Morgan Stanley’s $6.42 million worst-of notes tied to Canadian bank stocks focus on correlation

By Emma Trincal

New York, March 25 – Morgan Stanley’s $6.24 million of contingent income autocallable securities due March 26, 2018 linked to the worst performing of the common shares of Bank of Montreal, Toronto-Dominion Bank and Royal Bank of Canada have an unusual underlying given the concentration of three stocks in the same country and sector, sources said.

The notes have a worst-of structure with an autocallable feature.

They pay each month a contingent coupon at an annual rate of 8% if each stock closes at or above its downside threshold level, 75% of its initial share price, on the determination date for that month, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be redeemed at par plus the contingent coupon if each stock closes at or above its initial share price on any quarterly determination date.

If the notes are not called and each stock finishes at or above its downside threshold level, the payout at maturity will be par plus the contingent coupon. Otherwise, investors will be fully exposed to the decline of the worst-performing stock.

Three Canadian banks

“What’s unusual here is not the three stocks. A lot of worst-of deals are based on single stocks. What’s a bit different is the concentration around Canadian banks,” a market participant said.

According to data compiled by Prospect News, worst-of notes tend to be linked to the following underliers: two indexes and one exchange-traded fund; three indexes; three stocks; three baskets representing different asset class components; and sometimes very different assets such as gold and a currency exchange rate.

In the past, some deals have been structured around three U.S. financial stocks or two or three U.S. technology stocks. But the use of Canadian bank stocks is very unusual, sources said.

“I don’t think I’ve seen this before. First Canada, then bank stocks. That’s interesting,” a sellsider said.

“At first you would think that Canadian banks are doing well. But maybe there is a little bit of volatility that goes on that gives you a little bit of a coupon.”

Correlation

A market participant agreed.

“We tend to be a little bit bearish on Canadian stocks given the levels of oil. Canadian banks have provided leveraged loans to energy companies, and they’re not receiving the income they were expecting,” he said.

“From a macro perspective, it doesn’t sound like such a great trade. There’s definitely some risk.”

Worst-of structures are usually employed to bump up the coupon since it takes three underliers to meet the coupon condition while it only takes one of the three to breach the barrier. One factor lessening the risk of the notes is the high correlation between the three Canadian bank stocks.

“I don’t know if the 8% coupon is high or not. I would have to price it first. But the correlation is a good thing for the noteholder in this case. With a worst-of, investors are long correlation. The higher the correlation, the greater the probability that you’re not going to breach the barrier,” he said.

Oil exposure

Dan Werner, a senior equity analyst at Morningstar who covers Canadian bank stocks, said that Canadian bank stocks are not known for their volatility.

“They’re probably part of every single manager’s portfolio simply because they pay fairly high dividends ... anywhere between 3.5% and 5%,” Werner said.

He downplayed the impact of falling oil prices on Canadian banks’ balance sheets.

“Until the oil sell-off recently those stocks weren’t that much volatile. Most investors worried about Canadian banks’ balance sheets as energy is a portion of their loan portfolio. But their exposure to oil appeared to be limited overall from what they disclosed so far,” he said.

He said that RBC is believed to be among the most exposed to oil.

“But their loan portfolio is very diversified and oil exposure not that big at all,” he said.

Oil and gas loans represented 1.5% of the portfolio in the first quarter of 2015, according to a company slide.

The notes (Cusip: 61761JXS3) priced on March 20.

Morgan Stanley & Co. LLC was the agent.

The fee was 3%.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.