Morgan Stanley commodities offering unusual; HSBC's CIT note generous; terms change as markets swing

By Kenneth Lim

Boston, March 14 - Morgan Stanley's buffered leveraged securities linked to a basket of commodities offers an unusual method of determining the underlying gain, said structured products analyst Suzi Hampson of Future Values Consultants.

"It's unusual because of the way they determine the strike price for each of the commodities," Hampson said. "Usually they just use the initial value of the index, but here they use the forward price of the commodity."

The 0% securities due March 2013 are linked to a basket that comprises a commodity index and a number of individual commodities. The basket consists of the Dow Jones-AIG Commodity index with a 60% weight, natural gas with an 8% weight, primary aluminum and CBOT soybeans, each with a 7% weight and NYBOT cotton No. 2, gold and NYBOT sugar, each with a 6% weight.

If the final basket level increases over the initial level, the payout will be par plus any gain on the basket multiplied by a leverage factor of 130% to 145%. The exact upside leverage will be determined at pricing.

If the basket declines by 15% or less, the payout will be par. Investors will lose 1% for every 1% the basket declines beyond 15%, but will not receive less than $150.

For each component of the basket, the gain will be relative to the forward price on the pricing date for delivery of that commodity in March 2013.

"The rationale behind that, I guess, is that commodities unlike equities usually have a low forward price, so it might be lower than the current price, whereas I'm assuming someone did the research and probably the reality is that the price may have increased over the term," Hampson said. "So by using the forward price, which is lower than the start price, the difference will be higher, so you'd get a higher return, but of course this is based on an assumption, you can't guarantee that will happen."

Hampson said the product at first glance appears to offer potentially higher returns than a more typical commodity-linked offering, but noted that there are risks involved.

"It's accelerated growth, so your capital is not protected," she said. "If the basket finishes above the strike price then you get the participation rate of 130%-145%, and if it's between 85% and 100%, the 15% buffer, then you get your principal back. I think the geared upside is made possible by the fact that your capital is at risk."

HSBC's CIT note has high coupon

Hampson highlighted a reverse convertible offered by HSBC USA Inc. linked to the common stock of CIT Group Inc. as having an unusually high coupon.

The 30% reverse convertible matures on July 1, 2008. If the underlying stock falls below 60% of the initial price during the life of the notes and ends below the initial price, the payout at maturity will be the principal less 1% for every 1% decline in the underlying stock price. Otherwise the payout at maturity will be par.

The high coupon and the barrier are unusually generous if the risk of the underlying is not considered, Hampson said.

"It's a very high coupon, and looking at the term you only need three months to get that. And if the stock doesn't go below 60 during the product term, you'd get your principal back, which is a quite low barrier for the term, so the volatility of the underlying must be pretty high for them to offer such terms."

Indeed, CIT common stock lost about a fifth of its value in March and hit a 52-week low after an analyst raised concerns about the quality of the New York-based commercial finance company's student loans and said the company may have to write off a significant amount of debt.

Market affecting terms

The recent jump in the volatility of U.S. equity markets has been reflected in the terms of products being offered, Hampson said.

The observation struck her when she was looking at an auto-callable note by JPMorgan Chase & Co. and noticed that it was almost exactly the same as a product offered a few weeks ago. The only difference was the return if the notes are called.

"It's nothing particularly interesting in the structure, they're perfectly standard, they do this quite regularly," Hampson said. "It's exactly the same structure as one about three weeks ago, and I was just looking at them, and I noticed that the kick-out return that you can have has increased by quite a bit, considering the time period."

Hampson was looking at JPMorgan's annual review notes due March 24, 2011 linked to the S&P 500 index.

If the underlying index closes at or above the call level at each review date, the notes will be called for a cash payment that depends on the review date. On the first review date of March 19, 2009, the call level is 90% and the payout will be at least 110.65% of par. On the second review date of March 19, 2010, the call level is 100% and the payout will be at least 121.3% of par. On the third review date of March 21, 2011, the call level is 31.95% and the payout will be at least 131.95% of par.

If the notes are not called, they will be redeemed at maturity at par if the ending index level is at least 90% of the initial level. Investors will lose 1.1111% of the principal for every 1% that the index declines beyond 10%.

The earlier JPMorgan note that she referred to priced on Feb. 22. That issue will pay 109.8% if called on the first review date, 119.6% if called on the second review date and 129.4% if called on the final review date. Besides the dates on the notes, all other terms are the same.

"Because of the structure, if volatility increases, it decreases the price of the options, so they're able to offer a higher return," Hampson said.

The change in the kick-out return reflects the turbulence in the markets, Hampson said.

"I think it just shows that generally the volatility in the market has been pretty high," she said.

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