Morgan Stanley's Libor, S&P notes pay fat first-year coupon, but offer short call, long tenor

By Emma Trincal

New York, Nov. 23 - Morgan Stanley's announced six-month Libor and S&P 500 index range accrual notes pay an eye-catchingly big coupon for the first year but could be a risky bet for investors, given the 25-year tenor and the call feature the issuer may trigger as early as three months after issuance.

Morgan Stanley plans to price six-month Libor and S&P 500 index range accrual notes due Dec. 16, 2024, according to an FWP filing with the Securities and Exchange Commission.

The coupon will be 10% for the first year, payable quarterly. After that, interest will accrue at 10% per year for each day that six-month Libor is 7% or less and the S&P 500 index is at least 850. The payout at maturity will be par. But the notes are callable on any quarterly interest payment date, beginning March 16, 2010.

"You're only going to get the 10% if you don't want it," said Brian Battle, vice-president at The Performance Trust Cos. LLC, a broker-dealer specializing in fixed income. "You're committing to a long-term investment and taking on all the risk."

Call option

Battle said that investors are taking on two types of risk. The first one would be to see their bonds called if interest rates declined.

"If rates go down, they will call it away from you, so you stand to lose your 10%," he said.

Even when many in the market anticipate higher interest rates, Battle does not rule out the opposite scenario, which would trigger a call.

"Rates could very well go down. Eleven months ago, right at the bottom of the crisis, the 10-year Treasury rate was 2.05%. If rates go down, they'll call it away," he said.

Long-term bet

The second scenario would involve a "bigger" risk, Battle said.

"The bigger risk is if rates go higher and you're locked in. You get 0% interest if the prevailing rate is 15%. In six-months, Libor could move up quite a bit. You're taking 15 years of interest rate risk if it goes against you," Battle said. "Heads I win, tails you lose," he said.

Kirk Chisholm, principal at NUA Advisors agreed that the worse case scenario is for investors to have their money invested without any payout.

"It's callable in three months. Effectively, the long term prospect, assuming we have inflation, is not good. The upside is that you can get 10% for a three-month; but the downside is that you don't get paid for the remaining period."

Good hedge

The rationale for the deal appeared clear from the standpoint of the issuers, according to sources.

"The issuer is hedging a bet on Libor and the S&P," Battle said. "By offering this now, they're probably looking to hedge some exposure going into year-end. They're willing to pay you for three months to take this bet off their hands."

"I understand what the issuer is doing. They're making out really well. But why would an investor take that risk?" Chisholm said. "It's a very one-sided investment."

"The issuer can entice people with a 10% coupon because fixed-income investors buy yield," said Battle. "But anything that complicated requires a professional investor, otherwise stay clear."

Three-month paper

However, the investment may be valuable for investors in the event of a call, others said.

"Basically the investor is writing a put on the notes. He's getting paid to give the issuer the right to call the bonds," said Carol Simon, principal with Carol Simon Consulting, a financial services consulting firm in Roseland, N.J.

She added that pricing an option would require an in-depth analysis and more details on the deal, but offered to give an approximate value of what would be the price of the option by looking at ongoing market rates.

"You have to compare that 10% rate with a 15-year paper without bells and whistles and without the call," she said, pointing to a presumed comparable Treasury yield of 4.5%. "Then you would have to ask yourself: is there something in the structure that would make the issuer willing to offer 10% for 15 year when the market rate is 4.5%?"

She said the answer is the right to call the bonds at anytime.

"This is really a three month note," she said, assuming that the call option will be exercised. "What could an investor earn on three months? Virtually nothing," she said.

As a result, the offering is not all that bad for investors, assuming the notes get called, she said.

Catastrophe protection

From the point of view of the issuer, another factor that makes the bank willing to pay this rate, said Simon, is to buy a form of insurance protection.

"For the issuer, this is a form of calamity insurance," she said. "The S&P 500 would go below 850 under a crash or very bad market. And Libor rising above 7% would represent a scenario of high inflation. If only one of these conditions happens, the issuer has bought calamity insurance. They have borrowed money and the inter rate is zero," she said.

Currently six-month Libor is 0.59%. The last time the benchmark rose above over 7% was in June 2000. The S&P 500, currently at 1,106 dropped below 850 last year in November.

The notes will be callable at par on any interest payment date beginning March 16, 2010.

The notes are expected to price in December and settle on Dec. 16.

Morgan Stanley & Co. Inc. is the agent.

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