Morgan Stanley's protected notes linked to Dow offer unlimited upside, but pricing is mediocre

By Emma Trincal

New York, Sept. 7 - Morgan Stanley's 0% market-linked notes due Sept. 28, 2018 linked to the Dow Jones industrial average offer uncapped exposure to the equity benchmark with full principal protection, but the pricing of the product is not among the best, said Suzi Hampson, structured products analyst at Future Value Consultants.

Market conditions have made pricing of those structures very challenging in general, she said.

The payout at maturity will be par plus the index return, subject to a minimum payout of par, according to an FWP filing with the Securities and Exchange Commission.

"Principal-protected notes have become harder to do with the low interest rates environment. The banks that do them have the widest credit spreads because they can offer uncapped, 100% participation whereas the lower funding banks wouldn't be able to," she said.

Hampson said that a six-year maturity for these types of structures is "pretty standard" in the United States.

"It's uncapped, and that's why you have those long maturities, although six years is in the range for those products," she said.

"Sometimes you can even get a 105% or 110%, and that's not always capped. You're typically not going to get two or three times leverage even with a 10-year.

"In the equity asset class, longer durations prevail given the difficult market conditions. The principal-protection zero coupon is such a huge part of the product. You're not selling any put; you're not getting revenues from the downside. Pricing is driven a lot from interest rates and the CDS spreads. We know that rates are low and that the CDS spreads for Morgan Stanley are pretty wide."

Funding

She said that Morgan Stanley's five-year CDS spreads are 276 basis points, much wider than JPMorgan at 117 bps, Bank of America at 187 bps, Citigroup at 192 bps, Barclays at 194 bps and even Goldman Sachs at 215 bps.

Hampson said that three principal-protected notes linked to the Dow priced at the end of August. A couple more have been announced for September. Most of those deals have a six-year tenor - one is 6¼ years - and they were issued or will be issued by either Morgan Stanley or Goldman Sachs Group, Inc.

"It's not a coincidence if those deals are brought to market by the two issuers that have the widest credit spreads. They're the ones that can still offer principal-protected products in this environment, and that's because of their funding," Hampson said.

"JPMorgan's funding is less than [that] of Morgan Stanley. They just wouldn't be able to put together a competitive product. You'd be getting a lower participation rate or a cap."

With a lower participation rate, investors get less than the full appreciation of the underlying. For instance, with an 80% participation rate, a 10% increase in the underlying asset would only generate an 8% gain for the investor.

"Generally, rather than doing that, they put a cap," she said.

"For some reason, the Dow Jones industrial index is quite popular right now for this type of structure. I'm not sure why that's the case. The lower volatility of the underlying, the cheaper the option. But between the Dow Jones and the S&P, it's not a huge difference. They're both around 21%. The pricing may be slightly more favorable with the Dow," she noted.

Other underlying assets may make sense for principal-protected products, she said.

"An alternative is to structure them around volatility-controlled indexes. They're quite common in the U.K. The option is much cheaper when you use a lower volatility underlying," she said.

Riskmap

The notes are not without risk despite the repayment of principal at maturity, she said, commenting on the riskmap, Future Value Consultants' measure of risk on a scale of zero to 10. The higher the riskmap, the higher the risk of the product. The riskmap is the sum of two risk components: market risk and credit risk.

The riskmap for this product is 3.70. It is higher than the 2.92 average for similar products, although it remains less than the 4.11 average for all product types.

"By far the main factor here is credit risk," she said.

This product's credit riskmap of 2.99 is higher than other fully principal-protected notes, which have a 2.43 average credit riskmap, she said.

"There's always more credit risk with longer-dated products, but in this particular case the credit risk factor is also significantly more than the average we see for similar products. That's because investors are subject to this issuer's credit risk," she said.

Future Value Consultants' methodology does not remove market risk simply because a product is 100% principal protected, she said.

"We look at the probability of losses compared with cash. For this type of structure, the loss would be an opportunity cost if the index ended up negative."

She compared the return of the notes with the equivalent Treasury. She assumed a six-year Treasury yield of 0.8% and a flat or negative performance for the Dow at the end of the six years. The Treasury bond buyer at the end of the six years would pocket a 4.8% return while investors in the note would have earned nothing, hence the opportunity cost, she explained.

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

The notes have a 7.67 return score, compared with 8.13 for the average of the same product type.

"It's lower, and that's because the riskmap is higher," she said.

However, the notes offer a better risk/reward profile when compared with all products, which have a 6.55 average return score, she said.

Pricing

The picture is not as attractive when it comes to the price score, she said.

The price score is Future Value Consultants' estimate of the total costs taken out of the product from direct fees and profit margin on the underlying derivative. The higher the score, the lower the fees and the greater value offered to the investor.

The notes received a 6.05 price score, which is "much lower" than the 8.63 average price score for comparable products. It's also less than the average score of all products, which is 7.01.

"It's not priced very well," she said.

"Usually, longer-term products do very well on the price score scale. That's because we use a per-annum cost basis method, so there's more time to spread the cost."

She explained why.

"If you price a product at 95 over five years, it's 1% per year. With a one-year product, you would have to price at 99 to compete, which realistically is not going to happen," she said.

"It's unusual for principal-protected notes to have a lower price score than all products because they usually have longer terms, especially when you compare them to reverse convertibles."

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

With a 6.86 overall score, the notes have a lower score than the 8.38 average for their peers.

"It's not a bad score, but if you look at other six-year principal-protected notes tied to the Dow Jones, it's not among the best. As an investor, you would want the one with the best terms. I expect there may be a couple of more coming up in the next couple of weeks for pricing in September," she said.

"This principal protected is for the conservative investor. It offers principal repayment and unlimited upside. But there are still risks associated with it. Investors should just be aware of it. As long as they understand what they're doing and what the risks are, fair enough."

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.