Morgan Stanley to price first Nasdaq 100-linked product this year with bear market PLUS

By Emma Trincal

New York, April 27 - Morgan Stanley announced the first Nasdaq 100-linked deal so far this year. No other deal with this underlying has been announced or priced so far this year, according to data compiled by Prospect News.

Morgan Stanley plans to price 0% bear market Performance Leveraged Upside Securities due May 2011 linked to the Nasdaq 100 index, according to an FWP filing with the Securities and Exchange Commission.

The Nasdaq 100 index is a common benchmark for the performance of technology stocks.

If the index return is negative, the payout at maturity will be par of $10 plus 3% for every 1% that the index declines, subject to a maximum return of 10.5% to 12% that will be set at pricing.

If the index return is positive, the payout will be par minus 1% for every 1% that the index gains, subject to a maximum loss of 80%.

Scarcity

As previously reported, the Nasdaq 100 index has not been in favor as an underlying for notes in the U.S. structured products market.

The last deal to price was brought to market by Morgan Stanley in November, according to SEC filings. The bank then priced $3.61 million of 0% bear market PLUS due Dec. 16, 2010 linked to the Nasdaq 100 index.

Morgan Stanley has been the most active of the issuers for this underlying. It priced four out of the six deals tied to the Nasdaq 100 index last year, according to data compiled by Prospect News.

Bearish twist

Investors in the notes have a short exposure to the Nasdaq, according to the prospectus. The structure offers a triple leverage factor: investors will earn three times the index percentage decline up to a maximum cap of 10.5% to 12%.

"There is not a lot of demand for Nasdaq products, or when there is, it's very specific," said a New York sellsider. "It will be either bearish or for certain types of products. Demand for Nasdaq notes is very bespoke. It's based on the particular needs of some specific clients."

A bearish view on Nasdaq may make sense for some investors who have not forgotten the two years of bear market ensuing the bursting of the internet bubble in 2000, sources said.

From its peak in March 2000 to its low in September 2002, the Nasdaq declined by 83%.

"The index lost a lot of its allure after 2002. People turned to broader indexes after that," the sellsider said.

The Nasdaq 100 index hit its second-lowest point in February of last year. But since then, it has soared by nearly 80%.

Some in the market are positioning themselves for a correction, a source said, adding that for such investors, a bearish note on the Nasdaq 100 index is a timely product.

Some protection

On the downside, investors in the notes will not receive less than 20% of their principal at maturity, even if the index advances by more than 80%, according to the prospectus.

The prospectus also explains that investors forgo performance over the cap in exchange for the leveraged returns and the partial protection.

Not for bulls

"This deal would not be attractive to me. First, I am bullish on Nasdaq, not bearish. And if I was wrong, if something was going to happen, it would really, really go down," said Jim Delaney, portfolio manager with Market Strategies Management.

Delaney, assuming that the issuer would price the cap at its maximum of 12% - the best-case scenario - said that investors only need a 4% decline of the index to maximize their gains based on the leverage factor of three.

Strong bears, beware

"If it drops one year from now, it will fall by much more than 4%. Look at how it's trading. It's already down 2% today. Two more percent and you're capped out. If I was bearish, I would need a much higher cap than that," said Delaney, referring to a 12% cap.

Delaney explained that the deal would not be a good fit for him from the perspective of downside risk as well.

"There is virtually no protection in the deal. The first 80% of appreciation comes out of my pocket, and the only return I get is three to one on the first 4% of the downside move."

He said that, while bullish, he is only moderately bullish and does not anticipate the index to gain more than 5% to 10% a year from now. He reasoned that the Nasdaq, along with most equity indexes, should increase because in his view, the economy and business activity are in recovery. But he said that last year's performance - the Nasdaq gained nearly 60% in 2009 - is unlikely to be repeated this year.

The protection built into the notes for 20% of the principal is as a result too expensive and too small to be justified, Delaney said.

"The market has to stay where it is or go down by no more than 4% in the next year for me to win. It's almost impossible," he added.

"Why would I pay this protection with a cap? I'm not sure the risk/reward is worth the investment for me," he said.

Self-hedging

Instead of having to give up some of the upside for the partial protection, Delaney said that investors could build up their own protection being long a call.

"I could hedge the risk myself with a very well-defined and limited risk structure," he said. A way to do that would be to buy a call on the Nasdaq, he said. "That way if I'm bearish on the index and if I'm wrong, I can limit my downside risk. You can certainly build a lower-risk trade and get some level of protection rather than giving up so much of the upside."

The notes will price and settle in April.

Morgan Stanley & Co. Inc. is the agent.

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