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Municipal Bond Monthly Fixed Income Strategy

April 8, 2011

Portfolio Strategy & Research Group

MSSB North America - Morgan Stanley Smith Barney LLC

How Much is Too Much?

John M Dillon Chief Municipal Bond Strategist Executive Director John.Dillon2@mssb.com

Synopsis: Investment Thesis Although there are many challenges facing the municipal market as of late, the most popular topic for market participants in 2011 has been new issue supply (or the acute lack thereof). With this in mind, we begin yet another month’s edition without the benefit of much visibility on this front. Just as weekly new issue calendars were exhibiting evidence of growth with manageable price concessions, the primary market hit resistance in mid-March. Despite the following week’s calendar being minimal, losses continued. This troubling combination brought us back to where we began the year; not many bonds, fear of even “normal” sized supply and benchmark yields that rival holiday levels.

Our core strategy of purchasing mid-tier “A” rated general obligation and essential service revenue bonds with maturities between 6 and 14 years remains in place at this time. Although market timing is not our primary focus, we do suggest looking toward the new issue market if the calendar rises sharply on the road to a more normal issuance climate. Accordingly, periods of minimal supply may signal better value in the secondary market.

Given the dynamics now present in today’s municipal market, including higher rates, a stronger economy, organic budget balancing initiatives, lower supply, negligible defaults/bankruptcies and stronger seasonal factors in the coming months, it is possible that investors may be asking themselves by late summer why they didn’t capture the value readily apparent today.

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. Incorporated, 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.


April 8, 2011 Fixed Income Strategy

How Much is Too Much? Although there are many challenges facing the municipal market as of late, the most popular topic for market participants in 2011 has been new issue supply (or the acute lack thereof). With this in mind, we begin yet another month’s edition without the benefit of much visibility on this front. Just as weekly new issue calendars were exhibiting evidence of growth with manageable price concessions, the primary market hit resistance in mid-March. Despite the following week’s calendar being minimal, losses continued. This troubling combination brought us back to where we began the year; not many bonds, fear of even “normal” sized supply and benchmark yields that rival holiday levels. From mid-January to just beyond mid-March, the market had been recovering from what appears to have been an oversold position due to future supply concerns that have, to date, gone unfulfilled. Nonetheless, the largest new issue calendar of the year thus far (approximately $4 billion during the week of 3.21.11) sparked mild, but continuing, price erosion for the following two weeks (as of 4.07.11). With weekly mutual bond fund flows still consistently negative, but recently more manageable in scale, the most popular question on two fronts has simply become “How Much?” How much will bond supplies rise in the coming weeks or months and how much further do yields need to adjust from current levels for such prospective supply to clear the market? Using top quality 8- to 10-year maturity yields as a benchmark according to MMD, we have already experienced 30 to 35 basis points of the potential adjustment since mid-March. Using the 10-year “AAA” benchmark specifically, yields are now slightly (approximately 5 basis points) above the opening levels of 2011. Given the dynamics now present in today’s municipal market, including higher rates, a stronger economy, organic budget balancing initiatives, lower supply, negligible defaults/bankruptcies and stronger seasonal factors in the coming months, it is possible that investors may be asking themselves by late summer why they didn’t capture the value readily apparent today.

Supply, Supply, Supply Supply forecasts throughout the street are being sharply lowered to reflect the sparse primary market of 1Q11. We have recently seen forecasts ranging from $200 billion to $300 billion, with Morgan Stanley & Co. most recently coming in at $270 billion. Considering last year’s tax exempt issuance of $274 billion, twenty-eight new governors in office, federal stimulus funds that are vanishing, interest rates that may be slowly rising and austerity at the state and local government level, it seems reasonable to us that a level of $240 billion is attainable in this difficult market environment. Although last year’s total tax exempt issuance of $274 billion was insufficient to meet investor demand at multiple points during 2010, today’s supply-starved market now frets any semblance of that amount because the process to attain even our $240 billion level from today’s current calendar date requires a considerable uptick in average monthly issuance. Further, the demand side of the equation remains open to debate given stubbornly negative mutual fund flows. There’s very little question that an additional yield adjustment will be required beyond what has already transpired to move an uptick in supply, but we suspect that the majority of this “anxiety discount” has been priced into the market and further, that the balance may depend heavily on the direction of UST yields. Further, the quality and location of that prospective supply may matter more than the total dollar amount itself.

Figure 1. 30-day Visible Supply 25000 30-Day Visible Supply

Average

20000

15000

10000

5000

0 11/17/08

3/17/09

7/15/09

11/12/09

3/12/10

7/10/10

11/7/10

3/7/11

Source: Thomson Reuters, Municipal Market Data

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

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April 8, 2011 Fixed Income Strategy

Looking at the market dynamics of last year, Build America Bonds captured the lion’s share of longer maturities (beyond 13 years) and a significant amount of top-quality paper, while mutual funds experienced consistent inflows. The primary differences between last year and this year are the lack of the BABs program and consistently negative fund flows. However, the amount of tax exempt paper available is already lower than the BABs-impacted levels of April, 2010. Meanwhile, municipal benchmark yields are higher across the board versus last year and UST rates are lower than one year ago. With this in mind, the areas of the market vulnerable to further correction may be maturities beyond 15 years and ratings below mid-level “A.” In contrast, our current strategy espouses 6- to 14-year maturities with ratings of mid-level “A” and above. Another noteworthy difference this year is that governments throughout the nation are focused heavily on the organic and arduous task of balancing their respective budgets without federal assistance, which should place the states, in general, on a more solid footing versus relying on federal dollars. This process also implies that balancing budgets is much more of a front-burner issue than accessing the markets, which for many issuers was a primary focus in 4Q10.

What about the demand side of the equation? While it is true that recent primary market supply has been anything but normal (for almost six months) the same could be said for demand. After being whipsawed in the summer of 2010 by record low municipal yields, followed by sharply rising rates and outsized headline risk in the fall, investors found themselves scrambling for bonds by mid-January and a rally ensued. The typically weak seasonal factors (fewer maturing bonds, coupon payments and tax filing) of March and April then ushered in the notion that the very supply that the marketplace craves and relies on for price discovery (bond sales that either validate or adjust current offering levels) could be too much of a good thing if not absorbed in moderation and subsequently a sell off began. Our thoughts on recent market sentiment regarding primary market supply fears are that they appear overdone. Much of the needed adjustment may have already occurred and a higher level of supply has already been slowly working its way into the market, as evidenced by a $3.9 billion calendar the week of 3.21.11 and a $3.4 billion calendar the week on 4.04.11, both signaling a rising trend.

Weak seasonal factors should begin to ease after the April 18th tax filing deadline while available funds from maturing bonds and coupon payments may improve into May, June and July. As for the stubborn, but recently declining, municipal bond mutual fund outflows that have plagued the market for 21 weeks, we view such activity as an “accelerant” rather than a leading indicator. Since the municipal market is primarily driven by individual investors via individual bond purchases, mutual funds, separately managed accounts and exchange traded funds, there have been multiple periods during the last few years where institutional “leadership” has been lacking. That said, the very mutual fund flows so closely monitored by market participants often follow market momentum rather than providing leadership. As an aside, such a dynamic can leave the tax exempt market vulnerable to both a bout of exuberance and crisis of confidence, depending on the triggering event. Judging by impressive summer 2010 inflows versus the crippling winter 2011 outflows, it appears that the pendulum is now slowly swinging back toward center. If more favorable seasonal factors do in fact unseat the current set and supply rises moderately with minimal downward price adjustments, mutual fund flows may turn positive and provide much needed support for the municipal marketplace while price discovery becomes a bit easier for all involved. Simply stated, once we are beyond tax season, the “big selloff” may not occur.

What about credit? Although an enormous amount of market energy has been expended on future supply concerns, there has been nascent improvement on the credit front…and it may be going unnoticed. The economy is on the mend according to recent macro economic data and tax revenues continue to rise at the state level, while layoffs/attrition and other expenditure cuts transpire at the state and local level. In fact, according to MSSB’s Chief Fixed Income Strategist, Kevin Flanagan, March non-farm payroll data revealed 259,000 fewer jobs in the “local government” sector versus 2010 levels. We believe these developments, in aggregate, are positive in the long run for municipal credit quality generally and bondholders specifically. We also expect this activity to continue while states and local governments work to close recurring budget gaps until revenues rise to adequate levels.

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

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April 8, 2011 Fixed Income Strategy

However, these positives are mitigated by the reality that states and local governments are digging out of a deep hole that will take quite some time and effort. This fact is evidenced in a mid-March report by Moody’s entitled “2011 Sector Outlook for U.S. Local Governments – Toughest Year Yet.” This release represents the third consecutive year of negative outlooks.

MMA’s findings further revealed that only 4 of the 60 defaults were rated at the time of issuance. The important takeaway for investors from this visual is that defaults have most certainly been occurring and will likely continue, but the location of this activity has primarily been in areas of the market historically prone to defaults.

Aside from the expected takeaways like “downgrades are likely to outpace upgrades” and “We also expect a modest increase in defaults among rated local governments from their very low historical default rates…,” there were positives for current bondholders including “We expect defaults and bankruptcy filings to remain isolated and rare…” and “We also expect a number of near misses, or cases where defaults are in sight but averted…”

Sector Breakdown of First Time Default Filers Since 10/1/10

The outlook reflects Moody’s expectations for fundamental credit conditions during the upcoming 12 to 18 months. While many in the marketplace are quite concerned with defaults on what is often high quality, highly rated paper, the bigger concern for general obligation bonds in our opinion may be downgrades…an ongoing development that has long been factored into our strategy. In the spirit of fair and balanced reporting, we also note that Standard & Poor’s effected a noteworthy downgrade of a formerly “AAA” rated county last week from “AA-” to the “BBB” level and removed the rating in one rapid maneuver. The reasons cited were credit deterioration coupled with county officials’ “inability to provide sufficient and consistent information regarding the county’s current liquidity position and how they will manage projected cash flow imbalances in the near term.” While the action may well be warranted and appears to be an isolated incident at this juncture, this development places market participants on notice that a more vigilant level of ratings surveillance may be on the horizon. Although such a sharp fall from grace is thankfully rare in the municipal market, it does hammer home the point that the long road ahead is likely to be a bumpy one and further that downgrades may indeed be on the rise, as was noted recently by long time competitor Moody’s Investors Service (which has yet to make a similar move on this credit). While staying with the challenged credit theme (downgrades, defaults, bankruptcies), we turn our attention to the accompanying table, published on March 28th by Municipal Market Advisors (MMA), which highlights default filings since October 1st, 2010. Note that the table includes no general obligation bonds and no essential service revenue bonds (water & sewer). As indicated, the vast majority occurred in land, healthcare, housing or economically sensitive, non-tax backed sectors.

Figure 2. Where are the Defaults? Sector

Par ($MM)

Number

Land Secured

676

31

Hotel

231

2

Retirement

106

8

Housing

48

8

Solid Waste

45

1

Independent School

36

3

Electric/Gas/Power

16

1

Airport Sp. Fac

9

1

Entertainment

8

1

TIF/TAB

6

1

IDB

5

2

Tribal

2

1

Source: MMA Weekly Outlook, March 28, 2011

And finally, on the bankruptcy front, we thought it might be helpful to list the states that do not allow their respective constituent municipalities to file Chapter 9 bankruptcy. Such states include AK, DE, GA, HI, IL, IN, KS, ME, MD, MA, MS, NV, NH, NM, ND, RI, SD, TN, UT, VT, VA, WV, WI and WY (source: Bloomberg Law Reports, January, 2011). Further, as we have mentioned in previous editions, states are generally unlikely to turn away from municipalities in need, even as they may be reducing state aid to those same local governments. While investor concerns on this front have grown in recent months, there has been concrete evidence of states doing just the opposite by helping municipalities on the edge avoid the abyss.

About those pension liabilities Adding to the list of well balanced reports regarding state and local government liabilities, S&P released a study on March 31st entitled “U.S. State’s Pension Funded Ratios Drift Downward.” Despite the ominous title, one of the overview bullets on the first page states “Nevertheless, states will be able to meet their debt service obligations.” This comment was balanced by a somewhat sobering “…we do not view pension liabilities as immediately jeopardizing state governments’ capacity to fund their debt service obligations but we believe they can weaken a state’s relative credit profile.”

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

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April 8, 2011 Fixed Income Strategy

Evidencing the headway that some states have made as of late was the claim that “Pension reform efforts could help contain the rate at which some estimated long-term pension liabilities are growing.” On a more immediate basis and given recent investor concerns, it is also noteworthy that “Standard & Poor’s views pension obligations as long-term liabilities that must be funded over time.” Regarding the findings of the report and the genesis of recent market concerns by outside observers “In 2009, according to our analysis, the mean funded ratio for the state pension system was 75%. This is down from an 80% mean funded ratio for the principal state pension plans in 2008.” However, an important perspective to highlight is that “According to a study by the Federal Reserve, in 1975 the aggregate funded ratio of public pensions for states was 51%.” This means we’ve been here before (and worse). Recall also that the 1970s was a weak period for equity returns. It is similarly true today that poor investment returns contributed to part, but not all, of the current funding declines; the balance being attributed to insufficient funding. Our takeaway is that a combination of higher funding and improving markets may enable funding ratios to recover in the coming years. This brings us to the next quote: “Actuarial smoothing methods allow investment losses and gains to be phased in over several years (unlike with corporate pension plans, where federal law prohibits smoothing).” In plain English, this means that public pension plans have many years, five being the most common, to make up for investment losses. According to the report, approximately 88% of public pension plans have a smoothing period of 4 years or longer. The comments made in this S&P report are supportive of our long-standing assertion that the timelines for these liabilities matter greatly and that pension and retiree healthcare liabilities should not simply be aggregated to arrive at the misguided conclusion that states will be unable to pay debt service on a timely basis.

A (sort of) New “Wild Card” As we were putting the finishing touches on this edition, news came across the tape of legislative efforts to eliminate the tax exemption for municipal bonds issued after 2011 as part of a broader plan to overhaul the tax code and reduce the federal deficit. There are two specific developments currently at hand.

The first is a bill in the Senate by Ron Wyden (D-Oregon) and Dan Coats (R-Indiana) that would eliminate the tax exemption of municipal interest, eliminate advance refundings, eliminate the alternative minimum tax (AMT) and introduce three income tax rates of 15%, 25% and 35%. The tax exemption of interest would reportedly be replaced with a tax credit equal to 25% of the interest earned on newly issued (taxable) municipal bonds after 2011. The second development is the proposal of a fiscal 2012 budget resolution by House Budget Committee Chairman Paul Ryan (R-Wisconsin) that follows a number of recommendations made last year by President Obama’s deficit reduction committee, including the elimination of tax exempt interest on municipal bonds. What is interesting about both of these developments is that we have seen them both surface and vanish less than one year ago. Also interesting is that tax credit bonds, believed by academics to be a “more efficient” alternative to the current tax exempt marketplace, were proven to be a non-starter in 2009 when they were included in President Obama’s stimulus plan along with the popular direct subsidy Build America Bonds (BABs) program. In contrast, the BABs program, which captured over $187 billion in issuance during its 20 month lifespan (not necessarily more debt, but different debt), accounted for between 30% and 50% of total municipal issuance at various points in 2010. Despite facilitating lower borrowing costs while offering greater efficiency for municipal issuers (of both taxable and tax exempts) the program was allowed by Congress to expire as scheduled upon the close of calendar 2010 without even a temporary extension at a lowered subsidy rate (previously 35%). One of the key takeaways from the popularity of the BABs program among both issuers and investors is that support for taxable municipal bonds does exist and can be grown. Remember that the BABs offered no tax advantages to the buyers. The primary focus among market participants on the subsidy level only mattered to issuers who had an alternative (that being the tax exempt market). Without a tax exempt marketplace to fall back on, municipal issuers and market participants would strive to expand the buyer base, as they did during the last two years, but with renewed vigor and a much higher level of motivation.

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

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April 8, 2011 Fixed Income Strategy

In reviewing the magnitude of yield changes according to MMD since the mid-March correction began, we see that the heaviest losses were experienced by the highest rating categories of “AAA” and “AA”, with 10-year maturity “BBBs” outperforming corresponding “AAs.” Figure 3. 5 Year AAA Yield 03.17.11 – 04.05.11 1.85%

1.8%

1.75%

1.7%

1.65%

4/ 4/ 20 11

4/ 2/ 20 11

3/ 31 /2 01 1

3/ 29 /2 01 1

3/ 27 /2 01 1

3/ 25 /2 01 1

3/ 23 /2 01 1

3/ 21 /2 01 1

3/ 19 /2 01 1

1.6%

Source: Thomson Reuters, Municipal Market Data

Figure 4. 10 Year AAA Yield 03.17.11 – 04.05.11 3.3% 3.2% 3.1% 3% 2.9% 2.8%

4/ 4/ 11

4/ 2/ 11

3/ 31 /1 1

3/ 29 /1 1

3/ 27 /1 1

3/ 25 /1 1

3/ 23 /1 1

3/ 21 /1 1

2.7%

3/ 19 /1 1

When properly motivated, municipal issuers can either come to market en masse or simply sit on the sidelines. Within the last six months we have seen evidence of both. The BABs market penetration figures above are a perfect example of this dynamic. For much of 2010, when the BABs market was well-established, the program accounted for approximately 30% of total municipal issuance, but when the extension of the issuer friendly program was in doubt (November and December of 2010) issuance ramped up to account for 50% of the total market. This uptick occurred because issuers pulled forward deals to access the program before it expired. Should the proposals discussed above gain traction or become law, we would not be surprised to see issuers throughout the nation enter the market as much as possible to avoid the market access and price uncertainty of tax credit bonds (and expanding future liabilities at a time when taxpayers expect just the opposite). Following this activity, outstanding tax exempt bonds would likely trade higher in price, given the scarcity premium in a newly bifurcated marketplace. The current municipal bond system may indeed be far from perfect, but it has served issuers and investors well for quite some time.

In our last monthly edition, dated March 11th, we opined that “We would also view any significant supply-driven (as opposed to UST driven) price pressures as an opportunistic entry point.” Within one week of that publication, which coincided with the highest week of issuance thus far in 2011, the municipal market began to experience slow, but steady price erosion even without a sharp uptick in the primary market. As we suggested last month, we have now reached what we believe is that opportunistic entry point.

3/ 17 /2 01 1

Regarding the tax credit approach itself, it feels like we have seen this movie before and it wasn’t that good the first time. If the 2009 dead-on-arrival market for tax credit bonds is any indication of things to come, borrowing costs for states and local governments are very likely to rise across the board for all issuers if said proposals come to fruition (which we view as unlikely in their current form). Further, the implications of such a policy change could be drastic and unsettling for the municipal marketplace.

Market Performance

3/ 17 /1 1

Along with the much broader investor base (versus the current structure), municipal bonds would offer a much lower tax benefit for US buyers (assuming the state and local exemption survives) and thus would compete more directly with other fixed income products on a pure yield and credit basis. In such a “global” municipal marketplace, borrowing costs would very likely rise from current levels, which would be detrimental to issuers, but the higher yields could also beckon additional buyers. Although we do not believe such a change is on the near-horizon, it does seem to be a topic that may reappear repeatedly in coming years. This reality, however grim, makes pondering a fully taxable municipal market more than just academic.

Source: Thomson Reuters, Municipal Market Data

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

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April 8, 2011 Fixed Income Strategy

Although our performance discussion this month uses the limited window of March 17th (the beginning of the downturn) through the present, it is worth mentioning that the tail end of the rally that began in mid-January and extended through March 16th mitigated much of the aggregate month’s price action.

Figure 5. 30 Year AAA Yield 03.17.11 – 04.05.11 4.84% 4.8% 4.76% 4.72% 4.68% 4.64%

4/ 4/ 11

4/ 2/ 11

31 /1 1 3/

29 /1 1 3/

27 /1 1 3/

25 /1 1 3/

23 /1 1 3/

21 /1 1 3/

19 /1 1 3/

3/

17 /1 1

4.6%

Source: Thomson Reuters, Municipal Market Data

One factor that may be continuing to be a drag on top quality price performance is the continuance of negative mutual fund flows, though the trend line suggests evidence of “clotting.” Also noteworthy is that the lion’s share of 2011 price gains before the sell off began were enjoyed by the “AAs” and “AAAs,” so some pay back in the form of profit taking may have been in order. Another factor is that there was also a good amount of crossover buying by nontraditional investors seeking total return during the previous rally. Some of those investors may have simply taken their gains and moved on. Also representing a reversal from the prior month was the location of the losses on the yield curve. The largest rise in yields since the correction began occurred in the 6- to 13year range across the credit spectrum, which corresponds closely with our advocated target maturity range of 6 to 14 years. For the record, long maturity bonds in 20 to 30 years performed admirably during the correction, sustaining losses of only a few basis points higher than front-end adjustments, which we discuss below. Within the individual rating bands, “AAA” paper experienced the smallest losses of 9 basis points inside of 4-year maturities and the greatest losses of 36 basis points in 9 years. For “AA” rated bonds, minimal losses on the front end were identical in size and location to “AAA,” with peak losses of 38 basis points also found in the 9-year maturity. “A” rated debt only slightly outperformed, with identical, 9 basis point losses inside of 4-year maturities and a peak yield rise of 34 basis points at the 9-year point. Finally, “BBB” rated paper experienced the least of its losses (9 to 12 basis points) inside of 4 years and its greatest losses, though still handily outperforming higher ratings, of 27 basis points at the 9-year maturity.

Turning to the topic of relative value versus benchmark UST securities since the beginning of March, we see that gilt-edged “AAA” rated municipals handily outperformed in the front end, with the 1- and 5-year percentages of corresponding USTs falling to 114% from 165% and to 77% from 83%, respectively. Meanwhile, 10-year tax exempts simply could not keep pace with 10-year USTs, with that relationship rising to 92% from 87%. Recall that March was an exceptionally volatile month for USTs, as global events from Japan to Libya to Bahrain drove global funds in and out of USTs in accordance with the typical “flight-to-quality” fashion. Further out on the yield curve, performance changes were essentially unchanged, with 15-, 20- and 30-year tax exempts hovering at 97%, 101% and 105%, respectively. Figure 6. Tax-Equivalent Yields Are Attractive MMD Spot Yield*

TEY

TEY

(28% Fed Tax Rate)

(35% Fed Tax Rate)

Corporate Yield**

AAA 5 year

1.79

2.49

2.75

3.07

10 year

3.25

4.51

5.00

3.69

20 year

4.39

6.10

6.76

4.45

30 year AA

4.82

6.69

7.42

4.45

5 year

1.99

2.76

3.06

2.85

10 year

3.52

4.89

5.42

4.30

20 year

4.66

6.47

7.17

5.56

30 year

5.08

7.06

7.82

5.56

5 year

2.73

3.79

4.20

3.38

10 year

4.36

6.06

6.71

4.54

20 year

5.34

7.42

8.22

5.76

30 year

5.71

7.93

8.79

5.76

5 year

3.77

5.24

5.80

3.78

10 year

5.24

7.28

8.06

4.90

20 year

6.11

8.49

9.40

6.14

30 year

6.41

8.90

9.86

6.14

A

Baa (BBB)

Source: Thomson Reuters, Municipal Market Data *MMD Spot Yield as of April 4, 2011 **Citi US Broad Investment Grade Index as of April 1, 2011 The benefit of tax exemption diminishes for investors in lower tax brackets, as illustrated. The chart is for illustrative purposes only and does not represent any specific investment

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

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April 8, 2011 Fixed Income Strategy

Following a familiar pattern for 2011, investor focus on the highest rated paper continues to be the prevailing sentiment. In what continues to be a bifurcated market of “haves” and “have nots” in terms of ready market access for issuers and liquidity for investors, spreads for mid-range “A” rated paper and lower-range “BBB” paper have struggled in recent months to tighten from historically wide levels. The results have been mixed; “A” rated spreads for 10-year paper widened by 2 basis points during March, while “BBB” spreads tightened by an impressive 10 basis points. One simple explanation for this difference in performance may be that although “A” spreads hover around three times the long term average and “BBB” spreads are just 2.2 times the average, the absolute level of spread for “BBBs” is almost twice that of “A” paper. Accordingly, the yields are just plain higher. However, considering the downgrade activity we expect to see in the coming months, we are comfortable sticking to our “A” rated guns. There is also a steeper yield curve for “A” rated versus the “AAA” benchmark, while “BBBs” are actually flatter in slope, but we’ll come back to this shortly. The accompanying chart illustrates spread changes for “A” and “BBB” rated general obligation bonds. Figure 7. Credit Spreads To "Aaa" Rated Municipal 400 A

BBB

350

As we noted at the forefront of this edition, supply fears continue to remain unfulfilled. Looking specifically at taxable issuance data, we see that this once again infrequently used market accounted for approximately 9% of total issuance, which is now declining toward the preBABs long term average. Finally, bond insurance penetration of the new issue market continued its yearover-year decline in March (-35%), but the policies written during the month represented 6% of the primary market and an uptick from last month’s 4.5% level. This better showing brings the year-to-date figure up to 4.6% from 3.7% in February.

Targeting Value (curve structure) According to MMD, the aggregate slope, the difference in yield between 1 and 30 year maturities, of the municipal bond yield curve steepened during March by an impressive 18 basis points to total 450, a level that continues to inch closer to the record wide reading of 486 (on 12.15.08). In keeping with our earlier comments regarding the location of recently rising yields, virtually all of the action was contained in the front half of the yield curve. Even within these three 5-year bands, there was a major difference between 1 through 10 years versus 10 to 15 years. Specifically, the 1- to 5-year band widened by 9 basis points and the 5- to 10-year range widened by 26 basis points. This widening was partially offset by an 18 basis point tightening in the 10- to 15-year band. The back half of the curve was essentially unchanged during March. Figure 8 illustrates the slope/trajectory of the “AAA” rated benchmark yield curve since 1990.

300

250

200

150

100

50

0 Nov-97

The only positive we can glean from this data is that it is relatively consistent with the February -42% reading. Looking at the year-to-date data provides no relief, with a 46% decline for tax exempts.

Figure 8. Slope of the AAA Yield Curve Jul-99

Mar-01

Nov-02

Jul-04

Mar-06

Nov-07

Jul-09

Mar-11

Source: Thomson Reuters, Municipal Market Data, The Yield Book The chart is for illustrative purposes only and does not represent any specific investment

500

400

New Issue Supply Primary market issuance data, courtesy of The Bond Buyer, reveals yet another month of paltry new issue sales. Overall municipal bond issuance (both taxable and tax exempt) declined 59% year-over-year in March. However, given the absence of the now expired BABs program, a more appropriate comparison is the year-over-year change in tax exempt issuance. That number, -46%, is no cause for celebration either.

300

200

100

0 Mar-90

Mar-92

Mar-94

Mar-96

Mar-98

Mar-00

Mar-02

Mar-04

Mar-06

Mar-08

Mar-10

Source: Thomson Reuters, Municipal Market Data

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

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April 8, 2011 Fixed Income Strategy

While we typically stick to the “AAA” rated benchmark yield curve when discussing changes in slope, which is more than enough excitement for most readers, we would like to call attention to the fact that the slope of the “A” rated yield curve is 35 basis points steeper than that of the “AAA” benchmark. Meanwhile, the “BBB” slope is actually 10 basis points tighter than “AAA.” This means that investors are rewarded more for extending maturities (within reason) in “A” rated securities than in “AAA” or “BBB” rated bonds. When coupled with inordinately wide spreads, low default rates and a potential “buffer” against downgrades, this steep construct further supports our assertion that “A” rated general obligation and essential service revenue bonds represent the best value in the municipal marketplace.

Aside from this tactical move, our core strategy of purchasing mid-tier “A” rated general obligation and essential service revenue bonds with maturities between 6 and 14 years remains in place at this time. Although market timing is not our primary focus, we do suggest looking toward the new issue market if the calendar rises sharply on the road to a more normal issuance climate. Accordingly, periods of minimal supply may signal better value in the secondary market. Figure 9. Capturing the Yield Curve 6%

5%

4%

Closing thoughts

3%

There is no question that there is a great deal going on in today’s municipal market. The general direction of interest rates should also be included in any discussion of municipal value and related portfolio maneuvers. Interest rate risk is always a factor in our strategy, with our general sense being that rates will be trending gradually higher. The latest interest rate outlook for 10 year USTs from Morgan Stanley’s US economics team (as of 4.01.11) calls for just that, a slow and steady migration toward 4% by year end from the current level of 3.56%. The specific points along the way include 3.60% by the end of the second quarter and 3.75% at the close of the third quarter. As is often the case, the road to those destinations may not be a smooth one.

2%

Speaking of US Treasuries, our monitoring of the relative value found in 5-year maturity pre-refunded bonds (versus corresponding maturity USTs) indicates that the relationship, currently 74%, is now beyond fully valued. In the January 6th edition of our “Municipal Bond Monthly”, we advocated “adding exposure whenever they eclipse 95%.”

Approx 34% of the Yield Curve is Captured within our Target Range Close to 80% of the Yield Curve is Captured within 14 Years of Maturity

1%

0% 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Maturity

Source: Thomson Reuters, Municipal Market Data

As for the credit picture and related investor anxieties, we look forward to late-summer, not just for the weather, but also for an improved market sentiment following the closure (yet again) of stubborn operating deficits by the vast majority of states on a timely basis. Stay tuned! JD *Please note State Ratings Chart on the following pages.

By January 13th the market surpassed our target, hovered in that zip code for 10 days, then began a string of outperformance that has brought us to today’s 74% (as of 4.06.11), which is the richest (lowest percentage) relationship year-to-date. Total-return-oriented accounts may want to consider taking profits at this juncture. For modified buy and hold, income-oriented accounts, it may be worth limiting purchases in favor of a better entry point.

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

9


April 8, 2011 Fixed Income Strategy

Figure 10. Five-Year Munis as a Percentage of Five-Year Treasuries, Apr 96-Apr 2011 210

190

170

150

130

110

90

70

50 Apr-96

Apr-98

Apr-00

Apr-02

Apr-04

Apr-06

Apr-08

Apr-10

Source: Municipal Market Data as of 4/8/2011

Figure 11. Ten-Year Munis as a Percentage of Ten-Year Treasuries, Apr 96- Apr 2011 190

170

150

130

110

90

70 Apr-96

Apr-98

Apr-00

Apr-02

Apr-04

Apr-06

Apr-08

Apr-10

Source: Municipal Market Data as of 4/8/2011

Figure 12. 30-Year Munis as a Percentage of 30-Year Treasuries, Apr 96- Apr 2011 210

190

170

150

130

110

90

70 Apr-96

Apr-98

Apr-00

Apr-02

Apr-04

Apr-06

Apr-08

Apr-10

Source: Municipal Market Data as of 4/8/2011

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

10


April 8, 2011 Fixed Income Strategy

Figure 13. State Ratings STATE

MOODY''S RATING**

MOODY''S OUTLOOK

S&P RATING***

S&P OUTLOOK

ALABAMA

Aa1

Stable

AA

Stable

ALASKA

Aaa

Stable

AA+

Stable

ARIZONA

Aa3*

Negative

AA-

Negative

ARKANSAS

Aa1

Stable

AA

Stable

CALIFORNIA

A1

Stable

A-

Negative

COLORADO

Aa1*

Stable

AA

Stable

CONNECTICUT

Aa2

Stable

AA

Stable

DISTRICT OF COLUMBIA

Aa2

Stable

A+

Stable

DELAWARE

Aaa

Stable

AAA

Stable

FLORIDA

Aa1

Stable

AAA

Negative

GEORGIA

Aaa

Stable

AAA

Stable

HAWAII

Aa1

Negative

AA

Stable

IDAHO

Aa1*

Stable

AA+

Stable

ILLINOIS

A1

Negative

A+

Negative

INDIANA

Aaa*

Stable

AAA

Stable

IOWA

Aaa

Stable

AAA

Stable

KANSAS

Aa1*

Negative

AA+

Stable

KENTUCKY

Aa2*

Negative

AA-

Stable

LOUISIANA

Aa2

Stable

AA-

Stable

MAINE

Aa2

Stable

AA

Negative

MARYLAND

Aaa

Stable

AAA

Stable

MASSACHUSETTS

Aa1

Stable

AA

Positive

MICHIGAN

Aa2

Stable

AA-

Stable

MINNESOTA

Aa1

Stable

AAA

Stable

MISSISSIPPI

Aa2

Stable

AA

Stable

MISSOURI

Aaa

Stable

AAA

Stable

MONTANA

Aa1

Stable

AA

Stable

NEBRASKA

No G.O. Rating

Stable

AA+

Stable

NEVADA

Aa2

Stable

AA

Stable

NEW HAMPSHIRE

Aa1

Stable

AA

Stable

NEW JERSEY

Aa2

Negative

AA-

Stable

NEW MEXICO

Aaa

Stable

AA+

Stable

NEW YORK

Aa2

Stable

AA

Stable

NORTH CAROLINA

Aaa

Stable

AAA

Stable

NORTH DAKOTA

Aa1

Stable

AA+

Stable

OHIO

Aa1

Negative

AA+

Negative

OKLAHOMA

Aa2

Stable

AA+

Stable

OREGON

Aa1

Stable

AA+

Stable

(continued on the next page)

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

11


April 8, 2011 Fixed Income Strategy

STATE

MOODY''S RATING**

MOODY''S OUTLOOK

S&P RATING***

PENNSYLVANIA

Aa1

Negative

AA

Stable

RHODE ISLAND

Aa2

Stable

AA

Negative

SOUTH CAROLINA SOUTH DAKOTA

S&P OUTLOOK

Aaa

Stable

AA+

Stable

No G.O. Rating

Stable

AA+

Stable

TENNESSEE

Aaa

Stable

AA+

Stable

TEXAS

Aaa

Stable

AA+

Stable

UTAH

Aaa

Stable

AAA

Stable

VERMONT

Aaa

Stable

AA+

Stable

VIRGINIA

Aaa

Stable

AAA

Stable

WASHINGTON

Aa1

Stable

AA+

Stable

WEST VIRGINIA

Aa1

Stable

AA

Stable

WISCONSIN

Aa2

Stable

AA

Stable

No G.O. Rating

No Outlook

AA+

Stable

A3

Negative

BBB

Stable

WYOMING PUERTO RICO

*Issuer Rating ** Moody's (4-7-2011) ***Standard & Poors - U.S. State Ratings And Outlooks: Current List - March 30,2011 Sources: Moody’s, Standard & Poors

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

12


April 8, 2011 Fixed Income Strategy

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The appropriateness of a particular investment or strategy will depend on an investor's individual circumstances and objectives. Morgan Stanley Smith Barney 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. 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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. 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. 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13


April 8, 2011 Fixed Income Strategy

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

14

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