Large buffer on Morgan Stanley’s notes on S&P 500 offers pros and cons, advisers say

By Emma Trincal

New York, Jan. 2 – Morgan Stanley Finance LLC’s 0% participation securities due Jan. 5, 2024 linked to the S&P 500 index caught buysiders’ attention due to a generous buffer as investors are struggling with a year-end stock market rout.

The payout at maturity will be par plus at least 100% of any index gain, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 40% and will lose 1% for every 1% decline beyond the 40% buffer.

Heavy-handed

For some the size of the buffer may not be justified in the current market environment.

Protection does not have to be in excess of what investors really need otherwise they may pay for it in lower returns, said a buysider. After the severe December sell-off, getting a 40% buffer on a five-year note might not generate the best risk-adjusted return, he added.

“This buffer is going to have more appeal to investors right now. It offers quite a bit of protection. But when you think about it, it may be overkill,” he said.

“The market has already dropped 20% from its recent highs. The pullback has been pretty deep. Are your really going to need another 40% on the downside?

“A huge buffer like this makes sense if the market is toppish. That’s when you need the protection the most.”

If he had to customize the note for his clients, this buysider would rather see the protection cut in half with leverage on the upside.

“It’s a five-year note. The leverage may offset the loss of dividends and enhance the return. I’d rather see a 20% buffer with leverage,” he said.

Renewed interest

December saw the market plunge into bear market territory in the last week of the year. For this buysider the sell-off has been a conversation-starter.

“People are not afraid of structured products right now. On the contrary. The idea of having a buffer cutting some of your losses is very appealing,” he said.

“Some got caught in the sell-off. Now they see the benefits of structured products.

“I have a buddy who bought Amazon, Apple, Facebook. It was a bloodbath. Now he wants to talk about structured products again. I tried to bring his attention to structured notes for a while. He tells me that now my strategy makes sense. He wants to talk about it.”

Striking a balance

But there is a fine line with protection, he warned.

“Clients don’t like to lose money but they don’t want to miss an opportunity to make money either,” he said.

“If you have a buffer that’s too deep with no leverage or with a cap, when the Amazon and the Netflix recover your clients may say: ‘why am I not up more?’ You will tell them it’s because of the protection they had in place. But too much of a buffer could kill your return.

“And that’s the risk if the market recovers after a big sell-off.

Building up confidence

A financial adviser said that a large buffer such as this one is attractive on a psychological level. It gives investors more motivation to invest.

“That’s what everybody is thinking about right now: the downside,” this financial adviser said.

“I think this buffer makes people comfortable taking the market risk they wouldn’t want to take otherwise.

“Clients can’t pretend to be out of equities for five years. They need growth and therefore, the exposure to the market. If your client says: ‘I don’t want to take any risk’, you have to find a way around this otherwise you’re doing them a disservice.”

The 40% buffer may just be one option to solve this problem.

Assuming a catastrophic bear market with a 50% drawdown, investors would only lose 10%, he noted as an example.

Risk aversion

“Some people are more confident than others. Some want to jump back in, thinking December was just a normal swing. Others are scared and don’t want to lose anything. But you never know when it’s the right time to get out or get back in.

“This note is perfect for risk-averse investors. It’s enough protection to keep them in the market for five years.

“You can’t time the market perfectly. This does it for you.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes (Cusip: 61768DVA0) will settle on Jan. 7.

© 2015 Prospect News.
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