Morgan Stanley’s $2.88 million trigger jump notes on Dow, Russell offer rangebound, bull play

By Emma Trincal

New York, April 3 – Morgan Stanley Finance LLC’s $2.88 million of 0% trigger jump securities due March 29, 2028 linked to the Dow Jones industrial average and the Russell 2000 index allow investors to beat the market in a flat-to-mildly-bullish market while not penalizing the more aggressively bullish investor, advisers say.

If the return of the worst performing index is positive, the payout at maturity will be par plus the greater of that index's return and 61%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the worst performing index declines but finishes at or above the 75% trigger level and will lose 1% for every 1% that the worst performing index declines if it finishes below the trigger level.

So-so

The structure was attractive, but one adviser could not feel enthusiastic about it.

“I have no reason to be underwhelmed. This note gives me a minimum of 10% per year if the index is not negative and my expectation for the U.S. stocks is 8.5%. And yet I’m not overly excited about it,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“I guess the main reason is that I hate notes built over a worst-of. Also, five years is awfully long. I just don’t like structured notes that long.”

At the same time, Kunhardt said he could “see myself doing this note.”

One positive aspect was that both indexes are well-recognized U.S. equity benchmarks – the Dow Jones for large-cap equity and the Russell 2000 for small-caps, he said.

“Both are core positions I would have to have in my portfolio anyway.”

In addition, the indexes are positively and highly correlated with each other, displaying a 0.86 coefficient of correlation, he said.

“I would still prefer a single index, or if I had to live with a worst-of, at least get the S&P and the Dow because both of them are large-cap,” he said.

Kunhardt admitted that the notes offered some benefits in a variety of scenarios.

Time, protection

“You only lose when the market is down. If the index doesn’t go anywhere, you still get your 61%. If it goes higher, you’re not capped. Objectively, there are more positives than negatives in this deal,” he said.

“It doesn’t mean I have to get excited about the notes.”

He brought up two main drawbacks.

“A 25% barrier is okay but not great. Give me a 25% buffer and it would be great,” he said.

The tenor was another main issue for this adviser.

“I would want something shorter, maximum three years, possibly two. So many things can happen over five years. You have no way to ascertain the broad market condition when you’re looking at that time horizon,” he said.

Kunhardt disputed the idea that the chances of market losses diminish over longer periods of time.

“I can understand the argument. It’s true if you look back. But back testing is one thing, the future is another. So much can happen in five years. Once you get into a five-year or seven-year time horizon you have no idea what the market is going to be.

Barrier breach

Another financial adviser held a more distinct view about longer-dated notes, saying he does not hesitate to rely on back testing analysis.

“The nice thing about long-term notes is that you generally get uncapped returns. It also gives you good terms and this one certainly has good terms,” this adviser said.

Credit risk exposure increases with time, which is an issue with longer-dated products, he said. Yet default risk was not his main concern with a big issuer such as Morgan Stanley.

“Five years from now, I’m confident that Morgan Stanley is going to be around.”

Focusing on the market, he looked at five-year rolling periods on both indexes going back to 1985 for the Dow Jones and 1987 for the Russell 2000. His goal was to identify the frequency of return outcomes.

He first analyzed the chances of losses, which would correspond to one of the indexes falling below the 75% barrier at the end of a five-year period.

He found a rate of frequency for the barrier breach scenario of 0.4% for the Dow Jones industrial average and 0.6% for the Russell 2000 index.

“I feel very good about it. You have about half of a percent chance of hitting the barrier. That makes me comfortable,” he said.

Barrier at work

He then examined back testing results for the bucket of returns comprised between 75% and 100%.

“This is where your barrier does its job. You will outperform since you’re getting your money back instead of losing money,” he said.

The frequency for an underlier to finish within the barrier zone was 13.6% of the time for the Dow Jones and 9.7% for the Russell.

Digital alpha

The second band within which investors would outperform would be on the positive side, anywhere below the 61% threshold.

The probabilities for such outcome to occur were 40.7% for the Dow Jones and 46.3% for the Russell 2000.

In this scenario, investors would get a 10% annualized compounded return even if the worst-of index finished flat.

“This is certainly a good result if you expect the market to be moderately bullish or range bound,” he said.

Adding the two buckets of outperformance –from 75% to 100% and from 100% to 161% – the notes would outperform 54.3% and 56% of the time for the Dow Jones and the Russell 2000 respectively, he said.

“When you combine those two windows, you’re going to outperform at least half of the time. This is very attractive,” he said.

This adviser admitted he had no way to measure more precisely probabilities of return outcomes based on the worst-of payout.

“These figures are for each index. I’m not equipped to calculate the probabilities based on the worst of the two. Still, those probabilities are compelling enough,” he said.

Positive scenarios

In the case of the worst index finishing above 161%, investors would just “market perform,” he said.

“It’s as if you were long the index although you underperform by the dividend,” he said.

“Okay, the price return of the index is up 100%, you’re getting 100%, not 110%. I don’t think a client would care much about this to be honest,” he said.

He used an approximate 2% dividend yield for the underliers. The Dow Jones industrial index offers a 2.16% dividend yield. The Russell 2000 yields 1.4%.

“If I’m down but above the barrier, I win. If I’m up and below the 61% digital, I win. If I’m above the digital or below the barrier I’m long the index. My chances of beating the index are more than half of the time. Otherwise, I’m not worst of than being long the index except for the dividends. But you’re always going to trail by the dividends.”

A very bullish investor may prefer having leverage rather than a digital payout, he said.

“Certainly, the leverage is what meets the bull case scenario.

“This note is for the cautious bull or for someone who doesn’t expect a huge run.”

“Your view on a note is always going to depend on your philosophy on where the market is going to be at maturity.

“As far as I’m concerned, I like this note. I like the minimum guaranteed return. The downside protection is good. The 61% threshold is very good. You can lock in 10% a year even if the index doesn’t move up much.

“I would have no qualms about considering this note.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on March 29.

The Cusip number is 61774T5J7.

The fee is 0%.

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