Morgan Stanley's autocallables linked to Bank of America may offer too little protection

By Emma Trincal

New York, July 18 - Morgan Stanley's upcoming contingent income autocallable securities due July 2014 linked to the common stock of Bank of America Corp. offer quarterly contingent payments even if the stock trades down by up to 30%. But the nature of the downside protection coupled with a highly volatile underlying is seen as unattractive.

If Bank of America stock closes at or above the downside threshold level - 70% of the initial share price - on any quarterly determination date, investors will receive a contingent payment of 2.4% to 2.9%, according to an FWP filing with the Securities and Exchange Commission.

The exact contingent payment will be set at pricing.

If the closing share price is greater than or equal to the initial share price on any of the first 11 determination dates, the notes will be redeemed at par plus the contingent payment.

The payout at maturity will be par plus the contingent payment unless the stock finishes below the downside threshold level, in which case investors will receive a number of Bank of America shares equal to the principal amount of notes divided by the initial share price or, at Morgan Stanley's option, the cash equivalent.

'Lucrative' contingent payment

"You'd have to be slightly negative to slightly bullish on Bank of America to get this note," said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

"If the stock is down but not significantly down, you get paid. If it's up, you get paid plus you get called.

"The 2.5% quarterly payment is lucrative. That's 10% a year. If the stock goes nowhere, at least you're earning 10% on the coupon."

Kalscheur stressed another advantage: the call feature. If triggered, it would lower the duration, making the note shorter than it appears to be.

"You are tied up for three years, but you could get called after a quarter. So there is some liquidity compared to a non-callable three-year note; it's just not a guaranteed liquidity," he said.

Kalscheur, however, said that he would not consider the notes for his clients due to the downside risk that results from the barrier mechanism and the ups-and-downs of the stock.

Volatile stock

"Bank of America can drop 30%, no question about it," Kalscheur said.

"Just [Monday], the Dow was down 1% and Bank of America was down over 2.5%. So if the market falls by 20%, Bank of America could go down 50%."

Bank of America shares closed down 2.8% Monday at $9.72 (NYSE: BAC), hitting a new 52-week low. It fell 4.6% intraday.

"I love to have protection. That's what the barrier provides. But relative to the volatility of this particular stock and based on historical evidence, it's not enough," said Kalscheur.

"If the stock ends down 25%, that's good. You keep your principal, and you collect your coupon.

"But if it's down 30%, you take all the loss. You walk along; everything is fine until it isn't. Then you're down like everybody else.

"This is not a buffer. It's a cliff. This barrier is not the best kind of protection. I'd much rather have a 15% buffer than a 30% cliff."

Inadequate protection

A broker agreed.

"This is a phantom downside protection. It sounds good, but it's not," he said.

"If we have another financial crisis, having a 30% downside protection on this stock doesn't make you want to sleep at night."

Since July 2008, shortly before the Lehman Brothers collapse, Bank of America stock has lost 65%.

"This stock can move a lot in one week or one day. Today, it was down 4%. This can happen early on with the notes, and you get stuck with the stock," the broker added.

"With a stock like Bank of America, losing more than 30% is not outside the realm of possibilities.

"Just getting interest payments on a stock that's that volatile doesn't seem very attractive to me."

Execution date

Kalscheur said that the price the stock will be trading at when the deal closes later this month will influence investors. If the stock falls strongly, some investors may feel that they have acquired enough protection against future losses, leading them to buy the notes with more confidence.

"The execution date of this deal is going to have a big impact," he said.

"It's a bet on Bank of America. The closing price may be the make-or-break for this offering."

Collecting premium

For the broker, selling options may offer a better alternative if the investor's goal is to generate income.

"You could go out and sell options, and you could collect the premium," he said.

"If you really want to acquire the stock on the cheap, you could be selling some puts.

"And if you're long the stock and want some partial downside protection, then you can sell calls, trading off the upside."

The notes (Cusip: 61760E150) will price and settle in July.

Morgan Stanley & Co. LLC is the agent.

The fees are 2.25%.

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