Morgan Stanley’s $12.12 million leveraged notes on S&P offer short-term mildly bullish bet

By Emma Trincal

New York, Jan. 5 – Morgan Stanley Finance LLC’s $12.12 million of 0% leveraged buffered index-linked notes due Jan. 23, 2025 tied to the S&P 500 index allow for double-digit returns in an uncertain market, which, by the time the notes mature may or may not have recovered from the current pullback, sources said.

If the index return is positive, the payout at maturity will be par plus 2 times the index gain, subject to a maximum return of par plus 31.3%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 20% and will share in losses at a rate of 1.25% per 1% drop beyond the 20% buffer.

Cap

If the market rebounds, investors run the risk of hitting the cap too soon, said Steve Doucette, financial adviser at Proctor Financial. On the other hand, if the recovery drags on, the cap may be attractive.

“The average length of a bear market is about a year. And we’re pretty deep into it. If inflation persists through next year, we may not come back. I kind of like getting two-times leverage with 14% a year. You could cap out but 14% is nothing to bark at,” he said.

The 31.3% cap is the equivalent of a 14.6% annualized compounded return. This maximum return can be achieved if the index rises 7.5% a year.

Fat buffer

The buffer provided the real source of alpha although investors may not need as much of it, he added.

“I like the buffer because you’re guaranteed to outperform if the index is down. That said, a bear market only lasts so long. How quickly will we come out of it? We may not need that much protection,” he said.

Instead of 20%, Doucette said he would consider reducing the buffer size to 10%.

“I’d want to see how much upside I could extract from this,” he said.

Leverage trap

Over such a short tenor, cutting the buffer size may not be enough to raise the cap. Lowering the leverage factor may be necessary as well, which would not represent a costly sacrifice for this adviser.

“Leverage is a plus. But it can be a problem too,” he said.

“If the market goes on a run, you’re levered up, the value of the note goes up a lot and it looks great for the client.

“But if the market suddenly goes down, you’re losing that leverage. The value of the note is going down faster especially if you’re near maturity.”

As a result, Doucette would not mind giving up the 2x leverage for a 1.75 factor.

“What happens if I go 1.75x? Can I get rid of that cap?” he said.

Call it, stretch it

It may not be possible over a two-year term, unless the issuer introduces a one-time call midterm, which would transform the structure from bullet to autocallable, hence diminishing the chances of participating at maturity.

“You can put a call and get rid of the cap. Or try to push that cap as high as possible. If I really want to get rid of it, maybe I’d go into a three-year note and maybe I’d lower the leverage to 1.5x. I don’t know. You’d have to run the different scenarios,” he said.

The bottom line for Doucette was raising or better eliminating the cap altogether.

“The buffer can make you outperform, but not the cap. If you’re capped out, you underperform. That’s the only way you might underperform, but that’s a risk. I want to avoid that. With a growth note, I want to outperform in either direction,” he said.

Moderate returns

Matt Medeiros, president and chief executive at the Institute for Wealth Management, was less preoccupied by the 31.3% maximum return based on his market outlook.

“This is a note for somebody who is cautiously optimistic about the market over the next couple of years,” he said.

“Because it’s a short-term note, I’m not too concerned about the cap. I don’t expect my return to be restricted by the cap. My expectations are relatively muted for the next two years.”

This made the 2x leverage all the more helpful, he said.

Buffer, entry

The market risk exposure was moderate given the structure but also the current market environment.

“I like the buffer. I’m not super excited about the gearing. But I’m pretty comfortable with the 20% size,” he said.

“Also, we’re not pricing off the high, so the entry point is good,” he said.

When the notes priced, the S&P 500 index closed at 3,844.82, or 20.2% off its Jan. 4, 2022 high.

“At these levels, I get an additional layer of protection. So, while I’m not thrilled about the 1.25x downside leverage, I’m not too concerned about it either. It doesn’t preclude me from being interested in the note,” he said.

Medeiros does not expect the S&P 500 index to move in a straight direction over the next two years.

“We’re going to see some pretty big swings. It doesn’t mean that the S&P will have a negative return at the end. But the gains may be modest, which makes the leverage very attractive. Having limited expectations, I think the structure works in this note. The cap is sufficient, and the 2x leverage should pay off,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on Tuesday.

The Cusip number is 61774TEZ.

The fee is 0%.

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