PORTFOLIO STRATEGY & RESEARCH GROUP

FEBRUARY 13, 2014

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

A Waiting Game
Much has transpired in the municipal market since our last edition, but interestingly, what hasnt occurred, at least not yet, is more important than what has, in our view. We are speaking specifically of Puerto Ricos triple play of downgrades, all to sub-investment grade, from Standard & Poors, Moodys and Fitch. What has yet to occur, and perhaps may not, is a systemic market reaction that hinders liquidity and raises yield throughout the marketplace. A systemic market impact driven by strong outflows from mutual funds could present an opportunity to purchase high-quality bonds at attractive levels. If there is no outsized systemic impact, it would indicate that investors are increasingly differentiating between various credits in the marketplace. The municipal market has a troubled history when it comes to negative news. From the demise of the majority of bond insurersto the mayhem after a now unfulfilled call for rampant defaultsto last summers ratedriven bond rout with acute pressure for munis, there have been multiple instances where volatility has unlocked value for savvy investors.

INVESTMENT THESIS
We continue to view the bond markets recent rally as a temporary reversal rather than a sustainable trend and believe interest rates will continue to rise along with higher nominal GDP. Investors may wish to consider using the current market strength as an opportunity to shorten portfolio duration by exiting long-duration securities with low coupons. We continue to favor 4- to 9-year maturities with 5% coupons, as such structures will likely hold their value better in a rising interest rate environment.

Should headline-driven volatility occur, we would view it as Events and pressures impacting issuers such as Detroit and Puerto Rico an opportunity to add high-quality municipal securities only hasten the move to what we believe will be a healthier market where within our target-range and preferred structure. investors are increasingly rewarded for risk.
Figure 1. 10-Yr Puerto Rico GO Yield Spreads to AAA
750 700 650 600 550 500 450 400 350 300 250 200 150 10-Yr Spread (Basis Points)

Although trading patterns thus far have been encouraging, only time will truly tell whether the municipal bond market, like so many of its own securities, is finally maturing, or will it continue to act like the sky is fallingover and over again.

In this edition, we discuss: Potential impact from Puerto Rico challenges Opportunity in investment grade spreads Market review and outlook Our current strategy

1/2/13

3/1/13

4/28/13

6/25/13

8/22/13

10/19/13

12/16/13

2/12/14

Source: Municipal Strategy and TM3 as of 2/12/14 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.

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A Waiting Game
Much has transpired in the municipal market since our last edition, but interestingly, what hasnt occurred, at least not yet, is more important than what has, in our view. We are speaking specifically of Puerto Ricos triple play of downgrades, all to subinvestment grade, from Standard & Poors, Moodys and Fitch. The three largest rating agencies have finally spoken and the message was unanimous; the majority of unenhanced Puerto Rico debt is now sub-investment grade. What has yet to occur, and perhaps may not, is a systemic market reaction that hinders liquidity and raises yield throughout the marketplace for other, non-Puerto Rico debt. Regardless of whether its an adverse market reaction, or the lack thereof, both may be viewed positively by investors given the accompanying opportunities. The former would be from a shortterm perspective and the latter would apply to a longer-term horizon. A systemic market impact driven by strong outflows from mutual funds, as we discussed at some length in our last edition, would likely present an opportunity to purchase highquality bonds at attractive levels. On the other hand, if the current dynamic holds and there is no outsized systemic impact from the downgrades, we would view the development as an indication that municipal bond investors are slowly becoming more disciplined in differentiating between various credits in the marketplace. Such a positive non-impact would support the notion that credit spreads for mid-range investment grade municipals are simply too wide and should continue to tighten over time. In what can only be described as a tale of two investor reactions, prospective institutional buyers interested in gaining Puerto Rico exposure cant seem to find size offerings, while individual investors have been actively selling smaller odd-lot positions. With this in mind, the municipal market finds itself caught in a pivotal moment. In the span of just seven months, we have seen a major US city (Detroit) file for federal bankruptcy protection and one of the markets larger issuers (Puerto Rico) downgraded into sub-investment grade. There are also related challenges in the offing, with the center stage occupied by the future path for Puerto Rico. Challenges include the results of a recently announced upcoming general obligation bond offering, any potential mutual fund outflows that may be prompted by the downgrades (as there has already been considerable retail selling of small positions) and any related selling by fund managers who benchmark against the Barclays Municipal Index when that investment grade index transfers approximately $13 billion of Puerto Rico bonds to its high yield index at the end of February. On a mildly positive note, most investment grade municipal mutual funds are unlikely to be forced sellers of the now sub-investment grade Puerto Rico paper, but would likely be prohibited from buying more. Finally, the marketplace also awaits further information regarding bond recovery values in the Detroit filing (specifically, what will GO

holders recover and how will water and/or sewer bondholders fare?). These are all events that market participants will be monitoring closely in the weeks and months ahead. They are also events that may fuel price volatility. As our readers may recall, the municipal bond market has a troubled history when it comes to digesting negative news. From the demise of the majority of the formerly AAA rated bond insurersto the mayhem that ensued after a banking analysts (now unfulfilled) call for rampant defaultsto last summers ratedriven bond rout with acute pressure for munis, there have been multiple instances where volatility has unlocked value for savvy investors with a longer-term perspective. It is also important to note that todays post-financial crisis muni market has been largely stripped of the bond insurance training wheels that had helped to steady and homogenize this asset class for decades. Tax-exempts (and taxable munis) have basically been peddling on their own ever since. What needs to be reconciled, in our view, is the mismatch between individual investor demand for highly rated municipal bonds (after decades of buying triple Ainsured) and the reality that bond insurance market penetration has gone from a pre-financial crisis peak of over 50% of new issues to well under 5% today. Helpful in this reconciliation effort is the simple fact that historical default rates over the long term, remain substantially lower on a rating-by-rating basis for munis than for US corporates, according to Moodys and Standard & Poors. Since the advent of the financial crisis, we have been of the opinion that the municipal market has been transitioning toward a credit-based market akin to US corporates from a previously ratedriven market similar to USTs. Obviously, transitions of this scale are rarely smooth and take quite some time (measured in years). Although we do anticipate, and have witnessed, setbacks in the interim, the process still appears well under way. Events and pressures impacting issuers such as Detroit, Puerto Rico and a handful of others, while unwelcomed and uncomfortable, only hasten the move to what we believe will be a healthier market where investors are increasingly rewarded for risk and issuers will either be rewarded or penalized on a more idiosyncratic basis. Until we get there, mid-range investment grade municipal bond spreads remain distended. Recall that credit spread tightening stalled during mid-2013 amid rising rates, massive fund outflows, the Detroit bankruptcy filing and the beginning of anxiety-driven market pressure on Puerto Rico bonds. Meanwhile, high grade corporate bond spreads tightened by approximately 25 basis points, or 14% in 2013. As further background, A-rated municipal yield spreads (versus AAA rated) tightened to 72 basis points from 96 basis points during 2012, or by 25%, after being essentially flat for 2011 and actually rising by 10 basis points in 2010. It is important to note that substantial portions of both 2010 and 2011 were roiled by an ill2

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

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fated call for rampant defaults and bankruptcies. Spreads for Arated general obligation bonds are currently about double the longterm average, according to MMD. Taking a step back from the Puerto Rico saga to get a look at the 2014 landscape, we note that the outlook for munis this year appears more constructive than last given our expectations for lower year-over-year supply, a good portion (but not all) of the upward rates move should be behind us, the reality that many investors will be reminded by mid-April that tax rates did rise in early 2013 and that municipal income is not subject to the Medicare Surtax, and finally, the expectation that continued US economic momentum should quell the multi-year torrent of downgrades (with credit spreads responding accordingly). Total return for the asset class has been positive year to date, at +2.17% according to Barclays (though this may dwindle in coming months if rates rise as we expect), and new-issue supply is expected to experience a seasonal, yet moderate and manageable, increase in the coming months (which may drive relative-value ratios higher from current levels). Finally, mutual fund flows are capturing the markets attention yet again, as three weeks of mild inflows (which followed 33 consecutive negative weeks) ended with last weeks $227 million outflow. Given the recent and rapid string of Puerto Rico downgrades, market participants await the impact, if any, to municipal bond mutual fund flows and related trading. Although initial trading patterns thus far have been encouraging, only time will truly tell whether the municipal bond market, like so many of its own securities, is finally maturing, or will it continue to act like the sky is fallingover and over again.
Figure 2. Municipal Bond Fund Flows
3 2 1 0 -1 -2 -3 -4 -5 -6 Muni Bond Fund Flows (Billions) Muni Bond Fund Flows Become Positive

Other Developments
In other noteworthy news since our last edition, a string of weaker-than-anticipated economic data, including the January Non-farm payroll increase of 113,000, has extended the duration of the recent rally in US Treasuries (USTs), though after the immediate impact of such releases fades the drift appears to be toward higher yields. MS & Co.s Economics team believes weather played a role in both December and Januarys report cycle. According to Morgan Stanley Wealth Managements chief fixed income strategist, Kevin Flanagan, This leads us to believe that the big payback this time around versus the 2012 experience will come from the other direction, with Q2 potentially being set up for a visible rebound in economic activity. With Janet Yellen now at the helm of the FOMC, all eyes and ears were trained on her inaugural Semiannual Monetary Policy Report to Congress, which appeared to yield little in the way of new news regarding the general direction of monetary policy. That said, our base case anticipates additional $10 billion tapers at upcoming FOMC meetings and we expect the UST 10-yr to trend back toward 3% later this year. State of Illinois GO 10-year bond spreads have continued to tighten from their 173-basis-point peak on December 2, 2013 after the state passed pension reform legislation the following day, and now stand at 120 basis points, approximately 31% tighter (source: MMD). On 2/4/14, Standard & Poors downgraded Puerto Ricos GO to BB+, still on downgrade watch On 2/7/14, Moodys downgraded Puerto Ricos GO two notches, to Ba2, negative outlook On 2/11/14, Fitch downgraded Puerto Ricos GO two notches, to BB, negative outlook Moodys affirmed the ratings of both Assured Guaranty Municipal and National Public Finance Guarantee Corp. on 2/10/14, just one business day after downgrading Puerto Rico GO and related entities, but also included a caveat that Moody's analysis suggests that a default of Puerto Rico with meaningful loss severity could lead to a downgrade of both insurers.

Source: Municipal Strategy & The Bond Buyer as of 2/12/14

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

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Figure 3. 10-Yr Yield-Levels & Rel-Val Ratios

3.05 3 2.95 2.9 2.85 97 10-Yr MMD 10-Yr UST 10-Yr Rel-Val (Right Axis) 99

remain skewed until May, as issuance throughout the first four months of 2013 was significantly more robust due to the lower nominal rate environment, prior to the Feds taper discussion. Digging deeper into the data, deals issued for the sole purpose of refunding plummeted nearly 71% YOY, while new-money issuance continued to play a more prominent role and valuable offset, finishing 36% higher YOY. We continue to believe that refunding issuance will remain subdued due to the current rate environment and the fact that many issuers have already advancerefunded debt in recent years. In contrast, new-money issuance will likely continue to increase as fiscal austerity fades and municipalities fund deferred maintenance and other initiatives. Also worth noting, bond insurance penetration of the new-issue market last month was approximately 4%, a mild increase from a 3.6% market share in 2013. We will continue to monitor these developments closely, as demand for bond insurance may be rising due to negative headlines regarding select issuers such as Detroit and Puerto Rico and the perception of broader marketplace risks. However, we still suggest investors examine the underlying ratings of municipal securities before considering the value of any bond insurance wrapper. Primary market volume will likely remain tepid until March, as January and February hold the two lowest historical averages for monthly issuance, at $21.2 and $24.3 billion, respectively. As we will discuss in a moment, it remains to be seen whether the markets recent rally and subsequent decline in rates will help stimulate issuance in the coming months.
Relative-Value Ratio (% of UST Yield)

Yield (%)

2.8 2.75 2.7 2.65 2.6 2.55 2.5 2.45 11/01/13 11/14/13 11/26/13 12/09/13 12/19/13 01/02/14 01/14/14 01/27/14 02/06/14

95

93

91

89

Source: Municipal Strategy & Thomson Reuters MMD as of 2/12/14

New-Issue Supply
January finished with approximately $18 billion in total issuance among 587 primary market deals, marking a 33% year-over-year (YOY) decline vs. January 2013. As low as this metric may seem, this performance is actually not that distant from the months historical average of $21.2 billion. The January reading is still well below our 2014 expectation of an 8% to 12% decline in total newissue volume, but such direct YOY comparisons will probably
Figure 4. Monthly Supply & 10-Yr Rel Val (May 2013-Present)
Supply 32 28 24
Par-Value (Billions)

Monthly 10-Yr Rel-Val Ratio

108

104
10-Yr Relative-Value Ratio (%)

20 16 12 8 4 0

100

96

92

88

*White Columns Represent Supply AVGs Source: Municipal Strategy & Thomson Reuters MMD and The Bond Buyer as of 2/12/14

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

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Market Performance
2013 ended with the notion of economic optimism, as many investors exhibited exuberance over an improving global outlook and rapidly advancing equity markets, a feeling with which rising interest rates seemed to go hand in hand. This sentiment eventually changed, as the direction of financial markets shifted quickly after the beginning of this year. The sudden reversal had multiple catalysts, including Decembers weaker-than-anticipated Employment Situation Report, as well as broader concerns over weakness in emerging markets. The aforementioned factors ignited a risk-off trade throughout the markets, sending prices higher and yields lower for safe-haven US Treasury securities. This strength carried over to the municipal bond market, where it met the constructive seasonal technicals of minimal issuance and heavy bond redemptions. As market participants worked to place redemption monies in an environment of low new-issue supply, tax-exempts outperformed USTs. Stronger pricing also prompted municipal bond mutual fund flows to turn positive for the first time in 33 consecutive weeks which, in turn, further improved market liquidity (as funds became net buyers vs. sellers). Spread compression also resumed for A and BBB rated credit. Consequently, municipal yield levels are sharply lower since the release of our last publication. Please see the accompanying table for changes across the credit spectrum and throughout the yield curve since our last publication.
Figure 5. Market Performance Table
1/9/2014 AAA 5 Year 10 Year 20 Year 30 Year AA 5 Year 10 Year 20 Year 30 Year A 5 Year 10 Year 20 Year 30 Year BBB 5 Year 10 Year 20 Year 30 Year 2.48 4.24 5.18 5.43 2.34 4.02 4.92 5.19 -0.14 -0.22 -0.26 -0.24 1.75 3.49 4.58 4.88 1.61 3.27 4.32 4.64 -0.14 -0.22 -0.26 -0.24 1.34 2.94 4.03 4.34 1.23 2.76 3.78 4.10 -0.11 -0.18 -0.25 -0.24 1.23 2.71 3.79 4.10 1.11 2.54 3.54 3.87 -0.12 -0.17 -0.25 -0.23 2/12/2014 Change (bps) 1/9/2014-2/12/2014

As mentioned, spread compression was apparent in both A and BBB rated securities, as investors sought modest extensions on the credit curve to capture incremental yield. The difference in yield levels for A rated municipal securities vs. AAA bonds declined by 5 basis points (bps) to 73 from 78 bps; spreads on BBB bonds also compressed to 148 from 153 bps. Spreads within both credit categories continue to remain wide versus their historical averages, primarily due, in our opinion, to the currently higher volume of A and BBB rated supply following the decline of the bond insurance industry. We believe that this spread compression can continue, as net issuance (total supply less bond maturities/redemptions) remains minimal and the broader state of municipal credit quality continues to improve. Accordingly, we advocate modest extensions out on the credit curve into mid-tier A rated (or higher) general obligation bonds and mid-tier BBB (or higher) essential service revenue bonds, which include water and sewer securities.
Figure 6. Historical 10-Yr A & BBB Spreads Timeline
360 340 320 300 280 260 240 220

Basis Points

200 180 160 140 120 100 80 60 40 20 0 Nov-1997 Feb-2001 May-2004 Aug-2007 Nov-2010 Feb-2014

Source: Municipal Strategy & Thomson Reuters MMD as of 2/12/14

As noted, the aforementioned technicals helped relative-value ratios (the municipal yield as a % of corresponding US Treasuries) in the 10-year sector of the yield curve to remain in the vicinity of what we currently consider fair value. Ratios presently reside at 92% of comparable USTs. Although higher than the historical average (approximately 83% on the 10-year), we believe ratios in this area of the curve will remain elevated due to the current threats to the municipal tax exemption. While such threats will likely remain subdued as a result of this years mid-term elections, they no doubt have the potential to resurface in future years in an environment of heavily scrutinized government spending, budget deficits and federal debt. Ratios on 5-yr pre-refunded securities, however, are currently the exception to the rule, as these ratios actually reside below their long-term historical averages and appear fully valued on a relative-value basis.

Source: Municipal Strategy & Thomson Reuters MMD as of 2/12/14

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

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Figure 7. 10-Yr Rel-Val Ratio Timeline (Since Jan 2012)

122 119 116 113 10-Yr Ratios

% Of Corresponding USTs

110 107 104 101 98 95 92 89

maturities offer minimal yield pick up and remain vulnerable to rising rates. The yield curve flattens substantially between 20- and 30-year maturities, offering just 31 basis points of additional yield. Investors should also consider high (5%) coupons, as such structures will likely hold their value better in a rising interest rate environment.
Figure 9. Muni Yield Curve Slope Timeline (Since 2010)
460 440 420 400 380 360

Basis Points

86

340 320 300 280 260 240 220 200 Slope (1 Yr - 30 Yr)

Source: Municipal Strategy & Thomson Reuters MMD as of 2/12/14

Figure 8. 5-Yr Pre-Refunded Rel-Val Ratios (Since 2010)

135 125 115 Pre-Re Ratios AVG

% Of Corresponding USTs

Source: Municipal Strategy & Thomson Reuters MMD as of 2/12/14

105 95 85 75 65 55

From a broader perspective, the state of municipal bond credit quality continues to improve, though state and local governments will continue to face lingering headwinds. In Fitchs recently released 2014 U.S. Public Finance Outlooks report, the rater opined that they expect most U.S. Public Finance ratings to maintain stable outlooks in 2014 and that the strengthening U.S. recovery should support general improvements in government revenues; however, all sectors will continue to face varying degrees of fiscal, economic and regulatory uncertainties in 2014. Meanwhile, the market continues to confront potential challenges as a result of headlines emanating from select issuers such as Puerto Rico and Detroit. Though these developments are not indicative of state and local government credit quality as a whole (most issuers have successfully dealt with fiscal challenges for years), they continue to pose potentially systemic threats to the market, especially when considering that Puerto Rico debt is widely held throughout municipal bond mutual funds and that individual investors account for approximately two-thirds of the market via individual holdings and funds. Should headline-driven volatility occur, we would view it as an opportunity to add highquality municipal securities within our target range of 4-9 years on the yield curve carrying 5% coupons. JD MG

Source: Municipal Strategy & Thomson Reuters MMD as of 2/12/14

Targeting Value & Investment Strategy

The slope of the municipal bond yield curve flattened since the release of our last publication, to 370 basis points from 393 basis points. This is not particularly surprising, as US Treasuries benefited from a general risk-off trade and tax-exempts enjoyed a constructive technical backdrop, which bolstered Investment in both markets and caused yield curves to flatten. We continue to view the bond markets recent rally as a temporary reversal rather than a sustainable trend. In-line with the recommendations of our Global Investment Committee (GIC), we continue to believe that we are currently in the second stage of the current economic recovery, and that interest rates will continue to rise along with higher forecasted nominal GDP. Accordingly, investors may wish to consider using the current market strength as an opportunity to shorten portfolio duration by exiting longduration securities that carry low coupons. We continue to favor the 4- to 9-year sector of the yield curve, especially as longer

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

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Figure 10. State Ratings Table

STATE ALABAMA ALASKA ARIZONA ARKANSAS CALIFORNIA COLORADO CONNECTICUT DELAWARE DISTRICT OF COLUMBIA FLORIDA GEORGIA HAWAII IDAHO ILLINOIS INDIANA IOWA KANSAS KENTUCKY LOUISIANA MAINE MARYLAND MASSACHUSETTS MICHIGAN MINNESOTA MISSISSIPPI MISSOURI MONTANA NEBRASKA NEVADA NEW HAMPSHIRE NEW JERSEY NEW MEXICO NEW YORK NORTH CAROLINA NORTH DAKOTA OHIO OKLAHOMA OREGON MOODYS RATING Aa1 Aaa Aa3* Aa1 A1 Aa1* Aa3 Aaa Aa2 Aa1 Aaa Aa2 Aa1* A3 Aaa* Aaa* Aa1* Aa2* Aa2 Aa2 Aaa Aa1 Aa2 Aa1 Aa2 Aaa Aa1 No G.O. Rating Aa2 Aa1 Aa3 Aaa Aa2 Aaa Aa1* Aa1 Aa2 Aa1 MOODYS OUTLOOK Stable Stable Positive Stable Stable Stable Stable Stable Stable Stable Stable Stable Stable Negative Stable Stable Negative Negative Stable Negative Stable Stable Positive Stable Stable Stable Stable Stable Stable Stable Negative Stable Positive Stable Stable Stable Stable Stable S&P RATING AA AAA AA-** AA A AA** AA AAA AAAAA AAA AA AA+** AAAA** AAA** AA+** AA-** AA AA AAA AA+ AAAA+ AA AAA AA AAA** AA AA AAAA+ AA AAA AAA** AA+ AA+ AA+ S&P OUTLOOK Stable Stable Stable Stable Positive Stable Stable Stable Stable Stable Stable Positive Stable Developing Stable Stable Stable Negative Stable Stable Stable Stable Positive Stable Stable Stable Stable Stable Stable Stable Negative Stable Positive Stable Stable Stable Stable Stable

(continued on next page)

Please refer to important information, disclosures and qualifications at the end of this material. 7

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STATE PENNSYLVANIA RHODE ISLAND SOUTH CAROLINA SOUTH DAKOTA TENNESSEE TEXAS UTAH VERMONT VIRGINIA WASHINGTON WEST VIRGINIA WISCONSIN WYOMING PUERTO RICO

MOODYS RATING Aa2 Aa2 Aaa No G.O. Rating Aaa Aaa Aaa Aaa Aaa Aa1 Aa1 Aa2 No G.O. Rating Ba2

MOODYS OUTLOOK Stable Negative Stable Stable Stable Stable Stable Stable Stable Stable Stable Stable No Outlook Negative

S&P RATING AA AA AA+ AA+** AA+ AAA** AAA AA+ AAA AA+ AA AA AAA** BB+

S&P OUTLOOK Negative Stable Stable Stable Stable Stable Stable Positive Stable Stable Stable Stable Stable Downgrade Watch

*Issuer Rating **ICR -- Issuer Credit Rating

Data Source: Moodys, S&P & Bloomberg as of 2/12/2013 *Credit rating changes and outlooks are dynamic and frequently change. Investors should reaffirm ratings & outlooks with rating agencies directly prior to make any investment decision.

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

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Figure 11. 5-Year Munis as a Percentage of 5-Year Treasuries, January 1996-February 2014
240 220 200 5-Year Relative Value Ratio Average

% of Corresponding USTs

180 160 140 120 100 80 60 40 20 0 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Feb-10 Feb-12 Feb-14

Source: Thomson Reuters Municipal Market Data as of 2/12/14

Figure 12. 10-Year Munis as a Percentage of 10-Year Treasuries, January 1996-February 2014
200 180 160 10-Year Relative Value Ratio Average

% of Corresponding USTs

140 120 100 80 60 40 20 0 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Feb-10 Feb-12 Feb-14

Source: Thomson Reuters Municipal Market Data as of 2/12/14

Figure 13. 30-Year Munis as a Percentage of 30-Year Treasuries, January 1996-February 2014
240 220 200 30-Year Relative Value Ratio Average

% of Corresponding USTs

180 160 140 120 100 80 60 40 20 0 Jan-96 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 Feb-10 Feb-12 Feb-14

Source: Thomson Reuters Municipal Market Data as of 2/12/14 Please refer to important information, disclosures and qualifications at the end of this material. 9

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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 & Poors, offer their assessment of an issuers 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.

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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. Any such offer would be made only after a prospective investor had completed its own independent investigation of the securities, instruments or transactions, and received all information it required to make its own investment decision, including, where applicable, a review of any offering circular or memorandum describing such security or instrument. That information would contain material information not contained herein and to which prospective participants are referred. This material is based on public information as of the specified date, and may be stale thereafter. We have no obligation to tell you when information herein may change. We make no representation or warranty with respect to the accuracy or completeness of this material. Morgan Stanley Wealth Management has no obligation to provide updated information on the securities/instruments mentioned herein. The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investors individual circumstances and objectives. Morgan Stanley Wealth Management recommends that investors independently evaluate specific investments and strategies, and encourages investors to seek the advice of a financial advisor. The value of and income from investments may vary because of changes in interest rates, foreign exchange rates, default rates, prepayment rates, securities/instruments prices, market indexes, operational or financial conditions of companies and other issuers or other factors. Estimates of future performance are based on assumptions that may not be realized. Actual events may differ from those assumed and changes to any assumptions may have a material impact on any projections or estimates. Other events not taken into account may occur and may significantly affect the projections or estimates. Certain assumptions may have been made for modeling purposes only to simplify the presentation and/or calculation of any projections or estimates, and Morgan Stanley Wealth Management does not represent that any such assumptions will reflect actual future events. Accordingly, there can be no assurance that estimated returns or projections will be realized or that actual returns or performance results will not materially differ from those estimated herein. This material should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. This information is not intended to, and should not, form a primary basis for any investment decisions that you may make. Morgan Stanley Wealth Management is not acting as a fiduciary under either the Employee Retirement Income Security Act of 1974, as amended or under section 4975 of the Internal Revenue Code of 1986 as amended in providing this material. 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.

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FIXED INCOME STRATEGY

FEBRUARY 13, 2014

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. 19 009 145 555, holder of Australian financial services license No. 240813). Morgan Stanley Wealth Management is not incorporated under the People's Republic of China ("PRC") law and the research in relation to this report is conducted outside the PRC. This report will be distributed only upon request of a specific recipient. This report does not constitute an offer to sell or the solicitation of an offer to buy any securities in the PRC. PRC investors must have the relevant qualifications to invest in such securities and must be responsible for obtaining all relevant approvals, licenses, verifications and or registrations from PRC's relevant governmental authorities. Morgan Stanley Private Wealth Management Ltd, which is authorized and regulated by the Financial Services Authority, approves for the purpose of section 21 of the Financial Services and Markets Act 2000, content for distribution in the United Kingdom. Morgan Stanley Wealth Management is not acting as a municipal advisor and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of Section 975 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. This material is disseminated in the United States of America by Morgan Stanley Smith Barney LLC. Third-party data providers make no warranties or representations of any kind relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages of any kind relating to such data. Morgan Stanley Wealth Management research, or any portion thereof, may not be reprinted, sold or redistributed without the written consent of Morgan Stanley Smith Barney LLC. 2014 Morgan Stanley Smith Barney LLC. Member SIPC.

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

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