Morgan Stanley’s $3 million steepener on ICE swap rates show rare downside leverage exposure

By Emma Trincal

New York, Feb. 20 – Morgan Stanley Finance LLC priced $3 million of 0% securities with leveraged downside principal exposure due Feb. 22, 2021 linked to the spread between the 30-year U.S. dollar ICE swap rate and the two-year U.S. dollar ICE swap rate, catching market participants’ attention for the asymmetrical and negative leverage.

The notes enable investors to bet on the steepening of the curve or the difference between longer-term interest rates (the 30-year rate) and shorter-term interest rates (the two-year rate). A positive spread will generate at maturity 100 times the spread, which is the equivalent of 1% for every 0.01% that the final reference rate spread is greater than zero, according to a 424B2 filing with the Securities and Exchange Commission.

The potential gains are subject to a maximum return of 20%.

In the opposite scenario, in which the yield curve would be inverted rather than steeper, investors face the risk of losing their entire principal.

The downside exposure magnifies losses by a factor of 300 times. Investors will lose 3% for every 0.01% that the final reference rate spread is less than zero.

No floor

“I’ve seen deals like that with leverage on the downside a long time ago. Usually they came with a floor though,” said a trader.

“You’re betting on an inversion not happening while we’re so close.

“Maybe it was a reverse inquiry and they showed it out there.

“Maybe you have a position in your portfolio that you need to hedge out.

“It’s a pretty esoteric payoff. I’m surprised they would come up with something like that.”

Capital at risk

The notes differ from classic steepeners that provide for the full return of principal at maturity. However, capital-at-risk trades have recently been spotted when the steepeners come with high leverage factors such as the 100x seen in this deal.

The concern with the notes’ payoff was the enhanced risk on the downside, sources said.

As stated in the risk section of the prospectus, the 3x downside leveraged exposure allows for “a significant loss.”

If the final rate spread is approximately minus 0.3333% or lower, investors will lose their entire initial investment.

Downside gearing

“I’ve seen modest amount of gearing on the downside but I’ve never seen down three times if you’re wrong versus up one for one if you’re right,” a market participant said.

“The spread is quite flat right now. There is certainly a lot of chatter about the chances of a possible recession and an inversion of the curve. The risk-adjusted return if fairly unattractive.”

The leveraged downside exposure, he noted, contrasts with most structured notes that only lever up the upside.

Recently Barclays Bank plc priced steepeners on the 30-year U.S. dollar ICE swap rate and the two-year U.S. dollar ICE swap rate, according to data compiled by Prospect News. But the 100x leverage was applied evenly up and down.

The asymmetrical leverage used in the Morgan Stanley deal made the risk-adjusted return less compelling.

“You lose three times more than you gain,” the market participant said.

“You can make up to 20% but you can be wiped out if the spread drops by 34 basis points.

“It doesn’t seem particularly attractive to me.”

The notes are guaranteed by Morgan Stanley.

Morgan Stanley & Co. LLC is the agent.

The issuer noted that it may increase the issue size prior to settlement but is not required to do so.

The notes (Cusip:61766YDR9) priced on Feb. 14.

The fee is 3.55%.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.