Morgan Stanley's contingent income autocallables linked to Apple stock offer income, hedge

By Emma Trincal

New York, Jan. 15 - Morgan Stanley's $32.07 million of contingent income autocallable securities due Jan. 17, 2017 linked to the common stock of Apple Inc. were aimed at investors who expect Apple shares to move in a range, sources said.

The notes will pay a contingent quarterly coupon at an annual rate of 12% if the stock closes at or above its 80% barrier level on the determination date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

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

The payout at maturity will be par plus the final contingent coupon unless the stock finishes below the 80% barrier level, in which case investors will receive a number of Apple shares equal to par of $10 divided by the initial share price.

Puts

"This is an autocallable reverse convertible. The deal is a series of put options that start today, each with a maturity increase by three months. You have a three-month put option, a six-month put option, a nine-month, all the way to 36 months. Each of the put is struck at 80% of the initial price of Apple. The payoff is fixed at 3%," a structurer said.

"The structure has a certain complexity. It would be hard for an individual investor to reverse engineer it with options."

Because the notes are callable if the stock price is above its initial price, investors may prefer the shares to trade in an 80% to 100% range in order to collect the coupon as long as possible, he said. The upside risk is the early redemption. On the downside, a stock trading below the 80% threshold on a quarterly observation date deprives investors of the coupon. At maturity, the same scenario triggers a loss of principal of at least 20%, he said.

Call risk

"You can't be bullish because it increases the likelihood of getting called and losing this attractive return," this structurer said.

"However, even if it gets called, for instance on the first quarter, you still make 3% and you get your money back. It's still a great coupon for this short period of time. What you're really losing in this early call is the opportunity to earn the full 12%."

Another reason for not being too bullish, he said, is because the notes do not offer any upside participation in the stock price.

Bearish bias

Investors in the notes may have a slightly bearish bias, he noted. By being only mildly bullish, they are hoping to collect the contingent coupon as often as possible without losing any principal at maturity.

"Someone buying this deal would have to be mildly bearish because if the stock trades down, it's fine, you can earn your coupon. You just don't think it's going to trade below 20% down from the initial price. In fact, there is a clear bearish bias in the notes, but it's a mildly bearish bias."

Downside risk

A decline in the stock has implications at maturity: A drop of the price by more than 20% would represent a one-to-one loss of principal from the initial price, he said.

The notes are constructed around a European barrier. But the breaching of the 20% level on any quarterly observation date would have some pricing implications.

"First, you're losing your coupon for that quarter," he said.

"But also, if it drops by more than 20%, you're suffering a mark-to-market loss. As the stock is down, volatility has picked up, allowing issuers to structure similar deals with a much higher coupon."

Short-term trade

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that investors would have to be moderately bullish and moderately bearish since there is risk associated with wide price moves.

"Getting 12% and getting called at the very end of the deal, sure, that would be great. But that's not the nature of these autocallables as we know that the highest propensity of getting called is on the very first quarter," Kalscheur said.

The early redemption with reinvestment risk is not the worst-case scenario, he said, agreeing with the structurer.

"If I get called out, I still earned a coupon, which is 12% per annum," he said.

"Most investment advisers, especially in the broker-dealer arena, would actually want the money back because they can reinvest it. I'm not saying it's a bad thing or that they're churning the account. But if they get the coupon and reinvest right away, they get a story to tell their clients. So I'm sure most of them would want to have it redeemed.

"I don't think an overly bullish investor would have any interest in it though because they would know they're going to be called out."

Volatile underlying

As they are buying a note linked to a single stock, investors are exposed to the risk of Apple, a relatively volatile stock despite having regained momentum over the past six months, he noted.

In June, the stock had dropped by nearly 40% from its $700-a-share peak in September 2012. Since June, Apple shares have regained almost 30%.

The price of Apple on the pricing date was $532.94.

"The idea of Apple in three years being below 20%, or at $425, is entirely possible. It happened very recently. So you could definitely breach the barrier and lose money," Kalscheur said.

"If you don't expect Apple to jump through the roof but you don't expect it to plummet either, this might be a reasonable shot.

"If I'm willing to take the chance of being called out early on this and if I don't anticipate a big drop, this might be a pretty good deal."

Income generator

Investors who bought into the deal, which was the third largest offering last week, may have pursued several objectives, sources said.

"Getting income is what comes to mind first," Kalscheur said.

"Most people would do it for the income. To me, however, if my sole objective is to get income, I'd rather know what it is. I would prefer a fixed amount as opposed to a contingent coupon."

The structurer said, "If you're not interested in participating in the upside because you're not that bullish, what you're really doing here is converting Apple volatility into a bond.

"The 12% annualized coupon looks like a great return. It certainly looks like the fixed-incomization of the equity volatility using Apple as the underlying.

"But let's be clear: I am calling this the 'fixed-incomization' of the equity underlying, which reflects the structure of the deal, not the underlying risk. I am not suggesting that you're changing the underlying equity risk into a fixed-income type of risk."

Hedge

Kalscheur said that some investors may ignore the downside risk.

"Some may just see it as a way to roll the dice on Apple," he said.

But the trade could be more wisely used as a way to hedge a long position on the stock.

"If you own Apple and are not sure whether to sell it or hold it, you could buy this note as a hedge. If the share price drops, the income you're getting, assuming it drops by less than 20%, offsets some of the losses. If you're called, you have the appreciation from your long position and you still get your last coupon.

"If you're on the fence about your long position, this might be a nice option."

The notes (Cusip: 61762W869) priced Jan. 10.

Morgan Stanley & Co. LLC was the agent.

The fee was 2.25%.

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