Morgan Stanley’s $1.43 million equity-linked notes offer nearly full protection, growth

By Emma Trincal

New York, March 9 – Morgan Stanley Finance LLC’s $1.43 million of 0% equity-linked partial principal at risk securities due Jan. 20, 2028 linked to the performance of the Dow Jones industrial average and the S&P 500 index offer a good risk-adjusted return, advisers said, given losses capped at 5% with a potential double-digit return.

If each index finishes at or above its initial level, the payout at maturity will be par plus 150% of the return of the laggard index, subject to a maximum payout of par plus 60.5%, according to a 424B2 filing with the Securities and Exchange Commission.

If the laggard index declines, investors will receive par plus the return of the laggard index, subject to a minimum return of 95% of par.

Defensive play

Matt Medeiros, president, and chief executive of the Institute for Wealth Management, said he liked the emphasis on risk reduction.

“The downside protection is reasonable especially with this tenor. The probability of being in negative territory over a five-year period is minimal. Both the extensive protection and the timeframe should shelter you against big losses. I’m comfortable with that,” he said.

“The fact that it's pricing when the S&P is down 15% off its high adds another layer of safety.”

Medeiros also liked the 60.5% maximum return. Based on the tenor and leverage multiple, such cap is the equivalent of a 9.95% annualized return on a compounded basis.

Cap is fine

“Being capped out at 10% a year doesn't bother me considering the change in the economic cycle,” he said.

“There’s a growing concern in the market that we’re heading toward a recession, but we don’t know when and how severe it might be.

“That’s the uncertainty and volatility we’re facing each day and it’s exacerbated by the rise in short-term rates.”

Some advisers are reluctant to have their investment capped on the upside over longer maturities arguing that the market is already trading at a discount.

“For some, this cap could be an issue. Not for me. I wouldn't be in the camp of being super bullish at this time,” Medeiros said.

“I am optimistic but still concerned about the downside. You don't want to be too far over your skis. These are the kinds of uncertain markets where notes like these make a lot of sense because they offer the downside protection.

“When you're making your allocation decisions, some of your objectives are to pursue growth, others, to preserve capital. It really depends on the needs of your portfolio and where we are in the cycle.”

Intermediate rates falling

“Risking 5% to get 10% a year, I’m comfortable with that,” said Ken Nuttall, chief investment officer at BlackDiamond Wealth Management, in reference to the capping of the losses at 5%, which protects 95% of the principal against market risk.

“That's pretty decent compared to a lot of deals I've seen recently.”

He attributed the recent deterioration in the terms of notes to a relative decline in intermediate and long-term Treasury rates.

“With rates down, you haven't seen that kind of structure for some time. When I say rates are down, I'm referring to where they were back in October and November,” he said.

While short-term rates have been climbing, Treasury yields on other parts of the curve have indeed declined since last fall leading to a yield curve inversion.

The five-year Treasury rate now yields 26 basis points less than its 4.45% October level. On Oct. 21, the 10-year Treasury yield peaked at 4.33%, its highest level since June 2008, but it now yields 3.91%.

Principal protection notes benefit from higher interest rates and may be economically unfeasible if rates are too low, he explained.

“It's a pretty decent note on a five-year given where rates are,” he said.

Nuttall said he is familiar with worst-of payouts but found this one more attractive than usual.

“I like that you only have two indices. It’s usually three, which is riskier,” he said.

The risk-adjusted return appeared attractive, he said.

The right factor

“You're only willing to take a 1% loss each year to potentially get 10%.”

One caveat was the five-year holding period with non-payment of dividends.

“To be sure, you’re locking it up for five years. But when I look at a note, I look at what's my upside versus my downside. In this case, the risk-adjusted return is pretty favorable,” he said.

Despite its defensive nature, the notes could be used for growth.

“The indices will be up five years from now, so it’s really nice to be getting the leverage,” he said.

Most investors would rather see a leverage factor greater than 1.5. But such level was justified given the cost of protecting up to 95% of the investment, he said.

“Usually when you get a bigger leverage multiple, the protection is smaller. You may have an 80% barrier for instance,” he said.

Some notes offer up to three times upside leveraged exposure over 14- or 15-month tenors. Often dubbed “Accelerated Return Notes,” those structures come with lower caps and full downside exposure.

“These are more aggressive, very short-term paper,” he said.

Some more bullish investors would rather have no cap and less protection on the downside, especially on a five-year term.

Conservative investor

“I do understand the bullish argument. But each client is different. I can see this particular trade for a retiree, or a more conservative investor,” he said.

“If it were for me, I would tend to say: let's take a 20% buffer instead and get more leverage on the upside with no cap if we can. We are near bottom in this market so why not get the upside on it?

“But I have clients who don't want to lose anything and for those people, this is it.

“It’s a good conservative growth note.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on Wednesday.

The Cusip number is 61774T2A9.

The fee is 0.5%.

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