complex payouts in response to these queries. They keep changing the variables to increase the coupon. But if it takes a CFA or an MBA to understand it, I’m not going to recommend it,” he said.

It’s a tradeoff

A market participant explained that the perceived complexity is just a combination of additional risks designed to increase the return of the notes.

“Most often what happens is a client comes to his broker and says: I want to maximize the coupon. Combine everything you can do to give me the highest yield over the shortest time,” this market participant said.

“Everything is possible if you’re willing to take on more risk for the additional premium. That’s how they come up with the uncorrelated assets, the issuer call, the American barrier.”

The high coupon was not the only benefit of the structure, he said. While the barrier was observed daily, its 65% level was relatively deep. The 15-month term was short, and the call protection allowed investors to hold the notes for at least six months.

“It’s a tradeoff. If you want better terms, you have to be willing to use a number of different options,” he said.

While some of the riskier terms may scare some investors, others have grown familiar with the additional risk.

Issuer calls for instance “are not a big deal” for most investors, this market participant said.

“They’re more comfortable with it. We know that a discretionary call has more value to the issuer. As an investor, you have a higher probability of losing the coupon sooner than you may like so you get paid for it.”

The uncorrelated underliers and the American barriers provide more risk as well.

“Of course, it’s riskier. But if you do a worst-of you have to be comfortable with the view that none of the assets is going to breach the barrier whether it’s point-to-point or at maturity. Obviously, there is more risk in doing American style but that’s one of the reasons you get to a 21% coupon.

“Every structured note is a tradeoff. People have different levels of risk tolerance, different return expectations. Issuers build products taking those differences into account,” he said.

HSBC Securities (USA) Inc. is the agent.

The notes were expected to price on May 31 and to settle on June 3.

The Cusip number is 40439J6J9.

The fee is 0.75%.

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