Morgan Stanley’s partial principal at risk notes tied to S&P offer 95% protection, modest cap

By Emma Trincal

New York, Oct. 22 – Morgan Stanley Finance LLC’s 0% equity-linked partial principal at risk securities due Oct. 27, 2021 linked to the S&P 500 index offer almost full downside protection on a relatively short period of time, which may appeal to conservative investors. But some, with a more bullish view, believe the cap is too low for an equity-linked note and shy away from the ordinary income tax treatment of the product.

The payout at maturity will be par plus any index gain up to a maximum return of at least 27%, according to an FWP filing with the Securities and Exchange Commission.

If the index falls or remains flat, the payout will be par plus the return, with a minimum payout of $950 per $1,000 of notes.

Better than junk

“The most you can lose is 5%. The most you can make is 9% per year. It’s a bit less than that with the compounding and the dividends. But for someone a little bit cautious about the market, it’s a good way to put more of a defensive tilt on a portfolio,” said Jerrod Dawson, director of investment research at Quest Capital Management.

“I like it.”

Dawson said the notes may be compared to a high-yield bond and generate a higher return.

In both cases investors are subject to credit risk. But the odds of Morgan Stanley defaulting in three years were “not a concern,” he said.

The higher probability of default associated with junk bonds represented for Dawson a greater risk than the combined credit risk of Morgan Stanley and the 5% potential loss induced by the stock market.

“High-yield bonds could lose 20%, 30% of principal,” he said.

He then compared the notes to an index fund tracking the S&P 500 index.

The noteholders see their upside limited and they miss the 1.75% dividend yield of the index. But they won’t lose more than 5% of their initial investment.

Fair tradeoff

“With structured notes the give-and-take is not always favorable to investors,” he said.

“In this case the tradeoff seems reasonable.”

The cap was justified by the relatively short maturity given the high level of protection, he noted.

“There is a cap. There’s got to be. But at the same time, you keep 95% of your principal. 5% is not a big risk.

“It can make sense for an investor who is not in a situation where they’re willing to take on a lot of risk.”

The reverse of a buffer

Another financial adviser had a different view. To him, the 27% cap offset the benefit of the 95% principal-protection. The protection itself came with its own “problem.”

“It’s unusual. Typically, you have a buffer that protects you on the first 5% and after that, you can lose up to 95% of your investment. Here it’s the reverse. You take the first 5% losses, and then 95% of your money is protected,” said Steven Foldes, vice-chairman at Evensky & Katz / Foldes Financial Wealth Management.

“Obviously it’s interesting,” he said.

But for Foldes, the cap was “a deal-breaker.”

Not enough gains

“You have a very modest cap for a note tied to the U.S. equity markets,” he said.

The 9% per year was about “8% and change,” on a compounded basis. When taking into account the non-payment of dividend, investors get about 6% a year.

“That’s a big cut from the historical 10% annual return. I don’t like to see the cap so low especially on a lengthy period like three years,” he said.

His view reflected his outlook on the market.

Long-term outlook

“The market can be volatile and choppy and we’re seeing that right now with volatility going up. But the economy is strong and the 12-month forward-looking earnings are in line with their historical average,” he said.

“If you cap a client at such a low level, they are going to miss out over a certain period of time. You’re doing them a disservice. You can’t have market exposure and not get market returns.”

Investors with a less optimistic outlook may find the product appealing, he conceded.

“For somebody who is on the bear side or if not, very moderately positive, it makes sense.

“But it’s not something I would want to invest in,” he said.

Tax consideration s

There was another negative aspect for this adviser.

“It’s not exactly 100% principal-protected, but it’s close. The tax treatment is the same. It’s ordinary income. This is a big problem for us,” he said.

Using tax-shelter accounts is always an option, but not one Foldes would want to take advantage of.

“We work holistically. Some of our clients do not have tax-exempt accounts and therefore would be at a disadvantage. It’s not something we would want to do.”

Investors in the notes will be subject to annual income tax based on a “comparable yield” even though they do not receive any interest during the life of the notes, according to a legal opinion expressed in the “tax considerations” part of the prospectus. In addition, any gains at maturity will also be treated as ordinary income.

“You’re forcing clients to pay when they receive nothing.

“This tax consideration is a non-starter for us,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes (Cusip: 61768DJJ5) will settle Oct. 25.

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