Morgan Stanley’s $13.4 million contingent income notes on three stocks offer rare features

By Emma Trincal

New York, May 8 – Morgan Stanley Finance LLC priced $13.4 million of contingent income autocallable securities due Nov. 9, 2018 linked to the least performing of SAP SE, Microsoft Corp. and Nvidia Corp. shares. The securities use a common income type of structure but have two unusual features.

The standard aspect of the structure is the worst-of feature. For all events – coupon payment, automatic call and final redemption amount – only the least-performing stock is taken into account.

The notes will pay a contingent monthly coupon at an annual rate of 6.3% if the least-performing stock closes at or above its 55% downside threshold level on the observation date for that month, according to a 424B2 filing with the Securities and Exchange Commission.

The autocallable feature, also observed on a monthly basis, kicks off after four months. The notes are called at par plus the contingent coupon if all three stocks close at or above the redemption threshold.

Finally the payout at maturity will be par plus the final coupon unless any stock finishes below its downside threshold, in which case investors will lose 1% for each 1% decline of the least-performing stock.

Step down, euros

Sources pointed to two less common features of the product.

First, the call trigger, or redemption threshold, is not set at the initial share price as it almost always is. Instead, the threshold is below the initial share price and steps down with time.

The redemption threshold is 95% of the initial share price through March 2, 2018, stepping down to 90% through Oct. 2, 2018 and to 85% thereafter. The first call date is Sept. 5.

The second unusual element is the fact that the share price of SAP is observed in euros.

At pricing, the share price of SAP, a German software company, was €92.80. The price will be measured in euros through the life of the notes.

The stock is traded in euros on stock exchanges in Germany.

Too easily called

Jerrod Dawson, director of investment research at Quest Capital Management, paid little attention to the underlying but rather focused on the structure. He said he did not like the call risk.

“It’s a worst of, but the barrier on the coupon is so low you can get paid often. Problem is, for how long? With a call trigger below par and that keeps on going down, you’re very likely to be called,” he said.

The first four months during which the notes are not callable bring little relief.

“You may get the first four months of interest, or 2.1%. After that, I don’t know if you’re going to keep receiving your coupon for very long.”

Dawson said that the early redemption scenario is always a risk for investors who need income as they can never be certain to get a similar or higher yield.

The 2% fee payable upfront, which represents an annualized cost of about 1.3%, is also a concern if the notes are called early.

“You’re almost looking at 5.3% on a net basis,” he said.

“There’s a lot of moving parts in this deal, a lot of analysis to get 5.3%.

“If it was 6.3% net, I may consider it. But as it is, it’s not appealing to me.”

Euros to euros

Sources were also intrigued by the fact that one of the three underliers is quoted in euros.

“I haven’t seen this before,” a lawyer said.

“It could be a tax issue, perhaps for the issuer to avoid double taxation on the dividend,” said an investor.

But the lawyer, who specializes in taxes, did not think so.

“The dividend is based on the corporate entity whether you link it to the stock in the original country or in the U.S.,” this lawyer said.

“It’s not tax-driven. It’s more likely to be related to currency.”

A market participant agreed, citing “quanto” as the derivatives technique used to avoid exposure to currency risk.

“That’s the quanto effect, and it’s the advantage of structured notes,” he said.

He took the following example: “Let’s say it’s a simple one-to-one. Your SAP stock starts at €100. Your barrier is 55%. At maturity it declines by 60%. You breached. You then lose 60% of your original investment in dollars regardless of the exchange rate.

“You started with $1,000. You get $400 at maturity. Not a great result, but one that’s easy to understand.”

With quanto options, used in most structured notes, the performance of the underlying is reviewed in the indigenous currency. The resulting percentage of gain or loss is then applied to the investor’s notional, which is in dollars.

“It allows you to make a pure equity bet without worrying about the impact of the exchange rate,” he said.

Why not ADRs?

The market participant noted that SAP is also traded in the U.S. markets.

Investors in the notes could have had exposure to the American Depositary Receipts listed on the NYSE Arca under the symbol “SAP.”

But if the underlying had been the ADRs, the impact of exchange rates would not have been removed.

“If you use the ADR, you have to translate it into dollars. You’re not hedged,” a currency structurer said.

If the euro declined against the dollar and if the notes were linked to the ADRs, then investors could lose money even if the stock price appreciates, he said.

The market participant, however, said that issuers and their clients are not overly concerned about currency risk.

“Issuers want simplicity. They use quanto because they don’t want to do all the explaining in the prospectus with the complex FX formulas,” he said.

“They don’t use quanto to tell their clients, look! We’ve hedged you against the dollar versus the euro.”

For that reason, he said he was surprised that the issuer did not use the ADRs, which require no explaining.

“The ADR has some exposure since it’s cross-currency. But they do that for you. The issuer doesn’t have to explain this. It’s in dollars.

“I don’t think anyone cares about currency risk, so I think this stock quoted in euros is a little bit strange.”

High flyer

Finally, one trader said that one of the three stocks shows extremely high levels of volatility.

“Microsoft and SAP are relatively stable, but Nvidia is a little scary,” said Clemens Kownatzki, independent currency and options trader,

From February 2016 to February 2017, the share price of Nvidia rose from less than $25 to $120. The stock currently trades at around $100.

The options market prices the chances of the stock breaching the 55% barrier within a year at 8%, he said.

“It may not seem like a lot, but I would still be worried. If you have a stock that gained five times in a year, despite what the options say, obviously there is a risk. It’s not so unlikely that it would go down 50%.”

Morgan Stanley & Co. LLC is the underwriter.

Morgan Stanley is the guarantor.

The notes (Cusip: 61768CJB4) priced on Wednesday.

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