Morgan Stanley’s dual directional trigger PLUS on S&P, Russell offer ‘deep’ barrier

By Emma Trincal

New York, Oct. 24 – Morgan Stanley Finance LLC’s 0% dual directional trigger Performance Leveraged Upside Securities due Oct. 26, 2023 linked to the lesser performing of the S&P 500 index and the Russell 2000 index give investors a wide range of absolute return and downside protection due to a low barrier, sources said.

If each index finishes above its initial level, the payout at maturity will be par plus 106% of the return of the lesser-performing index, capped at par plus 45%, according to a 424B2 filing with the Securities and Exchange Commission.

If either index finishes at or below its initial level but each index finishes at or above its trigger level, 60% of its initial level, the payout will be par plus the absolute value of the return of the lesser-performing index.

If either index finishes below its trigger level, investors will lose 1% for every 1% that the lesser-performing index declines from its initial level.

Deep barrier

One characteristic of the absolute return index-linked note was its “deep,” relatively defensive barrier, a structurer noted.

The decomposition of the downside shows two option positions, he said.

One is a long at-the-money put; the other is two short knock-in puts.

The long at-the-money put protects investors from any loss below the initial price of 100. The “at-the-money” price or current price is 100. But the barrier is activated by the sale of two “at-the-money” puts “knocking in” at the barrier level, he added.

The seller of a put is obligated to buy an asset at the strike price when the price falls below the strike, which turns the position into a loss. The short put is bullish, the seller assuming that the price will never break below the strike. It is the reverse of the long put position designed to secure protection below the strike.

“What the structure is doing is allowing you to make money on the way down to 60,” the structurer said.

“As long as you’re above 60, you’re good. So if you’re down 40, your return is 40. But when the barrier is hit, when your puts get knocked in, not only you stop making money, you lose money. How do you do that? You sell two 100 strike puts that knock in at 60. The first one kills the 100 strike put you were long. The other makes you lose money from the 100 strike. That’s your barrier breach.”

Tough buffers

Investors tend to prefer buffers to barriers in general especially with absolute return or dual directional deals.

A deep barrier will be more attractive than a higher one all things being equal. Ultimately, investors will prefer hard buffers to barriers.

But the pricing of buffers on absolute return notes is costly.

JPMorgan Chase Financial Co. LLC for instance last month priced $4.79 million of three-year buffered dual directional notes tied to the MSCI EAFE index. The buffer was at 23.25% but the participation rate in the absolute return up to the buffer threshold was 50% of the index decline and not 100%. The upside was unlevered and capped at 30%.

Issuers when trying to price buffered absolute return notes may also extend the duration. Another solution is to lower the cap.

Crystal ball

“If you get caught in a bear market you can nicely outperform. Theorically the market could be down 40% and you’re up 40%,” said Steve Doucette, financial adviser at Proctor Financial.

“I wish I would have a crystal ball to time the bear. We know one is coming. We just don’t know when.”

The notes were likely to appeal to cautious investors for whom preservation of principal is a priority, another financial adviser said.

“It’s a really deep barrier. I’m not overly concerned about the downside,” said Matt Medeiros, president and chief executive officer of the Institute for Wealth Management.

He predicted more demand for non-directional plays in general.

“With the current market uncertainty, those absolute return strategies are going to be increasingly popular over the next few years,” he said.

“When you’re not sure about the market’s direction, products that can benefit investors if the market is either up or down will be in greater demand.”

10% cap

Advisers had different opinions on the cap based on their respective outlook.

“This cap is very generous,” said Medeiros.

The 45% maximum return offered by the notes corresponds to a 9.75% annualized compounded return.

“We have lower return expectations for those two underliers so this cap is totally fine for us.”

Doucette however was not sure the duration and the cap matched his outlook over the next four years.

“We’ve been more than 10 years in a bull market. Within the next four, it’s likely that we’ll hit a bear. During that time, the market can go all the way down and back up. We know bear markets are short-lived.

“So you’re capping yourself at 10% a year. It’s not bad, but if the market rebounds you’re limiting your upside,” he said.

The modest leverage factor would not help investors if the recovery was slower or performance sluggish.

“You’re mostly outperforming on the downside. That’s where the value is,” he said.

“I guess I would need a crystal ball to know when the bear is going to hit.”

More bullish version

If he had to restructure the notes, Doucette would opt for a shorter tenor. That’s because the likelihood of a pullback is greater over the short term.

“I would probably prefer to have this note on a two or three year. But you’d be giving up some terms.

“I may want to capture a little bit more upside even if I have to reduce the barrier a little bit.

“I’d try and get a little bit more leverage with a higher cap if it’s possible.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes will settle on Friday.

The Cusip number is 61769HZD0.

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