Morgan Stanley’s autocallable income notes on Stoxx Europe 600 Banks tap into risky sector

By Emma Trincal

New York, Oct. 24 – Morgan Stanley Finance LLC’s 0% trigger autocallable contingent yield notes due Oct. 31, 2019 linked to the Stoxx Europe 600 Banks index are too risky as an investment theme for the benefit they offer, even if the terms appear attractive, said financial advisers uncomfortable with the exposure to European banks.

The notes will pay a contingent quarterly coupon at an annual rate of 10% if the index closes at or above its downside threshold level, 69.75% to 74.75% of its initial level, on the observation date for that quarter. The exact downside threshold level will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par if the index closes at or above its initial level on any quarterly observation date beginning April 27, 2017.

The payout at maturity will be par plus the final coupon unless the index finishes below the downside threshold level, in which case investors will lose 1% for every 1% decline.

Sector play

“It all sounded good until we got to the part of the underlying, European banks, a sector that could explode as Deutsche Bank could potentially be the next Lehman Brothers,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“I don’t like sector investing to begin with. I got burned with the tech sector in 2000 like many other people.

“I wouldn’t touch it.”

Deutsche Bank’s woes

Deutsche Bank saw its share price drop when the U.S. Department of Justice last month requested $14 billion to settle an investigation related to the sales of mortgage bonds during the financial crisis.

“What is the risk to other banks? Huge, because there is so much counter risk. ... If Deutsche was to fail, it could potentially tear down the alternative portfolios of most major banks,” said Kunhardt.

The market may have overreacted about Deutsche Bank, however, he said. In the past month, the share price has risen by 13.75%.

“I don’t see how Germany could not bail them out, especially after we saw what happened when Lehman Brothers went under. Nobody has the appetite for this kind of disruption,” he said.

But the European banks offer risks other than the flagship German bank, he argued.

“When you go to Southern Europe, nothing has been fixed in the financial sector. All they did was kick the can down the road. In Italy, Spain, Greece, Portugal, the banks are still a mess.”

Terms

Kunhardt said his criticism is directed to the underlying and not to the structure of the product.

“It’s a nice little barrier to have a 30% or even 25% protection. But the potential to breach that barrier is very high, and if you breach it, you’re taking on a massive loss at the end of the three years,” he said.

The autocall feature, non-applicable for the first six months, is also a concern.

“You get called in six months with 5%. Now you get the reinvestment risk,” he added.

Domino effect

Kunhardt said he is “already cynical and weary” about sector investing because of his past experience during the tech bubble burst.

“I’ve seen the game,” he said.

“I will use sectors here and there like salt or pepper to overlay some exposure.

“But I will not use it in a note, especially not in a sector that I think is fundamentally weak where banks are tied at the hip. You have so much counterparty risk; if one bank is going to drown, others will too.”

Long, complex

Steven Foldes, vice-chairman at Evensky & Katz/Foldes Financial Wealth Management, said the structure itself is not very compelling given the risk associated with the underlying index.

“First, we don’t do long notes in duration. We cap it out at two years. Three years is a long time for us,” he said.

“Second, this is a pretty complicated note. We have to explain these notes to our clients, and there are a lot of iterations with this.

“Finally, we don’t really love European banks at this time. Even if the downside protection ends up being 30%, we don’t love it given the volatility of the European financial sector.”

The index offers diversification, but Foldes said he is “concerned” with the sector.

“If we have an issue like we had during the 2008-09 financial crisis, a 30% barrier is not going to help.”

Risk versus reward

“The coupon is nice, but it doesn’t outweigh the risk of this sector fund in an area as volatile as this,” he said.

“We couldn’t be investing in this area notwithstanding a reasonable coupon because there is no upside participation beyond the coupon itself.

“For all these reasons – length, volatility, terms, no upside – it becomes a non-starter.

“This is not the kind of notes we would embrace.”

The notes will be guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC and UBS Financial Services Inc. are the agents.

The notes (Cusip: 61766F359) will price on Thursday and settle on Monday.

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