Morgan Stanley’s lock-in notes tied to S&P 500 show renewed interest for lookbacks, protection

By Emma Trincal

New York, Jan. 9 – Morgan Stanley Finance LLC plans to price an innovative product that combines a high-water mark feature with nearly full principal protection. But the terms are not easy to explain to retail investors although those are likely to be the ones to benefit from the product the most, a market participant said.

The contingent minimum repayment lock-in securities due Feb. 5, 2025 linked to the S&P 500 index provide a minimum payout at maturity that starts at $8.50 per $10.00 principal amount and will increase if a lock-in event occurs, according to a 424B2 filing with the Securities and Exchange Commission.

A lock-in event occurs if the index’s closing level on any annual observation date is greater than the initial index level and the highest closing index level achieved on any previous observation date.

If a lock-in event occurs, the minimum payment at maturity will increase by an amount reflecting 85% of the percentage appreciation in the index’s closing level on the relevant observation date relative to the initial index level or the higher index closing level achieved on a prior observation date, even if the index has depreciated on subsequent annual observation dates or the valuation date.

However, the occurrence of a lock-in event will not necessarily increase the payment at maturity, because investors will receive at maturity only the greater of the final lock-in amount and the upside payment, and so the final lock-in amount will not be combined with the upside payment.

Payout at maturity

If the final index level is greater than the initial index level, the payout at maturity will be the greater of (a) par plus the index return and (b) the final lock-in amount.

If the final index level is less than or equal to the initial index level, the payout will be the greater of (a) par plus the quotient of the final index level divided by the initial index level and (b) the final lock-in amount.

The final lock-in amount will be the greater of (a) $10.00 multiplied by the lock-in payment factor and (b) $8.50.

Put it simply

“This is [like] a high-water mark – max risk 85% of initial and payout at 85% of highest annual return,” summarized a trader in an e-mail.

A structurer was not baffled by the prospectus description. Instead he found it exciting to see the deals pitched to what he assumed was a retail client base.

“The structure is actually pretty simple. It’s basically a lookback. At the end they pay you 85% of the high-water mark.

“It’s an 85% capital guarantee,” the trader said.

“So it’s just the combination of a lookback and a PPN.”

A lookback is the name of an exotic option, in which the strike price is determined after the initial date of the contract.

With structured notes, lookback options may help “lock in” a lower strike during a short period of time after the trade date, allowing investors to enter the trade at a discounted price should the market fall after inception during the set observation period, which can vary from days to weeks.

This case is slightly different as the lookback is observed repeatedly on an annual basis.

“I haven’t seen a lookback in a long time, especially for retail,” this structurer said.

The acronym “PPN” stands for principal-protected note. Although investors are not fully protected in this offering, a floor varying between 85% and 95% usually is sufficient for a product to fall into the PPN category due to the their very unique tax treatment.

“You see a lot of high-water mark features in the fund industry. It’s not that common with notes. But this is not a new technology. I’ve seen many in the past. What’s new here is that they’re using it combined with principal protection.”

Getting used to less

Individual investors who typically seek full principal-protection via a structured note or a market-linked certificate of deposit tend to hesitate twice before buying a note that may return less than their initial investment amount, he explained.

This product is an ingenious way to get retail investors more inclined to settle for less than 100% in principal-protection, he explained.

“It’s encouraging that retail is looking into these kinds of deals. I wouldn’t say it’s an enhanced PPN because I don’t believe you can compare deals and say this one is better than that one.

“But the idea is to help clients overcome their extreme risk aversion.”

If the high-water mark on any of the annual observation dates is 117.65%, noteholders will be guaranteed to get par since 85% of 117.65 is 100, he said.

“It’s like saying to the client: you’re not getting 100% of your principal guaranteed. I understand your frustration. But you are very likely to get it anyway. Besides if you don’t expect at least a 17.65% rise in the index on any of the next six years, why are you investing in stocks in the first place?”

Tradeoff

For investors there is an additional tradeoff for lowering the protection to 85%. They can “lock in” or capture the benefit of a rally during the six-year period.

“On the way down, this note is just like a PPN. On the way up, it’s different,” the structurer said.

“Most PPNs are point to point. In fact, most notes are point to point. When the market goes up, you’re protecting your gains. You’re getting at least 85% of the high as opposed to 100% of the point-to-point return.”

“This is a great product for retail. It just has to be explained properly.”

One caveat though: the tax treatment may be dissuasive to some.

Phantom income

As with most PPNs, investors in the notes will be subject to annual income tax based on the “comparable yield” of the securities, according to the prospectus.

The tax treatment of what is referred to as “phantom income,” because investors do not collect any interest, is one of the negative aspects of principal-protection, he explained.

“You can’t avoid it. It’s taxed that way because you’re buying a zero-coupon bond...”

In addition, potential gains at maturity are treated as ordinary income, another common tax feature with PPNs.

“There’s a reason why people do autocalls, buffered notes and other principal-at risk products. The tax treatment of PPNs is pretty bad.

“I guess this is one of the costs of true protection,” he said.

Complex but valuable

A trader for a structured products distribution platform said there is room for this type of product.

“As the market turns more volatile people are increasingly focused on downside protection,” said Matt Rosenberg, sales trader at Halo Investing.

“The more complex the terms, the harder it’s going to be to explain it to the client, and this is a deal with a lot of bells and whistles.”

But if investors can overcome the complexity of the payout structure, it may be to their benefit to pay a closer look.

“This product has more defined outcome than many others. People do like that.

“The protection, the lock-in are very compelling features. It’s just not meant to be sold to everyone,” he said.

The notes will be guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes are expected to price on Jan. 31.

The Cusip number is 61768W533.

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