Morgan Stanley’s $5.01 million “best-of” notes optimize allocation, lack protection

By Emma Trincal

New York, April 7 – Morgan Stanley Finance LLC’s $5.01 million of 0% participation securities due April 5, 2027 linked to a performance-allocation basket consisting of the S&P 500 index, the Stoxx Europe 600 index and the MSCI Emerging Markets index was one recent example of a “best-of,” a relatively rare structure in a sea of worst-of notes.

Unlike worst-of, best-of notes provide more return from the best performing index.

The basket component with the best performance will be allocated a weight of 70%, the basket component with the second-best performance will be allocated a weight of 30% and the basket component with the worst performance will be allocated a weight of 0%, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus any basket gain.

If the basket falls, investors will be fully exposed to the decline.

Automatic allocation

Steve Doucette, financial adviser at Proctor Financial, said he has been watching for best-of deals, hoping to see more from issuers.

“I like the idea of this note working as your asset allocator. When you do it yourself, you can be wrong on so many asset classes. It seems like a great opportunity,” he said.

“Some people say they’re better off having leverage. But if you get leverage on the wrong asset class, it may not do you much good.”

Peace of mind

However, when looking for best-of deals in the past, he often opted for those, which unlike this one, provided some downside protection.

“Having no protection is tricky,” he said.

Even if investors get an overweight position in the best-performing index and no allocation to the worst one, with the “in-between” performer being given only a 30% weight, such enhanced allocation was not a substitute for a buffer or even a barrier.

“Our clients look at their statements and when it’s negative, they get worried. They see the valuation of the note going down. We like to be able to tell them that at maturity, they’ll get the protection.

“It just adds some peace of mind.”

Red flags

Another reason to add protection is the evolution of the market since the start of the year, he added.

“It’s been pretty choppy,” he said.

“We’ve seen tech getting slaughtered and the Nasdaq in a bear market for a little while. The S&P has been in correction mode. It’s hard to predict anything in this environment.”

The Nasdaq-100 and the Russell 2000 index are still in correction mode from their 52-week highs.

“We could be headed toward a major market downturn.”

“There is more talk about a recession than before. The yield curve is inverted.”

Inversions, flattening

Yield curve inversions tend to predict recessions, with some parts of the curve more accurate than others.

Short-term yields have recently been rising above longer-dated ones as the Federal Reserve has been raising rates on the short-end of the curve in an effort to fight off inflation.

The five-year and 30-year Treasury yields inverted last week. More worrisome, the two-year yield exceeded the 10-year albeit momentarily. Inversions on this part of the curve are viewed by traders as the best indicator of a future recession. While the 10-year and two-year are no longer inverted, their spread has significantly flattened to 19 basis points on Thursday from 151 bps a year ago.

“In this market, I would be hesitant to get into a note with zero protection,” he said.

“We’re at a turning point with the Fed ending its monetary support. Now we have a recession warning.

It may not happen right away. It may be delayed for 12, 24 or 36 more months. The market could run up this year. But over five years, who knows?”

While Doucette does not expect the market to finish lower five years from now, a bear market in the interim could erode equity returns at maturity.

“Your three indices could end up flat. If that’s the case, it doesn’t really matter if you’re getting 70% of the best one,” he said.

Let me do it myself

Matt Medeiros, president and chief executive of the Institute for Wealth Management also stressed the need for protection.

“I can see the advantage of this note. You can use it as an allocation optimizer. But since you don’t get any buffer or barrier, I’m not sure it makes sense to give up the flexibility of doing the allocation on your own, outside of the note.

“You’re getting 70% allocated to the best index, zero to the worst. It’s an optimized allocation. I understand that.

“But you’re also tied up for five years without the flexibility of buying and selling assets in accordance with your own plan and the way the market is moving.”

Something missing

The deal would be very different if investors had the downside protection.

“It would make a big difference. I would much prefer it,” he said.

For Medeiros, one of the main advantages of a structured note is the downside protection. Without it, using long-only positions seems more practical for the purpose of asset allocation.

“If I don’t have the protection, I’m not sure why I would want to give up the flexibility of an ETF,” he said.

A new cycle

Medeiros sees the market flashing warning signs.

“Economically, we still look good. But the combination of overvalued markets, interest rates going up and the conflict in Eastern Europe suggests that we’re due for a downturn at some point,” he said.

He predicted that the markets may be moving towards more regular historical patterns.

“Typically, you have many more pullbacks in a given year and we haven’t seen many in the past 10 years.

“Major corrections, bear markets usually happen much more often than what we have experienced.

“Volatility is already high but it’s probably going to get higher.

“So, despite the benefits of this optimized portfolio, I would focus on being defensive first.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on Tuesday.

The Cusip number is 61773QD30.

The fee is 0.25%.

© 2015 Prospect News.
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