Fixed Income in a Rising Rate Environment: What Are the Alternatives?

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1 CONSULTING GROUP INVESTMENT ADVISOR RESEARCH JU N E 27, Fixed Income in a Rising Rate Environment: What Are the Alternatives? SUMMARY With interest rates recently rising off of historically low levels, a number of fixed income managers covered by CG IAR believe that rates could continue to increase. Accordingly, a number of managers have positioned their portfolios toward lower duration bonds and/or fixed income sectors they believe could outperform in a rising rate environment. MATTHEW RIZZO Vice President Matthew.Rizzo@ms.com The Global Investment Committee also believes that interest rates will normalize (rise) over its seven year strategic time horizon. Corporate, high yield, and emerging markets debt currently have favorable risk/return ratios and may outperform in a rising rate environment relative to other fixed income segments. Additionally, bank loans (floating rate) securities and TIPS have unique characteristics that may offer some degree of protection in a rising rate environment. Other investment categories may offer potentially more attractive risk/return profiles and increase diversification. We examine commodities and hedged strategies in the event driven, global macro, equity long-short, and managed futures categories, as well as convertible and preferred securities. For implementation, we highlight the following strategies*: SHORT DURATION BONDS o BlackRock Managed Account Short Duration (FS) & BlackRock Low Duration Fund (BFMSX) (TRAK/FS, UMA) BANK LOANS (FLOATING RATE) o Pioneer Floating Rate Fund (FLARX) (TRAK/FS, UMA) EMERGING MARKETS BONDS o T. Rowe Price Emerging Market Bond Fund (PREMX) (UMA) HIGH YIELD BONDS o BlackRock High Yield Fund (BHYAX) (TRAK/FS, UMA) COMMODITIES o PIMCO Commodity Real Return Fund (PCRIX) (TRAK/FS, UMA) EVENT DRIVEN o The Merger Fund (MERFX) (TRAK/FS, UMA) GLOBAL MACRO o Eaton Vance Global Macro Absolute Return Fund (EAGMX) (TRAK/FS, UMA) LONG/SHORT EQUITY o Diamond Hill Long-Short Fund (DIAMX) (UMA) MANAGED FUTURES o AQR Managed Futures Strategy Fund (UMA) *please see page 10 for additional strategies This report is only to be used in connection with investment advisory programs and not brokerage accounts. Before investing, consider the fund's investment objectives, risks, charges and expenses. Contact your Financial Advisor or Private Wealth Advisor for a prospectus containing this and other information about the fund. Read it carefully before investing. This is not a "research report" as defined by FINRA Rule 2711 and was not prepared by the Research Departments of Morgan Stanley Smith Barney LLC, Morgan Stanley & Co. LLC or Citigroup Global Markets Inc. INVESTMENT PRODUCTS: NOT FDIC INSURED*NO BANK GUARANTEE*MAY LOSE VALUE 2013 Morgan Stanley Smith Barney LLC. Member SIPC. Consulting Group is a business of Morgan Stanley Smith Barney.

2 INTRODUCTION While interest rates continue to sit at near-record low levels, there is little disagreement among fixed income money managers that rates will rise again in the future perhaps sharply or perhaps in a more gradual but sustained manner. In either case, the result would be a decline in bond prices and losses for holders of fixed income securities. But even if rates were to stay where they are for a prolonged period, many investment managers believe that current rates are not particularly attractive and may not even keep up with inflation. Nonetheless, fixed income securities continue to be important building blocks of most diversified portfolios, providing income and dampening the volatility of more risky assets. The following paper examines the behavior of various fixed income segments in rising rate environments to determine which ones might perform better under such conditions. Additionally, we look at various fixed income segments and other investment choices such as alternatives that offer greater current risk/reward characteristics and when added to a portfolio to increase diversification and potentially increase returns relative to traditional fixed income securities. THE MOST LIKELY DIRECTION FOR YIELDS MANY FIXED INCOME MANAGERS CALLING FOR HIGHER RATES Fixed income securities have been in a 30-year bull market since the early 1980s with interest rates on the 10-Year U.S. Treasury Note declining from 15.3% in September of 1981 to around 2% currently. 1 As Chart 1 on the opposite side of the page indicates, interest rates have been on a near-continual decline since Even if rates were to remain near their lows, fixed income securities still offer low rates of absolute and real (after inflation) rates of return and managed fixed income portfolios will likely experience periods of negative returns as rates rise. Chart 1 U.S. TREASURY 10-YEAR RATES 1971 TO % 13% 11% 9% 7% 5% 3% 1% Source: Federal Reserve, CG IAR September 1981 peak above 15% According to Dan Loewy, AllianceBernstein Co-CIO and Director of Research for the Dynamic Asset Allocation team, although inflation tends to be fairly sticky and stays in a fairly narrow range at times, real interest rates are not as sticky. Accelerating economic growth could cause real rates to go up through a decrease in bond prices even if inflation does not increase. On the other hand, if inflation does increase, interest rates tend to rise as well, as market participants demand a higher rate of interest to compensate for loaning money and/or because the Federal Reserve raises interest rates. In either case, the result is an increase in rates and a drop in bond prices. The asset allocation team at AllianceBernstein forecasts future returns for various asset classes using its Capital Markets Engine, which is a proprietary model that uses the firm s research and historical data to estimate a vast range of market returns taking into account the linkages within and among the capital markets, as well as their unpredictability. Expected market returns on bonds are derived taking into account yield and other criteria. According to AllianceBernstein, the 10-year outlook for global taxable bonds is a return of about 2.3% annualized, with spread sectors such as corporates, emerging markets, and high yield bonds expected to perform somewhat better. 2

3 Indeed, continued purchases of Treasuries by central banks around the world and increased purchases of long-term bonds by defined-benefit plans and insurance companies may keep rates relatively low. However, returns will still be more muted than they have been over the past 30 years. According to TCW MetWest fixed income portfolio manager Tad Rivelle, while neither we nor anyone else could tell you what a ten-year Treasury will return in 2013, we can tell you with certainty that the annualized return to 2023 will be 2% [assuming the bond is held to maturity]. Absent deflation, this is hardly a prescription for wealth accretion! Chart 2 LET S GET REAL IMPLIED FORWARD REAL RETURNS 16% 14% 12% 10% 8% Stocks 6% 4% 2% 0% -2% Bonds Consider that real interest rates in the U.S. have averaged close to 4% since 1961, but are now at about +0.4% comparing the rate on the benchmark U.S. 10-Year Treasury to the current rate of inflation (CPI) as of March 31, If rates were to normalize and get back to the long-term average real rate, the U.S. 10-Year Treasury yield would have to rise by more than 3.5%, which would imply a loss of principal of more than 30%. Of course, if an individual bond is held to maturity, an investor receives his principal back (assuming no default), but even if the bond were held to maturity, the 1.86% coupon rate may not keep up with inflation over time. -4% Source: Morningstar, CG IAR 2007 As can be seen from Chart 2 above, implied real returns for stocks and bonds moved in close tandem with stocks typically afforded a slight return premium prior to the financial crisis. However, since the financial crisis, stocks have been given a much greater risk premium and bonds implied real returns approached negative territory. Additionally, stocks implied real returns climbed since 2009, while bonds implied real returns drifted down BONDS RELATIVE TO STOCKS We could also compare fixed income yields to valuations for its main competition stocks. One way to do this is to compute the implied price/earnings ratio on fixed income securities and compare this to the stock market s price/earnings ratio, which is currently about 15 when looking at one-year forward estimates. Assuming a 1.86% yield on the 10-Year U.S. Treasury, the implied price/earnings ratio would be over 50 (1/.0186). Alternatively, one could compare the yield on fixed income to the earnings yield on stocks. A price/earnings ratio of 15 equates to an earnings yield (inverse of the price/earnings ratio) of 6.7%, which is obviously much greater than current Treasury bond yields. WHAT ARE IMPLIED FORWARD RETURNS OF STOCKS AND BONDS TELLING US? Chart 2 on the opposite side of the page compares the implied forward real return on stocks and bonds by subtracting the implied forward inflation rate calculated by subtracting the TIPS rate from the Treasury bond rate and then subtracting the implied inflation rate from both the current yield on the Barclays U.S. Aggregate Bond Index for bonds and the earnings yield for stocks. HOW WOULD VARIOUS FIXED INCOME SEGMENTS REACT TO RISING RATES? A number of the fixed income managers on the CG IAR separately managed account (SMA) and mutual fund platforms believe that rates will rise over intermediate- and long-term time frames. Similarly, the Morgan Stanley Wealth Management Global Investment Committee is calling for rates to normalize to a higher level over its seven-year strategic horizon with U.S. investment grade bonds returning 1.4% annually over this period. Although most bonds would decline in price in a prolonged rising rate environment, different types of bonds would react somewhat differently. In fact, CG IAR looked at various segments of the fixed income markets going back nearly 20 years to September of 1993 to determine which segments of the market held up best during periods of rising rates. Although the period from 1993 up to now was one of generally falling rates, there were periods when rates rose sometimes substantially which give us a clue as to how various fixed income segments might react in future rising rate environments. 3

4 As can be seen from Table 1 below, convertible bonds, high yield, emerging markets, and preferreds held up best in rising rate periods, while Treasuries performed worst. Table 1 FIXED INCOME SECTOR PERFORMANCE IN RISING RATE ENVIRONMENTS Average Quarterly Return in Rising Rate Quarters 4Q 1993 to 1Q 2013* Convertible Bonds 3.97% US Corporate High Yield 2.50% Emerging Markets Bonds 2.33% High Yield Municipal 2.28% Preferred Stock Fixed Rate 1.53% ABS Floating Rate 1.28%** US Treasury TIPS 0.62%*** US Aggregate 1-3 Year 0.56% US Intermediate Corporate 0.53% US Mortgage Backed Securities 0.40% US Aggregate 3-5 Year 0.32% Municipal Intermediate 5-10 Year 0.19% US Aggregate Bond 0.07% Global Aggregate -0.05% Treasury 3-5 Year -0.21% US Treasury -0.48% * See page 11 for table of indexes used. ** Since 12/31/1996 for floating rate securities. *** Since 03/31/1997 for TIPS. Source: Morningstar Direct, CG IAR CONVERTIBLES BONDS Convertible bonds performed the best in rising rate environments relative to the fixed income categories analyzed in Table 1 above. Convertible bonds are hybrid securities with both bond and equity characteristics. Although most convertibles pay interest and are thus affected by changes in rates, they are also convertible into their issuing companies common shares and are therefore affected by changes in underlying equity values. As a result, convertibles have tended to be less interest rate sensitive and have been relatively strong performers in rising rate environments. Although convertible bonds have performed well in rising rate environments, investors should be aware that convertibles have fairly high correlation to equities and therefore may not offer the diversification benefits of traditional fixed income and may decline along with stocks in down equity markets. HIGH YIELD As can be seen from Table 1 on the opposite side of the page, high yield bonds provided one of the best returns among the bond segments listed in rising rate environments. Additionally, although high yield bond returns were higher in periods of declining rates, returns were solidly positive in both rising and falling rate environments and the spread between the two was smaller than the spread found in many other bond segments. The high yield fixed income market has evolved from a universe of outstanding bonds of fallen angels, or bonds of former investment grade companies that were downgraded to below investment grade, to one that includes fallen angels, as well as new bonds issued by companies with below-investment grade ratings. However, unlike in the past when the bonds were often used to finance mergers and acquisitions or leveraged buyouts, high yield debt today is often used for general corporate purposes, such as financing for capital projects or consolidating lines of credit. Accordingly, the issuance of high yield credit has grown significantly over the years. High yield bonds tend to be less correlated with other fixed income sectors and have less interest rate sensitivity. High yield bonds generally have higher coupon yields, which subsequently lowers their duration. Duration measures the degree to which changes in interest rates affect bond prices and moves inversely to bond prices. Additionally, high yield bonds can experience price appreciation due to an improved economy generally or improved company performance or a ratings upgrade at the individual company level. As a result, high yield bonds may hold up better than other fixed income sectors in a rising rate environment, especially if rates rise due to an uptick in U.S. economic growth. Investors should note that while high yield interest rates are currently near their all-time lows, credit spreads are not, which indicates that high yield bonds might have a certain amount of cushion compared to other types of bonds in a rising rate environment. At the same, high yield bonds in general are currently trading well above par, which could potentially limit some of their upside from current levels. 4

5 EMERGING MARKETS Emerging markets bond returns ranked in third place behind convertible securities and high yield among the bond sectors we examined in rising rate environments. Despite the perceived higher risk of investing in the emerging markets debt space, the area actually provided better returns in rising rate environments. Emerging markets bonds tend to be somewhat more credit sensitive than interest rate sensitive. Investors in emerging market bonds are often more concerned with the fiscal health of the underlying countries than they are with interest rates. Additionally, many emerging markets bonds offer a higher yield relative to bonds in developed markets. Therefore, similar to high yield bonds, emerging market bonds could potentially provide better returns in a rising rate environment relative to other fixed income alternatives, especially in an environment where rates rise due to a pickup in the strength of the global economy. A number of managers are bullish on the prospects for emerging market debt. According to Western Asset Management portfolio manager Matthew Duda, positive economic and political factors and a reduction in sovereign risk have allowed a deep, robust and liquid local government debt market to develop. Thanks to years of increasingly transparent monetary policy coupled with fiscal discipline, many of these countries have increasingly financed themselves in their own currencies rather than in US dollars, the historical norm [A]s a result, the external hard-currency (U.S. dollar-denominated) borrowing space, which was once dominated by sovereign debtors, has opened dramatically for EM corporate issuers. The investment implication is that the recent history of improvement in credit fundamentals for EM issuers both governments and corporates offers a compelling counterpoint to the deterioration in government balance sheets in many developed markets. With income valued at a premium by many global investors, investments in EM corporate bonds can offer high levels of current income with prospects for total return enhancement through spread compression as the market continues to evolve and improve. PREFERREDS Similar to convertible bonds, preferred stocks have properties of both equity and fixed income securities and are considered hybrids, which causes them to be less interest rate sensitive. Some preferreds are convertible into common stock, but this is not always the case. Most preferred stock pays a fixed dividend that typically is paid out before common shareholders are paid, but unlike traditional fixed income securities, preferreds typically do not have a maturity date. Investors should be aware that preferreds have been more volatile than traditional bonds and have experienced steep drops during equity market downturns. BANK LOANS (FLOATING RATE) Bank loans ability to increase in yield as rates rise should improve their performance relative to other fixed income segments in rising rate environments. Although there is more limited index data for bank loans to judge their performance in rising rate environments, they did perform well relative to other fixed income segments in rising rate environments since the end of 1996 (see Table 1). Investor interest in bank loans has historically been overshadowed by high yield bonds; however, more recently, investors have started to appreciate their value proposition. Bank loans are typically floating rate securities and are issued by companies that also issue high yield bonds. However, because bank loans are secured by assets, they rank higher in the capital structure. Additionally, the rates on bank loans are normally set at a fixed spread over a benchmark rate such as LIBOR (London Interbank Offered Rate) with periodic resets. Therefore, the loans yields can rise or fall with the movement of interest rates. Similar to high yield bonds, bank loans often have five- to 10-year maturities, but with shorter call windows. Also, bank loans have recently had default rates similar to those of high yield, but historically have had lower default rates and higher recovery rates. As a result, bank loans have tended to have lower volatility than high yield bonds. Additionally, bank loans currently trade with yields only slightly less than those of high yield. According to Guggenheim Partners, bank loans have historically yielded about 130 basis points less than high yield bonds, but the spread heading into 2013 was about 30 basis points. 2 TREASURY INFLATION PROTECTED SECURITIES The Treasury Inflation Protected Securities (TIPS) index returns in Table 1 do not go back as far, but we can see that TIPS generally performed fairly well in rising rate environments. Conceptually, TIPS should hold up relatively well in a rising rate environment caused by rising inflation because they offer investors principal payments based on the level of inflation in the economy. Embedded in the TIPS yield is an implicit assumption about forward rates of inflation. For example, 10-year TIPS were yielding about 0.12% as of March 31, If we subtract this from the 10- year Treasury rate of 1.86%, then the market is pricing in a forward inflation rate of 1.74% over the next ten years. If inflation is higher than this over the next ten years, then the 10-year TIPS should outperform the 10-year Treasury with a comparable maturity due to the TIPS inflation adjustment. However, some fixed income managers believe that TIPS current interest rates are not particularly attractive. If there is a spike in rates without an increase in inflation (real rates rise), then TIPS could potentially underperform other types of bonds. 5

6 CORPORATES Corporate bonds generally have a somewhat higher yield due to their lower credit quality and higher perceived risk relative to Treasuries. While corporate bonds entail somewhat higher default risk, they may hold up better in a rising rate environment due to their higher yields and lower durations relative to similar maturity Treasuries. It may be somewhat difficult to make an apples to apples duration comparison of corporates to Treasuries when looking at the major indexes because the benchmark maturities often do not match. However, as one example, take the Barclays U.S. Treasury 3-5 Year Index and the Barclays U.S. Corporate 3-5 Year Index, both of which had an identical maturity of 4.0 years as of March 31, 2013, as noted in Table 2. Although their maturities were identical, the Treasury index was yielding 0.6% with a duration of 3.9, while the corporate index yielded 1.5% and had a duration of less than 3.8. As a result, corporate bonds may hold up somewhat better in a rising rate environment, especially if rates rise as a result of improving economic conditions. Additionally, investors can lower their durations using corporate bonds and still pick up incremental yield relative to Treasuries. On the other hand, corporate bond prices could be negatively impacted in a deteriorating economic environment. As Table 1 indicates, corporates have in fact fared better than Treasuries in rising rate environments. MORTGAGE-BACKED Mortgage-backed securities benefited from the long bull market in bonds. However, due to prepayment risk, mortgage-backed securities suffer from what is called negative convexity, which shortens duration in declining rate environments and extends it in rising rate environments. In a declining rate environment, prepayments and/or refinancing of mortgages causes mortgage bonds to be paid off more quickly at par. The resultant lowering of duration serves to cap the price appreciation of the bonds. But the opposite is true as well as interest rates rise, mortgage bonds decrease in value and their average lives tend to rise as prepayments slow. As a result, duration increases as rates are rising, causing a greater decrease in price. Thus, mortgage-backed securities could potentially be hurt more in a rising rate environment relative to other fixed income securities. As can be seen in Table 1, mortgage backed securities fell about in the middle in terms of returns in rising rate environments. MUNICIPAL Municipals tend be longer duration bonds when issued, which is detrimental in a rising rate environment. However, investors can buy municipals with shorter maturities in the open market. Additionally, municipal spreads to Treasuries remain above average relative to historical norms, which should provide some cushion in a rising rate environment. Finally, municipal bonds are priced off of the municipal yield curve, which tends to be less sensitive to rate changes. As can be seen in Table 1, municipals fell toward the bottom in terms of performance in rising rate environments. DEVELOPED GLOBAL While developed global bonds offer additional diversification benefits relative to U.S. bonds alone, the return patterns of the two have been quite similar in increasing and decreasing rate environments. In fact, the annualized return for the two from September 30, 1993 through March 31, 2013 was nearly the same at 6.0% for the Barclays U.S. Aggregate Index and 5.9% for the Barclays Global Aggregate Index. Additionally, as shown in Table 1, returns in rising rate environments were fairly similar, with global bonds slightly underperforming U.S.-only bonds. TREASURIES From a duration perspective, Treasuries may remain most vulnerable to rising rates. Because Treasuries are considered the U.S. benchmark by which other fixed income securities are measured, they tend to have lower interest rates (lower coupons) and lower coupon bonds have higher durations relative to higher coupon bonds. As a result of Treasuries longer durations and greater interest rate sensitivity, they tend to go down more relative to other types of bonds in rising rate environments. Of course, Treasury investors can mitigate this risk somewhat by shortening maturities, but interest rates on shorter maturity Treasuries are currently quite low. Looking at the Barclays U.S. Treasury Long Index, the duration was 16.7 as of March 31, 2013, meaning that if rates rose 1%, the anticipated price drop would drop be nearly 17%. As can be seen from Table 2 below, Treasuries have longer durations relative to corporates and other bond segments with similar maturities. However, it is worth noting that there is a wide discrepancy in duration among Treasuries. For example, while the overall Treasury index had a duration of only 5.3, the benchmark U.S. 10- Year Treasury had a duration of 9.2. Obviously, reaching for incremental yield in this environment could cause significant price declines should rates rise. As can be seen from Table 1, Treasuries have in fact been one of the worst performers in rising rate environments. 6

7 THE CASE FOR SHORT DURATION BONDS As noted above, a number of fixed income managers believe that rates will rise in the future. As a result, some managers favor securities on the intermediate to short end of the rate curve depending on their particular mandates. As one example, looking at the average duration of the CG IAR Focus List Core Plus fixed income managers at year-end 2012, they were at a 10% discount to their benchmark (4.6 for the managers versus 5.1 for the Barclays U.S. Aggregate Index). BlackRock s CIO of Fixed Income Rick Rieder has noted that the 10-Year U.S. Treasury yield might be more appropriate around 3.1%, given current economic conditions, but that rate normalization is likely to both take time and require adjustments to central bank policy. Additionally, as previously noted, the Morgan Stanley Global Investment Committee believes that interest rates will normalize and increase in the future. As recent Global Investment Committee positioning makes clear, moving toward short duration bonds could make sense to mitigate some of the affects of rising rates. Although shorter duration bonds would certainly mitigate the effects of rising rates, they do not offer current yields as high as those of similar credit bonds with longer maturities. However, as shown in Table 2 on the opposite side of the page, investors can pick up additional yield by moving down the credit scale, which is a strategy a number of fixed income managers have employed. Additionally, within sectors such as high yield, one could potentially shorten duration without giving up very much in the way of yield. This strategy could be especially effective should rates rise without an increase in defaults in lower credit quality bonds. Additionally, as shown in Table 3 on page eight, shorter duration bonds have historically provided a compelling risk/return tradeoff, as measured by the Sharpe ratio. Table 2 DURATION, MATURITY & YIELD As of 03/31/2013 Bond Sector* Modified Duration Maturity (Years) Yield to Worst (%) U.S. Treasury 10 Year U.S. Treasury U.S. Treasury 3-5 Year U.S. Treasury Int U.S. Treasury Long U.S. Gov t. 1-5 Year U.S. Agency U.S. Aggregate Global Aggregate U.S. Corporate Int U.S. Corporate Long U.S. Corporate 3-5 Year U.S. Convertibles U.S. Preferreds 3.18 NA 4.74 Municipal Municipal 5 Year U.S. High Yield U.S. High Yield Int ABS Floating Rate NA NA 5.26 Emerging Markets Pan-Euro EM 3-5 Year Global Credit 3-5 Years Global Credit * See page 11 for table of indexes used. Source: Barclays, S&P Dow Jones, CG IAR 7

8 ALTERNATIVE INVESTMENTS: THE RISK-RETURN TRADEOFF RELATIVE TO EQUITIES AND FIXED INCOME As Table 3 on the opposite side of the page shows, several alternative investment categories, as well as alternative mutual fund categories, have provided attractive risk/return tradeoffs relative to traditional equities (as measured by the S&P 500 Index) over the past 15 years. However, traditional fixed income securities (as measured by the Barclays Aggregate U.S. Bond Index) provided higher returns than many of the asset classes with less risk (as measured by standard deviation) than all of the other categories. As measured by the Shape ratio, the Barclays Aggregate U.S. Bond Index ranked third among all of the categories shown in Table 3. However, looking forward, it is a near impossibility that traditional fixed income securities could provide a similar type of return given current interest rate levels. As noted above, many investment professionals are calling for fixed income returns of around 2% or less looking out over intermediate- to long-term time frames. So while bonds may continue to provide diversification benefits through lower correlations to other asset classes and relatively low standard deviation, it is unlikely that bond returns will match the performance of the past fifteen years from current interest rate levels. Additionally, it would not take much of a back-up in rates for fixed income returns to turn negative. As a result, some investors are looking toward investments other than traditional intermediate- and long-term fixed income securities to provide more favorable forward-looking risk/return characteristics along with the ability to offer greater diversification. As PIMCO recently noted, the trend has been for investors to seek greater diversification away from traditional assets, and that increasingly, these trends will drive investors to nontraditional and highly active strategies with potential for incremental alpha and returns uncorrelated with traditional stocks and bonds. New sources of diversifying financial betas, including currency, commodity and volatility, will grow more common in portfolios. Strategies dependent on high degrees of manager discretion, such as market-neutral and long/short equity, will aid diversification and offer potential downside-risk mitigation. 3 Table 3 RETURN AND RISK STATISTICS January 1998 to December 2012 Barclays Aggregate U.S. Bond Standard Deviation Sharpe Ratio Maximum Drawdown 5.96% 3.48% % ML U.S. 1-3 Year 4.44% 1.52% % Barclays High Yld 7.10% 10.13% % BofA Leveraged Loan 5.14% 6.70% % EM Debt 10.42% 12.69% % S&P % 16.24% % MSCI ACW ex USA B of A ML Convertible Securities B of A ML Preferred Stock BarclayHedge Multi Strategy BarclayHedge Hedge Fund 5.75% 18.66% % 6.44% 13.76% % 4.90% 13.38% % 8.80% 4.84% % 8.66% 7.57% % BarclayHedge CTA 4.42% 6.99% % Morningstar Global Flexible Allocation Mutual Funds Morningstar Long/Short Mutual Funds Morningstar Market Neutral Mutual Funds Morningstar Natural Resources Mutual Funds Dow UBS Commodity Source: Zephyr StyleAdvisor, CG IAR 8.84% 13.12% % 5.77% 9.96% % 5.19% 4.89% % 9.47% 28.80% % 4.04% 17.38% % 8

9 PAST PERFORMANCE IS NO GUARANTEE OF FUTURE RETURNS: WHERE ARE THE OPPORTUNITIES LOOKING FORWARD? Given that traditional fixed income returns will likely be more muted from current interest rate levels, which asset classes might provide investors with portfolio diversification and relatively low levels of volatility, as well as respectable returns? If we use the Global Investment Committee s strategic return and volatility estimates for the upcoming seven years (as of December 31, 2012), U.S. investment grade bonds are expected to return 1.4% per year. This projected return compares unfavorably with the following alternatives: commodities are projected to return 5.6% per year, global macro 5.6%, hedged strategies 4.0%, U.S. REITs 3.9%, and managed futures 2.6%. 4 While most of these alternatives have higher projected standard deviations than fixed income, most of them have much lower expected volatility than stocks and higher expected Sharpe ratios due to their more favorable expected return to risk profiles. Additionally, these alternative asset classes may perform better than fixed income in rising rate environments. Table 4 ESTIMATED SHARPE RATIOS FOR SELECTED ASSET CLASSES USING SEVEN-YEAR GIC RETURN AND VOLATILITY ESTIMATES Return and Volatility Estimates as of December 31, 2013 Annualized Return Estimate Annualized Volatility Estimate Estimated Sharpe Ratio US Investment Grade Bonds US Short Term Investment Grade Bonds Global Investment Grade Bonds Global Corporate/Securitized US Inflation-Linked Securities US Municipal Bonds US High Yield Bonds Global Emerging Market Debt US All-Cap Stocks Developed Markets Equities Global Emerging Market Stocks US REITs Global REITs Commodities Diversified Commodities - Precious Metals Hedged Strategies Hedged Strategies - Relative Value Hedged Strategies - Event Driven Hedged Strategies - Global Macro Hedged Strategies - Equity Long-Short Managed Futures Source: Morgan Stanley Wealth Management, U.S. Treasury, CG IAR Table 5 below compares the correlation across a number of equity, fixed income, and alternative assets classes over the past 15 years. Table 5 Correlation Matrix: Returns vs. Russell 3000 January December 2012 Barclays 1-3 Yr Gov BofA ML U.S. Domestic Master 1-3 Yrs Barclays U.S. Aggregate Barclays U.S. Treasury: U.S. TIPS Barclays Intermediate U.S. High Yield S&P/LSTA US Leveraged Loan Index Barclays Global Treasury ex-u.s. BofA Merrill Lynch Emg Mkt Sovereign Plus BofA Merrill Lynch Convertible Securities BofA ML Preferred Stock Dow UBS Hybrid Precious Securities Metals Dow UBS Commodity Index Barclays 1-3 Yr Gov 1.00 BofA ML U.S. Domestic Master 1-3 Yrs Barclays U.S. Aggregate Barclays U.S. Treasury: U.S. TIPS Barclays Intermediate U.S. High Yield S&P/LSTA US Leveraged Loan Index Barclays Global Treasury ex-u.s BofA ML Emg Mkt Sovereign Plus BofA ML Convertible Securities BofA ML Preferred Stock Hybrid Dow UBS Precious Metals Dow UBS Commodity Index BarclayHedge Hedge Fund Index BarclayHedge Global Macro Index BarclayHedge Event Driven Index BarclayHedge Equity Mkt. Neutral Index BarclayHedge Equity Long/Short Index BarclayHedge CTA Index Russell Source: Zephyr, CG IAR Barclay- Hedge Hedge Fund Index Barclay- Hedge Global Macro Index Barclay- Hedge Event Driven Index Barclay- Hedge Equity Mkt. Neutral Index Barclay- Hedge Equity Long/Shor t Index Barclay- Hedge CTA Index Russell

10 FIXED INCOME STRATEGIES AND ALTERNATIVE MUTUAL FUNDS Given the expectation for rising interest rates and the potentially attractive risk/reward characteristics and diversification benefits of certain types of fixed income and alternative mutual fund strategies, we suggest the following products for implementation in portfolios. SHORT DURATION BONDS o BlackRock Managed Account Short Duration (FS) & BlackRock Low Duration Fund (BFMSX) (TRAK/FS, UMA) o PIMCO Low Duration Fund (PTLDX) (TRAK/FS, UMA) BANK LOANS (FLOATING RATE) o Eaton Vance Floating Rate Fund(EVBLX) (TRAK/FS, UMA) o Invesco Floating Rate Fund (AFRAX) (TRAK/FS, UMA) o Pioneer Floating Rate Fund (FLARX) (TRAK/FS, UMA) o Pioneer Multi-Asset Ultrashort Income Fund (MAFRX) (TRAK/FS, UMA) CORPORATE FIXED INCOME o PIMCO Investment Grade Corporate Bond Fund (PBDAX) (TRAK/FS, UMA) CORE, OPPORTUNISTIC AND ABSOLUTE RETURN FIXED INCOME o o o o Western Asset Mgmt Core Fixed Income SMA (FS, CES, UMA) & Western Asset Mgmt Core Bond Fund (WATFX) (TRAK/FS, UMA) Loomis Sayles Bond Fund (LSBDX) (TRAK/FS, UMA) PIMCO Income Fund (PIMIX) (TRAK/FS, UMA) Pioneer Dynamic Credit Fund (RCRAX) (TRAK/FS, UMA) INTERMEDIATE TERM FIXED INCOME o Sage Advisory Intermediate Taxable (FS, CES, UMA) EMERGING MARKETS BONDS o Goldman Sachs Emerging Markets Debt Fund (GSDAX) (TRAK/FS, UMA) o T. Rowe Price Emerging Market Bond Fund (PREMX) (UMA) o Western Asset Emerging Debt Portfolio Fund (SEMDX) (TRAK/FS, UMA) HIGH YIELD BONDS o BlackRock High Yield Fund (BHYAX) (TRAK/FS, UMA) o Eaton Vance Income Fund of Boston Fund (EVIBX) (TRAK/FS, UMA) INFLATION LINKED BONDS o PIMCO Real Return for Managed Accounts (FS, UMA) & PIMCO Real Return Fund (TRAK/FS, UMA) COMMODITIES o PIMCO Commodity Real Return Fund (PCRIX) (TRAK/FS, UMA) GLOBAL MACRO o Eaton Vance Global Macro Absolute Return Fund (EAGMX) (TRAK/FS, UMA) o Guggenheim Macro Opportunities Fund (GIOAX) (TRAK/FS, UMA) TACTICAL ASSET ALLOCATION o IVY Strategy Fund (WASYX) (TRAK/FS, UMA) o JP Morgan Income Builder Fund (JNBSX) (TRAK/FS, UMA) o PIMCO All Asset Fund (PASAX) (TRAK/FS, UMA) MANAGED FUTURES o AQR Managed Futures Strategy Fund (UMA) LONG/SHORT EQUITY o Diamond Hill Long-Short Fund (DIAMX) (UMA) MARKET NEUTRAL o Highbridge Statistical Market Neutral Fund (HSKSX) (UMA) EVENT DRIVEN o The Merger Fund (MERFX) (TRAK/FS, UMA) CONVERTIBLES & PREFERREDS o Franklin Convertible Fund (FISCX) (TRAK/FS, UMA) o Principal Spectrum Preferred Securities (FS, CES, UMA), Principal Spectrum Preferred Securities - Tax Advantaged (FS, CES, UMA), & Principal Preferred Securities Fund (PPSAX) (TRAK/FS, UMA) 10

11 1 Observations: 100 Years of Treasury Bond Interest Rate History, 2 Minerd, Scott B., et al., High Yield and Bank Loan Outlook, Perspectives, Guggenheim Investment Partners, January 2013, ;;.aspx 3 Hodge, Douglas M., Think Alternatively, Viewpoints, PIMCO, April 2013, Alternatively.aspx 4 Morgan Stanley Wealth Management Global Investment Committee Asset Allocation Team, Global Investment Committee Strategic Asset Allocation, Morgan Stanley Wealth Management, March Indexes Used in Tables 1 and 2 BofA ML Convertible Bonds All Qualities Barclays US Corporate High Yield Barclays US Corporate HY Intermediate JPM Emerging Markets BI Global Barclays Pan-Euro EM 3-5 Year Barclays HY Muni BofA ML Preferred Stock Fixed Rate ABS Floating Rate: BofA ML ABS Master Floating Rate (Table 1) S&P/LSTA U.S. Leveraged Loan 100 (Table 2) Barclays US Treasury TIPS Barclays US Aggregate 1-3 Yr Barclays Intermediate Corporate Barclays US Intermediate Credit Barclays US MBS Barclays US Aggregate 3-5 Yr Barclays Municipal Barclays Municipal 5 Year Barclays Municipal Interm 5-10 Yr Barclays US Agg Bond Barclays Global Agg Barclays Global Credit Barclays Global Credit 3-5 Years Barclays US Treasury 3-5 Yr Barclays US Treasury Barclays U.S. Treasury 10 Year Barclays U.S. Treasury Intermediate Barclays U.S. Treasury Long Barclays U.S. Gov t. 1-5 Year Barclays U.S. Agency Barclays U.S. Corporate Long Barclays U.S. Corporate 3-5 Year 11

12 DEFINITIONS 90-day Treasury Bills - Short-term obligations issued by the United States government. T-bills are purchased at a discount to the full face value, and the investor receives the full value when they mature. The difference or "discount" is the interest earned. T-bills are issued in denominations of $10,000 (auction) and $1,000 increments thereafter. Barclay CTA Index - is an industry benchmark of representative performance of commodity trading advisors (CTA). There are a large number of programs included in the calculation of the Barclay CTA Index, which is unweighted and rebalanced at the beginning of each year. To qualify for inclusion in the CTA Index, an advisor must have four years of prior performance history. Additional programs introduced by qualified advisors are not added to the Index until after their second year. These restrictions, which offset the high turnover rates of trading advisors as well as their artificially high short-term performance records, ensure the accuracy and reliability of the Barclay CTA Index. Barclay Equity Long/Short Index - This directional strategy involves equity-oriented investing on both the long and short sides of the market. The objective is not to be market neutral. Managers have the ability to shift from value to growth, from small to medium to large capitalization stocks, and from a net long position to a net short position. Managers may use futures and options to hedge. The focus may be regional or sector specific. The Barclay Equity Long/Short Index is recalculated and updated real-time on this page as soon as the monthly returns for the underlying funds are recorded. Only funds that provide net returns are included in the index calculation. Barclay Equity Market Neutral Index - This investment strategy is designed to exploit equity market inefficiencies and usually involves being simultaneously long and short matched equity portfolios of the same size within a country. Market neutral portfolios are designed to be either beta or currency neutral, or both. Welldesigned portfolios typically control for industry, sector, market capitalization, and other exposures. Leverage is often applied to enhance returns. The Barclay Equity Market Neutral Index is recalculated and updated real-time as soon as the monthly returns for the underlying funds are recorded. Only funds that provide net returns are included in the index calculation. Barclay Event Driven Index - This strategy is defined as 'special situations' investing designed to capture price movement generated by a significant pending corporate event such as a merger, corporate restructuring, liquidation, bankruptcy or reorganization. The Barclay Event Driven Index is recalculated and updated real-time the monthly returns for the underlying funds are recorded. Only funds that provide net returns are included in the index calculation. Barclay Global Macro Index - Global Macro managers carry long and short positions in any of the world's major capital or derivative markets. These positions reflect their views on overall market direction as influenced by major economic trends and or events. The portfolios of these funds can include stocks, bonds, currencies, and commodities in the form of cash or derivatives instruments. Most funds invest globally in both developed and emerging markets. The Barclay Global Macro Index is recalculated and updated real-time as soon as the monthly returns for the underlying funds are recorded. Only funds that provide net returns are included in the index calculation. Barclay Hedge Fund Index is a measure of the average return of all hedge funds (excepting Funds of Funds) in the Barclay database. Barclays Capital 1-3 Year Government Index - Composed of all publicly issued, non-convertible, domestic debt of the U.S. government or by any agency thereof, quasi-federal corporations, or corporate debt guaranteed by the U.S. government. Flower bonds and pass-through issues are excluded. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Index is rebalanced monthly by market capitalization. Maturity is between one and three years. Barclays U.S. Aggregate Agencies Index is the component of the U.S. Aggregate Bond Index that includes U.S. government-sponsored agency securities with a remaining maturity of at least one year. Barclays Capital Aggregate Index - The U.S. Aggregate Index covers the dollar-denominated investment-grade fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, MBS pass-through securities, asset-backed securities, and commercial mortgage-backed securities. These major sectors are subdivided into more specific sub-indices that are calculated and published on an ongoing basis. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. This index is rebalanced monthly by market capitalization. Barclays Capital Global Aggregate Bond Index measures a wide range of global government, government-related, corporate and securitized fixed-income investments, all with maturities greater than one year. Barclays U.S. 1-3 Year Aggregate Bond Index includes the 1-3 year component of the U.S. Aggregate Bond index. The U.S. Aggregate Bond Index represents securities that are taxable, registered with the Securities and Exchange Commission, and U.S. dollar-denominated. The index covers the U.S. investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Barclays U.S. 3-5 Year Aggregate Bond Index includes the 3-5 year component of the U.S. Aggregate Bond index. The U.S. Aggregate Bond Index represents securities that are taxable, registered with the Securities and Exchange Commission, and U.S. dollar-denominated. The index covers the U.S. investment-grade fixed-rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Barclays Capital Global Treasury Ex-US Capped Index includes government bonds issued by investment-grade countries outside the United States, in local currencies, that have a remaining maturity of one year or more and are rated investment grade. Barclays Capital US TIPS - This index consists of Inflation-Protection securities issued by the U.S. Treasury. Barclays Capital U.S. Corporate Intermediate High Yield Bond Index - is an unmanaged index of prices of U.S. dollar-denominated non-investment grade, fixedrate, taxable corporate bonds. Securities are classified as high yield if the middle rating of Moody s, Fitch, and S&P is Ba1/BB+/BB+ or below. Barclays Capital High Yield Index - The Barclays Capital U.S. High Yield Index covers the universe of fixed-rate, non-investment grade debt. Paid-in-kind (PIK) bonds, Eurobonds, and debt issues from countries designated as emerging markets (e.g., Argentina, Mexico, Venezuela, etc.) are excluded, but Canadian and global bonds (SEC registered) of issuers in non-emerging Markets countries are included. Original issue zeroes and step-up coupon structures are also included. Liquidity Rules: All bonds included in the High Yield Index must be dollar-denominated and non-convertible and have at least one year remaining to maturity and an outstanding par value of at least $150 million. Quality Rating Rules: Securities in the index must be rated Ba1 or lower. A small number of unrated bonds are included in the index; to be eligible they must have previously held a high yield rating or have been associated with a high yield issuer, and must trade accordingly. Barclays Municipal High Yield Bond Index is an unmanaged index of municipal bonds composed of municipal bonds rated below BBB/Baa. Barclays Capital Intermediate Credit Index - Composed of all publicly issued, fixed-rate, non-convertible, investment-grade, domestic corporate debt (collateralized mortgage obligations are not included). Total return comprises price appreciation/depreciation and income as a percentage of the original investment. This index is rebalanced monthly by market capitalization. Securities are in the intermediate range of the Barclays Capital Credit Index with maturities less than 10 years. Barclays Capital Municipal Index - The U.S. Municipal Index covers the U.S. dollar denominated long term tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and prerefunded bonds. 12

13 Barclays Capital U.S. MBS Index measures the performance of investment grade fixed-rate mortgage-backed pass through securities of Government National Mortgage Association ( GNMA ), Federal National Mortgage Association ( FNMA ) and Freddie Mac ( FHLMC ). Barclays Capital 5 Year Municipal Index - The composite measure of the total return performance of the municipal bond market. The municipal market contains over 2 million different bond issues. The market is divided into 7 major sectors: State Government Obligation Debt, Pre-refunded Bonds, Revenue Debt: Electric Utilities, Hospital, State Housing, Industrial Development/Pollution Control, Transportation. The index is comprised of investment-grade municipal bonds with maturities of four to six years. Barclays Capital Municipal Intermediate (5-10 Yr) Bond Index - the 5-10 year Municipal Securities Index tracks the performance of tax-exempt investment grade debt of U.S. Municipalities having at least four years and less than ten years remaining term to maturity. Qualifying bonds must have a fixed coupon schedule, a minimum original maturity issue size of $50 million and an investment grade rating from Moody's. In addition, securities must be within five years of their original issue date. The index is re-balanced on the last calendar day of the month. Issues that meet the qualifying criteria are included in the index for the following month. Issues that no longer meet the criteria during the course of the month remain in the index until the next month-end re-balancing at which point they are dropped from the index. Barclays Capital Intermediate Term Treasury Index - An index composed of all bonds covered by the Barclays Treasury Bond Index with maturities less than 10 years. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization. Barclays Capital 3-5 Year Treasury Index An index that measures the performance of public obligations of the U.S. Treasury that have a remaining maturity of more than three years and less than five years. Barclays Capital 7-10 Year Treasury Index - An index composed of all bonds covered by the Barclays Treasury Bond Index that have a remaining maturity of at least seven years and less than 10 years. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization. Barclays Capital Long-Term Treasury Index - An index composed of all bonds covered by the Barclays Treasury Bond Index with maturities of 10 years or greater. Total return comprises price appreciation/depreciation and income as a percentage of the original investment. Indexes are rebalanced monthly by market capitalization. Barclays U.S. Treasury Bond Index the U.S. Treasury component of the U.S. Government/Credit Bond Index (a subset of the U.S. Aggregate Bond Index), is composed of public obligations of the U.S. Treasury with a remaining maturity of one year or more and excludes Treasury Bills. Barclays Capital U.S. 1-5 Year Government Bond Index includes fixed income securities issued by the U.S. Treasury (not including inflation-protected securities) and U.S. government agencies and instrumentalities, as well as corporate or dollar-denominated foreign debt guaranteed by the U.S. government, all with maturities between 1 and 5 years. Barclays U.S Year Corp Index includes U.S. dollar-denominated, investment-grade, fixed-rate, taxable securities issued by industrial, utility, and financial companies, with maturities between 3 and 5 years. Barclays Capital Long-term Credit Index - Composed of all publicly issued, fixed-rate, non-convertible, investment-grade, domestic corporate debt (collateralized mortgage obligations are not included). Total return comprises price appreciation/depreciation and income as a percentage of the original investment. This index is rebalanced monthly by market capitalization. Securities in the long range of the Barclays Capital Credit Index have maturities greater than 10 years. Barclays Capital Global Credit index contains investment grade and high yield credit securities from the Barclays Multiverse Index. Barclays Capital Global Credit 3-5 Years index contains investment grade and high yield credit securities from the Barclays Multiverse Index with a maturity of 3-5 years. Barclays Capital Emerging Markets Pan-European Aggregate Index is a flagship hard currency Emerging Markets debt benchmark that includes fixed-rate debt denominated in EUR or GBP issued from sovereign, quasi-sovereign, and corporate EM issuers with a maturity of 3-5 years. This index was previously called Barclays Pan Euro EM Index, and history is available back to BofA Merrill Lynch All U.S. Convertible Index is an unmanaged market capitalization-weighted index of domestic corporate convertible securities that are convertible to common stock only. BofA Merrill Lynch Preferred Stock Hybrid Securities Index is a subset of the BofA Merrill Lynch Fixed Rate Preferred Securities Index including all subordinated securities with a payment deferral feature. BofA Merrill Lynch Fixed Rate Preferred Securities Index tracks the performance of fixed-rate U.S. dollar-denominated preferred securities issued in the U.S. domestic market. Qualifying securities must be rated investment grade (based on an average of Moody s, S&P and Fitch) and must have an investment grade-rated country of risk (based on an average of Moody s, S&P and Fitch foreign currency long-term sovereign debt ratings). The BofA Merrill Lynch Capital Securities Index is a subset of The BofA Merrill Lynch US Corporate Index including all fixed-to-floating rate, perpetual callable and capital securities. Standard and Poor s 500 Composite Stock Index (S&P 500) is an unmanaged index of 500 large capitalization, publicly traded stocks representing a variety of industries. BofA Merrill Lynch U.S. Domestic Master Index tracks the performance of U.S. dollar-denominated investment grade government and corporate public debt issued in the U.S. Domestic bond market, including mortgage pass-through securities. BofA Merrill Lynch ABS Master Floating Rate index tracks the performance of investment grade floating rate asset backed securities (ABS) publicly issued in the United States. BofA Merrill Lynch Emerging Market Sovereign Plus tracks the performance of USD sovereign debt of countries with a BBB or lower foreign currency long-term sovereign debt rating. Dow Jones-UBS Commodity Index Total Return is designed to provide diversified exposure to commodities as an asset class, this index relies on data that is both exogenous to the futures markets (production) and endogenous to those markets (liquidity) in determining relative values. No related group of commodities (e.g. energy, precious metals, livestock and grains) may constitute more than 33% of the Index as of the annual reweighting of the components. No single commodity may constitute less than 2% of the Index. Dow Jones-UBS Precious Metals Subindex Total Return is a multiple-commodity sub-index consisting of the contracts included in the Dow Jones-UBS Commodity Index Total Return related to precious metals. JP Morgan Emerging Markets Bond Index Global - The J.P. Morgan Emerging Markets Bond Index Global ("EMBI Global") tracks total returns for traded external debt instruments in the emerging markets. Morningstar Long/Short Mutual Funds - Long-Short Equity Long-short portfolios hold sizable stakes in both long and short positions in equities and related derivatives. Some funds that fall into this category will shift their exposure to long and short positions depending on their macro outlook or the opportunities they uncover through bottom-up research. Some funds may simply hedge long stock positions through exchange-traded funds or derivatives. At least 75% of the assets are in equity securities or derivatives. Morningstar Market Neutral Mutual Funds - These funds attempt to reduce systematic risk created by factors such as exposures to sectors, market-cap ranges, investment styles, currencies, and/or countries. They try to achieve this by matching short positions within each area against long positions. These strategies are 13