Municipal Bond Monthly Fixed Income Strategy

Transcription

1 PORTFOLIO STRATEGY & RESEARCH GROUP AUGUST 8, 213 Municipal Bond Monthly Fixed Income Strategy Location, Location, Location II: Two Ranges Emerge This month s title leverages our April note, as relative value and absolute yields offer similar alternatives to investors, albeit at vastly higher yields. Specifically, some investors may wish to add exposure, while others may wish to limit duration in order to prepare for what could be a protracted and uneven ascent toward higher rates. In certain cases, a combination of the two approaches is also possible. In April, we noted that We believe that positioning (or location) on both the municipal yield curve and municipal credit curve will be crucial to portfolio performance in the coming years should rates begin to rise even mildly, as we expect they eventually will. It s clear that investors are quite concerned over interest rate risk and are treading cautiously, despite compelling relative value. We are maintaining our 5- to 11-year focus maturity range, with 5% or higher coupons among mid- A rated (and higher) general obligation bonds and mid- BBB (and higher) essential service revenue bonds. In the aftermath of the May-June rout (July 1 to August 2), a period where the 1-year UST was generally range-bound, longer-term municipal yields kept rising. The largest muni-specific adjustments occurred beyond 1 years. In fact, longer benchmark tax-exempt yields increased almost twice as much as corresponding UST yields. The composition of recent municipal bond mutual fund outflows also supports this notion of newfound interest rate sensitivity. Based upon the dispersion and magnitude of yield adjustments over the last month and mutual fund outflows from long-term funds, it appears that investors have basically partitioned the municipal marketplace into two primary ranges: under 1 years and everything else. In this edition, we discuss: The bifurcation of the yield curve Capturing incremental yield Market review & outlook Our current strategy JOHN M DILLON Morgan Stanley Wealth Management Chief Municipal Bond Strategist Managing Director John.Dillon2@morganstanley.com MATTHEW GASTALL Morgan Stanley Wealth Management Municipal Bond Strategist Vice President Matthew.Gastall@morganstanley.com INVESTMENT THESIS The slope of the curve is currently steeper by 25 basis points since the release of our last publication, and by a material 146 bps since January 1. As discussed, the aforementioned price changes intensify the further one travels out onto the curve. Approximately 68% of the yield curve is captured by year 11, and nearly 9% is acquired by year 18. We have been recommending that investors consider selective selling to shorten maturities during periods of market strength, and continue to advocate such action at this time. Spreads on mid-tier A rated G.O.s and BBB essential service revenue bonds remain wide to their historical averages, and thereby offer additional yield without excessively extending out on the credit curve. We suggest investors target strong credit quality, be comfortable with their holdings and complete ongoing credit-quality maintenance and surveillance on a routine basis. Figure 1. Longer Maturities Continue to Weaken Basis Points Year 1 Year 2 Year 3 Year Source: TM3 MMD, Municipal Strategy (7/1/13-8/7/213) *Dark Columns Represent Muni Yield Changes. Lightly Shaded Columns Represent UST Yield Changes 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 Location, Location, Location II: Two Ranges Emerge While not big fans of sequels, this month s title does leverage our April note, as the state of relative value and absolute yields offers a similar range of actions to investors, albeit at yields that are vastly higher than approximately three months ago. Specifically, some investors may wish to add exposure at the new, higher yields, while others may wish to limit duration depending upon the structure and weightings of their individual municipal bond portfolios in order to prepare for what could be a protracted and uneven ascent toward higher rates. In certain cases, a combination of the two approaches is also possible. In the opening paragraph of our April Municipal Bond Monthly entitled Location, Location, Location, we noted that We believe that positioning (or location) on both the municipal yield curve and municipal credit curve will be crucial to portfolio performance in the coming years should rates begin to rise even mildly, as we expect they eventually will. In hindsight, we were only off by one key letter in that statement. That letter being the m in the word mildly. Unfortunately, the letter w would have been far more accurate. Looking ahead, whether yields rise mildly or wildly, it s clear that investors are now quite concerned over interest rate risk. From absolute yield levels to mutual fund flows, recent market action during the post-july 1 period (when most of the big fireworks were finished) suggests that municipal bond investors are indeed treading cautiously, despite compelling relative-value metrics. We are maintaining our 5- to 11-year focus maturity range at this time, with a strong preference for 5% or higher coupons among mid- A rated (and higher) general obligation bonds and mid- BBB (and higher) essential service revenue bonds. With the fixed income market rout that was May and June already well documented and discussed, we turn our attention to the aftermath (July 1 to August 7), a period where the 1-year UST was generally range-bound, but longer-term municipal yields kept rising. In terms of municipal absolute yield changes versus changes of corresponding maturity USTs, the largest muni-specific adjustments occurred in maturities beyond 1 years. Evidencing this dynamic is a five-year municipal benchmark that outperformed its UST counterpart and a 1-year municipal benchmark that only underperformed the 1-year UST by just a few basis points. Meanwhile, longer Aaa rated benchmark tax-exempt yields increased almost twice as much as UST yields for 15-, 2- and 3-year maturities, rising 34, 38 and 45 basis points, respectively. The accompanying chart (Figure 2) illustrates the changes in benchmark municipal yields versus those of USTs. The composition of recent municipal bond mutual fund outflows also supports this notion of newfound interest rate sensitivity. While mutual fund flows have been consistently negative for 1 weeks running, it is important to note that the dollar amount of long-term (+1-year) fund outflows has been multiples of outflows from both intermediate (3- to 1-year) funds and short-term (- to 3-year) funds. Figure 2. Longer Maturities Continue to Weaken Basis Points Year 1 Year 2 Year 3 Year Source: TM3 MMD, Municipal Strategy (7/1/13 8/7/13). Dark Columns Represent Muni Yield Changes, Lightly Shaded Columns Represent UST Yield Changes Please refer to important information, disclosures and qualifications at the end of this material. 2

3 Figure Timeline of 1-Yr AAA MMD and 1-Yr UST Yields Dow Continues to Climb Cypriot Banking Crisis Municipals Underperform Low Redemptions, Heavy Issuance Muni Fund Outflows April 15th Tax Deadline Downgrade of High Profile Issuers, Threats to Exemption 1 Yr AAA MMD 1 Yr UST 2.4 Yield (%) Strong April Jobs Report DJIA Hits 15, Weakness Continues Munis "Decouple" Massive Fund Outflows Influx of Supply Detroit Bankruptcy Italy's Contentious Election Munis Manage Supply, Threats to Exemption USTs Firm, Munis Underperform "Taper Talks" Surface Substantial Bond Market Weakness 2/1/213 2/18/213 3/7/213 3/24/213 4/1/213 4/27/213 5/14/213 5/31/213 6/17/213 7/4/213 7/21/213 8/7/213 Source: Thomson Reuters MMD, Municipal Strategy as of 8/7/213 Positive Economic Data, UST Weakness Munis Encounter Fund Outflows, Supply Based upon the dispersion and magnitude of yield adjustments along the municipal yield curve over the last month and the concentration of mutual fund outflows from long-term funds, it appears that investors have basically partitioned the municipal marketplace into two primary ranges: under 1 years and everything else. Coupon structure, as we will discuss in a moment, also matters increasingly, with our long-favored 5% coupon (or higher) solidly in the lead position. One interesting additional point regarding mutual fund flows is that they can be both leading and lagging indicators, as the pro-cyclical nature of this class of investors tends to follow the price movements in the cash market, basically selling when prices are declining and buying when prices are increasing. The tendency to lead the market stems from the ensuing pressure exerted upon fund managers to purchase or put money to work during periods of heavy inflows or sell bonds into the marketplace (typically via competitive bidding from the dealer community) to satisfy redemptions from exiting fund investors, as has been the case for the last few months. Although the weekly tally of inflows or outflows is received by the market late in the week, the presence of bids wanted lists (fund managers selling bonds) or bond purchases (by those same managers) often colors the sentiment of the market professionals well beforehand and serves as an accelerant that drives the market further in either direction. Accordingly, a fair amount of attention is routinely paid to mutual fund flows. As we discussed last month in The Finer Points section of our Municipal Bond Monthly, prospective buyers need to be paid, in the form of additional yield, to consider bonds when a potential tax liability may come with the purchase. The tax liability relates to de minimis allowances under current tax law (despite the interest payments remaining fully tax exempt.) Although we have experienced a number of municipal market cycles, we have yet to come across an investor who hopes their current coupon or premium coupon bonds will trade at a steep discount in the future. But yet it does happen from time to time, and is exactly what happened to many lowercoupon (3% and 4% handle) bonds since the beginning of May. Of course, the counterargument would be that high-quality bonds should mature at par (which is true) and investors who fully intend to hold to maturity should be less concerned (which is fair). However, investors interested in total return and those concerned about market risk, or statement risk, will certainly care. This second group characterizes the majority of bond investors. That said, most municipal bond investors should endeavor to keep their bonds from trading at discount prices for as long as possible and that means acquiring above-market coupons that could better withstand Please refer to important information, disclosures and qualifications at the end of this material. 3

4 potentially rising interest rates. Further, owning a high coupon bond, such as 5% or higher, also enhances the level of tax-exempt income should rates rise slowly. The exception would be for investors who spend the vast majority of their coupon income. Figure 4. Significant Weakness on the Long-End (213) Yield (%) Current Target Range January 3, 213 August 7, Maturity Source: Thomson Reuters MMD, Municipal Strategy as of 8/7/213 Are We There Yet? Given the rapid rise in interest rates over the last few months, a common question from clients relates to the final destination What is a normal rate for the 1-year UST and for a 1-year AAA municipal bond? While the current state of monetary policy accommodation is anything but normal, it is difficult to pinpoint what the future normal will be. The driving force behind this line of questioning is the very common refrain from the back seat on any long journey: Are we there yet? Just as the answer from the front seat is typically no, we also don t believe we are there yet. Although 1-year UST yields reside near the top of our 2.% to 2.75% near-term operating range, Morgan Stanley Wealth Management Fixed Income Strategy noted recently that an overshoot of our top should not be ruled out. Our new bear case scenario would put the 1-yr yield around the 3% threshold. Meanwhile, MS & Co. s US Interest Rate Strategist maintains a 2.7% year-end target and a 2.96% 1Q14 target for the 1- year UST. As we prepare this note, the 1-year UST reads 2.6%. To provide some historical context, the average yield of the 1-year UST according to Thomson Reuters over the last decade has been approximately 3.57% and since 199 the average has been 5.9%. To be sure, reaching further back elevates the average, but another factor worth considering is that interest rates have been steadily declining for decades and hit a record low of 1.4% in July 212. Turning to taxexempt municipals, the benchmark 1-year AAA municipal reached its record low yield of 1.47% a bit later, in November 212. In terms of averages, the municipal 1-year registers 3.18% over the last decade and 4.19% since 199. As we prepare this note, the 1-year AAA municipal yield reads 2.73%. Worth Extending Maturities? (If so, how far?) We have now discussed investors fleeing the longer end of the municipal market in terms of both individual bond price declines and via mutual fund redemptions. We have also noted (again) the importance of purchasing defensive, abovemarket coupons such as 5% and higher. The obvious next question is: If rates are now so much higher than three months ago, is it time to extend out on the yield curve (adding duration in the process)? And if it is time to extend, by how far? The short answer from our perspective is no. We are not extending duration given our expectations for a further rise (probably mildly, but possibly wildly) in benchmark UST rates. Accordingly, we are maintaining our 5- to 11-year focus maturity range with a heavy emphasis on 5% or higher coupons among individual positions carrying mid-level A ratings or higher for general obligation bonds and mid-level BBB ratings or higher in the case of essential service revenue bonds (water, sewer & electric). Our intent has been to balance principal preservation, the value of tax-exempt income and prevailing tactical opportunities (such as wide credit spreads in a slowly improving credit picture) with the risk of (further) rising interest rates. We believe that our current strategy continues to represent that mix. However, we do realize that one size does not fit all and that some investors may wish to extend beyond our focus range, while others may choose maturities shorter than our strategy. With this in mind, we will take a few moments to consider the full trajectory, or slope of the benchmark AAA municipal yield curve, courtesy of Thomson Reuters MMD. Although it s easy to say that it s historically steep, which is true, there are many subtleties to examine. For example, the basis point pick-up of incremental yield gained by moving from one maturity to the next can be as great as 37 basis points or as little as just 1 basis point. While moving out a whole year to capture just one basis point of additional yield seems questionable, and attaining 37 basis points for a similar 365 days sounds rather compelling, what about three basis points, or five, or seven? What about 32, or 25, or 16 basis points? All of these incremental values were represented throughout the 3-year yield curve on August 2, 213. Please refer to important information, disclosures and qualifications at the end of this material. 4

5 Looking at years one through four, the incremental yield gain each year ranges from 18 to 29 basis points but the absolute yield is just 1.1% in year four. The pace quickens into the five-year mark, reaching 37 before moderating to 16 basis points in year 1. The trajectory remains relatively steep after year 1, but begins to flatten into year 15, with incremental yield gains decelerating from 18 to 14 basis points. We now enter the back half of the curve, where the slope begins to flatten quickly and considerably. The incremental gains for 16 to 2 years reveal a sharply declining range from 16 to 6 basis points. A step further to year 21 brings a gain of 5 basis points and the increases dwindle to 3 basis points into year 25. Finally, years 26 through 3 offer only 1 to 3 basis points per year. In light of the aforementioned data, it seems to us that a case may be made, by those more sanguine on the US interest rate outlook than us, for moving beyond our 5- to 11-year range to as far as year 16, after which incremental gains begin to wane significantly. However, we believe the prospect of additional downside volatility weakens this extension argument considerably. Another way to view the yield curve is by the percentage of total (3-year) yield attained at a given maturity along the curve. For example, the five-year maturity captures 31% of the 3-year yield, the 1-year offers 64%, 15-year sports 84%, 2-year is 93% and the 25-year reaches 98%. For the record, the top of our range, year 11, captures 67% of the full yield curve and 9% is reached at year 18. Although this method is quicker, it lacks granularity. Given the abundance of diverse opinions regarding US economic momentum, the Fed s next move and the ensuing trajectory of interest rates, it s helpful to know exactly where the relative value resides within the asset class. Figure 5. Capturing the Yield Curve Yield (%) Approximately 67% of the Yield Curve Is Captured within 11 Years of Maturity Nearly 37% of the Yield Curve Is Captured within Our Target Range New-Issue Supply Despite being aided by the significant supply overhang of June (as many deals were postponed due to market volatility), total long-term municipal issuance for July finished at approximately $25 billion, roughly 1% lower than the average for the month ($27.87 billion), and 13% below last July s volume year-over-year (YOY). This descent was caused by an aggregation of factors, the most predominant being the substantial yield increases experienced throughout the fixed income markets since May 3, which increased issuers borrowing costs and sidelined some refunding issuance. In fact, deals issued for the sole purpose of refunding declined by a considerable -49.2% YOY (newmoney issuance actually finished slightly higher by 15.2% YOY). Figure 6. Monthly Supply Averages vs. 213 Issuance Par Value (Billions) January February March April May June July August September Source: The Bond Buyer, Municipal Strategy as of 8/7/ Total Supply Average October November December Not surprisingly, taxable issuance declined significantly as well. This dynamic has functioned in tandem with refunding issuance, as issuers have utilized the taxable primary to refinance outstanding securities a second time (and while tax-exempts traded at/near parity with US Treasuries). This transference has helped taxable issuance consume approximately 13% of this year s total volume, which is significantly higher that the Pre-Build America Bond average of nearly 7% of issuance. As 213 progresses, we anticipate the trends in taxable supply will continue to be impacted by future developments in refunding issuance Maturity Source: Thomson Reuters MMD, Municipal Strategy as of 8/7/213 Please refer to important information, disclosures and qualifications at the end of this material. 5

6 Figure 7. Tax-Exempt & Taxable Historical Supply Timeline New Issue Supply (Par Value) (B) Tax Exempt Taxable YTD Source: The Bond Buyer, Municipal Strategy as of 8/7/213 For the year, total new-issue municipal bond supply stands at $2.8 billion, roughly 1% lower than 212 year to date (YTD) YOY. As previously noted, year-to-date supply was significantly impacted by the recent bout of market weakness, as some primary issuance was postponed and new-issue volume slowed due to the higher nominal interest rate environment. It is interesting to note that total issuance was Year actually 2.9% higher YTD YOY in April, and has since declined substantially over the most recent months. Not surprisingly, deals issued for the sole purpose of refunding are currently lower by 22% for the full year, while newmoney issuance continues to play a mildly larger role and is higher by 2.9% vs As we put pen to paper, the market is currently managing a relatively robust calendar, especially by August s standards, of $7 billion $8 billion. This rather hefty slate appears to be a brief, but sizable, push before issuance finally slows for the summer. August and September are, historically, two of the five lowest months for new-issue volume (please see Figure 9). As discussed in last month s Midyear Review: Constructive Near Term, Defensive Longer Term, the new, higher interest rate backdrop may impede primary market activity and refunding issuance moving forward. Consequently, our 213 final supply expectations reside at flat to +5% vs. 212, slightly lower than our original prognostication of +5 to +1%. Figure 8. Refundings Play A Larger Role In Recent Years 45 4 New Money Refunding Combined 35 Supply (Par Value) (B) YTD Source: The Bond Buyer, Municipal Strategy as of 8/7/213 Please refer to important information, disclosures and qualifications at the end of this material. 6

7 Figure 9. Monthly Supply Averages (2-212) Par Value (Billions) Jun Oct May Mar Source: The Bond Buyer, Municipal Strategy as of 8/7/213 Market Performance Nov Dec In typical muni fashion, tax-exempts outperformed the weakness exhibited throughout the broader US Treasury market since the July 18 release of our last publication, as yields continued to rise in both arenas, albeit at a slower and more gradual pace than in May and June. USTs have been notably data dependent, especially with the timing of Fed tapering hanging in the balance. Positive international economic developments that exacerbated the weakness included stronger-than-anticipated June US New Homes Sales, a higher-than-consensus ISM Manufacturing release, positive news on purchasing manager sentiment in China, and European Central Bank President Mario Draghi s statements that the institution expects key ECB rates to remain at present or lower levels for an extended period of time. Regardless of the aforementioned outperformance, taxexempts still followed suit (but sold off less) while encountering scattered weeks of robust issuance as well as some selling pressure due to mutual fund redemptions (as a result of both rate and credit concerns). As mentioned, yieldcurve steepening was, once again, prevalent; yields are basically unchanged on the 5-yr AAA MMD benchmark, while higher by 1 and 25 basis points on the 1-yr and 3-yr spots, respectively. Consequently, relative-value ratios have declined. Please see the accompanying table for yield changes across the credit spectrum and throughout the yield curve, since the release of our Midyear Review on July 18. Apr Aug Jul Sept Feb Jan Figure 1. Market Performance Table AAA 7/18/213 8/7/213 Change (bps) 7/18/213-8/7/213 5 Year Year Year Year AA 5 Year Year Year Year A 5 Year Year Year Year BBB 5 Year Year Year Year Source: Thomson Reuters MMD, Municipal Strategy as of 8/7/213 Figure Yr Rel-Val Ratio Timeline (Since Jan 212) % Of Corresponding USTs /3/212 2/6/212 3/11/212 4/14/212 5/18/212 6/21/212 7/25/212 8/28/212 1/1/212 11/4/212 12/8/212 1/11/213 2/14/213 3/2/213 4/23/213 5/27/213 Source: Thomson Reuters MMD, Municipal Strategy as of 8/7/213 1 Yr Ratios 6/3/213 Prerefunded securities traded in a similar fashion, and outperformed in the 5-year sector after hovering at/near parity with USTs throughout most of the spring and early summer. We continue to recommend prerefunded securities, backed by an escrow of US Treasuries, to investors searching for exposure to shorter-duration bonds of high credit quality, especially when said securities are trading at or above 1% of corresponding USTs (currently at 95.6%). 8/3/213 Please refer to important information, disclosures and qualifications at the end of this material. 7

8 Figure Yr Pre-Refunded Ratio Timeline (Since Jan 212) Figure Yr BBB Spreads Timeline (Since Jan 212) % Of Corresponding USTs Pre Re Ratios Basis Points BBB Spreads 1/3/212 2/4/212 3/7/212 4/8/212 5/1/212 6/11/212 7/13/212 8/14/212 9/15/212 1/17/212 11/18/212 12/2/212 1/21/213 2/22/213 3/26/213 4/27/213 5/29/213 6/3/213 8/1/213 1/3/212 2/6/212 3/11/212 4/14/212 5/18/212 6/21/212 7/25/212 8/28/212 1/1/212 11/4/212 12/8/212 1/11/213 2/14/213 3/2/213 4/23/213 5/27/213 6/3/213 8/3/213 Source: Thomson Reuters MMD, Municipal Strategy as of 8/7/213 Credit spreads are largely unchanged since the release of our last publication. After widening slightly in the wake of Detroit s bankruptcy filing, spreads compressed in late July, as buying momentum was observed amid high relative-value ratios and a declining primary calendar (for the week of July 29). Not surprisingly, spreads on higher-quality A rated bonds recovered more than lower-rated BBB rated securities, and currently reside at 73 and 137 basis points above AAA rated municipals, respectively. We continue to advocate that investors looking to move out on the credit curve focus specifically on general obligation credits in the A rated space, and essential service revenue bonds (water & sewer) in the BBB rated vicinity. Figure Yr A-Rated Spreads Timeline (Since Jan 212) Basis Points /3/212 2/8/212 3/15/212 4/2/212 5/26/212 7/1/212 8/6/212 9/11/212 1/17/212 11/22/212 12/28/212 2/2/213 3/1/213 4/15/213 5/21/213 Source: Thomson Reuters MMD, Municipal Strategy as of 8/7/213 A Spreads 6/26/213 8/1/213 Source: Thomson Reuters MMD, Municipal Strategy as of 8/7/213 The market currently confronts significant headwinds, which have effectively delayed the arrival of the summer s typically constructive technical backdrop. Tax-exempt mutual fund outflows continue to be substantial, as many investors have exited funds over fears of rising interest rates and on municipal credit-quality concerns (potentially linked to Detroit s recent bankruptcy filing). At the same time, market participants continue to encounter sporadic challenges in the form of heavy new-issue bond supply. However, the market could establish a foundation for favorable price action, if newissue volume declines in August and September (as we anticipate) and if improvement is observed in municipal mutual fund flows. Targeting Value & Investment Strategy As previously mentioned, the famous expression Location, Location, Location, applies in the current market environment. The slope of the municipal bond yield curve continues to steepen, as both tax-exempt and US Treasury bond prices continue to decline. The slope of the curve is currently steeper by 25 basis points since the release of our last publication, and by a material 146 bps since January 1. As discussed, the aforementioned price changes intensify the further one travels out onto the curve. Again, one of the most notable questions in the current climate continues to be should investors extend duration following the most recent bout of fixed income market weakness? Our resounding answer is no. Though we are of the opinion that one of the most significant, and drastic, interest rate movements is currently behind us (following the advent of the Fed s taper talks ), we still anticipate that rates will continue to rise as what many pundits describe as interest rate normalization progresses. Please refer to important information, disclosures and qualifications at the end of this material. 8

9 Figure 15. Muni Yield-Curve Slope Timeline (Since Jan 212) Basis Points Slope (1 Yr 3 Yr) 1/3/212 2/6/212 3/11/212 4/14/212 5/18/212 6/21/212 7/25/212 8/28/212 1/1/212 11/4/212 12/8/212 1/11/213 2/14/213 3/2/213 4/23/213 5/27/213 6/3/213 Source: Thomson Reuters MMD, Municipal Strategy as of 8/7/213 8/3/213 In fact (and in-line with the recommendations of Morgan Stanley Wealth Management s Global Investment Committee), we have been recommending that investors consider selective selling to shorten maturities during periods of market strength, and continue to advocate such action at this time. Our target range for buyers stands at 5-11 year maturities. Keep in mind, longer maturities offer very minimal yield pick-up, as 68% of all of the curve is captured by year 11, and nearly 9% is acquired by year 18. This does question the risk/reward dynamic of excessive extension by investors in the longer section of the curve, especially in the current volatile interest rate environment. Transitioning our focus to investment selection, we continue to advocate exposure to high credit quality, specifically midtier A rated (or higher) general obligation paper, mid-tier BBB (or higher) essential service revenue securities (water & sewer), and prerefunded bonds. Spreads on mid-tier A rated G.O.s and BBB essential service revenue bonds remain wide to their historical averages, and thereby offer additional yield without excessively extending out on the credit curve. Though we do not believe the myriad problems that plagued Detroit for decades are systemic nor widespread, state and local governments do continue to face challenges. Municipal buyers should invest in strong credit quality, remain comfortable with the individual credit attributes of their respective securities, and complete ongoing credit-quality maintenance and surveillance on a routine basis. JD MG Please refer to important information, disclosures and qualifications at the end of this material. 9

10 Figure 16. 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 Negative 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 Negative AAA Stable MASSACHUSETTS Aa1 Stable AA+ Stable MICHIGAN Aa2 Positive AA- Positive MINNESOTA Aa1 Negative AA+ Stable MISSISSIPPI Aa2 Stable AA Stable MISSOURI Aaa Negative 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 Negative AA+ Stable NEW YORK Aa2 Stable 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. 1

11 STATE MOODY S RATING MOODY S OUTLOOK S&P RATING S&P OUTLOOK PENNSYLVANIA Aa2 Stable AA Negative RHODE ISLAND Aa2 Negative 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 Negative 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 Data Source : Moody s.com as of 8/7/213 Data Source: Rating Changes for the 5 States from Moody's July 1, 213 & Moody s.com Data Source : U.S. State Ratings And Outlooks: Current List -- S&P - - April 2, 213 Data Source: Bloomberg 8/7/213 Data Source: Municipal Strategy 8/7/213 Please refer to important information, disclosures and qualifications at the end of this material. 11

12 Figure Year Munis as a Percentage of 5-Year Treasuries, January 1996-August 213 % of Corresponding USTs 24 5 Year Relative Value Ratio Average Jan 96 Dec 97 Nov 99 Nov 1 Oct 3 Oct 5 Sep 7 Sep 9 Aug 11 Aug 13 Source: Thomson Reuters Municipal Market Data as of 8/7/213 Figure Year Munis as a Percentage of 1-Year Treasuries, January 1996-August Year Relative Value Ratio Averag e % of Corresponding USTs Jan-96 Dec-97 Nov-99 Nov-1 Oct-3 Oct-5 Sep-7 Sep-9 Aug-11 Aug-13 Source: Thomson Reuters Municipal Market Data as of 8/7/213 Figure Year Munis as a Percentage of 3-Year Treasuries, January 1996-August 213 % of Corresponding USTs 24 3-Year Relative Value Ratio Averag e Jan-96 Dec-97 Nov-99 Nov-1 Oct-3 Oct-5 Sep-7 Sep-9 Aug-11 Aug-13 Source: Thomson Reuters Municipal Market Data as of 8/7/213 Please refer to important information, disclosures and qualifications at the end of this material. 12

13 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. 13

14 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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Morgan Stanley Wealth Management and its affiliates do not render advice on tax and tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used or relied upon by any recipient, for any purpose, including the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws. Each client should consult his/her personal tax and/or legal advisor to learn about any potential tax or other implications that may result from acting on a particular recommendation. International investing entails greater risk, as well as greater potential rewards compared to U.S. investing. These risks include political and economic uncertainties of foreign countries as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less established markets and economies. Bonds are subject to interest rate risk. When interest rates rise, bond prices fall; generally the longer a bond's maturity, the more sensitive it is to this risk. Bonds may also be subject to call risk, which is the risk that the issuer will redeem the debt at its option, fully or partially, before the scheduled maturity date. The market value of debt instruments may fluctuate, and proceeds from sales prior to maturity may be more or less than the amount originally invested or the maturity value due to changes in market conditions or changes in the credit quality of the issuer. Bonds are subject to the credit risk of the issuer. This is the risk that the issuer might be unable to make interest and/or principal payments on a timely basis. Bonds are also subject to reinvestment risk, which is the risk that principal and/or interest payments from a given investment may be reinvested at a lower interest rate. 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. Credit quality varies depending on the specific issuer and insurer. 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. Build America Bonds described herein are backed by the credit quality of the issuer, and not the Federal Government. These Build America Bonds are structured as direct payment bonds, in which a direct Federal subsidy is paid to the state or local government issuer. 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. 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 Please refer to important information, disclosures and qualifications at the end of this material. 14

15 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, authorized by the Prudential Regulatory Authority and regulated by the Financial Conduct Authority and the Prudential Regulatory Authority, approves for the purpose of section 21 of the Financial Services and Markets Act 2, research 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. 213 Morgan Stanley Smith Barney LLC. Member SIPC. Please refer to important information, disclosures and qualifications at the end of this material. 15