Morgan Stanley’s floating-rate notes tied to CPI designed to bet on, hedge against inflation

By Emma Trincal

New York, Jan. 14 – Morgan Stanley’s floating-rate notes due July 31, 2020 linked to the Consumer Price Index should appeal to investors concerned about the resurgence of an inflationary environment over the next 18 months.

The notes could be used alternatively to generate income or as a hedge against inflation, which for bondholders is always a risk as it erodes portfolio returns. After decades of low inflation and low interest rates however, inflation so far is still relatively benign, some sources said.

The interest rate will be the year-over-year change in the index plus 100 basis points, according to an FWP filing with the Securities and Exchange Commission.

Interest will be payable monthly and cannot be less than zero.

The payout at maturity will be par.

No recession in sight

Kirk Chisholm, wealth manager at Innovative Advisory Group , said that he expects inflation to steadily increase, which would bode well for noteholders.

“Bond rates are going up. Unless we have a recession or some very ugly event coming from China or Europe, I’m not seeing any reason for rates to drop,” he said.

CPI in December increased 1.9% year over year, versus 2.2% in November, according to the Bureau of Labor Statistics.

“With a CPI of about 2% plus the 1% spread, you’re getting 3% a year, which is about half a point more than the equivalent Treasury. But that’s just for now. Your yield is tied to inflation so it should go up. I just don’t see why inflation shouldn’t trend upward unless we have a recession,” he said.

“I’m comfortable with this note based on the situation right now. For the next 12 months I don’t expect a great risk of a recession. But it’s hard to predict further because a lot of factors can impact inflation,” he said.

Wages, the Fed put

Two factors could make the case for higher inflation, sources said.

Prices for goods and services could increase short term under salary pressures, some sources argued.

With a tight labor market and an economy still growing, wage gains would be the first source of a new inflationary cycle. The last quarter has seen hourly earnings’ highest increase since April 2009, according to the Bureau of Labor Statistics.

Another factor could be imported inflation due to U.S. trade tariffs against China and other countries.

The Fed is expected to play an active role as well in countering those trends. Its dual mandate requires that it contains inflation above its target by tightening interest rates. Given the bearish impact of the central bank’s rate hike last month on equity markets, many futures traders have begun to expect the Fed to be more mindful about keeping market volatility in check than preventing inflation.

Defensive play

“This note could appeal to people looking for income,” said Chisholm.

“You’re taking on a little bit more risk because of the issuer’s credit risk and because of the fluctuating interest rate.

“But it’s not a huge risk.

“It’s not like buying a worst-of on two stocks with your principal at risk. Even if people buy those worst-of for income as well, it’s a very different conversation you can have with a client when they get full downside protection.”

Muted inflation

Carl Kunhardt, wealth adviser at Quest Capital Management, said he would not consider the notes in part because he does not expect inflation to rise, as many in the market do.

“Everybody is saying the inflation is not going up,” he said.

He cited consulting firm Mercer, which does not predict wages to increase this year even though the unemployment rate is at a record low.

“We use Mercer’s projections on inflation. They don’t think it’s going to be more than 2% for the next five years,” he said.

“Every year we look at the five-year projection. You get a sense of where it’s going. In the past five years we’ve noticed that it’s not going anywhere.”

The yield on the notes would be unlikely to go up very much, he said.

“I’m beating the Treasury rate by a few basis points but I’m not sure I’d want to take the credit risk for that,” he said.

The credit default swap rates for Morgan Stanley at 97 bps are the widest among large U.S. banks after Goldman Sachs’112 bps, according to Markit. By comparison, Bank of America showed spreads of 75 bps and JPMorgan, 69 bps. Citigroup stands at 85 bps.

Problematic allocation

“I can’t really put it in my cash allocation. I’m taking on the credit risk and I don’t have the liquidity,” he said.

The alternative would be to allocate the notes to a fixed-income bucket.

“But putting it in a short-term bond allocation doesn’t make much sense either. I’m no longer benchmarking it against Treasuries. I’m benchmarking it against a short-term bond index, which will give me a better return.

“It’s not liquid enough to be cash and it doesn’t give you enough yield to be a bond substitute. I’m taking Morgan Stanley’s credit risk and I’m not getting compensated for it.

“I would take a pass on this,” he said.

Morgan Stanley & Co. LLC is the agent.

The notes will settle on Jan. 31.

The Cusip number is 61760QMH4.

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