Morgan Stanley’s $5.79 million digital notes on Topix offer uncapped gains, Japan exposure

By Emma Trincal

New York, April 15 – Morgan Stanley Finance LLC’s $5.79 million of 0% buffered digital notes due April 9, 2026 linked the Topix index offer a minimum return with unlimited upside for investors eager to participate in a soaring Japanese stock market.

If the index finishes at or above its initial level, the payout at maturity will par plus the greater of the index return and 23.35%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will lose 1.1765% for every 1% that the index declines beyond 15%.

Rising sun

“That’s good. Usually for a two year, you’re capped,” said Ken Nuttall, chief investment officer at BlackDiamond Wealth Management.

“Everyone is loving Japan. I get more and more calls from clients talking about Japan and also India,” he added.

“Japanese equity markets hit aa 35-year high. That’s enough to get people excited.

“A year ago, it was at 2,000. Now it’s at 2,700. It gained 35% in one year.”

Nuttall also liked the structure.

“A digital return plus the unlimited participation is a good way to play the upside. Meanwhile, you’re lowering the downside,” he said.

Equity allocation

The 23.35% digital level gave investors an annualized return of 11% on a compounded basis.

“The issuer is not even using the yield that much. The Topix pays a 2% dividend rate, which is not huge. So, you miss out 2% a year. But you get the 15% buffer,” he said.

The notes would easily fit in the equity portion of a portfolio.

“It’s a good ETF replacer. I’ll take that. I would just do a little bit more research on Japan before pulling the trigger,” he said.

Minimum +

The uncapped upside above the digital was perhaps the best feature.

“Everyone likes to have some form of return enhancement without being capped out,” he said.

He noticed that issuers seem to have an easier time uncapping digitals than leveraged products.

“I’m not sure why, but I see more uncapped digital notes at least on shorter durations like this one.”

With leveraged products, issuers often have to extend the duration or include a one-time autocall, he added.

The use of some indexes may help as well.

“We recently did a five year on the S&P Futures index. We got a 60% digital with unlimited upside. But it was a five year,” he said.

“If you want exposure to Japan, this note is a pretty good one.”

Mysterious alpha

Jonathan Tiemann, president of Tiemann Investment Advisors, said he was surprised by the terms.

“This is strange. It looks like you outperform the index most of the time,” he said.

“If it’s negative, you have the 15% buffer. Even if the Topix falls by more than 15%, you still outperform.”

On the upside, investors could either outperform the index or market perform.

“Any gain below the 23.35% minimum return gives you a better outcome than if you were long the index.

“It’s only if the Topix is up above the digital that you lose your edge. But it’s not like you’re underperforming the index. So, when do you actually underperform? It’s intriguing,” he said.

Pricing

One explanation was the fact that noteholders (unlike shareholders) do not receive any dividends.

“But the dividend is not even that big. It doesn’t make a huge difference,” he said.

Another factor was the reduced liquidity, which does not impact ETF investors, he noted.

“These are small things. It doesn’t really explain how the note can so easily outperform a long position in the index,” he said.

One factor though could be key.

“I can only see one reason. The cost of owning the underlier is much greater than the financing cost. That must be what’s paying for this structure,” he said.

He pointed to the ultra-low interest rates in Japan: the two-year Japanese Government bond yields 0.26%.

“Their rates are no longer negative but they’re extremely low. That allows you to borrow money to buy the Topix at a very inexpensive cost.

“This is probably what is driving those terms.

“Regardless of how they priced it, this seems like a good deal to me,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes settled on April 10.

The Cusip number is 61771W5Y0.

The fee is 1.73%.

© 2015 Prospect News.
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