Morgan Stanley’s step-up autocall on SPDR S&P Bank, Russell to ‘double down’ on political risk

By Emma Trincal

New York, Jan. 24 – Morgan Stanley Finance LLC’s plan to price autocallable step-up notes due Jan. 29, 2019 linked to the worse performing of the SPDR S&P Bank exchange-traded fund and the Russell 2000 index offer compelling yields, but advisors objected to the payout structure as well as the timing of the investment.

The notes will be called at par of $10 plus an annualized call premium of 12.6% if each underlying component closes at or above the initial level on any of the first three semiannual determination dates, according to a 424B2 filing with the Securities and Exchange Commission.

If each underlying component finishes above its initial level, the payout at maturity will be at least 25.2%.

If either component falls but each component finishes above its 70% downside threshold, the payout will be 5%.

Otherwise, investors will be fully exposed to any losses of the worse-performing component.

Yield

“In general, I’m not a big fan of the worst-of. It puts a negative tone on the investment,” said Kirk Chisholm, wealth manager and principal at Innovative Advisory Group.

“It’s hard for investors to get excited about investing in the worst performing index.”

But a mildly bullish investor could consider the product.

“The performance for the two-year, 25.2%, you’re looking at 12.6% a year is still attractive. If you feel this market is going to be flat, it’s attractive,” he said.

When all underlying assets in a typical worst-of deal finish negative, yet above the barrier level, investors as a general rule receive their principal back and nothing more. This note is relatively different: if such a scenario occurs, investors receive a small coupon.

“Getting that 5% on the downside is also attractive,” he said.

“The numbers are reasonable. It’s the worst-of payout that makes it particularly challenging.”

Correlation

If the two underlying correlate, the potential negative outcome of the worst-of payout may be reduced, according to the prospectus, which emphasizes the risk of low or negative correlation.

“The bank ETF and small caps are somewhat interlinked. They’re relatively correlated, which is a good thing,” he said.

Unpredictable environment

But such positive items – high yield and fair correlation – did not offset the risk and the difficulty associated with the sale of those products, making the notes non-eligible for his portfolio.

With a new presidency just beginning, predictions were difficult to make, he said.

“It’s been two days only that we have this new Administration. It’s hard to say what’s going to happen in two years,” he said.

“We don’t have any idea.

“If rates go up, financials should do well. The Russell should do well too if there is a nationalistic economic policy. That should cause small-caps, which are primarily domestic-based businesses, to do reasonably well.

“But there is a lot of unknown, which makes it hard to predict anything.

Overall, his main objection was the worst-of as a concept.

“Try to sell that to investors. It’s not a very attractive marketing pitch,” he said.

Political risk

Jonathan Tiemann, president of Tiemann Investment Advisors, argued that he did not like the timing of the notes because the new president, Donald Trump, was still too new to be tested.

“We have a new Administration with new policies. It might work. If it doesn’t work, the economy could fall off the cliff. Please note that I’m not saying that’s what’s going to happen, but that’s the risk,” he said.

Tiemann said he would not consider the notes. But if he did, he would hope to see his investment called as early as possible. A call on the first observation date would generate a 6.3% return in just six months with no risk left in the trade since the notes would be redeemed early.

Limiting the risk exposure in time was probably one of the best outcomes, he said.

Tiemann said that the market awaiting new economic policies created a lot of uncertainty, hence a new political risk that needed to be hedged.

“The problem with this deal is that your risk has exactly the same shape as the political risk that comes with Donald Trump,” he said.

“The market response to the new Administration policy could be an uptrend that would turn out to be a sugar high followed by a crash later on. That’s the scenario to worry about.”

Hedging

Asked what he would do to protect himself against the uncertainty, he said that he would rather take the “other side” of the deal.

“I’d rather be hedging the risk than doubling down on it,” he said.

“I would be more comfortable hedging, taking the other side of the bet. I risk paying the high coupon. If I don’t, I either pay in two years a very small coupon or I make big gains.”

Tiemann said he was concerned that the market would initially rise as it did in the wake of the Elections but that disappointing economic results would lead to slower economic growth and a market pullback later on.

Inflationary pressures as well as job losses due to automation were among his biggest concerns.

“I’m not saying it will happen, but if it does, we won’t see it right away. That’s why I think the negative economic results could coincide with the maturity of the notes. In two years, if the market crashes, you don’t want to be in this note. You’d be taking unlimited risk for a limited return.”

“I don’t really like it,” he said.

Morgan Stanley & Co. LLC is the agent.

The notes are guaranteed by Morgan Stanley.

The notes will settle on Jan. 27.

The Cusip number is 61768CEC7.

© 2015 Prospect News.
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