Morgan Stanley’s 7% fixed, contingent income autocalls on indexes show innovative structure

By Emma Trincal

New York, Sept. 13 – The plain name behind Morgan Stanley Finance LLC’s contingent income autocallable securities due Sept. 29, 2033 linked to the S&P 500 index, the Russell 2000 index and the Euro Stoxx 50 index hides a creative income-oriented structure, which might as well be called fixed-to-contingent coupon notes, echoing the term “fixed-to-floating.”

Sources were attracted to the high teaser rate offered for five years. But the worst-of payout on three indexes introduced too much uncertainty. More importantly, despite an automatic call feature the product was deemed too long, especially given a long no-call period.

“I don’t like the 15 year,” said Steve Doucette, financial adviser at Proctor Financial.

Interest will be fixed at 7% for the first five years, payable monthly, according to a 424B2 filed with the Securities and Exchange Commission.

After that, the notes will pay a contingent monthly coupon at an annual rate of 7% if each index closes at or above its 70% coupon barrier on the observation date for that month.

The notes will be called at par if each index closes at or above its initial level on any review date after 5.5 years.

The payout at maturity will be par unless any underlying index finishes below its 50% downside threshold, in which case investors will be fully exposed to any losses of the worst performing index.

Income-generator

Without hesitation, Doucette said the notes were designed for bond investors.

“I see those autocalls and contingent coupon notes as fixed-income substitutes. Where can you get 7% today on a bond? Not in many places.”

Doucette drew a parallel between the notes and a regular fixed-income instrument based on the amount of protection at maturity.

“With a 50% barrier at maturity especially on a 15-year, I don’t think you should be too worried about losing principal even with a worst-of,” he said.

“Besides, you’re more likely to be called before that. That in itself cuts your risk too.”

Bear danger

However, Doucette still did not like the long tenor.

“What are the odds that you’re going to get stuck for some time if a bear hits?

“Given that it’s tied to three indices...it’s a worst-of... you run the risk of not getting your coupon for a while.

“It only takes one of them to drop more than 30% and you lose your coupon. How often does it happen in a bear market? Bear cycles don’t last, that’s true. But you don’t know. You still have to do your due diligence and look at the performance of all three.”

Evaluating the risk of not getting paid was difficult as it depends on a number of factors, such as volatility, correlation and valuations, he said.

One laggard in the mix

“Theoretically, the risk on the Euro Stoxx is less because the rest of the world especially the U.S. has gone up so much,” he said.

“But it looks like the Euro Stoxx could really block out your coupon.

“We forget the performance of this index. Even now it still has not returned to its level of 11 years ago.

“You could be stuck in this note and get no coupon. It’s scary.”

As markets are highly valued, he considered a comparison of the indexes going back to their pre-financial crisis highs in the summer or fall of 2007.

A quick look at the chart for the Euro Stoxx 50 index showed it peaked in December 2007 and dropped 30% below that high in September 2008. The benchmark fell further amid the global crisis. But it took the Euro Stoxx almost three years to regain its 70% level. Since then, the index has been touching without staying much above this resistance level.

Assuming the note would have priced at the peak in 2007, investors would have met the requirements to get paid a coupon on a limited number of occasions – in September 2009, April 2011, in the summer 2014 and January of this year.

“Scary. And it’s still way below its 2007 high even now. It hasn’t recovered,” he said.

As of today, the index is still trading more than 15% below its resistance level – which is the 70% barrier based on a hypothetical initial price at the 2007 peak. More worrisome, Doucette noted, its price remains 40% below the 2007 high.

“The risk is obviously that you may not get paid after the five-year fixed interest,” he said.

“One way to look at it would be to ask for a lower coupon barrier, at least 40% instead of 30%.

Not liquid enough

Matt Medeiros, president and chief executive officer of the Institute for Wealth Management, expressed unease with the long maturity.

“The 7% fixed interest rate for five years is very interesting. But you also have 10 more years. The concern for me is liquidity and the term of the notes,” he said.

In the absence of a call, selling the notes prior to maturity may not prove to be easy.

“Even if the indices may be doing well they may not be going to price well. You could have a pretty deep bid-ask spread.”

Investors should rely on the autocall rather than on the secondary market to liquidate their investment, he said.

But then again, the autocall is market-dependent and unpredictable.

“My preference would be to be called after five years. But I’m still not comfortable with the 15-year tenor,” he said.

Hard call

Medeiros perceived the risk as an opportunity cost – holding the notes for a long time without receiving income.

“This is one of those deals where it’s tough to make a decision. It’s not the kind that that jumps at you and you say, ‘I’d better do it.’ But it’s not terrible.”

“You have three indices. I don’t particularly like that. I don’t like three or even two underliers. Worst-of outcomes are difficult to predict,” he said.

The various “moving parts” of the deal also made it more difficult to monitor the investment.

“As a money manager I don’t know how I would position the structure in a portfolio.

“It would be good to know what the chances of missing some coupons are and how often. But it’s probably not something you can predict that easily especially with three indices.

“So I don’t think this would be a good fit for our clients,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes will price on Sept. 25.

The Cusip number is 61768DEB7.

Twin deal

Separately, Morgan Stanley Finance LLC plans to price a similar product with the same maturity date, pricing date, underlying indexes and principal repayment barrier at maturity.

The difference is that interest will be fixed at 8% for the first four years, payable quarterly.

After that, the payment becomes a call premium after 5.5 years with investors getting paid 8% a year when each index closes at or above its initial level on any quarterly review date.

Investors will receive principal plus the coupon for that quarter as well as all previously unpaid quarterly coupons.

There is a short window of time between the end of the fixed coupon period and the moment the notes become callable during which the 8% is a contingent coupon. But the “barrier” is also at, not below, par.

Doucette said he preferred the first deal as it offers a contingent coupon after the fixed rate obtainable at a lower barrier than par. In comparison, the conditions for the autocall are harder on the second one. Even if investors received unpaid coupons, they lose the ability to collect more once the notes become automatically callable.

The Cusip number for this second deal is 61768DEB7.

Morgan Stanley & Co. LLC is also the agent.

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