Morgan Stanley's TOPS tied to S&P 500 are built to and should outperform index, source says

By Emma Trincal

New York, Aug. 25 - Morgan Stanley's 0% Target Optimized Participation Securities due Aug. 31, 2017 linked to the S&P 500 index are structured in a such a way that they are very likely to outperform the index at all times, a source said.

"These notes are as good [as] or better than the index," a sellsider said. "There is no way you're going to underperform the S&P 500."

"If the market is up, you get the upside, with a 30% minimum.

"If it's down, you're still better off than the index."

The deal

If the final index level is greater than the initial index level, the payout at maturity will be par plus the greater of the lookback percent increase and 30%.

The lookback percent increase will be the percentage increase of the highest closing level of the index observed on the observation dates - every Wednesday during the life of the notes - from the initial index level, according to a 424B2 filing with the Securities and Exchange Commission.

There is no maximum return, the prospectus said.

The downside payment follows a complex calculation, but one that ensures that investors will profit from their investment as long as the underlying index does not decline by more than 23%.

According to the formula stated in the prospectus, if the final index level is less than or equal to the initial index level, the payout will be (a) par multiplied by (b) the quotient of the final index level divided by the initial index level multiplied by (c) 130%.

If the final index level has decreased from the initial index level by more than 23.077%, this calculation will result in a loss of principal.

Attractive upside

"It's a very good structure, especially on the upside," the sellsider said, pointing to the "lookback" feature that allows investors to lock in the highest weekly value over a six-year period as long as the S&P 500 index finishes positive.

"This lock-in is very attractive," he said.

"Say the S&P 500 at one point during one week closes up 60% from the initial price. And say it's up 20% at maturity. You get the highest close level, the 60% return rather than 20%. Plus there is no cap," he said.

Commenting on the weekly observation dates, Brad Livingston, a distributor at the Income Solutions Group with Capital Guardian LLC, said in an e-mail, "In my historical analysis going back to 1981, using daily closing values of the S&P 500 index, this type of structure would have always produced a positive payout. The data also shows that the average investor return in this type of payout was 11.9% per year. With the downward pressure we've seen in the market, I think this type of payout is extremely attractive because of the ability to lock in weekly highs."

The sellsider noted that investors enjoy the lookback observation on one condition: the final index level must end up greater than the initial level.

"It's like a contingent lock-in because you cannot have it if the index finishes lower," he said.

"Still, it's a nice feature to have.

"As long as the index is up at maturity, you get a minimum return of 30%."

"A minimum return of 30% over six years, that's almost double the dividend yield," noted Matt Medeiros, president and chief executive of the Institute for Wealth Management.

"I like it from that perspective," he said.

TOPS protection

The downside protection was also considered attractive even if not typical.

"If the S&P 500 declines, as long as it's not by more than 23%, you're still making money," the sellsider said.

In addition - and if the index falls further than 23% - the losses incurred with these notes would be lower than those caused by a direct investment in the index, he said.

He gave an example. "For any decline, you subtract 1.3 points for every point of decline. Say your index finishes down 30%. That's 39% minus 130%: your final value is 91% of par. You end up losing 9%. That's far less than 30%," he said.

"If the S&P is down 23%, you're still making a tiny bit of money.

"I've never seen something like that."

Asked whether the downside protection feature could fit into the category of a buffer or a barrier, he said: "None of the above. I would call it a TOPS, I guess."

Dividends, credit risk

The sellsider said that "I like it" but "you have to give up a couple of things to get this attractive" structure.

The first one is dividends. With the S&P 500 yield at 2.2%, investors give up about 13% over the six-year period, he noted.

"That's understood. That's the cost of potentially outperforming the S&P 500," he said.

"The second thing is you're investing in Morgan Stanley notes, therefore, you're taking Morgan Stanley's credit risk.

"Right now, Morgan Stanley's five-year credit swap spreads are 305 basis points. It's quite high.

"They can price that type of deal because they're paying for the funding.

"The wide spreads reflect the credit risk, and so people have to be compensated for the risk."

Medeiros said that independently of the structure, he was interested in the notes from a valuation standpoint.

"What attracts me is the value of the S&P 500. Due to the fact that the index has come down so much, it looks attractive to us going forward over the next six years," he said.

"You have a large-cap asset class with no upside cap and you're buying it at a discounted price from its historical value. That looks attractive to us."

The notes (Cusip: 617482WT7) will price Friday and settle Wednesday.

Morgan Stanley & Co. LLC is the agent.

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