Morgan Stanley's autocallables tied to iShares Russell, SPDR S&P 500 aimed at yield chasers

By Emma Trincal

New York, Nov. 27 - Morgan Stanley's 0% trigger phoenix autocallable optimization securities due Nov. 30, 2017 linked to the iShares Russell 2000 index fund and the SPDR S&P 500 ETF Trust are designed for income-seeking investors who are willing to see their investment redeemed early, a likely outcome, sources said.

"We are seeing tremendous demand for income notes. In this low interest rates environment, a lot of clients are really yield-hungry," said Dean Zayed, chief executive of Brookstone Capital Management.

"This note certainly satisfies these types of clients in a fairly straightforward structure. It's almost too good to be true."

If both funds close at or above the 55% to 60% trigger level on any quarterly observation date, the notes will pay a contingent coupon of 8% for that quarter, according to an FWP filing with the Securities and Exchange Commission.

The exact quarterly contingent coupon will be set at pricing.

If both funds close at or above the initial price on any quarterly observation date after one year, the notes will be called at par of $10 plus the contingent coupon.

If the notes are not called, the payout at maturity will be par plus the contingent coupon unless either fund finishes below the trigger price, in which case investors will be fully exposed to the decline of the least performing fund.

A win-win

"The conditions for the call are very easy to meet, which makes it likely that you're going to get called away as early as at the end of the first year," said Zayed.

"Yes, there is no principal protection, but the trigger level is so low that it reduces the downside risk significantly. Besides, chances are that you won't hold these notes for five years. But even if you do, how many five-year periods have we seen the index down 40%? It's highly, highly unlikely, especially with today's current market levels. It's not like we're going into this note in a ridiculously high market. The trigger is so low, even 2008 wouldn't hit those levels and 2008 is considered as one-in-a-generation catastrophe."

The iShares Russell 2000 index fund declined by 34.5% in 2008 while the SPDR S&P 500 ETF Trust lost 37.75%.

Zayed said that he liked the fact that the barrier, which determines the amount of principal repayment, was observed only at maturity and not throughout the life of the notes.

"You don't risk losing your principal each quarter. The worse that can happen is that you don't get paid your coupon on that quarter. The trigger can only penalize you that way: you lose a coupon payment," he said.

"Worst-case scenario, you get paid two coupons in the first year, making 4% instead of 8%. It's still very competitive.

"In an ideal world, I wouldn't want to be called because you're almost assured of an 8% every year. But you take what you have and it's acceptable.

"It's simple, short-term. The call feature is a good one. Most clients wouldn't complain to have earned 8% after one year."

"I love this note," he said.

Kirk Chisholm, principal and wealth manager at NUA Advisors, agreed that the notes were tailored to investors seeking income. But he outlined some of the risks and drawbacks associated with the structure.

"It's aimed at the income investor and it's callable. You have to consider this investment the same way you would consider a callable bond. You have the expectation of earning an income up to 12 months at which point you are likely to be called away," he said.

The low trigger price offered some contingent protection at maturity, but only if the market does not go through a major correction, he said.

Five-year tenor

"It's nice to have some downside protection if the market gets a little too crazy. This is the kind of product that would be good for someone who is mildly bullish to mildly bearish. It's designed for that type of investor who feels the market is not going into too many extremes. The volatility will have to remain within a certain variance for this to make sense. If we're seeing another 2008, this could become problematic," he said.

"You have to assume that the Russell and the S&P will both stay within a reasonable range on the downside. On the upside, it's a more narrow range because your return is limited to 8%. So of course, you can miss on some of the upside," he said.

The length of the product - which could be as short as one year and as long as five, made Chisholm uneasy about the product.

"I don't particularly like the five-year tenor if you don't get called," he said.

"A five-year outlook in this market is very hard to predict. A lot of people are expecting a bad market next year, parts of Asia and Europe are in recession and if the U.S. is in better shape, we're still not doing great. Things are starting to slow down globally, and that's an issue," he said. "As long as it's just a slowdown, these notes should perform relatively well. But if things become much worse, in particular in Asia or in the European Union, the downside risk could present major problems."

Early redemption

Aside from market risk, investors could be subject to reinvestment risk assuming the notes get called.

"Let's say that both funds close at the end of the first year above zero. You get called with an 8% return," he said.

"Now you have to fill that void in the portfolio. There is a possibility that a year from now, you wouldn't find 8%. Interest rates could be lower. I personally think interest rates will stay low longer than most people think. Trying to lock in decent rates will continue to be a challenge," he said.

Chisholm said that the complexity of the structure, with its various types of barriers and potential events, was another problem.

"A very complicated product like this one would potentially turn off a lot of investors. Many structured products are much simpler. This note has a variety of factors that will come into play in the performance, and once you reach that level of complexity, investors a lot of time will simply say - I'm not interested...It's too complicated," he said.

Alternatives

Chisholm said that better alternatives are available to investors without the complexity and the five-year horizon associated with the product, which he said were not attractive aspects of the product. He mentioned some preferred stocks of companies with strong balance sheets, which may offer yields between 7% and 8% without the risk of being called after 12 months.

"Using options to generate income can yield income of more than 8% if done properly.

"They are other ways to get income but they are not too many, I agree. The possibilities are limited so I wouldn't rule out this product completely. But it wouldn't be my first choice," he said.

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

The notes will price on Wednesday and settle on Friday.

The Cusip number is 61761H798.

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