Morgan Stanley’s five-year buffered PLUS linked to S&P 500 to outperform in bull market

By Emma Trincal

New York, Jan. 27 – Morgan Stanley’s 0% buffered Performance Leveraged Upside Securities due January 2020 linked to the S&P 500 index enable investors to potentially outperform the benchmark thanks to the combination of leverage, no cap on the upside and a buffer, sources said.

The payout at maturity will be par plus at least 133.4% of any index gain. The exact participation rate will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 20% and will lose 1.25% for every 1% decline beyond 20%.

‘Solid’

“This is a solid note for the investor that believes we will see modest gains or losses over the next five years,” said Dean Zayed, chief executive of Brookstone Capital Management.

“Given the length of this bull market and looking at indicators such as the Shiller P/E ratio, the end of QE [and] slowing growth globally, many believe that stock market gains will average in the single digits over the next five years. If you are in this camp and don’t believe that another 2008-like crisis is in the works within five years, then a leveraged note with a strong 20% buffer and no cap will perform as good or better than just about any other equity-like structure.”

Buffer

The downside buffer is geared, which means that any losses beyond the 20% buffer will accelerate at a rate of 1.25, according to the prospectus.

An example included in the prospectus stated that a 36% decline in the underlying index would create for investors a 20% loss. That’s because the 16% amount of decline over the buffer multiplied by 1.25 will generate a 20% loss. Still, geared buffers remain superior to barriers as they absorb first losses, sources said.

“The fact that you get a buffer and not a barrier is important because the likelihood of the S&P being down by more than 20% over a five-year stretch is low, unless the big downturn happened in the fourth or final year,” Zayed said.

Upside

On the upside, the appeal of the notes was the combination of leverage and uncapped return.

“The leverage with no cap is huge for those seeking outsized returns in an environment that may be a bit stingy in delivering consistent double-digit performance,” he said.

Zayed added that the leverage helped investors offset the absence of any dividend payments.

“It’s a given that you lose the dividend in a structured deal. ... It’s part of the math. ... The leverage makes up for that and then some in my opinion,” he said.

Dividends

Jonathan Tiemann, president of Tiemann Investment Advisors, LLC, said that at first glance, the notes appeared to allow investors to outperform the benchmark at all times.

“You never lose quite as much as the index due to the buffer. And you make more than the price change on the upside due to the leverage,” said Tiemann.

“The giveback has to be the dividends. The way you pay for this is by forfeiting the dividends.”

The dividend yield of the S&P 500 index is 1.8%. It represents over five years an opportunity cost of 9%, he noted.

“When you’re buying this thing, you’re long volatility,” he said.

“If it doesn’t move much in price, then you’re better off owning the index directly as you’re going to get the dividends.”

For instance, if the price finished up 10% at maturity, investors would outperform the index. The return on the notes in this example would be 13.3%, compared with 19% for the index.

On the negative side, investors would also need to see the index decline significantly in order to outperform the index, he noted.

“You don’t want the price of the S&P to fall, but if it goes down moderately, the dividends will give you a better return even without the buffer. Even if that’s not the purpose of the trade, you outperform with a greater decline,” he said.

“For instance, if the index falls by 5% after five years, your total return with dividends will be +4%. With the notes, you only get your money back with no profit.

“Either way, you have to have a pretty substantial move in the index price to be better off with the notes, which is why this trade is also a volatility play.”

Breakeven

The “crossover,” or breakeven, will be between a 9% decline in the index and a 27% appreciation, he said.

“In this -9% to +27% range, you are better off with the index. Anything lower than 9% on the downside and greater than 27% on the upside, the note is going to give you an edge.

“It’s a fairly tight range for five years, and that’s a good thing.

“But you’re still long volatility because your best outcome versus owning the underlying is when you have a bigger move.”

If the index grew by only 20% over the five-year term, investors in the notes would underperform the benchmark by about 2.5%.

“Is a 20% expectation foolish? I don’t think so. I think the next five years could be quite volatile and that there is definitely a possibility to get that type of return over the period,” he said.

The notes are designed for “pretty bullish” investors, he said.

“Someone may also use it as a volatility play combining this with a short position on the index. But in either case, you don’t buy this product if you expect only moderate increase in the index. In order to make up for the no-dividend, you need a pretty good price move,” he said.

Morgan Stanley & Co. LLC is the agent.

The notes will price and settle in January.

The Cusip number is 61761JWG0.

© 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.