Regional banking ETF helps boost coupon in Morgan Stanley’s $3.39 million 14% callable notes

By Emma Trincal

New York, July 19 – Morgan Stanley Finance LLC’s $3.39 million of callable contingent income securities due April 17, 2025 linked to Russell 2000 index, SPDR S&P Regional Banking ETF and Nasdaq-100 index pay an eye-catching coupon thanks in large part to the use of the volatile banking ETF, sources said.

Investors will receive a coupon of 14.1%, paid monthly, if each underlier closes at or above its 60% downside threshold on the related monthly observation date, according to a 424B2 filing with the Securities and Exchange Commission.

The securities may be called starting Jan. 18, 2024 at par on any quarterly call date.

At maturity the payout will be par unless the worst-performing asset closes below its 60% downside threshold, in which case investors will be fully exposed to the decline of the worst-performing asset.

Yield booster

“KRE adds to your coupon because it’s pretty volatile,” said Mark Dueholm, chief fixed-income trader at Landolt Securities, referring to the ticker of the SPDR S&P Regional Banking ETF.

The worst-of structure combined with the issuer call were not the primary sources of premium.

“It’s really the use of KRE that’s boosting your coupon.

“That ETF is all over the place. People like it because it pays a lot. Also, for many, we’ve come out of the banking crisis,” he said.

Term, barrier

The one-year and nine-month maturity did not seem odd to Dueholm.

“Morgan Stanley does a lot of 1.75-year deals. It’s not uncommon for them,” he said.

The barrier size was appealing.

“With a 60% barrier, I can see why people would do this. It’s attractive. It’s not for risk-averse investors obviously. If one of those banks goes under, KRE would go bonkers. But you’re getting paid for the risk.

“I suppose the client may have been an RIA or a brokerage. I see it as a one-off,” he said.

Correlations

Correlations between the two U.S. broad-based indexes was relatively strong, he said.

The Nasdaq-100 index, and the Russell 2000 have a coefficient of correlation of 0.77.

Indexes are showing gaps in their respective returns this year. For instance, the Nasdaq-100 and the Russell 2000 rose 37% and 14%, respectively, this year.

“They move pretty much in the same direction, but one can significantly outperform the other,” he said.

But the outperformance factor doesn’t matter much with an income product.

“All you need is to be either above initial price or above barrier level so you can collect your coupon.

“But KRE is different because it’s focused on banks,” he said.

The coefficient of correlation between the regional banking ETF and the Russell 2000 index is only 0.45.

Price action

Overall, Dueholm found the notes somewhat risky given the use of the regional banking fund.

“If anything happened in the banking industry, the ETF could be destroyed,” he said.

“Like any index or fund focusing on an industry, it’s very volatile.”

Price action for the past 12 months illustrates the magnitude of the funds’ price swings.

The ETF share price has somewhat recovered from a $34.52 one-year low in May, closing at $47.15 on Wednesday. But the ETF is still priced 31.5% off its 52-week high of August at $68.83.

“The only reason this note pays 14% is because of KRE. Take it out and the coupon will drop multiple points,” he said.

Polarizing choice

A market participant had a similar opinion.

“It’s really interesting that they would pick KRE. KRE is much more volatile than the Nasdaq since Nasdaq has been going up so much. With regional banks, there is still a lot of uncertainty. Some people think that the regional banking crisis is behind us and that it’s OK. Others don’t. It’s a bit of a polarizing choice,” he said.

For this market participant, the 60% barrier was tight.

“I would personally prefer a 50% barrier. I bet the coupon would still be very good, a least double-digit for sure,” he said.

“Other than that, it’s a pretty good deal. I’m surprised they didn’t sell more.”

This market participant said he has seen many deals tied to the regional banking ETF.

“Issuers are doing quite a bit of those KRE products. Many are linked to the ETF alone. I see a lot of CDs on it as well. When it’s a note, the downside protection is usually bigger. They’re selling a lot of that stuff,” he said.

A sense of relief

Despite the regional banking turmoil in March with JPMorgan purchasing First Republic’s assets and Silicon Valley Bank collapsing, investors are relatively comfortable with the SPDR S&P Regional Banking ETF, he said. “There is a lot of confidence that the government will step in.”

The fund itself appears relatively diversified, according to some buysiders. The weight for each of the 139 holdings does not exceed 2.17%.

But the market participant recommended caution.

“I don’t think KRE is as diversified as some may think. You shouldn’t rely on this. The holdings in the ETF are extremely correlated, which is why the ETF is so volatile.

“I do like the deal. But I would prefer to have a little bit more downside protection. I don’t think you would sacrifice much on the coupon if you had a bigger barrier,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on Monday.

The Cusip number is 61775HHF7.

The fee is 0.65%.

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