Morgan Stanley’s $10 million notes on index basket combine best-of, principal-protection

By Emma Trincal

New York, March 5 – Morgan Stanley Finance LLC’s $10 million of capped allocation notes due March 1, 2029 linked to a basket of indexes offer optimized allocation by adjusting the participation in the basket components based on their respective performance.

The underlying performance-weighted basket consists of the Euro Stoxx 50 index, the Nikkei 225 index and the S&P 500 index, according to a 424B2 filing with the Securities and Exchange Commission.

The basket component with the best performance will be allocated a weighting of 60%, the basket component with the second-best performance will be allocated a weighting of 30% and the basket component with the worst performance will be allocated a weighting of 10%.

If the final basket level is greater than or equal to the initial basket level, the payout at maturity will be par plus the basket’s return, capped at par plus 74%.

Otherwise, investors will receive par.

Late at the party

“These are called rainbow notes or sometimes, best-of. You give the highest allocation to the best index and then the allocation decreases as the performance goes down. I haven’t seen rainbow notes in a while,” said Tom Balcom, founder of 1650 Wealth Management.

The notes offered an additional benefit.

“Your principal is fully protected. It’s not always the case. This one is pretty conservative,” he said.

Balcom said he could identify the type of investors that may be interested in this type of structure.

“With all the indices at or near their all-time highs, this is designed for investors who worry that they may be late at the party. That’s why you have the principal protection. Some people want exposure to the market but are concerned about the timing. Here, they’re getting both the optimized allocation and the full protection on the downside,” he said.

Japan’s comeback

The riskiest basket component was probably the Nikkei 225 index, he said.

“Japan is one of the hottest markets right now. Here in the U.S., we may have a strong bull market driven by the Magnificent Seven, but Japan is growing much faster,” he said.

The Nikkei 225 index has jumped 23% year to date compared to 6.5% for the S&P 500 index.

Last month, it hit its first record high since 1989.

“Regardless of which ends up being the best performer, I really like this structure. It’s a good note for any skittish client afraid to lose money,” he said.

Tax issue

But the principal protection came with a caveat, he said.

“An adviser can’t really tell the client that they won’t lose money. If the basket doesn’t go up, they will lose money with taxes,” he said.

“Those principal-protected notes are not the most tax-efficient vehicles.

“You get stuck with the OID. You have to pay ordinary income taxes on the discount.”

Principal-protected notes consist of a zero-coupon bonds combined with call options.

The discount of the zero-coupon bond, or the difference between the redemption price and the issue price, called the original issue price or OID, is used to buy the options. But it also has negative tax implications as it is taxed as annual income even though no interest is payable on the notes. The taxable annual income is calculated using a “comparable yield” method defined by the Internal Revenue Service.

Full disclosure

“A client thinking they’re going to get all their money back could be disappointed in a flattish market.

“It’s an unwelcome tax for the owner of the notes,” he said.

Balcom said that he always brings the tax ramifications of principal protected notes to the attention of his clients, advising them to consult their accountants.

Another way to structure the note (and change the tax treatment) could be eliminating the full protection, replacing it with a buffer so that the cap could be removed, he said.

Safety first

“Personally, doing that would make more sense to me especially on a five-year where you have plenty of time to recover from a downturn. When you get rid of the principal-protection and use a buffer instead, you also get rid of this penalizing tax treatment,” he said.

Gains or losses from buffered notes held for more than a year are typically treated as long-term capital gains or losses.

“But again, it really depends on your client and the level of risk they’re willing to tolerate.

“For those who are scared about being exposed to equity markets, it’s a very good note,” he said.

Allocation tool

A financial adviser said the notes could be used in the global equity bucket of a portfolio.

“You get global equity exposure with a greater allocation to the best of the three,” he said.

“It sounds pretty attractive.

“It’s a five year. But I’m not worried about Morgan Stanley going under five years from now.”

This adviser said he was not familiar with the tax treatment of the notes and as a result would not comment on it.

“If it’s a real problem, you can always put it in an IRA account,” he said.

“But tax issue aside, this note offers a very good set up.”

Predicting which of the three components would be the best performer was not simple, he said, especially over five years.

“I would be tempted to think it would be the S&P. But at the same time the S&P has outperformed the two other indices so much in the last five years, it’s possible that either Japan or Europe may deliver the best returns,” he said.

Best-of

The allocation feature was the most attractive aspect of the structure, according to this adviser.

“You’re set up for success because it doesn’t matter which one is the best. You get the lion’s share of it,” he said.

The variable allocation guaranteed a higher return than an equally weighted index, he added.

“I haven’t seen that structure before. I guess for the issuer it’s probably expensive to price.

“They have to hedge it, they have to pay for it especially the principal protection,” he said.

Cap, protection

But for this adviser, the principal protection made the notes more appealing.

“I wouldn’t touch it. There is a cap. But most people if you give them that level of downside protection don’t mind the cap as long as it’s not too restrictive,” he said.

The 74% cap over the five-year tenor was the equivalent of nearly 12% on an annualized compounded basis.

“Most clients would be very willing to live with that cap for the principal protection.

“It seems like a fairly generous note,” he said.

The notes are guaranteed by Morgan Stanley.

UBS Financial Services Inc. and Morgan Stanley & Co. LLC are the agents.

The notes settled on Thursday.

The Cusip number is 61771WT40.

The fee is 3.5%.

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