Morgan Stanley’s $3.8 million autocallable jump notes on Russell show unusually short call period

By Emma Trincal

New York, March 25 – Morgan Stanley Finance LLC’s $3.8 million of 0% buffered jump securities with autocallable feature due Sept. 23, 2025 linked to the Russell 2000 index offer an unusual form of “catapult” structure with a very short call period and tenor.

The marketplace has coined the term “catapult” to designate structures that have a one-time autocall paying a premium and, if there is no call, then uncapped leverage at maturity. The overwhelming majority of those notes usually place the call date a year after issuance. In this case, the period is reduced by half.

If the index closes at or above its initial level on Sept. 18, 2024, the notes will be automatically called at par plus a call premium of 4.75%, according to a 424B2 filing with the Securities and Exchange Commission.

If the notes are not called and the index finishes at or above its initial level, the payout at maturity will be par plus 1.5 times the index gain.

Investors will receive par if the index falls by up to 10% and will lose 1% for each 1% decline beyond 10%.

On the plus side

“The note conceptually is very interesting because it’s a short-term play with uncapped leverage at maturity and a buffer,” said Steven Foldes, founder and portfolio manager at Evensky & Katz / Foldes Financial Wealth Management.

He pointed to some of the positive features.

“We like the credit of Morgan Stanley,” he said.

“Moreover, the idea of having one asset class is preferable to a worst-of.

“We also really like the exposure to the Russell, which has underperformed large-cap stocks over the past several years.”

The S&P 500 index has topped the Russell 2000 in the past 10 years except twice, in 2016 and 2020, according to Morningstar. For the year to date, the S&P 500 index has gained 9.5% versus 2.8% for the Russell, a 6.7% spread.

“The kicker on the notes assuming the index is negative on year one would be to get the leverage with no cap and the 10% hard buffer, which is the icing on the cake,” he said.

Short term

But Foldes mentioned a few issues with the deal, which would prevent him from considering it for his clients.

The first downside was the cost of 1.75%, according to the prospectus.

“1.75% for an 18-month note is way beyond what we would expect,” he said.

But Foldes’ major objection was the six-month call period.

Operational burden

“The coupon may be 9.5% a year, but if you receive it, all you get is 4.75% in six months. That return even on an annualized basis is not that much higher than a fixed-income return,” he said.

He gave the example of the six-month Treasury yielding 5.32% a year. Over six months, the T-bill would return 2.66%.

“You’re getting an incremental 2%, which is not a huge spread considering the equity exposure. But more importantly, the administrative cost of going through all of our clients’ portfolios and adding this note for six months is hardly worth it,” he said.

Tax treatment

An even greater drawback was the tax treatment of the call premium.

“Assuming the notes get called and we’re getting the 4.75% coupon, you then fall into the highest tax bracket, which can be as high as 37% for our wealthy clients. That would be a non-starter,” he said.

“While the six-month autocall is conceptually very interesting, on a practical level, it wouldn’t be an option for us.”

Extending the term

Foldes said he would have to make some changes to the structure in order to consider the notes.

“I would ask Morgan Stanley what the terms would look like if we extended the maturity to two years with a one-year coupon,” he said.

This setup would transform the notes into the more conventional catapult format, consisting of a one-time autocall at the end of the first year and a tenor varying from two to five years.

“Hopefully we would still be close to a 9.5% coupon, which would be much more attractive from an absolute return perspective.

“But as it is, the tax treatment and short-term coupon are a deal breaker for us,” he said.

Not an income solution

Ken Nuttall, chief investment officer of BlackDiamond Wealth Management, agreed that the tax treatment was not favorable.

“You’ll definitely have to pay income taxes if you get called,” he said.

The “risk” that the IRS may treat the gain as ordinary income is stated in the “risk factors” section of the prospectus.

“We usually see 53 weeks or 13 months to avoid the higher tax bracket,” he added.

Yet, Nuttall downplayed the issue.

“It’s just something to consider. But the implications depend on what you’re using the notes for,” he said.

Even with the 40% tax rate, noteholders would not lose significantly in net return compared to a T-bill, he said.

The call premium return net of the 37% income tax would be 2.85%. This would be slightly more than the 2.66% gain earned from the T-bill over the period although T-bills are exempt from state and local taxes.

“If you buy the noes as fixed-income replacement it’s not really worth it. The net return after tax is not that great and you still have the equity risk,” he said.

Participation ahead

Investors instead should buy the notes for growth, he said.

“You need the conviction that the Russell will be down in six months. That’s possible given that a lot of the companies in the Russell are not profitable plus you have all those banks in there that are still hurting.

“You get nothing in six months. But hopefully the Russell takes off in the next 12 month and you can benefit from the unlimited leveraged upside,” he said.

Overall, the note was unusual, not just for its short call period but for its short maturity.

“I haven’t seen a catapult with a six-month call. It’s usually one year followed by a multi-year trade,” he said.

“It wouldn’t work for me because I don’t think 18 months is enough for a good trade to happen. I would need to have a bit of a longer view on the Russell.

“But a lot of people want shorter trades. This would get you there,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on Thursday.

The Cusip number is 61776LFH5.

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