Morgan Stanley’s $1 million 8.5% RevCons offer short tactical bet on two communications stocks

By Emma Trincal

New York, May 29 – Morgan Stanley Finance LLC’s $1 million of 8.5% worst-of fixed coupon RevCons due May 27, 2021 linked to the worst performing of the shares of AT&T Inc. and Verizon Communications Inc. pay a guaranteed coupon and contingent protection on the worst of two relatively correlated stocks. Getting those terms, including the barrier level of 70%, on a one-year tenor is attractive, said Tim Mortimer, managing director of Future Value Consultants.

Several factors facilitated pricing: the relative volatility of the underlying stocks, which have declined in price, but also the high dividends paid by AT&T and Verizon to their shareholders.

Interest is payable monthly, according to a 424B2 filing with the Securities and Exchange Commission.

If each stock finishes at or above the 70% downside threshold level, the payout at maturity will be par plus the final coupon. Otherwise, investors will be fully exposed to the decline of the least performing stock.

“The income here is paid for the full term. It’s more expensive to price. If it had been an autocall, the yield would have probably looked better,” said Mortimer.

“You’re also getting quite a good barrier for a one-year.”

The premium used to provide the coupon and the barrier derives from the worst-of, the volatility and the dividend yields. In the case of AT&T and Verizon, the dispersion risk, hence the premium available to enhance the terms, is somewhat limited due to the high correlation (94.8%) between the two securities.

Down year

Volatility as always is key.

“The two stocks are highly correlated. But the volatility is not that low, and that helps,” he said.

Verizon’s implied volatility is 23% and AT&T’s is 28%.

The two telecommunications stocks, which tend to be seen as defensive names, have suffered significant losses during the February-March bear market. They also failed to recover as much as the broader market.

Verizon is down nearly 7% this year while AT&T has plummeted 21%.

Both stocks have largely underperformed the S&P 500 index, which only dropped 5.75% this year.

“They’re more volatile than equity indexes. What played out here is the fact that they lost quite bit of value,” he said.

But volatility is not the only factor driving the pricing of the fixed coupon and barrier.

Cash cows

“The dividend is a big part of it,” he said.

The dividend yield of AT&T is 6.7%. The yield for Verizon is 4.4%.

“They priced the barrier at quite decent levels given the big fall of the stocks this year, especially AT&T. You’ve got an extra 30% of possible decline from those levels. It’s a pretty reasonable barrier,” he said.

Future Value Consultants offers stress testing on structured notes encompassing simulation tables as well as back-testing analysis.

Mortimer ran a report for the notes.

“The structure here is very simple. There isn’t a lot of optionality,” he said.

“You’ve got a fixed coupon, no call. The only real moving part is the amount of capital you will get at maturity based on how the final price falls in relation to the barrier.

Scorecard

Mortimer first looked at one of the main tests called the scorecard. This table is built on the base case or neutral scenario. It reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying.

In addition to the neutral scenario, the Monte Carlo simulation model offers four distribution assumption sets based on volatility and growth rate assumptions. Those are bull, bear, less volatile and more volatile. But the neutral scenario is the basis of the simulation in all reports.

The scorecard displays different mutually exclusive outcomes of product performance. Given the simplicity of the structure, only two possible outcomes exist: full capital return and total return loss.

Another outcome is listed but could not occur with this product. It is called “capital loss but total return at or above capital.” For this outcome to have a probability other than 0%, the return would have to exceed the losses.

It is impossible, the gains being capped at 8.5% and the minimum loss being at 30%.

Small chances, big impact

A look at the two main possible outcomes shows a high chance of winning: there is an 81.5% probability of getting full capital back at maturity, which translates into a 108.5% payoff. In comparison, incurring a loss of principal happens only 18.5% of the time.

“This shows that the 70% barrier is quite deep. It’s a reasonable play,” he said.

However, the tail-end effect of a negative outcome is significant. Should the barrier breach, investors are sure to lose at least 30% of their capital by virtue of European barrier.

The average loss in this situation is 40%, according to the scorecard.

“18.5% is not a high probability of losing, but when losses do occur, it’s in average 40% of your capital, which is quite high. So, you’re not very likely to lose money but if you do, you’ll suffer painful losses,” he said.

Sector bet

“After the Covid situation, some sectors have been badly hit. Communications have not done so well. So, this is likely to be a tactical play,” he said.

Health care and technology fared best this year. Communications services have been somewhere in the middle between high-performing tech stocks and sectors in the red such as energy, financials, and industrials.

Forward price

Pricing is also based on what the market expects the price of the underlying stocks to be in the future, which is priced in the forward.

The forward price derives from the risk-free rate minus the dividend yield. The higher the dividend, as it is the case here, the lower the forward.

“The value of the put options is what determines pricing,” he said.

“It’s driven by the forward price on the stock plus the volatility.

“The low forward price reflects the fact that the stock has a lower expected value, which makes the downside risk more substantial. This will increase the value of the put. The investor is selling the put and therefore, they can capture a higher premium.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on Thursday.

The Cusip is 61771BGE8.

The fee is 0.2%.

© 2015 Prospect News.
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