Morgan Stanley's $110 million contingent income autocall step-ups tied to S&P top year so far

By Emma Trincal

New York, Jan. 23 - Morgan Stanley's $110 million of 0% contingent income autocallable step-up securities due Jan. 18, 2028 linked to the S&P 500 index topped the fresh list of new deals for 2013 and owed its success to an above-market potential coupon delivered in an innovative structure, sources said.

The structure offered a contingent monthly coupon payable only if the index closed above the coupon barrier, 70% of the initial index level, on a monthly determination date; otherwise no coupon was paid for that month, according to a 424B2 filing with the Securities and Exchange Commission.

After five years, the notes were to be automatically called at par plus the contingent monthly coupon if the index closed at or above the initial index level on any quarterly redemption determination date.

The contingent coupon will start at 7% a year but will step up to 8% on Jan. 18, 2018 and to 12% on Jan. 18, 2023.

If the notes were not called, investors at maturity would receive par plus the final contingent monthly payment as long as the index closed above the downside threshold, 50% of the initial index level. Otherwise, investors would be fully exposed to the index decline from its initial level, losing at least half of their principal.

Above-market rates

Jim Delaney, portfolio manager of Market Strategies Management, said that the notes were likely to have a shorter duration than the 15-year tenor given the autocallable feature, which may have added to the appeal of the product.

"This bond is going to get called in five years," he said.

The S&P 500 initial value at pricing was 1,472.34.

"There is no way the S&P is not going to be above that in five years. So you're looking at a five-year note that should pay 7% a year. Well, that's better than a five-year Treasury yielding less than 1%," he said.

"Even if rates do go up, you're ahead of the game. Rates might be at 7% in five years, but not before that, and chances are it's not going to be that high.

"These notes are for the non-risk-averse investor looking for yield. It has risk of course. Anything that pays 7% is going to have risk."

Among the risks, investors may lose principal at maturity if the S&P 500 closes below 50% of its initial value, or below 736.17.

Investors are also subject to Morgan Stanley's credit risk, according to the prospectus.

Finally, the notes do not guarantee the regular payment of interest as the contingent coupon is paid only when the index is above 70% of its initial level on the related monthly observation date.

Investors may even never receive any contingent monthly coupons through the entire 15-year term, the prospectus warned in its risk section.

Coupon risk

"This is ridiculous. The biggest risk here is not that your principal is at risk. If the S&P is at 700 15 years from now, we're in trouble," Delaney said.

"What's more likely is that you're not going to get your 7% every month, so at the end, it chops your yield below 7% to something less."

But getting the above-market yield, even if investors were to miss on some monthly payments, remained worth the risk, he said.

"I can definitely see myself doing something like that for a portion of my portfolio," he said.

Innovative

A market participant said that the bid last week was strong due to a well-designed structure.

"It is innovative in a way," he said.

"It provides potential for an attractive yield and has protection in it with a barrier well below average.

"It's an interesting hybrid. You have the combination of a generous barrier, stepped coupons with contingency and the potential autocall.

"If you combine an attractive yield potential with a meaningful protection both for the contingent coupon as well as the principal, you're going to get investors' attention."

He pointed to the 50% final barrier, whose level was set even lower than the 70% coupon barrier. In many similar structures, both the final and the coupon barriers are at the same level.

"As long as people are comfortable with the principal-at-risk concept, as long as they are willing to accept the contingency of their coupon payment, it's an interesting product," he said.

"You also have to be comfortable being invested in a long-dated security. The fact that it was such a large deal speaks to a greater willingness to be exposed to Morgan Stanley credit," he said.

A sellsider said that the offering fit into the types of products Morgan Stanley is known for.

"They have a very large rates structured products business. This is just a substitute for that. The barrier is far enough down for people to view it as a rate product," this sellsider said.

"They also tend to do a lot of this contingent autocallable business. This product must have met their clients' needs."

The notes (Cusip: 61761JAV1) priced on Jan. 15.

Morgan Stanley & Co. LLC was the agent. The fees were 3.5%.

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