Morgan Stanley’s $25.04 million callable notes on indexes pay double-digit contingent yield

By Emma Trincal

New York, Sept. 23 – Morgan Stanley Finance LLC priced $25.04 million of 2.5-year notes offering a double-digit contingent coupon on U.S. equity benchmarks.

When it comes to generating high yields on broad-based indexes, issuers cannot just rely on spurts of volatility and worst-of payouts. In its deal, Morgan Stanley used a coupon barrier observed daily. This type of barrier, known as “American,” is rarely employed. Most notes rely on the typical “European barrier,” which provides point to point observation for either coupon payments or principal repayment.

Morgan Stanley Finance priced $25.04 million of trigger callable contingent yield notes with daily coupon observation due March 23, 2023. Investors will be exposed to the worst performing of the Nasdaq-100 index, the Russell 2000 index and the S&P 500 index, according to a 424B2 filing with the Securities and Exchange Commission. Each quarter, the notes pay a contingent coupon of 11.01% per year if each index closes at or above its coupon barrier level, 65% of its initial level, on every day that quarter.

The notes will be callable at par of $10 plus any coupon on any quarterly observation date other than the final one.

If the notes are not called and each index finishes at or above its downside threshold level, 55% of its initial level, the payout at maturity will be par plus any final coupon. Otherwise, investors will lose 1% for every 1% decline of the least-performing index.

American option

“It’s easier to put an American barrier on the coupon than at maturity. Investors feel a little bit more in control with that,” a market participant said.

“The daily observation on the coupon allows issuers to get a double-digit return while achieving deep protection levels.

“It’s an odd maturity but they probably were trying to target a specific coupon.”

American barriers have the reputation of not being popular since they involve much more risk given the higher probabilities of a breach.

“But I think there’s a market for these types of barriers because they address a fundamental need: getting a higher yield with a decent level of downside protection.”

“Putting an American barrier on the coupon is something you can explain to a client. I think most clients can see the benefit of it,” he said.

Additional features are usually necessary to boost the coupon and possibly strengthen the barriers. Some are not widely used yet they are well-known such as issuer calls, which is one of this deal’s features.

The use of daily observations for the payment of the contingent coupon is more “innovative,” he said.

Volatility to the rescue

With the volatility pickup, however, issuers have other options than the use of those riskier barriers, he said.

“With the Elections coming up, the deadlock in Congress over a stimulus bill, now the nomination of a new Justice, volatility will stay elevated.

President Donald Trump is about to announce his pick to fill the Supreme Court vacancy left by the death of justice Ruth Bader Ginsburg last week.

The replacement of a Justice a few weeks before the Elections has heightened political tensions between Democrats and Republicans.

Since the deal priced last week, the S&P 500 index has already dropped 2.5%.

“If volatility continues to spike, you’ll be able to strike 11% or 12% coupons and doing that without American barriers,” he said.

Discretionary call

Issuer calls is another yield-enhancement strategy, he said.

“It’s more common than an American coupon barrier. You can definitely get a much higher return,” he said.

In addition, investors tend to be comfortable with issuer calls as the issuer is more likely to call the notes when the coupon on the note is above average.

“The issuer would call when rates are going down. Hard to imagine they could fall further than their current levels,” he said.

To be sure, an equity rally would also incite the issuer to call the notes. Such outcome and its causes however would be similar to an automatic call event, he said.

Know the risks

An industry source said the structure was attractive as long as investors understood the implications of a daily observation of a barrier.

“The 65% coupon barrier is not too bad. On a quarterly adjusted basis, it’s 2.75%. If you compare this to alternatives in bonds or with dividends, it’s quite advantageous,” he said.

“One of the benefits of an American barrier is to be able to price at very deep, low barrier levels.

“You’re getting exactly that here.

“But the devil is in the details. Daily observations have some limitations. You have to be aware of it.”

Another deal

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent, and UBS Financial Services Inc. is acting as dealer.

The notes priced on Sept. 18 and settled on Sept. 23.

The Cusip number is 61771D472.

The fee is 1%.

Morgan Stanley Finance priced another issue for $4 million. It was another worst-of note on the same three indexes with nearly identical terms.

The coupon barrier and daily observation were identical. However, the coupon size was higher at 12.13%, which raised the barrier at maturity to 60% instead of 55% in the larger deal.

The notes (Cusip: 61771D464) priced on the same day. UBS was also the agent. The notes carried the same fee.

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