Morgan Stanley's $70 million floating-rate notes tied to CPI reveal renewed inflation concerns

By Emma Trincal

New York, Dec. 16 - Morgan Stanley's upsized $70 million of floating-rate notes due Dec. 15, 2019 linked to the Consumer Price Index indicate a renewed interest for inflation-hedging products on the part of investors, sources said.

Steve Doucette, financial adviser at Proctor Financial, said, "$70 million is a big deal."

The bank on Tuesday priced an additional $8.41 million of the notes. The original $61.59 million of notes priced Dec. 10, according to a 424B2 filing with the Securities and Exchange Commission.

The interest rate is fixed at 4.5% for the first two years. Beginning Dec. 15, 2012, the interest rate will be equal to the year-over-year change in the index plus 200 basis points, subject to a floor of zero and a cap of 8.5%. Interest is payable monthly.

The payout at maturity will be par.

HSBC too

Separately, HSBC Bank USA, NA announced plans to price principal-protected fixed-to-floating inflation-linked certificates of deposit due Jan. 4, 2021 tied to the CPI

The coupon will be fixed at 3% per year for the first six months. After that, the coupon will equal 1.5 times the year-over-year change in the CPI, subject to a cap of 5% and a floor of zero, according to a term sheet. Interest is payable monthly.

The payout at maturity will be par.

Advisers said that the risk investors face when buying those products is two-fold: too much inflation or not enough of it.

Notes versus CDs

Doucette said that neither deal provides investors with sufficient protection against inflation because in both cases the floater is capped at a level that may not be enough if inflation rises drastically, a scenario Doucette said can be anticipated.

The securities in his view are more valuable during the limited period of fixed interest rates.

Comparing both products, he said that the Morgan Stanley notes were more attractive than the CDs.

"It's a nice inflation hedge to get a 2% above the CPI guaranteed.

"While with the other deal, the CPI times 1.5 is nice, but the 5% cap is much lower than 8.5%," he said.

"In addition, with the notes, you get the coupon for two years versus only six months for the CDs," he noted.

Based on historical average - a CPI averaging 4% over the past 50 years - the Morgan Stanley notes also come with a better payout outcome than the CDs, Doucette observed.

Taking a 4% CPI, he said that the formula for the CDs would result in a 6% interest rate. But because interest is capped at 5%, they would only earn 5%. Investors in the notes would get 6%.

While one product appeared more attractive than the other, Doucette said he would not be interested in either because their duration is too long. In addition, inflation could be greater than the maximum interest rates.

"Look at the 1980s when interest rates were at 12%, 13%. It may be that you're just better off if you go and get a bond," he said.

Short is sweet

If the duration were shorter, Doucette said that he would consider the notes.

"If it was a five-year play, I may look at it," he said.

Part of the appeal of the products, if they were shorter in duration, would be to provide a better alternative to other inflation hedges, he said, in particular Treasury Inflation-Protected Securities.

"TIPSs trade in limited supply, and they can go up and down in value due to supply and demand," Doucette said.

"But I wouldn't lock my money for nine or 10 years. No one knows what the inflation will be in 10 years.

"Brokers do a wonderful job at preying on investors' fear of inflation.

"Whether that's the right way to play inflation, I'm not sure."

Better alternatives

For others, the risk posed by these two products is that inflation may not be high enough, which would cost investors the opportunity to collect higher yields elsewhere.

"If inflation is not rising meaningfully, if it remains under control, you're better off investing in Treasuries," said Matt Medeiros, president and chief executive officer of the Institute for Wealth Management.

The CPI increased by 1.1% over the last 12 months ended in November. It increased 0.1% in November on a seasonally adjusted basis.

The 10-year Treasury yield is at 3.5%.

Medeiros said that the odds for investors in the notes to earn the 8.5% cap were limited.

"You'd have to see inflation hit 6.5%," he said. "I don't really see inflation reaching that level. I'm not sure I see inflation being a problem for quite some time."

Medeiros added that 6.5% is "well above historical averages," noting that the highest inflation level seen in about 30 years - or after 1981, when inflation peaked at 13% - was 6%.

"People are afraid of inflation. Everybody wants an inflation hedge in their portfolio," he said.

"But there are better alternatives such as commodities, TIPSs or even other structures.

"I wouldn't consider those products simply because I don't believe we're going to hit double-digit inflation anytime soon."

Morgan Stanley & Co. Inc. is the agent for the notes.

HSBC Securities (USA) Inc. is the underwriter for the CDs (Cusip: 40431GKC2), which will settle on Jan. 4.

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