Morgan Stanley's leveraged notes linked to Russell are riskier than average despite buffer

By Emma Trincal

New York, Feb. 8 - Morgan Stanley's 0% buffered return optimization securities due Feb. 27, 2015 linked to the Russell 2000 index offer investors leveraged participation in the small-cap equity benchmark. Despite a 10% buffer, the risk profile is higher than average due to the volatility of the underlying index, said Suzi Hampson, structured products analyst at Future Value Consultants.

The payout at maturity will be par of $10.00 plus double any gain in the index, up to a maximum return of 19% to 23%, according to an FWP filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 10% and will lose 1% for every 1% decline beyond 10%.

"This is a quite standard leverage return product, double geared on the upside with a 10% buffer and a 22% cap," she said.

The 22% figure represents the hypothetical cap used by Future Value Consultants in its methodology, which is 25% below the upper end of the 19% to 23% range.

"While the 10% buffer may seem generous in a two-year note tied to the S&P 500, it may not be the same for the Russell 2000," she said.

The Russell 2000's implied volatility is 22%, compared with 16% for the S&P 500, she said.

Underlying volatility

"Many notes are priced on the S&P, so you see fewer buffers than a couple of years ago, let alone 10% buffers. But this is a different index, one that's more volatile.

"The buffer depends on pricing. It is determined to a large degree by the volatility of the underlying," she said.

Hampson said the product has a higher risk level compared to the average leveraged note recently rated but also compared to all products.

The product has a 4.29 riskmap versus 3.70 for similar structures. The average riskmap for all products, a large portion of which are reverse convertibles, is 4.03.

Riskmap is a Future Value Consultants score that measures the risk associated with a product on a scale of zero to 10. It is the sum of two risk components: market risk and credit risk.

With this product, both the market risk and the credit risk are higher than average, she said.

Market risk

At 3.27, the market riskmap is comparable to the average of all products at 3.37, but it's much higher than the 2.87 average for the same product type, she said.

The underlying index is what explains the gap in market risk between the product and its peers, she added.

"Many leveraged notes use the S&P, which is less volatile. So with a note tied to the S&P 500, a 10% buffer would be quite attractive. But the extra volatility seen with the Russell does not make the 10% buffer all that appealing in comparison," she said.

"The score is measured against the average, and you're comparing this product with many notes that are tied to the S&P 500. This is why you see this significant difference in the market riskmap between this particular product and the average for the same product type.

"It's quite difficult to compare similar products with different underlyings. It doesn't take much of a change to impact the scores. For the investor, it's very hard to decide which one is more risky or which one has more return potential when you compare similar products with different underlying assets."

The market riskmap takes into account the probabilities of losing capital, she said.

"While you have the buffer, the chances of losing capital are higher, which the market riskmap reflects," she said.

"The difference between the S&P and the Russell in terms of implied volatility is five points a year. It's going to make a difference in how much movement you can expect on any given year. If the underlying moves more, you can lose more money whether you have a buffer or not. It makes a big difference."

The credit risk was also higher than average. The product's credit riskmap is 1.02 versus 0.83 for the average of the same product.

"It's a combination of the issuer and the maturity, although two years remains quite short, so in this case, it looks like it's more due to the issuer's credit," she said.

She looked at Morgan Stanley's five-year credit default swap spreads of 152 basis points and compared them with some other banks.

Bank of America's spreads are 117 bps, while JPMorgan and HSBC have CDS spreads of 86 bps and 85 bps, respectively.

Return and price

Future Value Consultants measures the risk-adjusted return with its return score on a scale of zero to 10.

At 6.41, the product's return score is "a little bit lower" than the average of all products and is "definitely much lower" than the average for the same product type," she said.

The average return score is 6.55 for all products and 7.29 for the same product type.

"This reflects a combination of potential losses and return. Given the risk you're taking on, you should have a higher potential return. The score suggests that the cap could be higher," she said.

Price score

Future Value Consultants measures a note's value to the investor on a scale of zero to 10 with its price score. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The notes show a 4.97 price score. In comparison, the average price score is 7.33 for the same product type and 6.76 for all products.

"This score is very low," she said.

"It suggests that they haven't spent on the options as much as what can be spent on other products.

"Sometimes for some underlyings, you have less liquid options or options that are less reasonably priced. But the Russell is liquid enough, so it's probably not the case here.

"It could be that products with this underlying are less competitive, but I still think that you should expect a higher price score. It's not a new product, and it's a pretty standard structure.

"Some market parameters may change, and they may end up pricing at the top of the cap range, which would be beneficial. But it would have to be quite a lot to move that score to the average."

Small-cap exposure

Future Value Consultants offers its opinion on the quality of a deal with its overall score. The overall score is simply the average of the price score and the return score.

The notes have a 5.69 overall score, which is less than the average for all products of 6.65. The gap is even greater when compared to similar structures, which have a 7.31 overall score on average.

"This product type generally scores quite well, but that's not the case with this one. The overall score is not very good, even compared to reverse convertibles, which are skewing the score for the all-product-types category," she said.

"Those types of products in general are quite popular: leveraged return notes often reduce your risk with a buffer, and you have the accelerated return. In exchange for that, you get a cap.

"The structure is popular because it's easy to understand. You have a point-to-point payout. It's not too complicated.

"With this particular product, investors are motivated by the underlying. They are looking for exposure to the Russell rather than to the S&P, which is much more available.

"They can expect an 11% annualized return, which sounds good.

"You need to be somewhat bullish," she said, adding that the Russell 2000 gained 9.62% over the past 12 months.

"With 11%, the product would still outperform.

"It sounds quite appealing to someone who wants exposure to the Russell. It reduces the risk with the buffer. If you have already decided to invest in small caps, the notes give you an alternative to a direct investment in the fund with a different risk/reward profile.

"So yes, you have less risk than with the ETF. But this is not a low-risk product compared to its peers," she said.

Morgan Stanley & Co. LLC and UBS Financial Services Inc. are the agents.

The notes (Cusip: 61761M458) will price Feb. 25 settle Feb. 28.

The fees are 2%.

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