Morgan Stanley's Australian dollar fixed-to-floating notes offer good rates with FX risk twist

By Emma Trincal

New York, May 21 - Morgan Stanley's senior fixed-to-floating notes due May 31, 2016 denominated in Australian dollars and payable in U.S. dollars offer competitive rates, but the trade-off for investors is the currency risk they are subjecting themselves to, sources said.

The coupon will be 8% for the first year. After that, it will be Libor plus 400 basis points, according to an FWP filing with the Securities and Exchange Commission. Interest will be payable quarterly.

The payout at maturity will be par.

Three-month Libor is currently 0.47%.

"The interest rate is fantastic. You're getting 8% on the first year and after that, at least 4%," said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

"You're not going to get there with any CD rates. A five-year CD is about 1.75%. Even U.S. CDs denominated in foreign currencies won't give you a yield anywhere near that.

"This note would be a good complement for a fixed-income portfolio. However, you're not buying a guaranteed-income type of product. So it wouldn't be suitable for a CD or muni bond buyer, for instance. Some people need a predictable income, and this note clearly doesn't offer that."

Rates

The notes are denominated in Australian dollars, but all interest payments and the payment at maturity will be made in U.S. dollars, according to the prospectus. If the U.S. dollar appreciates against the Australian currency, investors will lose money either when interest payments are made or at maturity upon the repayment of the initial investment.

As a result, investors in the notes need to be bullish on the Australian currency versus the U.S. dollar, Kalscheur noted.

"You have to expect higher interest rates and some level of depreciation of the dollar," he said.

Both expectations are in line with his general outlook.

"I am under the impression that rates are going to go up further and faster than most people anticipate," he said.

"I'm not sure whether it will be induced by some sort of commodities inflation or simply due to a recovery, but I see a rebound of rates and growth. And I'm not saying we'll get hyperinflation.

"Even if rates stay flat for another four years, which is unlikely, you still have this 4% for three years after getting 8% on the first year."

Currency risk, global growth

The exchange-rate risk, while real, is more of a concern for investors worried about a bearish economy worldwide, he said.

"The Australian economy is built around the mining industry. Over the last several years, this economy has been very strong due to China's massive buying. Now that China's growth is decelerating, the Australian dollar has been recently dropping," Kalscheur said.

"But I believe that the world economy will bounce back during that four-year period and that demand for raw materials will increase, which should be good for the Australian economy and currency."

Kalscheur said that it is not even necessary for the global economy to grow at a fast pace. It could just grow at a reasonable rate.

The opposite scenario, and the negative one for the noteholders, would be a U.S. dollar rally against the Australian currency. That would likely be the result of another shock or panic as seen in 2008.

"Over the next four years, I don't see the world economy going back to its 2008 levels," he said.

"Sure, if you're worried about a worldwide economic meltdown, then you wouldn't be interested in those notes. But I see that as a very remote situation."

Kalscheur also looked at the credit risk.

"Morgan Stanley is not the highest grade. The issuer's risk is a drawback. But it's only a four-year note, so it's certainly not a deal breaker."

Too risky

Scott Cramer, president of Cramer & Rauchegger, Inc., is more skittish on the product.

"The interest rate is a very fair rate. But the biggest risk is currency here. You have to decide if you want to take that risk," he said.

Cramer said that he likes the floating rate.

"If interest rates go up, you're not locked in. The rate part is fine," he said.

"But are you going to end up with more money at maturity than when you started? It all depends on the exchange rate, and that part, honestly, I don't know.

"I know that if we start tightening in the U.S., the dollar will begin to rise. Even if it's not done with higher interest rates, there are other ways to tighten money.

"In the face of a weakening Europe, the dollar is strengthening against the European currency. I am bullish on the dollar versus the European currency.

"But being bullish or bearish on the dollar versus the euro is one thing. It's another to have a view on the dollar against the Australian currency. And that's where the main risk is in these notes. A 10% drop of the exchange rate at maturity and you're losing principal.

"They give you fairly good rates, but there is a price for that: you're exposed to currency risk and you're taking Morgan Stanley's credit risk. I'm not sure I would want to do that."

Morgan Stanley & Co. LLC is the agent.

The notes will settle on May 31.

The Cusip number is 61760QBL7.

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