Morgan Stanley's note tied to S&P GSCI Gold seen as too long amid bubble, correction risks

By Emma Trincal

New York, Oct. 17 - Morgan Stanley's upcoming 0% trigger Performance Leveraged Upside Securities due October 2015 linked to the S&P GSCI Gold Index - Excess Return offer an attractive structure but are risky due to a tenor that is long for a relatively volatile underlying, sources said.

The payout at maturity will be par of $10 plus 1.2 to 1.3 times any gain in the index, with the exact participation rate to be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 35% and will be fully exposed to the decline if the index falls beyond the trigger level.

The unlimited and leveraged upside combined with a 35% downside barrier offer an asymmetric payoff that is favorable to investors, sources said.

For instance, if the index is up 4% at maturity, investors will receive 4.8% to 5.2%, according to an example in the prospectus.

On the other hand, the index could go down by up to 35% without triggering any losses.

Locked in

"It's good to have no cap and the downside protection. But what scares me is the four-year term and the massive correction we've seen with gold," said Matthew Bradbard, president of MB Wealth, a commodities brokerage firm.

"In September, gold prices fell almost 25% in just two weeks. If you can drop 25% in two weeks, you can certainly drop 35% in four years.

"Yes, it's good to have the leverage, but I'd rather be invested directly in gold on a one-for-one basis without being locked in. ... If gold prices are a lot higher in one or one and a half years from now, I can take my profits. I can't do that with the notes."

Bradbard said that gold prices may continue to go up, especially if "governments continue to kick the can down the road" and they "fail to deal with these sovereign debt problems."

But the price of gold is already very rich and remains highly volatile, he said.

Bradbard looked at the high and low of gold prices over the past four years: the high was $1,900 an ounce early last month, and the low was recorded at $700 in October 2008. The current price is $1,670 an ounce. That's a $1,300 median price for the four-year period, he noted.

"We're currently at a pretty high level, 28% above the median price for the last four years," he said.

"I have a tough time believing that gold will continue to rise indefinitely.

"There have been worse products than this note. But I'm not crazy about being tied up for four years."

Not a bear

Carl Kunhardt, wealth adviser at Quest Capital Management, said that he doesn't like the four-year term either.

His first argument is that betting on a continued rise in the price of gold is the equivalent of holding a bearish view on the economy and the stock market, which is not his outlook.

"Most often, gold is used as a hedge against a declining market. It's your ultimate flight to safety," he said.

"So if you believe that the price of gold will continue its trajectory, that means you're bearish on the economy and bearish on stocks.

"I'm not willing to bet against the stock market for four years."

Bubble alert

In addition, Kunhardt said that gold, which has hit new highs recently, is showing all the signs of a bubble.

While the 35% protection is good, it may not be enough to protect against a strong correction, especially given the fact that the downside protection is a barrier, not a buffer.

If the underlying commodity index depreciates 40%, the investor will lose 40% of his principal at maturity instead of losing only 5% had the protection been a buffer, according to the prospectus.

"Just look at the price of gold from 2000 to now. We've been in a gold bubble for a while. Over the past 20 years, it's been a space shuttle on the way up," he said.

"I don't care if it's gold or technology stocks, that type of trajectory is not sustainable. It has to come back to a mean.

"Every time somebody says this time it's different, lady destiny comes back to prove how wrong they are."

Too long

Kunhardt said that if the notes had offered a 12- to 18-month duration, "it would have been a reasonable speculation."

That's because he does not anticipate any major policy changes until the presidential election and even not much change for the first year of any new presidential term.

"But a four year? No, I'm not going to bet on that while gold is the next bubble to burst," he said.

Morgan Stanley & Co. LLC is the agent.

The notes will price and settle in October.

The Cusip number is 617482K52.

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