Morgan Stanley’s lock-in notes on Euro Stoxx target ultra conservative investors

By Emma Trincal

New York, Feb. 5 – Morgan Stanley Finance LLC’s contingent minimum repayment lock-in securities due Sept. 3, 2024 linked to the Euro Stoxx 50 index offer the double advantage of full principal-protection and high-water mark, effectively “locking in” the highest performance of the index as a minimum return. But for advisers the price to pay for those two features may offset the benefits, except for a particularly skittish kind of clients.

“It brings you peace of mind. I guess for an investor scared to death about Europe, it makes sense,” said Tom Balcom, founder of 1650 Wealth Management.

“We have exposure to Europe. If you don’t, you’re not really diversifying your portfolio. But with debt issues in Italy, Brexit in the U.K., clients are pushing back. This may be a way to provide exposure to this asset class, because the principal-protection makes people a little bit more comfortable.”

Lookback

The notes provide a minimum of par at maturity that will increase if a lock-in event occurs, according to an FWP filing with the Securities and Exchange Commission.

A lock-in event occurs if the index’s closing level on any annual observation dates is greater than the initial index level. The highest close is called the lock-in value.

The lock-in return represents the performance associated with the lock-in. It may be lower or higher than the final index return.

If a lock-in event occurs and if the final index return is positive, the payment at maturity will be the greater of the final index return or the final lock-in return.

If the final index level is less than or equal to the initial index level, the payout will be the greater of par and the final lock-in amount.

For instance, if the lock-in return is 40% at maturity and the final index return, 45%, investors will receive a 45% return. On the other hand, if the lock-in is 60% but the index finishes up 2%, investors will receive 60%.

On the downside, if the lock-in (best return of the five observations) is -5% and the index finishes down 35%, investors will receive par.

“This lookback is great if you have a crash in five years. You can lock in the high water mark,” said Balcom.

“Unfortunately they’re doing this on a very-high dividend yield. You’re going to have to give up a lot of dividends. And if the market is flattish, you could lose a lot of money in that period of time.”

A remake

Morgan Stanley priced a similar deal at the end of January for $694,000. The notes were linked to the S&P 500 index. Perhaps because the U.S. benchmark’s dividend yield (1.85%) is much lower than that of the Euro Stoxx, the formula for the lock-in was not 100% but 85% of its performance.

“I’m sure they’re able to give you 100% because of the high dividends here,” he said.

The Euro Stoxx 50 index yields 3.22%. Over five-and-a-half years, investors who only receive the price return of the index must forgo 17.7% worth of dividends, he noted.

“The Euro Stoxx hasn’t done much. In the last couple of years, the dividend has been all your return,” he said.

“If we have a flat performance over that time, it’s not a good thing for the client.”

OID

Another drawback is taxes. Principal-protected notes, structured on zero-coupon bonds, present a less attractive tax treatment than most notes.

“You have to deal with the tax issue too,” he said.

The discount of the zero, or the difference between the redemption price and the issue price, called the original issue price or OID 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.

In addition, any gain recognized by U.S. taxable investors on the sale or exchange, or at maturity, of the securities is generally treated as ordinary income.

“We don’t use PPNs because of the OID issue. You can always use a tax-free account as an alternative, but allocating to different accounts isn’t ideal. The downfall of this note is also the OID,” said Balcom.

“Suppose the notes mature flat. Clients have been paying five years of OID. They’re not going to be happy.”

Costly protection

Donald McCoy, financial adviser at Planners Financial Services, shared a similar view.

“The principal-protection is fair if the market goes down the tubes. But you’re locking in your money for five-and-a-half years and most of the time over such a long stretch, you’re going to get a positive return anyway,” he said.

“The only thing you have going for you is the lock-in part.”

McCoy considered that foregoing the 3.22% yield of the index was a “hefty” price to pay for those features.

“If you expect mid-single digit returns over the next five-and-a-half a year, say 6% a year, giving up half of it is a lot,” he said.

Not for everyone

“I’m not saying it’s a bad deal. But what you’re getting comes at a huge cost.”

Part of the “cost” was the fact that the upside return was not leveraged over the long holding period. Leverage, depending on the multiple, can help offset or even more than offset the “cost” associated with the “loss” of dividends, McCoy said.

“The only people I see this being suitable for would be ultra-cautious, conservative investors who otherwise wouldn’t put allocation to Europe.

“For someone who is petrified and sure the market is going to tank, at least it gives you the protection and some upside if you’re wrong.

“But for that protection, you’re giving up a significant portion of your return.”

ETF alternative

The cost of the structure was not only measured in unpaid dividends. The relatively illiquid nature of the investment over a period exceeding five years was another drawback for this adviser.

“The lock-in is OK. But that also comes at a price. I’d rather own the market directly. If I own the fund and I have four good years, I can get out from my investment.

“This is really for very skittish investors who don’t have that exposure to Europe. It’s a way to make them feel comfortable with the understanding that they’re going to give up a lot in dividends.”

The notes will be guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes are expected to price Feb. 28.

The Cusip number is 61768X127.

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