Morgan Stanley’s lookback trigger step securities linked to S&P 500 seen as risky due to tenor

By Emma Trincal

New York, March 27 – The long duration of Morgan Stanley Finance LLC’s 0% lookback trigger step securities due March 31, 2022 linked to the S&P 500 index makes the product too risky despite the risk-mitigating quality of its lookback feature, sources said.

If the index return is zero or positive, the payout at maturity will be par of $10 plus the greater of the index return and the step return, which is expected to be 30% to 33% and will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the index declines by 20% or less, the payout will be par.

If the index declines beyond 20%, investors will be exposed to the index’s decline from its initial level.

The initial index level will be the lowest closing level of the index during the two-month period from pricing through May 24.

Price return

Steven Foldes, vice-chairman of Evensky & Katz/Foldes Financial Wealth Management, said the five-year term was his main objection. Such tenor exceeds the usual duration of one to three years he typically uses when buying a note.

He stressed two disadvantages associated with this timeframe. First, investors have less liquidity for a longer period of time. Second, the non-payment of dividends has more drastic consequences over a longer timeframe.

Noteholders are not entitled to receive dividend payments.

Because the S&P 500 yields about 2% a year, the five-year tenor causes investors to forego about 10% in return.

Some of the more attractive aspects of the structure are not compelling enough to make up for this drawback, he said.

“Morgan Stanley is an acceptable credit. Their spreads continue to improve. We have no problem with their credit. We do have a problem with five years,” he said.

“The fact that you get a 30% coupon is nice. But at the outset, you’re giving up 10% to get 30%.

“Yes, you do get the uncapped upside, but you’re giving up a fair amount of return to get something.”

At first glance, investors would benefit from the 30% step return if the market were trading sideways. Yet, they would still incur a 10% discount caused by the non-payment of dividends, he noted.

“Even if you don’t take dividends into account, a 30% return for five years is a pretty modest gain.”

The 30% step return is the equivalent of a 5.39% annualized gain on a compounded basis.

Risk

Finally, the barrier at maturity offers little appeal.

“The idea of a 20% barrier over a five-year period is not that significant because the likelihood of the S&P being down in five years is low so they’re not giving you that much,” he said.

Most of the risk is on the upside.

“It’s unlikely that the market will be up only at a rate of 5% a year. It’s half of what the S&P has done historically on average.”

Investors, he continued, take the risk of being long the index without the dividends, which guarantees them a loss of 10% compared to a straight investment in the index fund.

Lookback

The lookback, which allows a better entry point over a two-month period following pricing, is not attractive enough to convince him that the deal is worth considering.

“The coupon is not that high. I’m giving up 2% a year. The barrier doesn’t really help that much because it’s unlikely that the market is going to be down in five years. You’re tying up your money for five years.

“We don’t love that note.”

Tough call

Clemens Kownatzki, independent currency and options trader, was less critical about the structure itself but shared with Foldes a concern about the length of the investment.

“I’m not comfortable predicting what the market will be like in five years,” he said.

“If I put that aside, if I look at it from the perspective of our current environment with the bullish sentiment that we have, the strong economic data that we have, it’s a great note.

“It has decent metrics on the upside. The downside risk is there, but the protection is fairly good.”

But the market is possibly about to take a new turn, and the timing of the investment may be risky despite the lookback, Kownatzki said.

Political risk

“There is so much uncertainty right now in the world. What worries me is that the market doesn’t seem to be pricing any of that. There is too much complacency. It’s a red flag. The market is ridiculously high,” he said.

“Meanwhile, it looks like we’re back in the Cold War era. We’ve had so many crises since 2008, and the market just ignored all of it. We had the Greek crisis, the European sovereign debt crisis, the Syrian conflict, the conflict between Russia and Ukraine, the immigration crisis, Brexit, this new administration nobody predicted and North Korea ready to do another nuclear test. ...

“It seems like the market is discounting a lot of these risk factors, so I wouldn’t want to make a five-year bet in this environment.

“We’re living in a really odd time. I don’t know if a 20% cushion is good enough to protect me.

“The fact that I can get the best closing price in the next two months is really not going to change anything about it.”

Morgan Stanley & Co. LLC is the agent with UBS Financial Services Inc. as dealer.

Morgan Stanley is the guarantor.

The notes priced on Friday.

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