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Bond of the Week: 9 April 2013

Morgan Stanley RPI linked bond.


A new retail bond with coupon protection against inflation has been launched for Morgan Stanley the US investment bank. Here are the terms

Issuer: Morgan Stanley B.V. (Netherlands)
Guarantor: Morgan Stanley (USA)
Guarantor Rating: A- (S&P), Baa1 (Moody’s), A (Fitch) as of
27th March 2013
Determination Agent: Morgan Stanley & Co. International plc
Authorised Distributor: Linear Investments Ltd
Term of the Bond: 10 Years
Denomination (Par): GBP 100
Issue Price: 100% of Par
Underlying: UK Retail Price Index All Items (UK RPI)
Redemption at Maturity: 100% of Denomination
Semi-Annual Coupons: 1.2% (2.4% p.a.) multiplied by
movement of the UK RP I for the relevant Coupon Payment Date

We can run through the details of the issuer pretty quickly. Morgan Stanley is one of the bluest of blue chip Wall Street Investment banks. They were one of only two Wall Street banks to maintain their independence in the debacle that followed the closure of Lehman brothers. The other one was Goldman Sachs. Although both were forced to obtain a banking licence at the height of the crisis (in order to be able to access liquidity from the Federal Reserve) independence was maintained.

Morgan Stanley was split off from the illustrious JP Morgan in 1935 following the Glass Steagall Act which forbade commercial banks in the United States from engaging in investment banking activities (this splitting of “nice” banking and “casino” banking being of course a hot topic of the moment). However, I don’t think we need to say much more about the issuer other than that its rating puts it roughly on a par with Tesco. It is certainly one of the most credit worthy issuers to come to the retail bond market and it can command fine terms in the institutional bond market. The longest dated Sterling bond, Morgan Stanley 5.75% 2017 trades at 113 to yield 2.18% and in USD the 3.75% of 2023 trades at 103% to yield 3.39%.

Inflation is and should be a persistent worry for all investors. It is clear that this and many other governments are intent on dealing with their debt problem in part by the use of inflation to shrink the ever growing mound of their indebtedness. Under normal circumstances a rise in inflation would produce a rise in interest rate, the long term risk free rate of interest reflecting the sum of investors’ inflation expectations. This automatic protection against inflation is sadly not available as supressed interest rates only allow you, if you do not take any credit risk, to lock in negative real returns. Hence the popularity of bonds linked to RPI.

However, these RPI linked bonds come at a cost. Such is their popularity, the retail bonds for Severn Trent 1.3%, Places for People 1%, National Grid 1.25% and Tesco 1% are now roughly all trading at a yield of flat to RPI.

This makes the Morgan Stanley RPI linked 2.4% bond seemingly attractive. But note: the redemption amount you receive, unlike typical inflation protection bonds, is not linked to RPI. If you invest £100 at the beginning you will receive back a £100 at the end. This makes it substantially different to the existing retail (or for that matter institutional) bonds. With RPI linked bonds the main principle is protect your principal. This new issue does not do that.

As to inflation protection via the coupon, it does not amount to much. If we assume an inflation rate of 3.5% the coupon after one year will adjust up from 2.4% to a not very stunning 2.48%. After 10 years of 3.5% inflation your last coupon will only be 3.385%. On the other hand you will not receive an RPI uplift on your original investment. At a constant 3.5% inflation rate that amounts to missing out on 41%! The maths is 100 x 1.035 ^10 = 141.06. Think of it another way; at a constant inflation rate of 3.5% you would receive an inflation uplift on the coupon over the life of the bond totalling 5.14% but loose out (versus the standard RPI linked bond) on 41.06% uplift on the principal. Enough said on the maths.

Conclusion: Just what is the point? I accept the name is good, I accept they may be able to borrow in the wider markets at this sort of level and I accept seeking out protection from inflation makes sense, but I cannot see the point in buying this bond as the actual return you will receive is so very low. In their information leaflet the arrangers are very clear that the principal of the issue is not linked to RPI (they have this point in bold). Nevertheless I feel the terms of this issue have been cleverly organised to give the impression you have a greater protection against inflation than is actually the case and to that extent it may be misleading. By all means disagree with my interpretation; you may like the credit of Morgan Stanley; you may think a bit of protection against inflation matched with a higher coupon than the traditional linkers have is good enough for you. However, make a conscious decision and do not sleep walk into buying this bond. Do not think “I might as well buy a bit of each retail bond” and stand in a queue, with your head in the clouds and a bowl in your hand ready to receive your portion. If you do, when you look down, like Oliver, you may find a bowl of workhouse gruel that only Mr. Bumble could serve up. I shall not be buying this issue or recommending it to my clients.

Oliver Butt

Oliver Butt is a Partner in City and Continental LLP, a leading independent broker in fixed income.

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