Morgan Stanley’s $1.3 million dual directional notes on S&P may offer bearish bet, income play

By Emma Trincal

New York, Dec. 14 – Morgan Stanley Finance LLC’s $1.3 million of 0% dual directional buffered participation securities due March 6, 2025 linked to the S&P 500 index appeared to be designed for bears given the return enhancement on the downside. And yet, advisers found in the relatively innovative structure other potential uses.

If the index return is positive, the payout at maturity will be par plus the index return, subject to a maximum return of par plus 9.6%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par plus 1.5 times the absolute return of the index if it declines by no more than 15% and will be exposed to any decline in the index beyond 15%.

Income substitute

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said he has seen a greater number of absolute return notes lately.

“I think we’ll see more coming up,” he said.

“This one is a little bit unusual because of the leverage on the downside. I haven’t seen this in a while.”

As its name indicates the note is non-directional, he said.

“I don’t see it as bullish or bearish although it looks more bearish. But to me this is an income play,” he said.

“With interest rates coming down, people are going to look for the yields they have been accustomed to over the past 12 months.

The high single-digit potential gain on the upside coupled with the double-digit cap offered on the downside provided attractive yields, he said.

Fed shift

Medeiros explained why he expects rates to fall next year.

“The market has stabilized. The economy is more resilient than expected. I don’t think the Fed can keep rates where they are for very much longer.

During Wednesday’s Federal Open Market Committee meeting, the Fed suggested possible rate cuts next year on the view that inflation has eased from its highs.

Bond yields fell across the board after the meeting.

Depending on how fast and how far interest rates may decline, investors may not be able to secure rates as high as those available today, a challenge known as reinvestment risk.

The yields offered by the bond market and money market funds have raised investors’ expectations, Medeiros said.

“I would definitely use the note as income replacement.”

Bearish tilt

Another financial adviser said the notes benefited bearish investors the most.

“You’re in a better position to maximize your return when the market is down as long as it stays above the buffer,” he said.

“Even if you blow through the buffer, you’re still better off. You will outperform the market regardless.”

The benefits on the downside versus the upside were many. First, the absolute return cap was much greater, which widened the range of potential returns; second the buffer allowed investors to outperform even beyond a 15% decline; finally, the absolute return and the leverage boosted the returns compared to the one-to-one exposure on the upside.

“Basically, if you’re between zero and -15% you’re going to do much better. You’re in the optimal zone,” he said.

As an example, a 10% decline in the index would bring the absolute return to 15% at maturity. The same price move in the opposite direction would limit the gains to 9.6%.

“It definitely looks like a bearish note and that’s a fact. You outperform on the downside, and you don’t if the market is up,” he said.

“We just hit a one-year high today. Maybe it makes sense to be a bit bearish. I guess that’s the idea.”

The S&P 500 index hit a fresh 52-week high on Thursday less than 2% shy from its all-time high of January 2022.

Bears tend to enter the market when stock prices are toppish and volatility low.

Portfolio challenge

“But who knows what’s going to happen in 15-months?”

One thing almost certain according to the futures market is that the Fed will cut interest rates, he said.

“So why be bearish? Are you going to bet against the Fed?”

Choosing the proper allocation of the notes would also be a challenge for asset allocators.

“As an equity substitute, it may work if the market is range-bound. But you need the conviction for that, and I’m not really convinced that it’s going to be the case.

He also ruled out the use of the notes as income replacement.

“In an environment of lower rates, I would play it for the capital appreciation, not for income.

“I guess the only way this thing will work is if you use it to hedge your equity.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on Dec. 6.

The Cusip number is 61775MN85.

The fee is 0%.

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