Morgan Stanley’s contingent income notes have high rate but are hard to fit into portfolio

By Emma Trincal

New York, Feb. 13 – Morgan Stanley Finance LLC’s contingent income securities due Feb. 26, 2027 linked to the worst performing of the S&P 500 index, the Euro Stoxx 50 index and the Russell 2000 index caught buysiders’ attention due to the product’s very high fixed coupon paid during the first half of the tenor.

But equity risks involved during the second half make the asset allocation and risk assessment overly challenging, advisers said.

The coupon will be fixed at 7% per year for the first five years, payable monthly, according to an FWP filing with the Securities and Exchange Commission.

After that, the notes will pay a contingent coupon at an annual rate of 7% per month that each index closes at or above its barrier level, 60% of its initial level, on the observation date for that month.

The payout at maturity will be par unless any index finishes below its barrier level, in which case investors will be fully exposed to the losses of the worst-performing index.

The notes are guaranteed by Morgan Stanley.

Generous coupon

Carl Kunhardt, wealth adviser at Quest Capital Management, said it is “an interesting note,” because of its “very generous coupon during the guaranteed period.”

As such, income-seeking investors would be likely to benefit most, but with caveats.

It would be appealing and appropriate for income clients but unfortunately only during the first five years.

“But after that you get into the floating rate and you’re exposed to three different indexes, two of which are pretty volatile.”

Barrier

The two most volatile indexes, he explained, are the Russell 2000, which tracks the U.S. small-cap equity market, and the Euro Stoxx 50, which is used as the euro zone benchmark.

During the floating-rate period, investors may not get paid or they may receive irregular payments.

“Your coupon payments are going to suffer from the worst of performance. That’s not good for clients who live from their income. It wouldn’t be a good fit for them,” he said.

But having full principal at risk at maturity is ultimately where he would draw the line. This level of risk makes the notes unsuitable for fixed-income investors even with a deep barrier.

“The 40% protection is a pretty good number,” he said.

“If I look at the market that I can see, I’m pretty confident we’re not going to drop 40%.

“But I have no confidence to project what this market is going to be in five or 10 years from now.”

Allocation

So where would the notes fit in the portfolio?

“After five years, you’re moving with equity. So I couldn’t really put it in my bond bucket,” he said.

“It only works as an equity play despite the income objective.

“I guess I could use it as high-dividend stock or equity hedge.”

But then comes another asset allocation dilemma. Since the notes are potentially linked to any of the three underlying indexes –and no one knows which one ahead of time – should the allocation go to U.S. large cap, U.S. small cap or international?

With worst of, some advisers take a risk-based approach. They look at volatility in order to guess which among the different underlying indexes is likely to drop the most. They then allocate the notes to the bucket associated with this benchmark. But Kunhardt has a different approach, which is based on expected returns.

“I wouldn’t want to cap my returns on more promising markets. I think a 7% cap is OK with the S&P but not necessarily great with small caps and European stocks. That’s why I would probably end up putting the notes in U.S. large cap,” he said.

No bond

Overall, the product is “tempting” but “difficult to use,” he added.

“It doesn’t fit neatly into any bucket.

“The only interesting thing is the 7% for the first five years.

“But after that you have the worst of, the risk of losing a lot of money at maturity ... too many ‘gotchas’ for an income investor.”

Income

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, distinguished the “coupon risk” from the risk of losing principal at maturity and concluded that he would not consider the notes because of the latter.

The 7% fixed rate is “obviously pretty good,” compared to a Morgan Stanley corporate bond, he noted.

Even if the last five years paid the 7% on a contingent basis, the odds of getting paid are “reasonable,” he added.

“The probability of a 40% decline and lasting to me is small.”

Since the Morgan Stanley corporate bonds yields 3.8%, investors in the notes, with 7% per annum guaranteed for five years, would likely fare better than plain-vanilla bondholders, at least from a return standpoint, he explained

“A 40% drop is certainly sizable. I wouldn’t expect the market to drop that much unless you have a black swan event, even though the market as we know is pretty expensive right now,” he said.

Principal at risk

The real drawback is the full downside exposure to the worst performer in the event of a barrier breach at maturity.

“I have a serious reservation on this note when it comes to the risk at maturity. Even though 40% is a big drop, anything can happen in 10 years,” he said.

“To me, it’s a huge deterrent.

“It’s one thing to assess the risk of not getting your coupon. It’s another to lose your money or a big chunk of it at maturity.

“Of course, if you remove that piece, the note with its 7% for five years is very attractive.

“But who knows what happens with the economy 10 years from now?

“The ending loss of principal would not be attractive.

“I would say the ending is a non-starter.”

The end of the beginning

Given the risks, the notes would not be suitable for fixed-income investors.

But the investment may not be a good fit in an equity portfolio either, he said.

“It’s more dividend-stock type of play without the possibility of upside.

“You take all the risk of equity without the possible benefits.

“It looks like a bond because of the coupon, but you’ve got huge potential losses similar to equities.

“It’s kind of an unattractive bond.

“I don’t find it to be a very attractive proposal at all.”

Morgan Stanley & Co. LLC is the agent.

The notes will price on Feb. 23.

The Cusip number is 61768CFC6.

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