Morgan Stanley’s $1.43 million 9% fixed-to-contingent coupon autocall on indexes show new idea

By Emma Trincal

New York, Aug. 1 – In a small deal, Morgan Stanley just came out last week with an innovative equity-linked structure: the fixed-to-contingent coupon deal.

“That’s a first. You see fixed-to-floaters with the steepeners. But not a teaser rate followed by a contingent rate,” said a market participant.

Morgan Stanley Finance LLC priced $1.43 million of contingent income autocallable securities due July 29, 2033 linked to the S&P 500 index, the Russell 2000 index and the Euro Stoxx 50 index, according to a 424B2 filed with the Securities and Exchange Commission.

The coupon will be fixed at 9% for the first three years. After that, the notes will pay a contingent quarterly coupon at an annual rate of 9% if each index closes at or above its initial level on the observation date for that quarter.

The notes will be called at par if each index closes at or above its initial level on any review date after 5.5 years.

The payout at maturity will be par unless any underlying index finishes below its 50% downside threshold, in which case investors will be fully exposed to any losses of the worst performing index.

Unlike others

Most deals beginning with a set coupon rate for a limited amount of time are found with rate underliers. The most common ones are linked to the 10-year swap rate or to the spread between long- and short-term yields, said the market participant. He mentioned the (often levered) spread between the 30-year Constant Maturity Swap and the two-year CMS rate as the most common form of fixed-to-floater deals.

“You can have an equity component too. So long as the S&P and the Russell are above a certain threshold you get your coupon. That’s the closest thing that I’ve seen to this one,” he said.

“But those, unlike this one, don’t have the memory.”

The memory is the feature that enables investors to “catch up” later on previously unpaid coupons when a payment was skipped because the index closing levels did not meet the payment criteria.

Long-term outlook

“It’s a calendar deal, a brokerage product. It’s interesting. The memory feature is helpful. It helps getting over the non-protection,” he said.

“The 9% coupon, especially as a fixed rate for the first three years, is attractive.

“There may be a market for this if you think that stock prices will be up over the long term.

“Maybe there will be a crash but the market has enough time to normalize during that period, so it will get called. That would be the rationale for this trade.”

The five-and-a half year non-call period allowed investors to count on getting at least three years of a guaranteed 9% fixed interest rate.

“After that, it will get called. People who buy this note have to think it’s going to be a five-and-a-half year deal. It makes it more palatable from that standpoint,” he said.

Limited distribution

Despite those positive features – the teaser rate, the size of the coupon and the memory – this market participant did not believe this new structure would have much traction.

“There are some compelling aspects to it. At the same time, it’s a niche deal,” he said.

“I don’t know if it’s for everyone. It’s very particular, especially the 15-year term.

“I’d be shocked if they did $5 million or $10 million of this.

“It’s clearly for a smaller pool of investors.”

Long term

The 15-year tenor was a big drawback, an industry source said.

“My first reaction was: it’s a 15-year note with a teaser rate. I’m getting a principal guarantee. When you see a 15-year worst-of, you’re thinking automatically: there’s got to be principal protection. I’m getting my money back,” this source said.

“But you have your principal at risk at maturity. The 50% knock in is great. But it’s your entire principal that’s at risk. That’s a lot of risk for a 15-year paper.

The worst-of based on three indexes added more uncertainty.

“You cover the world. It’s not like only the U.S. Anything happens except in Asia and you’re screwed.

“Maybe that’s why you have a high coupon.”

In and out

The five-and-a-half year call protection is beneficial for those who want to collect the coupon as long as possible. But the end of the no-call period should not be seen as bad news for investors.

“The call risk is not so much a risk in that situation. People want to get called. If they’re not, they have 10 more years to go,” this source said.

“Your main gripe is not the autocall.

“Your main gripe is to sit for a very, very long time with 100% of your principal at risk at maturity.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes (Cusip: 61768C6K8) settled on Tuesday.

The fee is 3.5%.

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