Morgan Stanley’s autocalls on SPDR S&P Regional Banking would benefit from deeper barrier

By Emma Trincal

New York, May 13 – Morgan Stanley Finance LLC’s contingent income autocallable securities due June 1, 2023 linked to the SPDR S&P Regional Banking ETF offer an attractive yield, but the risk on the downside is too high given the barrier size, said Clemens Kownatzki, finance professor at Pepperdine University.

Investors will receive a coupon of 16.88% per year, paid quarterly, if the underlying ETF closes at or above its 80% downside threshold on the related quarterly observation date, according to an FWP filing with the Securities and Exchange Commission. Previously unpaid coupons will also be paid.

The securities will be called automatically at par if the price of the underlying ETF is greater than or equal to its initial price and on any quarterly review date.

At maturity the payout will be par unless the final level of the ETF closes below its 80% downside threshold, in which case investors will be fully exposed to the decline of the ETF.

The final level will be the average of the five closing prices of the week preceding the maturity week.

Fed, inflation

Kownatzki first assessed the macroeconomic picture.

“Rates are higher, and usually banks benefit from higher interest rates since they borrow low and lend high,” he said.

“However, it doesn’t always work that way. During a recession for instance, people tend to borrow less, which of course puts banks’ profits under pressure.”

Kownatzki however does not think a recession is imminent.

“For now, the economy is still strong. The labor market is very tight. The economic activity remains robust in the U.S.,” he said.

But investors are facing a number of headwinds starting with a beaten-up stock market and the high inflation rate, he noted.

“If the Fed pursues an aggressive tightening policy, there’s a growing risk of a recession. My sense though is that the current Fed has been very accommodative towards the stock market. If this sell-off persists and gets worse, if we have another significant decline, the Fed would be likely to intervene,” he said.

No concentration

Kownatzki said he liked the underlying.

The ETF replicates the performance of the S&P Regional Banks Select Industry index, which tracks the regional banking segment of the U.S. banking industry.

“These are the smaller banks. One of the attractive features is the diversification. The weights are evenly divided,” he said.

M&T Bank Corp., the top holding, has a weighting of only 1.66%. The top 10 constituents represent 15% of the ETF, he noted.

“It has about 140 holdings versus 100 for the Nasdaq. But the Nasdaq is much more concentrated,” he said.

The top 10 stocks in the Nasdaq make for more than 50% of the index, he said.

“You can see how a 10% intraday drop in the share price of Tesla can drag down the performance of the Nasdaq.

“With this regional bank ETF, you don’t have this issue of an overly concentrated portfolio,” he said.

Thin barrier

Kownatzki examined the risk-adjusted return of the product.

“The contingent coupon is very high. That’s one of the most appealing things in that note. You’re getting a very attractive return. But you're also looking at a fairly high risk of losing some of your principal at maturity with a barrier of only 80%,” he said.

The ETF closed at $60.57 on Friday when the notes priced. At that level, the initial price was 23% lower than the January peak of $78.81, he noted.

“You could say the share price has already dropped a lot and it has. But one year is a very short timeframe,” he said.

“You get a better sense of the risk looking back to March 2020 when the ETF was trading as low as $12 a share. If we were to test those levels again, we would be looking at an 80% price drop. The 80% barrier, which only protects you for the first 20%, is not going to cut it in this scenario,” he said.

The pandemic-induced bear market of 2020 was short-lived but very severe, he said.

“If the economy falls into a global recession, the stock market may not plunge into such depth, but the 80% barrier would still be breached easily,” he said.

“On the other hand, if China gets its act together, if the situation in Ukraine gets resolved, the external environment would be more benevolent and the pressure on the equity market would ease somehow.”

But the economy may not be on solid footing.

“As the Fed is trying to accomplish a soft landing while taming inflation, we’re still in a very uncertain environment.

“It’s a challenge. If they’re forced to raise rates much more, we’re likely to slip into a recession,” he said.

Tenor

Kownatzki identified another risk factor, which was the short duration of the notes.

“One year is riskier than a longer period simply because over time, equities tend to outperform,” he said.

“Your entry point over a long timeframe is less crucial while it is very, very important over the short term.

“We just don’t know if this underlying ETF is going to be a falling knife because we don’t know how long this market sell-off is going to last.”

Kownatzki said he is “hesitant” to talk about a bear market yet because the bulk of the sell-off remains concentrated around technology stocks.

“The notion of a bear market is kind of arbitrary. But we are definitely in a bear market for tech stocks. Some names have been decimated,” he said.

Tech in free fall

He mentioned Peloton Interactive Inc., which is down 88% from its peak last summer, as well as Zoom Video Communications Inc., which dropped 77% from its July high. Amazon.com, Inc. shed more than 40% from its high in July and Meta Platforms Inc. lost half of its value since September, he said.

“We’re going through a major sell-off punishing primarily tech stocks at this point. But other sectors of the market are already in correction mode and the risk of contagion is high,” he said.

This is why Kownatzki said he could not reach a clear-cut conclusion about the value of the notes.

“I’m sort of sitting on the fence,” he said.

“I do like the underlying ETF. I like the high-double-digit coupon,” he said.

“But I don’t think you’re getting enough protection on the downside, not in this current environment.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent. J.P. Morgan Securities LLC and JPMorgan Chase Bank, NA will act as placement agents.

The notes are expected to settle on Wednesday.

The Cusip number is 61774DCF2.

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