Morgan Stanley’s 13% notes tied to 30-, two-year ICE swap rates present novel play on spreads

By Emma Trincal

New York, April 12 – Morgan Stanley Finance LLC plans to price 13% fixed-rate buffered securities due May 2018 linked to the spread of the 30-year U.S. dollar ICE swap rate over the two-year U.S. dollar ICE swap rate, according to a 424B2 filing with the Securities and Exchange Commission.

Interest will be payable monthly.

The payout at maturity will be par unless the final spread is below the 50% threshold, in which case investors will lose 2% for each 1% decline beyond 50%.

New structure

“This is kind of a new structure...not your traditional rate trade,” said a rate structurer.

Unlike the traditional steepener, which is usually a longer-dated note with principal protected and a contingent coupon based on the spread, the Morgan Stanley structure was just the opposite, he said.

“It’s very, very interesting. Your principal is totally at risk. But they pay a fixed rate,” he said.

“The 50% buffer looks attractive to be honest.

“The coupon is high, which makes sense given your risk.

“It’s an interesting trade with a high potential return. Getting 13% in 13-month is really attractive.

“I just don’t like the downside leverage.”

Investors in the notes are betting that the yield curve between the two-year and 30-year will remain steep or that it may flatten but not by more than 50%, he explained.

Not grandma’s steepener

Most traditional steepeners use the same underlying spread. But the view and the structure are distinct.

Lasting from 10 to 20 years, steepeners usually offer a fixed rate only for a limited period of time, usually the first one or two years. After that, investors receive an interest based on the spread. The spread is often leveraged to increase the contingent coupon. While most of those products are principal-protected, some offer a deep barrier up to 50%.

Investors in the traditional product type benefit from the steepening of the yield curve as their coupon increases in proportion of the spread, up to a cap.

In contrast the Morgan Stanley pays a fixed rate regardless of the final spread.

“It can go either way as long as the spreads doesn’t tighten by more than 50%,” he said.

This structurer also liked some of the terms.

“Getting a buffer of 50% on a short-term note like this and a 13% fixed rate is attractive and very different from what we see,” he said.

Risk eyed

But it was a reflection of the risk incurred.

“It’s short term, but it’s all principal-at-risk. You can lose a lot or even everything.”

He offered an example.

The current spread between the 30-year and two-year swap rates is approximately 1%.

If the final spread narrowed by 60% to 0.4%, the decline would represent a 10% drop in excess of the 50% buffer level.

Investors in that case would lose twice the 10% narrowing of the spread over the buffer. It would represent a 20% loss of principal.

Fed behind the curve

This structurer placed the investment theme in the context of the Federal Reserve’s course to raise interest rates this year.

Based on history, the spread between the long end and the short end of the yield curve will narrow when the Fed raises rates and widen when it cuts rates, he explained.

“The forward shows the spread is narrowing between the short end and the long end,” he said.

“The spread is at risk although it has a big buffer. But if they hike aggressively, you can lose quite a lot.

“Another source of risk to keep in mind: your spread is levered.”

The rationale behind the trade was two-fold.

First, the spread has already narrowed a lot, which may offer a good opportunity for entry, he said.

“Since the Fed started tapering, the spread has declined from 2% to 1%,” he said.

The so-called tapering refers to the Fed’s decision in 2013 to unwind its quantitative easing program. Investors at the time fled the bond market in reaction, causing bond yields to surge.

Second, the trade is based on the view that the Fed will act cautiously, raising rates only moderately and infrequently, an expectation that is somewhat relayed by the central bank itself in some of its most dovish statements issued since December.

In such scenario, even if the Fed hikes rates, a compression of the spread beyond the 50% mark is unlikely, he said.

“You’re betting on a steady, not aggressive rate hike, and since it’s a one-year trade there’s probably not enough time for the spread to narrow too much,” he said.

“At least that’s the view.

“As long as the spread doesn’t narrow by more than 50% you keep your principal and get a 13% coupon.

“Most people expect the spread between the two and the 30 to narrow. But I don’t know by how much.

“This is a conviction bet that hiking is not going to be that fast and also that the U.S. recovery is steady.”

Risk on

A market participant was also intrigued by the structure.

“This is a different kind of creature,” he said.

“The holder is taking the risk that the spread won’t narrow by more than 50%. The issuer is taking the opposite position, long a put on the spread.

“If the spread goes down to zero you lose all of you principal.

“The good news is you get to keep 13%.

“I’m not an expert on this market, but it looks like it’s a bold move to be doing that.

“I’m not really surprised that they would pay 13% in premium.”

An industry source said it was unusual to see this type of risk-adjusted return profile for these types of products.

“It’s good to see investors open to principal at risk on a yield curve play,” he said.

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The notes will price in April.

The Cusip number is 61766YBF7.

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