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    Financial Pacific - Reconfiguring the play book (third party) Financial Pacific - Reconfiguring the play book (third party) Document Transcript

    • Wealth Management Research 2 September 2011US fixed income Anne Briglia, CFA, strategist, UBS FSReconfiguring the play book anne.briglia@ubs.com, +1 212 713 3149 Barry McAlinden, CFA, strategist, UBS FS barry.mcalinden@ubs.com, +1 212 713 3261 Donald McLauchlan, analyst, UBS FS • Uncertainty over the strength of the economy and the donald.mclauchlan@ubs.com, +1 212 713 3771 European debt crisis are twin concerns. We recommend a David Wang, associate, UBS FS further dialing down of credit risk by moving to neutral on USD david-g.wang@ubs.com, +1 212 713 9295 denominated emerging market sovereign debt. Kathleen McNamara, CFA, CFP®, strategist, UBS FS • Within the investment grade segment, we favor non-Financials kathleen.mcnamara@ubs.com, +1 212 713 3310 versus Financials. • To hedge against the risk of recession and an unanticipated USD taxable fixed income strategy drop in bond yields, we have extended the recommended Tactical deviations from benchmark, in % maturity range on taxable bonds to the four to ten year area, Investment grade corporate 2.0 up from the four to seven year range. Mortgage 1.0What a difference a month makes Emerging market 0.0A month ago, the markets were focused on the debt ceiling High Yield 0.0debate, the potential for a default on Treasury securities, and S&Ps Preferred securities 0.0downgrade of the US sovereign credit rating to AA+ from AAA.Now, however, uncertainty over the strength of the economy and the Agencies -1.0European debt crisis are the twin concerns for investors. With growth TIPS -1.0hovering at stall speed, a key question is whether the US economywill manage to muddle through or will it lose altitude and slip into Treasuries -1.0recession. Source: UBS WMR, as of 1 September 2011The data have sent mixed signals, with survey based measures This table presents the recommended asset allocationshowing a sharp deterioration in sentiment that has yet to be for the US Fixed Income portion of a portfolio. It iscorroborated by the hard data. For example, the Philadelphia Fed developed by UBS Wealth Management Research for amanufacturing index fell to -30.7 in August, a level that has historically hypothetical, average US investor with a moderate riskbeen associated with recession. Other manufacturing surveys by the tolerance, intermediate investment horizon, and totalregional Federal Reserve banks have also fallen, although not as return objective. The weights may not be suitable for all investors or investment goals and should not be used assharply. Meanwhile, the University of Michigan consumer confidence the sole basis of any investment decision. Please consultindex, which slipped to 55.7, stands at a level last seen during your UBS financial advisor to learn how these weightingsthe 2008 to mid-2009 recession. Although we expect a rebound in should be applied to your individual investment goals.growth in 2H 2011, our economics team sees more downside riskto their forecasts than in prior months. With the economic recoverylooking more fragile, we have raised the probability of recession to30%, up from 20%.Also troubling is the European debt crisis, which threatens to envelopthe financial sector as it spreads closer to the core EU countries. Sincethe inception of the debt crisis, European leaders have been behindthe curve; the decision making process has been painfully protracted;and each "solution" has proven to be nothing more than a stop-gapmeasure. Ominously, the problem appears to be growing. Yields onThis report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosuresbegin on page 13.
    • US fixed income10-year Italian and Spanish government debt, which previously Regional manufacturing indices trend lowerspiked above 6%, only fell to the 5% area after the ECB stepped Federal Reserve regional bank surveys, index levelin to support the market. Given the tight linkages between 60 80sovereigns and banks, a key concern is that a sovereign debt 40 Another soft patch or genuine weakness? 70crisis morphs into a full-fledged European-wide banking crisis. 20 60 0 50Time to play defense (20) 40In view of these risks, we recommend a further dialing down of (40) 30credit risk by moving to neutral on USD denominated emerging (60) 20market sovereign debt, and increasing the overweight on Jul-01 Jul-03 Jul-05 Jul-07 Jul-09 Jul-11investment grade corporate (IG) bonds. Maintain a neutral Empire State (lhs) Philly Fed (lhs) Richmond (lhs) Kansas City (lhs) Dallas (lhs) Chicago (rhs)allocation to high yield (HY) and preferred securities, which arethe higher beta plays within the credit segment. Within IG, we Source: Bloomberg, UBS WMR, as of 1 September 2011favor non-financials versus financials. As the recent roller coasterin the spreads on Bank of America bonds and preferred securities ECB buying has lowered yields to around 5%demonstrate, US banks are not immune to negative headline 10-year government bond yields, in %risk. Should the sovereign debt contagion spread to theEuropean banking system, we believe spreads on US banks 6.50would widen in sympathy. Finally, to hedge against the risk of 6.25recession and an unanticipated drop in bond yields, we have 6.00extended the recommended maturity range on taxable bonds to 5.75the four to ten year area, up from the four to seven year range. 5.50 5.25Slower growth, sovereign debt fears should anchor yields 5.00On 16 August, we lowered our Treasury yield forecasts, a change 4.75predicated on several developments. The first was the FOMC’s 4.50 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11announcement at the 9 August meeting that it intends to hold 10-year Italian government bond 10-year Spanish governement bondthe target fed funds rate at zero to 25bps until mid-2013. Webelieve this policy change will shift the interest rate path Source: Bloomberg, UBS WMR, as of 1 September 2011downward and will keep Treasury yields lower for longer. Inaddition, the soft patch in 1H 2011 looks to be more persistentthan we originally believed, as the recent batch of economic data US interest rate forecast (%)suggest. As a result, we believe the odds of recession have 1 Sept. in 3 in 6 in 12 End 11increased. Finally, we view the ongoing sovereign debt crisis in months months monthsEurope with concern. The inability of the political establishment 3-month 0.33 0.3 0.3 0.3 0.6to tackle the debt crisis has eroded investor confidence at the Liborsame time the contagion appears to be spreading. Thus, theTreasury market should continue to benefit from flight-to-quality 2-year 0.18 0.3 0.4 0.6 0.3flows during those time periods when sovereign debt concerns Treasuryflair anew. Against this backdrop, we continue to recommend 5-year 0.90 1.0 1.3 1.8 1.1investors maintain a neutral duration allocation. Treasury 10-year 2.13 2.3 2.5 3.0 2.4Anne Briglia, CFA Treasury 30-Year 3.50 3.8 3.8 4.3 3.8 Treasury Source: Bloomberg, UBS WMR, as of 1 September 2011 Wealth Management Research 2 September 2011 2
    • US fixed incomeRecommendations 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 USD Emerging markets (EM) We move from overweight to neutral as we don’t expect EM to See the Corporate perform as well as it did in August should risk aversion pick-up Bond Valuation again. We generally recommend exposure to EM via diversified bond Report funds and/or exchange traded funds (ETFs). However, investors with a higher risk tolerance who want direct exposure to EM may want to consider investment-grade rated credits, including quasi-sovereign oil conglomerates and large mining companies. High yield corporates (HY) HY credit spreads have widened meaningfully, making valuations Diversified attractive relative to forecasted twelve month default rates. exposure, through However, given the uncertain economic outlook, we maintain a a mutual fund or neutral allocation that was established on 19 August. closed-end fund. Investment grade corporates (IG) IG bonds are now our only credit sector overweight as we See the Corporate believe IG offers the best upside/downside qualities in Bond Valuation different potential market environments. Given the Fed’s Report commitment to keep the funds rate low into 2013, we are more comfortable assuming slightly higher duration risk in bonds with 4 to 10 year maturities. We continue to favor bonds in the BBB-rating category, with a preference for non-Financials. Mortgage backed securities We believe agency MBS offer attractive carry versus Treasury Mutual funds securities. Preferred securities European financial preferreds will likely remain sensitive to sovereign See the Preferred concerns. We recommend these securities only for investors Securities who can tolerate equity-like price volatility. We favor preferreds Valuation Report likely to be called such as US bank trust preferreds (be mindful of extension risk and regulatory call risk) and high coupon DRDs. 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. Municipal bonds: Tax exempt We maintain our preference for intermediate-term maturities for new 7 to 12 years; add money purchases. Income-oriented investors with an ability to longer maturities withstand a higher degree of price risk can be rewarded by selectively allocating a small portion of a municipal bond portfolio to longer maturities selectively. Taxable Build America Bonds Spreads on taxable BABs widened recently along with other credit- 20 to 30 years sensitive segments of the fixed income markets, yet held up slightly better compared to an index of corporate bonds. We believe taxable BABs offer high credit quality and diversification benefits for taxable fixed income portfolios. Most BABs are high duration securities and thus are longer than our recommended maturity target.Note: Bold text in the comment and implementation columns indicate changes from last month’s report.Source: UBS WMR, as of 1 September 2011 Wealth Management Research 2 September 2011 3
    • US fixed incomeCorporate bonds: Spreads correct IG and HY excess returns over TreasuriesThroughout much of this year, our fixed income IG and HY index return less Treasury index return, in %recommendations have largely favored corporate credit,including investment grade (IG) and high yield (HY) bonds that 6.0we believed would likely continue to deliver positive excess 4.0returns over Treasuries in most scenarios. One scenario where 2.0corporate credit could underperform would be if market events 0.0were to spark strong selling across all risk assets. Although this -2.0 -4.0was not our base case outlook, this was exactly what transpired -6.0in August as a classic credit market selloff ensued. -8.0 Jan-11 Feb-11 Mar-11 Apr-11 May- Jun-11 Jul-11 Aug-11 Sep-11The reaction from the credit segments of the bond market was IG less Treasuries HY less Treasurieslargely a reflection of the degree of credit risk each sectorexhibits. IG credit spreads, as measured by the Barclay’s Source: BofA Merrill Lynch, UBS WMR, 30 August 2011Corporate Index, widened to 208bps from 150bps, an enormousmove for IG. The widening was led by Financials, which gapped IG and HY spreads now trade above 10-yearout by nearly 100bps, while Industrials and Utilities were roughly averages45bps and 35bps wider, respectively. However, lower Treasury Credit spreads, in basis pointsyields helped to cushion the blow and yields on IG moved only 900 2,000modestly higher. The yield-to-worst (YTW) of the index increased 750 1,600to 3.66% from 3.53% and IG total returns were mostly flat for 600 1,200the month. 450 800 300We continue to believe that the direction of IG credit spreads will 150 400largely be a function of moves in rates and that spreads will re- 0 0main at the wider end of recent ranges should lower Treasury 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011rates persist, as we expect. Nonetheless, at current spread levels, Barclays Corporate Index (LHS) IG Average (LHS) Barclays HY Index (RHS) HY Average (RHS)we believe IG valuations are attractive. Spreads remain wellabove their pre-crisis average of 130bps despite the strong Source: Barclays Capital, UBS WMR, as of 30 August 2011fundamental shape of the corporate sector. We thereforeincrease our IG tactical weighting to +2 from +1 this month, The yield differential between Financial andmaking it our largest credit segment overweight. In an Industrial sector bonds widened in Augustenvironment where returns are more likely to be driven by credit Credit spreads, in basis pointsrisk premiums rather than interest rate risk, we believe IG offers 800the best upside/downside qualities in different possible market 600environments. Should the economy turn out weaker then weexpect, any widening of IG spreads will likely be lower than what 400HY, EM and preferreds may experience. IG would probably 200benefit from a further decline in Treasury yields that would likely 0accompany another recession. However, should the economymuddle through and investor risk taking resume, we believe IG (200)will also likely perform relatively well. 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 201 Finance OAS Industrial OAS DifferenceDespite the wider credit spread differential between financial and Source: Barclays Capital, UBS WMR, as of 30 August 2011non-financial bonds, we believe that further spreaddecompression would likely occur on any further market volatilitydriven by US growth concerns or the European debt crisis. USbanks are in fundamentally better shape than they were duringthe financial crisis and the credit spreads for some banks havewidened to mid-2009 levels. We believe the risk of impairmentto senior unsecured bondholders of the largest US universalbanks is extremely low at the present time. However, we believefinancial spreads will continue to be higher beta relative to non- Wealth Management Research 2 September 2011 4
    • US fixed incomefinancials and we therefore generally favor non-Financialpositions for investors putting new money to work in the Within the Banking sector, the senior/subordinatedcorporate bond market. Within non-Financials, we continue to yield differential also widened Credit spreads, in basis pointsprefer BBB-rated credits in the managed care, insurance, mining 900and communications sectors. Given the Fed’s commitment to 800keep the funds rate low into mid-2013, we have extended out 700 600our recommended maturity range to 4 to 10 years, from 4 to 7 500years. 400 300 200Moving down into riskier credit sectors, we observed much 100 0higher spread volatility in HY and preferreds during August. HY (100)spreads gapped to 708bps from 540bps at the beginning of 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 201 2012August and the YTW of the Barclay’s HY Index increased to Senior Subordinated Difference8.5% from 7.15%. Preferreds exhibited a similar trend as thin Source: Barclays Capital, UBS WMR, as of 30 August 2011trading conditions and investor risk aversion towards Financialscontributed to a highly volatile and choppy trading environment.Preferred spreads increased to 385bps over long-maturity HY credit spreads remain correlated to equitiesTreasuries from 300bps, and the sector exhibited intra-month Credit spreads, in basis points and S&P 500 Index level 800 1,050price swings of nearly 10%. 750 1,100 700 650 1,150Despite being the highest yielding segments of the bond market, 600 1,200we remain neutral on HY and Preferreds. After being overweight 550 1,250since the beginning of the year, we established this neutral 500 450 1,300allocation on 19 August to reflect WMR’s more cautious view on 400 1,350risk assets stemming from continued financial stress in the 350 300 1,400Eurozone and higher risk of a US recession. Valuations of HY Aug 10 Nov 10 Feb 11 May 11 Aug 11bond spreads are attractive relative to the low level of forecasted HY OAS (LHS) S&P 500 Index (RHS, reverse order)corporate default rates over the next year. However, we believe Source: Barclays Capital, Bloomberg, UBS WMR, as of 30 Augusteconomic uncertainty will keep HY spreads elevated in the near- 2011term and we continue to observe a very high correlationbetween HY spreads and equities.Barry McAlinden, CFAPreferred securities: Correlated to equitiesFollowing a 40bps widening in July, spreads of investment gradefixed-rate preferred securities have widened a further 60bps inAugust at the index level. The preferred securities marketcontinues to demonstrate heightened sensitivity to the recentexodus from risky assets, driven by concerns of anaemic Preferred prices plummeted in early Augusteconomic recovery both in the US and Europe. A weakening Year-to-date price change, in %economy is not likely to provide banks in these regions the 10.0backdrop to build or maintain margins and capital at levels 5.0necessary to absorb losses in a scenario of further macro shocks. 0.0In the US, the impact of disappointing survey-based economic (5.0)data and S&P’s downgrade of the US AAA-rating resulted inheightened risk attitudes towards the large US banks, and BAC (10.0)in particular. Furthermore, we have seen accelerated concerns (15.0)about the ability of European leaders to contain the sovereign (20.0)debt crisis on their side of the Atlantic. This caused widespread Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May- Jun-11 Jul-11 Aug-11 REIT Preferreds Trust Preferreds Non-US QDIflight-to-quality buying, causing a rally in US Treasuries and a DRD-Eligible Floating-Rateflight from those fixed income sectors that contain the highestdegree of credit risk, including preferreds. The trading Source: Bloomberg, UBS WMR, as of 31 August 2011 Wealth Management Research 2 September 2011 5
    • US fixed incomeenvironment in preferreds has also been characterized by thin Preferreds have recently demonstrated equity-likemarkets and reduced liquidity. price volatility Trend in preferreds’ daily absolute price change, in %Preferreds abruptly corrected by roughly 10% on 5 August and 8 3.0August before snapping back somewhat, but returning close to 2.5nothing in price terms for the year. With prices suppressed, 2.0preferred credit spreads versus long-term Treasuries have gapped 1.5near 400bps, a level not seen since early to mid 2009. With 1.0spreads nearly double their pre-crisis levels, we believe that they 0.5provide sufficient cushion against any moderate rise in Treasury 0.0rates that may occur. However, we see credit risk as the main Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11driver of preferred security prices in the near term rather than REIT Preferreds Trust Preferreds Non-US QDIinterest rate risk. Credit sensitivity will likely remain high while DRD-Eligible Floating-Ratemacro pressures persist, and we look for the preferred asset class Source: Bloomberg, UBS WMR, as of 31 August 2011to continue to exhibit equity-like correlation while investor risk Note: chart shows 20-day moving average to smooth out resultsaversion remains high.We continue to believe that many US banks will redeem amajority of their outstanding trust preferreds (TruPS) based onthe Dodd-Frank phase-out from 2013 to 2015. Healthier bankssuch as WFC, JPM, PNC, and USB will be in a position to redeemthem sooner, while BAC will be a laggard in any redemptionsand Morgan Stanley and Citigroup likely to fall somewhere in themiddle. The recent volatility episode demonstrated that TruPS willnot be immune to price volatility, despite the regulatory incentivefor their redemption and their potentially short lifespan. Also, aswe originally published in our FinReg fizzles out TruPS report inJuly 2010, if TruPS are trading at significant discounts, thenbanks may elect to tender for them at a premium to their marketprice rather then call them at par. Therefore, they may stillexhibit greater price sensitivity relative to each bank’s shortermaturity bonds.On 19 August we moved to a neutral allocation from moderateoverweight on preferreds, based on our view that macroconcerns and the corresponding volatility in the preferredsecurities market will remain unabated in the near-term.Henry WongBarry McAlinden, CFAEmerging markets: Adopt a neutral Emerging markets look attractive relative to IG corporatesallocation Spreads, in basis points 1,200This month we also reduce our emerging markets (EM) allocation 1,000to neutral from +1. We established an overweight position last 800month based on the improving fundamentals of many EM 600sovereigns, which we believe could lead to positive ratings 400actions relative to developed markets. In fact, S&P upgraded Peru 200to BBB from BBB- on 30 August. However, while our positiveview has not changed, we do not expect EM to perform as well 0 2001 2004 2007 2010as it did in August should risk aversion pick up again. Despite All EM EM IG IG corporatesrelatively strong fundamentals in most EM countries, foreigndebt fund managers reported USD 506mn in outflows over the Source: Barclays Capital bond indices, UBS WMR, as of 29 August 2011last four weeks, as investors continue to shun riskier asset Wealth Management Research 2 September 2011 6
    • US fixed incomeclasses. Although supply is expected to be limited (the consensusview is for negative net sovereign bond issuance through yearend), we are concerned about the lack of a credible solution toEurope’s ongoing debt crisis. We see significant potential foradditional negative spillover effect to lower rated credits, andnote that approximately 50% of the countries in most broadlyfollowed EM indices are rated below investment grade. Economicgrowth in EM countries is likely to outstrip that of the developedworld, but we doubt this will matter to risk averse investors. As aresult, we are lowering the allocation to EM sovereign bonds toneutral from +1, and increasing the overweight to investmentgrade bonds to +2 from +1.Donald McLauchlanAgency MBS: Play the carrySince we moved to an overweight (+1) in June, investors’ lack offocus on the mortgage sector, the shift to “risk off” mode, and Agency MBS spreads have widenedunwarranted fears of a pre-pay spike have sent spreads on 30- 30-year FNMA current coupon spread, in basis pointsyear current coupon agency MBS approximately 20bps wider.Yet, there are several reasons we believe agency MBS valuations 175are attractive at current levels. In a low yield environment, withthe Fed likely to remain on hold until mid-2013, investors are 150hard pressed to find fixed income investments that offer anattractive combination of incremental income and high credit 125quality. At 175bps versus the 5/10-year blended Treasury yield,the spread on the current coupon is at the widest level in two 100and a half years. Aug-09 Feb-10 Aug-10 Feb-11 Aug-11 30-Yr FNMA current coupon vs 5/10 TreasurySome of this widening is due to fears of a spike in pre-pays. Source: Bloomberg, UBS WMR, as of 1 September 2011While previous government efforts to prop up the housing sectorhave been disappointing, recent press reports indicate that theObama administration is considering several new proposals to While refis have increased, the response has beenassist struggling borrowers. Headline risk around the president’s less pronounced than in the pastupcoming “jobs” speech on 8 September could trigger some Mortgage Bankers Association refi index (lhs) and 30-yearadditional widening. However, we believe Congress is in no commitment rate, in %mood to pay for additional costly measures to stimulate the 9.00housing sector, and think the chances of a substantial, expensive 9,250 8,250 8.00new housing program are slim. Moreover, capacity constraints in 7,250the mortgage industry and stricter underwriting standards have 6,250 7.00 5,250created a more muted refi response than the absolute level of 4,250 6.00mortgage rates would suggest. We think this trend will persist, 3,250which suggests that the market may be overestimating the 2,250 5.00 1,250amount of prepay risk faced by MBS investors. 250 4.00 1998 2000 2002 2004 2006 2008 2010In addition, the technical mix looks constructive. Demand for Refi index (lhs) 30-yr committment rate (rhs)mortgages by institutional investors such as banks and mortgage Source: Bloomberg, UBS WMR, as of 1 September 2011REITs should remain strong, since these types of investors willcontinue to enjoy positive carry as long as the Fed remains on thesidelines. The possibility of additional Fed purchases of agencyMBS in another round of quantitative easing would also bepositive from a supply/demand perspective. Finally, with volatilityelevated, it may be an auspicious time to position for an eventualdecline in volatility. Wealth Management Research 2 September 2011 7
    • US fixed incomeAnne Briglia, CFAMunicipal bonds: yields hit lows, yet M/Tratios attract buyersAbsolute muni yields are now at historic lows at most segmentsof the curve. And yet, on a relative basis to Treasuries, munis M/T ratios are volatile from Treasury bond swingsoffer value, in our view. Over the past month, exceedingly strong AAA Municipal-to-Treasury ratio, in %out-performance of Treasury securities drove AAA muni-to-Treasury (M/T) ratios to levels over 110% all along the curve. At 120these levels, municipals attracted some crossover buyers. As 110many market participants will undoubtedly recall, lackluster 100demand from traditional buyers in January drove M/T ratioshigher and attracted similar interest from non-traditional 90investors. As we go to press, AAA tax-exempt muni yields are still 80at or above 100% all along the curve with the exception of the 705-year spot. The 5-year M/T ratio is at 95%, while the 10-year 60and 30-year ratio stands at 102% and 108% respectively. Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 5 yr 10 yr 30 yrAustin retains its triple-A ratingsStandard and Poor’s downgrade of the United States sovereign Source: MMD, UBS WMR, as of 30 August, 2011debt rating to AA+ from AAA on 5 August 2011 prompted manyinvestors to question whether the rating revision would have amaterial impact on their municipal bond holdings. In our August M/T yield curve comparisonUS Municipal Bond Market Chartbook, we indicated that S&P’s AAA Muni Treasury Muni/ Maturity Yield Yield Treasuriesapproach to municipal ratings left room for the affirmation of 1 year 0.22 0.1 2.20AAA ratings on some states and local governments. The ratings 5 year 0.89 0.94 0.95agency subsequently reaffirmed its view that a state or local 10 year 2.25 2.21 1.02government can exhibit stronger credit characteristics than the 15 year 3.07 2.9 1.06sovereign even during times of economic or political stress. 20 year 3.56 3.24 1.10 30 year 3.89 3.59 1.08As if to demonstrate its commitment to this point of view, S&P Source: MMD, UBS WMR as of 31 August 2011has reaffirmed its AAA rating on the general obligation debt ofAustin, Texas. In assigning the gilt-edged rating, S&P cited the Yields are near historic lowscity’s diversified economy and tax base, strong financial AAA yield curve change, in %management, and moderate debt burden. The capital city’sjobless rate was substantially lower than the state and national 5average as employment in state government and at theUniversity of Texas provided a degree of economic stability. Dell 4Computer Corp. is the third largest employer in the area. Not 3surprisingly, Moody’s and Fitch also reaffirmed Austin’s triple-Aratings. 2 1Modest supply increase expected 0We look for new issue volume to increase modestly in the fourth 5 10 15 20 25 30quarter, pressuring yields slightly higher as is consistent with 8/27/10 8/29/11 7/29/11historical trends when there is a rise in the muni calendar. Thatsaid, we are not looking for a repeat of the sharp rise in rates Source: MMD, UBS WMR, as of 30 August 2011that occurred in the last three months of 2010 that was due inlarge part to a surge in supply. Any sell-off in the Treasury bondmarket would likely negatively impact municipal bond values butthe continued outlook for slow economic growth, increasedrecession risk and the Eurozone debt crisis should lend a flight-to-quality bid and temper a material rise in Treasury rates. Wealth Management Research 2 September 2011 8
    • US fixed incomeFor more information on developments in the municipal market Taxable BABs and Industrial corporate bondincluding Vallejo, CA, Harrisburg, PA and Jefferson County, AL, spreads widened in Augustsee WMR’s August Municipal Update, 27 August 2011. BABs versus Industrial corporate spreads, in basis points 225Key Portfolio Themes 210 195 Use the municipal bond market rally to take profits and 180 diversify portfolios at a reasonable cost. Given the strong 165 municipal market performance over the past several months, valuations on a significant portion of the market have risen, 150 producing potential capital gains. Returns on the broad muni Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11 US Industrial Corp 10+yr OAS index by BofA/ML are up 7.5% year to date through 31 Build America Bond Index OAS August 2011. Also, some yields along the curve are at the lowest point of the year. This may afford investors the Source: BofA/ML, UBS WMR, as of 30 August 2011 opportunity to capture gains and rebalance portfolios as necessary. Credit quality spreads moved modestly higher Maintain intermediate-term maturity preference for new Credit quality spreads, In basis points money purchases; add longer maturities selectively. We maintain our view that the intermediate term maturity range 375 of 7 to 12 years offers investors an adequate balance 300 between risk and reward for core new money purchases. Given the steepness, particularly at the front section of the 225 municipal curve, an incremental 1.00% return is available by 150 moving to the 7 year maturity on the high grade curve from 75 4 year maturities. Another 1.00% to 1.15% can be earned 0 by extending to a 12 year maturity. On average, the 7 to 12 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 year segment offers 55% of the maximum yield available on BAA GO 10 yr - AAA GO 10 yr the curve. Income-oriented investors with longer-term A GO 10 yr - AAA GO 10 yr holding periods and an ability to withstand a higher degree AA GO 10 yr - AAA GO 10 yr of interest rate risk can be rewarded by allocating a small Source: MMD UBS WMR as of 30 August 2011 portion of a muni portfolio to the 18 to 20 year maturity range where 90% of the maximum yield available on the curve can be attained. Beyond 20 years, incremental yield opportunities are more limited and do not justify the associated price volatility. Look for high coupon bonds that offer yield pick-up versus comparable par priced or discount bonds. When available, we recommend higher coupon bonds as a way to increase current yield (coupon income divided by purchase price) and provide some price protection in a portfolio against rising interest rates. Premium bonds have shorter durations than bonds priced at par or at a discount with the same maturity date. Also, high coupon bonds that are now trading on a yield-to-call basis because interest rates have fallen since the bonds were originally issued are apt to have higher yields than bonds of similar credit quality with lower coupon rates and valued near par. The rationale for cheaper offer yields of premium priced bonds relative to par priced bonds is often explained by the individual investor’s aversion to bonds priced above par. Many individual investors are not comfortable receiving more coupon interest over time (as occurs with premium bonds) as a trade off for a reduction in principal at maturity. As a result, investors who will only purchase bonds priced near par value are forced to significantly extend maturities and/or go down in credit Wealth Management Research 2 September 2011 9
    • US fixed income quality in search of higher yields. In our view, this is not necessarily the best approach.Kathleen M. McNamara, CFA, CFP Wealth Management Research 2 September 2011 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 Benchmark Tactical Current Yields Up Yields Down Duration allocation1 deviation2 allocation3 50 bps* 50 bps* (%) (%) (%)Treasuries 5.9 7.1 2.8 -1.6 3.6 5.7 Treasuries 12.0 -1.0 11.0TIPS 6.3 11.1 0.9 -1.5 4.2 6.1 TIPS 5.0 -1.0 4.0Agencies 4.7 4.1 1.4 -0.3 1.7 3.5 Agencies 22.0 -1.0 21.0Investment grade corporates 9.5 5.8 0.1 -0.8 5.3 6.4 Investment grade corporates 22.0 2.0 24.0High yield corporates 15.1 2.0 -4.0 2.5 6.1 4.6 High yield corporates 10.0 0.0 10.0Preferred securities 13.7 4.8 0.4 N/A N/A 6.1 Preferred securities 4.0 0.0 4.0Mortgages 5.7 5.2 1.3 N/A N/A 2.6 Mortgages 20.0 1.0 21.0Emerging Market sovereign 12.5 7.5 0.8 -0.6 6.1 7.3 Emerging Market sovereign 5.0 0.0 5.0bonds (USD) bonds (USD)Municipals 2.3 7.5 1.5 N/A N/A 7.8 1 The benchmark allocation refers to a moderate risk profile. SeeTaxable Fixed Income 6.8 5.9 1.5 N/A N/A 4.8 “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 31 August 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 31 August 2011Economic snapshot US money market rates (%)Indicator (%) 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 3.9 3.8 2.5 2.3 0.4 1.0 2.5 2.0 1.8 Index DepositCPI-U 1.5 -0.7 1.4 2.6 5.2 4.1 1.2 0.6 2.9 7-day 0.21 N/A N/A N/A N/ACore CPI-U 0.0 0.9 1.1 0.6 1.7 2.5 2.0 1.7 1.5 30-day N/A 0.01 0.01 0.22 N/AUnemployment 9.7 9.7 9.6 9.6 8.9 9.1 9.0 8.8 8.9 N/A 0.00 0.02 0.28 60-day N/AFederal funds rate 0.13 0.13 0.13 0.13 0.13 0.13 0- 0- 0.13 0.25 0.25 90-day N/A 0.00 0.03 0.32 0.25Note: Bolded values are actual; non-bolded values are forecasts. Values are quarter-over- 120-day N/A 0.00 0.04 0.35 N/Aquarter annualized, except as noted. 180-day N/A 0.02 0.08 0.42 0.30Source: UBS, as of 31 August 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 1 September 2011 Wealth Management Research 2 September 2011 11
    • US fixed incomeAppendixUS fixed income yields (%)Maturity Treasury TIPS STRIPS Agencies Mortgage IG Corporate HY Corporate BABs Municipal Municipal TEY Municipal Preferred Single-A Double-B AAA 35% TEY 28% Single-A 2-year 0.19 -1.03 0.27 0.35 N/A 1.44 3.87 1.10 0.27 0.42 0.38 N/A 5-year 0.94 -0.85 1.02 1.27 2.29 2.55 5.17 2.21 0.95 1.46 1.32 N/A 10-year 2.20 0.10 2.39 2.01 3.34 4.12 6.57 3.72 2.34 3.60 3.25 N/A 20-year 3.16 0.76 3.39 3.67 N/A 5.25 7.32 5.55 3.80 5.85 5.28 N/A 30-year 3.57 1.14 3.70 3.70 N/A 5.40 7.66 6.04 3.97 6.11 5.51 6.87Note: 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 1 September 2011Highlighted securitiesHighlighted Treasury Inflation Protected Securities (TIPS)Issuer Name Coupon Maturity CUSIP Yield to Mat. (YTM)* Current factor** DurationTIPS 2.500 7/15/2016 912828FL9 -0.82 1.11774 4.64TIPS 2.375 1/15/2017 912828GD6 -0.63 1.11933 5.10TIPS 2.625 7/15/2017 912828GX2 -0.60 1.08913 5.52TIPS 1.625 1/15/2018 912828HN3 -0.44 1.07748 6.10TIPS 1.375 7/15/2018 912828JE1 -0.39 1.04678 6.60TIPS 2.125 1/15/2019 912828JX9 -0.28 1.05137 6.90TIPS 1.875 7/15/2019 912828LA6 -0.20 1.05719 7.39TIPS 1.375 1/15/2020 912828MF4 -0.09 1.04385 7.95TIPS 1.250 7/15/2020 912828NM8 -0.02 1.03505 8.44TIPS 1.125 1/15/2021 912828PP9 0.06 1.03189 8.93TIPS 0.625 7/15/2021 912828QV5 0.12 1.00153 9.58Note: *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 31 August 2011 and will change daily.Source: UBS WMR, as of 31 August 2011 Wealth Management Research 2 September 2011 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 2 September 2011 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 securities described herein may not be eligible for sale in all jurisdictions or to all categories of investors.Distributed to US persons by UBS Financial Services Inc., a subsidiary of UBS AG. UBS Securities LLC is a subsidiary of UBS AG and an affiliateof UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate whenit distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through aUS-registered broker dealer affiliated with UBS, and not through a non-US affiliate. The contents of this report have not been and will not beapproved by any securities or investment authority in the United States or elsewhere.Version as per June 2011.© 2011. The key symbol and UBS are among the registered and unregistered trademarks of UBS. All rights reserved Wealth Management Research 2 September 2011 14