Morgan Stanley, RBC offer different kinds of risk for barrier fixed-income notes

By Emma Trincal

New York, July 13 – Investors are struggling to find yield in today’s market environment but without a call feature and a coupon based on contingent conditions, pricing can be even more challenging for issuers. Two reverse convertible deals paying monthly fixed rates illustrate how worst-of on indexes or exposure to a volatile single stock remain the most common ways to achieve competitive fixed income pricing.

Two premium extractors

Using the worst-of formula, Morgan Stanley Finance LLC priced $1.5 million of 4.75% fixed-income securities due Jan. 12, 2023 linked to the lowest performing of the Dow Jones industrial average, the Russell 2000 index and the S&P 500 index, according to a 424B2 filing with the Securities and Exchange Commission.

Interest is payable monthly.

The payout at maturity will be par plus the final coupon if each index is greater than or equal to the downside threshold level, 70% of the initial share, otherwise investors will be exposed to the decline of the least-performing index from its initial level.

In the second example, Royal Bank of Canada will price notes with a higher fixed coupon and lower barrier with Tesla, Inc. as the underlier, a stock with an implied volatility of 65.43%.

The notes, due July 25, 2023, will pay monthly a fixed rate of 9.5% to 10.5% a year with the exact rate to be set a pricing, according to an FWP filing with the Securities and Exchange Commission.

The barrier at maturity is at 60% of the initial price of the stock.

Business risk

“A 4.75% coupon is not that exciting, but it reflects the lower risk you’re taking,” said Tom Balcom, founder of 1650 Wealth Management, comparing the offerings.

“Correlations between indices are pretty high right now. So right there, you have a lower risk, lower return proposal. Volatility remains below average. We’re at all-time highs. Rates are low. These conditions hurt all the notes.”

The Tesla notes pay at least twice the rate of return offered by the other note, simply because they are much riskier, he said.

“Tesla is much more volatile. Even if the exposure is to one asset only, this is not a stock for the faint of heart,” he said.

“Tesla has a valuation problem. If it pulls back, you can take big losses. If we have a broad sell-off, the other note will lose money but probably not as much.”

Getting exposure to a single stock therefore represented a “business risk,” for a financial adviser.

“What if the market does poorly but ends up flat? You get your full income and money back with the first note. But Tesla shares plummet at maturity. Clients are going to say: why didn’t you diversify me?”

Another factor limiting the risk with the index deal was the low dispersion risk.

“Between those three equity benchmarks, correlation is pretty high,” he said.

The lowest coefficient of correlation is found between the S&P 500 index and the Russell 2000 index and is 0.794. The greatest one at 0.943 is between the Dow Jones and the S&P 500 index. The Dow Jones and the Russell 2000 in the middle of the range with a 0.864 coefficient. A coefficient of 1 indicates perfect correlation.

Better off with worst-of

Balcom said he would pick the index-based deal if he had to choose between the two offerings.

“We don’t usually do notes on single stocks. Tesla is particularly risky. It’s overvalued. Valuations matter at this point,” he said.

The price-per-earnings ratio of the stock is 691.

“We avoid all those mega-cap stocks, and by that, I mean Tesla, Facebook, Microsoft, Apple and Amazon. They’re not cheap.”

Balcom said he preferred the risk-adjusted return associated with the index deal.

“You get a lower coupon, but you reduce the risk a lot, especially with highly correlated underliers,” he said.

When Balcom buys structured notes with a fixed income, he typically uses them as a replacement for bonds.

“The good thing with those reverse convertibles is that you can always protect yourself with the coupon. It doesn’t mean it’s as safe as a bond of course. But it has the fixed income attribute.”

Popular stock

Another financial adviser compared the two notes and expressed a negative view on both.

“I don’t like either one of them for different reasons,” he said.

“You have two different kinds of risk. One is market risk, the other, taking the risk of a very unusual, peculiar company.”

Tesla’s share price, which closed at $668.54 on Tuesday has already lost more than a quarter of its value since its $900.40 high of Jan. 25, he noted.

“Tesla is what we used to call a story stock. Today, you would say it’s a popular stock. Personnally, I would call it a cult. Investors in the stock are worshippers of Elon Musk. It’s like a religion,” he said.

Elon Musk is Tesla’s chief executive officer.

“This is a company that loses a minimum of $1,000 per vehicle they sell. They don’t really care because they’re getting subventions from the government for producing Zero Emission Vehicles. But it doesn’t help the shareholders.

Risks ahead

“Tesla faces a number of safety and quality issues. On top of that, they have issued new shares in the past 12 months diluting shareholder’s ownership.

The stock was added to the S&P 500 index late last year. Throughout last year, the price skyrocketed in anticipation of the inclusion in the index, he explained.

“Investors were forced to buy Tesla since so many people own the S&P. Now that the stock dropped 25% this year, investors in the stock – but also to a certain extent in the S&P – are getting hurt,” he said.

Tesla is the eighth largest constituent of the S&P 500 index, according to S&P Dow Jones Indices. It is the sixth largest U.S. stock by market capitalization.

“Tesla gets a pass because its shareholders are worshippers. Even hedge fund managers who normally wouldn’t be easily fooled behave like Moonies when it comes to Tesla. They’re completely fascinated by this guy.”

Not a bargain

Moreover, the valuation of the stock is not justified by fundamentals, he said.

“The stock sells 100 times the average P/E of other carmakers only because they get such positive coverage,” he noted.

This has led to a stunning rally from an intraday low of $35.40 in June 2019 to the $900 all-time high in January.

“This dramatic increase in the share price is not because they’re selling more cars,” he said.

“It’s because Tesla is a cult. But it’s an unsustainable cult.”

This adviser was not as negative on the other offering. However, he would not consider it either.

“I don’t prefer the first one. The amount of risk is just easier to define with the indexes. They will behave in a less peculiar, more predictable way than Tesla,” he said.

“But the market itself is overpriced and due for a pullback. So, I wouldn’t risk my money in this one either.”

The Morgan Stanley notes (Cusip: 61773FFU2) are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on Tuesday.

The fee is 0.3%.

RBC Capital Markets, LLC is the underwriter for the Tesla deal.

The notes will price on July 20 and settle on July 23.

The Cusip number is 78016EKH9.

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