Morgan Stanley’s contingent income autocalls on S&P 500 index pay 5% with memory, short tenor

By Emma Trincal

New York, Nov. 8 – Morgan Stanley Finance LLC’s contingent income autocallable securities due Aug. 9, 2022 linked to the S&P 500 index pay a modest coupon, but the single asset exposure, memory feature and short maturity are appealing, advisers said.

The notes will pay a contingent quarterly coupon plus any previously unpaid coupons at the annual rate of 5% if the index closes at or above its coupon threshold level, 78% of its initial level, on the related determination date, according to an FWP filing with the Securities and Exchange Commission.

The notes will be redeemed early at par if the index closes above its initial level on any quarterly redemption determination date.

The payout at maturity will be plus the coupon for that period plus any previously unpaid coupon unless the final level of the index finishes below its 78% downside threshold, in which case investors will be fully exposed to the index decline.

The final level will be the average of the index closing prices of the five averaging dates – July 29, Aug. 1, Aug. 2, Aug. 3 and Aug. 4 of 2022.

Short, with memory

The note offers several characteristics that distinguishes it from similar products, sources noted. The nine-month term is relatively short for a contingent coupon autocallable product. More often, such short tenors (three to nine months) apply to reverse convertible bullet notes paying a fixed interest rate, according to data compiled by Prospect News. Another particularity is the memory feature used here on the coupon rather than on a call premium.

Usually, cumulative payments are employed with call premia earned at or above initial price strike. Coupon payments received above a barrier level can but typically don’t pay previously unpaid coupons, the data showed.

Those two characteristics are beneficial to investors and may explain the small coupon size, sources said. The first quarterly observation in three months may generate a 1.25% coupon payment. In six months, investors may expect 2.5% and the maximum payment will be 3.75% at maturity with the risk of losing 100% of principal if the barrier is breached.

Sources said the barrier was acceptable. The coupon size was more debatable.

No equity substitute

Jerrod Dawson, director of investment research at Quest Capital Management, said that at least the odds of getting paid the 5% coupon were high.

“There are a lot of moving parts for a pretty modest coupon,” he said.

An investor would have to be “almost bearish” to purchase the note if the goal was for equity replacement purposes, he said.

“As long as the Fed continues to inject liquidity in the market, there is a bullish case to be made. After all, earnings have been very strong. But we could also see the market slow down. Profit growth is already so high for so many companies, earnings may begin to fade.

“This is a note that would make sense for a moderately bullish investor, but you would still need to see an 8% to 10% coupon, not 5%,” he said.

On the other hand, the memory feature and a “relatively generous” barrier of 78% were positive aspects of the deal.

High-yield replacement

“If you look at it in terms of probabilities, it starts to look like a fixed-income play,” he said.

“Let’ say you have a 90% probability of getting the 5% annualized, that’s the equivalent of a 4.5% coupon.

“It’s in the ballpark of some of the junk bonds out there. That’s a way to look at it.

“But again, if you’re a bull on the stock market, you’re not going to buy this.”

Tis the season

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, could not agree more.

“It’s nice to have a nine month. That part is good. But 5% per year is not a good coupon. The probability of the market to be up in the next three months is very high,” he said.

“Statistically, the market tends to outperform towards the end of the year. Chances are the notes will be called early. Why would I want to restrict my upside to 1.25% for the first three months?

“We’re entering a seasonably strong period for the market. November, December...historically these are the best months for the stock market. I’d rather get direct exposure to the S&P at this time. The market has already broken out across the board. Technical indicators are bullish. They point to higher returns.

“You want to be long in a market that’s going up, especially for a short period of time.”

Call risk

Even if the annualized coupon was much higher, Chisholm would not want to see his gains capped for a duration that is likely to be a third as short as the tenor.

“Chances are this thing is going to last three months. I’m getting called in February with 2.5%. I’m not going to do that. I could do a lot better being long the index,” he said.

But income investors find some rationale in the notes. A financial adviser, for instance, said the yield was in line with his expectations.

“Given the shorter tenor and the exposure to a single index, that 5% coupon seems on par with what I would expect,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes priced on Nov. 5 and will settle on Nov. 10.

The Cusip number is 61773HEZ8.

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