Morgan Stanley’s $504,000 autocalls on ETFs too risky for income play, advisers say

By Emma Trincal

New York, Jan. 29 – Despite offering a buffer, the $504,000 contingent income autocallable securities due Oct. 27, 2025 issued by Morgan Stanley Finance LLC and linked to the worst performing of the SPDR S&P Biotech ETF, the VanEck Gold Miners ETF and the SPDR S&P Regional Banking ETF were too risky for income-seeking clients, according to two financial advisers. The size of the downside protection, the uncorrelated and volatile nature of the underliers and the short duration were all factors contributing to an excess amount of risk for conservative income investors.

Investors will receive a coupon of 13.1%, paid monthly, if each underlying fund closes at or above its 70% coupon barrier on the related monthly observation date, according to a 424B2 filing with the Securities and Exchange Commission. Previously unpaid coupons will also be paid.

The securities will be called automatically starting July 22, 2024 at par if the price of each underlying fund is greater than or equal to its initial price on any monthly call determination date.

At maturity the payout will be par unless either fund declines by more than its 20% buffer, in which case investors will be exposed to the decline of the worst performing fund beyond the buffer.

Deep barrier preferred

Ken Nuttall, chief investment officer at BlackDiamond Wealth Management, was concerned by the amount of downside protection.

“On the principal, I’d rather have a bigger downside protection. I usually choose a deeper barrier over a buffer.

“If the worst-of is down 30%, you only lose 10% with the 20% buffer, I get that.

“But you won’t lose anything with a 50% barrier.”

Low correlations

He then looked at the correlations between the three underlying ETFs.

The lesser coefficient of correlation was between the VanEck Gold Miners ETF (“GDX”) and SPDR S&P Regional Banking ETF (“KRE”) at -0.04.

The greater was between SPDR S&P Biotech ETF (“XBI”) and KRE at 0.5.

GDX and XBI have a coefficient of 0.13.

“Obviously these three ETFs are poorly correlated, which is expected,” he said.

Coupon barrier

Nuttall did not object to the payout structure.

“The 70% coupon barrier is decent for a 21-month,” he said.

“Having the memory on the coupon is always nice. It helps. But it doesn’t really change the fact that I’d like more protection on my principal.”

Usually, the coupon and principal barriers are the same, he noted.

“Here you have 30% for the coupon barrier but only 20% for the principal at maturity. Even if it’s a buffer, it’s still only 20%,” he said.

Volatile ETFs

The choice of the underliers made the case of a reinforced protection, he added.

“These are probably some of the three riskiest ETFs. They’re all highly volatile,” he said.

The implied volatilities of the ETFs are 32.22% for GDX and 34.47% for KRE. XBI has an implied volatility of 32.66%.

Adding the high volatility factor to the low correlations greatly increased the chances of losses at maturity, he said.

“XBI and KRE could be going up and GDX, fall apart. That’s just an example,” he said.

In order to consider investing in a worst-of income note tied to those three ETFs, Nuttall would need to see a 50% to 60% barrier at maturity.

“Obviously you would get a lower coupon. But investors buying those notes are more interested in preserving their principal than stretching for yield,” he said.

Too short

Jerry Verseput, president of Veripax Wealth Management, pointed to the short tenor as a major risk factor given the three underlying ETFs.

“It’s only one year and nine months. Regardless of the protection, I wouldn’t care for this note anyway,” he said.

The memory feature did not contribute to bringing more safety into the mix.

“It’s just such a short note, it doesn’t really make a difference,” he said.

Even if investors succeeded in accumulating some coupon payments, the protection would remain limited, he added.

“The safety of a note is a combination of its length and depth of the barrier.

“The longer a note, the more likely the underlying is to go up because markets do go up over time.

“But over one year and nine months, anything can happen,” he said.

A better deal

Verseput said he recently bought some of Citigroup Global Markets Holdings Inc.’s three-year callable notes linked to the VanEck Vectors Gold Miners ETF alone. The coupon of 12% per annum, which is also payable monthly, is based on a 60% coupon barrier. The notes are issuer callable monthly after six months. The barrier at maturity is also 60%.

“I look at that. It’s only one underlying. It pays 12%. Why would I do the other one for 1.1% more?” he said.

The use of a worst-of on uncorrelated assets significantly increased the risk, he noted.

“If GDX goes up, there’s a higher probability that one of the other won’t or go down.

“I would prefer to have correlated underlying so that I have some level of predictability,” he said.

The low correlation is supposed to give investors better terms.

“Yet, the coupon and the buffer aren’t great,” he said.

Margin of safety

“When you buy one of those autocalls, presumably what you want is income. You want as little chance as possible of losing money. With this type of worst-of, you stand a pretty good chance of one of these things being down more than 20%. It doesn’t make any investment sense,” he said.

The callability in general was not a problem for this adviser.

“You have to put up with the call. I’m not too worried about it. If it gets called, you do it again.

“If you want a decent income, you have to allow the note to be called,” he said.

Among the three ETFs, Verseput said his favorite was the VanEck Vectors Gold Miners.

“GDX is 38% off its high point. I like the note we did because it pays 12% and you have a 40% margin of safety on something that’s reasonably valued.

“I’m hoping it falls a little bit, and then kind of goes flat. Now is a good time to buy GDX,” he said.

The worst-of notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes (Cusip: 61771WPY8) settled on Jan. 25.

The fee is 0%.

The Cusip number for the Citigroup notes on GDX is 17291TSH2.

The issue date was Jan. 19 and the fee, 0.25%.

© 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.