Morgan Stanley’s $774,000 contingent income autocallables tied to Seadrill eyed for 30% coupon

By Emma Trincal

New York, March 19 – Morgan Stanley’s $774,000 of contingent income autocallable securities due March 20, 2017 linked to Seadrill Ltd. stock represent the highest-coupon deal seen so far this year, according to data compiled by Prospect News.

Yet sources were not surprised by the small size of the offering, arguing that the risk-reward of the notes is not enticing given the underlying volatility of the stock and the bearish oil sector in which the drilling company operates.

If Seadrill stock closes at or above the 50% downside threshold level on a monthly determination date, the notes will pay a contingent payment of 30% per year for that month, according to a 424B2 filing with the Securities and Exchange Commission.

If Seadrill stock closes at or above its initial price on any of the quarterly determination dates, the notes will be redeemed at par plus the contingent payment.

If Seadrill stock finishes at or above the downside threshold level, the payout at maturity will be par plus the contingent quarterly payment. Otherwise, investors will be fully exposed to any losses.

Volatility

“It’s a very high coupon. It’s also a very volatile stock,” a market participant said.

A nearly two-year put shows an implied volatility of 80% for the stock versus less than 20% for the S&P 500 index.

“The coupon you’re getting reflects essentially the volatility of the stock. But everything else gets priced in: credit risk, reinvestment risk, etc.” he said.

A trader described some of the risks: “You may not get your principal back. You may not even get your coupon. There is no upside participation like an equity position. You’re exposed to a variety of risk factors.

“This is treated like a debt instrument, but you’re not going to get any guarantee. For instance, you don’t know if you’re going to get your principal back. You don’t even know when you’re going to get your principal. There is reinvestment risk associated with that. If the stock appreciates in value, you don’t participate in that. There are a lot of reasons why you would earn that type of return.”

No single stocks

Steve Doucette, financial adviser at Proctor Financial, said that he would not buy the notes.

“You get compensated if it doesn’t fall by half of its price, and they’re bringing this on the lower part of the range – but still. It’s a very volatile stock, and you have unlimited downside,” he said.

The stock price is near its 52-week low. It closed at $9.37 on Thursday. The 52-week range is $8.58 to $44.44.

“But it’s oil. It’s just too crazy to try to get your hands around it,” Doucette added.

“I wouldn’t play the oil game right now. You’re taking a huge risk.”

Seadrill is a deepwater offshore drilling contractor providing worldwide drilling services to the oil and gas industry.

“If you’re comfortable with the company, you might consider it,” he added.

“But we’re not a single-stock picker, and while we do autocalls, we wouldn’t buy an autocall on a stock.

“The whole thing is crazy.”

Option alternative

For Philip Davis, options specialist at Philstockworld.com, the risk-reward of the notes is just not as attractive as an option trade.

When a note carries the risk of breaching a downside barrier and losing principal, the issuer compensates investors with a coupon. In a similar way, a put seller who is betting that the stock will close above a specific strike price on the contract expiration date is paid a premium to make that bet.

For Davis, shorting a put on Seadrill would provide a better risk-reward ratio in part because the put seller receives the premium while the noteholder gets paid a contingent coupon.

Davis offered a put sale example to illustrate his point.

The share price of Seadrill traded at $9.25 during the day on Thursday.

There is no March 20, 2017 expiration date for a put option, he said. Instead, he picked a “close enough” expiration date of Jan. 30, 2017.

He then compared the notes with an equity position using the $9.25 intraday share price.

He assumed an initial investment of 1,000 shares, which would represent a $9,250 position.

“Half of this is $4,625. That’s my 50% barrier. With the notes, if the stock each month is above $4.625, I collect a 2.5% coupon, or 30% per year. The interest paid to me is $2,775,” he explained.

“You get called away on any given quarter if the price moves above $9.25.

“At the end, if the stock is down below $4.625, you lose all the money down from the initial price.”

Different risk

He then compared the deal with a put sale and demonstrated that shorting a put limits the risk as the premium received is paid up front like a fixed coupon.

“With this debt instrument, my risk starts at $4.65. I begin to lose money if the stock falls by 50%. That’s a $4.65 risk threshold. Now let’s compare it with being short a put. If I sell a 7 put for $2.50 at Jan. 30, 2017 expiration, it means that I receive $2.50 up front for betting that the stock will stay above $7.00,” he said.

A 7 put means in options terminology that the option seller is betting that the stock price will not drop below $7.00 from its initial price of $9.25. The number 7 is called the strike price. The $2.50 figure is the premium paid for the bet, or $2.50 per contract. Each contract controls 100 shares of stock.

He calculated the risk per contract by subtracting the premium received from the strike price.

“I begin to lose money below $7.00, but I received my $2.50 premium up front, so my risk is $4.50. The premium is the equivalent of a cushion,” he said, adding that it would represent the equivalent of a 35% buffer.

“I cannot lose more than $4,500. I made $2,500. My return is going to be the premium I pocketed divided by my money at risk. That’s 55% for the 22 months of the contract. We’re talking 30%, just like the coupon on the notes.”

But the similarity ends there, he said.

Risk-return

“Same return but a completely different level of risk. The two trades are not comparable. I take much less risk in selling the put. The money I get goes straight to my account, regardless of the stock moves,” he added.

“I have this 35% buffer. I risk less money. I keep the money I received up front. It’s a completely different risk.

“I’m not even talking about the credit risk exposure you get from the notes or the call risk.

“With these notes, you’re risking your entire investment with a very volatile stock, a company that could easily go bankrupt. Drilling companies are not getting paid for their equipment. Oil is in a bear market. The equipment sits there and rots. If the lenders start to get nervous and ask to get paid, the company has no cash flow. They’re forced to sell assets at the bottom of the market. I’m not saying that’s what’s happening with Seadrill, but the entire sector is unbelievably risky. So why would you gamble all your money on it? If you really want to play that game, control your risk.”

The notes (Cusip: 61761JXN4) priced March 13.

The agent is Morgan Stanley & Co. LLC.

The fee is 2%.

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