Of Interest: Fixed Income Strategy Weekly Fixed Income Strategy

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1 PORTFOLIO STRATEGY & RESEARCH GROUP JULY 18, 2014 Of Interest: Fixed Income Strategy Weekly Fixed Income Strategy FIXED INCOME STRATEGY GROUP Morgan Stanley Wealth Management KEVIN FLANAGAN Managing Director JOHN M DILLON Managing Director John.Dillon2@morganstanley.com JON MACKAY Managing Director Jonathan.Mackay@morganstanley.com MATTHEW GASTALL Executive Director Matthew.Gastall@morganstanley.com KEY EVENTS 7/22 CPI (8:30 a.m.) 7/22 Existing Home Sales (10:00 a.m.) 7/24 New Home Sales (10:00 a.m.) 7/24 UST 10-yr TIPS auction 7/25 Durable Goods (8:30 a.m.) OUR TARGET RANGES FOR YIELD-CURVE POSITIONING US Treasuries I.G. Corps High Yield Municipals 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Yr 11 Yr 12 Yr 13 Yr 14 Yr 15+ Yr Source: Morgan Stanley Wealth Management Fixed Income Strategy Please note that Of Interest is being retired. This will be the last edition of this report. FIXED INCOME STRATEGIES Fixed Income Investors: We maintain our broader operating range for the US Treasury (UST) 10-year yield at 2.50%-3.25%. As the market begins to discount Fed lift-off, we look for the yield curve to bear flatten. Credit Investors: High Yield is in the clip your coupon stage of the credit cycle and we could be here for another year or two. Risk is skewed to the downside for CCCs. Stick with BB-rated issuers and higher-quality single-bs and Leveraged Loans. Investment grade (IG) is vulnerable to rising rates. Focus on the "belly" of the curve (3-7 years) and lower quality BBBs, but be prepared to extend duration if rates move higher as we expect. We would look for opportunities in year bonds. Emerging Markets (EM) debt has rallied with US rates this year; however, the reverse could happen as rates rise especially if geopolitical risks persist. Focus on US$ corporate and quasisovereign debt in countries such as Mexico, Colombia & Peru. Municipal Investors: Despite recent resilience, market participants should remain cognizant of potential broad market volatility stemming from Puerto Rico s credit challenges. If this occurs in the absence of rising UST yields, it may be an opportunity to add exposure to non-puerto Rico municipals (gradually, as interest rate risk remains). However, headline-driven muni risk and UST-driven rate risk may facilitate a longer span of price erosion that should be monitored for appropriate entry points. Our base case remains one of broader US economic recovery and (eventually) higher interest rates. We favor the 4- to 9-yr maturity range and prefer above-market coupons (5%) for defensive qualities. Our minimum credit-rating parameters (featured credit rating or higher) include mid-a GOs, mid-bbb essential service revs & public power, A2/A airports, AA hospitals, A higher-ed, & AA state HFAs. Please see our most recent Municipal Bond Monthly Midyear Review: Compare & Contrast for additional details. FIXED INCOME SOLUTIONS Morgan Stanley Wealth Management's fixed income strategists maintain four fixed income asset allocation models (Conservative, Moderate, Aggressive & Municipal). See July s Basis Points for details. 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 MARKET COMMENTARY Rates Economic data continue to reinforce the notion of a Q2 rebound in activity. The latest MS & Co. tracking estimate for real GDP during the Apr/Jun period now stands at +3.5%. Key for next week s slate is CPI on Tues., Jul 22 nd. The highlight of the week was Fed Chair Janet Yellen s Semiannual Monetary Policy Report to both houses of Congress. It was readily apparent Ms. Yellen did not want to create any new headlines regarding the Fed s policy intentions, and the testimony itself was one of the shortest we ve seen. The timing for the 1 st rate hike and the attendant rate guidance appear to be getting more data dependent in nature. The Fed Chair seems fully cognizant of not pulling the trigger too soon, especially because of some of the prior false starts the economy has signaled since the end of the great Recession. As we ve noted in the past, wage trends will most likely play a key role in the Fed s decision-making process. While Ms. Yellen s testimony noted the improvement in the labor market, the emphasis still seemed to be placed on the significant slack that remains. On this front, the next Employment Cost Index report is due out July 31 st. Geopolitical developments, especially in Ukraine, have created a flight to quality bid for Treasuries. We would expect the UST 10-yr yield to reside under our lower boundary only as a result of this safety bid and look towards next week's jobs report for fundamental direction. Credit The increasing tensions in Russia / Ukraine (reports of armored vehicles crossing the border, shelling across national lines and the Malaysian airlines tragedy, and economic sanctions against Russia) combined with the Israeli troop disbursement in the Gaza strip largely overshadowed a relatively strong week for economic data and a good start to earnings season. The S&P 500 was down 3 out of the last 5 days and HY credit spreads widened while the Treasury curve bull flattened. The outcome in Russia / Ukraine seems binary at this point and a further escalation could sap risk demand for a period of time. However, the bulk of the impact is likely to be felt in Emerging Markets versus domestic credit markets and is unlikely to impact our current economic trajectory barring a massive rise in oil prices. IG credit spreads remain unchanged on the week at 98bp while the yield dropped 1bp to 2.90%. The recent rally in long end rates combined with static spreads has helped longer maturity credit outperform shorter maturity credit. HY spreads took it on the chin, widening 14bp on the week, and yields were pushed 16bp higher to 5.32%. Year to date, IG credit is up 5.95% while HY is up 4.86%. We continue to recommend a selective approach in US credit, focusing on the "belly" of the maturity curve (3-7 years) and select opportunities in BBBs and BBs. However, we believe investors should be prepared to extend duration as rates move higher; specifically, we would focus on year IG credit and 7-plus year HY credit. EM investors should focus on US$ bonds in lower beta countries like Mexico, Colombia, and Peru. Municipals Tax-exempts appeared to hang tough this week after the market encountered the largest municipal bond fund outflows in over six months last Thursday. The aforementioned exodus can be mostly attributed to concerns over the credit challenges of Puerto Rico, especially as many funds net asset values (NAVs) suffered from the repricing of the Commonwealth's debt following downgrades from Moody s and Fitch. As municipals maintained their resilience, taxexempts outperformed US Treasuries; week-over-week yields were lower on the 5-, 10- and 30-yr AAA benchmarks by 5, 9, and 7 basis points, respectively, as of Thursday's close. Though the market has exhibited relative stability (thus far), it is important to stress that the aforementioned developments and their potential subsequent impacts are still "far from over." In fact, S&P continued their response to the Puerto Rico Corporations Debt Enforcement and Recovery Act shortly after we "went to press" last Friday, and downgraded the island s G.O. rating (to BB negative), COFINA, and many of the Commonwealth s affiliated entities. We continue to advocate that those investors who own Puerto Rico debt contact their Morgan Stanley Wealth Management Financial Advisor or Investment Representative, since multiple factors (which include bond insurance) should be considered with the current situation. Should broad market weakness transpire (this week's fund inflows suggest otherwise at only +$158 million), it may be an opportunity to add exposure to non-puerto Rico municipals; however, we would advocate doing so gradually in such an event, as significant interest rate risk remains, from our perspective. Though we are heeding a sense of caution due to the aforementioned developments, many municipal specific technicals remain notably strong. This summer s bond redemptions continue to be significant and issuance remains manageable (next week s calendar resides at nearly $6 billion). Please refer to important information, disclosures and qualifications at the end of this material. 2

3 TAXABLE FIXED INCOME MARKET DATA US Treasurys and TIPS 7/17/ Week Change Change since end of last Month YTD Change 2 year High 2 year Low 2-yr yield yr yield yr yield yr yield Spread (bp) yr TIP yield yr Breakeven inflation rate yr Breakeven inflation rate YR-5YR Forw ard inflation rate Credit and Emerging Markets 7/17/ Week Change Change since end of last Month YTD Change 2 year High 2 year Low Investment Grade Option Adjusted Spread Investment Grade Yield to Maturity High Yield Option Adjusted Spread High Yield Yield to Worst High Yield Bid Price Emerging Market US$ Option Adjusted Spread Emerging Markets US$ Yield to Worst FIXED INCOME TOTAL RETURNS Total Returns YTD MTD yr Treasury yr Treasury Barclays Aggregate Government Sponsored Barclays Municipal Index Investment Grade High Yield World Government Bonds (FX) Emerging Markets US$ Source: Morgan Stanley Wealth Management Fixed Income Strategy; Bloomberg; Analytics Provided by The Yield Book Software and Services Citigroup Index LLC. All rights reserved. Data as of 7/17/2014 and is subject to change at any time. Please refer to important information, disclosures and qualifications at the end of this material. 3

4 MUNICIPAL MARKET DATA 10-Yr AAA MMD & 10-Yr UST Yield Yield (%) Yr UST 10-Yr MMD Jun-1981 Feb-1986 Nov-1990 Aug-1995 May-2000 Feb-2005 Nov-2009 Jul Yr Pre-Refunded Relative-Value Ratios % Of Corresponding USTs Pre-Re Ratios Average May-1991 Sep-1994 Jan-1998 Apr-2001 Aug-2004 Dec-2007 Apr-2011 Jul Yr Relative-Value Ratios % Of Corresponding USTs Yr Ratios Average Jan-1990 Jan-1993 Feb-1996 Mar-1999 Apr-2002 May-2005 Jun-2008 Jun-2011 Jul-2014 Municipal Yield-Curve Slope Basis Points (Bps) Slope Average Jan-1990 Jan-1993 Feb-1996 Mar-1999 Apr-2002 May-2005 Jun-2008 Jun-2011 Jul Yr A Rated Credit Spreads Basis Points (Bps) A Rated Average Jul-1993 Jan-1997 Jul-2000 Jan-2004 Jul-2007 Jan-2011 Jul Yr BBB Rated Credit Spreads BBB Rated Average Jul-1993 Jul-1996 Jul-1999 Jul-2002 Jul-2005 Jul-2008 Jul-2011 Jul-2014 Market Performance (Yield Level Changes) Current Weekly Change Since 7/11/14 Month-to-Date Since 6/30/2014 Year-to-Date Since 12/31/2013 AAA 5 Year Year Year AA 5 Year Year Year A 5 Year Year Year BBB 5 Year Year Year Source: Thomson Reuters Municipal Market Data as of 7/17/ *Please note: Yield increases represent price declines. Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. Please refer to important information, disclosures and qualifications at the end of this material. 4 Basis Points (Bps)

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6 A taxable equivalent yield is only one of many factors that should be considered when making an investment decision. Morgan Stanley Wealth Management and its Financial Advisors do not offer tax advice; investors should consult their tax advisors before making any tax-related investment decisions. Treasury Inflation Protection Securities (TIPS) coupon payments and underlying principal are automatically increased to compensate for inflation by tracking the consumer price index (CPI). While the real rate of return is guaranteed, TIPS tend to offer a low return. Because the return of TIPS is linked to inflation, TIPS may significantly underperform versus conventional U.S. Treasuries in times of low inflation. Floating-rate securities The initial interest rate on a floating-rate security may be lower than that of a fixed-rate security of the same maturity because investors expect to receive additional income due to future increases in the floating security s underlying reference rate. The reference rate could be an index or an interest rate. However, there can be no assurance that the reference rate will increase. Some floating-rate securities may be subject to call risk. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. 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. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Yields are subject to change with economic conditions. Yield is only one factor that should be considered when making an investment decision. 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, 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 2000, 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 Morgan Stanley Smith Barney LLC. Member SIPC. Please refer to important information, disclosures and qualifications at the end of this material. 6