Morgan Stanley boosts contingent income with four U.S. equity indexes in autocallable notes

By Emma Trincal

New York, Oct. 30 – Morgan Stanley Finance LLC’s contingent income autocallable securities due May 5, 2022 tied to the worst performing of the S&P 500 index, the Russell 2000 index, the Dow Jones industrial average and the Nasdaq-100 index elevate the coupon to the low double-digit level by simply adding a fourth index in the worst-of structure.

While higher yields require more risk, such risk remains contained by limiting the four indexes to the same geographic area, said Tim Mortimer, managing director at Future Value Consultants.

“It’s every corner of the U.S. market,” he said.

Each month, the notes will pay a contingent coupon at the rate of 11.5% per year if each index closes at or above its coupon threshold level, 70% of its initial level, on the related determination date, according to an FWP filing with the Securities and Exchange Commission.

The notes will be automatically called at par plus the coupon if each index closes at or above its initial level on any monthly redemption determination date after three months.

The payout at maturity will be par plus the coupon unless any index finishes below its 70% downside threshold, in which case investors will be fully exposed to the performance of the least performing index.

Correlations

“The 11.5% coupon is quite high,” Mortimer said.

“The 70% barrier is shallow, but you have a high coupon and a shorter maturity. It’s only 18-month. If it was a five-year, you would expect more.”

Since investors are not exposed to the return of a basket of four indexes but to the performance of each underlying index, high correlations help reduce some of the risk, he explained.

“The good news is correlations between those indices are pretty high.”

The least correlated among the four are the Russell 2000 and the Nasdaq-100 indexes with a 92.5% correlation.

“It’s not surprising, one being big tech, the other small-cap. But they’re all above 90. So even though you have four indices, the high correlations help,” he said.

The highest correlation at 99.05% is found between the S&P 500 index and the Dow Jones Industrial average, both large-cap benchmarks. A 100% correlation would be a perfect one.

Domestic play

The main reason for having four indices, he noted, was probably to give investors exposure to the U.S. markets only.

“If you had the S&P and the Euro Stoxx 50 for instance, the pricing would be almost identical. It would be two indices instead of four. But they have a much lower correlation of 88%, so it’s a wash. By adding three extra U.S. indices instead of one index from overseas, you get equal pricing,” he said.

The issuer was probably looking to meet investors’ domestic bias, he added.

“It keeps U.S. investors happy with a risk they’re more familiar with in different parts of the domestic market. You have a domestic risk rather than overseas risk.”

Scorecard

Future Value Consultants offers stress testing on structured notes. The simulation shows the probabilities of occurrence of outcomes pertaining to a specific product and structure type.

Each report contains a total of 29 sections or tests, which encompass simulation tables as well as back-testing analysis. They can be customized in any combination.

The investor scorecard is one of the most used sections, or tables. It consists of different mutually exclusive outcomes of product performance.

The tests displayed in this table include probabilities of an automatic call at various call dates or “points.” Two other main outcomes include full capital return (no call and no loss) and total return loss.

“You have a 44.65% chance of calling at point one,” he said, commenting on the occurrence of the call triggered at the first opportunity, three months after issuance.

“In most autocalls with one underlying, you usually get called at point one half of the time. It’s less here because you have more indices. But since they’re correlated it’s not that much lower,” he said.

The Monte Carlo simulation showed a 15% probability for a total return loss, according to the scorecard.

While this probability is modest, the loss amount is not, he said.

If losses are incurred, investors will only receive 53% of their initial investment at maturity, a 47% loss.

“It’s an average. But it’s a lot of money. If you go through the barrier, the loss can be substantial,” he said.

Back-testing

The simulation results, as always, contrast with the back-testing analysis.

Over the past five years, the frequency for total return loss has only been 1%, according to the back-tested scorecard.

That figure rises to more than 4% for the last 15-year timeframe.

“It’s still pretty good given that the period still includes the Lehman Brothers crisis,” he said.

The back-testing also revealed much smaller loss sizes.

Instead of an average 47% loss in the simulation, the average loss is only 20% in the past five years. It rises to 30% when going back 15 years, which includes the financial crisis.

Three coupons

Another table in the simulation called “product specific tests” displays the probabilities of coupon payments at various dates. Getting paid three coupons is the most likely outcome with a 46.5% probability.

“It’s because you can’t get called in the first three months and that first call date is the most likely call outcome,” he said.

Getting four coupon payments is the second most probable outcome with an 11% chance. After that, the odds of getting paid more decrease, according to the test.

Overall, the notes were not as risky as the number of underliers would suggest

Risk

“There is moderate risk in the notes,” he said.

“While you have four indices, we’re talking about the U.S. market. Worst-of always involve more risk, but those indices are highly correlated since they’re in the same region.

“Is it without risk? No, of course.

“The contingent coupon is 11.5%. You can always tell the risk from the yield.

“You get 11.5% because it’s quite an aggressive strategy.”

Yet the structure was designed to offset some of the risk.

“It’s short term. You have a 70% barrier. The indices are highly correlated.

“Investors in this product are not expecting the market to go up a lot nor down a lot. If they’re right, they stand to get a very decent return,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes priced on Oct. 30 and will settle on Nov. 4.

The Cusip number is 61771EFT0.

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