Morgan Stanley's Lasers tied to S&P 500, two ETFs will do best when market moves sideways

By Emma Trincal

New York, July 15 - Morgan Stanley's 0% Equity Leading Stockmarket Return Securities due July 2013 linked to an equity basket could outperform the underlying in a flat, even moderately down market, said structured products analyst Suzi Hampson at Future Value Consultants.

The basket gives investors exposure to U.S. and international equities. It includes equal weights of the S&P 500 index, the iShares MSCI Emerging Markets index fund and the iShares MSCI EAFE index fund, according to an FWP filing with the Securities and Exchange Commission.

If the basket's closing level remains above the downside threshold value - 75% of the initial level - throughout the life of the notes, the payout at maturity will be par of $10.00 plus the greater of the basket return and 12%.

Otherwise, the payout will be par plus the basket return, which could be positive or negative.

In each case, the payout will be capped at $11.975 to $12.175 per note. The exact maximum payment will be set at pricing.

Small growth scenario

"In a flat market, this investment would do well," said Hampson.

"The cap is approximately 20%, so if you expect a return of 10% or more per year, you would be better off with an uncapped product.

"This is a growth product, so you wouldn't invest in it unless you expected some returns.

"But admitting that your basket is even slightly negative, as long as it's not down by more than 25% at any time, you get a nice bump up with a 12% gain.

"And if you're anticipating a moderate growth of only 5% per year, for instance, you still outperform the basket by getting 6% per year, which is the annual return you get from the 12% contingent minimum.

"You will outperform the basket if it performs sideways.

"The buyer of these notes would have to be slightly more cautious and slightly less bullish than someone investing straight in the basket."

Riskmap

The notes represent less risk than the average product recently rated by Future Value Consultants as measured by riskmap. Its risk is equivalent to products with a similar structure, according to the firm's report.

Riskmap reflects the risk associated with the product. The higher the riskmap, the higher the risk of the product. The rating compares, on a scale of zero to 10, the average product underperformance (relative to cash) with the average underperformance of five sample assets of different volatility levels.

The product received a 4.58 riskmap, and the average riskmap of all other products is 5.42.

"It's less risk here because we compare those notes with other products that have more risky features, for instance a more volatile underlying or the absence of any downside protection," Hampson said.

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

With these notes, credit risk is more than two times greater than the average product because it is a two-year product, she said.

"There are so many three-month reverse convertibles. Your average product is less than two years; in fact, it's more around one year. And credit risk starts to increase when your product gets longer," she said.

In addition, Morgan Stanley's credit default swap spreads are wider (170 basis points) than those of many other banks, she noted. Citibank's spread is 150 bps, Barclays' is 140 bps, and JPMorgan's is below 100 bps.

Risk-adjusted return

The notes with a return score of 6.38 fare better than the average for all products at 6.01.

"It means that the return compared to the risk is higher than for the average product," said Hampson.

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

However, the return score is less than that of similar products, which is 6.77.

"This could be a number of factors such as the underlying, the barrier or the cap," said Hampson.

The return score is derived 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.

For this product, investors have a 63% chance of generating a gain against a 37% chance of losses.

The biggest probability of losses - at 22.2% - is for losses exceeding 15%, according to the chart.

"That's because once you go down beyond 25%, the probability of recovery is quite small," explained Hampson.

For gains, the greatest probability - a 36% chance - is for the return bucket comprised between 5% and 10%.

"This matches your minimum contingent return of 12%, which is 6% per year," she said.

That bucket is associated with the greatest probability because any basket performance in a wide range between minus 25% and 12% enables the investor to earn the fixed percentage return that fits into the 5% to 10% return bucket.

Low pricing score

The product, however, does not score well on pricing, she noted.

The price score on a scale of zero to 10 is Future Value Consultants' estimate of the total costs taken out of the product from direct fees and profit margin on the underlying derivative.

At 4.08, the price score is "quite low" she said, especially when compared to 7.87, the average price score for comparable products.

"It means that you could get better value from other similar structures. It could also be due to the pricing range. The exact cap is not known at this time," she said.

Overall

Future Value Consultants delivers its opinion on the quality of a deal through its overall score by averaging the price score and the return score.

The notes received an overall score of 5.23, much less than the 7.32 score for similar structures.

"The overall is very low, and since the return is not bad, it's the price score that drags down this rating here," she said.

Hampson said that the notes, like any other product, have strengths and weaknesses.

"The big advantage here is the contingent minimum, which allows investors to outperform the basket in a small-growth environment. If the market is flat, this product would do quite well," she said.

"On the negative side, your capital is at risk. Any investor in this product would need to be prepared to lose capital.

"Finally, if you're very bullish, the notes wouldn't be appropriate at all due to the cap."

The notes (Cusip: 61760E143) will price and settle in July.

Morgan Stanley & Co. LLC is the agent.

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