Morgan Stanley’s PLUS tied to SPDR S&P Oil & Gas designed for aggressively bullish bet on oil

By Emma Trincal

New York, Aug. 7 – Morgan Stanley’s 0% Performance Leveraged Upside Securities due Sept. 12, 2016 linked to the SPDR S&P Oil & Gas Exploration & Production exchange-traded fund offer an above-average level of risk due to high levels of volatility in the oil market, said Tim Vile, structured products analyst at Future Value Consultants.

The payout at maturity will be par of $10 plus three times any ETF gain, up to 30.55% cap. Otherwise, investors will lose 1% for every 1% decline in the share price, according to an FWP filing with the Securities and Exchange Commission.

Vile said that the first notable aspect of the structure is the elevated cap.

“It’s a very aggressive cap for a 13-month product. On a compounded basis, investors get 27.71% return per annum,” he said.

The use of leverage makes it easier for investors to achieve a high return, which is appealing, he said.

“It’s a very impressive cap, especially with the volatility of the underlying, which can move down but also up in wide swings,” he said.

“To reach the cap, the fund would only have to grow by 9.30% a year. The implied volatility of the fund, which is highly correlated to oil, is 40%. With that, you have a very good potential for hitting the cap over a short-term period.”

Risky underlier

As an example of the fund’s ample movement, its price rallied between mid-March and mid-April, and in just 30 days, the price jumped by nearly 20%. Conversely, prices dropped in the second half of June and posted a loss of more than 13% in only 20 days.

Vile looked at the one-year chart. The ETF closed at $37.15 on Friday. The 52-week low and the 52-week high are $36.05 and $79.11, respectively.

“We’re almost half of the high of September. That’s how much the value of the shares dropped in a little bit less than a year,” he said.

“That’s the downside of the trade. The share price can collapse and you don’t have any downside protection. ... You can lose a lot of capital very rapidly.”

From a value standpoint, however, the notes may appeal to some investors noticing that the current price is only one point over the 52-week low.

“But how do you call a bottom? The fund could drop even further. There is always the risk of catching a falling knife,” he added.

Bullish

The underlying used for the notes suggests that the trade is designed as a bullish play on oil. The fund tracks an equity index, the S&P Oil & Gas Exploration & Production Select, which tracks the equity returns of oil and gas companies in the S&P Total Market index.

“The stocks of those oil and gas companies are highly correlated to oil prices. However, you’re not betting on the commodity directly. Using stocks rather than commodities is slightly more defensive,” he said.

While bullish, the note offer an unusual risk-reward profile: they are capped yet unprotected, he noted.

“Most often, the issuer caps a product to introduce some downside protection. Selling the call to cap the upside provides the necessary premium to include a buffer or a barrier.

“With this note, it’s a bit different. You get the cap but not the protection. What you’re getting instead is a much shorter duration than average and a highly levered upside. That’s the trade-off.

“Obviously the note is bullish. It’s bullish because of the full downside exposure. But it’s not extremely bullish because a more aggressive bull would choose a higher cap or even no cap versus the leverage, especially if it’s one-to-one on the downside.

“We end up with a product designed for bulls who want to maximize the odds of hitting the cap. In order to achieve their very short-term goal, they use as much leverage as possible. They’re also comfortable with the risk.”

Future Value Consultants in its research assesses risk, return and price using a variety of proprietary scores in order to compare a product with others. The notes are compared to products of the same structure type – in this case leveraged return. Scores are also measured against all products.

Risk

The firm calculates the market risk and the credit risk and adds the two components to generate the “riskmap,” which measures on a scale of zero to 10 the risk associated with a product with 10 as the highest level of risk possible.

The notes have a 7.14 market riskmap versus an average of 3.15 for the product type, according to Future Value Consultants’ research report.

“Market risk is double the average. It’s not much of a surprise though. ... Having such a highly volatile underlying coupled with the absence of any defense feature makes this product very risky,” he said.

“Only a pretty bullish investor would be willing to take that risk.”

The credit riskmap is 0.38 versus an average of 0.58, the report showed.

“It’s a very short duration for a leveraged note, which really helps the credit score,” he said.

The riskmap is 7.52 versus 3.73 for the average score for products of the same type.

“It’s one of the highest riskmaps we’ve seen recently. However, it’s understandable given the terms and the underlying. You’re getting indirect exposure to oil, and right now oil is in a bear market,” he said.

Crude oil futures have dropped 25% over the past 60 days, meeting the definition of a bear market, which requires a 20% decline.

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments.

At 6.01, the return score is lower than the 7.81 average for the leveraged return category, according to the report.

“It’s actually an impressive result given the huge volatility of oil and the amount of risk. It’s not too bad. The cap is reasonable. The score would have been lower with a less ambitious cap, obviously. This product still gives you high return potential. Say the fund is up 5%; you’re still going to get 15%,” he said.

Value, overall scores

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10.

The price score is 4.97 versus an average of 7.37 for the same product category and 6.89 for all products.

The higher the score, the lower the fees and the greater the value to the investor.

“It’s pretty much 5. Compared to all products and to the product type, it scores poorly. That’s because of the high risk profile. Also it’s only a one-year. Many similar products have much longer maturities, and you’re always doing better on the price scale with a longer-dated note,” he said.

The price score estimates the fees taken per annum. With a longer term, the fees get to be spread out over a longer period of time, which benefits the score, he explained.

“That said, there may not be a lot of deals with a similar profile. For bulls who want to generate high returns in a short amount of time, it may just be the right play,” he said.

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The notes have a 5.49 overall score, compared with an average of 7.59 for the product type and 7.28 for all products.

“The overall score is not great, obviously. But for aggressive bulls with high return expectations and a short-term investment horizon, it’s interesting as long as the risk is taken into consideration.”

Morgan Stanley & Co. LLC is the agent. Morgan Stanley Wealth Management is the distributor.

The notes will settle on Wednesday.

The Cusip number is 61765G879.

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