Morgan Stanley's two-year jump securities linked to Apple are at the top end of risk spectrum

By Emma Trincal

New York, May 25 - Morgan Stanley's 0% jump securities due June 2014 linked to the common stock of Apple Inc. represent a way for investors already bullish on the stock to boost returns even in a modest-growth scenario, said Suzi Hampson, structured products analyst at Future Value Consultants.

However, the notes are at the top end of the risk spectrum when compared to most structured products, she said.

"Rather than buying the stock, this note allows you to change the return payoff," she said.

If the final share price is greater than the initial share price, the payout at maturity will be par of $10 plus the greater of the stock return and the upside payment, which is expected to be 37% to 41% and will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the final share price is less than the initial share price, investors will be fully exposed to the decline.

The product is classified as a digital note under Future Value Consultants' methodology because a fixed return or minimum fixed payout in this case is offered provided that some conditions are met, she explained.

With this note, she noted that the "fixed return" is 40% for the two years, or 20% per year, providing that the stock does not finish lower at maturity.

Big risk

"This product has the highest kind of risk profile that you can get," she said.

"First of all, many digital notes give you access to a minimum coupon when the underlying finishes at a threshold that's less than the initial price, for instance at 70%. Here, it's got to finish above 100%. That's a little tougher to achieve," she said.

"Second, this one has no principal protection below the initial price. Most products give you a buffer or a barrier or some kind of protection. For instance a digital with a 70% trigger will return your principal with a margin for losses of 30%.

"Except for leveraged notes that are fully exposed to losses, I can't think of anything more risky that that for a structured product. Note, however, that you're not incurring any more risk than when you're long the stock, which is fine if that's what you want.

"Finally, many digital products are tied to indexes. This one is linked to a single stock. While Apple is not among the most volatile stocks, with an implied volatility of 35%, it's still considerably more volatile than the broad market."

Riskmap is a Future Value Consultants rating that reflects the risk associated with the product on a scale of zero to 10. The higher the riskmap, the higher the risk of the product.

The notes have a 6.66 riskmap. Hampson said this is elevated compared to an average 4.18 riskmap for products of the same structure type and an average 4.31 riskmap for all products recently rated by the research firm.

The riskmap is the sum of two risk components: market risk and credit risk. Both the market riskmap and credit riskmap for the Morgan Stanley notes are higher than the average for similar products and all products.

At 1.46, the credit riskmap of the digital product is more than the 0.70 average score for all products.

"This is more credit risk due to a combination of duration and issuer's credit risk," Hampson said.

Reverse convertibles weigh heavily on the average of all recently rated products, and they tend to have a short maturity of three or six months, she said.

Morgan Stanley's credit default spreads are not among the tightest, she said, at 444 basis points, versus 311 bps for Bank of America and 232 bps for Barclays.

The market risk (5.20) is also much higher than other digital notes (2.96) and the all-products category (3.60), she said.

"This again reflects the lack of downside protection. Even a reverse convertible, which is risky by definition, will tend to have a barrier. And if it doesn't, the coupon gives you some slight protection as a cushion, so you're not going to exactly lose one for one. Here, if the stock is down, you're down one for one from the initial price," she said.

High return

But risk can pay off in high potential returns, and this note is an example of a good risk/reward trade-off as measured by the return score, said Hampson.

The return score is Future Value Consultants' opinion of the risk-adjusted return calculated from five key assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. Future Value Consultants calculates a risk-adjusted average return for each assumption. The return score is the best of these five returns.

In this type of uncapped structure, the best scenario is "high growth," she said.

At 7.85, the notes' return score beat the average for all products (6.46) as well as the average score for similar products (7.19).

"You have a pretty high return rating here for a couple of reasons. First, a 20% annualized gain is pretty high for a minimum return. In addition to this, you get an uncapped return. Those two factors combined give you a high score," she said.

"For any annualized stock performance under 40% at the end of the two years, you'll outperform Apple," she said, if one does not take into account dividends.

"And if the stock appreciates by more than that, you get to participate in the return without being penalized.

"This note is good for a wide range of bullish investors whether you have a moderate growth outlook or whether you're aggressively bullish. Of course, you want the stock to grow as much as possible."

The probability table illustrates the strength of the return score, said Hampson.

With its probability chart, Future Value Consultants estimates how the product is expected to perform under the five key assumptions. It assigns a probability of return outcome for each of the payoff buckets.

The chart is generated using a Monte Carlo simulation using various parameters such as volatility, dividends and interest rates.

Based on the high-growth scenario used to score the product, investors in this note have a 70% chance to earn an annualized return of 15% or more. While the model structures the bucket in a 15% or more template, in this case, what the probability represents is really an annualized return of at least 20% since this is the minimum gain that can be made on the notes, she explained.

Separately, the odds of losing more than 15% of principal are 16%.

Price, overall

The product also offers value, she said, as measured by the price score.

Future Value Consultants measures the market value of the underlying components of the product on a scale of zero to 10 with its price score. Calculated as a percentage of the initial investment, the score gives an estimate of the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

At 9.51, the price score for those notes is "considerably better" than the average rating of 7.53 for other digital notes, she said.

"This deal prices well. The issuer is spending more money on the options, and that translates into more value to the investor," she said.

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

The notes received an 8.68 overall score, versus 7.36 for similar products and 6.70 for all products.

"This investment would be for anyone interested in Apple whether they already own the stock or not. They're not taking more risk. They're merely changing their return profile," she said.

"It can be used by an investor looking for a target return. It will give you 20% a year if the stock finishes up. It's a good way of boosting equity returns in a portfolio," she said.

The notes (Cusip: 61755S305) will price in May and settle in June.

Morgan Stanley & Co. LLC is the agent.

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