Morgan Stanley, Citi price small speculative trades with high-risk, very high potential gains

By Emma Trincal

New York, Sept. 21 – As volatility resumed since mid-August, issuers have shown creativity in the design of deals aimed at a limited group of speculators looking for high risk/high rewards structures.

While those deals are odd and rare, two recent ones wowed market participants – one with a nearly 50% annualized coupon, the other with a digital payout of 15 times the initial investment with the binary risk of losing nearly all of it.

49% yield

The first deal came out of Morgan Stanley Finance LLC and sold for $3.59 million. The one-year contingent income autocallable notes are tied to Peabody Energy Corp. and pay a monthly coupon of 49.25% per annum if the underlying stock closes at or above its 70% coupon barrier on the related monthly observation date, according to a 424B2 filing with the Securities and Exchange Commission.

The securities will be called automatically on a monthly call date after three months if the stock is greater than or equal to its initial price.

The downside threshold at maturity is 50% of the initial price. If breached, investors will be fully exposed to the decline of the stock.

Not even that wild

“This is really interesting just based on this outrageous coupon. If you get called right away, you get 12.5% in three months,” a market participant said.

“The stock doesn’t even look that wild when you check the chart although it’s down a lot. But still.”

The share price of Peabody Energy, a coal mining company, closed at $21.39 on Wednesday, or nearly 36% off its mid-April 52-week high.

The company runs 17 operations to produce and sell coal in the United States and Australia.

“I don’t know enough about the stock to assess the risk. All I know is that the company operates in the so-called dirty energy sector, which may be going through big changes after the Elections depending on the legislative agenda. At the same time, some countries in Europe have been buying coal due to the shortage of gas. It’s hard to see where the risk is,” he said.

The current implied volatility of the stock was extremely high at 85%, he noted, adding that it was even higher at 110% in the summer. In comparison, Tesla’s implied volatility is 62%, he noted.

“For sure that level of volatility will produce a lot of premium,” he said.

At first glance the short tenor and very high coupon are reminiscent of a reverse convertible, a fashionable structure of the past that has progressively disappeared.

The terms of the notes however were very different from a classic reverse convertible, he said.

“It’s a contingent not a guaranteed coupon and it’s callable. So, I wouldn’t call it a reverse convertible. It’s more of a Phoenix autocall with a huge coupon,” he said.

Risk off

Ken Nuttall, chief investment officer at BlackDiamond Wealth, found the notes “very intriguing.”

“That’s one of the top stocks of last year. The share price more than tripled then,” he said.

“The 50% barrier is pretty good. Both the high coupon and low barrier level reflect the volatility of the stock.”

He said he understood the rationale behind the trade.

“You’re already long the stock. You think maybe it topped out. You want to take some of the risk off. You buy the notes. If the stock drops 50% you lose money, but you already made 50%.”

15 times gain

The second deal, a dual digital structure, was even more peculiar and intriguing, both sources said.

Citigroup Global Markets Holdings Inc. priced $1.05 million of 0% dual digital securities due Feb. 24, 2023 linked to the S&P 500 index and the SPDR Gold trust, according to a 424B2 filing with the Securities and Exchange Commission.

If the final value of each underlier is below its final barrier value, the payout at maturity will be $14,479.32 per $1,000 security. The final barrier value for the index is 90.968% of its initial value, and the final barrier value for the trust is 90.727% of its initial value.

If either underlier finishes at or above its final barrier value, investors will receive a lower digital payout of $234.31 per $1,000 security, representing a 76.569% loss of the initial investment at maturity.

“This has got to me institutional,” said the market participant.

“Who would want such a binary outcome? Sure, I’d like to make 14.5 times my initial investment. But do I want to lose 76% of it? Not really...”

“At least the Peabody with its 50% barrier is a normal structure. This one is really weird. I can’t say I find it appealing. If you’re an institution with the right hedges in place, maybe. Otherwise, I hate to say it, but it really looks like gambling to me.”

Attractive risk-return

Nuttall had the opposite reaction.

“I want this deal,” he said.

“It’s a very asymmetrical trade. I wouldn’t show it to my clients, unless I have someone willing to take a speculative bet for a small amount. But I definitely would do it for my own account for a small amount.

“You put $1,000 in the trade. You either lose $750 or you win $15,000. And it’s a five-month trade. It’s a great risk return. I can only lose 75% but I can make 1,500%.”

He pointed to two of the main risks, the low correlation between the S&P 500 index and the gold ETF on the one hand; and the thin barrier on the other hand.

“But again, the risk-reward is very attractive. This is obviously for someone willing to take on a large amount of risk. You should not bet the house on it. But it’s a pretty good trade,” he said.

Morgan Stanley is the guarantor for the Morgan Stanley autocallable notes.

Morgan Stanley & Co. LLC is the agent.

The notes (Cusip: 61774HDA3) settled on Friday.

The fee is 0.2%.

Citigroup Global Markets Inc. is the agent for the dual digital securities.

Citigroup Inc. is the guarantor.

The notes (Cusip: 17330U249) settled on Wednesday.

The fee is 0%.

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