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Financial Pacific - June update, beyond QE (third party), may 27.2011


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  • 1. Wealth Management Research 26 May 2011US fixed income Anne Briglia, CFA, strategist, UBS FSJune update: Beyond QE, +1 212 713 3149 Barry McAlinden, CFA, strategist, UBS FS, +1 212 713 3261 Donald McLauchlan, analyst, UBS FS • We look for credit segments of the bond market to continue, +1 212 713 3771 to generate positive total returns, as incremental credit spread Kathleen McNamara, CFA, CFP®, strategist, UBS FS improvement can offset, to some extent, the price declines, +1 212 713 3310 resulting from a moderate rise in rates. Michael Tagliaferro, CFA, analyst, UBS FS • We recommend investors utilize recent market strength to, +1 212 713 9191 upgrade portfolios in the municipal and preferred securities sectors. USD taxable fixed income strategy • Municipal investors may wish to use recent strength to diversify Tactical deviations from benchmark, in % portfolios at a reasonable cost. Preferred security holders can High yield 2.0 limit interest rate induced price loss by reducing exposure to Investment grade corporate 1.0 high duration preferreds with a low probability of being called. Preferred securities 1.0 Emerging market 0.0 Agency -1.0The Fed is scheduled to complete its QE2 Treasury purchase program TIPS -1.0at the end of June, thereby removing a substantial buyer of Treasury Treasuries -1.0bonds from the market. Yet nominal bond yields have continued to Mortgages -1.0decline from their early April highs rather than moving higher, as wemight expect the natural reaction of the bond market to be. We view Source: UBS WMR, as of 26 May 2011the path towards lower nominal rates as primarily a function of the This table presents the recommended asset allocationcurrent economic soft patch, as well as global macro and geopolitical for the US Fixed Income portion of a portfolio. It is developed by UBS Wealth Management Research for arisk factors that have contributed towards a safety bid for Treasuries. hypothetical, average US investor with a moderate risk tolerance, intermediate investment horizon, and totalContinued headlines regarding European sovereign debt concerns, as return objective. The weights may not be suitable for allwell as moderating economic data are poised to weigh on yields in investors or investment goals and should not be used asthe near-term. Nonetheless, we view rate action during May as an the sole basis of any investment decision. Please consultovershoot and expect rates to revert to ranges that were established your UBS Financial Advisor to see how these weightingsin the December 2010 through April 2011 timeframe. Despite the should be applied to your individual investment goals.upcoming end of Fed purchases, we discount the potential for a"cliff effect" and believe foreign demand at Treasury auctions remainssufficient to provide a bid for Treasury supply after the Fed buyingstops.Across fixed income, performance in May was driven almost entirelyby the dramatic rally in Treasuries over the past few weeks. As aresult, longer duration segments which are more sensitive to rateincreases outperformed shorter duration segments. In a less volatileenvironment, we believe valuation and fundamentals will be thedifferentiators, rather than rates.This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosuresbegin on page 12.
  • 2. US fixed incomeWhat will the post QE2 bond market bring?Moderate growth should support fixed income Nominal Treasury yields rose when QE2 beganWealth Management Research forecasts a self-sustaining in the fall of 2010, but have recently retreatedmoderate economic recovery scenario. While we believe this 2-year and 10-year Treasury yields, in %recovery will ultimately drive Treasury rates towards historical 4.50norms, our recommendations are based on the belief that rates 4.00 3.50may remain lower for longer with the front end of the curve 3.00anchored at extremely low levels. This provides support for our 2.50continued call for a neutral duration positioning. In the absence 2.00 1.50of a dramatic move in rates, a scenario that we deem unlikely in 1.00the near-term given the aforementioned concerns, taxable bonds 0.50 0.00with maturities in the 4 to 7 year range will perform the best, in Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11our opinion, given the steepness of the curve. 2-year Treasury yield 10-year Treasury yield Source: Bloomberg, UBS WMR, as of 25 May 2011The winding down of QE2 signifies the end of the Fed’s easingcampaign and a move to quantitative neutrality. As we lookforward to the progression into the next monetary tightening Manufacturing still firm, services softcycle, we look for long-term Treasury yields to only gradually Institute for Supply Management Purchasing Managers Indexedge higher over time, rather than explode upwards. Provided 65that the bond market adjusts to this environment and the credit 60backdrop remains strong, we believe credit segments of the 55bond market can continue to generate positive total returns, as 50incremental credit spread improvement can offset, to some 45extent, the price declines resulting from a rise in rates. 40 35Given the post-crisis credit spread contraction that has already 30taken place, markets could demonstrate greater differentiation in 2005 2006 2007 2008 2009 2010 2011bond sector returns should rates move higher. Within credit, Manufacturing Non-manufacturinginvestment grade (IG) corporate bonds and preferreds, as a Source: Bloomberg, UBS WMR, as of 25 May 2011longer duration segments, will be more sensitive to rising ratesrelative to high yield (HY) corporates. However, the ability forcredit spread compression as an offset to higher rates will be a Monthly changes in 10-year Treasury yields arekey return driver. In the IG bond market, we foresee only well correlated to monthly IG total returnsperhaps 25bps of additional spread compression as available to Monthly change in 10-year Treasury and monthly IG total returns since 1980, in %help absorb higher rates. Preferreds and HY exhibit greaterspread tightening cushion, with the potential for perhaps 50bps 10.00and 75bps of additional spread compression, respectively. 8.00Therefore these sectors could outperform if credit fundamentals 6.00 monthly IG total returnremain strong for Financials and lower-rated issuers, the primary 4.00 2.00components of preferreds and HY. 0.00 (2.00)Lower for longer fuels muni rally (4.00)Lower supply, combined with a recent sharp drop in Treasury (6.00) 2 R = 0.4887 (8.00)yields helped fuel a sharp rally in the municipal bond sector, (10.00)particularly at the front and mid-section of the yield curve, -100 -75 -50 -25 0 25 50 75 100making munis the best performing fixed income segment in May. monthly change in 10yr TreasuryWhereas the yield on the 10-year Treasury benchmark bond hasfallen roughly 45bps in recent weeks, the yield decline occurring Source: Yield Book, UBS WMR, as of 25 May 2011on comparably maturing munis was even greater givencontinued light new issue supply. The AAA municipal marketdata curve at the 10-year maturity spot stands at 2.65%, adecline of 62bps from the 3.27% level offered in mid-April.Barry McAlinden, CFA, Strategist, UBS FS Inc.Kathleen McNamara, CFA, CFP®, Strategist, UBS FS Inc.Michael Tagliaferro, CFA, Strategist, UBS FS Inc. Wealth Management Research 26 May 2011 2
  • 3. US fixed incomeUS interest rate forecast (%) Monthly changes in 10-year Treasury yields show less correlation to monthly HY returns Monthly changes in 10-year Treasury and monthly HY total 26-May in 3 in 6 in 9 in 12 returns since 1989, in % months months months months 20.003-month 0.25 0.30 0.40 0.50 0.60 15.00Libor monthly HY total return 10.002-year 0.49 1.00 1.10 1.20 1.30 5.00Treasury 0.005-year 1.73 2.25 2.50 2.63 2.70 (5.00)Treasury (10.00) 2 R = 0.015610-year (15.00) 3.06 3.75 4.00 4.13 4.25Treasury (20.00)30-Year -100 -75 -50 -25 0 25 50 75 100 4.22 4.75 5.00 5.00 5.00Treasury monthly change in 10yr TreasurySource: UBS WMR, as of 25 May 2011 Source: Yield Book, UBS WMR, as of 25 May 2011Recommendations Wealth Management Research 26 May 2011 3
  • 4. US fixed income Sector Comment Implementation US Fixed Income: Taxable: Agency securities Callable agencies offer incremental income and could outperform 3nc6m-1x; 3nc1y- non-callable bonds should Treasury yields remain range bound to 1x; 5nc6m-1x; slightly higher over the next 12 months. 5nc1y-1x TIPS Rising real yields would hurt TIPS prices and result in poor absolute 5 to 10 years performance; we therefore recommend investors plan to hold TIPS to maturity. Treasuries With the Fed unlikely to tighten until 1Q 2012, the yield curve should 4 to 7 years remain steep. If the curve stays steep and yields rise as we forecast, bonds with maturities in the 4 to 7-year range should outperform shorter and longer maturities. Emerging markets We like exposure to emerging markets via investment-grade rated See the Corporate credits, including quasi-sovereign oil conglomerates, and large mining Bond Valuation companies. Report High yield corporates An improving default rate and strong investor appetite for HY is likely Diversified to provide continued support. However, the pace totals returns thus exposure, through far through 2011 is unsustainable, in our opinion. a mutual fund or closed end fund. Investment grade corporates Given the steepness of the yield curve, bonds that mature in 4 to 7 See the Corporate years should outperform both shorter and longer-dated bonds, Bond Valuation despite the likely upward trajectory of Treasury rates. We also favor Report bonds in the BBB-rating category. Preferred securities To reduce longer term interest rate risk, focus on securities likely to be See the Preferred called such as US bank trust preferreds (be mindful of extension risk Securities and regulatory call risk), high coupon DRDs, and floaters. Valuation Report Municipal bonds: Tax exempt We prefer the 7 to 12 year maturity range (previously 5 to 10 years). 7 to 12 years Since the market consensus began to shift in mid-April towards much lower tax-exempt issuance for 2011, investor demand increased, and did so dramatically at the 5-year spot helping push the AAA muni-to- Treasury ratio (M/T) ratio at that maturity to below 70%. Taxable Build America Bonds Spreads on taxable BABs continue to improve since the program’s 20 to 30 years expiration on 31 December 2010. Most BABs are long-duration securities and thus are longer than our recommended maturity target. However, they can be suitable for income buyers with long-term time horizons who are not concerned about price volatility.Note: Bold text in the comment and implementation columns indicate changes from last month’s report.Source: UBS WMR, as of 26 May 2011 Wealth Management Research 26 May 2011 4
  • 5. US fixed income Emerging markets spreads are wide relative to USEmerging markets: Remain neutral high grade Spreads in basis pointsEmerging markets continue to boast sound fundamentals, in 1,200our view. While rising inflation remains a major source of 1,000concern, encouraging growth prospects have fueled a rebound 800in investor flows in recent weeks providing support to prices. 600Furthermore, visibility in Peru’s presidential elections has 400improved, as the market-friendlier option now seems likely to 200win the 5 June run-off. 0 2002 2004 2006 2008 2010However, a possible deterioration beyond market expectationsin the sovereign debt situation in peripheral Eurozone, and/or All EM EM HG All US HGthe ongoing political crisis in the Middle East and North Africa Source: Barclays Capital bond indices, 24 May 2011may hurt appetite for risk, diverting crossover investor flowsaway from emerging markets. Under this scenario, total returnsfor emerging markets bonds are likely to rely on dedicatedinvestors only, which may not be strong enough to supportvaluations and avoid underperformance. In addition, on 24May, the US government imposed sanctions on Venezuela’sstate-owned oil company for doing business with Iran. USsanctions are not expected to affect oil flows, but will likelyconstrain the Venezuelan oil company’s –and possiblyVenezuela’s– access to US credit and capital markets. We notethat Venezuela’s weight in some of the most broadly followedemerging market indices ranges between 6% and 8%.We therefore maintain our recommendation for a neutralallocation to emerging markets.Donald McLauchlanCorporate bonds: Mind the gapCorporate bonds generated positive total returns in May as the IG corporate bonds with intermediate maturitiesstrong rally in Treasuries bolstered performance of both have outperformed post-crisisinvestment grade (IG) and high yield (HY) bonds. As we have Total return, in %discussed in the past, we believe that at current low yields, the 16directionality of credit spreads is largely a function of interest 14 12rates, with credit spreads unlikely to tighten further until there 10is a backup in rates. Accordingly, credit spreads widened a 8touch in recent weeks - a move that we see driven by 6exceedingly low yields, rather than any deterioration in 4fundamentals. 2 - (2)Our continued preference for credit segments over non-credit Nov09 Jan10 Mar10 May10 Jul10 Sep10 Nov10 Jan11 Mar11 May11segments recognizes that opportunities for relative price 1-3 Yr 3-5 years 5-7 years 7-10 yearsappreciation are more limited going forward given the strong Source: Barclays Capital, UBS WMR, as of 23 May 2011performance of credit segments over the past two years. Still,the incremental yield that credit segments offer will continue togenerate outperformance in our opinion. We thereforecontinue to overweight HY (+2) and IG (+1). Investor appetitefor corporate bonds remains insatiable, with strong new issueactivity in May. Fundamentals continue to be supportive.In consideration of the steepness of the yield curve, as well as Wealth Management Research 26 May 2011 5
  • 6. US fixed incomeour forecast for the Fed to remain on hold until early 2012, we The declining default rate could drive HY spreadscontinue to recommend investors focus their attention on tighterbonds with maturities of 4 to 7 years. Despite persistent chatter Default rates, in % and HY credit spreads, in basis pointsabout rising rates, which by our estimation has been a concern 2,000 14% 1,800for well over a year, we reiterate our belief that interest rates 1,600 12%will remain lower for longer. 1,400 10% 1,200 1,000 8%Against this backdrop, we believe there is a significant cost 800 6%associated with shortening portfolio durations too much. In the 600 4%past, we have discussed “gap analysis”, which demonstrated 400 2% 200that by remaining in cash while waiting for better buying 0 0%opportunities (after interest rates rise), investors might forego 1999 2001 2003 2005 2007 2009 2011positive performance that would be difficult to later recoup. TTM Default Rate (2011 projected) OASWhile rising interest rates would indeed lead to negative price Source: Moodys, Barclays Capital, UBS WMR, as of 23 May 2011returns on bonds with longer durations, we believe that theincremental income generated by these bonds would more Credit spreads have gradually improved thus farthan offset this price action. Demonstrating this, the total through 2011return of bonds in the 5 to 7 year maturity bucket has more Credit Spreads, in basis pointsthan doubled that of bonds in the 1 to 3 year bucket over the 900 2,100past 18 months. 800 1,800 700 1,500Other recommendations include preferences for ‘BBB’-rated 600corporates, due to their improving fundamentals and valuation 500 1,200advantage versus higher rated securities. In addition, bonds of 400 900Financial sector issuers, offer attractive yield pick-up versus 300 600Industrials, though may be more volatile in consideration of 200European sovereign debt concerns and potential settlements 100 300with states Attorneys General regarding mortgage servicing 0 0issues. 2001 2003 2005 2007 2009 2011 IG (LHS) 10-yr Avg IG HY (RHS) 10-yr Avg HYHY bonds continue to show improving fundamentals with the Source: Barclays Capital, UBS WMR, as of 23 May 2011default rates now forecast to be below 2% for the full-year2011. As the primary risk for HY bonds, such a low default rateis an indicator of continued strong performance. For mostinvestors, exposure to HY should be taken in a diversifiedmanner through an investment vehicle such as a fund, in ouropinion.Michael Tagliaferro, CFAPreferred securities: regulatory calls The rate and credit environments remain supportive for preferredsFifth Third Bancorp (FITB) announced on 18 May that it will Preferred price changes, in %redeem FTB pr C (8.875%) at par plus accrued on 15 June2011 through the use of a regulatory par call, which caught 9.0 8.0the market by surprise based on the premium trading price 7.0prior to the announcement. FITB was able to call this security 6.0 5.0due to the fact that the regulatory call language in its 4.0prospectus did not have a "90-day window" clause, so it 3.0 2.0allowed FITB to call it anytime following the Dodd-Frank Act. 1.0As a result of FITB’s announcement, the prices of premium 0.0 (1.0)trust preferreds (TruPS) repriced lower, though many continue Dec-31 Jan-31 Feb-28 Mar-31 Apr-30 May-31to trade above par. The fact that premium priced TruPS will begradually pulled to par is to be expected, but the rapid move REIT Preferreds Trust Preferreds Non-US QDI DRD-Eligible Floating-Ratewas likely due to increased market awareness that thepossibility of early regulatory calls exists and also the fact that Source: Bloomberg, UBS WMR, as of 24 May 2011 Wealth Management Research 26 May 2011 6
  • 7. US fixed incomesome TruPS do not contain 90-day window language. Spreads hover above their historical average andWe view FITB’s announcement as a unique situation, and we have moderate room for improvement, in our view Preferred credit spreads vs long-term Treasuries (bps)continue to believe that most banks will refrain from calling 1600their TruPS until 2012 or early 2013 since they will continue to 1400receive full Tier 1 treatment until 2013. However, the possibility 1200of regulatory calls is a risk factor that investors should consider 1000when holding premium TruPS. For those securities with 90 day 800window language, it remains unclear what may constitute 600another capital treatment event prior to the beginning of the 400Tier 1 phase-out on 1 January 2013. Citigroup recently stated 200during their fixed-income investor call that the Fed’s notice of 0 1999 2001 2003 2005 2007 2009 2011proposed rulemaking (NPRM) that is scheduled for release later YTM spread vs long Treasuries Pre-crisis averagethis year may open up a regulatory call window, but that they Crisis averagewill continue to review this with their legal team. While awindow must be open to call those TruPS with 90-day window Source: BofA Merrill Lynch, UBS WMR, 24 May 2011language, those with more flexible “anytime” call languageexhibit greater early call risk due to the flexibility that theyprovide issuers for early regulatory calls. For further details, seeour report titled Uncertainty of regulatory calls, 23 May 2011.We maintain our overweight allocation to preferreds based onour view that preferred credit spreads remain wide enough toabsorb a moderate move higher in benchmark Treasury rates.Over the longer-term, however, we believe that manypreferreds that are not called will likely experience some degreeof interest-rate related price loss relative to current levels.Preferred security holders who may be sensitive to pricefluctuation may utilize the current low rate environment toassess the duration risk of individual preferred holdings, usingthe coupon type and size and the security’s structure to assessits likelihood of being called. To lower potential interest rateinduced price loss, investors may consider reducing exposure tohigh duration preferreds with a low probability of being called.Barry McAlinden, CFAMunicipal bonds: Lower for longer fuelsrally Supply continues to surprise on the downside Total monthly municipal issuance, in USD millionsIn the recent bond market rally, munis followed the direction ofTreasuries to lower yields while the supply factor (or lack 50thereof) led to notable outperformance by the sector.Municipal-to-Treasury ratios at the 5-, 10- and 30-year maturity 40points stand at 69.4%, 84.6% and 100.5%, down from 3077.8%, 91.6% and 104.7%, respectively, in mid-April. In 20addition to the direction of Treasury rates, the performance ofthe municipal market hinges heavily on technical factors of 10supply relative to demand. We note that the continued 0absence of significant buyers of long-term munis has limited Jan-10 May-10 Sep-10 Jan-11 May-11the level of outperformance arising at that segment of the Total Issuancecurve. Despite the recent rally, yields on high quality 30-yearmunis are still in excess of Treasury yields with comparable Source: Bond Buyer, UBS WMR, as of 23 May 2011maturities. Wealth Management Research 26 May 2011 7
  • 8. US fixed incomeRally too far to fast? M/T ratios fall sharply at front part of the curveLast month we wrote about our expectation for technical AAA Municipal-to-Treasury ratio, in %factors related to high anticipated seasonal redemptions inJune to provide some near-term price support to the market. 200That said, we did not expect the magnitude of the bond rally 175that ensued. In our Municipal Bond Market Chartbook dated 2 150May 2011, we cited an industry survey conducted by Municipal 125Market Data (MMD) that showed market participants were 100reducing their bearish views on the sector yet few were 75outright bullish. 50 2007 2008 2009 2010 2011At this stage, it is evident that some confidence has returned to AAA GO 30 Year AAA GO 10 Year AAA GO 5 Yearthe sector. Yet risks remain. On the credit side, federal stimulusaid to US states ceases at the end of next month, coincidingwith the majority of states finalizing FY 2012 budgets. Also, Source: MMD, UBS WMR, as of 23 May 2011Moody’s cautioned in a recent special report that letter-of-credit expirations in the municipal market will create somerollover risk. As a result of these factors and a variety of other Tax-exempt curve is still steepchallenges facing state and local governments, we expect to AAA yield curve change, in %see credit rating downgrades to be more common thanupgrades and greater stress at the local level than for state 5governments. For our risk assessment and trends to watch, see 4page 40 in our new research report: Exchange: The municipalbond market: A whole new world, Spring 2011. 3 2Investors should be prepared for technical factors to weaken 1after Labor Day. A potential rise in Treasury yields from theircurrent low levels combined with some supply returning to the 0muni market could pressure muni yields higher. Offsetting 5 10 15 20 25 30 5/24/10 4/23/10 5/23/11factors that could keep municipal yields lower for longerinclude: a structural shift to a prolonged period of lowerissuance and Treasury rates not rising significantly. Source: MMD, UBS WMR, as of 23 May 2011Key Portfolio Themes• Use the recent municipal bond market rally as anopportunity to take profits and diversify portfolios at areasonable cost. While it is possible for muni yields to fallfurther in the near-term, we believe that recent price gainshave occurred in the midst of a longer-term secular shift tohigher interest rates that will pull muni yields along. Given thepositive municipal market performance over the past fewmonths, valuations on a significant portion of the market haverisen, producing potential capital gains. Returns on the broadmuni index by BofA/ML are up 4.1% year-to-date through 23May 2011.• Upgrade sectors. We continue to advocate the high qualitysectors of the muni market such as essential purpose revenuebonds in the water/sewer and public utility sector, broad basedsales tax bonds with ample coverage and a conservativeadditional bonds test, major established transportation agencyissuers, and voted general obligation bonds. Exercise cautionwhen a local government is overly reliant on state-sharedrevenue. With that said, payment defaults are still concentratedin the riskiest segments of the muni market, specifically, land-based finance, multi-family housing and long-term care. Wealth Management Research 26 May 2011 8
  • 9. US fixed income• Focus on the 7-to-12 year maturity range for newmoney purchases. We view this range as the bestcompromise between the attractiveness of earning extra yieldby extending maturities, given the steep tax-exempt yieldcurve, while seeking to limit exposure to rising yields should theTreasury market sell-off. Yields on AA and AAA high qualitymunis in this segment of the yield curve range from 1.93% to3.22%, compared to less than 1.00% on shorter-dated 1- to 3-year munis. We previously preferred the 5-to-10-year range.However, with the 5-year AAA muni-to-Treasury ratio now atjust 69%, we believe this maturity is overvalued. Since themarket consensus began to shift in mid-April towards muchlower tax-exempt issuance for 2011, investor demandincreased, and did so dramatically at the 5-year spot.Kathleen M. McNamara, CFA, CFP® Wealth Management Research 26 May 2011 9
  • 10. US fixed incomeAppendixSnapshot: Asset allocation, returns and yield tablesUS fixed income sector returns (%) US fixed income asset allocation 2010 YTD MTD 6-Month 6-Month Effective Bench Benchmark Tactical Current Yields Yields Up Yields Down Duration alloca devia allo allocation1 deviation2 allocation3 bps 50 bps* 50 bps*bps (%) (%) (%)Treasuries 5.9 2.1 1.1 -1.1 3.9 5.3 Treasuries 12.0 -1.0 11.0TIPS 6.3 4.7 0.1 -0.3 5.1 5.1 TIPS 5.0 -1.0 4.0Agencies 4.7 1.7 0.5 -0.4 2.1 3.3 Agencies 22.0 -1.0 21.0Investment grade corporates 9.5 3.7 1.0 -0.6 5.4 6.3 Investment grade corporates 22.0 1.0 23.0High yield corporates 15.1 5.9 0.4 1.9 5.5 4.3 High yield corporates 10.0 2.0 12.0Preferred securities 13.7 5.5 0.7 N/A N/A 5.2 Preferred securities 4.0 1.0 5.0Mortgages 5.7 2.5 0.9 N/A N/A 4.1 Mortgages 20.0 -1.0 19.0Emerging Market sovereign 12.5 3.5 1.3 -0.4 6.2 7.2 Emerging Market sovereign 5.0 0.0 5.0bonds (USD) bonds (USD)Municipals 2.3 4.2 1.9 N/A N/A 7.9 1 The benchmark allocation refers to a moderate risk profile. SeeTaxable Fixed Income 6.8 2.6 1.0 N/A N/A 5.0 “Sources of Benchmark Allocations and Investor Risk Profiles” in the Appendix of the Investment Strategy Guide for an*Note: Columns represent forecasted total returns of the respective index based on explanation regarding the source of benchmark allocations andparallel up and down yield curve shifts of 50bps over a six month time horizon. their suitability.Source: BofA Merrill Lynch Indices, Yield Book, UBS WMR, as of 25 May 2011 2 See "Deviations from Benchmark Allocations" in the Appendix of the Investment Strategy Guide for an explanation regarding the interpretation of the suggested tactical deviations from benchmark. 3 The current allocation column is the sum of the benchmark allocation and the WMR tactical deviation columns. Source: UBS WMR and Investment Solutions, as of 26 May 2011Economic snapshot US money market rates (%)IndiIndicator (%) 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q Ann. Muni Treasury Discount Commercial Certificates 10 10 10 10 11 11 11 11 2011 Swap Bill Notes Paper ofReal GDP 3.7 1.7 2.6 3.1 1.8 3.1 3.5 3.0 3.0 2.7 Index DepositCPI-U 1.5 -0.7 1.4 2.6 5.2 1.4 2.8 0.8 0.3 2.6 7-day 0.20 N/A N/A N/A N/ACore CPI-U 0.0 0.9 1.1 0.6 1.7 1.1 0.6 1.4 1.2 1.3 1.2 30-day N/A 0.04 0.04 0.16 0.15Unemployment 9.7 9.7 9.6 9.6 8.9 8.7 8.6 8.5 8.7 60-day N/A N/A 0.02 0.05 0.20Federal funds rate 0.13 0.13 0.13 0.13 0.13 0- 0- 0- 0.18 0.25 0.25 0.25 90-day N/A 0.04 0.06 0.22 0.15Note: Bolded values are actual; non-bolded values are forecasts. Values are quarter-over- 120-day N/A 0.05 0.08 0.24 N/Aquarter annualized, except as noted. 180-day 0.55 N/A 0.08 0.11 0.27Source: UBS, as of 26 May 2011 Note: Rates shown are discount yields on T-bill, discount notes, and commercial paper. CD rates are annual percentage yields (APY). Source: Bloomberg and UBS as of 26 May 2011 Wealth Management Research 26 May 2011 10
  • 11. US fixed incomeAppendixUS fixed income yields (%)Maturity Treasury Treasury TIPS STRIPS Agencies Mortgage Mort IG Corporate Corpo HY Corporate BABs Municipal Municipal TEY Municipal Munici Munici Preferred Pre Single- Single-A Double- Double-B AAA 35% TEY 28% aSingle-A Single- 2-year 0.42 -1.48 0.58 0.50 N/A 1.42 2.97 1.50 0.46 0.71 0.64 N/A 5-year 1.65 -0.45 1.83 1.85 3.15 2.82 4.68 2.81 1.33 2.05 1.85 N/A 10-year 3.06 0.76 3.26 2.87 3.97 4.46 6.12 4.17 2.84 4.37 3.94 N/A 20-year 3.96 1.46 4.12 4.35 N/A 5.51 6.79 5.91 4.21 6.48 5.85 N/A 30-year 4.25 1.78 4.32 4.40 N/A 5.58 7.14 6.36 4.40 6.77 6.11 6.71Note: Mortgage yields are for the 15- and 30-year current coupon. Municipal AAA curve reflects the taxable equivalent yield (TEY) based on the 35% and 28%federal tax bracket. Preferred yield is estimated YTM for a new issue Single-A trust preferred.Source: Bloomberg, Municipal Market Data, UBS, UBS WMR, as of 26 May 2011Highlighted securitiesHighlighted Treasury Inflation Protected Securities (TIPS)Issuer Name Cou Coupon Maturity CUSIP Yield to Mat. (YTM)* Current factor** DurationTIPS 0.125 4/15/2016 912828QD5 -0.38 1.01082 4.88TIPS 2.500 7/15/2016 912828FL9 -0.37 1.10481 4.84TIPS 2.375 1/15/2017 912828GD6 -0.13 1.10639 5.29TIPS 2.625 7/15/2017 912828GX2 -0.07 1.07654 5.69TIPS 1.625 1/15/2018 912828HN3 0.12 1.06502 6.29TIPS 1.375 7/15/2018 912828JE1 0.18 1.03468 6.79TIPS 2.125 1/15/2019 912828JX9 0.32 1.03921 7.06TIPS 1.875 7/15/2019 912828LA6 0.39 1.04496 7.55TIPS 1.375 1/15/2020 912828MF4 0.53 1.03178 8.13TIPS 1.250 7/15/2020 912828NM8 0.61 1.02308 8.61TIPS 1.125 01/15/2021 912828PP9 0.73 1.01996 9.09Note: *The interdealer price and the Yield to Maturity (YTM) listed herein represent an indicative price and yield on the date of publication and does not considertransaction costs. An investor should not expect to be able to execute at this price nor receive this yield.**Factor represents the inflation adjustment to bonds par value as of 26 May 2011 and will change daily.Source: UBS WMR, as of 26 May 2011 Wealth Management Research 26 May 2011 11
  • 12. US fixed incomeAppendixFor a complete set of required disclosures relating to the companies that are the subject of this report, please mail arequest to UBS Wealth Management Research Business Management, 1285 Avenue of the Americas, 13th Floor, Avenueof the Americas, New York, NY 10019.Analyst certificationEach research analyst primarily responsible for the content of this research report, in whole or in part, certifies that withrespect to each security or issuer that the analyst covered in this report: (1) all of the views expressed accurately reflect hisor her personal views about those securities or issuers; and (2) no part of his or her compensation was, is, or will be, directlyor indirectly, related to the specific recommendations or views expressed by that research analyst in the research report.UBS FS and/or its affiliates trade as principal in the fixed income securities discussed in this report. Wealth Management Research 26 May 2011 12
  • 13. US fixed incomeAppendixDisclaimerIn certain countries UBS AG is referred to as UBS SA. This publication is for our clients’ information only and is not intended as an offer, ora solicitation of an offer, to buy or sell any investment or other specific product. It does not constitute a personal recommendation or takeinto account the particular investment objectives, financial situation and needs of any specific recipient. We recommend that recipients takefinancial and/or tax advice as to the implications of investing in any of the products mentioned herein. We do not provide tax advice. The analysiscontained herein is based on numerous assumptions. Different assumptions could result in materially different results. 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The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved. Wealth Management Research 26 May 2011 13