Morgan Stanley's equity-linked notes linked to S&P 500 score high on return, price, overall

By Emma Trincal

New York, Oct. 28 - Morgan Stanley's 0% equity-linked notes due November 2017 linked to the S&P 500 index offer very competitive terms and better-than-average scores, said Suzi Hampson, structured products analyst at Future Value Consultants.

The notes give investors unlimited upside as well as a fixed return when the underlying index finishes below its initial level, according to an FWP filing with the Securities and Exchange Commission.

If the final index level is greater than the initial index level, the payout at maturity will be par of $10 plus the index return. If the final index level is less than or equal to the initial level, the payout will be par plus the fixed return, which is expected to be 12% to 14% and will be set at pricing.

"It looks really good. And it's unusual. I haven't seen something like that," said Hampson.

"Your main risk really is to underperform if the index grows by less than 12% compared to what you would have received if it had declined instead.

"This is a very attractive structure. Here you have the opportunity to participate 100% in the S&P 500. And if the index is down, you still get a minimum return.

"My guess is that the funding spread must be high. It's just such a funding-dependent product."

Fixed return

A 12% minimum return would represent 2% on an annualized basis for this six-year note, she said.

She compared it to the "risk-free" rates, or Treasury yields. With a five-year Treasury yielding 1% and the seven-year at 1.75%, she estimated a six-year risk-free equivalent rate to be about 1.35%.

The credit default swap spread of Morgan Stanly is currently 315 basis points, she said.

"They should be paying you that 315 basis points spread plus the 1.35% risk-free rate, something around 4.5%," she said.

"You're getting less than that. But the upside potential is unlimited, and you can make much more than that.

"Unless their funding is even higher than their CDS levels, it does seem to be very good."

Low risk

Given the principal-protected structure, the product shows very little risk as measured by riskmap.

Riskmap is a Future Value Consultants score that measures on a scale of zero to 10 the risk associated with a product. The higher the riskmap, the higher the risk of the product.

This product received a riskmap of only 2.95, which is much lower than 5.43, the average riskmap of all products, according to Future Value Consultants' report.

The riskmap is the sum of two risk components: market risk and credit risk.

The market risk for these notes is virtually zero at 0.03.

All the risk comes from credit risk, Hampson noted. The credit riskmap is 2.92, which is way above the average for all products of 0.48.

"It's principal protected, so your bottom-line risk is the default risk. And this is Morgan Stanley, which has wider CDS spreads than other banks. It's also a six-year product, which adds more credit risk," she said.

However, the risk remains very subdued overall, which leads to a high rating on the risk-adjusted return scale as measured by the return score. On a scale of zero to 10, the product received an 8.38 return score.

High return

The return score is Future Value Consultants' opinion of the risk-adjusted return calculated from five key assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. Future Value Consultants calculates a risk-adjusted average return for each assumption. The return score is the best of these five returns.

"This return score is pretty high. We may underestimate the funding levels, which are very difficult to estimate. We use 300 basis points here, based on the 300 basis points for the CDS spreads. That's because we never use more than the CDS levels. It's our methodology. We think CDS spreads are slightly higher than funding levels," she said.

Hampson interpreted the high return score as follows: "With such a low risk, you wouldn't expect such good returns."

The return score derives from the probability of return outcomes calculated by Future Value Consultants using a Monte Carlo simulation and displayed in a chart across different return buckets.

The performance is modeled based on a series of parameters, which include volatility, dividends and interest rates among others.

The probability table associated with this product shows that the odds of the notes generating an annualized gain of zero to 5% are 73.4%.

The chances of getting high returns in excess of 15% are only 1.2%.

Value

Future Value Consultants' estimate of the total costs taken out of the product from direct fees and profit margin on the underlying derivative is measured by the price score.

The price score for this product is 9.97 on a scale of zero to 10.

"This is also a top score. It's much higher than the average," said Hampson.

The average return score for all products is 6.07.

Pricing date

"The price score is very dependent on getting the funding levels of Morgan Stanley right," she said.

She noted that a week before, Morgan Stanley's CDS spread was 370 bps.

"They have dropped quite a bit, and that will impact the price score," she said.

"When the CDS jump around 370 to drop to 315 in one week, it makes it very difficult to estimate the correct funding levels."

The tightening of the spread by 55 bps represents a difference in rate of nearly 3.5% in six years, she noted.

"If the CDS spreads continue to fall, I don't know if they will be able to offer the same terms," she said.

Another factor that may modify the price score is the 12% to 14% range for the fixed return.

"The range of the minimum return - where that settles is going to be important," she said.

High overall

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

The notes have a 9.18 overall score, which is much higher than the average of all products at 6.10, she said.

"It seems like a win-win, really. There's obviously Morgan Stanley risk. You're locked in for six years. But most principal-protected products have that type of duration if not more. And you have this 100% participation to the upside," she said.

"The overall score is right at the top of the chart. This is an unusual product that scores really well, a lot higher than the average."

The notes (Cusip: 61760T173) will price and settle in November.

Morgan Stanley & Co. LLC is the agent.

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