Morgan Stanley’s principal-protected notes on Dow, S&P spark different views

By Emma Trincal

New York, May 1 – Morgan Stanley Finance LLC is planning to price two principal-protected notes with similar terms except for the tenor and underliers. The limits on the upside, which are required to price the full protection, generated different reactions from advisers.

The first offering consists of three-year market-linked notes tied to the Dow Jones industrial average, according to an FWP filing with the Securities and Exchange Commission.

If the index return is positive, the payout at maturity will be par plus the appreciation of the index subject to a maximum return of 18% to 23%. The exact maximum return percentage will be determined at pricing.

Otherwise, investors will receive par.

The second deal entails five-year notes linked to the S&P 500 index, according to another FWP filing with the SEC.

If the index return is positive, the payout at maturity will be par plus the appreciation of the index subject to a maximum return of 43% to 48% whose final amount will be set at pricing.

Otherwise, investors will receive par.

Picking the right bucket

Carl Kunhardt, wealth adviser with Quest Capital Management, said the notes would fit into his portfolio.

“I would probably do both,” he said.

The difference between the two indexes was not significant from an asset allocation standpoint, he noted.

“Because the notes are principal-protected, regardless of the underlying I can use them as a fixed-income alternative since I really don’t have the downside at risk.”

But the way the notes would be used would depend on the return potential.

“The one on the Dow, given the cap, would be more of a fixed-income substitute,” he said.

“If it wasn’t for the principal-protection, it would be an unattractive note because you would take equity risk for a return of 5% or 6%. But since it has the principal protection, it addresses the issue of equity risk. I’m getting a good return for a note that would fit right into my fixed-income allocation.”

The longer note had a higher cap, which may suggest a distinct place in the portfolio.

“The second one could be an equity alternative with the pick up in return. I can now get more than 8% a year compounded. It’s the low-end of an equity return but I took the equity risk component out of the equation,” he said.

The only disadvantage of the second note was its longer maturity, he said.

“Both products fit nicely in an allocation. I would just put them in different places,” he said.

Three-year on the Dow

A financial adviser compared the two notes to one another as well as to similar securities. His conclusion was negative.

“Both notes are capped and unlevered. I can understand that. You’re paying for the principal protection, and there is nothing unusual about that. The question is: is it worth sacrificing so much upside?” he said.

He looked at the three-year note on the Dow first.

“The cap is very low,” he said.

Looking at historical performance data for the Dow Jones industrial average, he concluded that the 100% protection may have been “overkill.”

“Did the Dow lose money over a three-year period? Yes, but only 15% of the time. So, you’re getting less upside – no dividends plus you’re capped – for something that will happen only 15% of the time, while you have an 85% chance of making money,” he said.

He then looked at the back-testing data related to a 20% decline. The probability for such price move on a three-year rolling period was only 5%. A 30% drop occurred only 0.5% of the time.

“You could do away with the principal-protection. It seems expensive for the relatively muted risk you’re taking,” he said.

Instead of the 100% downside protection, this adviser would pick a 10% buffer or preferably, a 30% barrier.

“When I look at a principal-protected note, I like to compare it with equivalent products,” he said.

He rounded up the maximum return offered by the notes linked to the Dow to approximately 6% a year on a compounded basis. In comparison, a three-year Treasury would yield 3.85%.

“That’s less but keep in mind that with the notes, the cap is not guaranteed. It’s just the highest amount you can get if the market is up to that point. What if it’s flat? Or what if we have a pullback and the market ends up only 10% higher at maturity? You would have been better off with the three-year Treasuries,” he said.

Five-year on the S&P

The five-year note tied to the S&P 500 index did not fare better.

Given the statistics, a 15% buffer on a five-year S&P-linked note would protect the investment 99.8% of the time. A 30% barrier would provide a similar amount of protection, he said.

“Here again, I would swap the principal-protection for a 30% barrier,” he said.

For the upside, he assumed the best possible cap at 48%.

“My data on the S&P shows that 52% of the time, the market will close above that 48% level over a five-year period.

The note offers no upside leverage and therefore, does not compensate for the lack of dividends, he said.

“Paying for the principal-protection is not justified.”

With each note, this adviser said he would replace the principal-protection by a barrier in an effort to uncap the upside and if possible, to achieve some leverage.

“But as it is now, I’m tying my money for five years and five years is a long time for something that’s not producing income,” he said.

“The principle behind a five-year note is to grow your money.

“None of those two notes is giving me enough juice for the squeeze.

“I can’t get excited with either one of them,” he said.

Both notes are guaranteed by Morgan Stanley and distributed by Morgan Stanley & Co. LLC.

The two offerings will price on May 25 and settle on May 31.

The Cusip number for the notes linked to the Dow is 61774XVU4.

The Cusip number for the notes linked to the S&P 500 is 61774XVY6.

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