Bond Swap

Some of you will be seeing confirmations coming in the mail from your custodian showing we have been busy buying and selling Morgan Stanley bonds recently.  In fact, many of you will see that we sold your Morgan Stanley bonds the same day as we bought you different Morgan Stanley bonds.  What gives you say?  It’s all part of a bond swap we’d
like to explain.

We’ve owned Morgan Stanley 4.75% bonds due in April 2014 for quite a while, having bought most of them at a nice discount during the crisis times of 2008.  These particular bonds are subordinated to most of the other Morgan Stanley bonds, meaning they rank lower in payoff priority.  However, they are still a high-quality bond, with an A3/A- rating from S&P and Moody’s.  We were content to hold this bond until maturity, especially in light of the extraordinarily low rates offered in the market today.

However, Morgan Stanley came to market this week with a new bond that caught our eye.  This bond is known as a fixed-to-floater bond – a bond that has a fixed rate of interest for a period of time followed by a period when the interest paid floats up and down based upon market conditions.  In this particular case, this bond pays a fixed 5% for the first year.  That’s a nice 0.25% bump up from the 4.75% paid on the Morgan Stanley bond we sold. This new bond also ranks higher in priority, so it carries a rating of A2/A – a notch higher than the other bond.  The icing on the cake is that we were able to sell the MS 4.75% bond at a price of $101 and buy the new, higher-rated, higher-paying bond at $100.

How is it possible to get a higher-paying bond from the same issuer with a better rating and pay less for it?  As you might (should!) suspect, there is no free lunch.  As we mentioned above, the new bond is a fixed to floater bond, so the 5% coupon payment is only fixed for the first year.  After that, the bond will pay interest quarterly (most bonds pay semi-annually) based upon what the 3-month LIBOR rate is plus 2% all the way until this bond matures  four years from now.   Today, 3-month LIBOR is just 0.33%, so the rate we receive could drop to just 2.33% if LIBOR stays the same until next year. However, we do get some protection from that happening, as the bond has an interest rate floor of 3%.  Of course, it’s hard to predict interest rates (or stock prices, for that matter) on a short term basis, but we like the idea that this new bond will pay us 3-month LIBOR plus 2%.  Below is a chart of the last 5 years of 3-month LIBOR rates:

As you can see, 3-month LIBOR is as low as it’s been.  That’s been true for just about interest rates of all types, and the press is starting to print stories about the Bond Bubble some believe exists.  Does that mean rates are about to go up significantly? Not necessarily, but the longer we stay in these economic doldrums with startling-low interest rates, the closer we are to resuming reasonable economic growth and, with that, higher interest rates.  All in all, we think the opportunity to profit from the sale of our 4.75% bonds and upgrade the credit quality of our portfolios was worth some uncertainty of future interest payments.  Time will tell.