Yield notes – the mechanics (part 2)

Following from part 1, the details of yield note terms and how they work are explained below for those looking for a deeper understanding.

Again, we will use the yield note that we mentioned on Tuesday in our January 24 portfolio update to show how yield notes work.

Key terms of the note:

Term: 18 months

Issuer: Morgan Stanley

Underlying: Russell 2000, Nasdaq, S&P500

Yield: 9.3%

Principal protection: 40%

Coupon protection: 40%

Coupon payments: Monthly

Callability: Issuer call, quarterly

Issue date: January 23 2023

Final valuation date: July 15 2024

How the note works

What is this yield note? This yield note is a package of bonds and derivatives structured into one note that pays a 9.3% yield so long as certain conditions hold true. Coupon and maturity payments depend on the performance of the worst performing underlying reference asset (in this case the underlying reference assets are the S&P500, the Nasdaq and the Russell 2000). Yield notes are ranked as senior unsecured debt, behind only senior secured debt and deposits in the capital structure. 

Term explained: The term of the above note is 18-months. The issue date of the note is January 23 2023, and the final valuation date is July 15 2024.

Principal and coupon protection and coupon payments: Principal and coupon protection levels are both set at 40% and are observed based on price movements of the underlying indices starting on the issue date. Coupons are paid monthly, which means investors receive monthly payments of the annual 9.3% return pro rata. These are taxed as ordinary income.

Principal protection explained: Principal protection is only observed once, on the final valuation date of the note. 40% principal protection means that investors will not lose any principal unless the worst performing underlying security is down by more than 40% between the issue date of the note and the final valuation date. In this case, if the worst performing underlying security is down 41% between issue date and final valuation date, investors will lose 41% of principal (the loss ratio below 40% is 1:1 with the underlying reference asset).

What would we do if a yield note breaches principal protection levels? We build yield notes with what we view as low probabilities of loss and are yet to lose principal on any yield note for investors (though it is possible). Notes may mark down on a statement between when they are issued and the final valuation date, but actual principal loss only occurs if the levels of principal protection are breached. If a yield note were to breach principal protection levels, we would look to invest the remaining capital into the equity market to benefit from recovery upside.

Coupon payment explained: 40% coupon protection is the level of protection for each coupon payment (observed monthly). Each coupon observation is independent and is based on movements in the underlying assets from the issue date. Investors will receive each monthly coupon payment so long as the worst performing underlying reference asset is not down by more than 40% between the issue date of the note and each respective coupon payment date.

Callability explained: The note is callable every quarter at the discretion of the issuer, which means that every quarter, if all three underlying indices are at a positive return from their levels at the start date, Morgan Stanley has the ability to ‘call’ the note away. When issuers call a note away, investors receive full principal plus monthly returns that the note has generated. At this point, we reassess options in the investment universe. If the terms on structured yield notes are attractive at that point in time, we will typically reinvest the proceeds generated from the structured yield note into a new structured yield note. If we view the risk/return on other assets (like stocks) as more attractive at that point in time, we may reinvest the proceeds into new opportunities.

We believe that structured yield notes provide an alternative outside of traditional stocks and bonds that can drive risk strong adjusted returns in an uncertain environment (including in a scenario where stocks and bonds are down). We tailor yield notes to the unique investment objectives of each of our investors.

Disclaimer
The information presented should not be considered personalized investment, financial, legal, or tax advice. This notification is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein. Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, and are based primarily on assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed. Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change. Past performance is not indicative of future performance. Principal value and investment return will fluctuate. There are no implied guarantees or assurances that the target returns will be achieved, or objectives will be met. Future returns may differ significantly from past returns due to many different factors. Investments involve risk and the possibility of loss of principal. The values and performance numbers represented in this report reflect management fees. The values used in this report were obtained from sources believed to be reliable. Performance numbers were calculated by Black Diamond using the data provided by your custodian. Please consult your custodial statements for an official record of value.

The securities involve risks not associated with an investment in ordinary debt securities. Selected Risks Associated with any of these structures include: - Notes are not principal protected and investors can lose some or all their initial principal if the underlying asset falls below the Principal Barrier Level. - Contingent coupon payments. Investors may not receive periodic interest payments if the performance of the underlying asset falls below the Coupon Barrier Level. It is possible that investors will not receive any coupon payments over the life of the Note. - Potential for early redemption and reinvestment risk. Notes will be automatically called if the performance of the underlying asset is at or above the Initial Strike Price on the defined Observation Date. If called, investors may not be able to reinvest their proceeds in a product with a comparable coupon. - Returns are limited to the coupon payments, if any. Investors will not participate in any price appreciation of the underlying asset. Additionally, investors will not receive dividend payments generated by the underlying asset. - Limited secondary market. Notes should be considered buy-and-hold investments and investors should hold them to maturity. They are not traded on an exchange and there may be little to no secondary market available. - Issuer credit risk. Notes are senior, unsecured debt obligations of the issuer and all payments of income and principal are therefore subject to the creditworthiness of the issuer. - Complex investments. Notes may have complex features and may not be suitable for all investors.