Morgan Stanley's buffered jump notes linked to S&P 500 offer attractive, uncapped upside

By Emma Trincal

New York, Oct. 18 - Morgan Stanley's 0% buffered jump securities due Oct. 28, 2015 linked to the S&P 500 index offer attractive terms for bullish investors, as they have a high minimum contingent return and no cap, sources said.

"It's very attractive," said Clemens Kownatzki, founder and chief executive of FX Investment Strategies LLC, an advisory firm specializing in global financial markets.

"I especially like the fact that the upside is not capped. That's always something that I appreciate."

Digital return

Not only is the upside not capped, but investors can outperform the index in some cases due to a contingent minimum payment. If the final value of the S&P 500 exceeds its initial value, the payout at maturity will be par of $10 plus the gain, with a minimum return of 44%, according to an FWP filing with the Securities and Exchange Commission.

"I've had notes on my desk with similar structures, but the upside was capped and that makes a big difference. It's not all that attractive," Kownatzki said.

The "jump" feature, which gives a digital return much higher than a small increase in the index, is also attractive.

For instance, if the index at maturity is up only 1%, investors will earn a 44% return, or the equivalent of an 11% annualized gain, noted John Farrall, senior vice president and director of derivatives strategies at PNC Wealth Management.

"I think this is very attractive for those who don't want to cap their upside and are bullish and still want to have some protection," Farrall said.

Fat buffers

Investors will receive par if the index falls by up to 20% and will lose 1% for every 1% that it declines beyond 20%.

"A four-year term might be a little bit long, but we recently did a three-and-a-half-year product. I don't think that four years is ridiculously long," Farrall said.

On the downside, investors have 80% of their capital at risk.

For Farrall, the 20% buffer amount is as good as it gets in today's market.

"You can't really have a buffer of more than 20% in equity-linked notes, because if your buffer is too wide, you're not going to qualify for long-term capital gains from a tax standpoint," he said.

"Even if you hold a four-year product at maturity, your gain may no longer be treated as long-term capital. That's why we don't buy anything with a buffer of more than 20%," he said.

According to a tax attorney, "big buffers" do indeed raise "an issue," although there are no set rules.

"The issue is whether it's principal protected or not," this attorney said.

"Principal-protected notes are subject to a special tax regime and you get the ordinary tax treatment.

"So even though on its face a buffer is not principal protection, if the buffer is big enough and the risk of loss is low enough, the concern is that your note could be treated as debt for tax purposes," he said.

There are no rules that define at which point a buffer may cause the tax treatment of the note to fall under the ordinary income tax category.

"It depends on the amount of buffer, the length of time to maturity and the underlying," the attorney explained.

Extra hedge

Regardless of the tax justification, Kownatzki said that he is not totally satisfied with the 20% protection on a four-year product in today's market.

"A lot can happen in four years, and I find the 20% a little skinny," he said.

"There's still enough concern in the market to make me uneasy, although I'm not necessarily bearish at this point."

But Kownatzki said that in the four-year timeframe, there is certainly room for a market downturn.

"Look at what's happening today. Every time you hear a little bit about Europe, the market tanks. We're still in dangerous territory," he said.

But Kownatzki said that he would consider the product if he could properly hedge it - in other words, if the economics of the hedge made the trade attractive.

"If I wanted to buy this note, I would buy a put option for additional protection. I could calculate the break-even point if the buffer is at a certain level and I want X amount of protection below that. I could have the put strike at that level, and the option would kick in if it goes below. That way I could hedge the risk a bit more," he said.

"But I would have to look at the cost of the option, price it and make sure that it makes sense."

Morgan Stanley & Co. LLC is the agent.

The notes will price on Oct. 25 and settle on Oct. 28.

The Cusip number is 617482D35.

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