Morgan Stanley’s $1 million notes show bearish bias with levered absolute return

By Emma Trincal

New York, Feb. 5 – Morgan Stanley Finance LLC’s $1 million of 0% dual directional buffered participation securities due April 30, 2025 linked to the Russell 2000 index and the iShares Russell 1000 Value ETF provide leveraged absolute return on the downside, rewarding bears significantly more than bulls. However, the note may be too bearish for most investors, said one adviser, while the chances of outperforming the market remains too slim, another one said.

If the return of the worst performing asset is positive, the payout at maturity will be par plus the return of the that asset, subject to a maximum return of par plus 12.8%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par plus 1.5 times absolute return of the worst performing asset if it declines by no more than 15% and will be exposed to any decline in the worst performing asset beyond 15%.

Value piece

“It’s not a bad note. I like the originality of it,” said Ken Nuttall, chief investment officer at BlackDiamond Wealth Management.

He pointed first to the to the leverage applied to the absolute return within the buffer zone.

“I haven’t seen it very often. It’s pretty creative,” he said.

Also unusual was the choice of the iShares Russell 1000 Value ETF, which tracks large- and mid-cap U.S. equities that exhibit value characteristics.

“It may help. Value is usually less volatile,” he said.

The ETF has an implied volatility of 12.27 versus 23.36 for the Russell 2000 index.

Banks’ sell-off

The Russell 2000 is down about 4.45%, lagging the other benchmarks, he noted.

Just in the past five days, the small-cap benchmark lost 3.7%.

“The index got pummeled last week because of the banks,” he said.

New York Community Bancorp reported losses on Wednesday, which were related to its commercial real estate portfolio.

This regional bank bought parts of Signature Bank last year when it collapsed in March.

“The whole sector last week came down and hit the Russell 2000, which has tons of banks,” he said.

Indeed, the financial sector is the second largest in the Russell 2000 index after industrials.

Absolute, leveraged

But the most “original” feature was the leveraging of the absolute return for any decline of 15% or less.

“15% is nice. But on a 15-month, I would like it bigger. However, you also get paid 1.5x on the downside,” he said.

The payout on the upside was quite different with a one-to-one participation and a lower cap, he added.

“It is certainly a bearish note,” he said.

The maximum potential return on the downside is 22.5% if the index drops 15% compared to 12.8% on the upside.

“If you think the market will be crazy up, of course you don’t buy the notes.

“This is definitely not a bullish play, that’s for sure,” he said.

Nuttall said he liked the note but that selling it may be challenging.

He invoked two factors.

“Most client never heard of the Russell 1000 Value. So, it’s a little bit hard to talk about it.

“Also, advisers in general don’t play the downside. They tend to be optimistic people.

“I still think it’s a fairly good trade,” he said.

Back-testing

A financial adviser analyzed the notes using back-testing. He said he had data on the Russell 2000 index going back to 1997 but not on the ETF.

“It’s a little tricky. I’m going to run my analysis on the Russell 2000 only. Obviously, it’s not going to give me the full picture,” he said.

He also noted that he lacked the statistical tools to analyze probabilities of a worst-of payout.

Over 15-month rolling periods, the odds of the Russell posting a negative result are 28.2%, leaving a 71.8% chance for a positive return.

The probabilities for each bucket were as follows:

•∙18.8% for the leveraged absolute return, which is associated with a price drop of 15% or less;

• A 9.4% probability for a declining price below the buffer;

• On the upside, a 21.4% chance of a gain below the cap; and

• A 50.4% probability to underperform if the price rises above the cap.

One-to-one, capped

This adviser said the back-testing analysis yielded “disappointing” results.

“First, you’ll never outperform on the upside. You will only market perform 21.4% of the time and that’s without taking into account the loss of dividends.

“Once you’re above the cap, you definitely underperform and that’s more than half of the time. That’s kind of a lot. You really win if the market is down. You have to have a pretty negative outlook, some kind of half empty glass type of outlook,” he said.

Occasionally great

The downside outcomes also disappointed this adviser even though the buffer always allows investors to beat the market thanks to the hard protection.

“It’s good to lose only 5% if the index is down 20%. You’re losing less money. But you’re not making any money either,” he said.

The real attractive part of the payout was within the absolute return range, or any decline at or above the minus 15% buffer threshold.

“But this outcome only happens 18.8% of the time. That’s less than 20% while you have more than 50% chances to outperform,” he said.

Overall, this adviser was not inclined to consider the notes for his clients.

Bearish

“It’s a little strange. You’re kind of rooting for the market to go down to make money,” he said.

“There may be a case here for downside protection or hedging.

“We hit all-time highs. I don’t believe the market is overvalued but a lot can happen in 15 months.

“But I can’t get too excited.

“You’ll outperform not even 20% of the time and you’ll underperform more than 50% of the time.

“The chances of doing well and being happy are pretty slim.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on Jan. 30.

The Cusip number is 61771WSA7.

The fee is 0%.

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