Morgan Stanley’s contingent income on Bank of America likely to call early, says analyst

By Emma Trincal

New York, Oct. 27 – Morgan Stanley Finance LLC’s contingent income autocallable securities due Oct. 30, 2020 linked to the common stock of Bank of America Corp. offer an attractive coupon, but investors should not consider the notes as a pure income play as the product is likely to last three months rather than three years, said Suzi Hampson, structured products analyst at Future Value Consultants.

The notes will be guaranteed by Morgan Stanley.

If the shares close at or above the downside threshold, 80% of the initial share price, on a quarterly determination date, the notes will pay a contingent payment that quarter at an annualized rate of 9.15%, according to an FWP filing with the Securities and Exchange Commission.

The notes will be called at par plus the contingent coupon if the shares close at or above the initial share price on any of the first 11 quarterly determination dates.

If the final share price is greater than or equal to the downside threshold, the payout at maturity will be par plus the final contingent coupon. Otherwise, investors will lose 1% for every 1% that the final share price is less than the initial share price.

“The potential is there to get some good income but it’s a conditional coupon and the autocall means you don’t know in advance how long you will be holding the notes for. Investors should understand that they’re likely to call early, which is not a bad outcome. They have to keep in mind that as they get closer to maturity, the risk is much higher,” said Hampson.

Future Value Consultants generates stress test reports on structured products. Each report contains “tables” or tests investors can choose from in order to assess products. The model displays probabilities associated with outcomes of product performance, which will vary depending on the product type. Part of the Monte Carlo simulation will show result across a “base-case” scenario based on a neutral growth assumption of the underlying.

The investor scorecard, one of the 29 major tests, lists all the different outcomes for this product. Those are: probabilities of call for each of the 12 “call points;” probabilities of getting full capital back at maturity; and probabilities of a barrier breach, hence capital loss.

“The scorecard helps us determine what is the likely duration of the product,” said Hampson.

“We see that the probability of a call at point one is 50%. Not a surprise. It’s the case with all autocalls. You’re always most likely to call at the first observation date.”

When adding the probabilities for each of the first four call points, or quarters, the models reveal a 72% chance of a call occurring on the first year.

“It’s a three-year maximum maturity. But investors have to be prepared to be called much earlier than that,” she said.

“Ideally you would want to hold the notes for three years and see the stock trade between 80% and 100% of its initial price so you can collect your coupon all the time and as long as possible. This is unlikely.

“After the first year, it becomes increasingly hard to be called. You’ve been below the initial level four quarters in a row. The stock definitely needs to rise now.

“The chances of getting back there are lower and the chances of getting below the barrier are higher.”

Time and risk

After the first year, the probability of a call declines, becoming 7% on year two and 3% on year three, according to the scorecard.

With reduced chances of a call comes a greater risk.

“If you don’t call on the first year the chances of a bad outcome are much higher,” she said.

Investors need to modify their expectations if they invest in an autocallable note, she notes.

“They can’t expect to earn a coupon for three years. It would not be a realistic expectation. Perhaps getting less over a short period of time is not just a more probable outcome it’s also a more desirable outcome,” she explained.

“If you call early you get less but on the other hand you lock in 9% a year and you don’t have any risk exposure anymore.

“The product calls. That’s it. That’s the end of the product.”

When no call occurs, investors have a 3% chance of recouping their entire principal when the stock price is negative but above the barrier level. The chances to lose money associated with the barrier breach are 15%.

Bull and bear

Capital performance tests, another table, offers comparisons between different market assumptions other than just the neutral scenario. For its simulation, Future Value Consultants uses four other market scenarios, which are – bull, bear, less volatile and more volatile.

The bull scenario has the lowest chances of a loss at 8% versus 15% for the neutral scenario and 23% for the bear scenario.

The average payoff is a direct result of the actual duration of the notes, according to the capital performance tests.

In the neutral scenario, investors get on average a 4.8% positive return.

“This is skewed by the high chances of calling in the first quarter,” she said.

In the case of a decline of the stock below the barrier, the amount of losses varies across the different market scenarios. In the neutral environment, the average loss is 41% while it is 36% in the bull and 46% in the bear.

This product presents some risks associated with having a single-stock as underlying asset, said Hampson.

The volatility of Bank of America is 25.35%, according to the report, versus approximately 10 for the S&P 500 index.

Investors need to be aware of the uncertainty around the duration of the notes as the extension of the holding period increases the risk.

“You can certainly earn an above average rate of interest for a little while. But it would be wrong to get into this product expecting to collect income for three years,” she said.

“Hopefully you’ll get a good year, maybe two. But if you don’t get called or don’t get your coupon, that’s the risk you’re taking.

“And while you shouldn’t expect to hold the notes to maturity, you should be prepared for it as it is the worst outcome. A lot can happen in three years and your chances of losses are significantly increasing with time.”

Unlike a short-term fixed rate reverse convertible with no autocall, this product provided with the automatic call feature a risk mitigation tool.

“Here your coupon and your duration are not guaranteed. That’s in part why you can get a 9% coupon,” she said.

“The call however plays in the investor’s favor as it lowers your chances of losing capital at maturity.

“If the call occurs, your risk is removed.

“That’s why investors really need to understand the pros and cons of the early redemption scenario.”

Morgan Stanley & Co. LLC is the agent.

The notes will settle on Wednesday. The Cusip number is 61768J698.

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