Morgan Stanley's renminbi-denominated step-up notes seen as atypical structure, currency play

By Emma Trincal

New York, Jan. 25 - Morgan Stanley's Chinese renminbi-denominated senior fixed-rate step-up notes due Feb. 11, 2016 offer an unusual payout structure, sources said. Investors get paid based on the exchange rate between the currency and the dollar rather than on the performance of an underlying asset.

The securities are renminbi-denominated, but all interest payments and the payout at maturity will be made in dollars.

The coupon will be 0.5% for the first year. After that, the rate will step up by 25 basis points each year. Interest is payable annually.

The payout at maturity will be the principal amount of the notes converted into dollars at the then-current exchange rate.

Unusual payout

"It's really a currency play more than an income play," said Elliot Noma, managing director at Garrett Asset Management.

"It's a pretty interesting deal. You don't see that often a note denominated in one currency and payable in another. An example comes to mind, but it's in the sovereign debt market," he said.

Noma pointed to the dollar-denominated sovereign debt issued by the past Chilean government. As with the Morgan Stanley notes, he noted, the debt was denominated in a foreign currency but payable in the currency of the originating country.

"Investors bought this sovereign debt to protect themselves against the depreciation of the Chilean peso. In this case, U.S. investors would buy it to hedge themselves against the depreciation of the dollar relative to the Chinese currency. It's the same idea," Noma said.

"I guess it's not the first time this payout structure is being used. But it's used here in a structured note," he said.

Conventional wisdom

Noma said that a strong case could be made for a bullish bet on the renminbi, making the notes compelling for investors.

"I can see why this deal could be successful," he said.

"Sarkozy is calling for an appreciation of the renminbi; Obama is doing the same; all the pressure is on the upside.

"The conventional wisdom tells us that there is only one direction for the Chinese renminbi to go and that's up because of all the political pressure."

In addition, the renminbi has begun to "slowly appreciate" even though "it's a very controlled process. Investors see this as their baseline," Noma said.

"This is a currency note. It's sold as a bet that the dollar will depreciate against the renminbi.

"But there is risk. You could see the reverse happen. I never exclude the impossible."

Too little incentive

Philip Davis, founder of hedge fund Capital Ideas, agreed about risk. He said that investors in these notes are exposed to too much risk for the potential rewards, which he considered to be limited.

"For a long-term duration like this, you should at least get some principal protection from the issuer," he said.

"You're taking all the risk and what do you get in return? A 1% a year with a real possibility of getting even less interest than that and to lose a chunk of your principal if the exchange rate turns against you.

"Morgan Stanley is gambling with your money, hedging their bet and leveraging their gains. They're just not paying you out enough for the risk you're taking."

Davis said that the issuer is taking the opposite bet by selling calls on the renminbi. But the bank - unlike the investor - is hedging its bet, he said.

"They collect the premium up front. If the renminbi goes up, they'll cover the bet by buying calls. If it goes down, they keep the call money and your money," he said.

Davis added that the popularity of the renminbi among bulls does not make the trade less risky given the state of the Chinese economy.

"While being bullish on the renminbi is a great story, it's also a very risky bet. And it's your bet as the bank's counterparty. China has a big inflation problem, and it may face a hell of a currency crisis sooner than later," he said.

The notes (Cusip: 058615234) are expected to settle Feb. 11.

Morgan Stanley & Co. International plc is the underwriter.

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