Morgan Stanley’s contingent income autocalls on indexes feature two-year teaser rate

By Emma Trincal

New York, Nov. 14 – Morgan Stanley Finance LLC’s contingent income autocallable securities due Nov. 22, 2034 linked to the least performing of the Russell 2000 index, the S&P 500 index and the Euro Stoxx 50 index borrow from interest-linked notes a feature which is less common for equity products: the payment of a fixed rate for a limited period of time along with a long tenor. Other than that, the structure follows the classic framework of a typical income-oriented note: a worst-of payout on indexes with an autocallable option and a contingent coupon.

For the first two years, the notes will pay a fixed coupon each quarter at a rate of 7.75% per year, according to a 424B2 filing with the Securities and Exchange Commission.

After that, the notes will pay a quarterly contingent coupon of 7.75% per year if each index closes at or above its coupon threshold level, 60% of its initial level, on the determination date for that quarter, plus any previously unpaid coupons.

Beginning Nov. 15, 2021, the notes will be automatically called at par if each index closes at or above its initial level on any quarterly redemption determination date.

The payout at maturity will be par unless any index closes below its 60% downside threshold level in which case investors will lose 1% for every 1% that the least-performing index declines from its initial level.

Fixed-rate at first

A financial adviser showed a strong interest in the structure.

“I haven’t seen notes like that where you get a guaranteed coupon for the first two years. I kind of like that,” said Steve Doucette, financial adviser at Proctor Financial.

“Of course, you don’t see 15-year notes very often. But it doesn’t matter because this thing is callable.

“For the first two years, you know you’re getting 7.75% a year. Not bad.

“After that, you either get called or you collect your coupon along the way.”

Low barrier

While the coupon payment is contingent and no longer guaranteed after the end of the second year, Doucette said the probabilities of getting paid were still relatively high.

“40% is a pretty strong barrier to breach. One of the three indices would have to fall more than 40%.

“It’s possible but then the market comes back. While you’re holding the notes, your principal is not at risk. It’s only at maturity.

“The odds are slim that you’re not going to make money. Worst case, you might miss a coupon or two, but that’s not even a full year...that’s less than 4%. Even if you miss the coupon for a year, you’ll recover. A 40% pullback is a big drop,” he said.

Call option

A 15-year maturity is unusual for buyers of equity-linked notes.

“It looks strange. But you’re not going to be holding the notes during all that time. You’ll be called way before maturity,” he said.

One downside of the note for an adviser may be how clients may react if the market tumbles.

“Your risk is that the valuation of the note is going to get ugly if the market goes down,” he said.

But this concern had more to do with managing clients’ expectations than risking any principal.

“You can only lose money 15 years from now. Your risk is at maturity. It’s a matter of making the client comfortable,” he said.

The chances of getting called also reduced the risk of losing principal at maturity. The exposure is tied to three underliers (instead of the more commonly used number of two). But these three underliers were broad-based equity benchmarks, showing less volatility than single stocks.

“Besides, I’m not very concerned about the Euro Stoxx as it hasn’t done a whole lot except for the last three months.

“You typically just have the S&P and the Russell in most deals. Adding this third index doesn’t represent a huge problem,” he said.

Expensive

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said income products have a place in portfolios at this point in time. But he expressed concerns about the long tenor and the cost.

The fee is 3%, according to the prospectus.

“If you get called on the first call date, in November 2021, that’s 1.5% a year. It’s a lot,” he said.

Bright future for yield

The structure however offered some appeal.

“We’ll see more of this income-type of notes over the next few years because we believe that we are in the late stages of a bull market,” he said.

When growth is limited, investors are better off with a target return. The coupon offered by the notes was in line with his predictions.

“Having a stated interest will be preferable in the future, especially if it’s at or above our return expectations.”

His firm expects equity returns in the low to mid-single digits in the next few years.

Despite those advantages, Medeiros said that he would not consider the product.

“I just don’t particularly like the long term of this note. I wouldn’t buy it because of the term and the cost.

“If it gets called in two years, it’s costly. If it’s not, it’s risky.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes will settle on Nov. 22.

The Cusip number is 61769HQ57.

© 2015 Prospect News.
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