Morgan Stanley’s PLUS tied to S&P 500 index designed to take advantage of leverage

By Emma Trincal

New York, Jan. 24 – The high leverage applied to Morgan Stanley Finance LLC’s 0% Performance Leveraged Upside Securities due May 5, 2021 linked to the S&P 500 index increases the odds of scoring the maximum return, said Suzi Hampson, head of research at Future Value Consultants. While the product has no downside protection, it can maximize returns in a slow, mildly bullish market, she added.

If the final index level is greater than the initial index level, the payout at maturity will be par plus 300% of the index return, capped at 11%, according to an FWP filing with the Securities and Exchange Commission.

If the final index level is less than the initial index level, investors will be fully exposed to the decline.

Downside exposure

“There is no downside protection, therefore potential for loss of capital. It’s quite a risky product in that sense,” said Hampson.

“But maybe you wouldn’t invest a huge part of it in your portfolio, just because it’s risky and also because the leverage allows you to put less money for the same notional.

“If combined with the less risky part of your portfolio, the risk gets balanced out.”

The notes are risky compared to other structured products, such as barrier and buffered notes.

“But having the exposure to losses is really part of the territory in equity investing. If you compare the risk profile of this note with an ETF, it’s similar.”

Asymmetrical leverage

Of course, any comparison with an ETF has its limits. An ETF does not have a holding period, she said. Shareholders get paid dividends and they do not have credit risk exposure, she added.

The leveraged notes however offer something unique with the asymmetrical leverage: the leverage is only applied to the upside while investors in a leveraged ETF would have the same amount of leverage on the downside and the upside.

“It’s hard to compare structured products with ETFs except for the risk. These are not symmetrical tools,” she said.

Modestly bullish

The notes are not designed for everyone. The first to benefit from the high leverage would be investors with a moderately bullish outlook. Given the amount of leverage and the cap level, those investors tend to seek a targeted return, she said. The notes provide just that by raising the probabilities of “capping out,” to an exceptionally high level.

“Any kind of very small growth in the underlying will give you the cap, which is a decent rate of return,” she said.

The 11% cap on a 15-month note with 3x leverage will generate a gain of 8.7% a year on a compounded basis. Such return can be reached if the index grows by only 2.92% a year.

Cap

If the cap at first glance may not seem very high, it’s also because investors can easily reach the maximum return.

“The cap is a function of what’s possible at the moment given volatility, dividends and interest rates.

“Because of the full downside exposure, you would expect a higher return. But the low volatility of the underlying index limits your options,” she said.

The one-year implied volatility of the underlying is 14.8%.

“Investors with a very bullish outlook would be better off with less leverage and a higher cap,” she said.

Stress tests

Future Value Consultants offers stress testing on structured notes. A number of tables (or tests) determine the probabilities of occurrence of outcomes pertaining to a specific product and structure type.

“We break it down here to maximum return; return more than capital and less than maximum; return exactly capital; and return less than capital,” she said.

Five distribution assumption sets are included in the firm’s report. They represent five market scenarios, which are based on volatility as well as different growth rate assumptions. Those are bull, bear, less volatile and more volatile. In addition, a neutral scenario is used as the basis of the simulation in all reports. It reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying.

Easy target

“Our tables illustrate the effects of leverage and the chances of getting the maximum return,” she said.

In the neutral scenario, investors reach the cap 49.08% of the time. The probability rises to 62.86% in the bull market and is 34.56% in the bear market.

The growth rates used in the Monte Carlo simulation are modest: 5.1% a year for instance under the bull assumption.

“This product is designed for targeted returns. It’s not the most eye-catching rate of return but the chances of getting it are high,” she said.

In a similar way, the chances of getting a positive return below the cap are relatively low: 9.15% in the neutral scenario, 7.71% in the bull scenario, according to the report.

“The gearing means that it doesn’t take a lot of growth to reach the cap,” she said.

Finally, the third bucket – “return exactly capital” – has a 0% probability of happening due to the absence of any downside protection.

“There is no buffered zone allowing you to get your capital back. Any price decline is a loss,” she said.

Average payoff

The report also provides tests for the average payoff by market assumption.

In the bull scenario, the average payoff for “return more than capital” (cap and any gain below it) is 110.4%. It is nearly identical to the average for the neutral scenario, which is 110.2%.

These are average payoffs only if the outcome is “return more than capital,” not for all outcomes, she noted.

On the downside, the average loss is 15.9% under the neutral assumption and 13.6% under the bullish scenario. Again, these averages only apply to the loss scenario, not to the combination of all outcomes.

Back-testing

Aside from the simulation tables, each report provides back-testing analysis.

The back-testing for the past five and 10 years showed average losses of approximately 3%, a much lower number than in the simulation, she noted. The frequency of “capping out” in the back-testing analysis exceed 92% in both timeframes.

“We can see that results are very sensitive to growth. We had a strong bull market in the past five years, which really raised the probabilities of reaching the maximum return,” she said.

Best-sellers

Short-term, 3x levered notes with a low double-digit cap and full downside exposure are extremely popular, according to data compiled by Prospect News.

In May, Bank of America priced the top deal of the past year on the behalf of Bank of Nova Scotia for $145.8 million. It was a 14-month offering based on the S&P 500 index with 3x leverage, a 12.15% cap and no downside protection.

The top 10 offerings that priced last year fit the same description with a one-to-one downside exposure and 3x upside leverage. Only the cap and the terms slightly varied, all products remaining very short from 13 to 15 months. The sizes of those deals exceeded $100 million.

“If people keep on maximizing their chances of winning with small average losses, it’s understandable they would repeatedly reinvest in the same product. It probably explains the size of these deals,” she said.

“It will do well as long as the S&P continues to go up and when it won’t, then it will go very badly.”

Simple and transparent

The chance of losing money in the bull scenario is 13.6%, according to the model.

“It’s not a low-risk product by any means,” she said.

But the advantages of the product could not be overlooked in particular the simplicity of the structure.

Despite the lack of protection, several factors reduced the risk.

“You can put less money at work with the high gearing, so a small portion of the portfolio is at risk.

“It can also be used in conjunction with other structured products, which provide barriers or buffers.”

Overall, the purpose of the note is to maximize the benefits of leverage.

“There are high-probability gains with a small price move over a short timeframe,” she said.

“The S&P 500 is quite transparent. It’s a common underlying, which you can easily fit in any portfolio.

“The simplicity of the product and transparency of the underlying can be very attractive.”

The notes will be guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes will price Jan. 31.

The Cusip number is 61770E844.

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