Morgan Stanley’s $6.96 million absolute return step notes on basket offer minimum gain, no cap

By Emma Trincal

New York, April 25 – Morgan Stanley Finance LLC’s $6.96 million of 0% trigger absolute return step securities due April 21, 2027 linked to a basket of indexes pay a digital return with no upside cap while investors benefit from a barrier and absolute return on the downside. For some, the structure offers some balance. Others believe that the issuer should have offered more return enhancement.

The basket includes the Euro Stoxx 50 index with a 40% weight, the Nikkei 225 index with a 25% weight, the FTSE 100 index with a 17.5% weight, the Swiss Market index with a 10% weight and the S&P/ASX 200 index with a 7.5% weight, according to a 424B2 filing with the Securities and Exchange Commission.

If the final basket level is greater than or equal to the initial basket level, the payout at maturity will be par of $10 plus the greater of a step return of 46% and the basket return.

If the final basket level is less than the initial basket level and greater than or equal to the downside threshold level, 75% of the initial basket level, the payout will be par plus the absolute value of the basket return.

Otherwise, investors will lose 1% for every 1% that the final basket level is less than the initial basket level.

Diversified basket

“I would do it,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“These indices offer tremendous diversification across the main developed markets,” he said.

“I like the fact that they have included Australia and Japan. It reduces your exposure to Europe.

“I don’t expect dramatic volatility from the basket.”

Guaranteed minimum

The step return or minimum return was the most attractive feature, according to this adviser.

“Being guaranteed 9% a year on a five-year note with uncapped upside...I’m in love with this,” he said.

The downside structure was also “compelling,” he said, as it allowed investors to outperform on the downside anywhere above the 75% strike.

No dividends

The only “downside” as with any structured note was the absence of dividend payments, he noted.

“Even without the dividends, assuming for instance a dividend of 3% per year, it’s still a very decent return, especially if this mini portfolio does not go up very much. I like that it’s a guaranteed return as long as the basket doesn’t go down. And if it goes higher, you’re not capped. You have unlimited upside.

“There’s really nothing not to like about this note,” he said.

Creditworthiness, fee

Steven Foldes, wealth manager and founder at Evensky & Katz / Foldes Financial Wealth Management, held the opposite point of view.

“I wouldn’t invest my clients’ money in this. At least not the way they designed the note,” he said.

His first comment was about the creditworthiness of the issuer.

“We have no problem with Morgan Stanley. Its ratings are quite good,” he said.

But the 3.5% fee as disclosed in the prospectus was “on the high side.”

One of Foldes’ top concerns was the length of the notes.

“Five years is way too long for us,” he said.

Low entry point

The payout structure did not capture the high upside potential of the underlying, this adviser said.

Foldes said that the basket was very comparable to the SPDR MSCI EAFE fund based on its composition and weightings per country.

“You’re buying this basket 15% lower than its peak over the last year,” he said, using the ETF as a proxy for the basket.

The EAFE ETF closed at $70.13 on Monday. The share price hit a 52-week high in September at $82.28.

“It’s a five-year note. I would guess that over five-year rolling periods, your chances of finishing negative are less than 10%,” he said.

“So, you’re spending a lot of money in this structure to protect something that doesn’t need protection.

“Furthermore, if the chances of finishing negative are very small, how would you justify the use of another expensive and unnecessary feature, which is the absolute return?

“You could use some of this money to structure better terms.”

Foldes would “refashion” the notes mainly to make the product more bullish.

On the downside, he would eliminate the barrier and the absolute return and include a buffer instead if possible.

For more aggressive investors, he would remove both the downside protection and absolute return in an attempt to strengthen the upside.

Firing on all cylinders

“I would still want to keep this step return. But I would try to increase it above 46%. That’s not all. For any gain above the step return, I would want to see some leverage, not just one-to-one,” he said.

If such repricing could not be done, Foldes would keep the 46% step return as is and add the leverage feature for any basket gain in excess of the step. Such gains would be measured from the initial price as with any leveraged product.

“I think it can be done. Keep in mind I am getting rid of the protection and absolute return on the downside,” he said.

The leverage factor would not have to be high. Foldes said he would be looking at levels comprised between 1.2x to 1.5x.

Those changes were necessary given the upside potential of the basket.

“You’re not starting at a high. You’re buying at a discount,” he said.

“You should expect a strong return over the next five years, which is why having no leverage once you exceed the minimum return is not very exciting to me.

“I would raise or keep the 46% minimum return. Compounded, it’s about 8.5% per year. I would add the leverage above that minimum return level. That way, I’m well positioned to gain if things are really taking off over that period of time, which they should.”

Yes, no, maybe

Getting a digital payout plus leverage is rarely seen except when the issuer incorporates a one-time autocall usually after one year. Foldes said he would consider this solution.

On the other hand, capping the leveraged return on the upside was not an option.

“I could never settle for a cap on a five-year,” he said.

The tenor may not be a variable easy to change.

“I really don’t like long maturities and I would love to reduce the length to two or three years. But a lot of the benefits go away when you do that,” he said.

The notes are guaranteed by Morgan Stanley.

UBS Financial Services Inc. and Morgan Stanley & Co. LLC are the agents.

The notes settled on Thursday.

The Cusip number is 61773Y409.

The fee is 3.5%.

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