Advisers evaluate cap/leverage trade-off on two of Morgan Stanley’s buffered notes on S&P 500

By Emma Trincal

New York, Feb. 3 – Morgan Stanley Finance LLC is planning to price two buffered notes offerings tied to the S&P 500 index, according to distinct 424B2 filings with the Securities and Exchange Commission. The notes’ different characteristics allowed financial advisers to opine and reflect on the advantages of leverage versus uncapped upside. Buffer sizes were also debated in relation to the notes’ durations.

The first deal, the 0% buffered participation securities due Feb. 6, 2025 linked to the S&P 500 index, will pay par plus any index gain at maturity. The downside buffer is 30%.

The second issue – Morgan Stanley Finance’s 0% buffered Performance Leveraged Upside Securities due Oct. 20, 2022, offer par plus 120% of the index return, but the gains are capped at 20%. On a compounded basis, the maximum return is the equivalent of 7% per year.

The buffer is 20%.

Tenors matter

Carl Kunhardt, wealth adviser at Quest Capital Management, said he liked both offerings.

“Do I have to choose?”

Since both notes are linked to the large-cap benchmark, they would equally fit into this adviser’s portfolio.

“I’d have to hold them in my core holding anyway,” he said.

At first glance, the first deal seemed more attractive.

“There’s no leverage; that’s true. It’s as if you were long on the upside. But there is no cap and you have a terrific safety net of 30%,” he said.

What does the other note with its shorter maturity of two years and eight-and-a-half months have to offer?

“Well in the current environment, we could have systemic risks, which may derail the market,” he said.

“I’d like to have some downside protection: the 20% buffer gives me that.

“But I would also like to have a shorter term to be able to redeploy my money when the market is down, which brings the two-year note a little bit more in focus.”

This adviser, who is not overly bullish for the short term, added that there is “nothing wrong” with getting a 7% annual return in the interim.

In the scenario of a pullback, the 20% buffer should be also sufficient, he said.

Kunhardt said he could tolerate the cap in order to get the leverage. He could also tolerate the one-to-one return with no cap.

“It’s good to be uncapped and it’s good to have the leverage. The way I assess those notes...any note is compare them with a long position. Am I better off than owning the index? Yes. In both cases I am better off because they both have a buffer.”

Another advantage shared by the two products was their simplicity.

“They’re not complicated notes. They’re easy to get your arms around, and they come from a pretty well-known issuer.”

In conclusion, Kunhardt said he could use the first note for his core allocation and the second one for a more tactical approach.

Buffer within reason

Michael Kalscheur, financial adviser at Castle Wealth Advisors, who also appreciates the value of buffers, was more critical about both notes, hoping the issuer could have introduced one note wrapping the benefits of both products into one.

“We like buffers. The downside protection is one of the main reasons we buy structured products,” said Kalscheur.

“Five years is good for us. We lean toward these longer-dated notes.”

However, Kalscheur noted that the 30% buffer associated with this five-year product, while attractive on paper, was probably more than what investors needed.

“You could use some of it to improve the upside,” he said.

Based on data his firm collected since 1950, he found that the S&P 500 index dropped more than 30% on any five-year rolling period only 0.2% of the time.

“You’re talking very small probabilities, almost to the point where you have to wonder: do I really want to give up the leverage to protect against 0.2%?” he said.

A barrier would be much cheaper, he noted, although he was not sure he would opt for that solution.

“You still can end up negative. My tables show it may happen 17% to 18% of the time. So I wouldn’t be comfortable with a barrier.

On the other hand, the 30% buffer will end up “costing” investors something.

“The bigger the buffer, the more you pay for that, the less other stuff you get,” he said.

“We feel confident that for buffers over 20%, even 15% it doesn’t really make mathematical sense to pay for that.

“You’re giving up something to protect yourself against something that has a 99.8% chance of not happening.”

He compared the two buffer sizes in terms of his relationship with his clients.

“The market is down 31%. There’s less than half a percent chance that it will happen. But assuming it does. You have a 30% buffer. Your clients lose 1%. They love you.

“Now if you only have a 20% buffer, the market is down 31%. They lose 11%. They still love you.

“If you’re not going to lose them, why would you pay the extra? You could significantly improve the terms on the upside with a 20% buffer. So why not create more balance?”

The capped one

Next, Kalscheur examined the second note.

“It’s a very odd maturity,” he said.

“The term is much shorter. I’ll definitely do it with the buffer here.

“The 20% buffer they offer is fine. It’s still significant.

“I like the 1.2 times leverage.”

But the “downside” of this second deal was its cap.

“If they could do a 15% buffer to get rid of the cap, it would probably work for us.

“Maybe a little bit less leverage, perhaps 1.15 although that’s usually our minimum.

“If they could swap the buffers, give us a 20% buffer instead of 30% but with the leverage on the upside and no cap, we would put money on that one.

“We think this would be a good deal.”

All notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent for both issues.

Both deals were set to price on Monday and will settle on Thursday.

The Cusip number for the five-year note offering is 61770FFP6.

The other’s Cusip is 61770FFM3.

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