Morgan Stanley’s partial principal at risk notes on Euro Stoxx reintroduce rarefied structure

By Emma Trincal

New York, Feb. 1 – Morgan Stanley Finance LLC’s 0% equity-linked partial principal at risk securities due Feb. 5, 2021 linked to the Euro Stoxx 50 index allow investors to protect most of their principal while capturing the upside, a combination buysiders said was attractive. Such notes, which priced in the past, have never been all that common. But because they have nearly disappeared as a result of low interest rates, some advisers see them as almost new.

The payout at maturity will be par of $1,000 plus 110% of any index gain, according to an FWP filing with the Securities and Exchange Commission.

If the index declines or finishes flat, investors will receive par plus the index return, subject to a minimum payout of $975 per security.

Intermediate growth

Jeff Pietsch, head of capital markets at the Institute for Wealth Management, said the notes met his firm’s intermediate outlook on this asset class.

“This appears to be a call option on European equities with levered upside participation and nearly full downside protection,” he said.

Combining unlimited upside with 97.5% in downside protection was appealing.

“As the Institute has a positive intermediate outlook on developed overseas markets based on the current environment of synchronized global growth and relative stock valuation, this could be a good option for growth investors seeking European exposure, but who are nevertheless concerned about the length of this epic bull market recovery,” he noted.

Fee

However some aspects of the deals should be given more thoughts especially the agent’s commission, which he said he could not find directly on the FWP filing.

The issuer disclosed the estimated value on the pricing date at approximately $983.60 per security, or within $15.00 of that estimate. But the amount of the commission itself was not directly displayed.

“This would be another factor for consideration. We would need to better understand the cost of this product,” he said.

Ordinary income

Another consideration for his clients would be taxes.

The securities should be treated as contingent payment debt instruments for U.S. federal income tax purposes, according to the prospectus.

As a result investors will have to pay an income tax annually even though no interest payment is collected during the life of the product.

Leverage, dividends

Finally the dividend yield of the Euro Stoxx 50 index at about 2.45% represents a greater opportunity cost than that involved with notes linked to other common benchmarks, such as the S&P 500 for instance, which offers a yield of 1.80%.

However, this disadvantage is addressed via the 110% upside participation rate.

“The leverage factor would appear to provide more than enough compensation for the opportunity loss in dividend yields,” he said.

Recommendable

The tenor of the notes was also adequate.

“We are bullish on European equities for the intermediate term. Therefore the term of these securities would match our three-year window.

Before buying the product, investors “should speak with their advisor to understand its additional risks, tax implications and cost structure,” he cautioned.

But overall it was an attractive offering, he said.

Alpha tool

Steve Doucette, financial adviser at Proctor Financial, said he liked the structure because investors may outperform regardless of the direction of the index.

“It’s a pretty interesting note,” he said.

“You’re leveraged with no cap so you’re going to outperform the upside.

“The only time you’re not going to outperform is if the index is down up to 2.5%.”

In such case, the index would just “market perform”, he said.

Endangered species

Most products with some downside protection come with either barriers or buffers. When the protection is said to be “full” it typically covers 100% of principal, not 97.5%. Both types however are considered principal-protected instruments, which is one of the reasons those securities are treated as generating ordinary income for tax purposes, according to tax attorneys.

Principal protected notes are not new but have become rare as record low interest-rates have rendered the pricing of the zero-coupon bonds used for those products very expensive.

Golden age

The best years of principal-protected notes issuance were in 2006 and 2007, a time which coincides with higher rates, according to data compiled by Prospect News. (The data classifies only notes with 100% protection as principal protected so the Morgan Stanley structure with 97.5% protection would not be included.)

In 2006 when the 10-year Treasury hit the 5.25% mark, issuers sold $1.81 billion of fully protected structured notes, according to data compiled by Prospect News.

Volume was even greater – and hit the record high – the following year with $2.34 billion.

Last year in comparison only $357 million of such products were brought to market, a 0.70% part of total issuance volume. The market share of this structure was 4.8% in 2006 and 9.80% in 2007.

“We don’t see that structure a lot. It’s kind of a new thing,” said Doucette.

“The only problem is that you have this ordinary income tax thing.

“But the downside protection you have while keeping the upside is really kind of neat.”

Shorter tenor

Doucette said that having just 2.5% of capital at risk was more favorable than a buffer.

“This is really for ultra conservative investors. I mean if all you can lose is 2.5%, that’s almost like a bond,” he said.

And yet the note was not a bond as it allows growth.

“It’s an equity investment. I may consider reducing the protection to be able to shorten the duration. “Adding more leverage would be an option too. But I’m more inclined to cut the length of it,” he said.

How long will the bull run?

“The prognosticators say that we have at least another year of this bull market. But nobody is saying it’s going to continue for the next three years,” Doucette added

“That’s why I’m more thinking in terms of reducing the term than adding leverage but it may be a combination of both.

“I would need to see what the numbers are. What do you get by reducing your 2.5% loss limit to 5%, 10% or even 15%?”

Overall, Doucette also expressed a positive view on the notes.

“This principal protection component is a neat new concept except from a tax perspective. I wouldn’t exchange that for a buffer. I like the structure. I would just want to play a little bit with it.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes will price on Friday.

The Cusip number is 61768CZL4.

© 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.