Municipal Bond Monthly Fixed Income Strategy

Transcription

1 PORTFOLIO STRATEGY & RESEARCH GROUP APRIL 11, 214 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 Executive Director Morgan Stanley Wealth Management Matthew.Gastall@morganstanley.com INVESTMENT THESIS We expect US economic momentum to further bolster tax revenue for states and expect an improving housing market to slowly increase property tax revenue for local governments. Sectors and recommended ratings for individual investors beyond our core mid-a GO and mid- BBB essential service revenue focus include public power above Baa2/BBB, state housing finance agencies at Aa3/AA- or higher, higher education carrying A2/A or better, not-for-profit hospitals above Aa3/AA- and airports in the A2/A category or higher. We favor defensive (+5%) coupon structure across the board. Our 4- to 9-year focus maturity range is intact and we note value in the 2-year area for investors interested in adding duration. Fig 1. Tax-Time Fund Outflows Minimal, Supply Manageable Fund Flows (Millions) Fund Flows 3-Day Visible Supply (Right Axis) Day Visible Supply (Billions) Positive Thinking There have been significant changes since our last monthly note. In addition to better weather, good, but not great, economic data, substantial changes in market behavior and meaningful yield curve adjustments, we have also gained additional clarity regarding two high-profile conversation topics in the municipal market. The tax filing season is winding down and the muni market appears to have a better tone to it than a month ago. Issuance has increased, but remains manageable. The back half of the municipal yield curve has found more buyers and short-range maturity yields have increased substantially, providing the better entry points we were waiting for. Credit quality continues to improve and investors appear focused on acquiring paper ahead of what could be sparse supply in the summer months. We are now removing our near-term cautious outlook and replacing it with a constructive outlook. Since we voiced our cautious call on February 28, benchmark municipal yields for 5-, 1- and 3-year paper, have increased by 21 basis points (to 1.21% from 1.%), decreased by 3 basis points (to 2.37% from 2.4%) and decreased by 2 basis points (to 3.52% from 3.72%), respectively. Following the upward yield adjustments, shorter maturities now offer better value than just six weeks ago. Although our base case is still one of rising yields, for investors interested in adding duration, value in the 2-year range is worth mentioning due to year-over-year (YOY) adjustments and outperformance we have recently seen (17-basis-point decrease in yields)...a flattening dynamic that may continue as the year progresses and rates eventually rise. In this edition, we discuss: Our constructive outlook Credit diversification Detroit and Puerto Rico Market review and outlook Source: Thomson Reuters Municipal Market Data (MMD) as of 4/1/214. *Yellow line denotes 3-Day Visible AVG Since 2 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 Positive Thinking There have been significant changes since our last monthly note on March 13. In addition to better weather in much of the country and good, but not great, economic data, there have been substantial changes in market behavior, meaningful yield curve adjustments, and we have gained additional clarity regarding two high-profile conversation topics in the municipal market. We are also running out the clock on the tax filing season and have seen minimal mutual fund outflows and/or related selling pressure thus far. All in, the muni market appears to have a better tone to it than a month ago. Fig 2. Municipal Bond Mutual Fund Flows Source: Morgan Stanley Wealth Management Municipal Strategy, The Bond Buyer as of 4/1/214 Weekly new issuance has increased, but remains manageable. The back half of the municipal yield curve, along with taxable fixed income curves, has found more buyers and short-range maturity yields have increased substantially, leaving significant calendar roll intact while providing better entry points within our target maturity range. Municipal credit quality continues to improve despite long-term legacy issues (pensions/retiree healthcare) and municipal investors appear focused on acquiring paper ahead of what could be sparse issuance in the summer months (if year-todate (YTD) patterns are any indication). That being said, we are now removing our near-term cautious outlook and replacing it with a constructive outlook, which is in line with our long-term view of the asset class. Since we voiced our cautious call on February 28, benchmark municipal yields for 5-, 1- and 3-year paper, have increased by 21 basis points (to 1.21% from 1.%), decreased by 3 basis points (to 2.37% from 2.4%) and decreased by 2 basis points (to 3.52% from 3.72%), respectively. Following the upward yield adjustments, shorter maturities now offer better value than just six weeks ago. Looking back a bit further, we also note that despite the YTD fixed income rally, municipal yields still remain substantially higher than a year ago. In fact, our continuing 4- to 9-year focus maturity range captures the steepest part of today s yield curve and the latter part of our range captures the lion s share of the YOY adjustments, as the yields for 7-, 8- and 9-year maturities are now higher YOY by 66, 69 and 67 basis points, respectively. The next largest YOY adjustment (6 basis points) throughout the yield curve occurred in 19-, 2-, 21- and 22-year maturities. Although our base case is still one of rising yields, for investors interested in adding duration, value in the 2-year range is worth mentioning not only due to the YOY adjustments, but also due to the outperformance we have recently seen (17-basis-point decrease in yields) a flattening dynamic that may continue as the year progresses and rates eventually rise. Morgan Stanley & Co. s base case year-end forecast for 2-, 5-, 1- and 3-year USTs stands at 1.5%, 2.25%, 3.3% and 3.85%, respectively. Fig New-Issue Supply Manageable (Weekly Data) Par-Value (Billions) Weekly Supply 3-Day Visible Supply (Right Axis) *Weekly Supply Based On Morgan Stanley & Co. Estimates Source: Morgan Stanley Wealth Management Municipal Strategy, Thomson Reuters MMD as of 4/1/214 Turning to credit, we expect positive US economic momentum to continue to bolster tax revenue at the state level and expect the modestly improving housing market to slowly increase property tax revenue at the local level. Meanwhile, the investor euphoria we noted last month regarding the highly successful Puerto Rico general obligation bond sale was short-lived, with market levels now hovering near the original issuance after a sharp, but short rally weeks ago. As we noted last month the investor focus for Puerto Rico will likely shift more toward a show-me story in the coming months Pricing dynamics aside, we continue to view the record-setting high yield sale rather positively for the broader market, as it provided concrete evidence that a backstop can be found outside the traditional investor channel Visible Supply (Billions) Please refer to important information, disclosures and qualifications at the end of this material. 2

3 Fig 4. An Eventful Year Timeline of 1-Yr AAA MMD & 1-Yr UST Yield-Levels Munis "Decouple" - Fund Outflows - Supply Accelerates Detroit Bankruptcy 1-Yr AAA MMD Yield Puerto Rico Downgraded 1-Yr UST Yield 2.8 Yield (%) Strong April Jobs Report -DJIA 15, - "Taper Talks" - Substantial Weakness - Taper Anticipated - Puerto Rico Headlines - Summer Illiquidity - Fund Outflows Continue - Weak Aug Jobs Report - "No-Taper" Rally - Low Muni Issuance - Munis Outperform - Strong Oct Jobs Report - FOMC Minutes - Taper Possibilities Again - USTs and Munis Weaken - EM Concerns - Weak US Economic Data - Dismal Muni Supply - Munis Outperform Detroit's Plan of Adjustment FOMC's Hawkish Rate Projections Source: Morgan Stanley Wealth Management Municipal Strategy, Thomson Reuters MMD as of 4/1/214 With regard to the second highest profile credit, Detroit, breaking news came across the tape as we penned this note stating that the city had reached an agreement with three bond insurers regarding the recovery value for its outstanding unlimited tax general obligation bonds (UTGOs). While the negotiated 74% of principal recovery requires the federal bankruptcy court judge s approval, if confirmed, this much higher recovery value (versus the city s latest proposal of 15%) would likely render the bankruptcy not much more than a non-event as far as the broader market is concerned considering that, according to Moody s, Historical local government defaults tracked by Moody s since 197 had relatively high recoveries, averaging approximately 8%... In addition to the market potentially placing the Detroit UTGO recovery value in the near-miss file, the substantially higherthan-proposed recovery value may be beneficial (and obviously less costly) to the bond insurance industry in terms of future business prospects and primary market penetration, provided claims continue to be paid on a timely basis. After all, safeguarding investors through the largest municipal bankruptcy suggests some well-deserved bragging rights. Fig 5. Morgan Stanley Wealth Management s Broad Municipal Sector Outlooks & Minimum Rating Parameters Sector Minimum Rating* Commentary State GO & Appropriated Debt All Economic recovery has driven increases in both revenue & reserve levels for many states; pension challenges exist Local GO A2/A Revenue composition different than states; dependent on housing recovery; pension challenges exist Essential-Service (Water & Sewer) Baa2/BBB Debt levels may rise to meet select infrastructure needs; essential-purpose beneficial, where applicable US Public Power Baa2/BBB Near essential-service status; future challenges likely from evolving power markets State Housing Finance Agencies A2/A Diversified business models; directly exposed (positively or negatively) to housing market momentum Higher Education A2/A Expense growth exceeding revenue growth (public & private); continued demand for higher education exists US Airports A2/A Increase in enplanements; we favor major metropolitan areas and airline hubs Not-for-Profit Hospitals AA3/AA- Uncertainty over Affordable Care Act; we believe the larger systems are positioned best *Minimum rating represents our strategy's recommendation for the referenced rating (with a stable outlook) and/or higher. Select opportunities outside these rating guidelines may exist. Source: Morgan Stanley Wealth Management Municipal Strategy, Moody s, S&P as of 4/1/214 Please refer to important information, disclosures and qualifications at the end of this material. 3

4 Circling back to the theme of broadly improving credit quality, select municipal sectors and recommended rating parameters for individual investors beyond our core mid-a GO and mid-bbb essential service revenue focus include public power with ratings at or above Baa2/BBB, state housing finance agencies in the Aa3/AA- category or higher, higher education carrying ratings of A2/A or better, not-for-profit hospitals with ratings at or above Aa3/AA- and airports in the A2/A category or higher. We continue to favor defensive (+5%) coupon structure across the board. This sector list is not all-inclusive and is intended to suggest various conservative alternatives for individual investors seeking portfolio diversification in the coming months, which may (hopefully) coincide with increased levels of issuance. New-Issue Supply New-issue supply finished the month with approximately $27.6 billion in total primary market volume, approximately 16% lower on both a YOY basis and in comparison to the average of roughly $33 billion. It is worth noting, however, that this metric was bolstered by last month s massive Puerto Rico GO offering, which was marketed predominantly to a non-traditional buyer base. Without counting the Puerto Rico offering, last month s issuance would have been lower by a substantial 22% YOY. This month s total decline was experienced throughout new money and refunding offerings, as both finished notably lower, by 29% and 38% YOY, respectively. Through March, YTD total new-issue supply was approximately $62.5 billion, which was 26% lower than the same period in 213. The higher nominal interest rate environment and its adverse impact on refunding activity has played a significant role in the aforementioned decline, as refunding issuance is remarkably lower, by nearly 52% YTD YOY. However, since current yield levels reside significantly lower than where they opened the year, it is possible that some issuers may renew their refunding efforts. At the same time, we anticipate that new-money issuance will remain relatively consistent (down by just 2% YTD, YOY) as state and local governments continue to address delayed and/or postponed infrastructure and borrowing needs. Though many market participants believe that this year s elections coupled with the residual political impact of fiscal austerity will sideline additional new-money issuance, we do believe it will remain a bright spot, as the necessity of such borrowings will aid them in coming to market. Though the market has yet to encounter an unmanageable newissue calendar this year, we continue to suggest that investors pay close attention to the primary market for pockets of opportunity in the upcoming (and typically busy) spring months. Fig 6. Monthly Historical Supply Averages Since 2 Par-Value (Billions) Source: Morgan Stanley Wealth Management Municipal Strategy, The Bond Buyer as of 4/1/214 Market Performance Short and intermediate maturity US Treasury bond prices declined sharply after the release of our last publication, as March s FOMC statement seemed to work nearly hand-in-hand with this year s first day of spring. The majority of this weakness was prevalent in shorter maturity USTs, as market participants began to discount the possibility of earlier rate hikes due to the more hawkish projections from the FOMC on the Fed s benchmark rate. The aforementioned decline actually intensified at the beginning of April, only to subsequently and abruptly reverse course following a slightly below-consensus March Employment Situation Report and the minutes from the March FOMC meeting. Fig 7. 1-Yr Relative-Value Ratio Timeline (Since Jan 212) % Of Corresponding USTs Yr Relative-Value Ratios Source: Morgan Stanley Wealth Management Municipal Strategy, Thomson Reuters MMD as of 4/1/214 Municipals tracked the price action of the broader US Treasury market, but continued to outperform due to this year s very modest amount of municipal new-issue supply. Accordingly, relative- Please refer to important information, disclosures and qualifications at the end of this material. 4

5 value ratios declined throughout the majority of the municipal bond yield curve, except in the shortest maturities. Please see the accompanying table for changes across the credit spectrum and throughout the yield curve since March 13, 214. Fig 8. Market Performance Table 3/13/214 4/1/214 Change (bps) 3/13/214-4/1/214 AAA 5 Year Year Year Year AA 5 Year Year Year Year A 5 Year Year Year Year BBB 5 Year Year Year Year Source: Morgan Stanley Wealth Management Municipal Strategy, Thomson Reuters MMD as of 4/1/214 On a positive note, this year s tepid primary market volume has also helped credit spreads on A and BBB rated securities to compress, as buyers have chosen to extend out onto the credit curve in search of yield. We continue to advocate that investors searching for yield take modest extensions on the credit curve. Fig 9. 1-Yr A & BBB Rated Spreads Timeline Basis Points Nov-1997 Feb-21 May-24 Sep-27 Dec-21 Apr-214 Source: Morgan Stanley Wealth Management Municipal Strategy, Thomson Reuters MMD as of 4/1/214 Targeting Value & Investment Strategy Fig 1. Muni Yield Curve Slope Timeline (Since Jan 21) Basis Points Source: Morgan Stanley Wealth Management Municipal Strategy, Thomson Reuters MMD as of 4/1/214 Though the total slope of the municipal bond yield curve flattened modestly last month, the current yield-difference between the 5-yr and 3-yr AAA benchmark helps to tell a more granular story regarding price action throughout March. Shortly after the release of the FOMC s more hawkish rate projections on March 19, yield levels on shorter maturities began to rise sharply, thereby compressing their spread difference to longer maturities and flattening the 5s-3s slope by approximately 12% since March 13. Fig 11. 5s 3s Slope Flattens Considerably Slope (1 Yr - 3 Yr) 22 2/21/214 3/1/214 3/9/214 3/17/214 3/25/214 4/2/214 4/1/214 Source: Thomson Reuters MMD as of 4/1/214 5s - 3s Slope As previously discussed, following the upward yield adjustments, shorter maturities now offer better value than just six weeks ago. Though this sector of the yield curve remains susceptible to future volatility, the front of our target maturity range (4-9 year maturities) now appears better positioned for buy-and-hold investors who can withstand interim price volatility. Our penchant for defensive (+5%) coupon structure continues. It is also worth Please refer to important information, disclosures and qualifications at the end of this material. 5

6 noting that the longer end of the yield curve performed quite well during these upward adjustments, which could be a harbinger of future price action (further flattening) and suggests continued outperformance in 2-year maturities amid recently stronger market sponsorship. Domestic data, though short of market expectations, continue to exhibit modest improvement and may be indicative of this winter s chilling impact on economic activity. Consequently, financial market focus appears ready to transition back toward the broader economic recovery (though equity market volatility has proven a formidable diversion), while yields on short USTs and municipals have risen significantly since February. Given these yield adjustments and the near conclusion of tax-filing season, we are now removing our near-term cautious call and replacing it with a constructive outlook, as investors may soon have an opportunity to add exposure during periods of potentially increased, but manageable issuance prior to the arrival of what may be rather sparse summer months. Aggregate yield adjustments for the 5-, 1- and 3-year AAA benchmarks since our cautious outlook on February 28 currently stand at +21, 3 and 2 basis points, respectively. As previously discussed, investors searching for yield may wish to consider taking modest extensions on the credit curve for yield, while diversifying beyond core general obligation bonds and essential service revenue bonds, as muni credit continues to generally improve. JD MG Please refer to important information, disclosures and qualifications at the end of this material. 6

7 Fig 12. 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* Positive AA-** Stable ARKANSAS Aa1 Stable AA Stable CALIFORNIA A1 Stable A Positive 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 Positive IDAHO Aa1* Stable AA+** Stable ILLINOIS A3 Negative A- Developing 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 Stable 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 Negative A+ Stable NEW MEXICO Aaa Stable AA+ Stable NEW YORK Aa2 Positive AA Positive NORTH CAROLINA Aaa Stable AAA Stable NORTH DAKOTA Aa1* Stable AAA** Stable 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. 7

8 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+ Stable TEXAS Aaa Stable AAA** Stable UTAH Aaa Stable AAA Stable VERMONT Aaa Stable AA+ Positive VIRGINIA Aaa Stable AAA Stable WASHINGTON Aa1 Stable AA+ Stable WEST VIRGINIA Aa1 Stable AA Stable WISCONSIN Aa2 Stable AA Stable WYOMING No G.O. Rating No Outlook AAA** Stable PUERTO RICO Ba2 Negative BB+ Downgrade Watch *Issuer Rating **ICR -- Issuer Credit Rating Data Source: Moody s, S&P as of 4/1/214 Credit rating changes and outlooks are dynamic and frequently change. Investors should reaffirm ratings and outlooks with rating agencies directly prior to making any investment decision. Credit ratings throughout this report are cited from Standard & Poor s and Moody s given they are two of the most widely followed credit agencies in the fixed income markets. Credit quality is a measure of a bond issuer's creditworthiness, or ability to repay interest and principal to bondholders in a timely manner. The credit ratings shown throughout this report are based on each issuer s security rating as provided by Standard & Poor's and Moody's, as applicable. The credit quality of the issuers listed in this report does not represent the stability or safety of the bonds. Credit ratings shown range from AAA, being the highest, to D, being the lowest based on S&P s classification (the equivalent of Aaa and C, respectively, by Moody s). Ratings of BBB or higher by S&P (Baa or higher by Moody s) are considered to be investment grade-quality securities. If the two agencies have assigned different ratings to a security, the highest rating is applied. Securities that are not rated by the agencies are listed as No G.O. Rating. Please refer to important information, disclosures and qualifications at the end of this material. 8

9 Fig Year Munis as a Percentage of 5-Year Treasuries, January 1996 April 214 % of Corresponding USTs 24 5-Year Relative Value Ratio Average Jan-96 Jan-98 Jan- Feb-2 Feb-4 Feb-6 Mar-8 Mar-1 Mar-12 Apr-14 Source: Thomson Reuters MMD as of 4/1/214 Fig Year Munis as a Percentage of 1-Year Treasuries, January 1996 April Year Relative Value Ratio Average % of Corresponding USTs Jan-96 Jan-98 Jan- Feb-2 Feb-4 Feb-6 Mar-8 Mar-1 Mar-12 Apr-14 Source: Thomson Reuters MMD as of 4/1/214 Fig Year Munis as a Percentage of 3-Year Treasuries, January 1996 April 214 % of Corresponding USTs 24 3-Year Relative Value Ratio Average Jan-96 Jan-98 Jan- Feb-2 Feb-4 Feb-6 Mar-8 Mar-1 Mar-12 Apr-14 Source: Thomson Reuters MMD as of 4/1/214 Please refer to important information, disclosures and qualifications at the end of this material. 9

10 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. 1

11 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. Please refer to important information, disclosures and qualifications at the end of this material. 11

12 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 2, 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. 214 Morgan Stanley Smith Barney LLC. Member SIPC. Please refer to important information, disclosures and qualifications at the end of this material. 12