Morgan Stanley’s worst-of autocallable RevCons on three stocks offer innovative structure

By Emma Trincal

New York, Jan. 8 – Morgan Stanley Finance LLC’s 7% to 8.2% worst-of fixed coupon autocallable RevCons due July 15, 2021 linked to the worst performing of the shares of Chevron Corp., Walt Disney Co. and Newmont Mining Corp. combine several features making the structure different from most of its peers, sources said.

First, the notes akin to traditional reverse convertibles pay a guaranteed coupon payable quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

Second, the automatic call steps down. The notes are automatically called after six months on a quarterly basis.

But the call trigger starts at 95% of the initial price on the first call date then falls by 5% every quarter to 80% on the final determination date.

Finally, the repayment of principal is determined by the performance of the worst-performing underlying.

But those are single-stocks, not indexes.

If each stock finishes at or above the 70% downside threshold level, the payout at maturity will be par plus the final coupon. Otherwise, investors will receive a number of shares of the worst performing stock equal to $1,000 divided by the initial price of that stock or, at the issuer’s option, the cash value of those shares.

“It’s an interesting structure,” said Matt Rosenberg, sales trader at Halo Investing, noticing the fixed rate and the step-down.

“I like it.”

Correlation

Two factors are at play, he noted. One increases the risk of market losses; the other limits it.

The risk came for the most part from the choice of the underlying assets.

“While Newmont and Chevron may relate to the tensions with Iran as gold is a safe haven and Chevron is correlated to oil, I still can’t think of an investment theme prompting you to link those three names together,” he said.

On the other hand, the stepping down of the call threshold makes the call more likely.

Step-down

“The step-down is for investors who want to increase their chance of being called and don’t mind getting only a fraction of the coupon,” he said.

“Yes, you might only get two coupons, but 3.5% in six months is appealing.”

The feature represents a tradeoff between reinvestment risk and market risk.

Easy calls

“Step-down autocalls are in vogue because most investors want to be called,” he said.

“As the chances of being called increase, you’re more likely to get your money back.

“Brokers like it too and, in that case, their interest is aligned with the client’s.”

The step-down trend has been seen among offshore clients through Regulation S and privately placed offerings, he said.

“We also see step-ups with calls at 105%,” he said.

Those function the opposite way.

“It’s harder to get called so there’s more downside risk. That’s how they pay a better yield.”

Unusual structure

The Morgan Stanley deal, by combining a short maturity, a worst-of barrier on three uncorrelated stocks and a step-down autocall, offered an unusual mix.

“This note is not something you see every day,” he said.

“It’s more tactically driven.

“It’s a higher-risk investment because of the three stocks. But the step-down, making the call a little bit more achievable, mitigates some of the risk.”

While it’s hard to tell how much market risk can be mitigated, there has to be enough of it left to give the issuer the necessary premium to price a guaranteed coupon over a short maturity.

Most coupons are paid on a contingency basis nowadays unlike a few years ago when very short-term reverse convertibles tied to a volatile stock inundated the market, data compiled by Prospect News showed.

“The low correlation between the three stocks is what gives the issuer the ability to offer the fixed rate,” he said.

Allocation

Jerry Verseput, president of Veripax Financial Management, focused on the risk associated with the structure. The low correlation but also the nature of the underlying assets brought a significant amount of risk.

“These are three names in three completely different sectors with not much correlation,” he said.

“I don’t like messing up with individual stocks.

“Any of those stocks could be losing 30% at the end of 18 months.

“I don’t know how this would fit into a portfolio.”

“If we’re looking at an individual investor who wouldn’t mind owning these stocks and take the risk, that’s one thing. But as an adviser, I’m not sure. It’s just too esoteric.”

Stocks versus indexes

The use of stocks gives issuers more flexibility to price the deal.

“They’re getting more premium selling puts on single names, which is why you get the fixed coupon,” he said.

But Verseput added that he prefers to buy worst-of autocallables linked to broad-based indexes.

He gave the example of a recent bespoke trade he did with Barclays Bank plc.

The six-year paper is linked to the worst of the Dow Jones industrial average and the Nasdaq-100 index. The 8.3% contingent coupon is based on a 70% barrier. At maturity, the repayment barrier is set at 60%.

Tax strategy

Verseput also likes step-down autocalls but uses them in a different way.

“I do long-term autocalls that pay a lump sum. That way your return gets long-term capital gains tax treatment. We cut a huge chunk of risk by linking the notes to indices. And we add the step-down to increase the odds of getting out. That way, we don’t miss out if the market has higher returns.”

He was referring to snowballs, a form of autocallable product which pays a cumulative premium upon the call, not a coupon during the life.

“I like the step-down on a longer-dated note. It increases the chances of getting called in the middle so I can grab my return.

“I’m not sure what to make of that on an 18-month note,” he said.

Risk-return

One of the main challenges with structured notes paying income or premium is to assess the risk in order to decide if they should fit into a fixed-income allocation or equity bucket.

“If I want income, I would go with the contingency notes on indices,” he said.

“I’m not sure what role this note plays.

“You keep it for six months and you made 4%. What does it do for you? You have to find something else.

“I think the risk is disproportionate to the potential gain.

“If you need income, you don’t want that much market risk.

“And if you want growth, this note doesn’t offer enough upside to justify taking on that risk.”

The notes will be guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes were scheduled to price on Jan. 8 and settle on Jan. 15.

The Cusip number is 61770FCK0.

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