Morgan Stanley's jump securities linked to iShares FTSE/Xinhua China to attract moderate bulls

By Emma Trincal

New York, Feb. 26 - Morgan Stanley's planned securities linked to the iShares FTSE/Xinhua China 25 index fund offer moderately bullish investors the possibility to beat a direct investment in the Chinese large-cap equity fund, said structured products analyst Suzi Hampson at Future Value Consultants.

Morgan Stanley plans to price 0% jump securities due March 28, 2012 based on the performance of the iShares FTSE/Xinhua China 25 index fund, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus an upside payment of 36% to 41% if the index fund finishes above its initial level. The exact percentage will be set at pricing.

Investors will be exposed to any losses if the index fund finishes below its initial level.

"If the index [fund] ends up positive at maturity, you get a return of 36% to 41% in just two years. If not, you are exposed to the index [fund] and you lose some of your principal," said Hampson.

"You have a payout structure that is somewhat similar to an autocallable deal, in that the performance of the underlying is reviewed and if it's positive you get a fixed payment. But it's different than the autocallable structure in that there is only one review date - at maturity, so that eliminates the early return of principal possibility," she noted.

No barrier

Hampson said that one of the most striking characteristics of the structure is the lack of any form of downside protection.

"In terms of risk, this product sits very high on our scale with a riskmap of 7.62," she said.

Riskmap is Future Value Consultants' rating that measures the risk associated with a product on a scale of zero to 10.

"I think we can put this down to the fact that there is no protection or barrier on the downside and the investor is fully exposed to any decline of the fund. Most structured products we look at include a barrier or buffer which would protect the investor from falls in the underlying to a certain degree. Although this is not the most volatile underlying we have ever looked at, the fact that there is no barrier means that there is a high chance of losing capital - which equates to a high riskmap score," Hampson said.

The annualized volatility of the underlying fund is 45.14%.

"Sometimes products have more risk due to the underlying. For instance, reverse convertibles tend to have a high riskmap because the volatility of the underlying is high," she added.

"Here, we're dealing with a risky structure rather than a risky underlying."

Hampson said that it is "quite unusual" for a growth product to lack some sort of downside protection.

"The issuer could have chosen a higher volatility underlying including a barrier. They chose instead to eliminate the barrier, and that still makes it risky," she said.

Gains and losses

Given the potential for both high gains and high losses, the return rating of this product is "fairly average," said Hampson, saying that it is 5.45.

Return rating is Future Value Consultants' indicator, on a scale of zero to 10, of the risk-adjusted return of the notes.

"The return is calculated from the Monte Carlo simulations, which are also collected up into the probability buckets. The return score reflects that fact that this product is a high-risk product with the potential to offer high returns. This can be seen from the probability buckets as well," she said.

The probability tables included in the report revealed that investors face a 37.3% chance to lose more than 5% of notional per year. But the probability of making more than 15% is 56.4%.

"Due to the structure of the product, the only possible returns are that either the index [fund] is below its initial level, in which case capital is lost, or this index [fund] is above its initial level, in which case the investor receives a return of 36% to 41%. This explains the shape of the probability chart. If the investor receives a 36% to 41% return, it will fall in the more-than-15% return probability bucket," Hampson explained.

Fair overall

Future Value Consultants evaluates the general quality of a deal through its overall rating. The score, on a scale of zero to 10, takes into account costs, structure and risk-return profile. With this product, the rating is 7.44.

This indicator is an average of three component scores weighted 40% to the value score, 40% to the return score and 20% to the simplicity score.

Hampson said that the simplicity of the product - rated 8 on a scale of zero to 10 - and the value rating of 9.15 contributed to an overall "reasonable" score.

The value rating on a scale of zero to 10 is the firm's measurement of how much money the issuer spent directly on the assets versus other transaction costs such as direct fees and the profit margin on the underlying derivative.

"The high value rating of this product means that the issuer spent more money on the options and the bonds and took on less on commissions and fees," she said.

For moderate bulls

Hampson said that if the iShares FTSE/Xinhua China 25 index fund posts only a small growth rate over the next two years, the notes would "do much better" than a direct investment in the fund.

As a result, investors with a moderate bullish view on this market are likely to find the notes attractive, she said.

"If you believe that the iShares FTSE/Xinhua China 25 index fund will have a flat or small growth, then you're much better off with those notes because the payout would be better. In order for a direct investment in the fund to exceed this payout, you would need at least an 18% annualized return," she said.

She took into account the lower end of the 36% to 41% range. On the higher end, the annual growth would have to be at least 20.5%.

"On the downside, the risk is the same as investing in the fund. So your choice between the two will depend on your degree of bullishness. If you think that there will be contained growth, then you might decide that you don't need the barrier and go for the higher returns with these notes. In fact, you would have to be quite bullish to go directly into the fund," she said.

The notes will price and settle in March.

Morgan Stanley & Co. Inc. is the agent.

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