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PORTFOLIO STRATEGY & RESEARCH GROUP

FEBRU ARY 5, 20 13

Basis Points
Fixed Income Strategy

Not in it for the Duration


In the Conservative, Moderate and Aggressive Portfolios, we are tactically reducing our weightings to Investment Grade (IG) Corporates and reallocating to government/agency MBS. Within the Tax-Advantaged Model Portfolio, we are reducing our allocation to Municipals and raising our weighting to UST. The fiscal cliff deal and temporary suspension of the debt ceiling has turned the focus in the Beltway to the dual March deadlines for the delayed sequestered spending cuts and the continuing resolution (CR). After starting the new year with upside surprises to economic data, more recent reports have revealed a softer performance. The MS tracking estimate for 1Q 2013 real GDP stands at +1.6%, or essentially the same pace as the prior six-month period. The UST 10-yr sell-off to begin 2013 is centered around some layers of uncertainty being removed from the investment backdrop, as fundamentals have taken more of a back seat. We are raising our trading range to 1.50%2.25%, but nearer term, buyers continue to re-enter the longer end of the UST market when the 10-yr yield moves toward the 2.00%2.05% threshold. For fixed income investors who are overweight in longer-term maturities, we recommend lessening duration in their portfolios. Our preferred strategic target maturities are as follows: o o o o US Treasuries: 3-yr to 5-yr Investment Grade Corps: 3-yr to 7-yr High Yield: 2-yr to 5-yr Tax-exempts: 5-yr to 11-yr

KEVIN FLANAGAN
MSSB North America - Morgan Stanley Smith Barney LLC Chief Fixed Income Strategist Managing Director Kevin.Flanagan@mssb.com

JON MACKAY
MSSB North America - Morgan Stanley Smith Barney LLC Senior Fixed Income Strategist Executive Director Jonathan.Mackay@mssb.com

The statistics listed below are as of February 5, 2013: Fed Funds Target Rate Year-Over-Year Change in CPI GDP (4 Qtr 2012) DXY Index Unemployment Rate
th

zero to 0.25% 1.7% (-0.1%) 79.72 7.9%

Source: Morgan Stanley Smith Barney Fixed Income Strategy, Bureau of Labor Statistics, Bureau of Economic Analysis

Upcoming Federal Open Market Committee Meetings: March 19 and 20 April 30 and May 1

Source: Federal Reserve Board Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

Taxable Fixed Income: Credit spreads continued to narrow in January, but we feel the High Yield (HY) market could be vulnerable at current valuations. Municipals: The municipal market cleared one hurdle as the fiscal cliff deal did not include any changes in the tax-exemption status of these securities, but upcoming federal budget battles could be a platform for renewed negative headlines.
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. This is not a research report and was not prepared by the Research departments of Morgan Stanley Smith Barney LLC, Morgan Stanley & Co. LLC, or Citigroup Global Markets Inc. It was prepared by Morgan Stanley Smith Barney sales, trading or other non-research personnel. Past performance is not necessarily a guide to future performance. Please refer to important information, disclosures, and qualifications at the end of this material.

FIXED INCOME STRATEGY / FEBRUARY 5, 2013

Fixed Income Asset Allocation


In the Conservative, Moderate and Aggressive Portfolios, we are tactically reducing our weightings to Investment Grade (IG) Corporates by 5% and reallocating the entire amount to government/agency MBS. This decision was purely from a pre-emptive and tactical vantage point. We still carry IG corps as our priority overweight in all three models, and also continue to like the risk/reward dynamics of IG over HY within the credit space. In the near-term investment horizon, we see the potential for a slightly more challenging backdrop for the IG market as upcoming political risk (sequestration and CR battles) could provide the platform for a risk-off setting in the markets. In addition, the fundamental outlook remains a cloudy one as MS economists continue to forecast only a modest growth track at best, with recent data on GDP and employment falling below expectations. If this near-term scenario plays out, we feel the government/agency MBS market could outperform on a relative basis. In addition, the January FOMC meeting reiterated the Feds current QE measure, which consists of both MBS and UST purchases. According to MS Agency MBS strategy, continued QE is expected to have the desired effect of spread tightening with Fed purchases as a percentage of gross issuance to rise. Within the Tax-Advantaged Model Portfolio, we are reducing our allocation to Municipals by 5% and raising our weighting to UST by a like amount. Once again, this decision falls under the pre-emptive/tactical banner as the aforementioned political debates could provide the platform for renewed negative headlines regarding the federal tax-exempt status of municipal securities. Here are the new weightings in our four models, which are impacted by our reallocations:

Recommended Fixed Income Model Portfolios


Conservative Fixed Income Portfolio
1 5% 20 % 10 % 5% 20 %

30 %

20 % Mo rtg a g e-Ba cked S ecurities 1 0 % Fed eral Ag encies 1 5% Ca s h & Eq uivalents

30 % Inves tm ent G rad e Co rp o ra tes 20 % U .S . Treas uries 5% TIP S

Moderate Fixed Income Portfolio


5% 5% 5% 5% 15% 20 %

10 %

35%

20 % Mo rtg ag e-Backed S ecurities 10 % Fed eral Ag encies 5% N o n-U SD 5% H ig h Yield S ecurities

35% Inves tment Grad e Co rp o rates 5% Preferred S ecurities 5% TIPS 15% Cas h & Eq uivalents

Aggressive Fixed Income Portfolio


10 % 5% 5% 5% 10 % 20 %

45%

Conservative Model: IG Corps 30%; government/agency MBS 20%. Moderate Model: IG Corps 35%; government/agency MBS 20%. Aggressive Model: IG Corps 45%; government/agency MBS 20%. Tax Advantaged Model: Municipals 80%; UST 10%. Our Municipal strategists continue to advocate high credit quality, including mid-tier A or higher general obligation paper and mid-level BBB or higher-rated essentialservice revenue bonds (such as water and sewer).

20 % Mo rtg ag e-Backed S ecurities 5% H ig h Yield S ecurities 5% N o n-U S D 10 % Fed eral Ag encies

45% Inves tment G rad e Co rp o rates 5% Preferred S ecurities 10 % Emerg ing Markets

Tax-Advantaged Fixed Income Portfolio


10% 10% 80%

80% Municipal Securities

10% Federal Ag encies

10% U.S. Treasuries

Source: Morgan Stanley Smith Barney Fixed Income Strategy Please refer to important information, disclosures and qualifications at the end of this material.

FIXED INCOME STRATEGY / FEBRUARY 5, 2013

Investment Backdrop

UST Market: Not in it for the Duration


The recurring question we always seem to receive is when is The Great Bear Market in Bonds coming. In our opinion, calendar year 2013 will not be that timeframe. It is important to keep in mind that all rates are not created equal. To be sure, trends for shorter-dated maturities as compared to the intermediate and longer end of the curve do not have to move in tandem. This is the scenario we continue to see playing out. Specifically, short-term rates should remain anchored to a fed funds policy approach that foresees no increases while the unemployment rate remains above 6% and expectations for inflation stay no more than a half percentage point above the Committees 2 percent longer-run goal. In broader terms, we continue to expect interest rates to stay historically low, but we also see a landscape of ongoing volatility where intermediate and longer-dated rates can move higher, at times. Indeed, weve been down this road before even when the Fed is actively purchasing Treasuries as is currently the case with their QE3+/QE4 program. Since reaching a recent low of 1.70% right before year end, the UST 10-yr yield moved up above 2% following the jobs report earlier this month. This sell-off to begin 2013 has been centered around some layers of uncertainty being removed from the investment backdrop (the full effects of the fiscal cliff were avoided, the debt ceiling debate was postponed), as fundamentals have taken more of a back seat. Let us not forget developments across the Atlantic either. To be sure, there seems to be a complacency that has set in, as the ECBs various policy responses to the Euro Zone crisis have created an environment where it is believed tail risks have been reduced. The recent announcement whereby European banks first repayment of LTROs was much larger than expected added to this reduced demand for a safe-haven asset like Treasuries. Along these lines, Euro Zone rates in both the core and periphery countries have remained subdued. However, weve been down this road before, and one should not let his or her guard down too much, a point underscored by recent headlines of potentially renewed political turmoil in periphery countries. If the UST market were to go back to focusing just on the fundamentals, what could the 10-yr yield look like? According to our analysis, we would first go back to August 1, 2011 right before the first debt ceiling debacle, attendant US downgrade and the Euro Zone implosion. At that time, the 10-yr stood at 2.75%. In order to understand what ones portfolio could potentially look like in such a reset, we did a one-year horizon or interest rate shock analysis utilizing the yield levels that

existed on the aforementioned date for the UST coupon curve. As one can see in Figure 1, the 2-yr to 5-yr sectors post modest positive returns while at the other end of the spectrum, the 30-yr would post a negative figure of nearly 12%. Against this backdrop, we feel a prudent strategy is for investors to revisit their fixed income portfolios, and for those who are overweight longer-term maturities, we recommend lessening duration, and keeping to our preferred target maturity ranges. Figure 1. US Treasury One-Year Hypothetical Horizon Analysis
6.0 4.0 2.0 0.0 Percent -2.0 -4.0 -6.0 -8.0 -10.0 -12.0 Start Yields End Yields Total Returns

2Y 3Y

5Y

7Y

10Y

30Y

Source: Bloomberg. Data as of 2/4/13. Hypothetical performance should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets.

So, where is the 10-yr yield going? In the near term, we continue to see buyers re-entering the longer end of the UST market when the 10-yr yield moves toward the 2.00%2.05% threshold. For the record, the MSSB Technical Analysis Group has the first level of support at 2.06%, followed by 2.28%. However, from a more broader time horizon, we see an escalation in the 10-yr trading range playing out in the months ahead, and we are raising our target band to 1.50% 2.25%. Underscoring our volatility theme, the 10-yr yield traded between these two extremes in 2012: 1.39% and 2.38%.

Econ & The Fed


After starting the new year with upside surprises to economic data, more recent reports have revealed a softer performance. The MS tracking estimate for 1Q 2013 real GDP stands at +1.6%, or essentially the same pace as the prior six-month period. According to MS economists, if the sequestration slated for March 1 goes into full effect and is not reversed in the CR discussion in any way, the total fiscal drag as a percentage of GDP for 2013 would be 1.7%. Going back to

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

FIXED INCOME STRATEGY / FEBRUARY 5, 2013

1960, there have only been two other fiscal years that show more tightening: 1969 and 1987. In our opinion, the January FOMC meeting was uneventful, as the policymakers decided to lay low to begin the new year. The January jobs report did not improve substantially, and as such, does not pass the Feds criteria for reconsidering the size and pace of the current QE program.

Municipal Outlook
Early on in 2013, the municipal market has visibly outperformed the UST arena. With the fiscal cliff deal not including any changes of the federal tax-exempt status of municipal markets, participants were able to shift their focus to the higher tax regimen that was put in place for upper income wage earners. While 10-yr UST yields were rising in excess of 30bp as of early February, the AAA state GO-like maturity witnessed a far less visible move of only 10bp, according to Municipal Market Data. As a result, the percentage to Treasuries ratio dropped from as high as 101.2% on December 28 to 90.1% as of this writing. It is interesting to note that, other than a quick bout in November, one would have to go back to January of last year to see ratios this low. It should also be noted that the lions share of the outperformance versus Treasuries was more of an early to mid-January phenomenon. Indeed, the MSSB Municipal Strategy team noted that recent municipal price movements matched their 2013 outlook that 10-year muni yields would mirror UST yield changes. In the near term, the landscape could become less friendly if the looming political budget battles in Washington, D.C. bring about renewed negative headlines regarding the federal tax exemption.

first time since September 2012 (see Figure 2). Third, Europe is back in focus as Spanish 10-year bond yields have moved up more than 50bp since they hit a one-year low on January 11, 2013 at 4.87%. The cause of the sell-off is political as Prime Minister Mariano Rajoy bas been accused of taking bribes and the opposition political party is pressuring him to hold new elections, raising the specter of political turmoil in one of the economically weakest countries in the Euro Zone. Italy is also in the headlines with an election in three weeks and a banking scandal undoing some of the goodwill Prime Minister Mario Monti has built up over the past year. Other peripheral country sovereign bond yields are also on the rise in sympathy with Italy and Spain and concerns that a stronger euro will hinder a return to growth. Figure 2. US Economic Data Is Struggling to Surprise to the Upside
200 150 100 Standard Deviations 50 0 -50 -100 -150 -200
8 Ju n08 -11 Au g11 ec -1 0 -10 8 Jan -1 2 09 M ay -12 Ju l-0 9 0 No v09 Se p12 Jan -0 ct -0 ar -1 Fe bFe bAp r Ju l 13

Citi Economic Surprise Index (US)

Source: Bloomberg. Data as of 2/4/13.

Fixed Income Sector Commentary


Credit Rough Seas Ahead
The risk-on trade since the beginning of the year, based largely on optimism over the fiscal cliff deal, stronger economic growth and little to no noise out of Europe, seems to have run into a sobering dose of reality. First, the resolution of the fiscal cliff simply created three additional cliffs in the form of sequestration, the continuing resolution and the debt ceiling, all of which need to be resolved in the next couple of months. Second, while economic growth has generally been stronger and data has been meeting or beating expectations, this strong run of data has pushed consensus expectations higher, setting the market up for disappointment. The Citi Economic Surprise Index, which measures whether or not data is coming in above or below consensus expectations, recently dropped below zero for the

Valuation is also troubling, more so in High Yield than Investment Grade, as low Treasury yields and tighter spreads offer little in the way of cushion if the markets do sell off. Investment Grade spreads have tightened roughly 5bp year to date to 134bp, just shy of the two-year low of 128bp. However, the spread tightening has been completely offset by a greater rise in risk-free rates. If investors were spooked by any or all of the risks we mentioned above, we would expect the opposite to happen. Risk-free rates would rally while Investment Grade spreads would likely widen, potentially offsetting each other. The net result for Investment Grade investors would likely be neutral. The bigger concern from our point of view is High Yield. The current price of the Citi High Yield Market Index is 105.44, slightly below the recent all-time high of 106.3 and significantly above the average call price of the index, which is 103.7. The current yield on the index is 5.8%, just above the all-time low of 5.6% while the spread on the index has been
4

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

FIXED INCOME STRATEGY / FEBRUARY 5, 2013

sitting below 500bp since the middle of January. Many investors view High Yield as the total return component of their Fixed Income portfolio as it can offer a combination of relatively high coupon income and the potential for price appreciation. However, at current valuations we believe High Yield no longer exhibits an attractive risk/reward profile and offers little in the way of price appreciation. We believe investors are risking dollars of downside while gathering pennies. We believe the negative catalysts we discussed above will outweigh the positive tailwinds the credit markets have enjoyed recently, and therefore, a tactical approach is warranted. We continue to favor Investment Grade over High Yield within the credit space. Yet we also believe a slight reduction to our Investment Grade weightings within our Basis Points asset allocation models is warranted as government/agency MBS is likely to modestly outperform Investment Grade credit in the short term, in our view. Currently, we believe investors should either improve the quality of their High Yield holdings or reduce exposure to High Yield outright and redeploy the proceeds into the Investment Grade market. Within High Yield, we continue to recommend BB rated credits over CCC rated issues. In our opinion, CCCs are trading well through fair value from a fundamental perspective and appear rich relative to BBs. The spread difference between BBs and CCCs is below the longterm average and is approaching levels we last saw in the fall of 2011 when CCCs underperformed BBs by a significant margin. Over the coming months we see Investment Grade credit outperforming High Yield but believe positioning within Investment Grade is where investors will generate the greatest amount of alpha. We see value moving down the ratings curve to BBBs, which trade cheap to As, in our opinion. We would expect that spread differential to compress further as investors move further down the risk spectrum within Investment Grade looking for yield. From a sector perspective, we continue to like Financials over Industrials. Although the spread differential has tightened significantly over the past year, we expect further tightening due to continued credit improvement in the Financials space. We continue to like the belly of the Investment Grade curve. We see value in maturities between 3-7 years, especially at the longer end of that range.

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

FIXED INCOME STRATEGY / FEBRUARY 5, 2013

Fixed Income Snapshots: Treasuries and Municipals


U.S. Treasury Yield Curve (2s/5s: 2s/10s)
350 300 250 Basis points 200 150 100 50 0 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug -10 Jan-11 Jun-11 Nov-11 Apr-12 Sep-12 Feb-13 5-Year vs. 2-year 10-Year vs. 2-Year

Source: Morgan Stanley Smith Barney Fixed Income Strategy, Bloomberg. Data as of 2/1/2013. Differential in yields between U.S. Treasury 10-year maturity and U.S. Treasury 2-year maturity, and differential in yields between U.S. Treasury 5-year maturity and U.S. Treasury 2-year maturity.

10-Yr Municipal Yield to Treasury Ratio


200 180 Percent (%) 160 140 120 100 80 60 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug -10 Jan-11 Jun-11 Nov-11 Ap r-12 Sep-12 Feb-13

Source: Municipal Market Data (MMD), Bloomberg. Data as of 2/1/2013. The 10-yr AAA municipal bond yield as a percentage of the benchmark 10-yr U.S. Treasury note yield. The 10-yr AAA municipal index, which is derived from MMDs daily generic yield curves, represents the average yield of non-insured AAA-rated State G.O. bonds and reflects the offer-side of the market determined from trading activity and markets. The benchmark 10-yr U.S. Treasury yield is the yield of the most recently auctioned 10-yr Treasury note reported on a daily basis (as of the prior days close).

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

FIXED INCOME STRATEGY / FEBRUARY 5, 2013

Fixed Income Snapshots: Agencies and Mortgage-Backed Securities


5-Year Federal Agencies Spread to Treasuries
200 160 Basis points 120 80 40 0 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug -10 Jan-11 Jun-11 Nov-11 Ap r-12 Sep-12 Feb-13

Source: Morgan Stanley Smith Barney Fixed Income Strategy, Bloomberg. Data as of 2/1/2013. Fair Market Value U.S. Government Federal Agency spreads to Fair Market Value U.S. Treasuries for 5-yr maturities. Federal Agency and Treasury indices shown are derived from Bloombergs Option Free Fair Market Yield Curves, which provide the composite yield of all outstanding securities around each maturity point. For example, the Federal Agency 5-yr includes all outstanding Federal Agency securities maturing in 2018.

30-Yr Fannie Mae MBS Current Coupon Spread to 10-Yr Treasuries


300 250 200 Basis points 150 100 50 0 -50 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug -10 Jan-11 Jun-11 Nov-11 Apr-12 Sep-12 Feb-13

Source: Morgan Stanley Smith Barney Fixed Income Strategy, Bloomberg. Data as of 2/1/2013. Fair Market Value 30-yr FNMA MBS Current Coupon spread to Fair Market Value 10-yr Treasuries. Due to risks of MBS structure (e.g., prepayments and extension risk), the 10-yr Treasury is used as the benchmark for the 30-yr FNMA maturity. The MBS and Treasury indices shown are derived from Bloombergs Option Free Fair Market Yield Curves. The 30-yr FNMA MBS index represents the composite yield of all outstanding FNMA MBS current coupon securities maturing in 2043, while the 10-yr Treasury index represents the composite yield of all outstanding Treasury notes maturing in 2023.

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

FIXED INCOME STRATEGY / FEBRUARY 5, 2013

Fixed Income Snapshots: Investment Grade and High Yield Corporates


Investment Grade Corporate Index to Treasuries
700 600 Option Adjusted Spread 500 400 300 200 100 0 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug -10 Jan-11 Jun-11 Nov-11 Ap r-12 Sep-12 Feb-13

Source: Analytics Provided by The Yield Book Software and Services. 2013 Citigroup Index LLC. All rights reserved. Data as of 2/4/13. The Citi US BIG Corporate Index is designed to track the performance of US dollar-denominated US and non-US corporate bonds. It excludes US government guaranteed and non-US sovereign and provincial securities. Bonds must have a fixed coupon, a minimum of one year to maturity and be rated a minimum of BBB-/Baa3 by both S&P and Moody's.

High Yield Corporate Index to Treasuries


2000 1750 1500 Spread to Worst 1250 1000 750 500 250 0 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug -10 Jan-11 Jun-11 Nov-11 Apr-12 Sep-12 Feb-13

Source: Analytics Provided by The Yield Book Software and Services. 2013 Citigroup Index LLC. All rights reserved. Data as of 2/4/13. The Citi High Yield Market Index is designed to capture the performance of below investment grade debt issued by corporates domiciled in the United States or Canada. Bonds must have a fixed coupon, a minimum of one year to maturity and be rated a maximum of BB+/Ba1 by both S&P and Moody's.

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

FIXED INCOME STRATEGY / FEBRUARY 5, 2013

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 Smith Barney is involved in many businesses that may relate to companies, securities or instruments mentioned in this material. This material has been prepared for informational purposes only and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. 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Morgan Stanley Smith Barney 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. 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. 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 Smith Barney to measure performance are representative of broad asset classes. Morgan Stanley Smith Barney retains the right to change representative indices at any time. Investing in foreign emerging markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. The majority of $25 and $1000 par preferred securities are callable meaning that the issuer may retire the securities at specific prices and dates prior to maturity. Interest/dividend payments on certain preferred issues may be deferred by the issuer for periods of up to 5 to 10 years, depending on the particular issue. The investor would still have income tax liability even though payments would not have been received. Price quoted is per $25 or $1,000 share, unless otherwise specified. Current yield is calculated by multiplying the coupon by par value divided by the market price. The initial rate on a floating rate or index-linked preferred 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/linked index. However, there can be no assurance that these increases will occur. Please refer to important information, disclosures and qualifications at the end of this material. 9

FIXED INCOME STRATEGY / FEBRUARY 5, 2013

Some $25 or $1000 par preferred securities are QDI (Qualified Dividend Income) eligible. Information on QDI eligibility is obtained from third party sources. The dividend income on QDI eligible preferreds qualifies for a reduced tax rate. Many traditional dividend paying perpetual preferred securities (traditional preferreds with no maturity date) are QDI eligible. In order to qualify for the preferential tax treatment all qualifying preferred securities must be held by investors for a minimum period 91 days during a 180 day window period, beginning 90 days before the ex-dividend date. CDs are insured by the FDIC, an independent agency of the U.S. Government, up to a maximum amount of $250,000 (including principal and interest) for all deposits held in the same insurable capacity (e.g. individual account, joint account) per CD depository, through December 31, 2013. On January 1, 2014, the maximum insurable amount will return to $100,000 (including principal and interest) for all insurable capacities except IRAs and certain self-directed retirement accounts, which will remain at $250,000 per depository. Investors are responsible for monitoring the total amount held with each CD depository. All deposits at a single depository held in the same insurable capacity will be aggregated for purposes of the applicable FDIC insurance limit, including deposits (such as bank accounts) maintained directly with the depository and CDs of the depository held through Morgan Stanley Smith Barney. A secondary market in CDs may be limited. CDs sold prior to maturity are subject to market risk and therefore investors may receive more or less than the amount invested or the face value. Callable CDs are callable at the sole discretion of the issuer. For more information about FDIC insurance, please visit the FDIC website at www.fdic.gov. Contingent return (e.g. index-linked) CDs are treated as having original issue discount (OID) for tax purposes. Although interest is not received until maturity, the CD is assumed to pay a pre-determined interest rate that will be treated as current income for tax purposes if held in a taxable account. Investors should be made aware that contingent return CDs generally feature an averaging method of return calculation, which averages the changes in value of the relevant index as measured on predetermined dates over the life of the CD. Therefore, the CDs return will not mirror the actual index value or return. If the measured index return using the averaging method is zero or negative, the investor receives no interest. Some contingent return CDs also have a participation rate (the degree to which an investor participates in the measured return of the index) that is less than 100%. Interest on contingent return CDs is not eligible for FDIC insurance before the final valuation date. Principal is returned on a monthly basis over the life of a mortgage-backed security. Principal prepayment can significantly affect the monthly income stream and the maturity of any type of MBS, including standard MBS, CMOs and Lottery Bonds. Yields and average lives are estimated based on prepayment assumptions and are subject to change based on actual prepayment of the mortgages in the underlying pools. The level of predictability of an MBS/CMOs average life, and its market price, depends on the type of MBS/CMO class purchased and interest rate movements. In general, as interest rates fall, prepayment speeds are likely to increase, thus shortening the MBS/CMOs average life and likely causing its market price to rise. Conversely, as interest rates rise, prepayment speeds are likely to decrease, thus lengthening average life and likely causing the MBS/CMOs market price to fall. Some MBS/CMOs may have original issue discount (OID). OID occurs if the MBS/CMOs original issue price is below its stated redemption price at maturity, and results in imputed interest that must be reported annually for tax purposes, resulting in a tax liability even though interest was not received. Investors are urged to consult their tax advisors for more information. Interest income from taxable zero coupon bonds is subject to annual taxation as ordinary income even though no interest payments will be received by the investor if held in a taxable account. Zero coupon bonds may also experience greater price volatility than interest bearing fixed income securities because of their comparatively longer duration. Investing in foreign markets entails greater risks than those normally associated with domestic markets, such as political, currency, economic and market risks. Hypothetical Performance General: Hypothetical performance should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. Asset allocation and diversification do not assure a profit or protect against loss in declining financial markets. Hypothetical performance results have inherent limitations. The performance shown here is simulated performance based on benchmark indices, not investment results from an actual portfolio or actual trading. There can be large differences between hypothetical and actual performance results achieved by a particular asset allocation. Despite the limitations of hypothetical performance, these hypothetical performance results may allow clients and Financial Advisors to obtain a sense of the risk / return trade-off of different asset allocation constructs. Indices used to calculate performance: The hypothetical performance results in this report are calculated using the returns of benchmark indices for the asset classes, and not the returns of securities, fund or other investment products. Indices are unmanaged. They do not reflect any management, custody, transaction or other expenses, and generally assume reinvestment of dividends, accrued income and capital gains. Past performance of indices does not guarantee future results. Investors cannot invest directly in an index. Performance of indices may be more or less volatile than any investment product. The risk of loss in value of a specific investment is not the same as the risk of loss in a broad market index. Therefore, the historical returns of an index will not be the same as the historical returns of a particular investment a client selects. Investing in the market entails the risk of market volatility. The value of all types of securities may increase or decrease over varying time periods. This Analysis does not purport to recommend or implement an investment strategy. Financial forecasts, rates of return, risk, inflation, and other assumptions may be used as the basis for illustrations in this Analysis. They should not be considered a guarantee of future performance or a guarantee of achieving overall financial objectives. No Analysis has the ability to accurately predict the future, eliminate risk or guarantee investment results. As investment returns, inflation, taxes, and other economic conditions vary from the assumptions used in this Analysis, your actual results will vary (perhaps significantly) from those presented in this Analysis. The assumed return rates in this Analysis are not reflective of any specific investment and do not include any fees or expenses that may be incurred by investing in specific products. The actual returns of a specific investment may be more or less than the returns used in this Analysis. The return assumptions are based on hypothetical rates of return of securities indices, which serve as proxies for the asset classes. Moreover, different forecasts may choose different indices as a proxy for the same asset class, thus influencing the return of the asset class. Because of their narrow focus, sector investments tend to be more volatile than investments that diversify across many sectors and companies. Credit ratings are subject to change.

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

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FIXED INCOME STRATEGY / FEBRUARY 5, 2013

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

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