Morgan Stanley's dual directional trigger PLUS linked to Russell offer leverage, some risk

By Emma Trincal

New York, April 16 - Morgan Stanley's 0% dual directional trigger Performance Leveraged Upside Securities due October 2013 linked to the Russell 2000 index offer an attractive payout structure with an absolute value return on the downside and leverage on the upside.

But some advisers saw a few risks with the credit rating of the issuer and the amount of downside protection.

The product type, often called a twin-win note, gives investors a positive return even if the underlying finishes negative as long as the decline stays within a range or above a certain trigger price.

Advisers said that they like this type of feature, sometimes called absolute value payout.

Many among the recently priced twin-win notes have a shorter duration of typically one year, according to data compiled by Prospect News. The 80% barrier on the downside is standard as well as the existence of a cap on the upside. What makes this product slightly different, according to the data, is the leverage offered on the upside.

If the final index level is greater than the initial index level, the payout at maturity will be par plus 150% of the index return, subject to a maximum return of 26% to 28% that will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the final index level is less than or equal to the initial index level but greater than or equal to the trigger level, the payout will be par plus the absolute value of the index return. The trigger level will be 80% of the initial index level.

If the final index level is less than the trigger level, investors will be fully exposed to the decline from the initial index level.

Credit rating wildcard

"I don't see anything not to like. There is leverage on the upside, a nice cap of 26%, which is good even for a year and a half. The Russell, despite what some clients say, is not hugely risky as an asset class. You have a gain if the index is down by less than 20%. Of course everything sort of falls apart beyond that," said Carl Kunhardt, wealth adviser at Quest Capital Management.

"I really like the structure. If it was on the Raymond James platform, I would certainly consider it," said Kunhardt.

Kunhardt said that "the only potential concern" with this deal would be an eventual downgrade of Morgan Stanley by the rating agencies.

"There were recent news reports saying that Morgan Stanley may go ahead and buy Citi's remaining shares in Smith Barney. If they do it in one chunk using leverage, they may be considered for downgrade by Standard & Poor's," he said.

"But even still, on an 18-month product, there is not really a lot of credit risk," he said.

Good upside

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that he likes the notes, especially for the upside potential. But he added that he is less comfortable with the downside risk given the volatility of the underlying index.

"The features are unquestionably good. The fees are very competitive," he said.

"Morgan Stanley's credit is not in that top tier of credit, but that would be more of a concern on a five- or six-year product, not so much a one-and-a-half year," said Kalscheur.

The 26% to 28% maximum return over the period represents an annualized cap of 17.3% to 18.6%.

"Most people wouldn't complain of getting that type of annualized return on the Russell 2000," he said.

But Kalscheur noted that he considers the small-cap equity benchmark too volatile to warrant taking the risk given the amount of protection offered by the issuer and the fact that it is only contingent protection and not a buffer.

Trigger concerns

Once the 80% downside barrier is breached, the protection and absolute value return features disappear and the decline of the payout becomes proportional to the decline of the Russell 2000, according to the prospectus.

Investors can lose their entire investments in the notes; the issuer does not guarantee any return of principal, the prospectus stated in the risk section.

"This is the only thing wrong with this structured note," said Kalscheur. "A 20% trigger point on the Russell 2000 is just too small. The standard deviation on the Russell is 22%. I think it will trigger.

"If you have a sideways view of the market, it's a very competitive product.

"But I stay away from those bets. This is not why I buy structured notes. When you buy those structured products over the index directly, there's got to be a differentiating factor. To me, it's the risk mitigation. I buy those notes for the assured downside protection. If the market is down 40%, I want to be down 20%."

Point to point, pricing

One "saving grace" of the structure is the point-to-point payout, Kalscheur noted.

"If it could get triggered at any time, it would be much worse," he said.

"Just last year we had a bad quarter when the Russell was down 22%. It would have triggered out in 2011 and in 2010. At least the point to point gives you a little bit more peace of mind," he said.

Another factor investors should always consider before making a decision is the price on the trade date.

The index, currently trading at about 800, is up 7.7% year to date. From this year's high at the end of March, however, the index has lost 5.5%.

"If the index was at 700, I would be much more comfortable. But then I would be more inclined to say 'I want more upside,'" Kalscheur said.

Given the volatility of the underlying, the idea of losing the entire cushion of downside protection once the trigger is hit is "a deal breaker" for this adviser.

"I really want to have confidence that some level of protection is going to be there," he said.

"Those twin-win products may be great. But that's not why I buy structured notes. I'm more concerned with the downside risk.

"This is a great product. It's just not for us."

The notes (Cusip: 617482Q56) are expected to price and settle in April.

The fees are $2.50 per $1,000 principal amount of notes.

Morgan Stanley & Co. LLC is the agent.

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