Morgan Stanley’s 9.25% contingent income notes on three indexes show rare long duration

By Emma Trincal

New York, June 14 – Morgan Stanley Finance LLC’s contingent income securities due July 1, 2032 linked to the least performing of the S&P 500 index, the Russell 2000 index and the Euro Stoxx 50 index offer an attractive yield based on a longer-than-usual tenor seen in similar deals, according to data compiled by Prospect News.

The 15-year notes will pay a contingent monthly coupon at an annual rate of 9.25% if each index closes at or above its 75% coupon barrier on the observation date for that month, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par unless either index finishes below its 50% downside threshold, in which case investors will be fully exposed to the decline of the worse performing index.

A large majority of worst-of products do not exceed five years in duration, according to the data.

Funding

The coupon for this product was commensurate with the risks, a market participant said.

“You get a very nice pickup in funding by committing your clients to Morgan Stanley paper for 15 year. That’s all,” he said.

“The funding you get is the risk you take in holding a Morgan Stanley paper for 15 year.”

The notes offer no call or autocall feature.

“It’s a long time but at the end of the day it’s up to the client to decide what they want to do. If you want to be clipping 9% a year you have to take risk.”

Contingent coupon

For this market participant, the greatest risk was to miss some of the coupons during several years in a bear market scenario or simply during prolonged periods of correction.

“Indices go up and down. We could have a downturn and it could take a while before the market can go back up,” he said.

“It’s a dual play on the credit and market risk.”

Not autocallable

An industry source said the most surprising part of the structure was the absence of any call option.

“There’s no autocall and it’s designed that way. They calculate this on the option model. They don’t give anything away for free. You can rest assured,” this source said.

Most worst-of are autocallable contingent coupon notes. Some of them feature a discretionary call. But bullets are not the norm, he said.

“It benefits the issuer. From the bank’s perspective, this is probably done this way to get long-term funding.

When a note can be called after one year, it’s treated as a one-year note. It’s not long-term funding,” he said.

The length of the security helped explain how the issuer was able to price a nearly 10% coupon. But this source cited other factors as well.

CDS spreads

“Issuing 15-year debt on Morgan Stanley’s credit spread gives you the opportunity to boost the yield,” he said.

Credit default swap spreads for Morgan Stanley are relatively wide compared to other U.S. banks.

The five-year CDS rate for Morgan Stanley is 67 basis points. Goldman Sachs with 71 bps shows the widest spreads, according to Markit.

The other main U.S. banks – Citibank, Bank of America, JPMorgan and Wells Fargo – have all tighter spreads ranging from the mid-40’s to the mid-50’s, according to Markit.

Yield booster

“The wider spreads give you more to buy the options. It’s even more spread on 15 year...These are just the five year CDS,” he said.

“Selling puts also gives you more premium for your coupon.

“And as always the contingency, the worst-of provide additional juice.

“All you do is convert the option premium on a 15-year term into a coupon.

“That’s how it looks quite appealing.”

The notes were designed for yield-seeking investors.

“The barrier at maturity is very low. I think it’s likely you’ll get your money back at the end,” he said.

“On the other hand you’ll have periods when you don’t get paid because of the market.”

Investors also had to consider the “upside risk,” by comparing the expected return with a growth instrument referencing the same markets over the same period of time.

“Even though 9% is high, you won’t always get it,” he said.

“You could very well underperform the market. But that’s part of the trade-off.”

Morgan Stanley & Co. LLC is the agent, with Morgan Stanley Wealth Management handling distribution.

Morgan Stanley is the guarantor.

The notes will price on June 27 and settle on June 30.

The Cusip number is 61768CKL0.

© 2015 Prospect News.
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