Exactly Where Are We?

Transcription

1 PORTFOLIO STRATEGY & RESEARCH GROUP OCTOBER 10, 2013 Municipal Bond Monthly Fixed Income Strategy JOHN M DILLON Chief Municipal Bond Strategist Managing Director Morgan Stanley Wealth Management John.Dillon2@morganstanley.com MATTHEW GASTALL Municipal Bond Strategist Vice President Morgan Stanley Wealth Management Matthew.Gastall@morganstanley.com Exactly Where Are We? The municipal bond market, along with the broader US Treasury market, has now improved significantly and substantially recovered from its summer funk, which had driven benchmark 10-year UST yields to approach 3% and municipals to beckon investors with 5%s at par. Fully acknowledging the impressive municipal outperformance since, both markets now appear to have rallied themselves into a corner and the muni market just feels heavy. Yields have been steady here for the last two weeks, but where exactly is here? INVESTMENT THESIS Pulling multiple factors together UST yields near the bottom of our After shortening our target maturity range twice since last range, the current economic data vacuum, low municipal supply (probably December, we continue to believe the 4-9 year maturity band as price favorable as it gets prior to year end), the loss of the muni ratio offers the best value along the yield curve without taking buffer (now just fair value), mutual fund outflows that have clearly excessive interest rate risk. Credit spread momentum has moderated (but not ceased) and the loss of the alluring 5% at par (long) been bifurcated as of late. As both A and BBB spreads muni it is conceivable that the focus on interest rate risk may soon continue to trade wide to historical benchmarks, we advocate reassert itself, as it did in the prior months before the tepid payrolls/no capturing select opportunities within this space (mid-tier A Summers/no-taper rally was bolstered by shutdown/debt ceiling anxieties. rated or higher for GOs and mid-tier BBB or higher for Away from these metrics, the current muni market tone seems lethargic. essential service revenue bonds). With this in mind, and in keeping with the recommendations of our Global Investment Committee, we continue to view the current market as We advocate using the current market strength to either an extended opportunity to shorten portfolio duration ahead of potential shorten duration toward our target maturity range or improve volatility, with tax-loss swaps being a primary consideration ahead of portfolio credit quality (by selling weaker credits). With what may turn out to be a year-end rush. many investors currently enjoying significant equity market gains while confronting substantial YTD bond market losses, In this edition, we discuss: we anticipate a robust tax-loss swap season. Investors may Our current strategy wish to consider beginning such tax-efficient strategies sooner than later to avoid a crowded trade toward year end. Targeting value Puerto Rico update Figure Yr UST & 10-Yr AAA MMD Yield Market review & outlook Yield (%) Yr AAA MMD 10-Yr UST Source: Municipal Strategy & Thomson MMD as of 10/9/13 Morgan Stanley Wealth Management is the trade name of Morgan Stanley Smith Barney LLC, a registered broker-dealer in the United States. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy. Past performance is not necessarily a guide to future performance. Please refer to important information, disclosures and qualifications at the end of this material.

2 Exactly Where Are We? The municipal bond market, along with the broader US Treasury market, has now improved significantly and substantially recovered from its summer funk, which had driven benchmark 10-year UST yields to approach 3% and municipals to beckon investors with 5%s at par. Fully acknowledging the impressive municipal outperformance since, both markets now appear to have rallied themselves into a corner and the muni market just feels heavy. Yields have been steady here for the last two weeks, but where exactly is here? Reviewing the closing yields over the last 12 trading sessions (from to ) for both 10-yr USTs and 10-yr AAA munis according to MMD, we see that the net move for each market was exactly zero basis points (unchanged). Meanwhile, 10-yr municipal relative-value ratios have been anchored in an uninspiring range of 95% to 98% during this same period after touching 108% in late August. We consider ratios in the 93% to 95% range to represent fair value. On the supply side of the equation, weekly new issuance has clearly ebbed since mid- September (opposite of the typical seasonal flows), but demand has also faded with the more recent departure of the much ballyhooed long 5%s at par. Although $3.5 billion to $5.5 billion per week appears to be a manageable, and therefore constructive, deal flow for the marketplace, it is tepid, historically, for the month of October. On the demand side of the equation, mutual fund outflows have slowed substantially, but not ceased. At 19 weeks running and totaling over $27 billion, a significant ratedriven move higher in benchmark yields could facilitate a reacceleration in outflows especially since municipals didn t do well in the last bond market downturn. Figure Yr Rel-Val Ratio Timeline (Since Jan 2012) % Of Corresponding USTs Yr Ratios As for the rate picture itself, absolute yields reside near the bottom of our near-term operating range of 2.50% to 3.25% for benchmark 10-yr USTs. As noted in our October 8 Basis Points publication, Chief Fixed Income Strategist, Kevin Flanagan, expects that any undershoot of our bottom would be modest and short-lived, with intermediate and longer-dated yields resuming an ascending sawtooth pattern. Figure Market Timeline Yield (%) Cypriot Banking Crisis - Low Redemptions, Heavy Issuance - Muni Fund Outflows - April 15th Tax Deadline - Downgrade of High-Profile Issuers - Munis Underperform -Strong April Jobs Report -DJIA Hits 15,000 Detroit Bankruptcy 10-Yr AAA MMD Weak Aug Jobs Report 10-Yr UST Weakness Continues - Munis "Decouple" - Massive Fund Outflows - Influx of Supply - "Taper Talks" Surface - Substantial Bond Market Weakness - Taper Anticipations Continue - Headlines About Puerto Rico - Summer Illiquidity - Fund Outflows Continue - No-Summers / No Taper - USTs Advance, Munis Follow - Low Muni Issuance - Munis Outperform Please refer to important information, disclosures and qualifications at the end of this material. 2

3 Regarding the current US government shutdown and impending debt ceiling limitation, we expect negotiations (or lack thereof) to remain contentious, but Morgan Stanley Wealth Management s base case does not include an actual default. Generally speaking, once the US political uncertainty (regarding the debt ceiling) is resolved, we expect yields to begin rising slowly based on the removal of the flight-to-quality bid and, more importantly, based on a now back-logged set of economic data. Pulling all of these above factors together UST yields near the bottom of our range, the current economic data vacuum, low municipal supply (probably as price favorable as it gets prior to year-end), the loss of the muni ratio buffer (now just fair value), mutual fund outflows that have clearly moderated (but not ceased) and the loss of the alluring 5% at par (long) muni it is conceivable that the focus on interest rate risk may soon reassert itself, as it did in the prior months before the tepid payrolls/no Summers/no-taper rally was bolstered by shutdown/debt ceiling anxieties. Away from these metrics, the current muni market tone seems lethargic. With this in mind, and in keeping with the recommendations of our Global Investment Committee, we continue to view the current market as an extended opportunity to shorten portfolio duration ahead of potential volatility, with tax loss swaps being a primary consideration ahead of what may turn out to be a year-end rush. Figure 4. Timeline of 10-Yr UST & 10-Yr AAA MMD Yield Yield (%) Where s the Value? 10-Yr AAA MMD 10-Yr UST Despite the recent rally, we remain cautious on rates and constructive on credit. We advocate mild extensions on the credit curve to capturing distended credit spreads for mid-tier A rated (and higher) general obligation and mid-tier BBB (and higher) essential service revenue bonds. Above-market coupons such as 5% are preferable. Our recently revised target maturity range of 4 to 9 years remains intact. As we discussed last month, the point of diminishing returns has migrated down the yield curve during 2013, as has the best risk/reward range for extending maturities. Figure 5 illustrates the incremental value available throughout the 30-year municipal yield curve. Approximately 90% of the 30-year yield can be attained by year 19, which makes it difficult to justify new money commitments beyond this point (as the curve then flattens significantly). Regarding potential candidates for the sell side of tax-loss swaps, we suggest exploring the 20- to 30-year maturity range with specific focus on sub-5% coupon structures and on upgrading credit quality, as needed. Figure 5. Capturing the Yield Curve Yield (%) Maturity Credit Update: Is it really getting better? Only 37 Basis Points of Yield "Pick-Up" Offered Between 20 & 30 Year Maturities Approximately 58% of the Yield-Curve Is Captured Within 9 Years of Maturity Yes. We believe it is. While the Detroit bankruptcy filing in July and more recent Puerto Rico investor concerns are clearly weighing on market sentiment, between those bookends is a slowly improving credit story for both states and local governments. In past editions, we have highlighted consistently positive Case-Shiller housing price momentum and multi-year state-level revenue growth according to the Nelson Rockefeller Institute of Government, as well as a newly stable outlook from Moody s on the US states sector (after 5 years of negative outlooks). This month, we note recent first-time default statistics according to independent muni research firm MMA, who stated in their October 7 note that only 39 unique issuers defaulted during the first three quarters of this year. This figure, which includes the full spectrum of municipal credits (including high yield & nonrated) compares quite favorably to 68 in the similar period last year, 80 in 2011 and 97 in This is clearly a positive trend and rather impressive for a marketplace comprised of over 60,000 unique issuers. Please refer to important information, disclosures and qualifications at the end of this material. 3

4 Puerto Rico Update: Recent developments As we noted in our last edition, heightened investor awareness and subsequent price discovery has resulted in sharply elevated yields. This week saw yet another wave of volatility and there have been a few recent developments. Among them was an affirmation by Moody s of the Commonwealth s Baa3 rating (still negative outlook), the downgrading of the senior sales tax revenue bonds (aka COFINA ) to A2 from Aa3 and affirmation of the subordinate bonds at A3. Outlooks were changed to negative from stable for both senior and subordinate bonds. Among the rationale offered for the move was the close and enduring linkage between the Commonwealth s credit and that of the sales tax bonds. Also potentially impacting market sentiment was a Wall Street Journal article dated October 6, 2013 that featured a senior Puerto Rico government official discussing communications between the Commonwealth, the Treasury Department and the President s Task Force on Puerto Rico s Status. A Treasury spokeswoman was also quoted as saying Given the potential for Puerto Rico s financial challenges to impact U.S. markets, including the municipal market, Treasury continues to closely monitor developments. While the article gave airplay to the notion of potential US government support and we do agree that Puerto Rico is among the very few systemically important credits in the municipal market, we find the prospect of substantial preemptive U.S. financial support for the Commonwealth (or even for US states or local governments) unlikely. Indeed, the day before Figure Total New-Issue Supply vs. Historical Averages outsized volatility returned, Bloomberg reported an unnamed Treasury spokeswoman saying that the US Treasury Department isn t planning to provide assistance to Puerto Rico and continues to monitor the situation. Further, the same Bloomberg article included Puerto Rico s Senate President clarifying comments made to analysts the previous day stating I did not say that U.S. Treasury was going to bail out Puerto Rico. Finally and importantly, yet another high-profile article appeared in The Wall Street Journal on the morning of October 9, which coincided closely with the start of this more recent wave of volatility. The news behind Puerto Rico s various credits and related market values is both complex and developing. Headline risks are rampant. Prospective investors and current bondholders interested in obtaining a deeper perspective regarding the Commonwealth and its many related issuers are urged to contact their respective Morgan Stanley Financial Advisor or Investment Representative. New-Issue Supply A Different Story This year's second-half supply story continued last month, as primary market volume remained notably anemic. Not surprisingly, last month's minimal post was predominantly caused by the recent plummet in refunding deals, as such issuance continued to suffer following this summer's dramatic rise in interest rates (hence, placing many refinancing candidates "out of the money"). New-issue supply for September finished the month lower by a staggering 26% YOY (year-over-year), with approximately $19.4 billion in total issuance Total Supply Average Par-Value (Billions) Source: Municipal Strategy & The Bond Buyer as of 10/9/2013 Please refer to important information, disclosures and qualifications at the end of this material. 4

5 Figure Day Visible Supply Visible Supply - Billions (B) Though September doesn't normally play as large of a role in primary market activity as many participants believe (as the month actually holds the third lowest average for volume despite the acceleration in both banking and market activity following the summer), last month's issuance was also 26% below September's average of $ 26.2 billion (from ), and was even the lowest month for total new-issue supply since January As discussed, deals issued for the sole purpose of refunding plummeted by 34% YOY, and accounted for roughly 30% of September s volume (vs. 42% for all of 2012). Slow and steady continues to win the race for new-money issuance, as such supply was higher by 21% YOY. This summer's substantial rise in yield levels and subsequent bond market volatility have truly left their mark on 2013 s total primary volume. For the year, total issuance stands at approximately $249 billion, roughly 12% percent lower than 2012 on a year-to-date (YTD) YOY basis. As a result of the aforementioned technicals, refundings are currently lower by 28% YTD YOY, while newmoney deals are higher by 7% YTD YOY. Figure 8. Historical Monthly Averages ( ) Par-Value (Billions) Day Visible Supply One-Year Average Regardless of the relatively anemic levels of current supply, we still do not believe that the coast is clear for the primary market, as October, November and December hold three of the largest six monthly averages for issuance. Though we believe that this uptick will be notably lower than in past years due to the aforementioned dynamics, it is still prudent for clients to position themselves for a minor seasonal acceleration in primary activity. Market Performance A Second Chance to Shorten? Municipals are notably stronger since our last publication, as taxexempts have kept pace with price gains in the broader UST market. The advance brought the 10-yr UST yield down to 2.65% from 2.93% on September 6, and the 30-yr UST to 3.73% from 3.86%. Gains were even greater in the municipal marketplace, as September's new-issue volume remained light (as discussed above) and as dealers scrambled to position bonds for those investors chasing the yield that once was prior to September s rally. Please see the accompanying table for yield changes across the credit spectrum and throughout the yield curve since September 12. Figure 9. Market Performance Table 9/12/ /9/2013 Change (bps) 9/12/ /9/2013 AAA 5 Year Year Year Year AA 5 Year Year Year Year A 5 Year Year Year Year BBB 5 Year Year Year Year The aforementioned technicals also helped relative-value ratios decline throughout most sectors of the yield curve, as 10-yr ratios declined to 96.6%, from 98.6% on September 12. Source: Municipal Strategy & The Bond Buyer as of 10/9/2013 Please refer to important information, disclosures and qualifications at the end of this material. 5

6 Though high by historical standards, as the long-term historical average resides closer to 82%, we continue to believe that this range (approximately 93% to 95%) represents fair value while threats to the longevity of the full federal tax exemption linger. We continue to assign a 15%-20% probability that some type of modification occurs, and believe that the timing may follow next year's mid-term elections (if ever), as measures to increase taxation/eliminate exclusions and deductions are typically unpopular topics during reelection campaigns. Credit spread action has been bifurcated, as spreads between A to AAA rated municipals tightened and BBB rated spreads widened. Though spreads for both data sets have compressed since 2008, we believe the bifurcation is driven by recent developments throughout the municipal market. As muni pricing advanced since September 6, we believe investors viewed A rated securities as a comfortable balance of additional yield without excessive credit risk. This same comfort level has not been apparent with BBB rated securities, especially while isolated credit challenges from high-profile issuers such as Puerto Rico continue. Investors seeking additional yield may wish to consider general obligation bonds in the mid-tier A or higher-rated credit band and, if venturing to the BBB arena, essential service revenue securities (water, sewer, electric). Figure Yr A Rated Spreads Timeline Basis Points A Spreads Figure Yr BBB Rated Spreads Timeline Basis Points We continue to advocate that investors utilize the current market strength to either (1) shorten duration into our target maturity range, or (2) improve portfolio credit quality (sell weaker credits). As many investors are currently enjoying significant equity market gains while confronting substantial bond market losses for 2013, we anticipate the early arrival of a robust tax-loss swap season this year. Investors may wish to consider beginning such tax-efficiency strategies sooner than later to avoid a crowded trade this year. Targeting Value and Investing Strategy The slope of both the US Treasury and municipal bond yield curve flattened since our last edition, which reflects the market perception that interest rates may stay lower for longer after the postponed tapering and the more recent Yellen nomination for the next Chair of the Federal Reserve. The slope of the US Treasury yield curve flattened to 359 basis points, from 374 bps; the slope of the municipal bond yield curve flattened to 396 bps, from 423 bps. Figure 12. Muni Yield-Curve Slope Timeline (Since Jan 2012) 440 BBB Spreads Basis Points Slope (1 Yr - 30 Yr) Source: Thomson Reuters Municipal Market Data as of 10/9/2013 Please refer to important information, disclosures and qualifications at the end of this material. 6

7 After shortening our target maturity range twice since last December, we continue to believe the 4-9 year maturity band offers the best value along the yield curve. This section of the curve offers yield (close to 60% of all yield throughout the 30-yr curve) without taking excessive interest rate risk. Although we generally advocate our focus range, some investors may wish to tailor their exposure to suit varying individual risk tolerances and investment needs. Investing proceeds in short-call, low dollar-priced kicker paper with final maturities within 4 to 9 years could also be an avenue to maintain current income while shortening duration. As discussed, credit spread momentum has been bifurcated as of late. As both A and BBB spreads continue to trade wide to historical benchmarks, we advocate capturing select opportunities within this space (mid-tier A rated or higher for GOs and mid-tier BBB or higher for essential service revenue bonds). Our preference for modest credit risk over interest rate risk is supported by positive news on the municipal credit front, which includes 13 consecutive quarters of state revenue growth, according to the Nelson A. Rockefeller Institute of Government and consistently positive housing price momentum according to Case- Shiller. These positive developments notwithstanding, investors should strive to know what they own and become comfortable with the individual credit attributes of their municipal securities. JD MG Please refer to important information, disclosures and qualifications at the end of this material. 7

8 Figure 13. State Ratings Table STATE MOODY S RATING MOODY S OUTLOOK S&P RATING S&P OUTLOOK ALABAMA Aa1 Stable AA Stable ALASKA Aaa Stable AAA Stable ARIZONA Aa3* Stable AA-** Stable ARKANSAS Aa1 Stable AA Stable CALIFORNIA A1 Stable A Stable COLORADO Aa1* Stable AA** Stable CONNECTICUT Aa3 Stable AA Stable DELAWARE Aaa Stable AAA Stable DISTRICT OF COLUMBIA Aa2 Stable AA- Stable FLORIDA Aa1 Stable AAA Stable GEORGIA Aaa Stable AAA Stable HAWAII Aa2 Stable AA Stable IDAHO Aa1* Stable AA+** Stable ILLINOIS A3 Negative A- Negative INDIANA Aaa* Stable AAA** Stable IOWA Aaa* Stable AAA** Stable KANSAS Aa1* Negative AA+** Stable KENTUCKY Aa2* Negative AA-** Negative LOUISIANA Aa2 Stable AA Stable MAINE Aa2 Negative AA Stable MARYLAND Aaa Stable AAA Stable MASSACHUSETTS Aa1 Stable AA+ Stable MICHIGAN Aa2 Positive AA- Positive MINNESOTA Aa1 Negative AA+ Stable MISSISSIPPI Aa2 Stable AA Stable MISSOURI Aaa Stable AAA Stable MONTANA Aa1 Stable AA Stable NEBRASKA No G.O. Rating Stable AAA** Stable NEVADA Aa2 Stable AA Stable NEW HAMPSHIRE Aa1 Stable AA Stable NEW JERSEY Aa3 Stable AA- Negative NEW MEXICO Aaa Stable AA+ Stable NEW YORK Aa2 Positive AA Positive NORTH CAROLINA Aaa Stable AAA Stable NORTH DAKOTA Aa1* Stable AA+** Positive OHIO Aa1 Stable AA+ Stable OKLAHOMA Aa2 Stable AA+ Stable OREGON Aa1 Stable AA+ Stable (continued on next page) Please refer to important information, disclosures and qualifications at the end of this material. 8

9 STATE MOODY S RATING MOODY S OUTLOOK S&P RATING S&P OUTLOOK PENNSYLVANIA Aa2 Stable AA Negative RHODE ISLAND Aa2 Review for Downgrade AA Stable SOUTH CAROLINA Aaa Stable AA+ Stable SOUTH DAKOTA No G.O. Rating Stable AA+** Stable TENNESSEE Aaa Stable AA+ Positive TEXAS Aaa Stable AA+ Stable UTAH Aaa Stable AAA Stable VERMONT Aaa Stable AA+ Positive VIRGINIA Aaa Stable AAA Stable WASHINGTON Aa1 Negative AA+ Stable WEST VIRGINIA Aa1 Stable AA Stable WISCONSIN Aa2 Stable AA Stable WYOMING No G.O. Rating No Outlook AAA** Stable PUERTO RICO Baa3 Negative BBB- Negative *Issuer Rating **ICR -- Issuer Credit Rating Source: Moody s, S&P, Bloomberg as of 10/9/2013 Please refer to important information, disclosures and qualifications at the end of this material. 9

10 Figure Year Munis as a Percentage of 5-Year Treasuries, January 1996-October 2013 % of Corresponding USTs Year Relative Value Ratio Average Jan-96 Dec-97 Dec-99 Dec-01 Nov-03 Nov-05 Nov-07 Oct-09 Oct-11 Oct-13 Source: Thomson Reuters Municipal Market Data as of 10/9/13 Figure Year Munis as a Percentage of 10-Year Treasuries, January 1996-October Year Relative Value Ratio Average % of Corresponding USTs Jan-96 Dec-97 Dec-99 Dec-01 Nov-03 Nov-05 Nov-07 Nov-09 Oct-11 Oct-13 Source: Thomson Reuters Municipal Market Data as of 10/9/13 Figure Year Munis as a Percentage of 30-Year Treasuries, January 1996-October 2013 % of Corresponding USTs Year Relative Value Ratio Average Jan-96 Dec-97 Dec-99 Dec-01 Nov-03 Nov-05 Nov-07 Oct-09 Oct-11 Oct-13 Source: Thomson Reuters Municipal Market Data as of 10/9/13 Please refer to important information, disclosures and qualifications at the end of this material. 10

11 Fixed Income Risk Considerations Call Risk - Some securities may be callable. If the security is called, the investor bears the risk of reinvesting the proceeds at a lower rate of return. Credit Risk - The risk that the issuer might be unable to pay interest and/or principal on a timely basis. Widely recognized rating agencies, such as Moody's Investor Services and Standard & Poor s, offer their assessment of an issuer s creditworthiness. U.S. Treasury securities are considered the safest investment as they are backed by the full faith and credit of the U.S. Government. On the other end of the scale, high yield corporate bonds are considered to have the greatest credit risk. Duration Risk - Duration, the most commonly used measure of bond risk, quantifies the effect of changes in interest rates on the price of a bond or bond portfolio. The longer the duration, the more sensitive the bond or portfolio would be to changes in interest rates. Generally, if interest rates rise, bond prices fall and vice versa. Longer-term bonds carry a longer or higher duration than shorter-term bonds; as such, they would be affected by changing interest rates for a greater period of time if interest rates were to increase. Consequently, the price of a long-term bond would drop significantly as compared to the price of a short-term bond. Interest Rate Risk - The risk that the market value of securities might rise or fall, primarily due to changes in prevailing interest rates. All fixed income securities are susceptible to fluctuations in interest rates; generally, if interest rates rise, bond prices will fall, and vice versa. Prepayment Risk - In a CMO or MBS, the risk that an investor's principal will be returned sooner than originally expected, due to principal prepayments made by homeowners on the underlying mortgage loans. Reinvestment Risk - The risk that the income stream from the investment may be reinvested at a lower interest rate. This risk is especially evident during periods of falling interest rates where coupon payments are reinvested at a lower rate than the current instrument. Secondary Market Risk - While a secondary market exists for most fixed income securities, there is no guarantee that a secondary market will exist for a particular fixed income security. Furthermore, if a security is sold prior to maturity, the price received may be more or less than face value, or the amount of the original investment. Index data is based on index total return - Fixed income securities, including municipal bonds, are subject to certain risks including interest rate risk, credit risk, reinvestment and valuation risks. The value of fixed income securities will fluctuate and, upon a sale, may be worth more or less than their original cost or maturity value. Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Information provided herein has been obtained from outside sources that are deemed to be reliable. However, Morgan Stanley Wealth Management has not independently verified them and we make no guarantees, express or implied, as to their accuracy or completeness or as to whether they are current. Past performance is not a guarantee of future performance. The indices are unmanaged and are shown for illustrative purposes only and do not represent the performance of any specific investment. Investors cannot invest directly in an index. Please refer to important information, disclosures and qualifications at the end of this material. 11

12 Disclosures The author(s) (if any authors are noted) principally responsible for the preparation of this material receive compensation based upon various factors, including quality and accuracy of their work, firm revenues (including trading and capital markets revenues), client feedback and competitive factors. Morgan Stanley Wealth Management is involved in many businesses that may relate to companies, securities or instruments mentioned in this material. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. 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Bonds rated below investment grade may have speculative characteristics and present significant risks beyond those of other securities, including greater credit risk and price volatility in the secondary market. Investors should be careful to consider these risks alongside their individual circumstances, objectives and risk tolerance before investing in high-yield bonds. High yield bonds should comprise only a limited portion of a balanced portfolio. Interest on municipal bonds is generally exempt from federal income tax; however, some bonds may be subject to the alternative minimum tax (AMT). Typically, state tax-exemption applies if securities are issued within one's state of residence and, if applicable, local tax-exemption applies if securities are issued within one's city of residence. Insurance does not pertain to market values which will fluctuate over the life of the bonds; it covers only the timely payment of interest and principal. 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13 A taxable equivalent yield is only one of many factors that should be considered when making an investment decision. Morgan Stanley Smith Barney LLC and its Financial Advisors do not offer tax advice; investors should consult their tax advisors before making any tax-related investment decisions. Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. The indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Wealth Management retains the right to change representative indices at any time. Credit ratings are subject to change. This material is disseminated in Australia to retail clients within the meaning of the Australian Corporations Act by Morgan Stanley Wealth Management Australia Pty Ltd (A.B.N , holder of Australian financial services license No ). Morgan Stanley Wealth Management is not incorporated under the People's Republic of China ("PRC") law and the research in relation to this report is conducted outside the PRC. This report will be distributed only upon request of a specific recipient. This report does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors must have the relevant qualifications to invest in such securities and must be responsible for obtaining all relevant approvals, licenses, verifications and or registrations from PRC's relevant governmental authorities. Morgan Stanley Private Wealth Management Ltd, which is authorized and regulated by the Financial Services Authority, approves for the purpose of section 21 of the Financial Services and Markets Act 2000, content for distribution in the United Kingdom. Morgan Stanley Wealth Management is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This material is disseminated in the United States of America by Morgan Stanley Smith Barney LLC. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. Morgan Stanley Wealth Management research, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney LLC Morgan Stanley Smith Barney LLC. Member SIPC. Please refer to important information, disclosures and qualifications at the end of this material. 13