Morgan Stanley notes on hybrid basket a commodities play with no cap, partial participation

By Emma Trincal

New York, Sept. 30 - Morgan Stanley's $3 million of 0% market-linked notes due Sept. 30, 2016 linked to a hybrid basket have a payout structure that gives investors the opportunity to get commodities exposure with principal protection, sources said.

The basket includes gold with a 40% weight and the S&P GSCI Agriculture Index - Excess Return, the S&P GSCI Livestock Index - Excess Return and the iShares MSCI Emerging Markets index fund, each with a 20% weight, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 80% of the basket return, subject to a floor of par.

Low interest rates

Issuers are finding it increasingly "difficult" to structure principal-protected products because the low-interest-rates environment makes it "tough to give attractive terms," a sellsider said.

The problem with low interest rates, he said, is that a principal-protected deal requires putting together a zero-coupon bond that will mature at par and a call option. When interest rates are low, the cost of the zero-coupon bond increases, which leaves less money for the purchase of the option, this sellsider said.

Most of the time, the problem is resolved by extending the maturity of the notes, said Suzi Hampson, a structured products analyst at Future Value Consultants.

Data compiled by Prospect News shows that the average tenor for a principal-protected note over the past two months is 5.42 years.

Unusual payout

Another way, used in this deal, is to change the payout structure.

"The options on the underlying basket must have been too expensive for the issuer to give you 100% of the return. Usually, that's what you get: 100% of the underlying return, to which you add a cap."

A recent example is Bank of America Corp.'s $29.77 million of 0% Market Index Target-Term Securities due Oct. 1, 2015 linked to the spot price of gold, which had a payout of par plus the gold return, subject to a 52% cap.

But in the case of the Morgan Stanley notes, the issuer chose to eliminate the cap altogether and to lower the participation rate to 80% from 100%, said Hampson.

"Investors tend to find it less attractive to get less than 100% of the return. They generally would want to get full return with a cap," said Hampson. "You won't see the less-than 100% payout very much with liquid indexes like the S&P 500, where it's easy to buy the option. I guess they did it that way here because it's hard to directly invest in the underlying basket."

Less liquid options

Hampson said that the basket combined several vehicles, including one commodity, two commodity indexes and one exchange-traded fund, making the purchase of the related options more difficult.

"You have indexes, but they are not particularly liquid indexes. So there are not so many options on that," she said.

"In addition, the combined volatilities make the options more expensive on the underlying basket.

"It's hard to tell whether some investors may have found it more appealing to get rid of the cap in this case or if the issuer structured it that way to reduce the cost. But when structuring principal-protected notes, issuers always have to make that call. They have to decide whether they want to give 100% of the return with a cap, and that's what they do most of the time, or whether they want to eliminate the cap and give less than the full return."

Principal-protected deals linked to commodity assets have been rare so far this year. Out of 93 offerings with full principal protection, only nine were mainly linked to commodities, according to data compiled by Prospect News.

The most common underlyings were either the price of gold or the Dow Jones - UBS Commodity index, data showed. With both of these, options are easier to find.

"Options on commodities depend on what you're buying ... the different terms ... the strike prices," said Matthew Bradbard, president of MB Wealth, a broker who trades futures and options on commodities.

"To be sure, gold is extremely liquid," he said.

Basket's pros and cons

Bradbard said that some of the aspects of the underlying portfolio and deal structure were attractive but that he did not like the correlation between the various basket components.

"I like the six-year term, because I'm short gold today. Six-year duration for gold is better than short-term. The agriculture and the livestock indexes, I love it. These will be two of the best performers in the next six years. And I like the structure, only because of the principal protection," Bradbard said.

But the broker added that other aspects of the deal were less compelling.

"To begin with, I'd rather pick the underlying commodities myself and take long/short positions," he said. "I'm short gold, I'm short the S&P, I'm short sugar, coffee. Gold is too crowded right now. The 40% weighting is a little bit too much. I'd be much happier with 40% in silver. I'm bullish on silver."

But Bradbard said that his main objection to the product was the correlation between the basket components.

"My real problem is that it's not as diversified as it sounds. It has commodities, and it has emerging markets. Emerging markets are the ones buying a lot of gold. And demand for agriculture and livestock is coming from the growth in the emerging markets," he said.

Morgan Stanley & Co. Inc. is the agent.

Fees are 2%.

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