Morgan Stanley’s 10.01% contingent income autocalls on Stoxx 50 show unusually long tenor

By Emma Trincal

New York, Aug. 31 – Morgan Stanley Finance LLC’s contingent income autocallable securities due Sept. 5, 2023 linked to the Euro Stoxx 50 index offer income-seeking investors a remarkably long tenor for this type of product, said Suzi Hampson, head of research at Future Value Consultants. However, the longer maturity and the longer time span between coupon payments and autocall observation dates does not mean investors should expect their income stream to last longer, she warned.

The notes will pay a contingent semiannual coupon at an annual rate of 10.01% if the underlying index closes at or above the 80% coupon barrier on the determination date for that period, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par plus the contingent coupon if the index closes at or above its initial level on any determination date after six months.

The payout at maturity will be par unless the index finishes below its 75% downside threshold, in which case investors will lose 1% for each 1% decline.

Longer term

“A five-year autocall is not common at all in the U.S. Even a five-year would be unusual,” Hampson said pointing to two or three years as a more common time frame.

“What the length gives you here is less frequent autocalls. When you have a monthly or quarterly call, typically your reinvestment risk is greater and you’re more likely to get less.

“Here your first call date is in six months. If you’re concerned about reinvestment risk this note almost guarantees that you will get at least 5%, which isn’t bad.”

Natural call protection

But reducing reinvestment risk can also be done with shorter-dated autocalls, she said.

“Sometimes the call is delayed by one period...for instance you won’t kick out during the first quarter for a monthly autocall or not for the first six months when it’s quarterly,” she said.

“Still this one won’t call for six months without even introducing a call protection, which is not bad. For that reason, the coupon is probably lower than a similar deal that calls sooner.”

“In general, the more frequent the call, the lower the coupon. If you have 12 monthly call dates the opportunity to kick out is higher and that’s what put a limit on the amount you receive.”

Income, not premium

The notes are geared toward income investors, she noted, since coupon payments can happen independently from the call. That’s because the notes provide a contingent coupon, which can be triggered at a lower barrier than the call threshold.

“The advantage of this one is that you don’t rely on the kickout to get paid. There is a decent chance of not calling and still receiving the coupon,” she said.

As a result, a product like this one tends to offer a contingent coupon that is lower than what you would get from an autocall, she said.

Early redemption likely

Despite those subtle differences between call premia and coupon as well as long and short frequency of calls, the rationale behind those notes is the same.

“With every product the probability of getting called on the first call date is always overwhelmingly higher than later. It just decreases in time. Here you just have a longer term. But the distribution patter remains similar,” she said.

“One risk with this note is if investors begin to make the wrong assumptions and believe that they’re going to be paid semiannually for five years. It’s extremely unlikely.”

Stress testing

She proceeded to make her point using Future Value Consultants’ stress testing methodology through the analysis of a simulation report generated by the firm’s model for this deal.

Each report contains a total of 29 sections or tests that can be customized in any combination.

She picked one of the tests called “product specific tests,” which shows the probabilities of key events relating to this structure.

The outcomes displayed in this table include barrier breach, call at point one through nine, no call occurrence and probabilities based on the number of paid coupons.

The higher probabilities gravitate around the soonest call dates and the smaller number of coupon payments.

Early, early calls

The table showed a probability of being called at point one (the first call date after six month) as the highest at 43.66%. As time elapses, the probabilities decrease: 10.96% on call point two, 6.25% at call point three and less than 4% on the fourth call date. After that the chances of being called drop from less than 3% to less than 1%.

“You still have a decent chance on call point two. After that it drops dramatically,” she said.

The chances of a call on the first year reached 55%, she noted, adding the two probabilities.

The probability of coupon payments followed the same pattern: as high as 45.81% for one coupon, down to 14.53% for two. When it comes to a hopeful scenario in which investors would collect all coupon payments, the model has a way to reduce expectations, showing that such outcome has only a 1.37% chance of happening.

No overlap

The tests unfortunately do not assign a date for the coupon payments. It simply provides a probability for each number of payments as separate outcomes. Therefore, the distribution of payments cannot be directly compared with the distribution of autocall events, which is defined by dates.

For instance, the probability of a call on the first call date does not necessarily mean that all one-time payments took place at the same time, she explained.

“It doesn’t tell you when the coupon is paid. It just said you receive the coupon once, or twice or five times,” she explained.

But what the table showed is the strong likelihood of an early call as well as the high probabilities of receiving fewer rather than more income payments.

“You can see how investors hoping to get paid until maturity could be disappointed when the chances of that happening are so slim...1.37% of the time,” she said.

“U.K., regulators have looked into this. They want to make sure that investors are not told they can expect the highest return.

“We run those stress tests for that reason. Yes, you can in theory get all the coupons, but it’s so unlikely! You’re not allowed to shout that anymore when selling those notes.”

Barrier and no call

The table also showed the probabilities or recouping all or part of one’s principal.

The chances of breaching the 75% barrier at maturity are not insignificant, she said, pointing to a 19.75% probability.

She juxtaposed that probability with another one – a 26.48% chance of the notes never getting called.

The difference between the two figures, or 6.73%, represents a scenario in which the index finishes negative at maturity (no call) but does not breach the barrier, therefore ends above the 75% level.

It is a small probability as the likelihood of calls reduce the chances of the product reaching maturity. It also measures the efficiency of the barrier if the market is down at that point.

Managing hope

“This note is different from a two-year autocall because it won’t call as often. But the length of it almost magnifies the chances of an early call,” she said.

“More than half of the time, the notes will kick out in the first year.

“With this type of product, people need to manage their clients’ expectations. Investors should not imagine that they’ll get paid for five years. As long as they’re aware of it, it is a reasonable income supplement.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes are expected to settle on Sept. 5.

The Cusip number is 61768DDD4.

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