Morgan Stanley’s leveraged CMS curve securities on S&P, Russell show new take on steepeners

By Emma Trincal

New York, June 1 – Morgan Stanley Finance LLC’s leveraged CMS curve securities due Feb. 28, 2037 linked to the worse performing of the S&P 500 index and the Russell 2000 index present an innovative structure offering a leveraged bet on a steeper yield curve via the combination of a worst-of payout and a range accrual formula, both of which will be used to determine the floating rate.

Interest will be fixed at 9% for the first three years, according to an FWP filing with the Securities and Exchange Commission.

After that, the rate will be 20 times the spread of the 30-year ICE swap rate over the two-year ICE swap rate for each day that each index closes at or above its 70% reference level, up to a maximum rate of 9% per year. Interest will be payable monthly.

The payout at maturity will be par unless either index finishes below its 50% barrier level, in which case investors will be fully exposed to the decline of the worse performing index.

Innovative structure

“CMS-linked coupons sometimes have an equity-index linked contingency condition, but I don’t think I have seen a CMS-linked coupon with a worse-of contingency condition before,” said a structurer.

The 20 times leverage at first appeared high. But it is so because the range accrual condition makes the interest accrue only on the days when both indexes are greater than 70% of their initial level, he noted.

“This is not for the retail-retail. First you’re taking a 20-year bet. And then you’re talking about the yield curve. It’s more for sophisticated investors,” he added.

Pain if no gain

The main risk in his view was to receive little or no payment over the years.

“If it goes against you, in theory you’re talking about 20 years with zero coupon,” he said.

“The leverage can go either way.”

Asked about the 9% fixed rate for the first three years, he said that “it’s priced to attract people,” but added that “if it’s your view that the curve will be steeper then you have a good reason to do it.”

Investors holding that view would have to make some assumptions, at least over the short term regarding the widely expected Federal Reserve rate hikes.

“If you think it’s already priced in and that hopefully the curve won’t flatten, it makes sense. Problem is that the longer end of the curve is more of an unknown at this point. And on the short end, if the Fed raises rates more or faster than expected your curve could very well flatten,” he said.

“So without even mentioning the equity piece of the deal and the risk you’re taking there, you’re on for 20 years on a leveraged bet on the curve... that to me is pretty risky.”

Downside

A market participant emphasized the risk of loss of principal at maturity despite the 50% barrier.

“We’ve done an analysis and you would be surprised at how high the probability is to breach that 50% level after 20 years,” he said.

“People always refer to the past. They do some backtesting and find that maybe they have a 5% or 10% chance to breach the barrier over such a long period of time. So it looks OK. But backtesting is very misleading.

“Add to that the worst-of and you’ll find that the risk is greater than you think.”

Too soon

Because the U.S. stock market is richly valued, the barrier may not be sufficient. A better way to find protection would be to wait for a better entry point, he said.

“We’re seeing the up part of this bull cycle. I like that trade. But I would like it even more after we have a 30% to 40% correction, which would be unusual not to have over a 20-year span. We haven’t seen that type of correction just yet. But when we do, that’s when it’s worth selling those options. That’s when you can build a fortune laughing all the way to the bank.”

Morgan Stanley & Co. LLC is the agent.

The notes will be guaranteed by Morgan Stanley.

The notes will settle on Wednesday.

The Cusip number is 61766YBJ9.

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