Morgan Stanley's CMS curve, S&P 500 notes too long for some advisers despite 10% teaser rate

By Emma Trincal

New York, Oct. 22 - Morgan Stanley's leveraged CMS curve and S&P 500 index-linked notes due Oct. 31, 2028 with barrier linked to the index offer attractive terms, but the 15-year duration is an insurmountable obstacle for some advisers.

The coupon will be fixed at 10% for the first two years, according to an FWP filing with the Securities and Exchange Commission.

After that, it will accrue at four times the spread of the 30-year Constant Maturity Swap rate over the two-year Constant Maturity Swap rate for each day that the index closes at or above the 50% coupon barrier level, up to a maximum rate of 10%. Interest will be payable monthly and cannot be less than zero.

The payout at maturity will be par unless the index finishes below the 50% trigger level, in which case investors will be fully exposed to the index's decline.

Steepener

"My quick take is that I think these are pretty attractive terms except for the 15-year term," said Dean Zayed, chief executive officer of Brookstone Capital Management.

"The 50% is good enough. I like the four times leverage on the spread. If it's capped at 10%, as long as the spread is at 2.5%, you'll get your 10% maximum coupon.

"If you take the 30-year minus two-year, it's realistic to predict that there will be a spread even if it's less than 2%.

"It's a bet on the steepening of the yield curve, which typically indicates expectations of rising interest rates and anticipations of a strong economy; at least, that's what the textbook tells you."

The 30-year CMS rate is the fixed rate of interest payable on an interest rate swap with a 30-year maturity. It is considered to be one of the market-accepted indicators of longer-term interest rates, according to the prospectus.

"You have to believe in this theme. You have to anticipate the steepening of the curve, which will allow you to maximize the coupon. Now of course, the S&P can't collapse on you," he said.

Despite the attractive terms, Zayed said that he would be reluctant to invest in the note due to its long duration.

"I wouldn't buy a 15-year with no callable feature," he said.

"I would like it much shorter. A five-year term would be pretty appealing even though you may not find that type of structure on such a shorter term.

"It's still an attractive note for people who expect higher inflation and a strong economic growth.

"There are just not that many investors willing to lock in their money for such a long period of time."

Long duration

For Thomas Balcom, founder of 1650 Wealth Management, the 15-year term is also a concern given currently low interest rates.

"If it's your viewpoint that the curve will be steeper and the spread wider, then it makes sense to buy these notes as a strategy to generate a high coupon," he said.

"The 10% fixed rate for the first two years is good. The 50% barrier on the S&P is attractive because the chances for the S&P to be down by more than 50% 15 years from now are quite slim.

"But I am not a fan of durations that long."

The fixed rate of 10% paid each year for the first two years of the life of the notes is a "teaser" rate, he said.

"It makes the product very enticing, but in reality you could lose your principal if rates do go up," he said.

"I'd prefer having a shorter maturity, especially in today's environment where interest rates are still very low and the likelihood of interest rates rising quite high. You want to insulate yourself from interest rate risk."

The floating rate is designed to limit interest rate risk. When rates rise, the floating rate is supposed to rise as well, he explained. However, the floating rate is capped at 10%.

As stated in the prospectus, no matter the amount of increase in the reference CMS spread, given the leverage factor of four, investors would not benefit from any increase above 2.5%.

"Each structured note has two components: the options and the bond itself," he noted.

"The interest rate risk is non-existent for the option part, but you do have it for the bond portion. Investors have to be aware of it."

On the options side, investors are exposed to the 30-year versus two-year CMS levels. Should the spread narrow due to a flattening or inversion of the curve, investors would then find themselves in the position of not getting paid any coupon at all, he said.

"If the investor understands the risks associated with this type of long-term security, including the fact that principal is at risk, that's fine. But if you're not aware of these risks, it's problematic. As far as I'm concerned, I would stay away from a 15-year-term product," he said.

Morgan Stanley & Co. LLC is the agent.

The notes will price and settle in October

The Cusip number is 61760QDQ4.

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