Morgan Stanley’s notes tied to S&P 500 offer full protection, high risk-adjusted return

By Emma Trincal

New York, July 11 – Morgan Stanley’s 0% market-linked notes due January 2022 linked to the S&P 500 index offer investors 100% upside participation up to a cap with no downside risk exposure, which makes for an attractive payout but one that can only be priced over longer durations, as is the case with this seven-and-a-half year product, said Tim Mortimer, managing director at Future Value Consultants.

The payout at maturity will be par plus any index gain, up to a maximum return of 67.25%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index falls, the payout will be par.

“These principal-protected notes are appealing since you don’t have exposure to declining markets. Unfortunately they have become harder to price in today’s market environment. When such products come across our screens, they tend to earn solid scores. The main drawback for investors is the long durations associated with these low-risk investments,” he said.

Future Value Consultants scores the notes based on risk, return and price metrics. This product falls into the principal protected category. The research methodology generates reports designed to assess the quality of a product within its own category or against all products.

There is still risk

Future Value measures risk by adding two risk components: market risk and credit risk. The riskmap is the sum of those two riskmaps. It is measured on a scale of zero to 10, with 10 measuring the riskiest product.

The notes guarantee the repayment of principal at maturity provided that there is no negative credit event.

“It looks like market risk should be zero, but it’s not the case, at least not based on how we calculate the market riskmap,” he said.

The notes showed a 0.80 market riskmap versus 1.43 for the average of the same product type, according to Future Value Consultants report.

Mortimer explained the discrepancy in two ways.

“In our database, these notes have a maturity that’s longer than average. Longer maturity in general makes the market risk lower,” he said.

“Other reason: we measure the market riskmap against the risk-free rate. We look at how much the product underperforms compared to cash.”

The credit risk at 1.12 was in line with the average for this product type, which is 1.00, according to the report.

“It’s slightly higher but not by a whole lot. It could be because Morgan Stanley’s credit spreads are still a bit higher than other issuers,” he said.

Morgan Stanley’s five-year credit default swap spreads are 75 basis points versus 55 bps for JPMorgan; 69 bps for Bank of America; and 66 bps for Citigroup, according to Markit.

Overall, the product’s riskmap of 1.92 is much lower than the average, which is 2.43 for the structure type and 3.86 for all products, the report showed.

Pricing challenge

“Notes offering capital protection are very attractive in theory, but investors have to sacrifice something to get the downside protection,” he said.

“Principal protected notes have become very uncommon. There are two reasons for that. First, the pricing environment is just not conducive to those deals right now.”

Low interest rates and low credit spreads were the main culprit.

“Those principal-protected notes combine a zero coupon bond that will mature at par and a call option. Typically you swap the coupon for a call option. But if your coupon is low to begin with, you’re not going to have much left to buy the call. On top of that, fees have to be paid before you can even buy the option.

“With interest rates and credit spreads as low as they are, the amount of money you have to spend before fees is very limited.”

These pricing constraints explain why investors will usually not have the benefit of capital protection over a short duration.

“Unless you go in longer maturities, you really don’t have a lot to play with, which is why most of those deals are long term deals,” he said.

“There’s always some part of the upside that has to be given up. But in order to price those deals, investors first have to settle for long term bets.”

A handful of deals

In addition to this “supply” constraint, “demand” was also a factor behind the shrinking population of principal-protected products.

“People don’t like to tie up their money for so long. Any product over five year in the U.K., and over three-year in the U.S. is considered long. For both reasons, pricing problems and unattractive durations, those products have become quite rare,” he said.

A few more deals priced this year compared to last year, but principal-protected products remain an extremely small segment of the U.S. market, according to data compiled by Prospect News.

Only 20 offerings totaling $76 million, or 0.35% of the total volume this year, have priced compared to $31 million in 15 deals during the same period last year, as of July 4.

Cap, participation

“As long as interest rates and funding are low, it will be more and more challenging for issuers to offer those products,” Mortimer noted.

In order to get the capital protection, investors have to give up some part of the upside, he explained, which can be done in two ways:

“They can keep the full upside participation but see the returns capped; or there may not be a cap but then, you’re not getting 100% of the upside. You’re getting less,” he said.

“Suppose for instance that you have the choice between this note – 100% participation up to a 167.5% cap or a no cap deal but with only 80% of the upside. Which one is the best? It depends on the type of market you’re in.

“In a moderate growth scenario, the capped version would do better than the low participation rate; on the other hand, if the market does very well, you would be better off with the uncapped upside.

“A simple break-even analysis indicates that if the index grows by less than 84%, investors are better off with the 100%, capped upside. Below that, they would benefit more from eliminating the cap even if the participation rate is only 80%.”

Price score

For each product, Future Value computes a price score that measures the value to the investor on a scale of zero to 10.

This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The notes have a 9.82 price score versus 9.74 for the average of the same product type. Compared with the 6.71 average for all products, the score is even better, according to the report.

“Fee levels in structured products don’t tend to increase much when the maturity increases. A lot of the fees are one-off fees. When you have a longer-dated product, the fee doesn’t go up in proportion of the maturity. That’s the reason why longer-dated notes tend to price better,” he said.

“Since the principal protected category is so small it makes sense to compare the score with all products. You can tell how well this product prices compared to an average structured product,” he said.

The wider gap between 9.82 and 6.71 also reflects the impact of duration since the average duration on the main category, which includes reverse convertibles, is much shorter,” he noted.

High risk-adjusted return

Future Value measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions – neutral assumption, bull and bear markets, and high and low volatility environments. A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

The product’s return score is 8.18. The average score is 8.22 for the category and 6.95 for all products.

“Same thing. We’re comparing it with the general average since capital protected deals are so rare. The 8.18 return score is very high here, as you can see....about 1.25 points over the all product average,” he said.

Overall score

The overall score measures Future Value Consultants’ general opinion on the quality of a deal. The score is the average of the price score and the return score.

The overall score for the notes is 9 versus 6.83 for the average of all products.

“This is not really a surprise,” he said.

“Principal protected products tend to score really well in our models.

“All you need is a zero coupon and some call options. Issuers usually use indexes, so you get a great deal of simplicity, liquidity and transparency. There are no good reasons to justify high fees so you would expect those products to price better. And they do.

“The return score is also going to be above average. With the bullish scenario, which we use to calculate the score and the principal protection, you are likely to have a solid risk-adjusted return as it is the case here.”

Morgan Stanley & Co. LLC is the agent.

The notes will price in July and settle in August.

The Cusip number is 61761S679.

© 2015 Prospect News.
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