Morgan Stanley’s fixed-rate autocalls on indexes show fair risk-adjusted return, analyst says

By Emma Trincal

New York, Sept. 4 – Morgan Stanley Finance LLC’s plan to price 12% fixed income autocallable securities due June 23, 2021 linked to the least performing of the S&P 500 index, the Russell 2000 index and the Nasdaq-100 index strike a relatively good balance between risk and reward, said Tim Mortimer, managing director of Future Value Consultants.

Interest is payable monthly, according to an FWP filing with the Securities and Exchange Commission.

After three months, the notes will be called at par if the worst performing index closes at or above its initial price on any coupon payment date other than the final one.

If the notes are not called, the payout at maturity will be par if the worst performing index declines by up to 30%.

If the worst performing index finishes below its 70% downside threshold level, investors will be fully exposed to the decline.

Solid correlations

Investing in a worst-of note requires carefully examining the correlations between the underliers as risk decreases with higher correlation levels, Mortimer said.

“Even though we’re talking about different segments of the U.S. economy, large-cap, small-cap and tech, it’s all U.S. equity, so we get three highly correlated underlying,” he noted.

Future Value Consultants offers stress-testing on structured notes to determine the probabilities of occurrence of outcomes pertaining to a specific structure type.

The correlation matrix in the report generated for this product showed that the Nasdaq and S&P 500 were the most in synch with a correlation of 97.19%. This is due to the overrepresentation of technology in the S&P 500 index where five mega-cap technology stocks constitute a quarter of the index, he said.

The Russell 2000 and the Nasdaq on the other hand displayed the lowest correlation at 92.57%. The Russell and the S&P stood half-way with a 96.62% correlation.

“These correlations are pretty high, so you limit some of the risk somewhat,” he said.

Short tenor, high yield

One advantage of the notes was the short duration along with the existence of a barrier.

The short term helped with the pricing of the coupon, he said.

“It's a nine-month. With shorter-dated income notes you get a higher coupon. It’s the essence of reverse convertible products,” he said.

He explained why.

“The downside risk pays for the income. The value of the income is linear. If you had a two-year note versus a one-year, your income would double. However, the risk does not go up as steeply. The issuer has to pay double the amount of income, but the risk doesn’t keep pace with the income. Since you’re selling the risk to pay for the coupon, you’re not getting as much value all things being equal when you go out longer. In fact, it becomes more expensive,” he said.

Barrier

The question for investors is whether they think the market can drop more than 30% in the next nine months.

“We’ve seen a 35% crash in February and March, so will it happen again between now and June?” he said.

The answer to this question is not obvious.

“There is risk. But in order to pay 12% there’s got to be some risk.”

The protection size contributed to lessen the risk.

“A 70% barrier in nine months is pretty good,” he said.

“You can afford all indices to drop 30%, which is quite drastic. If you’re willing to take that risk and none of the indices fall by more than 30% in nine months, the trade will be successful. You’ll get your principal back and your full coupon.”

The automatic calls, which start after three months, also mitigate the risk of principal loss, he said.

Stress-testing

Mortimer analyzed the probabilities of various outcomes, including calls, based on the model’s Monte Carlo simulation.

In each of its reports, Future Value Consultants offers 29 sections or tests, which encompass simulation tables as well as back-testing analysis. They can be customized in any combination.

The investor scorecard is one of the most used tables. It consists of different mutually exclusive outcomes of product performance. The table shows for each outcome, probabilities of occurrence, average return and average duration.

The outcomes for this product are as follow: calls at various dates or “call points;” full capital return; and loss. The bucket for a separate outcome called “capital loss but total return above capital” has a 0% probability associated to it since the minimum loss of 30% exceeds the maximum return of 12%.

Calls

Looking first at the call probabilities, Mortimer found a 46.72% chance of a call taking place on the first call date, following the three months no-call period.

“This is pretty high for a worst-of. The call at point one typically happens half of the time with most autocallables tied to a single index. It’s usually lower for a worst-of. If your chances of calling on the first date are close to average as it is here, it’s probably because of the high correlations,” he said.

The distribution of probabilities for the following call points is also slightly different than what it is for the average autocall, he said.

The call at point two for instance has an 8.72% probability of occurring, followed by 5.48% for the call at point three. The next calls see their respective probabilities decline but not as drastically as usual.

“It holds quite well. If it hasn’t called on the first date, you still have a reasonable chance of calling later. The correlations here again are probably the main factor,” he said.

Average loss

On the downside there is a 10% chance of a barrier breach, the simulation showed.

The back-testing table showed that the barrier never breached over the past five and 10 years. The frequency observed for this outcome in the last 15 years was only 3.16%.

Upon the breach of the barrier, investors will lose on average 36% of capital, according to the scorecard.

This amount is not overly far from the minimum possible loss of 30%, which occurs at the first breach.

The payment of nine-months’ worth of coupon, or 9%, helped cushion the total loss amount, he explained.

For instance, the best-case scenario would be a total loss of 21%, which is the minimum loss minus the coupon.

“In the same way, your 36% average includes the 9% coupon. If you didn’t have that cushion, the average loss would be 45% of capital,” he said.

“It’s quite high but not out of the ordinary for an autocall.

“Those products typically offer a good chance of getting a small return and a small chance of taking a massive loss. It’s the typical skew.”

Worst-of reverse convertible

The notes belong to the traditional reverse convertible category of products. Those notes’ main characteristics are their short maturity and fixed coupon.

The difference is the exposure to the worst performing of three broadly diversified indexes rather than to a single, volatile stock. The automatic call is also not characteristic of traditional reverse convertibles.

“While the worst-of adds some risk, I personally would rather take the worst of three indices than going with a single stock,” he said.

“The single stock has to be quite volatile, and anything can happen when you get exposure to one name.”

The notes are not a good fit for everyone.

“This is for people who don’t believe any of those indices can decline by more than 30% in nine months,” he said.

“It’s not for anyone who expects big gains in the market since the coupon is a cap.

“If you were bullish, you’d go for something more bullish obviously.

“This is mostly designed for income investors who expect the market to trade range bound.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes will price on Sept. 18.

The Cusip number is 61771B3F9.

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