Morgan Stanley's step-down redemption feature in autocallables linked to Apple adds complexity

By Emma Trincal

New York, July 17 - Morgan Stanley's contingent income autocallable securities due July 2015 linked to the common stock of Apple Inc. include a "step-down" feature that makes the structure more complex than usual and difficult to evaluate given a variety of "moving parts," financial advisers said.

If Apple stock closes at or above the downside threshold level - 75% of the initial share price - on a quarterly determination date, investors will receive a contingent payment of 2.125% to 3.125%, which is 8.5% to 12.5% on an annualized basis. Otherwise, no contingent payment will be made for that period. The exact contingent payment will be set at pricing.

Separately, the notes will be called at par plus the contingent payment if the stock closes at or above a certain redemption threshold on any of the 11 quarterly observation dates.

What makes the structure of this product unusual, according to sources, is the fact that the redemption threshold goes down with time, hence the term "step-down."

The redemption threshold is 95% of the initial share price on determination dates one through four, 90% of the initial share price on determination dates five through eight and 85% of the initial share price on determination dates nine through 11.

"This particular feature is something I have never seen before in an autocallable," said Dean Zayed, chief executive officer of Brookstone Capital Management.

If the securities are not redeemed early, the 75% downside threshold, which is used to determine the payment of the contingent coupon, will be the final test to determine the payout at maturity.

If the final share price is 75% or more of the initial price, investors get their principal back. If it is below 75%, the payout will be a number of Apple shares equal to $10.00 divided by the initial share price or, at the issuer's option, a cash amount equal to the value of those shares.

Complex

"I like the terms, but it's way too complicated to explain," said Zayed. "For the savvy investor, spending 10 or 15 minutes to explain the product is not impossible. But I wish they could do it with less features and make it more straightforward."

Another adviser agreed.

"There are a lot of moving parts. It makes it hard to evaluate," said Jonathan Tiemann, president and chief investment officer of Tiemann Investment Advisors, LLC.

"Your maturity can vary and be very short with the call. The payment of the coupon is contingent upon the stock closing above 75% on specific times. If it closes below, you don't get the coupon.

"At maturity, you could get your principal back or you could lose at least 25% of it.

"If you want to collect the entire coupon, quarter after quarter, you want the stock to move in a very narrow range, not lower than 75% to clip the coupon but not higher than the redemption level that keeps going down so that you don't get called."

The step-down feature

Zayed said that the declining redemption threshold level is an attractive feature.

"I like it," he said. "It provides more protection. This note is not fully protected, and by increasing the probability of being called - since the longer you go, the lower the threshold - they're actually reducing the risk. I think you are likely to get called, and once you are, your principal is obviously no longer at risk by definition.

"This feature allows you to get what investors want from these types of products, a high coupon and the principal protection. It actually increases the chances of getting both - the coupon and your money back."

But if the goal of the investor is to stay invested as long as possible in order to avoid reinvestment risk and accumulate the maximum return in dollar terms, the step-down feature may not be ideal, said Tiemann.

"I'm not sure this is in your favor. First, you want to close between 75% and 95%, then between 75% and 90%, then 75% and 85%. It gets narrower. They make it difficult for you to get the full return for the three years without missing a coupon date. I'm not saying impossible, but it's a narrow set of outcomes that would give you that result," he said.

Rationale

Understanding what would be the main motivation for an investor to buy the notes really depends on what the investor wants to accomplish, sources said.

For Zayed, it's generating income.

"Usually you would compare this to buying the Apple stock," he said. "To me, they're using Apple because it's a big name. It's got volatility, so you can get a nice coupon.

"But I don't see it as an alternative to buying Apple. This is something different that uses the stock to give you a nice coupon and a high probability of getting called.

"This is a fixed-income product using the stock. I like the terms. I just think it's too complicated."

Tiemann said he is not sure who would invest in the product.

"I don't really like it because you give away the upside for a high coupon but you retain all the tail risk," he said.

"That reminds me of the hedge fund guy who claims that he can produce equity returns with a fixed-income risk profile. Here, it's the other way around!

"In essence you're selling your entire upside for a high contingent income. You have some measure of downside protection, it would be wrong to say that you don't. But the protection is a soft barrier, not a buffer, which is why they can pay for the high coupon. And the income is contingent upon a lot of things.

"To think this note is going to work is to think that Apple is at the very top of its valuation and that it's not going to be very volatile. And to believe both of these things are going to happen is quite surprising, really."

The notes will price and settle in July.

Morgan Stanley & Co. LLC is the agent.

The Cusip number is 61755S461.

The fees are 2.25%.

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