Morgan Stanley's dual directional notes linked to S&P show less risk due to tenor, sources say

By Emma Trincal

New York, March 18 -Morgan Stanley's 0% dual directional trigger jump securities due March 2016 linked to the S&P 500 index illustrated that investors pay as much attention to duration as to downside protection when assessing the likely return of a deal, according to sources.

If the index finishes above its initial level, the payout at maturity will be par plus the greater of the gain and 15%, according to an FWP filing with the Securities and Exchange Commission.

If the index falls but finishes at or above the 85% trigger level, the payout will be par plus the absolute value of the index return.

If the index finishes below the trigger level, investors will be fully exposed to the index's decline.

Carl Kunhardt, wealth adviser at Quest Capital Management, said that he felt comfortable with the market risk of the notes because there is enough time for the index not to drop below the barrier level.

Long is sweet

"I like the three-year term on the point-to-point basis because what happens in between is irrelevant," he said.

"The chances of being down 15% for a three-year period are very low.

"It's only going to happen if my third year is my down year."

He looked at the barrier as a form of return enhancement given the absolute return feature.

"I'd like it to be a larger barrier not so much for the downside protection, although it's always good to have it, but because it's taking whatever my loss is and gives it to me as a return," he said.

The upside, he said, combined a minimum contingent digital payout and a 100% uncapped participation, leaving investors with the potential for unrestricted gains.

"I like it. It's simple, not overly complex, which is always good since I actually have to explain the structure to the clients," he said.

"I like that there is no cap. It's point-to-point. You have a 15% minimum return. That's 5% a year. It's not something to write home about, but that's a little bit better than cash because cash right now is zero. A good bond could give you a 5% or 6% return, but there's a lot of volatility, plus you get issues with rising rates.

"If it was a one-year, I would not be so confident. But with a three-year, the chance of not getting a 5% annualized return is very low."

Another absolute return

Kunhardt compared the notes with a 14-month deal that priced Friday, JPMorgan Chase & Co.'s 0% capped dual directional contingent buffered equity notes due April 21, 2014 linked to the S&P 500.

With this separate product, if the index is greater at maturity, the payout will be par plus the index return up to a 10% cap. Any decline of the index by less than 10% gives investors the absolute value of the index return. If the final index level is down by more than 10%, investors will lose 1% for every 1% that the final index level is less than the initial index level.

Kunhardt said that he preferred the Morgan Stanley product.

"It's less attractive not just due to the upside but from a risk standpoint," he said, talking about the JPMorgan notes.

"Chances of being down over three years are lower," he said.

"I'll play the long-term game all day. I'm not even going to play the short term."

Many advisers tend to prefer buffers to barriers because the feature allows them to outperform the benchmark, he said.

"But you have to be very careful. Everyone wants to outperform the index. If you make 12% and the index is up 10%, you're a hero. But by the same token, if you lose 8% when the index is down 10%, you still outperform the index but the perception of the client is different. They should be happy. But in reality, they'll just be less mad," he said.

Kunhardt said that as a risk-control approach, he does not just look at the size and nature of the downside protection but also at the term of the notes.

"I'm just looking at the odds. My odds of being up on a point-to-point basis over three years are simply better than over one year. And that's what matters," he said.

Barrier problem

Michael Kalscheur, financial adviser with Castle Wealth Advisors, said that the duration played a role in his decision as well. But to him, the quality and size of the downside protection were essential.

"It just boils down to this: Why do we do structured notes at all? Our firm's position is and always has been risk reduction," he said.

Commenting on the Morgan Stanley absolute return notes with the 85% barrier, he said, "If the index is down 15%, great; in this case, I get my15%. If it's down 16%, I lose 16%. That's not why I'm buying structured notes. I am not interested in the 100% downside participation."

The three-year term reduces the odds, but the risk remains too high, in his view.

He mentioned the worst downside seen on a three-year rolling period in the past 40 years, which was approximately 16%.

"The 15% should protect you. Is it likely that the index will be down 15% in the three-year term? No. But has it happened? Yes. The probability isn't high, but it's hardly negligible. Call it a barrier or a cliff, we just don't do it," he said.

Kalscheur said that the upside was appealing, however.

"You get the greater of the two, the 15% minimum or the index. Other than the barrier issue, it's a pretty nice payout," he said.

But the 3% fee on the notes was a negative, he said.

"It's expensive. The 3% fee obviously eats up your performance. For us, it needs to be half of that or less than half of that," he said.

"But it's not the deal breaker. The deal breaker is the barrier.

"The 15% should give you some protection. But it's the one-time event that I'm trying to prevent against. And I need the protection to feel comfortable about other things, as I'm taking other risks in a structured note. I'm taking additional credit risk. I'm not getting dividends. I'm also taking liquidity risk because I have no flexibility to sell when I want to.

"These are significant downside risks of having a structured note in general.

"If I'm going to get additional risk, I want safety. That's my number one priority.

"Unfortunately, while this is a nice product as it is, it doesn't meet my criteria."

Kalscheur said that the other product, JPMorgan's absolute return 14-month note, did not fit the bill either. This time, the market risk lied in the shorter duration.

"I do get the buffer. It's a key feature. But in a simple year, the market could move up or down a heck of a lot more than 10%," he said.

"The shorter the term, the bigger the buffer needs to be.

"That's why you don't see a lot of big buffers on short-term notes because you can't price it. It's too expensive. You're not going to price anything with a 40% buffer.

"A 10% buffer is better than nothing. But with a short-term note, 10% would just not be enough."

Morgan Stanley & Co. LLC is the agent.

The notes will price and settle in March.

The Cusip number is 61761M763.

J.P. Morgan Securities LLC is the agent for the 14-month notes (Cusip: 48126DD22).

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