Morgan Stanley’s contingent income autocall tied to Wells Fargo seen as stock substitute

By Emma Trincal

New York, April 5 – Morgan Stanley Finance LLC’s contingent income autocallable securities due April 8, 2022 linked to the common stock of Wells Fargo & Co. are designed for income investors with a moderately bullish view on the stock as well as a possible alternative to owning the shares based on this market view, said Suzi Hampson, head of research at Future Value Consultants.

If Wells Fargo shares close at or above the downside threshold level, 80% of the initial share price, on a quarterly determination date, the notes will pay a contingent payment that quarter at an annualized rate of 10.75%.

After six months, the notes will be called at par of $10 plus the contingent coupon if Wells Fargo shares close at or above the initial share price on a quarterly determination date.

If the final share price is greater than or equal to the downside threshold level, the payout at maturity will be par plus the final contingent coupon. Otherwise, investors will lose 1% for every 1% that the final share price is less than the initial share price.

Not so volatile

“The double-digit coupon seems quite high. You would therefore expect the stock to be volatile. But we haven’t seen a huge spike recently,” Hampson said.

On March 28, Wells Fargo’s chief executive officer stepped down. He took the leadership role after a wave of scandals put the bank under tight regulatory scrutiny. The share price dropped nearly 3% on the next day but has stabilized since and is now back to where it was prior to the announcement. The notes have been set to price a week prior to the bank’s earnings expected to be reported on Friday.

Despite the news and the upcoming earnings, the stock has not displayed much signs of volatility, noted Hampson.

The implied volatility was at 23.24% on the week of the announcement and at 23.5% on Thursday, the day prior to the pricing date.

“Volatility didn’t really shoot up. There hasn’t been a huge price drop,” she said.

But another factor may have helped pricing, she noted, pointing to the dividend yield of 3.68%.

“It’s pretty high,” she said.

Mildly bullish

The structure is typical of an autocallable contingent coupon product, she noted. It is designed for income but also to monetize a mildly bullish outlook.

“As long as the stock stays above the 80% barrier, you get the coupon. Three years might seem like a long time, but the notes can be called after six months,” she said.

Compared to an equity investment, the notes offered an advantage.

“You don’t need the underlying to grow in order to get paid. In fact, it can even be down as much as 20%.

“This should satisfy investors who are not really bullish on the stock and not really bearish either. You couldn’t really do that easily by just owning the shares.”

Tradeoff

Unlike the long position, however, investors are exposed to the issuer’s credit risk. Reinvestment risk is also a consideration as the notes can be as short as six months due to the autocallable feature, she noted.

“But at least you do have this six-month no-call, which guarantees you a minimum return of 5.375% in the event of a call,” she said.

Without any call protection, the terms would have been different. She was referring to the first autocall happening after six months, not three.

“You would expect it to change the potential return. It would not be a huge change because it would only add one call date, which is one data point. The change would have been more drastic on a shorter-dated note,” she said.

The elimination of the six-month call protection would have allowed for a higher coupon, she said.

Hampson did not price this scenario. If she had, she said, the modified report would have shown a higher coupon.

Alternatively, if she had repriced the deal under this assumption (first call after three months) and left the coupon unchanged, she would have seen the price of the notes go down.

First call

Hampson ran a report on the notes as described in the prospectus, using Future Value Consultants’ stress testing model.

Each report contains 29 sections or tests generating forward-looking and back testing analysis.

She first examined the “product specific tests.” The table provides probabilities of call at various dates.

“Like with any autocall, the most likely scenario is that it will call at point one,” she said.

Such an outcome will occur 51.29% of the time in the neutral scenario.

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

Four other market assumptions are included in the model, which are: bull, bear, less volatile and more volatile.

In the bull scenario, the chances of a call occurring on the first call date rises to 59.69%.

“At that point you get your coupon for the six months and your money back. Whether or not it happens we don’t know. It’s just the most likely outcome historically,” she said.

“You then have to reinvest the proceeds. Most people buying autocalls know that and are comfortable with that. But it’s not for everyone.”

Either loss or gain

Another table, the “capital performance tests” analyzes the probabilities of outcomes specific to the structure.

Those are: “return more than capital,” “return exactly capital” and “return more than capital.”

Since investors receive payment even when the stock is negative as long as it stays above the barrier, the probability of “return exactly capital” is zero.

“Either investors will receive their principal back with some income, or they will lose some or all of their principal,” she said.

“It’s always the case when the coupon barrier is below par, which is how these autocalls with contingent coupons are usually structured.”

Probabilities of losses

The probability of getting “more than capital” or at least one coupon payment is 86.42% in the neutral scenario. It goes up to 92.94% in the bull scenario and drops to 78.42% in the bear, according to the table.

The reverse way to look at these figures is through losses: investors will get less than their principal back 13.58% of the time in the neutral scenario and 7.06% of the time in the bullish scenario.

“You are not going to lose money very often. But when you do, your losses will be significant,” she said.

Average loss

A subtable shows the average payoff in each scenario. In the neutral one for instance, the average loss is 40%.

“You will lose at least 20%. That’s the minimum loss. But it’s a three-year and if you’re looking at the average it’s going to be more. Your average is twice that,” she said.

“But you would have lost quite a lot as well if you had invested in the stock.”

Equity investments however are more liquid and do not include credit risk.

“We know that in general structured products are designed to be held until you kick out or until maturity. But there’s always a tradeoff. With the notes, you have the 20% contingent protection, which you don’t have with the stock.

Back testing

Future Value Consultants’ reports include back testing tables over the last five, 10 and 15 years.

Back testing frequency of occurrences are much more encouraging than forward-looking probabilities, she said, especially given the record 10-year old bull market.

The frequency of getting more than capital is 100% over the last five years, 95.19% over the last 10 and 96.79% over the last 15.

“This is very encouraging but of course back testing should be looked at carefully,” she said.

“What the report suggests in general is that we have a product that can be used as an alternative to owning the stock.

“It’s a slightly less-risky way of being exposed to this underlying.

“You’re giving up the dividend, but you don’t have to take all the risk associated with equity. Also, you can generate a pretty good return even if the stock doesn’t move much.”

The notes will be guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent, with Morgan Stanley Wealth Management handling distribution.

The notes (Cusip: 61768X705) priced on Friday and will settle on Wednesday.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.