Morgan Stanley’s $8.63 million buffered digital notes tied to oil index seek excess returns

By Emma Trincal

New York, July 27 – Morgan Stanley Finance LLC’s $8.63 million of 0% buffered digital notes due Jan. 7, 2019 linked to the S&P GSCI Crude Oil Index – Excess Return can help investors generate excess returns in a range bound market, advisers said.

If the index return is greater than or equal to negative 10%, the payout at maturity will be $1,212 per $1,000 principal amount, according to a 424B2 filing with the Securities and Exchange Commission. Otherwise, investors will lose 1.1111% for each 1% that the index declines beyond 10%.

Steve Doucette, financial adviser at Proctor Financial, likes to buy structured notes when he can use them to outperform the underlying benchmark on both sides of the trade. The buffer level was appealing in two ways: it provided the protection for up to 10% and triggered below par a 21% digital payout.

Alpha up and down

“The only way you don’t outperform is if it goes above 21% on the upside. Anywhere between near zero and +21% you outperform and if you’re lucky, if it’s down 10% you beat the asset class by 31%,” he said.

The S&P GSCI Crude Oil index has seen more very bad years than good years over the past decade, according S&P’s website.

The index was down 46.5% in 2008, nearly 10 percentage points more than the S&P 500 index. It dropped 33% in 2014 followed by a second 33% drop the next year. It regained some strength last year with an 11.4% positive return, its second best year since gaining 13.5% in 2009. The only strong bullish year dates back to 2007 with a 32.0% positive return.

Downtrend

“The trend in oil has been down since ‘07 except for a couple of good years,” said Doucette.

“I would be curious to see what the trend is over an 18-month rolling period though. The market may tilt toward the upside. But even if you’re up 15% you still outperform the index with a 21% digital.”

The 10% buffer, although geared at a rate of 1.11, was also beneficial to the investor, he said.

“I’ve always liked geared buffers. I’m not worried about the gearing because you’re still outperforming unless the index goes all the way down.”

Wide range

Another advantage, he noted, was the wide price range in which investors were able to generate excess return over the market. Unlike other similar products, such as absolute return notes with high barriers, hence very little protection, or digitals with a strike at par, this one offered room for error with a range of nearly 100 percentage points on the downside plus 21 points on the upside, he said.

Even if the index fell beyond the buffer level, dropping 45% from its initial price for instance, investors would lose 38.88%, still outperforming a long position in the futures.

The magnitude of this range, allowing investors to achieve better results than the index, was helpful in a market where shifts in demand and supply can have significant repercussions on oil prices, he added.

Volatile market

“The biggest wildcard are the alternative fuel sources,” he said.

“At some point we’ll have to get into the solar. Fracking is another source of alternative energy... Oil got stammered.

“If you have oil as a piece of your portfolio, this note is a way to play this market as long as it’s not overly volatile.

“You have to believe it’s going to trade sideways in order to profit from it.”

Doucette said that he had no special allocation to energy.

“I don’t have an independent bucket because you get down to a sector level rather than market level.

“We tend to avoid that,” he said. “We prefer making allocations to broad indexes.”

Sideways

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said the structure fit his outlook on oil.

“This index has been under a great deal of challenges. The oil sector has been very cyclical,” he said.

Future oil prices may not be as volatile as in the recent bear market, he said.

“We’re getting to the upper end of what we anticipated being the range.

“In that case, a digital return is quite attractive. I do believe it’s going to stay range bound.”

Downside, term

The notes offered adequate protection based on this outlook.

“I’m not concerned with the geared buffer. I just don’t see a pullback in oil going back to 30.”

The S&P GSCI Crude Oil index-Excess Return references West Texas Intermediate crude oil futures contracts, which represent the U.S. benchmark for oil.

U.S. crude oil futures dropped below $30 a barrel early last year. The Sept. 2017 contract is trading at $49.15 on the New York Mercantile Exchange.

In addition, Medeiros said the 18-month period was compelling.

“I like that it’s relatively short so I can make different decisions 18 months from now.

“I think it’s a reasonable note if you want exposure to oil,” he said.

Morgan Stanley & Co. LLC is the agent.

The guarantor is Morgan Stanley.

The fee is 1.24%.

The notes (Cusip: 61766YBT7) settled on Thursday.

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