Morgan Stanley’s $23.3 million notes on Topix to miss the FX leg of the trade, contrarian says

By Emma Trincal

New York, Dec. 8 – Morgan Stanley Finance LLC’s $23.3 million of 0% trigger jump securities due Dec. 4, 2028 linked to the Tokyo Stock Price index give investors exposure to the Japanese stock market, but not to the Japanese yen, which may be detrimental to investors, said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

If the return of the index is zero or positive, the payout at maturity will be par plus the greater of the index return and 70%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index declines but finishes at or above the 60% trigger level and will lose 1% for every 1% that the index declines if it finishes below the trigger level.

Weak yen

“Anyone investing in Japan is making a currency bet,” said Kaplan.

“The Japanese equity market is becoming overvalued again. But the yen is very depressed.”

Japan is one of the cheapest countries in the world for tourists and it has also become a destination for American retirees, he added.

“In this particular trade, the stock market is not the primary factor. The primary factor is the yen.”

The Japanese yen has been weakening against the U.S. dollar for more than a decade, he said.

“Its value against the U.S. dollar is half of its high point in 2012.”

Buyers of international equity ETFs will typically incur currency exposure, which may either benefit them or adversely impact them, he explained.

Quanto

When the U.S. dollar strengthens, U.S. investors see their returns diminish. That’s because the weaker foreign currency will buy fewer dollars and the shares are worth less when converted. The exchange rate will also trim the value of the dividends paid in the foreign currency. This is called currency risk.

But U.S. investors in structured notes linked to foreign indexes are not impacted by that risk because issuers hedge it using “quanto” options.

The investment is “currency neutral.”

Quanto on the other hand suppresses the additional gains noteholders would receive if the Japanese yen appreciated against the U.S. dollar.

Yen bull

“That’s a big problem,” said Kaplan. “The yen is so undervalued. It’s likely to go up a lot. It has actually begun to rise. And you won’t benefit from that. You will certainty underperform the index fund.”

He offered an example.

If in five years the yen was to rise 40% but the Topix remained flat, investors in an equity ETF would get a 40% return but noteholders would earn nothing.

“The yen is so undervalued that most of the gains you could expect would come from the currency, not equities,” he said.

Japanese equities

For Kaplan, the Japanese stock market is “not a bargain” but not excessively overpriced either.

“I wouldn’t short the Japanese stock market. I wouldn’t buy it either,” he said.

The main risk for Japan is the same as it is in all other countries.

“The problem with the Japanese stock market is not Japan. It’s the U.S. The stock market in the U.S. is the most overvalued in the world. The burst of the AI bubble in the U.S. will have devastating effects on a global scale,” he said.

A stronger yen could also impact the stock market.

“As the yen appreciates, the Japanese economy, which depends a lot on exports, will suffer. I can see Japanese stocks going down while the yen goes up. If you’re in an index fund with exchange rate exposure, you win. If your currency exposure is hedged, you lose,” he said.

For instance, if the yen rose 50% and the Topix dropped 10%, ETF holders would net 40%, but investors in the notes would suffer a 10% loss.

“The fact that the note is currency neutral will destroy your gains,” he said.

The wrong bet

The only reason to buy the notes, he said, is if one expects the yen to fall even further than it already has.

For Kaplan, who is bullish on the yen, the note would not be an attractive investment.

“The note is competing against the ETF. The only reason to buy the note is if you expect the yen to be down.”

“I don’t think this is a very likely scenario,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on Dec. 4.

The Cusip number is 61775MD52.

The fee is 3.5%.

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