Morgan Stanley’s leveraged buffered notes linked to fund basket offer diversification, hedge

By Emma Trincal

New York, Aug. 10 – Morgan Stanley’s leveraged capped notes due March 3, 2020 linked to a basket of exchange-traded funds are seen as a “reasonable” diversification tool for investors who wish to have longer-term exposure to equities with the benefit of leverage on the upside and protection on the downside, sources said.

The basket consists of the SPDR S&P 500 ETF Trust with a 50% weight, the iShares Russell 2000 ETF with a 15% weight, the iShares MSCI EAFE ETF with a 15% weight, the iShares MSCI Emerging Markets ETF with a 10% weight, the PowerShares DB Commodity Index Tracking Fund with a 5% weight and the Vanguard REIT ETF with a 5% weight, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 150% of any basket gain, up to a cap that is expected to be 45% to 50% and will be set at pricing. Investors will receive par if the basket falls by up to 10% and will lose 1% for every 1% decline beyond 10%.

Barriers

Andrew Valentine Pool, main trader at Regatta Research & Money Management, said he likes the general profile of the notes but would need more protection given the length of the term.

“From very early on, we’ve been looking for downside protection on most of our deals. At first we wanted standard buffers only, but we’ve moved toward the use of barriers when they provide a deeper protection,” said Pool.

“While the note sounds like a good investment for diversification, we would probably like a bigger buffer or a deeper barrier. If not, we would have to use it for a smaller position.”

Recent deals

Pool said that the last two deals his firm purchased had contingent buffers.

“There were barriers, not buffers. But the protection was much deeper,” he said.

One of the products was a four-year note linked to the S&P 500 index with 1.1x upside leverage up to a 50% cap. There was a final barrier on the downside at 70% of the initial index level. If the index fell by less than 30%, investors received the absolute return within the 30% decline range. Beyond the barrier threshold, the risk exposure was 100%, he said.

The second security was a three-year worst-of dual directional note on the S&P 500 and the Russell 2000 index. The 1.1x upside leverage multiple and the absolute return offered above the 70% barrier were identical to the other product, but the upside gains were uncapped.

“We want deeper protection. The buffers that we were looking for about a year ago just don’t seem to be enough for us anymore. If getting more protection means contingent protection, so be it. We’ve been moving away from small buffers toward deeper barriers,” he said.

“The notes offer good terms otherwise. But the protection matters a lot to us. Not that we expect another 2008. We don’t. But for that type of timeframe ... if we happen to have an economic downturn, the 15% buffer may not be enough.”

Diversification

The notes do a good job of offering a diversified exposure to equities and even to commodities and real estate to some degree, he said.

“The notes tied to diversified baskets are useful. We don’t see that many out there, and for some advisers it could be a good fit. I like that they’re trying to offer these products because it gives opportunities to advisers,” he said.

However, Pool said his firm tends not to use basket-linked notes very much.

“This would be our main reason not to consider the notes. The basket is well-diversified, but we diversify ourselves,” he said.

“It’s somewhat complicated to allocate these types of notes and to decide where to put them. You have U.S. equities, developed countries, REITs, commodities. ... Which bucket do you choose?”

Other buysiders may not be predisposed to use this investment simply because of their market outlook.

The diversified basket and the terms of the notes are “decent,” said Kirk Chisholm, wealth manager and principal at Innovative Advisory Group. But he said that he is cautious about equities at this point in the market cycle.

“The allocation is fine. The basket of ETFs is historically sound,” he said.

“If you’re looking at equities, it’s a reasonable, diversified basket.”

Terms

“It’s also fine as an investment strategy. You’re getting a cap in the 8.5% to 9.5% range annually for the next four and a half years. In the current market, it would be a bit of a stretch to get that from a long-only position,” he said.

“The 15% buffer is a nice feature, perhaps the most attractive feature, especially with a 50% allocation to the S&P.”

Chisholm noted that investors’ exposure to U.S. assets is 70% including REITs.

The Vanguard REIT ETF tracks the return of the MSCI U.S. REIT index, a gauge of real estate stocks.

“Right now, U.S. stocks are a bit overvalued,” he said.

But the notes could make sense for a number of investors who may seek to hedge their existing positions.

“If you need allocation to equities, it’s a nice way to get the exposure. ... It’s the preferable way to play it.

“The benefits are quite straightforward: you get the protection and the upside advantage in a market which in my opinion has very little upside left. The leverage is very favorable over the course of four and a half years.”

Equity outlook

However, Chisholm said he would not use the notes despite the attractiveness of the terms and underlying basket.

“I’m just not a fan of equities at the moment. Even though I like the protection, I wouldn’t want to be in equity anyway,” he said.

“Four and a half years is a long time. We have a presidential election and a lot of potential risks, including the chances of a correction.

“We’ve reduced our overall equity exposure. Whatever we have in equities, we do hedge at the moment so if there is a sell-off, we would be making up on the downside.”

But for some clients who already have equity exposure, the notes could come in handy.

“I would see it as a substitute. If I had a client with an equity allocation made of a certain percentage in the S&P and other ETFs, similar to what’s in the basket, I would use it as a substitute. It would not be adding to an existing portfolio. It would be a substitute, like a hedge on a portion of the equity allocation.”

Morgan Stanley & Co. LLC and Wells Fargo Securities LLC are the agents.

The notes will price on Aug. 31 and settle on Sept. 3.

The Cusip number is 61761JF53.

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