Morgan Stanley's buffered jump securities tied to S&P 500 offer unusual alternative to index

By Emma Trincal

New York, March 5 - Morgan Stanley's 0% buffered jump securities due March 28, 2024 linked to the S&P 500 index give investors an opportunity to outperform the market under a moderate-growth scenario and may represent a good alternative to the index for long-term investors, sources said.

If the index return is positive, the payout at maturity will be par plus a minimum positive return of 100% if the index has appreciated at all and an uncapped one-to-one participation in the index if the S&P 500 appreciates by more than 100%, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by up to 20% and will share in losses beyond the 20% buffer.

"If the market goes down, you get the 20% buffer. If the market goes up, you get the higher of 100% ... or the actual index return. I kind of like it," a market participant said.

Atypical step-up

The structure employed in the product is similar to the typical digital used in market-linked step-ups, this market participant explained.

The main difference is the longer-dated maturity and the bigger step-payment as a result of the longer term.

"We've seen the step-up before, but step-ups are typically short-term products, usually a two- to four-year maturity," he said.

"The typical step-up also tends to show a 20% to 30% step. If the market is up, you get that step. Above the step, you're long the index.

"Ten years is really going long, in this case. But at the same time, you're getting a much higher step payment of 100%. That's how this deal is different from other step-ups. First there is this unusually long maturity and then the fact that if the market is up, you can double your money.

"I personally think it offers you a greater value. If you want to be invested for the long haul, it's a fairly attractive alternative to a direct investment in the S&P."

Outperformance opportunity

In a modest market growth scenario, the notes offer a better value than a direct equity investment, he said, even though dividends are not paid on the structured product.

"Let's compare it to a direct investment in the S&P 500," he said.

"One of the things you get with a direct investment is dividends, roughly 2% per year with the S&P. So that's about 20% over the 10-year period.

"If the market is down a lot and you're getting a 20% buffer, then the notes are similar to a direct investment where you would have accumulated 20% in dividends. You are performing just as well as you would with a dividend-paying index fund.

"But on the upside, you would always have a 20% in dividends if you were an equity investor, and so for you the noteholder, to outperform the S&P, you would need the index to rise by less than 80% over the 10-year period.

"If you believe that the market will grow a lot, a direct investment would be a better alternative because you would not only get the price appreciation but also the dividends of the index and your investment would be more liquid than if you were to hold the notes for 10 years."

'Well-defined goal'

This market participant said that predicting the market return a decade from now is impossible. But the simplicity of the structure makes the product appealing for a large range of investors looking for equity exposure.

"It is possible to do better with the index, especially if the index performance is strong. Having said that, I still like the structure. It's very simple. It has a well-defined goal. The return is fairly attractive," he said.

"If the market is up, you're guaranteed to double your money over 10 years. If it's up even 1%, you double your money, which is a very nice feature.

"Whether the notes will turn out to be better than a direct investment remains unclear. But it's still a comfortable feature to know that if the index is up, you will double your return."

Three scenarios

In 10 years, the S&P 500 may have declined, scored modest gains or posted strong gains, he said, underlying three different market scenarios.

"We don't know what will happen in 10 years. But we have three possibilities," he said.

"Scenario one: the S&P goes down. Is it possible? Yes. Is it likely? No, not very likely, but still possible. In that case, you're doing pretty much the same as a direct investment in the index.

"Second possibility: the index is up but not a lot. In this case, this note clearly outperforms the S&P. That's where the notes are really attractive because if it happens, you get a fairly substantial outperformance over the benchmark.

"The third scenario is when the index is up a lot more than 10% a year, or I should say up by more than 7% per annum if you take into account the compounded return. In this scenario, your return in the note is going to keep up with the market except for the dividend, which you don't get. It's still very attractive. No one is going to be complaining about doubling their money over 10 years. If you're not doing super well, it's not because of the structure, it's because of the market."

Good for mild bull market

Kirk Chisholm, principal and wealth manager at NUA Advisors, developed a similar analysis, but his personal preference is for a long-only position in the index rather than the notes.

Looking at the current 1.9% dividend yield on the S&P 500, he said that the downside payout of the notes with the 20% buffer is slightly better than the protection obtained with the accumulation of dividends over the 10-year period, although the difference is not significant.

The comparison between the notes and the index is the most relevant on the upside, according to Chisholm, who pointed to a 7% annual growth in the index as sufficient to allow investors to double their return over 10 years.

Since the index performance includes the 1.9% dividend - assuming no change in the yield over the period - the price appreciation of the benchmark would only need to be 5.1% a year in order for investors to double their return, he explained, adding that this minimum rate is likely to be even less since dividend yields do increase in reality.

"If you believe that the index is not going to grow by more than approximately 5% a year, then the notes make sense. If not, you're better off in the S&P," he said.

While the value of the notes depends on how strong a bull market the next decade is likely to offer, Chisholm said that he would prefer to buy the index directly.

The case for equity

"Personally, I think 10 years is a long time given global events, in particular the state of emerging markets and what's going on in Ukraine," he said.

"It's not going to take much for the global economy to be put into a tailspin if some of those events get worse. That could slow down the growth of the S&P over the next 10 years, which would justify an investment in the notes."

History is also favorable to the notes.

"Over the past 10 years, the S&P 500 has gained approximately 62%, which is not very much if you think about it. Of course, history is no guide to the future, but if you assume that over a long period of time the index is not going to grow that much, then it would make sense to choose the notes," he said.

"But I think that it's likely that U.S. stock prices will continue to go up, and if you exclude those negative events, I'd still rather invest in the S&P itself because I would have the dividend on top of the index as well as the liquidity. The market could be down and you could be stuck with this note for 10 years. With the S&P index, I can trade in and out of my position or use options."

The notes (Cusip: 61761JPL7) are expected to price March 26 and settle March 31.

Morgan Stanley & Co. LLC is the agent.

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