Morgan Stanley's PLUS notes tied to S&P 500, Russell 2000 halve downside with worst-of payout

By Emma Trincal

New York, April 30 - Morgan Stanley's 0% Performance Leveraged Upside Securities due May 31, 2016 linked to the S&P 500 index and the Russell 2000 index reduce losses by half on the downside, a feature that is not often seen, sources said.

If each index finishes above its initial level, the payout at maturity will be par plus the 1.5 times leveraged upside performance of the worst-performing underlying index, up to a maximum gain of 30% to 36%. The exact cap will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Otherwise, investors will lose 0.5% for every 1% decline in the worst-performing underlying index.

The notes, designed for investors seeking U.S. equity exposure, fit into the "worst of" product category as the payout is based on the value of the worst-performing index.

But the most "interesting" feature, sources said, was the downside factor of 0.5, which reduces by half the negative return of the worst-performing underlying index.

The downside factor as a result protects up to 50% of principal, subject to credit risk, according to the prospectus.

Phantom versus buffer

"That's interesting," a market participant said.

"I haven't seen that specific structure. I wonder what kind of tax treatment you get though, since the most you could lose is 50%. The worst thing that could happen is if they treated it as phantom income because you pay taxes without receiving anything. And if that's the case, I don't like it. Taxes shouldn't be the first consideration, but nonetheless. To me, the deal doesn't seem that exciting."

"Phantom income" is a form of ordinary income taxation in which the annual tax is paid prior to earning interest at maturity, just like the taxes that are paid yearly on accrued interest on zero-coupon bonds.

In terms of downside protection, this market participant said a buffer may be more appealing.

"People like buffers because they get the protection on the first losses. It's significantly better than taking the losses first like you do here," he said.

"Say you have a 10% buffer and the market is down 20%. You lose 10%. With this product, you also lose 10%, or half of the 20% decline. Each time the market is down by less than 20%, you're better off with the buffer. It's only when the market is down by more than 20% that your downside factor gives you a better protection.

"I guess it should reflect your own market outlook and risk tolerance.

"I just don't like the fact that you start losing from the very beginning.

"This type of downside protection is not seen very often, and maybe there's a reason for it. People may have tried it and it was just not taking off."

On the contrary, Kirk Chisholm, principal and wealth manager at NUA Advisors, said that he liked the 0.5 downside factor.

"The 50% loss protection is substantial, and it is the nice feature of this deal," he said.

"It makes the risk reward of this deal OK even though other aspects of the structure are not as compelling."

The market participant said that the structure could have gained by being simpler.

"There are too many moving parts: the 50% downside, the 1.5 time leverage, the cap, the worst-of. It doesn't seem that much appealing," he said.

"If you're going to have a new product, it's better to grab investors' attention. I'm not sure this one does that.

"Yes, it's 1.5 times leverage, but you have a cap and they leverage out the worst index of the two.

"On a three-year, 30% is not such a high cap.

"Then you have the two indexes, which are correlated, but still, they're two different indexes.

"It doesn't seem like you could earn a lot on the upside.

"The losses are somewhat limited, but again, you start losing from the get go."

Dual exposure

Chisholm had a different take, being more concerned about the upside and the duration of the product.

"The downside protection is nice. I like it. But the cap is too low, and the maturity is too far," he said.

The concept of a return tied to the worst performing of two indexes was also a difficult sale for the issuer, he also noted.

"It's probably very challenging to talk to the client about something that gives you the worst return and trying to convince them that it makes sense for them. But this is Morgan Stanley's issue, not really my concern," he said.

"From an investor's standpoint, my main objection is the term. In this environment, three years is a long time," he said.

Having two underlyings instead of one was not seen as a setback by this adviser, as he suggested that investors could easily anticipate which index they may have exposure to depending on the market.

"From a volatility standpoint, historically, the Russell tends to be more volatile on the upside and the downside. It's not always the case, but statistically it is," he said.

"So you're basically getting exposure to the Russell on the downside and the S&P on the upside.

"During bull markets, the two indexes are less correlated; but during bear markets, they are more correlated. It's unlikely that you're going to get the S&P down 5% and the Russell down 30%.

"So it's really a function of people's view and where they think equity markets are going to be in three years."

Cap

The 30% to 36% cap was appropriate if the market continued to be as it has been for the past 13 years, Chisholm said. But for the bulls, the upside was too limited, he reasoned.

"On the upside, you're probably going to get S&P 500 exposure, and the question is whether the 10% cap per year is enough," he said.

"The risk reward of the notes depends on your view of the market.

"If you look at the S&P 500 since 2000, the market hasn't gone anywhere really. Although we've just hit new highs, we've been trading sideways for the past 13 years.

"That's why three years is a long time for this type of product.

"From 2009 to 2012, a lot happened. In 2009, very few would have suspected the upcoming bull market.

"In 2007, very few would have imagined what was coming.

"That's why I don't like the term."

If the market was to continue its seesaw trading pattern alternating between short-term bullish and bearish cycles, investors may find the cap attractive, he said.

"Assuming you're getting 10% to 12% a year, I don't think you'd fall off the mark," he said.

But more bullish investors would expect more, he added.

"You have 1.5 times leverage. It means you only need 6.66% a year to hit your cap, which isn't much. The 6.66% annual return is not a high hurdle. It's nice. But if you're bullish, if you think the market will continue higher, it's not leverage that you want. You want a higher cap. It looks to me that the 1.5 times leverage is somewhat of a useless component. It looks like your cap may not be high enough. I would prefer having no leverage on the upside but a higher cap," he said.

Chisholm said he liked the notes except for the tenor.

"The risk reward on this note is still OK because the 50% downside protection covers a lot of other issues," he said.

"Overall, the security is fine notwithstanding the maturity issue.

"If it was a one- or two-year note, I would consider it for equity exposure, but not for three years."

Morgan Stanley & Co. LLC is the agent.

The notes will price on May 24 and settle on May 30.

The Cusip number is 61761JFZ7.

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