Morgan Stanley’s leveraged buffered notes on the S&P 500 may need higher cap, advisers say

By Emma Trincal

New York, Aug. 16 – Morgan Stanley Finance LLC’s 0% leveraged buffered index-linked notes tied to the S&P 500 index may not offer enough return on the upside, according to financial advisers.

The tenor and the cap for this note are quoted in a range in a 424B2 filing with the Securities and Exchange Commission. The final terms will be set at pricing.

The tenor is expected to be between 27 and 30 months. The payout at maturity will be par plus 170% of the index gain, with a cap expected to be between 28.85% and 33.93%.

Investors will receive par if the basket declines by 17.5% or less and will lose 1.2121% for every 1% that it declines beyond the 17.5% buffer.

Creditworthiness, fee

Steven Foldes, wealth manager and founder of Evensky & Katz / Foldes Financial Wealth Management, pointed first to two positive features.

“Morgan Stanley’s credit is good. We don’t have a problem working with them,” he said.

Morgan Stanley’s five-year credit default swap rate is 89 basis points, a much tighter spread than for instance Goldman Sachs’ 97 bps, according to Markit. Citigroup’s CDS spreads are 88 bps while Bank of America and JPMorgan show spreads of 77 bps and 74 bps, respectively.

The notes carry no commission, according to the prospectus.

“The fee-based cost structure is fine. This is also how we charge our clients: on an asset under management basis. So, this works out fine,” he said.

Already down

But for Foldes, who is bullish on U.S. equities, the payout on the upside was disappointing.

“This note is for somebody who is really bearish or very mildly bullish on the market for the next two-and-a-half years,” he said.

“Having the 1.7 times leverage is nice, particularly on an investment like the S&P, which is the foundation of most clients’ portfolios on the equity side.

“But a cap of 28.85% or even 33.93% ... given that the market is still down from its January peak, we think is not very compelling.”

Tenor and caps combinations

Due to the undefined final terms of the notes, two extreme scenarios can emerge.

In the worst one, the tenor would be the longest of the two, or 30 months, and the cap, the lowest, which is 28.85%. On this basis, the cap would be the equivalent of an annualized return of 10.7% on a compounded basis.

In the best scenario (27-month tenor and cap of 33.93%), the annualized compounded return would be 13.9%.

“Those returns are not bad on a historical basis. But they’re not in line with the current market environment,” he said.

Insufficient upside

“We had a pullback and we’re starting at a low point. The S&P is down 9.6% for the year. In 24 or 27 months, hopefully we will have gone through the interest rate cycle the Fed is putting us through. We can certainly hope for a resolution to the tragedy in the Ukraine. Covid-related issues and supply shortages-related issues that have fueled inflation should be behind us as well.

“Our view is more bullish.

“Capping out at 28% seems to us as something we wouldn’t want our clients to be restricted by a note like this.”

Buffer

The size of the downside buffer was acceptable but not the type, he said.

“17.5% is fine. I have nothing against that. But I don’t love the gearing,” he said.

Foldes said he would rather have a smaller buffer without the downside leverage.

“Just having to explain to clients that, after a 17.5% drop, they’re looking to add 21% more in each incremental loss is not so compelling even though we understand that that’s what the issuer probably needs to do in order to price the note.”

But the buffer type was “not the deal-breaker,” he said.

“The bottom line is that we wouldn’t be predisposed to use this note simply because of the relatively low cap.”

Presidential elections

A financial adviser agreed but first looked into the length of the trade.

“One thing I don’t like is notes that mature soon before a presidential election. The 27-month will mature just a few days after the elections, assuming the notes would price today,” he noted.

The issuer did not disclose the trade date in the prospectus.

“But with the 24-month tenor, the maturity date would fall about three months before the Nov. 5 elections.

“The period just before the elections is a time of heightened volatility, so that could be a concern,” he said.

Extending the term

This adviser’s top objection was identical to that of Foldes: the cap in either scenario was not high enough.

“I don’t like the capped upside on a growth note to begin with,” he said.

“I can understand they need to cap it due to the short maturity. Twenty-four, even 30 months are short tenors. But the caps are not very attractive.

“I would probably make it longer. A five-year would be better.”

Rather than using a growth note with a cap, this adviser would switch to an income product.

“I’d much prefer to see a five-year snowball with a 12% a year with an annual autocall. At least you get something even if the market doesn’t go up,” he said.

In a snowball structure, investors receive previously unpaid coupons when the notes get called, allowing them to never miss a payment.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The Cusip number is 61774DZ67.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.