Morgan Stanley’s trigger absolute return digitals on S&P 500 target prudent investors

By Emma Trincal

New York, Sept. 21 – Morgan Stanley Finance LLC’s 0% trigger absolute return digital securities due Oct. 11, 2023 linked to the S&P 500 index are designed to mitigate risk while increasing the odds of making money, said Suzi Hampson, head of research at Future Value Consultants.

If the index finishes at or above its initial level, the payout at maturity will be par plus the digital return, which is expected to be 40% to 44% and will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the index falls but finishes at or above the 65% downside threshold, the payout will be par plus the absolute value of the return.

Otherwise, investors will be fully exposed to any losses.

Digital advantage

Hampson said that absolute return notes offering participation was more common than digital absolute return notes, such as this one.

“When you have a growth product with absolute return, there is a conflict because you need the volatility to move the underlying upward yet you certainly don’t want the volatility to push it down too far,” she said.

“This one, because it’s a digital, is different. You don’t need the volatility. Even if the index is flat you get your fixed payout.”

Sideways market

The note is well-adapted to markets trading range bound.

“It makes a little bit more sense. If you don’t think the index is going to move much you can benefit from this structure and get quite a decent return in five years,” she said.

She picked for the digital return the midpoint of the range at 42% in order to run her analysis.

“That’s 8.5% per year. It’s not that high. But it’s pretty compelling knowing that you don’t need the growth in the underlying index plus you get a 65% barrier and a positive return if you don’t breach it.”

A 35% contingent protection even over a five-year term was “quite generous,” she said, at least for the U.S. markets.

Investors in this note, given the digital payout, should anticipate volatility to stay low, she said.

Straightforward structure

Future Value Consultants offers stress testing on structured notes as a service to its clients allowing them to determine the probabilities of occurrence of outcomes pertaining to a specific product and structure type.

Each report contains a total of 29 sections or tests, which encompass simulation tables as well as back testing analysis. They can be customized in any combination.

The structure for this product, unlike an autocallable contingent coupon for instance, is relatively simple.

Only two possible outcomes exist. Either investors get a positive return or the barrier is breached and they lose some of their initial investment.

Probabilities of gains

The probabilities for a positive return are 86.52% versus 13.48% for the chances of losses, according to the investor scorecard, which is one of the report’s tables. Since investors can earn a positive return if the index is down by less than 35%, the outcome in which investors would only receive par back has a 0% probability of happening, she explained.

“The 86.52% probability does not give you the breakdown between what you earn on the downside as an absolute return and the fixed return that comes from the digital on the upside,” she said.

Hedge feature

But another table called “product specific tests” provides a way to make the distinction by showing the probability of receiving the digital only, which is 62.18%.

By subtracting this figure from the 86.52% probability of all gains, one finds for the gains induced by the absolute return feature a 24.24% probability.

“You get to make money from the downside a quarter of the time, which is not insignificant,” she said.

“It offers value as it can work as a hedge.”

Other market scenarios

Another test – the capital performance table – displays the same outcome but broken down by market scenarios. While the prior tables were based on a “neutral scenario,” Future Value Consultants also provides four different market assumptions. Those are: bull, bear, more volatile and less volatile.

While the chances of getting a positive return under the neutral scenario is 86.52% it becomes as high as 96.22% in the bull market. The odds of gaining drop to 70.63% under the bear market scenario.

Future Value Consultants uses muted hypothetical growth and volatility assumptions to run its model as part of its methodology.

Average payoffs

Another table – the capital performance tests – displays average payoffs by outcome and market types.

The “return less than capital” bucket shows an average loss of 58% under the neutral assumption.

“It’s quite bad, but it’s also the result of the barrier being so low. Once it breaches you are by definition going to lose at least 35%,” she said.

Under the bear scenario, the average loss increases to 63.1% but it drops to 53.5% in the bullish environment.

“These average loss figures are quite drastic.

“At the same time, you are not likely to lose principal with this type of product although the results differ based on the market scenario,” she said.

In the bear market, there is a 29.37% chance of getting less than principal at maturity, which contrasts with the 13.48% probability seen under neutral conditions, according to the capital performance tests. However, there is only a 3.78% chance of losing money in the bull scenario.

Risk-return profile

“The probabilities of losses are pretty low. This in a way offsets the amount of losses when the barrier is breached. It’s quite a deep barrier, which is why it doesn’t get breached easily,” she said.

Because the return is moderate as well as the chances of losing money, this product can be categorized as relatively defensive, she said.

Future Value Consultants aside from its Monte Carlo simulation also provides back testing in each of its reports.

The product shows a high frequency of success, at or close to a rate of 100% in terms of generating a positive return.

For instance, over the past five years the probability for the “return more than principal” bucket is 100%. It drops imperceptibly to 99.68% over the past 10 years and to 99.79% over the last 15.

“This note would have performed very well in this bull market even going back to the years of the financial crisis,” she said.

From a simulation standpoint, the notes offer a lower chance of losses along with modest returns.

“This product is not for the return-chasing type. The digital payout isn’t huge. Everything has a defensive edge,” she said.

“The barrier is deep. The maximum return is small. But you can make money on the downside. It’s a product that targets conservative investors.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC and UBS Financial Services Inc. are the agents.

The notes will price on Oct. 5 and settle on Oct. 10.

The Cusip number is 61768T225.

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