* Adjusted profit 28 cents/share vs Street view 24 cents
* Clients coming back to bank's bond trading desk
* Shares down 3.7 percent
By Lauren Tara LaCapra
Oct 18 (Reuters) - Morgan Stanley reported better-than-expected adjusted quarterly earnings on Thursday as it boosted revenue from trading bonds, long a sore spot for the investment bank.
Morgan Stanley's bond trading business suffered over the summer, hurt by an expected ratings downgrade by Moody's. But the cut was smaller than many observers had feared, and Morgan Stanley's trading business revived in the third quarter, Chief Financial Officer Ruth Porat said.
"Clients re-engaged and continued to re-engage throughout the quarter," Porat told Reuters in an interview.
Morgan Stanley laid off hundreds of its fixed-income trading staff after the financial crisis, leaving it poorly positioned to benefit from the frenzied bond trading that occurred in 2009 and 2010.
For more than three years, executives have been talking about boosting market share in fixed-income trading. Last year the bank set a target of raising its share of Wall Street's bond trading revenue pie by 2 percentage points. At the time, analysts said its share was 6 percent.
Progress has been halting, but on Thursday Morgan Stanley said bond-trading revenue in the third quarter climbed 33 percent from a year earlier to $1.5 billion, excluding the accounting impact of changes in value of the bank's debt.
Overall adjusted trading revenue rose 21 percent, to $3.6 billion, with gains in interest rate and credit trading. Most of the increase came from increased client activity, rather than rising asset values, Porat said.
Despite better-than-expected results in both its bond trading and wealth-management operations, Morgan Stanley shares fell 3.8 percent on Thursday, with analysts citing concerns about the sustainability of its performance, and investor concerns about high costs weighing on returns.
Roger Freeman, an analyst who covers Morgan Stanley for Barclays Capital, said the company's bond-trading performance far surpassed his expectations and rose more than Wall Street rivals like Goldman Sachs Group Inc, which had earlier reported better-than-expected results.
"These results likely put Morgan Stanley at the top of the pack," Freeman said, but he also noted skepticism about the bank sustaining its No. 1 position, given its uneven performance over the past several years.
Since setting out its market-share gains target, Morgan Stanley management has also made strategic decisions about how to adjust its bond-trading business to lessen capital needs.
The bank is more focused on areas of the market that can be automated and where securities can easily be sold to clients instead of being kept in inventory, such as U.S. government debt. The firm plans to reduce risk-weighted assets by more than $100 billion from their Sept. 30, 2011, level, in part by exiting riskier, more complex trading businesses.
There was a slight rise in risk-weighted assets last quarter, though Porat said Morgan Stanley is still "very much on track" to meet its target.
The bank's capital levels rose during the quarter, partly because of a change in the way it calculates value-at-risk (VaR), or the amount of money the firm can lose in a single trading day.
Instead of using the last four years of volatility in its measurement, as it previously did, Morgan Stanley now looks back just one year. That reduces volatility measures, and therefore the amount of capital it must hold against assets.
Under the new formula, Morgan Stanley's average daily trading VaR last quarter was $63 million, rather than $82 million under the previous model. The change helped capital levels by a "modest" amount, Porat said. Under upcoming Basel III capital standards, Morgan Stanley's Tier 1 common capital ratio would be above 9 percent, she said, up from just under 8.5 percent in the second quarter.
Overall, Morgan Stanley lost money in the third quarter due to a $2.3 billion accounting charge to reflect an increase in the value of the bank's debt.
Including that charge, Morgan Stanley lost $1 billion, or 55 cents per share, in the quarter.
U.S. accounting rulemakers are changing the rule that requires earnings to reflect changes in a bank's debt values. Analysts and investors tend to ignore income and losses from debt value adjustments because the adjustments swing wildly but have little impact on a bank's daily business.
On that basis, Morgan Stanley's income from continuing operations totaled $561 million, or 28 cents per share, in the third quarter, compared with $64 million, or 2 cents per share, a year earlier. Analysts had been expecting comparable earnings of 24 cents per share, according to Thomson Reuters I/B/E/S.
In addition to the trading business, Morgan Stanley's global wealth management business also showed improvement, when excluding one-time integration costs and its purchase of an additional stake in a retail brokerage joint venture with Citigroup Inc.
The adjusted pretax profit margin for the business rose to 13 percent from 11 percent. Management has targeted a pretax margin in the "mid-teens" for wealth management by next year.
However, overall expenses rose 11 percent on higher integration costs, as well as litigation costs. And while compensation declined as a percentage of revenue, those expenses rose on an absolute basis.
On a conference call with analysts, Porat and Chief Executive James Gorman said they are examining ways to reduce compensation costs further.