Morgan Stanley's floaters with variable cap, floor for those expecting rates to rise soon

By Emma Trincal

New York, June 28 - Morgan Stanley's upcoming floating-rate notes due July 15, 2017 with variable maximum and minimum interest rates are designed for investors who are betting on an imminent and significant rise in interest rates, a source said.

"This issue would best serve an investor who believes rates will rise significantly very soon and maintain that upward trend," said Tony Romero, co-founder and managing partner at Suncoast Capital Group, a deposit brokerage firm.

The interest rate is Libor plus 175 basis points, and it is payable quarterly, according to an FWP filing with the Securities and Exchange Commission.

There is no minimum interest rate or maximum interest rate for the first quarter. After the first quarter, the floor for each quarter will equal the interest rate in the preceding quarter, and the cap will equal the interest rate in the preceding quarter plus 50 bps.

The payout at maturity will be par.

"This is a very interesting issue and one I have not seen before," said Romero.

"The buyer is betting that interest rates will rise substantially to the extent that the floating-rate note outperforms what one would have received from simply buying the fixed-rate alternative at the outset."

Floor

One benefit of the deal is the minimum interest rate payment, or floor, which gives investors a minimum coupon that protects them against lower interest rates, Romero said.

"Since Libor cannot go below zero, in a worst-case scenario the first interest payment will be based on a rate of 1.75%," said Romero.

But most people expect rates to go up, not down, he added, and the question is when.

"I certainly believe rates are going to go up, but it's difficult to say when that will begin," he said.

Fixed versus floating

"Rates will rise, but whether they'll rise 18 months from now or three years from now makes a significant difference," he added.

This difference can be measured by comparing this product to what an investor would be able to earn from a comparable corporate note with the same credit rating, Romero said.

Looking at six-year fixed-rate note issues with a single-A rating from Standard & Poor's, Romero said that the fixed-rate equivalent is now trading at or near 4.7%.

"This variable-rate issue represents a significant reduction in interest income as compared to what one might expect from a fixed-rate offer," he said.

Late start scenario

Romero used the following scenario: rates remain the same for the first three years of this issue, during which time investors receive an annual rate of 2%. After that, there is a "dramatic rise" in rates for the next three years, leading the coupon to hit its cap each quarter during years four, five and six.

For the fourth year, the average rate would be 3.25%. He reached that figure by starting with the 2% initial rate and by applying to each quarter's cap the incremental increase of 50 bps, which results in 2.5% in the first quarter, then 3%, 3.5% and 4%. Using the same method, he calculated a 5.25% annual rate for the fifth year and a 7.25% rate for the sixth year.

In summary, the average return would be 3.625% per year.

"If rates stay at 2% for three years, even if they reach their cap each quarter for the following three, you'll still end up earning less than a single-A with a 4.7% fixed rate," he said.

He added that the chances of the coupon experiencing a maximum rate increase each quarter for three years is "highly unlikely."

"After one year, rates would have to go up significantly to end up with a rate of return higher than the fixed rate the issuer is paying now," he said.

Interest rate risk

"This deal is good if rates start to rise sooner rather than later," said Romero.

"The sooner the rates start to rise, the more likely the investor will come [out] ahead."

A New York-based trader at a fixed-income institutional brokerage firm said that the notes are designed for investors who are concerned about inflation. But whether this sentiment reflects the view of most institutions remains to be seen, he said.

"The prevailing thought six months ago was that interest rates were going to go up fast and that we were going to have inflation. But it no longer seems to be accurate," this trader said.

"The prevailing view now is that we're going to be in a low-interest-rates environment for the foreseeable future."

The notes (Cusip: 61745E3E9) will settle July 15.

Morgan Stanley & Co. LLC is the agent.

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