Morgan Stanley's contingent income notes linked to Freeport-McMoRan aim at neutral investors

By Emma Trincal

New York, April 29 - Morgan Stanley's contingent income autocallable securities due May 24, 2012 linked to the common stock of Freeport-McMoRan Copper & Gold Inc. offer above-average yield for investors who believe that the underlying stock will trade range bound, said Tim Mortimer, managing director at Future Value Consultants.

If Freeport-McMoRan stock closes at or above the downside threshold level - 80% of the initial share price - on a quarterly determination date, investors will receive a contingent payment of $0.35 to $0.40 for each $10.00 note, according to an FWP filing with the Securities and Exchange Commission. Otherwise, no contingent payment will be made for that period.

The exact contingent payment will be set at pricing.

If the closing share price is greater than or equal to the initial share price on any of the first three quarterly determination dates, the notes will be automatically redeemed at par plus the contingent payment.

"If on each quarterly point the stock is at least at 80%, you get the 3.5% to 4% coupon for the quarter. If it's above 100%, you get the coupon plus redemption," he summarized.

If the notes are not called and the final share price is greater than or equal to the downside threshold level, the payout at maturity will be par plus the contingent payment.

If the final share price is less than the downside threshold level, the payout will be a number of Freeport-McMoRan shares equal to the principal amount of notes divided by the initial share price or, at Morgan Stanley's option, the cash value of those shares.

"For the final payment, if it's above 80, you get the coupon and your principal back. If it's below, you get the share price," he explained.

Hybrid structure

"This structure is a hybrid between a knock-out and an autocallable," he said.

"It's a clever structure. Investors don't like when the issuer has a right to call. They much prefer autocallable structures."

Mortimer said that investors in these notes need to have a neutral view on the stock as they cannot be either too bearish or too bullish.

"If you think the stock will rally, this is not a good investment," he said, because investors do not participate in the growth of the stock.

"This is really for an investor looking for high yield and who believes that the stock will range trade," he added.

Bearish investors would not choose this product either because they would encounter a loss of principal if the shares finish below 80% of the initial price.

"Investors in this product have to be comfortable with the direction of the stock."

Best scenarios

The best outcome for investors, Mortimer said, would be to receive their contingent quarterly payments along with their entire principal at maturity.

The "second-best" scenario would be to get their principal back early.

"Sure there is a risk of an early kick-out, for instance after only three months, but at least you're getting the income and your money back," he said. "Finishing early is not a bad outcome even if ideally investors would want to play the coupon as long as possible."

Variable terms and price

Mortimer compared this product with a reverse convertible and said that the contingent income autocallable structure enabled the issuer to offer a higher coupon.

"You'll get better terms with this note than what you would get with a reverse convertible because you don't have a fixed maturity and you don't have a fixed interest rate payment," said Mortimer.

With a reverse convertible, the investor receives the coupon regardless of the performance of the underlying. "It's only the capital that's at risk," he said. This difference allows the structurer to increase the coupon for the contingent income autocallable notes.

Additionally, the maturity can vary. If the stock rallies above par on one of the call dates, the contingent income autocallable notes will be redeemed early. "The shorter maturity creates value, which allows the issuer to add more yield," he said.

Investors' preferences for a reverse convertible, traditional autocallable or contingent income autocallable will depend on their "investment views and risk appetite," he said.

In this particular product, "the investor is hoping that the stock will trade in a range of 80 and slightly above par," Mortimer said.

Risks

Part of the risk resides in the volatility of the underlying stock.

Freeport-McMoRan, a gold and copper mining company, has an implied volatility of 38%, which is about twice as volatile as the S&P 500 index, Mortimer said. With the risk comes the reward in the form of a relatively high coupon of 3.5% to 4% per quarter.

Risk can take several forms.

"Worse-case scenario: the stock goes to 75 at maturity. You get no coupon plus you suffer losses, which is pretty bad news," Mortimer said.

Another risk is the "opportunity risk" that the investor might not receive any coupon during the life of the notes, he added.

The notes (Cusip: 61760E655) will price May 24 and settle May 27.

Morgan Stanley & Co. Inc. is the agent.

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