Morgan Stanley's range accrual notes tied to CMS curve, Russell 2000 aimed at the risk averse

By Emma Trincal

New York, Nov. 7 - Morgan Stanley's CMS curve and Russell 2000 index-linked range accrual notes due Nov. 23, 2019 provide investors with above-average yield and principal protection, a good fit for conservative, income-seeking investors, said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

But the trade-off is a floating rate versus a fixed coupon, he said.

In addition, range accrual notes are not easy to sell to retail investors due to their complexity, sources noted.

The coupon will accrue at 8% per year on each day that the 30-year Constant Maturity Swap rate is equal to or greater than the two-year CMS rate and the index closes at or above 500, according to an FWP filing with the Securities and Exchange Commission.

Interest will be payable monthly.

The payout at maturity will be par.

Attractive yield

When selecting products, Kalscheur said his firms looks at whether the product reduces risk.

"This one certainly does, given the 100% principal protection. That's pretty good. Your risk is the opportunity cost. Worse-case scenario: You get zero interest."

Income product

Kalscheur said that the product, despite an equity index component in the underlying, is not a growth investment but rather an income product.

"You're not betting on the Russell to go up a certain percent," he said.

"Your real bogey for that should be the equivalent CD rate.

"For an eight-year CD, I don't think you're going to get much more than 2.5% or 3%.

"Obviously, a potential 8% rate is very attractive. And it's nice to get it monthly.

"I'd rather get my income back sooner rather than later, especially in a rising-rate environment because you are allowed to reinvest at higher rates."

The downside of course, he said, is that the 8% is not a fixed rate. It depends on the number of days during which the CMS spread is positive and the equity index closes above 500.

The Russell 2000 is now at 745. It closed under 500 most of the time between 2000 and 2003 and also between November 2008 and April 2009, he noted.

Kalscheur said that one advantage with range accrual payout structures is that when the two conditions - spread and index level - are not met, the income is not eliminated.

"It only reduces the number of days of accrual. So you're probably not going to get the full 8%. But you're not going to get 0% either. It's somewhere in the middle," he said.

"You would have to do your homework and find out what type of income your investors may expect.

"No matter what, chances are you're going to get a better rate than what's out there.

"I can see why people would like something like that."

Credit risk, complexity

However, Kalscheur said that he is concerned with credit risk, especially with the long tenor.

"Morgan Stanley is single-A. It makes me a little uncomfortable. I'd be wary on that," he said.

Another concern is how to market this type of product and how to find the type of investors who may benefit from the notes.

"It's a little confusing and a bit hard to explain," he said.

"Most people don't know what CMS stands for.

"You also have to get a sense of what the rate may end up being. There's a big difference between expecting a 4% or a 6%.

"I don't want to estimate a rate and set the wrong expectation for a client on a product like that."

Finally, fixed-income investors, who would be the type of buyers for those products, would have to be flexible and willing to substitute a traditional fixed coupon for a floater, he said.

"These notes would be appropriate for the conservative investor who isn't spending every last dollar of income. You'd have to be comfortable with the idea of getting an unpredictable stream of income," he said.

Institutional investors

A fixed-income trader at a broker-dealer said that range accrual notes are not very popular among financial advisers.

"These are more for institutional investors. They buy it more than retail. They'll put it in their pension accounts or trust accounts," this trader said.

"We used to show it to financial advisers, but it doesn't really work. We've stopped selling them.

"It's complicated for an advisor to understand. It's difficult to follow. They don't necessarily have access to CMS rates."

For these notes, the principal protection can be seen as an advantage, especially for retail investors, this source said.

But the benefit is partially offset by the creditworthiness of the issuer.

"It's principal-protected up to Morgan Stanley's ability to repay principal."

Morgan Stanley & Co. LLC is the agent.

The notes will settle on Nov. 23.

The Cusip number is 61745EZ38.

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