Morgan Stanley's $270 million callable notes with contingent coupon on S&P 500 top the year

By Emma Trincal

New York, Sept. 29 - Morgan Stanley priced the largest deal of the year so far that is not an exchange-traded note with a $270 million offering of callable notes linked to the S&P 500 index, according to data compiled by Prospect News.

Sources said that the popularity of the deal was due to its structure and a growing appetite for hybrid products that give equity-based payouts delivered in an income product format.

Morgan Stanley priced $270 million of callable notes with contingent coupon due Sept. 29, 2022 linked to the S&P 500 index, according to an FWP filing with the Securities and Exchange Commission.

Interest is payable quarterly. The interest rate is fixed at 7.5% for the first year. After that, the notes will pay a coupon of 7.5% per year if the index closes above 750 on the relevant observation date, which is also quarterly.

If the index closes at or below the barrier level, no interest will be paid for that quarter.

The payout at maturity will be par.

Beginning Sept. 29, 2013, the notes will be callable at par on any interest payment date.

Three years of call protection

"My adviser clients found this deal very attractive," said Brad Livingston, a distributor at Laidlaw & Co.'s Income Solutions Group. "Seven-and-a-half percent is a very nice coupon, that's the biggest point. And this coupon is fixed for one year. But in addition to that, clients really like the three-year non-call."

"The reason this deal was so popular is because it's not going to get called for three years. And there is a very reasonable probability of getting your 7.50% coupon after the first year," he added.

The S&P 500 closed at 1,132 on Friday, the pricing date. Therefore, a decline of the underlying index to 750, Livingston reasoned, would translate into a loss of more than a third of the S&P 500's initial value, an outcome he said was not very likely, at least in the early years.

There is no buffer or barrier in the structure, he noted, as investors receive par at maturity.

Investors' main risk, he said, was to receive no coupon if the S&P 500 did not close above the 750 threshold.

"As long as this condition is met, you get this 7.5% coupon, which is a very good coupon, extended to the other years," Livingston said.

Biggest so far

This deal surpassed in size what was so far the top non-ETN offering of the year: Credit Suisse AG, Nassau Branch's $257.19 million of 0% autocallable index knock-out notes due May 2, 2011 linked to the S&P 500 index sold via JPMorgan in April.

The only bigger non-ETN offering hit the market back in July of last year when Deutsche Bank AG, London Branch sold $500 million of buffered return enhanced notes due Aug. 3, 2011 linked to a currency basket.

Commenting on last week's product, a New York sellsider said, "It's enormous. It's an incredible deal. That's a long maturity, but on the other hand, you have this very attractive coupon with a decent 750 level and that's fair. The downside I guess is the 2.25% fee. They must have made tons of money. As an investor, your risk is to have your money tied up in a long-term deal with no coupon if the S&P 500 collapses five years from now."

Marrying income and equity

For a market participant, the deal was symptomatic of a new trend marked by the strong bid for income products. This source said that more and more products are being created in hybrid form as a way to satisfy investors' appetite for yield in an environment of very low interest rates.

"This offering is representative of a trend. Fixed-income structures are becoming prevalent. You're seeing more and more hybrids that mix a fixed-income structure with an equity underlying," the market participant said.

Commenting on the "hybrid" aspect of the product, he said, "The notes pay a coupon on the first year. Next, it's a digital equity-based product."

He noted that some characteristics of fixed-income structuring such as range accrual payouts and, in this case, a call feature were becoming increasingly popular among investors across underlying asset classes that may not be contained to mere rate products but also equity.

"People are looking for yields, so they like callable deals. That's because the issuer benefits from a call and therefore must pay investors a premium for it," he added.

Morgan Stanley & Co. Inc. was the agent.

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