Morgan Stanley to price first fixed-to-floating rate notes tied to CPI in nearly two years

By Emma Trincal

New York, April 22 – Morgan Stanley Finance LLC’s fixed-to-floating rate notes due April 28, 2032 tied to the Consumer Price Index are the first inflation-pegged note offering to hit the market in nearly two years, according to data compiled by Prospect News.

The interest rate will be 7% per annum for the first year, according to an FWP filing with the Securities and Exchange Commission. After that, the interest rate will be equal to the year-over-year change in the index. Interest, which is payable monthly, cannot be less than zero and will be capped at 7% per annum.

“It’s nice to see those CPI notes coming back. I haven’t seen many in a while,” said a market participant.

The last CPI-linked note offering came out in June 2020. Morgan Stanley was also the issuer. The $3 million deal of 10-year fixed-to-floating rate notes had the same structure. The cap and teaser rate were 4%.

“Ideally you would get CPI plus something. I don’t know if it’s because of Morgan Stanley’s funding. Perhaps inflation is going up so much ... the idea is that linking it to the CPI only is still going to give you a good return,” he said.

Some previous versions of inflation-linked notes indeed provided exposure to the CPI plus a spread. But they also showed differences in their structure.

For instance, in December 2018, Bank of America Corp. priced $1 million of three-year floating-rate notes on the CPI. The payout was the annual percentage change in the inflation index plus 1%.

Growing threat

“Those notes make sense right now because of the way prices are rising,” the market participant said.

“I don’t know how long inflation is going to last, but right now, it’s pretty alarming. It’s going to depend on what the Fed does.”

In March, consumer prices were up 8.5% on an annual basis, the largest 12-month increase in more than 40 years, according to the Bureau of Labor Statistics’ latest report.

“What caused inflation is simple. The Fed has been printing money at a crazy pace. Trillions of dollars between Covid and a variety of giveaway programs have been added to the national debt. That’s a huge increase in the money supply,” he said.

“When on top of that you cut off oil supply, the situation gets even worse. I see the U.S. economy heading toward a stagflation cycle if things don’t get under control.”

Hawkish Thursday

During an International Monetary Fund panel discussion on Thursday, Fed chairman Jerome Powell said that a 50 basis point rate increase “will be on the table for the May meeting,” causing a bond and equity sell-off. The 10-year Treasury yield flirted with 3% level at 2.97% on Friday. The Dow Jones industrial average fell 981 points.

For the market participant, a 50 bps rate hike was still not enough and the Fed chair in his battle against inflation needed to show more resolve.

“Even with 1% they would still be behind the curve. But at least they would show they’re doing something,” he said.

“If you look at the price increases, food prices, gasoline prices, heating prices, it’s clear like the nose on your face that inflation is now growing at a double-digit rate. We know that because there’s a three-month lag with CPI. In two or three months, the reports will show a double-digit increase.”

Time will tell

Investors considering the notes would have to decide whether they believe the Fed will succeed in taming inflation and if so, how fast. If inflation turns out to become less controllable, in a similar scenario as in the 1970s, the 7% cap of the notes may not be high enough.

“The issuer did what they could,” the market participant said.

“This is a 10-year note. A lot of things can happen in 10 years. My inflation forecast is very pessimistic. But it’s for the next year or two.

“I think this note is a good bet for most people.”

Above expectations

A financial adviser said that his goal was to provide not just yield but also diversification and protection against inflation. In that regard, the notes fit the bill, he said.

“Given the rising interest rates environment, being indexed to the CPI could be a well-timed investment and a good alternative to bonds,” he said.

The 7% cap so far exceeds long-term inflation expectations, he said.

These expectations are reflected by the breakeven inflation rate, which derives from a comparison between the 10-year Treasury inflation protected securities (TIPS) and the 10-year Treasuries. On Thursday, market participants expected inflation to be 3.02% in the next 10 years, according to the Federal Reserve Bank of St Louis.

“The 7% cap allows you to capture a return well above this 10-year expectation in the event of a sustained inflation,” he said.

“This is very positive.”

Short-term pain

But this adviser agreed that the inflation picture could rapidly get worse in the next couple of years.

“We may have a brief period of time during the next12 months where the CPI will significantly surpass the 7% cap of the notes. We’re already at 8.5%. The next reading of CPI is likely to be higher than 8.5%.

“Buyers of the notes will underperform and may feel some short-term buyer’s regret. But we don’t think this soaring inflation is going to last. We actually believe that inflation has reached a peak right now.”

He explained why.

“We had supply chain disruption, but China is reopening. The Fed is hawkish. I’m not saying inflation will go away. But it won’t continue at a rate of 7% to 9%. It will settle down probably somewhere between 3% and 5%.”

With the Fed’s announcement of an interest rate hike of 50 bps next month, this adviser continued to find the notes appropriate.

“If clients look for a hedge against inflation, it’s still a hedge,” said Pietsch.

“The 7% cap still looks like a good return for a bond.”

The note also provided some level of protection against interest rate risk, he said.

“When rates go up, the capital value of your bond goes down. Here, with the rate pegged to inflation, you get a smoother ride, you’re mitigating some of that capital risk.

“Clients with dead money should be looking for something like this,” he said.

The payout at maturity will be par.

Morgan Stanley & Co. LLC is the agent.

The notes will settle on April 28.

The Cusip number is 61760QNG5.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.