Morgan Stanley’s barrier notes on Regional Banking ETF show ‘straightforward’ sector bet

By Emma Trincal

New York, Jan. 9 – Morgan Stanley Finance LLC’s 0% contingent buffer equity notes due Jan. 24, 2019 linked to the SPDR S&P Regional Banking exchange-traded fund offer an attractive tradeoff making the product a good substitute for an outright investment in the underlying fund, buysiders say.

But that is only if one wants to bet on the sector, which is not necessarily the case, according to those sources.

Some advisers tend to prefer broader indexes. Others do not view bank stocks as the most compelling play at this time.

Under the expected terms of the notes, if the final share price is greater than or equal to 85% of the initial share price, the payout at maturity will be par plus the greater of the contingent minimum return of 0% and the fund return, capped at 23.3%, according to an FWP filing with the Securities and Exchange Commission.

Otherwise, the payout offers full exposure to the fund’s decline.

No sectors

“The only thing I don’t like here is the regional bank underlying. It’s a pure sector play, actually, it’s an industry play on banks,” said Carl Kunhardt, wealth adviser at Quest Capital Management

“I don’t bet on sectors anymore. I got burned in 1999 with tech stocks. We only buy diversified indexes for an entire asset class.”

His stance on sector bets reflected “a personal bias,” he conceded.

“Assuming that I was going to play the sector, I would find the notes pretty attractive.”

Trade off

Investors in the notes “sacrifice” returns above 23.3% a year for a 15% contingent protection on the downside.

“I don’t think it’s a sacrifice, really because I can’t see this sector or any other going up more than 23% in one year,” he said.

While Kunhardt admitted he does not follow the sector, his overall market outlook is very conservative.

As the ninth anniversary of the current bull market is just around the corner, he said he is not expecting returns to exceed 8% to 10% this year for most asset classes.

As a result, the tradeoff is favorable to mildly bullish investors, a group in which he includes himself.

Simplicity

“If the sector is between negative 15% and 0%, I get the protection. After that, I am one-to-one up to a 23% cap.

“I’m paying for the downside protection with the cap.

“That’s pretty straightforward.”

Before purchasing a structured note, Kunhardt always asks himself whether he would be better off investing in the underlying directly or in the notes.

“If I was long the position, I wouldn’t have the cap. But I would also be exposed to the downside.

“Do I expect the regional banking sector to be above 23% in a year? I don’t know. I don’t follow the sector.

“But in most cases, I don’t expect anything above 10%.

“So if I was going to make that sector bet, I would be willing to take the cap in order to get the 15% protection.

“This is a very simple trade off. I like simple things.”

Good substitute

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, said the structure offered benefits to investors compared to the ETF. But the investment theme was not as compelling.

“If you compare the notes to the underlying, it’s a preferable way to invest because 23% is a lot and you’re getting the benefit of the downside protection.

“I don’t think you’ll get 23% in a year.

“The 15% barrier is fine although I would have preferred a buffer.”

Overall for investors seeking exposure to the sector, the notes offer a better alternative than a long position in the fund, he said.

“It’s a worthwhile investment compared to owning the ETF. It’s a reasonable way to do it....and probably a better way to do it because you have up to 15% in downside protection.”

Cautious on financials

But this adviser said that is not particularly bullish on financials.

Rising interest rates are certainly beneficial to banks, he said. Yet financial institutions make money on the spread between the short and the long end of the curve, he noted.

“As the spread is narrowing, it creates an interesting divergence for the bank and that’s not good for their bottom line.

“I tend to think things will get worse and that that the curve will flatten even more. We could have an inverted curve. That wouldn’t be good for the banks.

“I know that the market has been very bullish on banks, in large part because of the corporate tax cut.

“But the shape of the yield curve is such a big risk factor.

“I see so many other opportunities out there. Banks are not on top of my list.”

Morgan Stanley & Co. LLC is the agent with J.P. Morgan Securities LLC and JPMorgan Chase Bank, NA as placement agents. The notes will be guaranteed by Morgan Stanley.

The notes will settle on Wednesday.

The Cusip number is 61768CXR3.

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