Morgan Stanley enters MLP ETN space with notes linked to Cushing MLP High Income index

By Emma Trincal

New York, March 17 - Morgan Stanley launched a new exchange-traded note linked to the Cushing MLP High Income index.

It is Morgan Stanley's first foray in this asset class under an ETN format, following on the lead of several competitors that have created similar ETNs over the past two years.

It is also Morgan Stanley's first ETN brought to market by its institutional equities division, according to a spokesperson at the firm.

Master limited partnerships are partnerships that trade on U.S. public exchanges or markets. Most MLPs own and operate assets in the energy sector. An example is natural resource-based companies that own, build and maintain energy infrastructure such as pipelines and storage facilities.

The ETN, which is set to begin trading on Friday, targets both the retail and institutional markets, according to an industry source.

More ETNs to come

"The MLP structure gives investors access to companies that operate in a market that has historically had high barriers to entry and growing distributions. We believe this ETN is differentiating in this space by referencing an index that both provides a diversified exposure to MLP issuers and whose constituents have had among the highest current yields," Nikki Tippins, head of equity derivatives sales for the Americas at Morgan Stanley, said in a press release.

"We anticipate launching more ETN products throughout the year," Tippins added.

A spokesperson declined to elaborate on those plans.

Industry trend

"A number of MLP ETNs came out last year. This is just the latest," said Hinds Howard, a money manager who buys MLPs for retail clients at Curbstone Group.

"MLPs offer a great combination of high yield with inflation protection and growth."

JPMorgan Chase & Co. initiated the trend among large firms in April 2009 with an ETN linked to the Alerian MLP index. The total issue size is now $1.28 billion, according to data compiled by Prospect News.

UBS AG, Jersey Branch followed suit in April 2010 with its own version of the product, an ETN tied to the Alerian MLP Infrastructure index. The firm later on launched a two-times leveraged version of the same product.

Credit Suisse AG, Nassau Branch also launched its own MLP ETN almost a year ago with a product tied to the Cushing 30 MLP index.

Morgan Stanley exclusive

It's the first time the Cushing MLP High Income index has been used in an ETN, Dan Spears said in an interview. He is partner and portfolio manager at Swank Capital LLC, the firm that created the Cushing indexes.

"Morgan Stanley is the exclusive licensee of this index for an ETN," he said.

"But we're open to discussions with firms to license the MLP Cushing High Income index for traditional, non-ETN structured notes."

The Cushing MLP High Income index is a criteria-weighted index tracking the performance of 30 MLPs that hold energy infrastructure and related shipping assets in North America. It was created by Cushing MLP Asset Management, LP, a subsidiary of Swank Capital.

"The index uses a three-tiered weighting system that screens for the highest yield based on a fundamental indexing approach," Spears said. "This method makes the index more diversified; it eliminates single-stock risk and provides a pick-up in yield over the Cushing 30. It's based upon fundamental selection criteria and not on market cap selection criteria."

Spears said that the current yield for the Cushing MLP High Income index was 6.9%.

"You pick up 75 to 100 basis points over the Cushing 30. That's pretty significant," he said.

The Cushing MLP High Income index generated a 46.27% return over the past year as of March 1, according to a Morgan Stanley fact sheet.

In comparison, the one-year return on the Alerian MLP index was 35.72%. The S&P 500 posted a 19.43% gain during the same period.

"I'm not familiar with the [Cushing MLP High Income] index, but it's hard to select high-yield names and to be sure that the underlying MLP has good fundamentals," said Howard.

MLP rush

MLPs represent a newer asset class, and their appeal is growing among retail investors, sources said.

"Investors in those MLPs are definitely looking for alternatives to traditional bond portfolios. They're looking for a higher income strategy," said Matt Medeiros, president and chief executive at the Institute for Wealth Management.

"We see energy, like the rest of commodities, as having the potential to rise in the near future. I think this new product is predicated on the rising demand for oil and natural gas."

"MLPs have historically performed well in a variety of market environments, typically with low correlation to the market," Morgan Stanley said in its fact sheet.

Tax benefits

One important factor driving investors to this new asset class is the preferential tax treatment, sources said.

"MLPs are partnerships not corporations, and as such they generally do not pay federal or state income taxes," according to Morgan Stanley's fact sheet.

In addition, the tax treatment is simplified, an industry source said.

"The ETN provides simplified tax reporting. Investors receive Form 1099 for the coupon payments, not K-1 forms to deal with for underlying MLP exposure," the industry source said.

A K1 filing often represents an "administrative burden" compared to a 1099 form, according to a tax expert.

"The ability to get passive exposure to the MLP space and to receive a 1099 versus a K1 makes those investments very attractive to investors," Spears said.

Income

Investors are also driven to this asset class for the high and stable income distributions generated by MLPs, sources said.

"MLPs are used as a substitute for corporate bonds because a 6% yield is the highest yield you can get, and you get some growth as well, so you can get double-digit total returns. And that's nice," said Howard.

"The yield is higher than a REIT and it's more stable. Oil and gas prices are volatile, but demand for oil and gas is very stable. People still need to drive their car and to heat their home. The vast majority of MLP companies are paid a fee for transporting refined gas and oil through a pipeline, so this type of income stream is less subject to an economic downturn.

"People are looking into the MLP sector in general because they're reaching out for yield. Just look at money markets yields. They pay next to nothing."

The notes (Cusip: 61760E846) will settle on March 21.

The notes are listed on NYSE Arca under the symbol "MLPY."

Morgan Stanley & Co. Inc. is the underwriter.

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