Morgan Stanley's equity-linked notes to offer optimal allocation and floored, uncapped return

By Emma Trincal

New York, June 4 - Morgan Stanley's U.S. and international equity allocation market-linked notes due June 2019 linked to a basket of indexes offer several attractive features to long-term holders who are willing to accept illiquidity and take on credit risk, sources said.

Among the benefits are a guaranteed minimum of 7% at maturity regardless of the basket performance in the absence of default. In addition, a weighting mechanism at maturity gives investors a greater exposure to the best-performing index.

The basket is composed of the Euro Stoxx 50 index, the Dow Jones industrial average and the Hang Seng index, according to a 424B2 filing with the Securities and Exchange Commission.

The index with the best performance at maturity will be assigned a weighting of 85%; the index with the second best performance will receive a 15% weighting; and the index with the worst performance will be assigned a weighting of zero.

The payout at maturity will be par of $10 plus the greater of the basket return and 7%.

Long tenor

"I've not seen that before," said Carl Kunhardt, wealth adviser at Quest Capital Management.

"I've seen notes tied to a basket of indexes, but there's always a fixed allocation.

"The only thing you're giving up is your liquidity and the FDIC insurance you would get in a CD.

"It could be a problem for some investors. I recently saw a really great 15-year note, but I had only one taker. In the current market, people do not have appetite for locking up their money. That would be the only pull back."

The obvious issue related to the long duration is investors' exposure to Morgan Stanley's credit risk, said Kunhardt, who put such risk in perspective.

"The credit risk is credible. But I don't think it's a major factor. Among the top banks, Morgan Stanley is sitting in the middle. Citigroup and Bank of America are worse. JPMorgan is the strongest," he said.

Kunhardt said that he would use such a note as a fixed-income substitute.

"It has a fixed minimum rate, but you avoid a good deal of the interest rate risk because of the equity-like return. If rates jumped up, chances are that equity prices would go up as well. You would get the optimized equity returns," he said.

Kunhardt compared the minimum return of 7% at the end of the seven years to the seven-year Treasury yield. Both instruments offered the same 1% annualized yield.

"It's got great features: you cannot earn less than the equivalent Treasury yield and at the same time you get unlimited upside with this enhanced allocation mechanism. These are valuable terms," he said.

Flat scenario

One possible risky scenario, he argued, would be if the basket was to finish flat at the end of the term.

"In that case, you would have been better off investing in short-term bonds," he said.

For instance, an investor buying one-year bonds yielding between 2% and 3% and reinvesting them year after year for seven years would end up with a 14% to 21% return, which would be considerably better than 7%, he said. Such yields are available in the current market, he added.

"A flat market is your Achilles heel with this note," he said.

"But if you have money that you want to allocate to safe, uncorrelated assets, this has a place in your portfolio."

Equity-linked

Scott Cramer, president of Cramer & Rauchegger, Inc., said that as long as investors know what they are getting into, the notes offer strong advantages.

"This is for somebody who wants zero risk exposure as well as the ability to participate in equity markets. The good news is that they're going to give you a favorable weighting at maturity. It's very favorable to the investor because you know you'll get the greatest allocation to the best index," he said.

Cramer said that despite the 7% minimum return, he does not consider the notes to be a fixed-income product or a bond substitute.

"It's definitely an equity-linked product. It would go into an equity bucket. Your return depends on stock performance," he said.

"Your real risk is Morgan Stanley. But as long as Morgan Stanley does not evaporate, you're getting back 107."

He pointed to the liquidity risk, saying that the intrinsic value of the notes "may not be so good" because of the long-term maturity and point-to-point payout.

"You're basically trading off liquidity risk for principal protection," he said.

"I like this note for what it is."

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said that credit risk is more of a concern than the lack of liquidity, although both risks are tied to the same cause: the long tenor.

"It's a little long, but I like it. Most of my investors know that they should hold a structured note to maturity. If you're comfortable with the company that's underwriting it, seven years shouldn't be a problem. Most private equity funds keep your money for that period of time or longer, and they don't have a guaranteed return. Here you're getting fairly compensated for the liquidity risk," he said.

Credit risk

The issuer's credit risk is related not just to the long tenor but also to the issuer's creditworthiness. Morgan Stanley is rated A- by Standard & Poor's.

"The rating is not horrible, but you're exposed to credit risk for seven years. At 1% a year, you're being paid at Treasury levels. Even Morgan Stanley would agree that they're not compensating you for the credit risk at that rate," Kalscheur said.

"It's an equity play. The 1% gives you a minimum replacement for the loss of dividends but not more than that," he added.

But getting exposure to the two best returns of the three indexes is very appealing, he noted.

"This note is a very interesting opportunity. The portfolio construction is not in question. It's very attractive for the investor. The problem is the seven-year commitment. You have to be ready for that. If you are, the long duration is not a deal-breaker, especially if this goes into your 401K," he said.

Uncertain allocation

Kalscheur said that one of the difficulties an adviser may face with the notes is to pick the right allocation bucket.

"Some products carry a certain degree of uncertainty around the coupon, the duration or the downside," he said.

"Here you may not know how to allocate this because it's the allocation part that is unknown. You don't know what it's going to be like until the end of the seven years."

An investor, he said citing an example, could end up with a portfolio made of 85% U.S. equity and 15% international equity, 85% international equity and 15% U.S. equity or even 100% international equity.

"If you don't know what you're exposed to, it's going to be difficult to find the right bucket and decide where your investment fits in," he said.

"And when the asset allocation is part of your risk allocation, it may complicate your investment process.

"Because of that, I would probably put it in a segregated portion of my portfolio. I think I would treat it as an alternative allocation."

The notes (Cusip: 61755S313) will price and settle in June.

Morgan Stanley & Co. LLC is the agent.

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