Morgan Stanley's knock-out notes tied to Yum! Brands designed for real bulls

By Emma Trincal

New York, Aug. 19 - Morgan Stanley's 0% knock-out notes due Feb. 15, 2013 linked to the common stock of Yum! Brands, Inc. are designed for investors who have a strong bullish outlook on the stock, said Suzi Hampson, structured products analyst at Future Value Consultants.

If the price of Yum! Brands stock falls by more than 20% from the initial share price during the life of the notes, the payout at maturity will be par plus the stock return, which could be positive or negative, according to an FWP filing with the Securities and Exchange Commission.

Otherwise, the payout will be par plus the greater of the stock return and a contingent minimum return of at least 5%.

Sky is the limit

"This would appeal to bullish investors because the upside is not capped," said Hampson. "The higher the stock goes, the higher your return, so this is a growth product really."

She noted that investors were long the stock in two circumstances - either if the share price fell by more than 20% at maturity, in which case the return would be the negative performance of the stock; or if the stock finished higher than the contingent return of 5%.

"In between the knock-out barrier and the contingent minimum return, the investor will outperform the stock," she said.

"But that's not what you're aiming for. You want the stock to go up as much as possible.

"The knock-out barrier and the contingent minimum return give you some protection against losses on the stock."

Investors in the notes are cautiously bullish, she said. Yet, they have a favorable outlook on the underlying stock.

"They're more cautious than the investor who buys the stock directly," she said. "But they definitely don't hold the view that the stock will trade sideways.

"Anyone with that view would choose a reverse convertible instead or leveraged note with three-times leverage, for instance."

"Here, the 5% potential return is more of a defensive play. It's what you get paid for taking the downside risk. That's not what the investor is aiming for," she said.

The notes have a risky profile but end up with a good overall rating because the potential for gains is also high, she noted.

Relatively risky for category

The riskmap, a Future Value Consultants' rating that measures the risk associated with a product on a scale from zero to 10, is 7.05 for the notes.

It's more than the riskmap for products in the same category, which averages 4.77.

Hampson said that the riskmap of the notes derived from a combination of factors: the barrier type and the underlying.

"The barrier is an American-style of barrier option. It can be breached anytime. Therefore it's more likely to be breached than if you had a product with a final day barrier," she said.

The underlying stock has an implied volatility of 28%.

"It's not that high, but it's more than the volatility of the S&P 500 index currently at around 23%-24%," she said.

"You compare those notes with similar structures that tend to be linked to indexes or funds. It can explain the difference in risk," she added.

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

Both components are higher than the average with this product, Hampson noted.

The high market riskmap is due to the combination of the volatile underlying relative to an index and the barrier type.

The credit riskmap is high because the creditworthiness of the issuer lags behind other banks.

Morgan Stanley's credit default swaps spreads are 240 basis points, said Hampson.

This compares unfavorably with Barclays (190 bps), Citigroup (180 bps) and Deutsche bank (140 bps).

Return and value

"The notes however show a high return score," said Hampson.

"A high riskmap does not necessarily mean that the deal is bad. What matters is that it's balanced," she said.

The return score is Future Value's opinion of the risk-adjusted return under reasonable and consistent forward-looking assumptions for underlying asset evolution on a scale of zero to 10.

"With this product, even though the risk is high, the return can be high as well," said Hampson. "That's why you have a high return score."

The notes received a return score of 6.78, which is slightly more than comparable products (6.68) and higher than the 5.97 return score observed for all product types recently rated by Future Value Consultants.

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.

Investors in the notes have a 31.8% chance of losing more than 15% of their initial investment on an annualized basis, according to the table.

However, the probability of generating a gain in excess of 15% is high too at 28.2%.

The notes also offer value to investors, said Hampson, based on the price score of 8.56.

This score, on a scale of zero to 10, represents the real value to the investor after deducting the costs the issuer charges in fees and commissions on an annualized basis and profit margins on the underlying derivative.

"The product looks good," she said. "The high price score means that we think it's good value for investors."

"The gap between the price and the value of the assets is not too big," she said.

The overall score of the notes is 7.67.

This rating represents Future Value Consultants' opinion on the quality of a deal, based on the average of the price score and the return score.

"The product scores very well overall," she said. "It's still high risk, but in this risk spectrum, this is one of the good ones."

J.P. Morgan Securities LLC is the dealer with Morgan Stanley & Co. LLC as agent.

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