Morgan Stanley’s upside participation autocall on S&P not a pure income play, advisers say

By Emma Trincal

New York, Nov. 19 – Morgan Stanley Finance LLC’s 0% autocallable securities with upside participation feature due Nov. 30, 2026 linked to the S&P 500 index is an innovative structure allowing investors to get paid a premium when the notes are called while still being able to fully participate in the upside at maturity in the event the call never occurs.

But the long tenor of the notes as well as the fact the payout is a call premium, not a coupon, made the investment too difficult to use in a portfolio and unlikely to offer the potential upside participation, advisers said.

The notes will be called at par plus at least 7.43% per annum if the index closes at or above its initial value on an annual observation date other than the final one. The exact call premium will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the notes have not been called and the index finishes at or above its initial level, the payout at maturity will be par plus the greater of 25% and the index gain.

If the index finishes negative but greater than or equal to the threshold level, 75% of the initial price, the payout will be par. Otherwise, investors will lose 1% for every 1% that the index declines from its initial level.

Not income

Steve Doucette, financial adviser at Proctor Financial, noted the difference between the call premium paid by this product and the contingent coupon that comes with most autocallable securities.

“If the index is not up, you don’t get called and you don’t collect. Where do you put this in your allocated portfolio? It’s not really fixed-income,” he said.

“It’s not like a bond fund or an income-providing asset that produces a little income.”

No cap

One advantage of the notes compared to almost all autocalls was the potential for full upside participation at maturity.

“But six years is a long time,” he said.

“You need to have a long-term view. You don’t expect the market to do much over the next few years. And if that’s your view, you need to be sure that you’re going to be happy with 7.5% a year.”

The downside protection with the 75% barrier was acceptable over the six-year term.

“You should get your principal back,” he said.

“If your view is wrong, if the index is down for several years and you don’t get called, well at least you still have the upside participation with no cap.”

Such a scenario however was not very probable, he noted.

“But it’s still good to have that. You never know. You could have an ugly period with a series of down years,” he said.

Memory

More realistically, investors should see the note called.

“You may have two or three bad years and then you collect. At least you capture the entire premium,” he said.

He was referring to the so-called “memory” feature of call premium structures, which provides for cumulated payments. For instance, if the notes are called on the second observation date, the call premium will be 14.86%.

The memory allows investors to “catch up” with prior unpaid premium.

No exit

This advantage along with the uncapped upside at maturity were positive terms, he said.

“It’s an interesting note.

“My problem is the six-year. It’s a long time and you have a limited ability to exit this note.”

By “exit” he meant the difficulty to find a reasonable bid on the secondary market.

“I wonder what type of valuation you would get if the market is down. If you want to sell it early, it’s not going to be easy.

“You’re really locking up your money for six years at a time when we have so much uncertainty to deal with.

“That’s a little bit too much to handle right now.”

Lower minimum payment

Jeff Pietsch, founder of Eastsound Capital Advisors, said better alternatives exist for investors seeking to collect a premium.

“It’s a complex structure. And some things are a bit odd. For instance, the minimum payment goes down at maturity.”

The minimum payment of 25% is indeed lower than the sum of the call premium, whose amount would hypothetically be six times 7.43% or 44.58% based on the cumulative nature of the premium.

Modest expectations

“The structure is supported by the idea that valuations are extremely high, which implies low-digit returns if not negative returns for the next five to 10 years,” he said.

“It does have a barrier, but if that’s broken you really have full equity risk.

“So, you’re capping your return potential with unlimited downside. Not that the barrier is likely to be hit, but you still have that risk.”

Long holding period

The unlimited upside was a positive yet unlikely outcome.

“This note is going to be called, obviously,” he said.

“Over the course of six years, there are going to be at least one or two years when the index will be up. That’s almost a given.”

Still, investors have to assume they will hold the notes for six years from a risk management standpoint.

“Six years is a long time for that small premium even if the probability of a call is very high,” he said.

“I think there are alternatives to doing this that won’t tie up your capital for so long.”

Alternative strategy

He suggested writing a put option.

Shorting a put consists of betting that the underlying price will not decline below a preset strike price. The put writer earns a premium for the bet. If from its current level (at-the-money) the price drops below the strike, the put seller is obligated to buy the underlying at the strike price. The loss will be measured as the difference between the price of the underlying and the strike minus the premium received.

He explained the strategy as follow:

“I can write puts away from the money, collect a premium which I can use as a real buffer,” he said.

“The index is at 100. I write a put at a 75 strike. I get paid for taking the risk of buying the stock at 75 if it drops below that. If the index finishes above the 75 strike, I win. I don’t lose my capital and I keep my premium.

“If it breaches the 75 level to 70, I’m obligated to buy at 75, so I lost 5. But my loss is buffered by the premium I received upfront.”

Getting paid to wait

In addition, the put seller is not obligated to keep the position open until the end of the contract. He can close it by buying back the put at any time, he noted.

“It’s a much more liquid strategy.

“I collect a premium without such a long lock up, and I have a buffer,” he said.

There is still risk however since the underlying could drop significantly lower than the strike price. But for investors seeking to buy a particular asset while generating income, writing puts remains a sound strategy, he said.

“I’d rather be paid for buying things on sale than risking not being paid while being responsible for the losses.

“At least I get paid a premium upfront. It’s guaranteed,” he said.

“This one is not giving me guaranteed income.”

The notes will be guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes will price on Nov. 24 and settle on Nov. 30.

The Cusip number is 61771ELX4.

© 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.