Morgan Stanley’s $9.55 million autocalls on Exxon offer alternative to dividend income play

By Emma Trincal

New York, May 22 – Morgan Stanley Finance LLC’s $9.55 million of contingent income autocallable securities due May 20, 2021 linked to Exxon Mobil Corp. stock offer an income replacement, which may provide a less risky alternative to a dividend investment strategy, said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

The notes will pay a contingent quarterly coupon at an annual rate of 10.35% if the stock closes at or above the 50% downside threshold on the determination date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par plus the contingent coupon if the stock closes at or above its initial level on any determination date.

The payout at maturity will be par unless the stock finishes below its 50% downside threshold, in which case investors will lose 1% for each 1% decline.

Aristocrat

Many investors buy the shares of Exxon for its highly attractive dividend yield, currently at 7.8%, the portfolio manager said.

“In March the dividend yield was 11%. Now it’s a t7.8%. It’s still above the average for this stock which is around 5%,” he said.

The stock is a constituent of the S&P 500 Dividend Aristocrats index, which tracks S&P 500 index companies that have increased dividend payments each year for at least 25 years.

Despite reporting a first-quarter loss of $610 million earlier this month, the company decided not to cut its dividend.

Noteholders are not entitled to receive dividend payments. However, the size of the contingent coupon and a difference in tax treatment make the net returns between the two types of investments very comparable if not equivalent, he said.

The main difference is risk.

“If income is your objective, this note cuts your risk a lot compared to owning the shares.”

Diversified energies

One factor reducing risk for both shareholders and noteholders is the value of the stock defined by an excessively depressed price in relation with the fundamentals of the company.

“The stock collapsed with the coronavirus panic,” said Kaplan.

“Even before, Exxon sometimes often got negative media attention as it’s been the target of environmental activists concerned about climate change.”

For Kaplan, this negative publicity is misplaced.

“Exxon is not as nearly concentrated on oil as people think. It’s also a top chemical manufacturer and it has diversified its businesses around all kinds of products related to energy. In fact, it has massively invested in renewable energies.”

The company itself is “solid,” he added, pointing to its long history –going back to Standard Oil in 1870 – and its resiliency.

“It’s one of the largest publicly held companies in the world and it has been around for a very long time.”

“Exxon has overcome a series of antitrust issues through the decades.”

“It’s a very high-quality company.”

Equity correlation

The stock is also “more stable” than most of its peers.

“Exxon is a major constituent in many indices. As such it’s very representative of the U.S. equity markets, perhaps more so than the oil market,” he said.

“If the entire U.S. market is strong and energy prices go down, Exxon won’t go down as much.

“There isn’t a strong positive correlation between Exxon and other energy companies. It’s one of the very few oil stocks that will diverge.”

This was visible when Exxon hit a low on the same day as the S&P 500 index on March 23. Energy shares according to the SPDR S&P Oil & Gas Equipment & Services exchange-traded fund, plunged about a week earlier.

The same ETF, between its July high and March low plummeted by approximately 80% while Exxon, also at its peak in July, fell by 60% during the same time.

“Exxon is kind of a hybrid. It’s not a pure energy play,” he said.

“It’s a good thing because the stock price is more stable.

But what really makes the notes far less risky than the stock obviously is the 50% barrier.

“I see this note as a pretty conservative product. The risk of losing money is rather limited,” he said.

“The chances that Exxon would drop by half a year from now are very small. The stock has already fallen to lows in March not seen in a long time.”

Net, net is a wash

As with any income product, investors need to understand how their returns will be taxed, he said.

A comparison between the notes and the stock showed that in both cases investors would receive approximately the same amount of income net of taxes.

The 7.8% dividend would be taxed as qualified dividend, he explained. The tax rate is 15% for “middle-class” income (less than $200,000 a year of income) or even 0% for married couples earning less than $75,000.

At a tax rate of 15%, the net income provided by the dividend would be 6.63%.

The coupon of the notes would be taxed as ordinary income, according to the prospectus. Assuming a tax rate of 38%, the net gain would be 6.4%.

“It’s a wash if you look at it from a pure income standpoint,” he said.

This of course does not consider the capital appreciation, which the note lacks since returns are capped at the coupon level.

“You’re not buying this note for growth. If you want to speculate on higher oil prices, this is not the right instrument,” he said.

“But if you want income, it’s a good opportunity.

“Your chance of losing money is very low.

“Your chance of making a small amount of money is very high.

“There is 0% probability of making more than the 10.35% coupon.

“But it’s a much less risky income strategy than dividend investing.”

Qualified dividend reform

The advantage of the notes in tax terms would be even more visible if Joe Biden was to win with a Senate majority in November, he said. That’s because the Democratic candidate plans to tax qualified dividends at the ordinary income tax rate.

“This represents a political risk for dividend investors, especially for senior citizens holding it as qualified dividend,” he said.

“By removing this special status, they now would have to pay income taxes.”

While the measure if adopted should not make a difference for noteholders as those are already subject to income tax, it could however impact them to the extent that the new tax treatment of dividend income would make the stock less appealing, he said.

“It could put pressure on the price,” he said,

Income-oriented play

Other risks are more obvious, such as reinvestment of the proceeds if the notes are called, which could happen as early as three months after pricing.

“You have to be comfortable with that. It can be called away and you don’t know when,” he said.

“This note is an alternative to a dividend strategy, one that’s less risky if you don’t mind the early redemption.

“You’re giving up a huge dividend and you’re giving up liquidity. But at least you’re taking much less risk.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent. Morgan Stanley Wealth Management is handling distribution.

The notes (Cusip: 61769P727) settled on May 20.

The fee is 1.75%.

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