Morgan Stanley’s $1.67 million callable notes on ETFs show sector bet, but deep barrier

By Emma Trincal

New York, Oct. 16 – Morgan Stanley Finance LLC’s $1.67 million of callable contingent income securities due Oct. 15, 2026 linked to the worst performing of the Technology Select Sector SPDR fund, the Energy Select Sector SPDR fund and the Utilities Select Sector SPDR fund present a number of risks allowing for the pricing of a double-digit coupon and low barrier. Advisers expressed different views about how the downside protection was sufficient to offset the risks.

Investors will receive a coupon at the rate of 14.1% per year, paid monthly, if each underlying ETF closes at or above its 70% coupon barrier level on the related observation date, according to a 424B2 filing with the Securities and Exchange Commission.

The securities may be called at par on any quarterly call date.

At maturity the payout will be par unless the worst performing ETF closes below its 50% downside threshold in which case investors will be fully exposed to the decline of that ETF.

Deep barrier

Ken Nuttall, chief investment officer at BlackDiamond Wealth Management, liked the 50% barrier at maturity.

“What’s really attractive here aside from the coupon is the 50% barrier at maturity. If it was 70%, I wouldn’t touch it,” he said.

“But 50% is a good protection over three years.”

He said he ran a back-testing analysis on the Technology Select Sector SPDR ETF (ticker: “XLK”) using three-year rolling periods over the past 25 years.

The share price breached the 50% level only once, in 2001, amid the 2000-02 bear market, he said.

Tactical pick

The choice of the Utilities Select Sector fund (ticker: “XLU”) did not surprise him as several deals including this ETF have come up in the past few months along with other underliers in worst-of structures.

“XLU pays a high dividend. That’s one of the reasons people use it as an underlying,” he said.

The ETF has a dividend yield of 3.58%.

But another factor may have also played out.

“It looks like the timing was right because this deal struck when the volatility of XLU suddenly popped up,” he said.

“That probably helped price the double-digit coupon and the low barrier.”

The Utilities ETF dropped 16% between mid-September and Oct. 6. The notes priced on Oct. 10 at $58.61, or nearly 19% off their year-to-date high of $72.18.

The sell-off was due to the top holding in the fund, Nextera Energy, experiencing heavy selling pressure late last month, he said.

“Nextera is a renewable energy company. They rely on debt to finance their projects and with rates rising so fast they got hit pretty hard,” he noted.

The share price of the stock dropped nearly 60% between Sept. 25 and Oct. 9. During that time, the 10-year Treasury yield jumped 38 basis points.

The Energy Select Sector SPDR fund (ticker: “XLE”) provided additional volatility, he said.

“All those factors helped price this very defensive barrier at maturity,” he said.

“I like the fact that the most conservative barrier is for the principal, not the coupon. I care a little bit more about principal protection,” he said.

Issuer call

The issuer call could be seen as a disadvantage for some advisers but not for Nuttall.

The first benefit of a discretionary call is the higher payout, he said.

“You get paid 1.5% to 2% more with an issuer call than with an autocall,” he said.

In addition, investors should not necessarily assume that they are more likely to be called when the issuer has the discretion to do so.

“The autocall is automatic. If the index is flat or up, you get knocked out. But the issuer may not necessarily call you if the indices are flat or slightly up. They could decide to let it go. It happens all the time. Also, if rates continue to go up, they’re less likely to call,” he said.

For investors seeking to reduce reinvestment risk, issuer calls may not be a bad option.

“Notes with issuer calls tend to last longer. Typically, autocalls get called after three or six months,” he said.

Low correlations

Nuttall said that the three underlying ETFs were not highly correlated, which introduced some dispersion risk. But he downplayed the issue.

“The negative correlation between some of the funds depends on the period. For three-year we found a weak, not an inverted correlation,” he said.

The correlation coefficient between XLK and XLU is 0.25. Between XLE and XLU, the coefficient is 0.34 and between XLK and XLE, it is 0.39. A perfect correlation is 1.

Those low correlations, the issuer call and the volatility spike on XLU help explain the favorable pricing, which he defined as the combination of a high coupon and low barrier at maturity.

“You could get more coupon with a 70% barrier at maturity. I suppose you could get close to 20%. But it would be much riskier. We wouldn’t do that,” he said.

Nuttall did not deny the risky nature of the security. But for the right size, the note has a place in a portfolio, he said.

“You could use it for a small portion of the portfolio, which reduces your risk. You already have a very conservative barrier. Put those two things together – small allocation and low barrier – and you have a reasonable amount of risk. I would be comfortable with it,” he said.

Dispersion risk

Scott Cramer, president of Cramer & Rauchegger, did not share this view.

“Typically, I don’t like worst-of, and I certainly don’t like them on three sectors especially with those correlations.

“XLK and XLE are negatively correlated. It sets you up for failure. The bias is to the downside.

“Those two funds are not going to behave in the same way. If one goes up, the other can go down.

“I wouldn’t do it just for that reason,” he said.

Volatility

For Cramer, the bet was only designed for investors reaching for yield. But even with a 14.1% coupon, investors were not compensated for the risk, he said.

“If we have an economic meltdown due to the situation in the Middle East, oil will be tremendously volatile, you could see a 50% decline. I still like energy. But I don’t like the combination of those three ETFs in a worst-of,” he said.

The quarterly issuer call was another issue.

“If something goes well, you get called.”

“You get sucked in by the 14% coupon. But there’s too much risk in there despite the 50% barrier,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on Oct. 13.

The Cusip number is 61775MJK3.

The fee is 0.75%.

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