Morgan Stanley, Bank of America price CPI-linked deals to match growing investor appetite

By Emma Trincal

New York, Feb. 23 - Morgan Stanley's recent sale of $35 million of notes linked to the Consumer Price Index comes amid a recent wave of fixed-to-floating structures linked to inflation issuers are offering investors in response to a growing demand for long-term inflation hedges, sources said.

Fixed-to-floating deals

Morgan Stanley priced last Thursday $35 million of floating-rate notes due March 1, 2020 linked to the CPI, according to a 424B2 filing with the Securities and Exchange Commission. The notes - based on a fixed-to-floating structure - offer a 5% rate for the first six months, payable monthly. After that, the rate will be the year-over-year change in the index plus 205 basis points, up to a maximum of 9% and subject to a minimum of zero.

The payout at maturity will be par.

On Monday, Morgan Stanley priced an additional $2 million of the same offering, bringing the total deal size to $37 million.

Bank of America Corp. also priced $5 million of notes due Feb. 22, 2017 linked to the CPI. The notes pay a 5% rate for the first year, payable monthly. Thereafter, interest will accrue at an annualized rate equal to the year-over-year change in the CPI plus 125 bps. The coupon is also subject to a floor of zero. The cap in this shorter-term deal is 7% per year in each interest period.

Following a slightly different structure, issuers also came to market with purely floating-rate notes this month.

Bank of America priced $25 million of floating-rate notes due Feb 18, 2020 linked to the inflation index with an 8% cap and a floating rate of 210 bps over the changes in the CPI.

HSBC USA Inc. priced $1.15 million of floating-rate notes due Feb. 26, 2020 tied to the CPI. The cap is 7%, and the floating rate is the index change plus 125 bps.

Demand-driven market

"We've definitely seen demand for inflation-linked notes. That's quite expected when inflation expectations have risen in most G7 countries," said Jakob Bronebakk, associate partner at Jubilee Financial Products, a structured products arranger.

Zero-coupon pricing

What both the Bank of America and Morgan Stanley deals have in common is a combination of a fixed-rate period and a floating-rate period, principal protection and long-term duration.

"The use of zero-coupons would be the normal construction for the issuer," said Bronebakk. Almost by default, he said, principal protection is established by the issuer through the combination of a zero-coupon bond and an embedded option.

"The floor of zero for the interest gives you the principal protection. You could really have deflation and a negative CPI," he said.

Challenging pricing

When structuring principal-protected notes, issuers must find options that are reasonably priced. Otherwise, the economics of the deal may not work for investors, and the terms may not be attractive enough, experts said.

The lower the cost of the embedded option, the more attractive a structure may be, they noted.

Bronebakk compared inflation-linked principal-protected structures with equity-linked notes that also offer full principal guarantee. He said that the pricing of inflation products is less advantageous than that of equity-linked notes in today's market.

"Inflation expectations are up, so inflation pricing is more expensive than equity. Inflation is quite expensive because everybody is anticipating higher prices," he said.

In addition, options on the CPI trade over the counter, said Bronebakk. As a result, the issuing bank would have to find another bank "taking the other side."

"The bank selling the options is likely to be a large institution with a natural exposure to inflation," he noted.

If pricing conditions for those structures are not ideal, "deals [however] are getting done," said Bronebakk. "That's really driven by demand," he said.

Short term, long term

Fixed-to-floating CPI notes, such as those recently offered by Bank of America and Morgan Stanley, offer another advantage to investors: The fixed rate paid during the initial short period of six months or a year allows long-term inflation hawks to express a view, said Matt Lloyd, chief investment strategist at Advisors Asset Management.

"There is really a contradiction between short term and long term when you look at the CPI," Lloyd said.

"Short term, we're not going to have inflation given the excess capacity and the high level of unemployment. But long term, inflation considerations will take hold," he said.

Lloyd predicted that employment will begin to improve at the end of this year. Inflation should follow.

"We'll see some picking up of inflation in 2011. It's not going to be a spike, but it's going to happen gradually," said Lloyd.

Without commenting on specific deals, Lloyd said that fixed-to-floating structures may offer value to those looking not only for an inflation hedge but also for an appropriate time to put the hedge in place.

"Inflation is a matter of timing and finding out when it will hit. For an inflation hawk, it's not a bad thing to have a fixed rate at first," he said, given that "inflation is unlikely to strike in the short term."

"I can see how those notes may be appealing because in the long run, it protects you against inflation."

Lloyd added that in general, having an inflation hedge is important for an investor. Finding out which asset class provides the best hedge in a portfolio is also an important consideration, he said.

"I think it's best to get it through asset exposure, such as commodities or real estate. But for those looking for income, the notes are probably not a bad investment because it does give you a hedge against inflation," he said.

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