Morgan Stanley's contingent income autocallables tied to S&P 500 are long-term only on paper

By Emma Trincal

New York, Nov. 19 - Morgan Stanley's contingent income autocallable securities due Nov. 30, 2022 linked to the S&P 500 index target income-seekers with a short-term bias despite the 10-year duration given the fact that the autocallable feature makes an early exit scenario very likely to occur, sources said.

Investors in the notes get an opportunity to earn a 6.5% annualized return, but the coupon and the duration of the notes are not guaranteed. And while principal is at risk at maturity, sources said that the greater issue for investors by far should be reinvestment risk.

The notes will pay a contingent monthly payment at an annualized rate of 6.5% if the index closes at or above the barrier level of 690 on the determination date for that month, according to a 424B2 filing with the Securities and Exchange Commission.

If the index closes at or above the initial level on any quarterly call date beginning November 2013, the notes will be called at par plus the contingent coupon.

If the index finishes at or above the barrier level, the payout at maturity will be par plus the contingent quarterly payment.

Otherwise, investors will be fully exposed to any losses.

No long-term income

Carl Kunhardt, wealth advisor at Quest Capital Management, said that he would not be interested in the notes because a highly probable early call would deprive investors from the potential income stream they tend to rely on.

"I wouldn't go near that note in a hundred years. There is no way you're going to get full coupon payment for 10 years," he said.

The conditions for early redemption are easy to meet, said Kunhardt.

"All it takes is for the benchmark to be flat in a given quarter," he said.

"I'm never going to hold this note for 10 years. This is not a 10-year paper."

The notes are not callable on the first year, but this call protection feature makes "little difference," he said because investors are still uncertain about the duration and the final coupon payment associated with their investment.

"You are likely to be called on the first call date. You're not going to collect the coupon for 10 years. At the same time, you could be stuck. You don't control any of this," he said.

"I would rather be in a bond, something where I know it's not going to be short-term and I'm getting my full coupon payment. At least with a bond, I can sell easily. I am not stuck," he said.

While the notes have a long-term tenor, they are not suitable for the buy-and-hold investor, he said, because the odds of collecting the coupon without being called over the long period of time are very slim.

"The only way it would work would be if you're in a mildly bearish scenario. In order to pick up the coupon without the early exit you would have to be down every month a little bit and not be up on any of these quarters. It seems hard to imagine.

"Think about it: What are the odds that, quarter after quarter, you're not going to be at the initial price or higher?"

Kunhardt said that the risk of losing principal at maturity was not as much of an issue although investors should always consider this possibility.

He assumed an initial price for the S&P 500 of 1380. In this hypothetical scenario, the 690 downside threshold would represent a 50% barrier.

"Imagine a scenario where you lose 5% every year for 10 years. At maturity, you've hit the barrier: you're down 50%. But you've gained 65% in 10 years from your coupon. So net, you end up with a 15% gain for the period, or 1.5% per year. Big deal! It's a lot of trouble for nothing," he said.

Two unlikely scenarios

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that investors who buy the notes should expect to be called and probably do.

"You would have to be pretty pessimistic to imagine a scenario in which quarter after quarter you would not be at or above the initial price," he said.

"It's hard to imagine not getting called at some point."

Another unlikely scenario, in his view, is principal loss at maturity, given the likelihood of a call and the depth of the final barrier.

"The downside risk is not huge. We're not in a market where the S&P 500 is egregiously overpriced; it's more like it's undervalued. To say that we're going to go to 690 is a little bit of a stretch. I don't see a scenario where that happens and certainly not 10 years from now," he said.

"Not being called, breaching the final barrier - it's equally implausible to hit either one of these extremes."

Reinvestment risk

For Kalscheur, the main risk associated with the product derives from the occurrence of a call.

"What investors should have in mind is reinvestment risk, which always takes place when you deal with a callable instrument," he said.

"If you are called after a year with your 6.5% return and can't find anything better out there than 4.5%, that's a problem."

Kalscheur said that he liked the call protection.

"It makes the deal interesting," he said.

"You're buying a one-year 6.5% rate of return and you're assuming that either the market will be up, and that you'll get your principal back or that the market is down but not by more than 50% and in that case, you collect your coupon.

"The one-year call protection makes the product much more enticing. Without it, you would have to worry about being invested for just three months or maybe six and if you had income needs you wouldn't be able to rely on this very long.

"If you have at least one year, it could be two or three years, but with one year, it gives you something.

"You wouldn't want to be a big bull since your return is limited, but for somebody a little bit nervous about the market, it may be appropriate. If I had to get a two or three years CD anyway, I could say let me lock in 6.5% with Morgan Stanley for one year and maybe more.

"Morgan Stanley is not the safest credit, but it's acceptable. It's not at the top of my list, but it's not at the bottom of my list either," he said.

Morgan Stanley & Co. LLC will be the agent.

The notes will price on Nov. 28 and settle on Nov. 30.

The Cusip number is 61761JAD1.

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