Morgan Stanley’s equity-linked partial principal at risk notes on Stoxx offer defensive play

By Emma Trincal

New York, Oct. 22 – Morgan Stanley Finance LLC’s 0% equity-linked partial principal at risk securities due April 30, 2024 tied to the Euro Stoxx 50 index give investors uncapped and leveraged upside exposure to the European stock market with only 5% of risk exposure, making the note a relatively “attractive” and “reasonable” play, according to advisers. The main concession for investors is to be invested for a longer maturity than average, they said.

The payout at maturity will be par plus 120% of any index gain, according to a 424B2 filing with the Securities and Exchange Commission.

If the index finishes flat or falls, investors will receive par plus the index return, subject to a minimum return of $950 per $1,000 of notes.

Risk-reward

“I like this kind of structure. I don’t like the maturity though. Four and a half years is a long time,” said Kirk Chisholm, wealth manager and principal of Innovative Advisory Group.

“But having 1.2 times on the upside, no cap with only 5% exposed to the downside is pretty appealing.

“This type or risk-reward is favorable.”

The underlying index has a 2.87% dividend yield. The noteholders will not receive the yield during the period unlike investors in the exchange-traded fund.

“You may not get the dividends with this note but you’re getting other features in exchange. Overall, it’s a reasonable tradeoff,” he said.

Favorable pricing

Chisholm compared the tradeoff of the note with an option trade, a comparison which makes sense since in both cases the exposure is to the price return of the index, not the total return.

“The risk-reward is better on this note than if I was to create an equivalent trade through options,” he said.

But Chisholm said he would probably not consider the notes due to his view on the euro zone market.

“I’m not at all bullish on Europe. But if you’re going to allocate to the Euro Stoxx, this would be a good way to do it,” he said.

Dividends

Jonathan Tiemann, president of Tiemann Investment Advisors, LLC, had a positive view on the notes as well.

“It’s probably relatively easy to replicate it with options. But it’s convenient as a note and it’s not a bad structure, really,” he said.

Tiemann said the non-payment of dividends had to be taken into consideration.

“You’re losing 13% worth of dividends. So, you’re probably going to be a little bit behind on the upside especially if the index trades sideways or is up only moderately,” he said.

The breakeven price return for the noteholders is 10.5% a year. Below this annual rate of return, the performance of the ETF should outpace the leveraged gains of the notes due to the dividends. However, above this level, noteholders would fare better because the leverage would offset the “loss” of dividends.

Return expectations

As always, the investment decision always boils down to one’s outlook on the underlying asset class.

The trailing return of the SPDR Euro Stoxx 50 exchange-traded fund, which tracks the index, was only 9.21% over the past three years and 3.95% over the past five years, according to Morningstar.

However, the fund is up 20% through Oct. 21 this year, which is only 1.75 percentage points less than the S&P 500 index during the same time.

Tenor

The dividends are what allowed the issuer to price the structure,” said Tiemann.

“After all you have the leverage. You don’t have a cap. You can’t lose more than 5% at maturity. There are a lot of good things in this product. They couldn’t do it without using the dividends, especially with interest rates being as low as they are.

“They also had to extend the maturity for the same reason.

“You’re not selling any options in this deal. You’re buying the calls and the put. So, you need to pay for it and the issuer is paying for it with the dividends.”

The notes would be appealing for conservative investors worried about the downside.

“This downside protection is what you get for giving up the total return. Is a negative return very likely at the end of four-and-a-half years? Probably not... But for many people, peace of mind is important.”

Perhaps the real “cost” of the protection is the long maturity making the product only suitable for long-term investors, he said.

“You have to be comfortable with this four-and-a-half year term,” he said.

“Personally, I don’t know if I would want to invest that defensively and lock in for that length of time.

“But it’s still a good structure as a defensive play. I kind of like it.”

Morgan Stanley & Co. LLC is the agent.

The notes are guaranteed by Morgan Stanley.

The notes will price on Oct. 25.

The Cusip number is 61769HB87.

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