Morgan Stanley’s $10 million floaters tied to Consumer Price Index seen as premature

By Emma Trincal

New York, Oct. 28 – Morgan Stanley’s $10 million of floating-rate notes due Oct. 28, 2024 linked to the Consumer Price Index offer a hedge against inflation for income investors, but sources questioned the timing of an inflation bet as well as the yield offered, saying shorter or better alternatives are available to investors pursuing this investment theme.

The coupon will be equal to the year-over-year change in the index plus 120 basis points, according to a 424B2 filing with the Securities and Exchange Commission.

Interest is payable monthly and cannot be less than zero.

The payout at maturity will be par.

Not enough juice

Jonathan Tiemann, president of Tiemann Investment Advisors, LLC, said the notes did not offer enough yield to compensate investors for taking the credit risk associated with the issuer.

He compared the notes with the yield on a 10-year U.S. TIPS, which is currently a stated rate of 0.38% plus the accrual interest investors get from the indexation to inflation. While the semiannual adjustments on the TIPS are only paid at maturity, they constitute part of the return along with the coupon.

“Right now, the U.S. TIPS yields at CPI plus 0.40%,” he said.

“This [structured note] is offering you CPI plus 1.20%.

“The spread between the two is 0.80%. You’re getting 80 basis points from Morgan Stanley’s credit on the CPI-based note. It’s an awfully good deal for Morgan Stanley. To me, the 80 bps spreads I’m getting is not enough to pay me for Morgan Stanley credit risk.”

Morgan Stanley’s five-year credit default swap spreads are 79 bps on Tuesday, according to Markit. In comparison, Goldman Sachs spreads are 82 bps; Bank of America is 70 bps; and JPMorgan is 60 bps.

Tiemann then looked at the “premium” or spread Morgan Stanley paid on its nominal paper over a 10-year U.S. Treasury yield, the former offering a 3.75% yield “or so” versus the 2.30% yield on the 10-year Treasury.

“The spread is 1.45%. You’re getting about 150 basis points over Treasuries on Morgan Stanley for taking the credit risk.

“Conclusion: If I worry about inflation, I prefer TIPS. If I like Morgan Stanley credit, I buy the nominal Morgan Stanley paper,” he said.

Too long

Dean Zayed, chief executive of Brookstone Capital Management LLC, said that investors seeking to protect themselves from the negative impact of inflation could use better alternatives, which would also be shorter.

“The most attractive parts of this note are the principal protection and the formula for paying interest as I think it accomplishes the goal of providing an inflation hedge during inflationary times,” he said.

“But the biggest issue is the term. You are locked in for a 10-year period.”

Since investors only get paid on the floating rate, one risk associated with the trade is to earn no interest, according to the issuer.

In times of small inflation or deflation, for instance, the interest rate could be as low as zero if inflation was less than or equal to the 1.20% spread. This would mean zero interest payment, warned the prospectus in its risk section.

For Zayed, such risk is compounded over a long period of time.

“If inflation protection is the investor’s goal, there are certainly other ways to provide this without locking in for 10 years,” he said.

“Alternatives offering liquidity would include investments in gold and precious metals, commodities, TIPS, hard assets like real estate – essentially buying asset classes that tend to perform well in inflationary times.

“And let’s not forget that equities have been a great inflation hedge, especially those with a high and growing dividend,” he said.

Timing

One more serious problem with the notes was the underlying theme.

“Add to this [liquidity issue], the fact that we have very low inflation now, so one may prefer to wait until there is a more established inflationary trend before pursuing an inflation hedge,” he said.

The Consumer Price Index increased 1.7% over the last 12 months through September, the U.S. Bureau of Labor Statistics reported last week.

In comparison, inflation reached double-digit levels during the stagflation in the late 1970s while deflation following the 1929 crash in the 1930s showed negative rates for several years.

“Given the uncertainty of when inflation really rises – if ever – it seems like a ‘timing’ issue whether an investor wants to buy this note. Those that think inflation is coming soon couldn’t pile into this note fast enough while those that think it won’t happen for some time will avoid this structure for now.

“Since timing is certainly not an exact science, my preference would be to wait until the data tells us that we need to build in some inflation hedges. This note seems a bit premature, although its structure and target goals are well taken,” he said.

Stick to treasuries

A structured products trader on the fixed-income side agreed.

“Inflation is not a threat right now,” he said.

“We really haven’t had a growth rate in this country indicating inflationary concerns. The CPI growth is not even at 2%.

“You would need at least 3% to begin to pay more attention to inflation.

“Look, people have their own investment ideas and there is no panacea. If people feel that the Fed’s policy will lead inflation to roar its ugly head, that’s what this is for. But I’m not seeing things that way.

“Fuel prices are at four-year lows; food is up a little, but durable goods, housing starts are not.

“I don’t think the Fed will be raising rates anytime soon,” he said.

Even if he shared the viewpoint of investors skittish about inflation, this trader said he would proceed differently.

“I would stick to Treasuries. For me, I don’t see any value into this note because you give up a lot,” he said.

“First I don’t really look at inflation right now. But even if I did, I would buy a 10-year Treasury instead because the coupon to me is fine. I would get 2.25% and I would know what I’m getting into.

“And if you’re not really worried about Morgan Stanley’s credit risk – and you shouldn’t – you’re better off with Morgan Stanley paper,” he said.

The notes (Cusip: 61760QFD1) priced on Oct. 28.

Morgan Stanley & Co. LLC was the agent.

The fee was 1.25%.

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