Morgan Stanley's fully protected notes linked to S&P 500 offer uncapped gains, minimum return

By Emma Trincal

New York, Feb. 21 - Morgan Stanley's 0% market-linked notes due March 2018 linked to the S&P 500 index should appeal to conservative bulls despite the cost and drawbacks attached to full downside protection with unlimited upside, sources said.

The payout at maturity will be par of $10 plus the index return, subject to a minimum return of 2% to 6%. The exact minimum return will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Positive points

"Obviously, this is for someone who is concerned about the economy and to which principal protection is going to be important," said Carl Kunhardt, wealth adviser at Quest Capital Management.

"The investor is getting full principal protection and a minimum return. He is likely to be willing to pay a premium for that."

For bulls

But the notes are also designed for bullish investors as they can get 100% of any index gains with no limitation.

"Not having a cap is lifting a huge psychological barrier," a buysider said.

Kunhardt said the trade-off for investors attracted to these features is the payment of a fee and the willingness to give up dividends, which is the case with other structured products, he said. In addition, these notes have a longer duration than most capital-at-risk products or buffered notes. But this too is to be expected, he said.

The fee is 3.5% for the product.

The annualized dividend paid to investors in the S&P 500 is about 2%.

"The 3.5% fee is a little high, but it's not out of the ordinary for these principal-protection deals," said Kunhardt.

"And it's not a fair comparison to say that you're giving up 12% of return because a direct investment in the S&P means dividends but also exposure to downside risk while here you have the value of the full protection plus the minimum return, as small as it may be."

Opportunity cost

Ultimately, investors in the notes need to be bullish on the index in order to make up for those costs, he said.

"You have no cap, so you can capture 100% of the gains in the index," Kunhardt said.

"I think that after six years, the capital appreciation of the S&P 500 will make up more than the opportunity cost of forgoing dividends. If you expect only 6% of annualized return on the S&P, and that's on the low side, that's 36% at maturity.

"My point is that if you're getting 6% a year, the 2% opportunity cost from the dividends becomes irrelevant."

Kunhardt said that assuming a 6% rate of return a year is not overly bullish.

"We've had a lost decade in stocks with flat returns, but we also had exceptional corrections during that period, such as 2001-02, a once-in-a-lifetime crisis, and the 2008 crash, [whose] only precedent was 1929," he said.

Two out of three

Another drawback to the notes is the long duration, Kunhardt noted, with investors "locked in" for six years. But again, Kunhardt said that the positives offset the negatives.

"As I always tell my clients, when investing you need to look at three things: return, risk and liquidity. You can control two of the three; you can never control all three. Here you can control returns, since you have no cap on the upside and a minimum return, and you can also control risk. But you can't control liquidity," he said.

"It's a very comfortable note, one that I would have no problem recommending to some of my clients."

Retail appeal

A buysider said that she liked the simplicity of the notes.

"At the end of the day, a product tied to a well-known benchmark is easier to digest, easier to follow," she said.

The structure is also likely to appeal to investors.

"Having a minimum return, as little as it may be, is the cherry on the mud pie. It's a nice way to compensate somebody for holding a note for six years. At least you know that you won't end the six years with nothing. It's one of those gestures that go a long way to please investors.

"I can see this product selling very well. It has a lot of retail appeal," she said.

Not a CD

However, the buysider said she is concerned about how investors will perceive credit risk.

"It really feels like a CD. It's a six-year. You have the principal protection, the generic structure. But it's not FDIC-protected," she said.

"My concern would be that people don't realize that it's a note.

"And even for note investors, the concern would be to get caught up in a longer-term product without realizing that you're taking on credit risk.

"It always makes me nervous when people have short-term memory," she noted in reference to the fall of Lehman Brothers in 2008.

"This is a nice structure as long as you understand what you own."

The notes (Cusip: 61760T488) are expected to price in February and settle in March.

Morgan Stanley & Co. LLC is the agent.

On Feb. 15, Morgan Stanley sold a very similar fully principal-protected product, $10.53 million of 0% market-linked notes due Feb. 21, 2018 linked to the Dow Jones industrial average.

The 100% participation on the upside was uncapped. The bank offered a 5% minimum return. The fee was also 3.5%.

© 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.