Morgan Stanley’s $1.97 million leveraged notes on Stoxx add FX risk to market risk

By Emma Trincal

New York, Aug. 6 – Morgan Stanley Finance LLC’s $1.97 million of 0% capped leveraged notes due Nov. 3, 2022 linked to the Euro Stoxx 50 index converted in U.S. dollars give investors exposure to the eurozone equity benchmark as well as to the exchange rate between the U.S. dollar and the euro. The inclusion of currency risk in an equity-based structured note is not common as issuers typically remove it when the underlying is a foreign equity index.

A contrarian portfolio manager, who is bullish on the dollar, downplayed the importance of the exchange rate risk in the notes focusing instead on the risk-adjusted return of the overall structure and the broader meaning of a rising greenback. Most analysts are bearish on the dollar.

The payout at maturity will be par plus 300% of any index gain, capped at par plus 18.3%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will be fully exposed to any decline in the index.

No downside protection

“It’s a low cap given the fact that you don’t have any protection on the downside whatsoever,” said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

The 3x leverage made it easy to reach the maximum return level, he noted.

If the index is up 4.85% per year, investors get “capped out” at 14.4% on an annualized compounded basis, he noted.

“That t may look like a nice return, but it’s a limited return and your downside is unlimited. Once you get more than that on the upside, you’re not getting anything else.

“It doesn’t strike me as a good tradeoff.”

Unbalanced structure

Kaplan did not consider the high-leverage multiple as a sufficient reward to justify the one-to-one downside exposure.

“Usually when there’s a cap, there’s also some kind of downside protection. Those two features balance each other out.

“If it’s not the downside protection, there should be another type of compensation. I don’t think the 3x leverage is compensating you fairly for the cap, the full downside risk, the no dividend payments and the lack of liquidity.”

Buying the index fund directly would be more favorable to investors in this case, he said.

“For a note to be interesting, to be a reasonable alternative to the index, you need to make up for the limited liquidity with a number of advantages. I don’t see them here,” he said.

Probabilities out outcome

Kaplan said that any “serious investor,” should run a Monte Carlo-type of simulation to find out if the note can increase the odds of a better return.

“The window of outperformance compared to a long-only play is limited here. If you lever up three times the index, the only way the note can come ahead is if the index is up less than 5% year.

“That’s a tiny window to generate excess returns.”

Even if investors in the note may outperform by nearly 10 percentage points, the probabilities of beating the market within that window given the low cap are limited.

“The probabilities of a good outcome are limited. You’re giving up a potential 40%, 50% upside, all that extra upside and still have all the downside exposure plus no ability to trade in and out.”

Without directly running the simulation, Kaplan said the notes are likely to increase the chances of a negative outcome or lower the gains, if any, compared to investments in equities.

“The more you’re reducing your risk, the more favorable it becomes to buy an alternative investment like a note. And that means, having a buffer or a barrier,” he said.

Currency exposure

Another aspect of the structure is the U.S. dollar conversion. Investors’ returns are not only based on the equity performance of the index but also on the exchange rate between the U.S. dollar and the euro since the index performance is converted into U.S. dollars.

As a result, any appreciation of the U.S. dollar between the trade date and the determination date against the euro will negatively impact the return on the underlier and on your notes, according to the prospectus.

Kaplan said the U.S. dollar has been rising, although moderately, according to the U.S. dollar index, which measures the value of the U.S. dollar against a basket of foreign currencies. The U.S. currency has also appreciated against the euro, especially since last spring.

In theory, and as mentioned in the prospectus, the U.S. dollar appreciation should hurt the return of noteholders. But Kaplan disagreed.

“It’s just a disclosure, but in reality, it has a very limited impact on the note,” he said.

The U.S. dollar is rising when the world economy is contracting, he explained.

“When the U.S. appreciates against other currencies, it indicates a flight to safety. It also signals negative investors’ expectations ahead. Usually, it can be seen as a sign that price-per-earnings ratios will compress.”

Bearish signal

The U.S. dollar has been rising not by a huge amount, but it’s rising,” he said.

“But this would not be a reason not to invest in the notes.

“The currency aspect of the note is too small of a feature to be relevant. What’s relevant is that the dollar is slowly rising because institutions, sophisticated investors, anticipate stock markets to sell off, and not just in the U.S.

“That’s the reason why you don’t want to invest in the notes.”

He further elaborated, bringing up his bearish view on stocks.

“The reason you don’t want the U.S. dollar to rise is not because of the conversion factor that plays against you as a U.S. investor. It’s because it signals that the world is contracting. A rising dollar is bad for stocks.”

An investment in the Euro Stoxx 50 index did not appear to be timely, this portfolio manager, said.

Kaplan was not particularly bullish on the eurozone equity market.

“The Euro Stoxx is less overvalued than the U.S. stock market. But almost everything is less overvalued than the U.S. market. Our domestic market is unusually popular.

“It doesn’t mean other markets are cheap though.

“You’re entering the trade at a high point.

“From that standpoint, I’m not sure a bet on the Euro Stoxx with no downside protection is a compelling idea.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes (Cusip: 61773FKP7) will settle on Monday.

The fee is 1.25%.

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