Morgan Stanley’s $7.06 million buffered PLUS tied to energy stocks ETF show timely sector bet

By Emma Trincal

New York, Nov. 17 – For investors looking for value in “beaten up” sectors, Morgan Stanley’s $7.06 million of 0% buffered Performance Leveraged Upside Securities due May 19, 2017 linked to the Energy Select Sector SPDR fund may offer a timely play at the right price, said Michael Kalscheur, financial adviser with Castle Wealth Advisors.

The payout at maturity is par plus 200% of any fund gain, subject to a 36.8% cap.

Investors would receive par if the fund fell by up to 15% and would lose 1.1765% for every 1% decline beyond the 15% buffer, according to a 424B2 filing with the Securities and Exchange Commission.

Kalscheur said that his firm was “actually looking for a play on oil stocks,” and that he recently reviewed the PowerShares Dynamic Energy Exploration & Production Portfolio, a fund he has invested in in the past.

“Energy stocks have got beaten up quite a bit with oil going down as much as it has,” he said.

“My first impression when I saw these notes was: no! Not another cap; and ...I don’t like these sector funds; and also Morgan Stanley credit isn’t my favorite. But I quickly changed my mind. It’s actually a very nice note.

“With oil prices as low as they are, I think it’s also very timely. The fund is not that far from its 52-week low and it’s still 15% off its 52-week high of the summer,” he said.

Hard lessons learned

Some advisers stay away from sector plays, such as Carl Kunhardt, wealth adviser at Quest Capital Management, who said that he would “never use the note because it’s a sector-specific product and we have an internal policy not to do that.”

Kunhardt invested in technology stocks in 1999.

“We learned our lesson. No sector bet. We got burned in 2000. When we did our due diligence the year before, we didn’t realize how many managers were overweight technology stocks. Even value managers were in tech. It blew up in everybody’s face, ours included. Since that time, we haven’t done any sector funds.

“The markets are volatile enough, they’re difficult enough to predict and even if you get a good projection, at best, it’s just a best guess. To take such a narrow bet on a sector when the bigger picture is only a guess is not how we want to invest. It’s just introducing too much uncertainty in what’s already an uncertain process.”

Kalscheur said that “normally, I don’t invest in notes tied to a specific sector,” because sector performance can be “fickle” but also because he needs more liquidity.

“We would buy a fund when the sector is down and resell when it rebounds. I want to be able to sell. I’m especially leery about sectors in structured notes because of this liquidity issue,” he said.

Value play eyed

Kalscheur however said the theme behind the notes offered an attractive value play.

“The energy sector is already on our radar. We look at it as an opportunity. That’s what kind of intrigued me,” he said.

The short duration was an advantage as it reduced credit risk exposure.

“Morgan Stanley is not my preferred credit based on their CDS spreads. Obviously U.S. issuers like Wells Fargo or even JPMorgan Bank offer much better credit. At the same time, when you compare CDS spreads today with what they were three years ago, they all look fantastic. But we know it could all be wiped out in a hurry. That’s the risk you have. That said, I feel relatively comfortable looking at the short duration. On two-and-a-half year, credit risk is not going to be too big of an issue for me,” he said.

The five-year credit default swap for Morgan Stanley is 80 basis points, according to Markit. The CDS spreads of Wells Fargo and JPMorgan are 47 bps and 62 bps, respectively.

“The underlying is easy to understand. This is a fund with all the big oil companies. Who doesn’t know Exxon or Chevron? I can explain this to a client,” he noted.

Exxon Mobil Corp. and Chevron Corp. are the two top positions in the fund. Combined they make for 28% of the total. The third holding is Schlumberger Ltd., with a nearly 8% weighting.

Terms

Kalscheur said the risk-reward profile of the notes was attractive given the existence of a “true” buffer and the cap level.

“I like the 15% buffer. There’s leverage on the downside, OK. But it’s still a true buffer. It’s not a barrier,” he said.

“In fact the gearing presents certain tax benefits if the structured note is held in a taxable account, which a non-geared buffer would not offer. I look at things that have the potential to offer tax benefits.

“Then you have the two-times leverage with a cap. I probably would prefer less leverage so that I can eliminate or raise the cap. But on an annualized basis, this is a 13.5% return. Most people are not going to complain about that, especially if you can reach this performance with an index up only in the single-digits.

“The 36.8% cap over the term is high enough for me to be fine with it. If it was 22% or 25% I would say no. It wouldn’t be worth the risk. But if you can get 13.5% it’s a decent upside. And as far as the downside you’re somewhat protected.”

Two wins

Kalscheur went on to say that the structure passed his “two-win out of three” test.

“I have two wins here to show to my clients,” he said.

“First, the downside. If the index is down less than 15%, you will outperform the fund. If it’s significantly down, say down 50%, you’re going to lose 41% with the gearing instead of 50%. Granted, clients are not going to be happy if they’re down 40 but you’re still better off. And to get to these levels, oil would really have to collapse. That’s the first win.

“Second, if the index is moderately up by 10% or 15%, you can pick up 20% to 30% in return. That’s another plus.

“The third one that’s not a win is the upside risk: you’re really up, up 50% and you exceed your cap. Still, you’re looking at a 13.5% a year.

“So while I didn’t particularly like the product at first blush, as I’m looking at it more closely, I think it’s a pretty good one.”

Illiquidity, gearing

For advisers who avoid theme investing in sectors, the terms of the notes were not that important.

“It’s a moot point,’ said Kunhardt.

“We wouldn’t even do sectors on a plain-vanilla note.

“But on this one, I really don’t like the leverage on the downside. It’s especially risky for an illiquid instrument. If this thing is down 40%, you’re going to find no market for this note. If it’s falling like a knife, the deeper you go, the more leverage is going to cut deeper and deeper.

“I understand they would give you that if you want leverage on the upside. I would rather have no leverage at all on the upside and no leverage on the downside.”

Unpredictable oil

Another objection on the part of Kunhardt was the volatility of oil, which is strongly correlated to the energy stocks, which compose the underlying fund.

“The oil sector right now is under pressure. But there are so many factors behind the price of oil that you can’t predict for sure that it’s going to go back up. It could go either way,’ Kunhardt said.

“If Saudi Arabia or Iran cut supply abruptly, crude oil would skyrocket. But if Congress votes on the Keystone pipeline, if it’s a strong vote that’s veto-proof, then prices would go down. You can’t get away from macroeconomics.”

Fee

For Kalscheur, risk could be mitigated in a careful allocation of the notes and by paying attention to suitability factors.

“It should only be an ancillary addition to someone’s portfolio who is already well-diversified. It’s not something to put your grandma in for her first structured note because it still has a lot of moving parts,” he said.

One of the final “positive surprises” of the deal, Kalscheur said, was its cost.

“I like the 0.25% fee very much. I would love to get that type of pricing more often,” he said.

“That’s the great thing about structured notes and working with companies that have bigger spreads. Firms like Morgan Stanley, Goldman Sachs can sometimes show decent products but they’re way too expensive. Or it’s the other way around: they have reasonable fees but the terms aren’t good.

“When issuers pour money into the product, not in commissions, this is what you get: a very attractive note. It’s not perfect. But it’s a very impressive offering.

“If it hadn’t already priced, I would have considered it,” he said.

The notes (Cusip: 61761JUT4) priced on Nov. 12.

Morgan Stanley & Co. LLC was the agent.

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