Morgan Stanley’s two-year leveraged buffered notes on S&P 500 target prudent, moderate bulls

By Emma Trincal

New York, Aug. 23 – Morgan Stanley Finance LLC’s 0% 24- to 27-month leveraged buffered notes linked to the S&P 500 index offer a “plain-vanilla” structure for mildly bullish investors seeking some level of downside protection as the market remains near its highs, said Tim Mortimer, managing director at Future Value Consultants.

If the S&P 500 finishes above its initial level, the payout at maturity will be par plus 150% of the index return, subject to a maximum payout of $1,175.35 to $1,205.80 per $1,000 principal amount, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by 10% or less and will lose 1.1111% for every 1% that it declines beyond 10%.

Future Value Consultants ran a stress-testing simulation for this note in order to gauge risks and probabilities of outcomes. To generate its report, the Monte-Carlo simulation model picked a maturity of 25½ months and a 19.05% cap, both at midpoint of their respective range.

Downside leverage

One slight difference with the classic leveraged buffered note was the geared buffer, he noted.

“If the S&P goes to zero, you will lose all your principal because of the 1.11 gearing while the maximum loss would be 90% with a classic buffer,” he said.

“It’s more aggressive. But that’s one way to price a higher coupon.”

The gearing on a buffer offered a superior protection to a barrier all things being equal.

“When you go through a barrier, the barrier disappears,” he said.

“If I’m only going to get a 10% protection, I’d rather have a buffer. 10% is so easy to breach. When you breach a barrier, you’re long the index. With a buffer, you’re still ahead.”

Muted return

The moderately bullish characteristic of the notes derives from the analysis of the cap.

“The maximum return is 19%. That’s 8.5% per year on a compounded basis. All you need is the market to go up by 5.75% a year. That’s not a lot,” he said.

“This is for someone who thinks the S&P is set for moderate growth and wants a little bit of principal protection through the buffer.

“If you think the S&P is going to go up more, you buy the ETF. Here you get a more balanced trade with a little bit of growth and some buffered protection. It’s a slightly different risk-reward.”

Fair value

Mortimer said his report found a fair value for the notes of 97%, which was “fairly close” to the fair value disclosed in the filing of 97.4%.

“We agree with their estimation,” he said.

This fair value is the issuer’s estimate of the assets at trade date.

“If you were to value your deal today, the value of your assets would be 97.4 per 100,” he said.

The SEC has required issuers to publish their estimated value in order to help investors get a better grasp at pricing and costs.

“There’s been a debate about what kinds of fees are in a structured note. You have to hedge the product. There is a cost associated with it. It’s not quite as simple as an ETF,” he said.

In the case of the notes, the implied cost is the difference between par and the estimated value, or 2.6%.

“The broker takes 2% of it, which is also disclosed in the filing. The estimated value gives investors an idea of where the profit is taken.”

Running stress tests

Each report contains a total of 29 sections or tests, which encompass simulation tables as well as back testing analysis.

The factors used in the Monte Carlo simulation are the typical market and implied data, including risk-free rate, issuer credit spread, deposit rate, dividend yield and volatility as well as correlation matrix, he explained.

Scorecard

Mortimer first used one of the most straightforward tests called scorecard. This table shows the various outcomes associated with a product type as well as their probability of occurrence.

“This test is based on the neutral scenario, which is quite conservative,” he said.

The neutral scenario reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying. It is used in all tables.

This structure is simple, he said. It only has four potential outcomes, which is far fewer than other products such as autocallables whose durations, date of payments and dates of calls vary widely.

The outcomes or “buckets” are: capital loss; return full capital (and nothing more); positive return; and maximum return.

Winning half of the time

“We find evenly split outcomes,” he said.

“The probability of a maximum return achieved with the cap is 32.9% while the loss of capital has a 31.23% chance of happening,” he said.

Between those two extremes, investors get a positive return below the cap at a rate of 21.33%, according to the scorecard. Full capital repaid at maturity without any gain is the scenario in which the buffer fulfills its mission. It occurs 14.53% of the time.

“You will be making money 50% of the time and losing money a third of the time,” he said.

Looking back

The back-testing analysis applied to the same table showed very different results.

“The bull market has picked up in intensity over the past few years,” he said.

The implication is that back-testing results will be better over the past five years than the last 15-year period.

For instance, the “maximum return outcome” happened at a frequency rate of 80.52% over the last five years but 72.33% of the time in the past 15 years.

No occurrence of losses was observed in the most recent period; in the last 15 years, the rate of occurrence was only 13.08%.

“Even over the long period of time, which includes the financial crisis and the Great Recession, this product has performed very well,” he said.

Five distributions

Mortimer analyzed another test called capital performance. More complex, it adds four additional distribution assumptions. Based on different index growth rates and volatilities, those are – bullish, bearish, less volatile and more volatile.

In the bull scenario, the probability of hitting the cap is 71.56%.

“It’s interesting to note that it’s roughly equal to the 15-year period back-testing. This is because we’ve had this very long bull market during that time,” he said.

In conclusion, one of the benefits of simple structures such as leveraged buffered deals on the S&P 500 index was the ease at which investors may compare one product against another.

The rationale for those investments is moderate expectations in both directions of the market.

“This is a very standard product. Leveraged buffered notes have been around for as long as the U.S. structured notes market has been around,” he said.

“Investors buying this product are not too greedy. They’ll be happy with an 8.5% annual return and a 10% buffer especially at this stage of the bull market.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The Cusip number is 61769HRE7.

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