Morgan Stanley's notes linked to hybrid basket lower risk of volatile non-traditional assets

By Kenneth Lim

Boston, Sept. 15 - A planned series of notes linked to a hybrid basket offers principal protection on a relatively volatile group of underlying assets in exchange for less than 100% participation on the upside, an investment adviser said.

Morgan Stanley plans to price zero-coupon market-linked notes due September 2016 linked to a basket of gold, two commodity indexes and an equity exchange-traded fund.

The basket comprises a 40% weighting in the price of gold; 20% weightings each in the S&P GSCI Agriculture Index - Excess Return and the S&P GSCI Livestock Index - Excess Return; and a 20% weighting in the iShares MSCI Emerging Markets index fund.

At maturity, investors will receive par plus 80% to 85% of any gain in the basket. Investors will receive at least par.

The participation rate will be set at pricing.

Unusual underlyings

The basket's components are an unusual group of underlying assets, the adviser said.

"They look like very specific indexes," the adviser said. "You're exposed to gold, agriculture and livestock and emerging market stocks. So it's also three very different asset classes."

The product could have been driven by inquiries from investors who have specific hedging needs, the adviser said.

"I don't know if you can have broad-based appeal with something like this," the adviser said. "How many people are familiar with agriculture, livestock, gold and emerging markets? And combining all of them into one product makes them even harder to understand."

Taken individually, each of the basket components can be rather risky, the adviser added. If the components are positively correlated, that could make the product even more volatile. But if they are negatively correlated, the basket could have a lower combined volatility than its components.

"Just based on first impressions, it does seem like this is one of those cases where the combined volatility could be lower," the adviser said.

The product could offer an investor a way to diversify a portfolio by increasing exposure to less-traditional assets, the adviser said.

"Assets like gold and commodities, and to a certain extent emerging equities, they are all what we call non-traditional assets," the adviser said. "For the typical U.S. investor who has most of his or her investments in domestic equities and bonds, products like these can offer some exposure to other asset classes that are not as closely correlated, so you can add a bit of diversity to your portfolio."

Lowered upside

Because of the volatility of the basket, investors will have to give up some of the upside participation in the underlying in order to still enjoy principal protection, the adviser said.

"That's not necessarily a bad thing because you are getting principal protection," the adviser said. "You won't lose anything on the downside as long as the issuer can still repay you, and on the upside there's no cap on the payout. You only get 80% to 85% of the upside, but you might still get more than an investment-grade bond of similar maturity."

Investors are also locked in for six years, which can be a longer period than what some investors are comfortable with.

"The investor has to take a view that's six years out on assets that they might not be familiar with," the adviser said. "It's certainly a product that has to be very carefully considered."

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