Morgan Stanley's $1.02 million contingent coupon notes linked to WTI crude offer income play

By Emma Trincal

New York, March 31 - Morgan Stanley's $1.02 million of commodity-linked notes with contingent coupon due March 29, 2029 linked to West Texas Intermediate light sweet crude oil offer investors a fixed-income substitute with a chance to lock in a coupon as high as 10%, but the long-term outlook for oil does not guarantee such rate can be achieved nor that the notes will outperform a comparable fixed-income instrument, sources said.

The notes will pay a contingent annual coupon at a rate equal to the greater of the commodity return and the highest contingent coupon paid on any previous interest payment date, subject to a floor of 0% and a cap of 10%, according to a 424B2 filing with the Securities and Exchange Commission.

The commodity return is the change in the commodity price on the applicable interest determination date relative to the initial price.

The payout at maturity will be par plus the final coupon, if any.

"I find it interesting if you're fortunate to get the upside return early on, then you can be locked in at 10% for the rest of the term," said Steven Foldes, president and chief executive at Foldes Financial Management LLC.

Locking in the cap

In a hypothetical return table shown in the prospectus, investors on the first year would get no coupon if the commodity price was down 2%. In year two, if the WTI crude oil price was to rise 5%, investors would receive a 5% coupon for that year. The third-year price appreciation assumption was 8%, leading to an 8% return for that year. On the fourth year, the prospectus assumed an underlying price appreciation of 12%, yielding for investor the 10% cap. From that point on and during the next 11 years, the annualized coupon would be locked in at 10%.

A 15-year Morgan Stanley corporate bond maturing March 27, 2029 is currently offering a 4.36% yield to maturity.

Foldes compared the corporate bond with the structured note.

"We would look at this structured note as a fixed-income substitute because you have the cap and because the return is going to be taxed like income. So you'd have to compare it with a taxable bond," he said.

"If a 15-year Morgan Stanley yields 4.35%, the bet is that you're able to do better than that over 15 years. The tax treatment will be the same, and the credit risk of course will be the same. But if I'm lucky enough to get the 10%, it would probably outperform the fixed-income instrument."

The 15-year credit risk exposure is not a major concern, he said.

"Morgan Stanley is a pretty solid institution. I don't have a big problem with that issuer," he said.

Morgan Stanley is rated A- by Standard & Poor's and Baa2 by Moody's.

Foldes said that the appeal of the notes depends on how early an investor could "jump to" the 10% cap.

"But once you get it, it's a steady cash flow of 10% until the end," he said.

Ordinary income, fee

The less attractive characteristics of the deal are its tax treatment and cost.

"We don't really like principal-protected notes unless used in a retirement account because of the ordinary income tax treatment," he said.

"But what I also don't like is the 3.5% fee. We do these things as reverse inquiries, and we would never do a 3.5% fee," he said.

While the underlying is a commodity, Foldes said the product should be seen as a fixed-income substitute rather than a note offering commodity exposure.

"It's an income play," he said.

"If you're looking for yield or for a bond substitute, this product would make sense as long as you're comfortable with the credit of Morgan Stanley and also with the idea of holding it for 15 years.

"But it seems to me that if you get the 10% return, that type of capital appreciation would make it easy for you to put it back to the issuer at a decent price."

But other sources were less confident about the product, in particular investors with a long-term bearish outlook on oil.

Jack Ablin, chief investment officer of BMO Private Bank, was one of them.

Bearish outlook

"You could find yourself in the hole if oil drops early on because you would have to go back up from the initial level. It's an interesting deal but not one that I would do," he said.

"I just read two bearish reports on oil this weekend. One was the cover of Barron's, and they predict oil at $75 a barrel over the next five years from $100 now. The other was from the World Bank."

Both reports, he said, were bearish on oil due to weak demand and increased supply.

"What this note may be useful for is giving you protection against geopolitical risk that could disrupt oil supplies. If you believe that some of the Middle East conflicts could cause oil prices to spike, then this note could be an insurance policy for you.

"But don't expect to make money on an insurance policy."

Overall, Ablin said that macroeconomic factors, which are likely to depress oil prices long term, make for poor timing when considering the investment.

"The trend is not your friend on this one," he said.

"There are so many alternatives to oil now, so much competition. You have electric cars. We're not relying on oil to run automobiles anymore. And then you have those new exploration techniques with the extraction of shale liquids. I am definitely not bullish on oil."

Complex pricing

For Scott Rothbort, founder of LakeView Asset Management, nothing proved that the notes may offer a higher rate return than the Morgan Stanley 15-year corporate bond.

"There are some complex calculations involved in this. These things are already priced so that the issuer will make money. The question is, will it benefit the investor?" he said.

"It's more a roll of the dice than anything else. It really depends on oil prices. If it goes down 5% every year, you have a problem. You're giving up a 4.5% bond that pays a fixed coupon. That's 67.5% over 15 years. You're not necessarily guaranteed to beat that return.

"In order to calculate it, you would have to look at what the volatility of the underlying has been over a long period of time. You'd have to measure going back 15 years before what is the risk of performing less than the corporate bond. It's a more complex calculation than it seems, and investors don't have the tools to do it, so it becomes a play from their instinct.

"I wouldn't be comfortable doing that, especially over 15 years. It would be hard to price it up even in a quick and dirty way."

Morgan Stanley & Co. LLC was the agent.

The notes (Cusip: 61762GBF0) priced March 26.

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