Morgan Stanley's income securities tied to Russell 2000 offer contingent yield, low barrier

By Emma Trincal

New York, Oct. 15 - Morgan Stanley's contingent income securities due Oct. 31, 2019 linked to the Russell 2000 index offer enhanced yield, but investors must be willing to accept the longer duration and the contingency of the coupon payment. In addition, capital is at risk even though the risk is somewhat reduced by a conservatively low barrier, sources said.

"It's an interesting structure. They can price it. The question is: how will it sell? It's probably a little bit harder to sell because this is a hybrid, some sort of a niche product," a market participant said.

The notes will pay a contingent monthly payment of 8% per year, or $6.6667 per $1,000 principal amount of notes, if the index closes at or above the downside threshold level of 51% of the initial price on the determination date for that month, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, no coupon will be paid that month.

If the final index level is greater than or equal to the downside threshold level, the payout at maturity will be par plus the contingent monthly payment. If the final index level is less than the downside threshold level, investors will be fully exposed to the decline of the index from the initial level.

Reasonable bet

Carl Kunhardt, wealth advisor at Quest Capital Management, said that his first reaction was to find the product "fairly aggressive for an income-oriented" account.

But after a second look, he found the risk to be less elevated than he had earlier thought.

"It looks aggressive at first especially with a seven-year maturity. Seven year is a pretty long investment period," he said.

"Since there is risk, you have to ask yourself: what are the odds of the Russell 2000 to be down 51% after seven years? I have to think it's very small. So, I'm not sure it's such an aggressive investment. I could probably show it to some of my income clients," he said.

While the securities do not guarantee the return of principal, Kunhardt said that the combination of a long duration and a deep barrier made him feel relatively comfortable.

"Investors always want to know one thing: what's my worst case scenario?

"For clients seeking income, two questions really matter: am I getting my income return stream or am I not? Am I getting my principal back or am I not?

"That's what they care about.

"With this, they know that the index has to lose half of its value for them not to get their coupon.

"And the index would have to be down by half after seven years for them to lose principal."

"I just don't see that happening. Nowhere in history have we lost that much over a seven year period," he said.

He looked at the Russell 2000 performance in 2008.

"Even at the worse time, in 2008, we didn't go down by 50%," he said.

The index declined by 34% during this "very bad year," he noted.

"And we were down from the highs of 2008. It's not like we were down from 2001."

From the end of 2001 to the end of 2008, the Russell 2000 gained 2%.

Longer is better

For this type of structure, Kunhardt said that the longer maturity may actually be favorable to investors.

"If it was a three-year notes oddly enough I would be more cautious about the risk of hitting the 50% level," he said.

"You've had bad years between 2000, 2001 and 2002.

"We've had plenty of years where the Russell was down. The small-cap benchmark is more volatile, so no doubt it can happen. But you can count on one hand the number of times the Russell has been down 50% over a five or seven year rolling period," he said.

"You do have the credit risk. With a single-A-, Morgan Stanley is not the most creditworthy issuer. But it's also a 'too-big-to-fail' bank. Their credit is not junk. You're still talking about an investment-grade security," he added.

Separately, Morgan Stanley announced the pricing of a quasi-identical product based on a different index - the S&P 500. Instead of a seven-year maturity, the notes due Oct. 31, 2022, had a 10-year term. And the coupon was one percentage point lower at 7%. The conditions required in order to get the monthly interest contingent coupon payment were identical except for the downside threshold level set at 50% instead of 51%.

"I like it just the same," said Kunhardt.

"The 10 year doesn't bother me. It's odd because normally the shorter, the safer. But in this case, the longer-term works for you. I'm betting that I won't lose half of my principal over 10 year. I see that as a reasonable bet.

"You don't have principal protection. It's kind of long. But you're getting an 8% income stream if you don't fall below 50%.

"I would do it and it's based on my economic outlook. I just don't see the Russell dropping 50% and staying there for seven years," he said.

Tenors and odds

A market participant said that the notes were attractive to income-seekers but that the duration may make it harder for the issuer to sell the product. Unlike Kunhardt, he did not think that a longer tenor was a plus for this particular product.

"In the equity markets, the old assumption was that as you go longer in time, your index or asset is going to rise in price. But these models are based on historical levels and things have changed over the past recent years with the lower interest rates. The options are not based on historical values. Issuers look at what the stock is trading now," this market participant said.

"They look at the forwards, which, among other things, take into account the relationship between dividends and interest rates. With interest rates so low now, the assumption that you have a high probability of getting more over time may no longer be necessarily true."

This market participant compared the two planned offerings, noting that the main differences were the underlying indexes and the 7% versus 8% coupon amounts. Those two elements were related, he said.

"The Russell 2000 is more volatile than the S&P, which is why they're paying you more. The chances of hitting the barrier are greater with the more volatile underlying index so you get a higher contingent coupon for that reason," he said.

"It's an interesting product. The structure is interesting - nothing wrong with it. The question is will they be able to sell it?" he said.

Part of the difficulty, he explained, may be the duration. But the main drawback could simply be that the structure did not fit into a box due to its hybrid nature.

"For the adviser, the problem may be: fine. But where can I put this note?

"It's not principal protected. It's not income because your income depends on the index level."

"It's not growth because you're not getting any participation in the index growth. That probably makes it a little harder to sell," he said.

The notes tied to the Russell 2000 (Cusip: 6174823A0) and the notes linked to the S&P 500 (Cusip: 6174822Z6) will price on Oct. 29 and settle on Oct. 31.

Morgan Stanley & Co. LLC will be the agent for both products.

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