global fixed income bulletin - morgan stanley€¦ · global fixed income bulletin february: a tale...

COMMENTARY | MARCH 2016

INVESTMENT MANAGEMENT

Global Fixed Income Bulletin

February: A Tale of Two MarketsOutlook

• Recession worries, exacerbated by oil-related anxiety, caused risky assets to perform poorly in February. Led by equities and high yield, risk premia rose significantly; however, markets rallied in the second half of the month as oil prices stabilized. Although it may be too early to be sure markets have troughed, we expect economic data to gradually improve in the months ahead as headwinds from a strong dollar, low oil prices and weakening Chinese growth diminish. In the near term, volatility may not go away, but the yields on many risk assets, such as those in High Yield (HY) and Emerging Markets (EM), now give what we consider to be a significant margin of safety against more bad news. We see opportunities for patient value investors comfortable with the additional risks that these asset classes entail.

• Government bonds performed well in February. With most Federal Reserve (Fed) rate hikes priced out of markets, there is scope for disappointment if data does not build on their January and early February levels. However, given uncertainties surrounding the economic outlook and lingering issues, particularly in EM, we are not recommending reducing duration exposure. In our opinion, better opportunities can be found in taking advantage of potential stability amongst government bonds and consider allocating additional funds to EM sovereign markets. For instance, Eastern European bond markets have performed well and we expect that relative performance to continue. But, opportunities in Mexico, Argentina, Brazil and India are improving with valuations in currencies and yields on the attractive side of “fair value.”

• We continue to believe that the credit markets represent an attractive opportunity, with a focus on subordinated financials where valuations look extreme. The U.S. Investment Grade (IG) and HY markets appear to be compensating investors for deterioration in both macro and credit fundamentals that are unrealistic.

• Overall, we do find agency mortgage-backed securities (MBS) to be attractive on an outright basis, but agency MBS can complement a more credit-sensitive portfolio which is valuable in current market conditions. In Europe, we believe the spread widening in UK and peripheral Europe in 2015 and early 2016 represents an attractive buying opportunity. European real estate markets are still recovering, particularly in peripheral Europe where real estate prices remain well below their peaks, and the European Central Bank (ECB), stimulus should help support real estate prices.

Risk markets were a tale of two halves in February, when things started off very much in line with January’s negative direction. Focus remained on concerns of Chinese growth expectations and the seemingly relentless drop in oil prices. Additionally, concerns about the banking sector also came back into focus. In China, the focus remains the ability of policy makers to make the transition to consumer lead growth in an orderly fashion and at the same time wrestling with a potentially overvalued yuan (CNY) which has served to reduce China’s competitiveness relative to other low cost producers. Oil prices continued their downward trend, with the market focusing on the potential additional capacity coming from the readmission of Iran into the global trading community, and OPEC’s (Organization of the Petroleum Exporting Countries) decision not to intervene in markets with oil prices at multi-year lows. Market sentiment was not helped by a number of weaker economic data releases, particularly in the U.S., but also in Europe, which raised concerns that growth weakness in the emerging markets might be affecting

TABLE OF CONTENTS

1 Outlook

2 Interest Rates & Currency Outlook

3 EM Outlook

3 Credit Outlook

4 Securitized Outlook

5 Market Summary

5 Developed Markets

7 Emerging Markets

7 External

7 Domestic

8 Corporate

8 Corporate Credit

9 Securitized Products

The views and opinions expressed are those of the portfolio management team as of March 2016, and are subject to change based on market, economic, and other conditions. Past performance is not indicative of future results.

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GLOBAL FIXED INCOME BULLETIN


developed markets. There has been increasing focus on the risk of recession, particularly in the U.S., where there is evidence of late stages of the credit cycle, and the Fed has been incrementally tightening policy for some time.

However, market sentiment bottomed in the second week of the month and many markets rallied into the end of February. Crude oil prices remained volatile, but ended the month some 18 percent up from the intra-month lows. 1 We do not believe the U.S. economy will move into recession in 2016, nor in 2017, although we are less confident of that forecast. To us, this means, markets are overly bearish and the risk rally seen in the second half of February is likely to continue, at least in the near term. Longer-term, we view credit and asset backed markets as undervalued and we expect risk premia to contract meaningfully.

Market moves in equities, HY, and other risk assets have become much more correlated to changes in oil price, which hit a low in mid-February. Meanwhile, the economic picture for the U.S. became a bit clearer and affirms that near-term recession fears may have been overblown. Core PCE has been steadily trending up, and has hit 1.7 percent year-on-year. 2 This strengthens the idea that low headline inflation has been the by-product of the large drop in oil prices rather than structural weakness in the domestic economy. As such, because of base effects, a small increase in oil prices could lead to a recovery in headline inflation. While we expect oil prices to be volatile, we also expect supply and demand to rebalance, leading to a 2016 stabilization of prices. Given how much oil is linked to current market psychology, this makes us hopeful for a risk sentiment recovery from the currently overly bearish levels.

If sentiment does improve, we believe several risk assets are poised to outperform. For one, EM local debt and currency have underperformed for the last three years, finally creating some value. Excluding the 2008 crisis period, EM local spreads have reached the highest in the last eleven years. 3 After the recent market corrections, we see opportunities in countries and sectors with better fundamentals to withstand the current headwinds facing EM. We believe many of these names now offer attractive yields.

On the other hand, deflationary/recessionary forces elsewhere in the world are proving to be persistent. In Japan, the market has become skeptical of the efficacy of increasing Bank of Japan (BoJ) stimulus, especially that of negative rates. In Europe, negative rates policy has strained bank earnings, sparking a sell-off in major European bank spreads. Moreover, Euro Area inflation for January turned negative, renewing worries around growth. There is now increasing pressure for central banks to prove their resolve and power to the markets in March. And, U.S. manufacturing continued to be in recession.

Politics is also becoming a bigger source of volatility for the markets. After many years of successful austerity, fringe parties with anti-austerity and populist platforms have gained wide following in Portugal, Spain, and Ireland, which has produced political stalemate. The refugee crisis exacerbates existing political tensions and is casting a shadow over elections in Germany and France in 2017, as well as the Brexit referendum scheduled for June 2016. The rise of populist outsiders is apparent even in the United States. Fear-mongering is becoming a source of risk globally.

Interest Rates & Currency OutlookThe Fed has promised that this rate hike cycle will be “gradual.” Recent market volatility has probably all but guaranteed that! However, the market may be too pessimistic about the U.S. economy and too optimistic that “gradual” means no rate hikes. There is a meaningful probability that the Fed will deliver more rate hikes in 2016 than the market currently believes. On the other hand, given the relative weakness of the global economy and tightening of financial conditions, we do expect the Fed to do all it can to implement a “dovish” hiking path. This means, aggressive market re-pricing of short-term U.S. Treasuries could be disappointed by the actual hiking path. In light of these forces and market realities, we remain modestly underweight U.S. duration. We also believe that current market pricing of inflation through TIPS underestimates the potential for higher inflation. We are overweight inflation break-evens.

We expect continued ECB purchases to push euro periphery real yields lower in order to bring about the necessary financial and economic rebalancing to increase inflation expectations. Based on this view, we continue to be overweight inflation-protected bonds in Italy and Spain, and remain essentially neutral on Euro Area duration.

We expect that a China-related commodity-based slowdown and slow growth should keep monetary policy in Australia and New Zealand easy. We believe that Australia and New Zealand government bonds should outperform. We continue to be overweight these markets.

After significant sell-offs in EM assets, value is starting to emerge. In contrast to many other EM countries that are more tied to Chinese growth, Mexico fundamentals should improve if the U.S. economy recovers. Thus, we are more bullish on Mexican peso and government bonds within the EM world. Central European bonds also remain attractive, although given their recent outperformance, we may look to reposition in other markets.

In terms of currency positioning, we see the trend towards a stronger U.S. dollar eventually resuming as the Fed prepares to hike later this year, but do not expect the dollar to rebound in the near term. On the back of moderate global growth, China slowdown, and dovish central banks, we have also been underweight commodity and Asian currencies.

1 Source: Bloomberg. Data as of February 29, 2016.2 Source: Bloomberg. Data as of February 29, 2016.3 Source: JP Morgan. Data as of February 29, 2016.

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EM OutlookOver the next few months, the primary risks that we will continue to monitor include the potential for rising U.S. interest rates, the path of Chinese economic growth, currency and monetary policy, and the direction of commodity prices.

Broadly, we expect a modest rebound in EM growth in 2016 and 2017 should the negative impact from Brazil and Russia lessen. In China, we continue to believe that the country will avoid a hard landing. We do believe, however, that “actual” Chinese economic growth will fall far short of the official targeted growth rate of 6.5 percent this year and approach 5.5 percent; despite that, significant fiscal and monetary stimuli remain in the pipeline. With manufacturing PMI releases at low levels, we expect further stimulus in the form of, most likely quarterly, interest rate/required reserve ratios (RRR) 4 cuts, infrastructure spending, and easing of credit conditions. Property prices continue to show signs of stabilization/recovery, which should continue to support growth. We continue to believe that China’s economic policy makers may widen the trading band of the CNY against a basket of currencies over the next six to nine months, but avoid sharp moves, to avoid talk of Chinese “currency wars.” We see risks for a sharper depreciation after the G20 summit in September and an actual special drawing rights (SDR) 5 inclusion in October.

Sovereign credit ratings risk has increased in EM with Brazil’s loss of its IG ratings from Moody’s. South Africa’s credit rating was cut to BBB- by Fitch, from BBB, in December, and, again, it appears Moody’s is poised to do likewise. Poland was unexpectedly downgraded by S&P last month which highlights the propensity for the ratings agencies to be more ahead of the curve than in previous down cycles. Given the general election outcome in Turkey, we now expect the country to hold onto its IG rating as long as it re-commits to fiscal discipline and avoids attempts once again to put central bank independence into question. Bucking the negative ratings trend, there are upgrade candidates in EM. During the first half of the year, we expect Hungary to regain its first IG rating in five years, and the Philippines to be upgraded.

Despite a narrowing of the EM/ developed markets (DM) growth differential and a weakening of fundamentals since the Global Financial Crisis, EM economies are still in better health than they were 10 to 15 years ago. In the absence of extremely attractive valuations and/or an improving fundamental outlook, EM economies must recommit to structural reforms to address economic challenges and restore widespread faith by the investment community. The election of reform-minded

candidates, such as those in Indonesia, India, and most recently Argentina, are steps in the right direction for these economies. There may even be some scope for political reforms in Venezuela after the opposition victory in the recent congressional elections. For long-term investors, EM debt still offers attractive real yields for an IG asset, on average; although deteriorating, it provides carry and potential spread compression.

Credit OutlookThe continued volatility in the energy market has put pressure on all the major risk markets, and correlation appears to be extremely high between crude oil prices and equities, credit, inflation expectations and even government bond yields. The weakness seems largely supply driven, with Saudi Arabia and Kuwait increasing production, while Iran’s potentially significant supply is expected to come into the market given the recent loosening of sanctions. This additional supply has thrown the market temporarily out of balance, which has resulted in storage levels rising to historically high levels, which has caused high price volatility. However, markets typically self-correct, and we have already witnessed significant curtailment of higher cost projects as market prices make the economics of investment more challenging. The demand side of the equation looks to continue to be fairly constructive as continued EM consumption growth combined with higher demand arising from lower prices. While it is very difficult to predict the timing of a recovery in oil prices, we do expect significantly more stability in the remainder of 2016 than over the past year. A good outcome would be a range between $30 to 40 per barrel.

Furthermore, it is far from clear that low oil prices are necessarily a negative for the global economy. Lower energy prices should benefit far more consumers and companies than those negatively impacted. While the correction to the downside is very sharp, with immediate noticeable impact on oil exporting countries, exploration & production (E&P) companies and oil service and equipment providers, the impact on consumers of oil is much more gradual. The extra purchasing power of consumers and the lower input prices to industry is less dramatic in nature, but we would expect the positive impact to show up in consumption trends in the coming quarters.

Finally, while the investment case for bank equities is likely to continue to be challenging as regulators demand more capital and reduce the capabilities of banks to make an adequate return on that capital, the higher buffer for unexpected losses offered by high core capital ratios, the more liquid balance sheets and lower risk taking are all undisputed positives for bank’s credit quality, and represent a secular trend which should reduce credit risk in banks. While subordinated bonds should be partially correlated to equity risk premium, we think they should also stand to benefit from the secular de-risking trend. Part of the sharp downward movement in price this month reflects the

4 The Required Reserve Ratio (RRR) is the fraction of deposits that regulators, in this case, the Federal Reserve, require a bank to hold in reserves and not loan out.5 Special drawing rights (SDR) are supplementary foreign exchange reserve assets defined and maintained by the International Monetary Fund.

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consensus long risk position amongst investors in subordinated debt in our opinion. The sell-off in stocks impacted investor demand for the more subordinated parts of the capital structure, and brought out a limited number of sellers. With the higher cost of capital for trading financial hybrid notes restricting market making capacity, combined with shallow new demand for these bonds, the sell-off early in the month was sharp. However valuation after the sell-off looked extremely attractive and a small number of new investors entered the market, which caused a sharp recovery in price late in the month.

Valuation appears quite extreme across the credit markets. In particular, the U.S. IG and HY markets appear to be compensating investors for a deterioration in fundamental backdrop that appears to us to be unrealistic. Spreads have not been this wide outside of periods of economic recession or systemic stress, and risk premia are compensating for an extremely high level of defaults. The U.S. credit markets have suffered a multiyear technical unwind of positions that were put in place during quantitative easing, where demand was artificially elevated by the portfolio rebalancing effect. The Fed has been tightening conditions since it first made reference to the tapering of asset purchases back in 2013. “Yield tourists” into the credit market have been a key driver of the weakness, along with elevated issuance levels as companies have sought to lock in low yields. The lower demand and higher supply have served to push prices lower and increased spreads. However, spreads have now widened to levels that we consider as being extreme, especially given our expectation for continued low, but positive, economic growth which should keep defaults constrained. In Europe, the opposite appears to be true, with the ECB likely to extend its buying program, and issuance year-to-date being extremely tight. However, with the exception of pockets of subordinated financial issuers, valuations in Europe do not look as attractive as in the U.S.

We continue to believe that the credit markets represent an attractive opportunity and have positioned portfolios to take advantage of this. Portfolios remain overweight of credit risk, with a focus of that exposure being in subordinated bonds from financials where valuations seem to us extreme, and with a leaning towards the U.S. credit markets which we believe offer superior value and the potential for strong excess returns over the coming months.

Securitized OutlookAgency MBS valuations continue to be stretched and we remain underweight relative to other sectors. However, current market volatility and increases in credit risk premiums have increased the value of the potential stabilizing effect of agency MBS. Overall, agency MBS can complement a more credit-sensitive portfolio which is valuable in current market conditions.

Non-agency MBS remains one of the more stable and attractive fixed income asset classes in our opinion. Given the attractive carry, improving fundamentals, and shrinking net supply, we remain overweight the non-agency MBS sector. Non-agency MBS offers spreads of 250+ basis points (bps) above U.S. Treasuries for IG bonds, and 350 to 400 bps for non-IG bonds on a loss-adjusted basis. We remain positive on the U.S. housing market given the strength of the U.S. economy, continued low mortgage rates, and above-average home affordability. From a supply perspective, we project outstanding non-agency MBS to decline by $60 billion to $70 billion in 2016, while new securitizations are projected to only amount to $30 to $40 billion.

We are cautiously overweight commercial mortgage backed securities (CMBS). We expect that commercial real estate fundamental conditions will continue to improve as the U.S. economy strengthens, and we believe CMBS is poised to perform well as a result, but we have some concerns over supply/demand dynamics given the recent spread volatility and given our expectations of future increases in new origination and issuance. We also have some concerns over 2015 and 2016 vintage origination CMBS due to the substantial increase in property values over the last few years. We favor seasoned CMBS issues, which have benefited from recent property price appreciation, over newly originated deals which may have somewhat inflated property valuations as part of its underwriting. For more recent issuances, we favor moving up the capital structure to benefit from increased structural credit protection while still receiving attractive spreads resulting from recent spread widening. Although we expect continued volatility in CMBS in 2016, we still believe that CMBS offers attractive yields and should continue to benefit from improving fundamental market conditions. While we remain overweight, we are limiting our overweight to a manageable level depending on portfolio risk profiles, given the increased volatility and mark-to-market risk in this sector.

In Europe, we believe the spread widening in UK and peripheral Europe in 2015 represents an attractive buying opportunity in 2016. The ECB appears to be committed to keep interest rates low and provide additional stimulus, and the Bank of England (BoE) seems to have delayed any potential plans to raise rates in 2016. European real estate markets are still recovering, particularly in peripheral Europe where real estate prices remain well below their peaks, and the ECB stimulus should help to reflate real estate prices. Oil price declines should also provide a positive stimulus on most European markets and improve borrowers’ abilities to afford mortgages. With improving fundamental conditions and wider spread levels, we continue to like the European residential mortgage-backed security (RMBS) and CMBS markets.

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Display 1: Asset Performance Year-to-Date

-20% -15% -10% -5% 0% 5% 10% 15% 20%

Japan Nikkei 225Euro Stoxx (Euro)Euro Stoxx (USD)

GSCI soft commoditiesMSCI developed equitiesMSCI emerging equities

US S&P 500Brent crude oil

ML Euro HY ConstrainedS&P/LSTA Leveraged Loan Index

ML US HYDollar index

CopperEUR vs. USD

Barcap Euro IG CorpBarcap US IG Corp

ML US Mortgage MasterJPM Local EM Debt

JPM External EM DebtItaly 10yr gov. bonds

Spain 10yr gov. bondsJapan 10yr gov. bonds

US 10 year TreasuryGerman 10y Bund

UK 10yr gov. bondsJPY vs. USD

Gold

1.8

-2.0

-0.4

2.02.63.3

5.1

16.7

1.8

6.65.8

1.61.21.1

0.10.0

-1.2

-3.5-5.1-5.1

-6.6

-9.5

-15.7

5.8

-1.1

-8.4

-9.6

Note: U.S. dollar-based performance. Source: Thomson Reuters Datastream. Data as of February 29, 2016. The indices are provided for illustrative purposes only and are not meant to depict the performance of a specific investment. Past performance is no guarantee of future results.

See page 12 for index definitions.

Market SummaryGlobal bonds broadly gained in the month as risk-off episodes continued. For the month, U.S., Euro Area, and UK yields all declined. Dollar strength faded against many currencies, including the yen and euro as worries about U.S. recession grew and expectations of Fed rate hikes diminished. 6

Over the month, 10-year U.S. Treasury yields decreased by 19 bps while the 2s10s curve flattened by 19 bps. 7 Euro Area bonds also gained. Ten-year German yields decreased 52 bps, while 2-year German yields, moving deeper into negative territory, decreased 23 bps. 8 Ten-year yields in Ireland, Italy, Spain decreased by 8 to 24 bps. 9 Portugal 10-year yields increased 47 bps and Greek 10-year government yields increased by 64 bps as risky assets sold-off. 10 Japanese government bond (JGB) 10-year yields decreased by 16 bps. 11

In February, the dollar lost against many major currencies. The euro gained 0.4 percent while the Japanese yen appreciated by 7.5 percent for the month, the biggest gainer in the month. 12 Fears of a negative outcome (i.e. Brexit) from the British EU referendum drove down the pound by 2.3 percent versus the dollar. Crude oil (Brent) prices sold-off again mid-month before recovering, ending at $36 from $35 last month. After a sharp sell-off in previous months, the Canadian dollar recovered some of the weakness this month and gained 3.2 percent. 13

Developed MarketsIn the U.S., the January minutes to the Fed meeting sounded mildly dovish. The Fed continues to see positive domestic progress but it will monitor financial conditions and possible international growth spillovers when making decisions. Uncertainty around its outlook has increased, which warrants additional evidence-gathering. In terms of data, January nonfarm payrolls increased 151,000 versus expectations of 195,000, and December nonfarm payrolls were revised lower to 262,000 from 292,000.14 The unemployment rate decreased to 4.9 percent, in line with consensus. Average hourly earnings rose 2.5 percent and the prior month was revised higher 0.2 percent to 2.7 percent. 15 The ISM manufacturing index rose to 48.2 in January, below consensus expectations of 48.4. Q4 GDP was revised up to 1.0 percent quarter-on-quarter, above consensus expectation of 0.4 percent. This brings 2015 growth to 1.9 percent year-on-year. Headline CPI was 1.4 percent and core CPI was 2.2 percent for January. 16

In the Euro Area, the ECB published accounts of its January meeting. The Governing Council saw increased downside risk, highlighting the declines in 5-year/5-year inflation swap rates 17 in conjunction with oil prices and the possible second-round effects of lower inflation expectations. As a result, there was broad support for reconsideration of policy at the March meeting. The Council discussed the need to avoid creating excessive expectation of easing, as had occurred before the December meeting. In terms of survey data, Euro Area manufacturing PMI came in at 51.0 in February, below 52.3 in January, and below consensus expectations of 52.0.18 Euro Area GDP for the Q4 of 2015 was 0.3 percent quarter-on-quarter, in

6 Source: Bloomberg. Data as of February 29, 2016.7 Source: Bloomberg. Data as of February 29, 2016.8 Source: Bloomberg. Data as of February 29, 2016.9 Source: Bloomberg. Data as of February 29, 2016.10 Source: Bloomberg. Data as of February 29, 2016.11 Source: Bloomberg. Data as of February 29, 2016.

12 Source: Bloomberg. Data as of February 29, 2016.13 Source: Bloomberg. Data as of February 29, 2016.14 Source: Bloomberg. Data as of February 29, 2016.15 Source: Bloomberg. Data as of February 29, 2016.16 Source: Bloomberg. Data as of February 29, 2016.17 The 5y5y inflation swap represents a swap beginning in 5 years with a maturity of 5 years whereby a counterparty pays the fixed rate while the other pays the actual inflation rate. 18 Source: Bloomberg. Data as of February 29, 2016.

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line with consensus expectations. 2015 growth was 1.5 percent for the year. Euro Area inflation was -0.2 percent for February, down from 0.3 in January. 19

In the U.K., the BoE voted 8-0 to keep monetary policy unchanged. In a dovish move, the past dissenting vote for an immediate rate rise was dropped. The Monetary Policy Committee (MPC) also published the February Inflation report. The MPC is now expecting a slower recovery in inflation and will monitor for second-round effects of low inflation. Growth was also revised down for 2016, from 2.5 percent to 2.2 percent. In terms of data, headline CPI inflation was 0.3 in January, up from 0.2 in December and in-line with consensus. 20 The unemployment rate, three-month average, stayed at 5.1 percent in December. Q4 GDP was 0.5 percent quarter-on-quarter, in line with the consensus, and unrevised from the initial estimate. This brings 2015 growth to 1.9 percent year-on-year. UK manufacturing PMI increased to 52.9 in January, from 51.8 in December, below consensus expectations of 51.6.21

In Japan, the BoJ did not meet in February. While the market interpreted the January decision by the BoJ to introduce a tiered negative interest system as the central bank came close to its policy limits, BoJ officials reiterated that the BoJ will use any available tools and can do more than the market expects. On the data front, manufacturing PMI was 50.2 for February, down from 52.3 in January. Q4 2015 GDP was -1.4 percent quarter-on-quarter, down from Q3 of 0.3 percent and below consensus expectations of -0.2 percent. Growth for 2015 was 0.5 percent. The December core national CPI (ex-Food & Energy) came in at 0.7 percent, down from 0.8 in December, and in line with consensus. 22

Display 2: Government Bond Yields for Major Economies

COUNTRY

2YR YIELD LEVEL

(%)

MONTH CHANGE

(BPS)

5YR YIELD LEVEL

(%)

MONTH CHANGE

(BPS)

10YR YIELD LEVEL

(%)

MONTH CHANGE

(BPS)

Australia 1.77 -12 1.91 -16 2.40 -24

Belgium -0.33 8 0.03 -34 0.97 -38

Canada 0.52 10 0.67 -1 1.19 -3

Denmark -0.31 -7 -0.08 -11 0.46 -16

France -0.31 -14 0.08 -32 0.99 -52

Germany -0.35 -23 -0.05 -36 0.63 -52

Ireland -0.31 3 0.04 2 0.88 -8

Italy -0.03 0 0.50 -11 1.60 -17

Japan -0.24 -16 -0.22 -16 -0.06 -16

Netherlands -0.37 -12 -0.04 -36 0.79 -54

New Zealand

2.22 -19 2.47 -26 2.97 -25

Norway 0.62 -39 0.68 1 1.48 -13

Portugal 0.11 57 1.06 82 2.52 47

Spain 0.01 2 0.67 -19 1.77 -24

Sweden -0.61 -5 -0.14 -10 0.47 -14

Switzerland -1.08 -16 -0.89 -15 -0.44 -19

United Kingdom

0.38 4 0.74 -15 1.34 -22

United States

0.77 0 1.21 -12 1.73 -19

Source: Bloomberg LP. Data as of February 29, 2016.

Display 3: Currency Monthly Changes versus U.S. DollarCurrency Monthly Change vs. USD (+ = appreciation)

-4 -2 0 2 4 6 8 10

South KoreaUK

MalaysiaBrazil

ColombiaNorwayMexico

South AfricaSweden

EuroRussia

HungaryAustralia

SingaporeNew Zealand

PolandChile

SwitzerlandIndonesia

CanadaJapan

-3.0

1.3

-2.3

-0.4

1.62.02.32.5

7.5

0.8

3.23.0

0.5

0.1

0.7

0.1

0.4

-0.2-0.2-0.3

-1.6

% Change

Source: Bloomberg LP. Data as of February 29, 2016. Note: Positive change means appreciation of the currency against the U.S. dollar.

19 Source: Bloomberg. Data as of February 29, 2016.20 Source: Bloomberg. Data as of February 29, 2016.21 Source: Bloomberg. Data as of February 29, 2016.22 Source: Bloomberg. Data as of February 29, 2016.

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Emerging MarketsAfter a painful start to the year in January, attractive valuations met with improving risk sentiment, driving a rebound for EM fixed income assets in February. Stabilization in energy and commodity prices, combined with supportive policy actions from the People’s Bank of China and relatively dovish comments by the U.S. Federal Reserve, provided a benign backdrop for EM fixed income assets. A lack of bond supply and economic data given the Chinese lunar New Year holiday also contributed to the stable environment for February. External sovereign debt outperformed domestic debt, which outperformed corporate debt as sovereign and corporate credit spreads tightened 10 bps, while domestic debt yields fell three basis points.

Brazil completed its seven-year ratings roundtrip after Moody’s stripped the country of its final IG rating as it cut Brazil’s foreign currency rating two notches to Ba2 from Baa3, and left the outlook at negative. The negative outlook suggests that more ratings downgrades could follow. The downgrade will also impact the ratings of companies within the country as the sovereign rating acts as an informal ratings ceiling. South Africa’s Finance Minister Pravin Gordhan released the government’s budget for the upcoming year. The budget was viewed slightly negative by the market, weighing on South African assets in the month, as it insufficiently addressed needed fiscal consolidation, but used relatively credible economic assumptions. The South African government is trying to rebuild credibility lost after President Jacob Zuma unexpectedly shuffled Finance Minister appointees in 2015 and must tackle an economy struggling amid the weak commodity environment.

Political uncertainty in Ukraine weighed on Ukrainian bond prices after the governing coalition broke down as infighting over corruption elevated. As the conflict continued, it was rumored that Prime Minister Arseniy Yatsenuk was ready to resign and appoint a technocratic cabinet which would be acceptable to the splintered coalition parties to avoid early elections. Ukraine is also facing a lawsuit by Russia, which was filed after Ukraine failed to make payments on $3 billion of debt Russia loaned to Ukraine during the prior government. Tensions between Turkey and Russia also escalated after a car bomb was detonated in Ankara. The Prime Minister, Ahmet Davutoglu, blamed Kurdish groups and called for NATO allies to break ties with the group, which is supported by the U.S. in its fight against ISIS in Syria. As the rhetoric escalated, Russian leaders promised to protect the territorial sovereignty of Syria, including the Kurdish fighters within Syria if Turkey were to attack with ground forces.

Positive developments in Mexico, India, and Argentina highlighted the willingness of some governments to adjust to the new economic realities they face. Mexico’s leaders took action to defend the peso at an extraordinary meeting where

the central bank hiked interest rates by 50 bps and announced that it would replace daily dollar auctions with a plan to sell U.S. dollars to banks whenever the currency needed support. In a coordinated action, the Finance Minister Luis Videgaray also announced plans to reduce government spending by 0.7 percent of gross domestic product as lower oil prices reduced government revenues. India’s government released the budget for the upcoming year where they maintained their fiscal target. The fiscal discipline provides maneuvering room for the central bank to cut interest rates to address slower economic growth without stoking inflation. In Argentina, the government made progress in negotiations with holdout creditors. With a possible deal in sight, Judge Greisa, who is overseeing the dispute, agreed to lift payment injunction if Argentina took steps to allow for payments to holdout creditors. Argentina may issue up to $15 billion in bonds to pay the holdouts and return to the international capital markets.

ExternalEM external sovereign and quasi-sovereign debt erased January’s losses as it returned 2.02 percent in February, as measured by the JP Morgan EMBI Global Index. 23 Falling U.S. Treasury yields and tightening spreads drove returns for both the HY and IG segments of the market. However, strong performance in Latin America and Africa drove the outperformance of higher-yielding bonds in the month. The stabilization in energy and commodity prices led to the outperformance of countries such as Venezuela, Gabon, Ecuador, Zambia and Ghana, while progress returning to international capital markets aided Argentina in February. Belize, Mongolia, Ukraine and Malaysia were the only countries to post negative performance in the month, while European countries such as Turkey, Serbia and Hungary lagged the broader market.

DomesticEM domestic debt returned 1.44 percent in the month as measured by the JP Morgan GBI-EM Global Diversified Index. EM currencies appreciated 0.67 percent versus the U.S. dollar and EM bonds returned 0.78 percent in local terms. 24 Indonesia, Chile and Poland outperformed the broader market as their currencies rebounded in the month. Russian debt also outperformed as local bond performance drove returns. Malaysia, Colombia and Peru underperformed the broader market as currency weakness versus the U.S. dollar weighed on performance. In addition, South Africa and Mexico underperformed as returns were hampered by local bond returns.

23 Source: JP Morgan. Data as of February 29, 2016.24 Source: JP Morgan. Data as of February 29, 2016.

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CorporateEM corporate debt returned 1.03 percent in the month as measured by the JP Morgan CEMBI Broad Diversified Index. 25 Higher-yielding, lower-quality companies underperformed IG companies over the month. Regionally, companies in Africa (South Africa), the Middle East (Qatar and UAE), and Latin America (Argentina, Peru and Guatemala) outperformed the broader market, while those in Asia (China, Hong Kong, Singapore) and Europe (Turkey) lagged.

Display 4: EM External and Local Spread Changes

COUNTRY

USD SPREAD

(BPS)

MTD CHANGE

(BPS)

INDEX LOCAL

YIELD (%)

MTD CHANGE

(BPS)

Brazil 530 -10 14.8 -30

Colombia 368 -10 8.6 7

Hungary 228 10 2.4 -11

Indonesia 345 -3 8.5 -8

Malaysia 266 19 3.8 9

Mexico 353 -9 6.1 12

Peru 260 -13 7.3 -25

Philippines 133 5 5.2 0

Poland 128 -18 2.2 -14

Russia 306 -19 9.4 -58

South Africa 443 10 9.7 26

Turkey 329 19 10.4 -17

Venezuela 3255 -305 – –

Source: JPM. Data as of February 29, 2016.

Corporate CreditAll risk markets remain extremely highly correlated with oil and both equity market and credit market performance rallied over the same period. Stocks finished the month strongly, with the S&P 500 up moderately during the month, but up 6.5 percent from the lows, and while European bourses ended the month slightly lower, the rally from the intra-month low was more than 11 percent. 26 The global credit markets ended 14 bps tighter than the intra-month wides, a spread tightening of approximately 7 percent. 27

Excess returns in the credit markets ended up negative 0.43 percent and the intra-month volatility of returns was very high. 28 This is the third consecutive month of negative total returns as spreads continue to come under pressure. The U.S.

credit market moderately outperformed Europe, generating excess returns of 0.31 percent and 0.33 percent respectively. 29

Bonds from financial issuers, and particularly subordinated financial issuers significantly underperformed the broader market reflecting the challenges facing the sector, generating excess returns of -1.06 percent. Regulatory risk has become more apparent during the year across a number of fronts. The Bank of Portugal surprised markets late in 2015 by moving some bonds from the “good” bank to the “bad” bank in the resolution of Banco Espirito Santo, while the ECB announced it would be taking a closer look at standardizing the treatment of non-performing loans across the European banking sector. This could have a material impact on capital, notably within the Italian banking system. In addition, the market started to focus on coupon deferral risk in Additional Tier 1 (AT1) bank bonds,30 particularly at Deutsche Bank where management were forced to release a statement reassuring investors they had sufficient capital to pay coupons for the next two years without the risk of regulator interference. With recession fears rising, investors have started to look at the asset quality of banks and the potential requirement for further charges for non-performing loans should the economy slow materially. Banks’ exposure to energy companies has also been a focus, and the risk that banks suffer asset quality problems as a result of this exposure has added to worries. In addition, one of the unintended consequences of the Negative Interest Rate policy is that banks’ ability to organically generate capital has been severely constrained, leaving a secondary rights issue as the only alternative source of core tier one capital. These factors have combined in investors’ minds and banks share prices have fallen sharply so far this year. Consequently, subordinated debt risk premium which is highly correlated to equity risk premium, has risen sharply. Hence bonds issued by banks have underperformed industrial bonds, which have returned -1.06 percent and -0.04 percent respectively. 31 With Lower Tier 2 (LT2) bonds 32 underperforming senior bonds, and more subordinated bonds materially underperforming versus LT2.

Primary markets in Europe remain extremely quiet. The U.S. new issue market opened back up, particularly in the latter half of February as the market tone improved. This is following a well below consensus issuance month in January. However, February issuance has been concentrated in the higher quality part of the market, and issuance of bonds with higher beta to

25 Source: JP Morgan. Data as of February 29, 2016.26 Source: Bloomberg. Data as of February 29, 2016.27 Source: Barclays. Data as of February 29, 2016.28 Source: Barclays. Data as of February 29, 2016.

29 Source: Barclays. Data as of February 29, 2016.30 Additional Tier 1 bonds qualify as core or equity capital under Basel III. They come with loss absorbency features, often automatically triggered when a bank’s capital is below a certain threshold.31 Source: Barclays. Data as of February 29, 2016.32 Tier 2 capital is one of two categories by which a bank’s capital is divided. Tier 2 capital holds a higher risk weight than Tier 1 capital in capital requirement calculations because it is considered less reliable. Lower Tier 2 capital has coupons not deferrable without triggering default.

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the market was limited. In Europe, new issuance was down across the board, and most notably in higher risk parts of the market with issuance in the first two months of the year down 95 percent in subordinated bank debt, down 89 percent in HY debt and with no issuance at all in the corporate hybrid market. 33 The only area where issuance was up was covered bonds, where issuance has been supported by the ECB’s covered bond program. Any bond that has been brought to market required a significant new issue premium to guarantee a good uptake by investors, which in turn has put pressure on the secondary market.

Display 5: Credit Sector Changes

SECTOR

USD SPREAD LEVEL (BPS)

MONTH CHANGE

(BPS)

EUR SPREAD LEVEL (BPS)

MONTH CHANGE

(BPS)

Index Level 197 +4 156 +6

Industrial Basic Industry 290 -81 213 -109

Industrial Capital Goods 134 +3 120 -2

Industrial Consumer Cyclicals

171 +6 150 +1

Industrial Consumer Non Cyclicals

147 +4 125 +1

Industrial Energy 407 -7 177 +6

Industrial Technology 159 +1 107 +9

Industrial Transportation 174 +3 131 +6

Industrial Communications 227 +5 154 +8

Industrial Other 130 -4 190 -9

Utility Electric 161 +3 170 +9

Utility Natural Gas 181 +6 144 +5

Utility Other 175 +4 131 +4

Financial Inst. Banking 169 +21 144 +21

Financial Inst. Brokerage 194 +22 149 +15

Financial Inst. Finance Companies

217 +27 112 +7

Financial Inst. Insurance 199 +20 319 +25

Financial Inst. REITS 205 +25 186 +5

Financial Inst. Other 133 +17 185 +10

Source: Barclays Capital. Data as of February 29, 2016.

Securitized ProductsThis year continues to be a tale of two securitized markets, with agency MBS performing very well and all credit-related MBS performing very poorly. The Barclays U.S. MBS Index has returned 1.7 percent through the first two months of 2016, making it one of the best performing investment sectors this

year. 34 Agency MBS underperformed U.S. Treasuries slightly in February, but outperformed all MBS credit sectors. The U.S. Treasury curve rallied and flattened in February. 35 Historically, flattening yield curves are not beneficial to agency MBS as lower mortgage rates cause faster prepayments, but agency MBS valuations performed better than expected given this curve shift. Current coupon agency MBS spreads widened 3 bps to 105 bps above interpolated U.S. Treasuries. 36 Thirty-year mortgage rates fell 7 bps to 3.69 percent, but hit 3.53 percent intra-month, the lowest level since May 2013.37 The Fed continues to reinvest pay downs and maintain their agency MBS portfolio at $1.75 trillion. 38

Non-agency MBS continued to underperform in February, widening another 25 to 50 bps. IG non-agency MBS are roughly 50 bps wider while non-IG MBS are 75 to 100 bps wider this year. Non-agency MBS spreads are at the widest levels seen since 2013. The spread widening seems to be largely a result of global risk premium increases rather than increased credit risks in the U.S. housing and mortgage markets. In contrast to the non-agency MBS price performance, mortgage fundamental market conditions remain positive. Home prices rose 0.1 percent (+0.8 percent when adjusting for seasonally) in December, and are up 5.4 percent for all of 2015.39 Home prices are up 38 percent nationally from the lows in 2012, but remain 11 percent below the peak in 2006.40 A few areas have now seen home prices exceed their previous peaks, namely San Francisco, Denver, Dallas, and Portland, but the majority of the country remains below the 2006 levels, even when not adjusting for inflation. Existing home sales remain robust, up 0.4 percent in January, to the highest annual rate in six months and pushing the annual pace to 5.47 million homes. Home sales are up 11.0 percent from a year ago. 41 With the unemployment rate now below 5 percent and with GDP growing slowly, U.S. homes remain very affordable from a historical perspective. The National Association of Realtors Home Affordability Index, which compares the median income to the cost of the median home, shows affordability to be roughly 10 percent above the 20-year average home affordability. 42 Mortgage performance also remains strong. New defaults were essentially unchanged in December at 0.8 percent annually, which is 0.2 percent lower

33 Source: Santander. Data as of February 29, 2016.

34 Source: Barclays. Data as of February 29, 2016.35 Source: Bloomberg. Data as of February 29, 2016.36 Source: Yield Book. Data as of February 29, 2016.37 Source: Bankrate.com. Data as of February 29, 2016.38 Source: Federal Reserve Bank of New York. Data as of February 29, 2016.39 Source: S&P Case-Shiller 20-City Index. Data as of February 29, 2016.40 Source: S&P Case-Shiller 20-City Index. Data as of February 29, 2016.41 Source: National Association of Realtors. Data as of February 29, 2016.42 Source: National Association of Realtors. Data as of February 29, 2016.

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than a year ago and roughly 5 percent lower than the peak in 2009.43 With unemployment low, the economy still improving, and home prices still recovering from the mortgage crisis almost 10 years ago, we expect mortgage credit performance to remain stable.

CMBS spreads widened substantially again in February. AAA-rated CMBS widened roughly 15 bps for the month and almost 30 bps on the year, while BBB-rated classes widened 50 to 100 bps during February and 250 to 300 bps in 2016.44 New CMBS issuance remains lighter than expected with roughly $10 billion issued through the first two months of the year. The market has been forecasting roughly $100 to 120 billion in 2016 to facilitate the refinancing of 2006 originated loans that are reaching their maturities, but market conditions with materially wider spread levels are likely deterring many new deals from being issued. 45 Fundamentally, CMBS performance remains on solid grounds. Commercial real estate prices were up 0.2 percent in January and up 8.8 percent over the course past 12 months. Commercial real estate prices have risen roughly 10 percent per year for the past three years and are now 23 percent above the previous peak in August 2007.46 Hotel occupancy rates remain high with 2015 averaging 65.6 percent, up from 64.4 percent in 2014 and above the previous cycle peak in 2005 of 63.2 percent. 47 Similarly, national office vacancy rates fell to eight-year lows in Q4 2015, multifamily vacancy rates remain low, and demand for industrial space remains high. 48 While price volatility and supply-demand dynamics continue to cause concerns, the fundamental conditions of the CMBS market appear to be stable.

European ABS spreads widened significantly in February, particularly in the UK and non-core Europe. Greek and Portuguese MBS widened roughly 50 bps, while Italian. Spanish and UK MBS widened 10 to 15 bps. 49 The ECB purchased €2.3 billion European ABS in January, one of their largest monthly purchases to date, and now hold €17.6 billion. 50 European ABS issuance remained low in February, totaling roughly €5 billion. 2016 year-to-date issuance totals €10.7 billion which is on a slower pace than 2015, which totaled €78.4 billion for the year. 51 European ABS issuance continues to be challenged by regulatory issues.

43 Source: S&P/Experian First Mortgage Default Index. Data as of February 29, 2016.44 Source: Barclays. Data as of February 29, 2016.45 Source: Deutsche Bank. Data as of February 29, 2016.46 Source: Green Street. Data as of February 29, 2016.47 Source: Statistica.com. Data as of February 29, 2016.48 Source: CBRE. Data as of February 29, 2016.

49 Source: MSIM. Data as of February 29, 2016.50 Source: European Central Bank. Data as of February 29, 2016.51 Source: Deutsche Bank. Data as of February 29, 2016.

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This material is for use of Professional Clients only, except in the U.S. where the material may be redistributed or used with the general public.

The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness

All information provided has been prepared solely for information purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline. Accordingly, you can lose money investing in a fixed income portfolio. Please be aware that a fixed income portfolio may be subject to certain additional risks.

Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall. In a declining interest-rate environment, the portfolio may generate less income.

Credit risk refers to the ability of an issuer to make timely payments of interest and principal.

Interest-rate risk refers to fluctuations in the value of a fixed-income security resulting from changes in the general level of interest rates. In a rising interest-rate environment, bond prices fall. In a declining interest-rate environment, the portfolio may generate less income.

Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future.

Public bank loans are subject to liquidity risk and the credit risks of lower rated securities.

High yield securities (“junk bonds”) are lower rated securities that may have a higher degree of credit and liquidity risk.

Sovereign debt securities are subject to default risk.

Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks.

The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates.

Investments in foreign markets entail special risks such as currency, political, economic, and market risks. The risks of investing in emerging-market countries are greater than the risks generally associated with foreign investments.

Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks.

Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).

Due to the possibility that prepayments will alter the cash flows on Collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third party guarantees are insufficient to make payments, the portfolio could sustain a loss.

Charts and graphs provided herein are for illustrative purposes only. Past performance is no guarantee of future results.

Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.

INDEX DEFINITIONS The indices shown in this report are not meant to depict the performance of any specific investment and the indices shown do not include any expenses, fees or sales charges, which would lower performance. The indices shown are unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

The National Association of Realtors Home Affordability Index, compares the median income to the cost of the median home.

Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector.

Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.

The J.P. Morgan Emerging Markets Bond Index Global (EMBI Global) tracks total returns for traded external debt instruments in the emerging markets, and is an expanded version of the EMBI+. As with the EMBI+, the EMBI Global includes U.S. dollar-denominated Brady bonds, loans, and Eurobonds with an outstanding face value of at least $500 million.

The JP Morgan CEMBI Broad Diversified Index is a global, liquid corporate emerging-markets benchmark that tracks U.S.-denominated corporate bonds issued by emerging-markets entities.

The JP Morgan GBI-EM Global Diversified Index is a market capitalization weighted, liquid global benchmark for U.S.-dollar corporate emerging market bonds representing Asia, Latin America, Europe and the Middle East/Africa.

The ISM Manufacturing Index is based on surveys of more than 300 manufacturing firms by the Institute of Supply Management.

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The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries. A composite diffusion index is created that monitors conditions in national manufacturing based on the data from these surveys.

The Barclays US Mortgage Backed Securities (MBS) Index tracks agency mortgage backed pass-through securities (both fixed-rate and hybrid ARM) guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The index is constructed by grouping individual TBA-deliverable MBS pools into aggregates or generics based on program, coupon and vintage. Introduced in 1985, the GNMA, FHLMC and FNMA fixed-rate indices for 30- and 15-year securities were backdated to January 1976, May 1977, and November 1982, respectively. In April 2007, agency hybrid adjustable-rate mortgage (ARM) pass-through securities were added to the index.

The Nikkei 225 Index (Japan Nikkei 225) is a price-weighted index of Japan’s top 225 blue-chip companies on the Tokyo Stock Exchange. The US Dollar Index (DXY) is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of US trade partners’ currencies. Italy 10YR gov bonds - Italy Benchmark 10 Year Datastream Government Index. The MSCI World Index (MSCI developed equities) captures large and mid cap represen-tation across 23 Developed Markets (DM) countries. Spain 10YR govt bonds - Spain Benchmark 10 Year Datastream Government Index. The BofA Merrill Lynch European Currency High Yield Constrained Index (ML Euro HY constrained) is designed to track the performance of euro- and British pound sterling-denominated below investment grade corporate debt publicly issued in the eurobond, sterling domestic or euro domestic markets by issuers around the world. The S&P 500® Index (US S&P 500) measures the performance of the large cap segment of the U.S. equities market, covering approximately 75% of the U.S. equities market. The Index includes 500 leading companies in leading industries of the U.S. economy. The JPMorgan Government Bond Index-Emerging Markets (JPM External EM Debt) tracks local currency bonds issued by Emerging Market governments. The Index is positioned as the investable benchmark that includes only those countries that are accessible by most of the international investor base (excludes China and India as of September 2013). UK 10 Yr govt bonds - UK Benchmark 10 Year Datastream Government Index. For the following Datastream government bond indices, benchmark indices are based on single bonds. The bond chosen for each series is the most representative bond available for the given maturity band at each point in time. Benchmarks are selected according to the accepted conventions within each market. Generally, the benchmark bond is the latest issue within the given maturity band; consideration is also given to yield, liquidity, issue size and coupon. German 10 YR bunds - Germany Benchmark 10 Year Datastream Government Index; Japan 10 Yr govt bonds - Japan Benchmark 10 Year Datastream Government Index; and 10-year US Treasury - US Benchmark 10-Year Datastream Government Index.

The BofA Merrill Lynch US Mortgage Backed Securities (ML US Mortgage Master) Index tracks the performance of US dollar denominated fixed rate and hybrid residential mortgage pass-through securities publicly issued by US agencies in the US domestic market. The S&P/LSTA U.S. Leveraged Loan 100 Index (S&P/LSTA Lever-aged Loan Index) is designed to reflect the performance of the largest facilities in the leveraged loan market. The Barclays Euro Aggregate Corporate Index (Barclays Euro IG Corporate) is an index designed to reflect the performance of the euro-denominated investment-grade corporate bond market. The Barclays U.S. Corporate Index (Barclays US IG Corp) is a broad-based benchmark that measures the investment grade, fixed-rate, taxable, corporate bond market. The Bank Of America Merrill Lynch United States High Yield Master II Constrained Index (Merrill Lynch US High Yield) is a

market-value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. Its securities have maturities of one year or more and a credit rating lower than BBB-/Baa3, but are not in default. JPY vs USD – Japanese Yen Total return versus USD. Euro vs USD – Euro Total return versus USD. MSCI Emerging Markets Index (MSCI emerging equities) captures large and mid cap representation across 23 Emerging Markets (EM) countries. The MSCI AC Asia ex Japan Index (MSCI Asia Ex-Japan) captures large and mid cap representation across 2 of 3 Developed Markets countries* (excluding Japan) and 8 Emerging Markets countries* in Asia. - The S&P GSCI Softs (GSCI soft commodities) Index is a sub-index of the S&P GSCI that measures the performance of only the soft commodities, weighted on a world production basis. In 2012, the S&P GSCI Softs index included the following commodities: coffee, sugar, cocoa and cotton. The Dow Jones Commodity Index Gold (Gold) is designed to track the gold market through futures contracts. The JPMorgan Government Bond Index-Emerging Markets (JPM local EM debt) tracks local currency bonds issued by Emerging Market governments. The Index is positioned as the investable benchmark that includes only those countries that are accessible by most of the international investor base (Excludes China and India as of September 2013. The ICE Brent Crude futures contract (Brent crude oil) is a deliverable contract based on EFP delivery with an option to cash settle. The S&P GSCI Copper Index (Copper), a sub-index of the S&P GSCI, provides investors with a reliable and publicly available benchmark for investment performance in the copper commodity market.

This communication is only intended for and will be only distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Prior to investing, investors should carefully review the strategy’s/product’s relevant offering document. There are important differences in how the strategy is carried out in each of the investment vehicles.

EMEA: This communication was issued and approved in the United Kingdom by Morgan Stanley Investment Management Limited, 25 Cabot Square, Canary Wharf, London E14 4QA, authorized and regulated by the Financial Conduct Authority, for distribution to Professional Clients only and must not be relied upon or acted upon by Retail Clients (each as defined in the UK Financial Conduct Authority’s rules).

Financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. MSIM shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary. If such a person considers an investment she/he should always ensure that she/he has satisfied herself/ himself that she/he has been properly advised by that financial intermediary about the suitability of an investment.

U.S.: A separately managed account may not be suitable for all investors. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2.

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Please consider the investment objectives, risks, charges and expenses of the funds carefully before investing. The prospectuses contain this and other information about the funds. To obtain a prospectus please download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.

Morgan Stanley Distribution, Inc. serves as the distributor for Morgan Stanley funds.

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Morgan Stanley Investment Management is the asset management division of Morgan Stanley.

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