Morgan Stanley shows innovative barrier with ‘Cannon’ securities tied to two indexes

By Emma Trincal

New York, Feb. 4 – Morgan Stanley’s contingent income autocallable cannon securities due Feb. 27, 2030 linked to the worst performing of the Russell 2000 index and the Euro Stoxx 50 index introduced an unusual type of payout at maturity, sellsiders said, if the notes are not called.

The notes will pay a contingent monthly payment of 7% per year if each index closes at or above its barrier level, 75% of the initial level, on the observation date for that month, according to an FWP filing with the Securities and Exchange Commission.

After five years, the notes will be redeemed at par plus the contingent payment if each index closes at or above the initial level on any quarterly redemption date.

Innovative feature

“Now here is the interesting part,” said an industry source, commenting about the payout at maturity if there is no early redemption scenario.

The payout is based on the return at maturity of the worst-performing index in relation to 50% of its initial price, which the prospectus designates as the threshold level.

Investors will receive a positive return of 2% for each 1% by which the final value of the worst-performing index is greater than its threshold level.

If the index finishes below the 50% threshold level, investors will lose 2% for each 1% by which the final value is less than its threshold level. There is no minimum payment at maturity.

“I’ve never seen that. It’s very interesting,” said an industry source.

“If you don’t get called and the worst of index ends up between flat and negative 50, you get two times the value above 50.

“The leverage at maturity around the barrier is something I’ve never come across before.

“I guess the idea is that if you’ve never been called, maybe the model shows that you are more likely to be down by more than 50%. Therefore by putting the leverage of two on both sides, maybe it helps the economics and perhaps it also helps as a selling point because the worst index could be down 30% or 40% and you’re still getting something positive at maturity.

“If you get to maturity, it probably means that you haven’t collected any coupon for a while, so getting a little premium at maturity is not that much of a consolation but it helps.”

Decent coupon

While the payout at maturity was the most “intriguing” part of the deal, this source said that the “most attractive” aspect of the structure was the 7% coupon with a five-year call protection.

“If you didn’t have that, you’d get called early and the game is over,” he said.

“I like this call. For five years, it cannot get called away from you. It’s a decent yield for a five year.

“Both indexes need to be above 75%, and you get a 7% a year coupon. It’s a decent coupon. The 75% level is a decent condition.

“Best-case scenario, it goes well and you’re collecting 7%. That’s the type of coupon that can attract investors.”

Among the risks were the possibly low correlation between the two underlying indexes and Morgan Stanley’s creditworthiness.

“You have two well-known, broad-based benchmarks. Now they may not necessarily move in synch. There is a divergence between Europe and the U.S. Europe seems to have a mind of its own. The worst of could very well be the Euro Stoxx. Most people don’t anticipate the Russell to plunge 50% but with European equity it happened before,” he said.

“It’s Morgan Stanley credit, so you have a little bit of credit risk.”

The five-year credit default swap spreads for Morgan Stanley are 80 basis points, compared to 69 bps for Bank of America, 68 bps for JPMorgan and 51 bps for Wells Fargo, according to Markit. However Goldman Sachs is at 88 bps and Citigroup at 82 bps.

“It’s a very different type of product. Will others try to replicate the structure? It’s always a possibility. But I’m not certain about it because it looks like the deal targets some of the bank’s most sophisticated clients.”

A twist

A structurer said that he had been looking at contingent autocallables lately and that the product caught his attention.

“This one is a little bit of a twist. I don’t think I’ve seen it before. They call it ‘cannon,’ which is very intriguing,” he said.

The structurer explained that the “contingency autocallable part” was “pretty standard.”

“You get the coupon under certain conditions. You get called under certain conditions. If you’re not called, you get something else,” he said.

“But here is the difference: with a traditional autocallable, you get at maturity either par back or the index decline if you finish below the barrier. Here the strike is at 50 but it’s two-times leverage up or down.

“If you get two-times what’s above the 50% threshold, it’s actually quite good for the investor.

“They’re probably giving you this because the coupon is not something like ‘wow.’ It’s a 15-year Morgan Stanley, a worst of, 7% is not a huge pick-up. But you have even less of a chance of losing.”

Gains from losses

He offered the following example.

A hypothetical investor would be “lucky” to see at maturity the worst-performing index down 0.1%. The final price would be at 49.9 points above the 50% threshold. Based on the formula, the investor would receive two-times that range in gains or 99.80% in positive return.

“You double your principal,” he said. “One hundred percent in return is the maximum you can get.”

In another example, describing a downside scenario, the worst-performing index would decline by 60%, or 10% below the 50% level. As a result, investors would lose two times 10% or 20%.

“It’s pretty protective: you lose 20% versus losing 60% in the regular version of the structure.”

Forward, not knock-in

The “normal” contingent autocallable deal features a barrier, which is built on a knock-in put, he explained.

The components of the structure were different with this product.

“It’s a zero. But it’s not a knock-in put. It’s a two times forward,” he said.

“You’re long two-times leverage a 50 strike call capped at 100 and short two-times leverage a 50 strike put.

“For the put, the maximum you can lose is your principal, and that’s 50 points below the strike times two. “On the upside however, there is a 100 cap because the maximum you can get is twice the difference between 50 and 100.

“This gives investors something very attractive. Normally, if you don’t get called, meaning you finish negative, you get... best case scenario... par back if you close above 50. Here you get more than par. You can get up to 100%.”

The structurer was “intrigued” by the structure and wondered why it had not been seen before.

“Maybe it’s because normal investors are always too happy to get par if the underlying index is down at the end. The standard way to do those deals is to give investors par back but to throw in a much better coupon.

“Maybe most investors have expectations on the upside. If the price is down, give me my money back... That would be the expectation. I don’t need more money if it’s down. But I need a higher coupon.”

Morgan Stanley & Co. LLC is the agent.

The notes will price on Feb. 24 and settle on Feb. 27.

The Cusip number is 61761JWR6.

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