Morgan Stanley’s buffered digital notes tied to Russell see resistance due to underlying theme

By Emma Trincal

New York, March 14 – Morgan Stanley’s 24- to 27-month 0% buffered digital notes linked to the Russell 2000 index offer attractive terms, but advisers were more concerned about the underlying investment theme – which they said has little appeal at this time – than the structure.

“You could have a great note, but if the timing is off, if you don’t like the asset class, it’s irrelevant,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

If the index return is greater than or equal to negative 15%, the payout at maturity will be the maximum settlement amount, which is expected to be $1,135 to $1,158 per $1,000 principal amount of notes, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, investors will lose 1.1765% for every 1% that the index declines beyond 15%.

“The terms are not bad,” Kunhardt continued, pointing to a potential return of 13.5% to 15.8% if the index does not drop more than 15%.

The size of the buffer is also a plus.

“I usually don’t like geared buffers, but you would have to see a huge decline before the leverage overcomes the buffer.”

Volatile benchmark

Kunhardt’s main objection was the small-cap benchmark itself in a market environment that remains uncertain.

“It’s really going to depend on where you think we are in this investment cycle. If we’re going into a market correction, then I don’t want to be into small caps,” he said.

“Small caps tend to be more volatile. They lead us into recovery; they lead us into market downturns.”

The S&P 500 index closed down 1.2% for the year on Monday. The Russell was off 4.55% for the year.

“When you’re down in small caps, you tend to be down more, and when you’re up, you’re up more,” he said.

Elections

In a bid to reduce volatility in his clients’ portfolios, Kunhardt has recently eliminated his exposure to the asset class.

“I got out of small caps. It’s just too much volatility. I only kept a small allocation for my more aggressive investors,” he said.

The duration was also a concern.

“It’s basically a two-year. My crystal ball doesn’t work that well short-term,” he said.

“If it was a five- or a seven-year, it would be a different conversation.

“There are just too many questions about what’s going to happen in November. The market doesn’t care about Republicans or Democrats, liberals or conservatives, left or right. The market only cares about uncertainty and stability. We have no idea what the business climate is going to be or the regulatory environment or the fiscal and monetary policies.

“When you have that big a question mark, fund managers sit on their hands, and that’s what we’ve seen for the past six to eight months.”

Good terms

For investors “more positive” on the market, however, the notes may offer an attractive structure.

“If you think that we had that correction already and that last week was the signaling that we’re going back up, it’s a different situation. But I’m not in that camp,” he said.

“If I was going to do small caps, I would probably do it through this note. But I don’t like the asset class, so it’s a moot point.”

Range bound

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, saw the product as a tool to outperform the index if it trades sideways. One of the drawbacks may be the digital cap, which limits the potential gains. But he downplayed such risk as he also lacks conviction on the index.

The Russell 2000 was trading at 1,080 at mid-day Monday. A 15% decline would bring down the benchmark to 920, he said. Assuming a 13.5% maximum return, investors would be capped at 1,227, he noted.

“As long as you’re within that range, between 920 and 1,227, you’ll do better with the notes. Actually even if the Russell is less than 920, you’ll do better because of the buffer,” he said.

“If I need to invest in the Russell for the next two years, this would be a better solution than investing in the index itself. I don’t think the Russell is going to be that much higher in two years, although two years is a long time in the world we’re in.

“Personally I wouldn’t be interested based on my market expectations. But for someone who needs to have exposure to small caps as part of an allocation, this would be a better option than investing straight in the Russell 2000.”

Morgan Stanley & Co. LLC is the agent.

The notes will price and settle in March.

The exact maturity date and maximum settlement amount will be set at pricing.

The Cusip number is 61761J2L2.

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