Morgan Stanley’s $18.46 million autocalls on Tesla to deliver high yield, targeted bearish bet

By Emma Trincal

New York, Feb. 2 – Morgan Stanley Finance LLC’s $18.46 million of contingent income autocallable securities due Jan. 25, 2024 linked to the common stock of Tesla, Inc. are not for the faint of heart. But rather than seeing the notes as mere sources of income, one adviser suggested it could be used as a mildly bearish bet for investors concerned about the rich valuation of the underlying.

Each quarter, the notes pay a contingent coupon at an annualized rate of 23% if the stock closes at or above its downside threshold level, 50% of its initial share price, on the observation date that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be automatically called at par of $10 if the stock closes at or above its initial share price on any quarterly observation date other than the final date.

If the stock finishes at or above the downside threshold level, the payout at maturity will be par plus the contingent coupon. Otherwise, investors will lose 1% for every 1% that the stock declines from its initial share price.

The initial price of Tesla was $864.64 when the notes priced earlier this month, setting the downside threshold and the coupon barrier levels at a price of $423.32 a share.

High-flyer

Donald McCoy, financial adviser at Planners Financial Services, pointed to the volatility of the underlying stock. From its $70 low in March to a $900 high in Jan. 25, the stock has increased by nearly 13 times. In just the last three months, the share price has already gained 14%.

On Tuesday, news at the open reporting a recall of 135,000 Model S and Model X vehicles due to touch-screen failures did not stop Tesla’s share price from rising.

It closed the session at $872.79, up nearly 4%.

Downside risk

Yet it was not so long ago that the stock hit the $423 barrier level and fell even lower, McCoy noticed.

He pointed to a $379 price at the end of October.

“There’s no reason the stock couldn’t go back to this level given how valued it is,” he said.

Morningstar has a fair value price of $306, he noted.

“We’re well above that. Even a 50% decline from today’s price is well above that,” he said.

“When you put together the rich valuation, the high degree of uncertainty and the potential for extreme market volatility due to outside circumstances out of Tesla’s control like last week’s short squeeze on GameStop, Tesla could easily trace back to the low 400s.

“So, I probably wouldn’t use it as an income play.”

Short-term interest

Investors seeking income are likely to be called in three months and pocket the 5.75% return, or the 11.5% gain in a call after six months, he said.

“There is of course the risk of losing at least 50% of your money and in theory, 100% of it. If you’re not called, you run the risk of missing some payments if the stock is down by more than half. But it’s not a death blow because you have three years to recover,” he said.

Still, income should be a short-term goal.

“The way the stock is moving, you’re not going to earn your coupon for very long. It wouldn’t make sense to use it as an expected source of income,” he said.

Slightly bearish

However, McCoy found an alternative use of the notes, which may be suitable for investors concerned about the wild run of the stock.

Sometimes, excessive valuations boost short interest. But shorting Tesla could be a dangerous sport, he said.

Less than 6% of the outstanding shares of Tesla correspond to short trades as of Jan. 15.

“It doesn’t make a lot of sense to short Tesla right now. Too much risk,” he said.

The risk is even more obvious now considering last week’s short squeeze around GameStop, which saw a few hedge funds short the stock getting crushed by a crowd or retail investors using leverage, he added.

“Maybe this note makes sense if you think Tesla is overvalued but also that it’s not going to crash.

“You’re getting paid to hold the position. At least you have the potential to earn something in the interim if it drops even a lot, as long as it doesn’t drop more than 50%.

“By doing it this way, you can bet the stock will go down without taking the inherent risk of shorting.

“In that regard, it’s not a bad strategy,” he said.

Overvalued

Tom Balcom, founder of 1650 Wealth Management, said the notes offered a high coupon for a reason.

“23% is a pretty juicy yield. Worst-case scenario, the stock pulls back, and you lose some of your principal,” he said.

If one had to imagine how the stock could pull back 50%, it wouldn’t be the work of short sellers, he said.

“The stock is surging so fast. You short it and you get burned pretty badly.”

But it was not necessarily the best timing to be long the shares at this time.

“It keeps on going up. Valuations don’t matter with some stocks lately. People love the name. It doesn’t make sense. Personally, I would probably not buy at these levels,” he said.

Competition

Balcom saw the risk in the fundamentals of the company.

“Right now, they’re the top electric car company. But others like GM, Ford, Toyota are starting to compete with them. There will be more of a risk when Tesla is no longer the only game in town,” he said.

Allocation

“It’s 23% a year versus 1% for a 10-year Treasury. That’s what they’re paying you. You’ve got to have some risk when you get paid such a high return,” he said.

“If you’re willing to take on that risk, you could end up with nearly 6% in return after three months.

“I think that’s what people are looking for.”

One issue with autocallable contingent coupon notes paying equity-like returns is how to position them in the portfolio, he said.

“It’s a healthy gain even for equity. But it’s an income product. Where do you put it? In your equity portfolio? Your fixed income? It’s not easy to tell. If it’s not called, you then run the risk of losing money at the end of the term. What do you tell your clients?”

Tesla notional

Tesla was founded in 2003 as Tesla Motors.

There have been 390 structured notes deals based on the single stock totaling $1.33 billion since 2004, according to data compiled by Prospect News going back to 2004.

The notes, which settled on Jan. 27, are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent with Morgan Stanley Wealth Management as selected dealer.

The Cusip number is 61771J594.

The fee is 2.5%.

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