Morgan Stanley’s $56.64 million notes on Russell, S&P offer booster, buffer, absolute return

By Emma Trincal

New York, Feb. 23 – Morgan Stanley Finance LLC’s $56.64 million of 0% dual directional buffered jump securities due May 20, 2024 linked to the S&P 500 index and the Russell 2000 index give investors three types of return enhancement – one via a “boost” on the upside, the other with dual directional gains on the downside and finally by using a hard buffer to provide downside protection.

If each index finishes at or above its initial level, the payout at maturity will be par plus 22%, according to a 424B2 filing with the Securities and Exchange Commission.

If the final level of either index is less than its initial level but the final level of each index is greater than or equal to its downside threshold level, 85% of its initial level, the payout will be par plus the absolute value of the lesser-performing index’s return.

If the final level of either index is less than its downside threshold level, investors will lose 1% for every 1% that the lesser-performing index declines beyond 15%.

Buffered absolute return

“It’s an attractive note. You get a 22% digital coupon, which is quite decent, and if the market is down, you’re still getting paid a positive return one-to-one and up to 15%,” said Matt Rosenberg, director at Halo Investing.

“You’re looking at a digital with a buffer, which is always attractive. Getting an absolute return with a buffer is even better.”

Absolute return notes with buffers have always been harder to price, he noted, especially on relatively short-term deals, such as this one – a two-year and three-month tenor.

“Market conditions have significantly improved so it may be easier to do. We now have more volatility. Funding spreads have improved as well. Rates moving up provide more optionality,” he said.

A different digital

The use of an absolute return feature in a digital note is relatively rare, according to data compiled by Prospect News. Payoffs on the upside tend to be delivered via coupons in callable notes or via a delta one participation up to a cap.

“This is not a very common structure. I’m not sure it has the potential to be massively replicated. The note requires more sophisticated pricing capabilities, more diligence on the part of salespeople to follow up,” he said.

One of the benefits of digital payouts for investors and sellsiders alike is simplicity, he added.

“I’m not sure you’ll see a lot of deals mixing the digital coupon with the absolute return component although it’s a very attractive mix as demonstrated by the size of the trade.”

More common forms of “jump” securities which also pay a positive return on the downside are the so-called “in-the-money” digitals. If hypothetically applied to this product, such structure would entitle investors to get paid the digital coupon if the underlying fell anywhere at or above minus 15% instead. Such booster contrasts sharply with the one-to-one inverse participation of the notes.

Mildly bearish view

“Whether you use the absolute return payoff or the in-the-money digital depends on your outlook and mandate,” he said.

The coupon rates and terms would obviously be different, he added.

“In general, people like to be paid more than just par in a sideways or moderately bearish market,” he said.

A more “extreme” version of structure paying positive returns in a declining market are the bear notes.

But those are less popular due to their directionality, he said.

“I haven’t seen bearish notes this year. They tend to show up in bear markets. But people don’t really like them because you only make money if the market is down.

“Bearish notes are trading products, not as much investment products. They’re designed to hedge.”

Worst-of

Scott Rothbort, founder of LakeView Asset Management, said Morgan Stanley’s dual directional notes were designed to provide a fixed rate of return.

“I look at these types of notes as something you would put in a yield enhancement portfolio,” he said.

“The problem is I’m not a real fan of those worst-of.

“Worst-of are very popular though. We see them month after month.

“But I personally would prefer a single variable rather than a two-way variable.”

For this adviser, the tenor was not all that short.

“I would much rather have a 13-month paper on the S&P 500. But that’s my opinion. Other money managers may look at it differently.”

Issuers have the functionality to hedge those structures while generating fees, he said. For investors, assessing and mitigating the risk of those products is more challenging.

“The current market environment provides a little more juice for both the bank and the client,” he said.

“But for investors looking into those worst-of, you’d have to have more sophisticated modeling techniques like Monte-Carlo simulations or other statistical tools.

“It may not be worth using such in-depth analyses for these types of products.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on Friday.

The Cusip number is 61773HW96.

The fee is 0.5%.

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