Morgan Stanley’s notes tied to Hang Seng China: contrarian play with lots of risk, sources say

By Emma Trincal

New York, July 28 – Morgan Stanley’s 0% performance securities due July 31, 2018 linked to the Hang Seng China Enterprises index surprised some for the timing as China’s market is in a meltdown, but some investors considered the product as a value or contrarian play worth exploring.

The payout at maturity will be par of $10 plus 140% to 145% of any index gain, with the exact participation rate to be set at pricing. Investors will be exposed to any losses, according to an FWP filing with the Securities and Exchange Commission.

The underlying index consists of shares of companies incorporated in mainland China that are listed on the Hong Kong Stock Exchange (H-shares) as opposed to A-shares, which are listed on the Shanghai exchange and tend to be restricted to domestic investors.

Sell-off

The Hang Seng China Enterprises index dropped nearly 25% over the past three months.

Mainland Chinese stocks plunged on Monday and Tuesday due to disappointing economic data and the fear that the Chinese government’s attempts at controlling the sell-off with a series of new policies may not be working as well as previously anticipated.

“Nobody can predict what will happen with the Chinese stock market over the next three years,” said Dean Zayed, chief executive of Brookstone Capital Management.

“The recent correction can be seen by some as a buying opportunity while others may view it as the beginning of a more prolonged bear market.”

Small dose

But the structure is appealing, in his view.

“I like the terms of this note for their simplicity and the great leverage. I would buy it as a tactical bet on China with a small portion of a client’s portfolio that has been earmarked for growth,” he said.

While there is no downside protection, Zayed said he would mitigate risk by keeping the allocation small so that the long-term financial strength of a client would not be affected.

“There is no sense in making a big bet on an index that we know can suffer severe losses. But getting the opportunity for huge upside for some dollars that will not cause long-term harm for a client if they suffered losses is an appealing idea,” he said.

“Would I put up to 5% of a portfolio here? Yes. Would I allocate more? No.”

Risky market

Jonathan Tiemann, founder of Tiemann Investment Advisors, LLC, expressed concerns about the underlying index and the timeframe of the investment.

“Presumably they pay for the upside with the dividends, so if the market is down, you’re worse off, and if it’s up, you may be better off depending on the return,” he said.

“It’s a slightly risky play on the Hang Seng index, which is risky enough for my taste already.

“I think this is an instance where the three-year commitment is a real problem. People playing China will tell you that transparency is very limited. Economic indicators are not reliable. Corporate earnings are not reliable. You’re speculating on limited information. There are going to be some people who are playing for the greater fool.

“In this kind of environment I don’t find it very appealing to take a three year commitment you can’t get out of.”

Liquidity concerns

Issuers often argue that there can be a secondary market on most notes.

“Yes, in any prospectus you have the best effort statement. They tell you they intend to buy it back if you want to put it back to them. But it’s never a guarantee. You don’t know what kind of spread they’re going to give you or whether they’re going to do it. To me it means that you’re stuck for three years. That’s what I mean with commitment,” he said.

On the brighter side, the use of the H shares, which are widely traded on the international markets, could facilitate liquidity, he said.

“It’s better than the Shanghai. If anything, the issuer will be better able to manage their hedge. It might be easier for them to buy you back at a reasonable spread.

“But I wouldn’t try it. It’s a levered play on a market that’s already wildly risky.”

Yield

The dividend yield on the index is 3.66%. Over the three-year term, investors in the notes would be missing on about 11% in return.

Marc Chandler, global head of currency strategy at Brown Brothers Harriman, said he was not impressed with the terms of the notes.

“They’re giving you 1.4 times leverage, and in exchange you’re giving up 3.66% in coupon for three years without any downside protection for three years? Good luck,” he said.

Hong Kong

One more positive aspect of the notes was the choice of Hong Kong versus Shanghai as the exchange for the underlying benchmark.

The Shanghai market is more domestic and includes a majority of retail investors, many of which with limited experience in equity investing who have taken excessive risk in margin accounts, according to recent news reports.

China “does not have an equity culture,” Chandler wrote in a research piece on Tuesday, which stated that equities account for about 12% of Chinese household financial assets versus 58% in the United States.

“Chinese shares that trade in Hong Kong, Taiwan, and the U.S. have fared considerably better than the A-shares that trade in Shanghai and Shenzhen,” according to the paper.

Chandler explained why: “We define risk as volatility. The A shares which trade in China are more volatile than the Hong Kong Enterprise index or H shares.

“In a bull market, the A shares will do better. In a bear market, they’ll do worse.

“One reason for that is the composition of the index. The Hong Kong market is only the top blue chips; you have other stuff on the Shanghai.

“Also you have different types of investors. Institutional investors who do not want to be limited to ADRs tend to play more on the Hong Kong market. They’re more sophisticated. Maybe they’re longer term investors. Maybe they use less margin.”

Morgan Stanley & Co. LLC is the agent with UBS Financial Services Inc. as dealer.

The notes were scheduled to price on July 28 and settle on July 31.

The Cusip number is 61765G721.

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