Global Fixed Income Bulletin Where Is All The Yield Going?

WHERE IS ALL THE YIELD GOING?Fixed Income OutlookDespite all the Sturm und Drang of market action and confusingnews flow in June (inflation, employment, supply bottlenecks),we do not believe there are big investment implications beyondthe fact that risk-free government yields are getting as lowas they likely can without a fundamental rethink about thetrajectory of economies and policy responses. Looking at thefacts, we can see business outlooks and confidence surveys athigh levels; strong employment growth; strong productivitygrowth (no sign in margin squeezes); strong economic growth(as measured by GDP); easy monetary policy (U.S. financialconditions continue to set new levels of easiness) despiteworries about the Fed and other, particularly EM, central bankstightening policy; and easy fiscal policy, at least in Europe andthe U.S. While policy actions will not continue forever, U.S.supplemental unemployment benefits are slowly expiring,household and corporate balance sheets are flush, almost neverstronger. An indication of how flush is the ratio of bank depositsto loans on bank’s balance sheets. Currently deposits are greaterthan bank credit! The need to borrow is low. And, deposit growthis twice as high as credit growth. Household savings rates areat very high levels, providing ample ammunition to fund strongspending for the next few years; ditto for corporations.This leads to a critical question. Will savings built up over thepandemic be spent? As policy support inevitably fades, even ifslowly, will private sector spending pick up the slack? Most likelyyes, allowing the economic expansion to remain strong (albeit atlower levels than 2021) and continuing through 2022, pushingthe U.S. economy to over full employment at sometime late thisyear or early next year. With U.S. financial conditions at historicaleasy levels and European levels moving in that direction, it seemsunlikely that the economic cycle is anywhere near its end point.Indeed, with office workers just beginning to trickle back tooffice buildings, it seems perverse to think we are near the end ofthe cycle.Despite the ongoing rally in credit markets, we believe asanguine view remains appropriate. Strong economic data (evenif decelerating, as U.S. H1 growth is unsustainable), strongcorporate revenue and robust balance sheets remain quitesupportive despite high valuations. Historically, we have seencredit spreads, both IG and HY, remain on the expensive sideof average for long periods of time, especially when economicgrowth is this strong and monetary tightening is still far away.Moreover, with government bond yields still negative in muchof the world, the search for yield is not likely to abate in anysignificant way. That said, it is dangerous to completely ignorevaluations, so we continue to advocate a selective approach,looking for companies that will thrive in the post-pandemic worldand not engage in too much creditor unfriendly activities. We doexpect companies, in general, to be a bit more conservative incash flow/balance sheet management after the searing pandemicexperience in 2020.The rally in government bonds is fast approaching levels whichlook too low relative to a sanguine view of the future. U.S.Treasury 10-year real yields are back near -1%, not far fromlows seen in May or even during depths of despair in February2020. This is not sustainable unless we are returning to asecularly stagnant world even worse than experienced priorto the pandemic. This could happen if the COVID epidemichas left permanent scarring on the economy, causing potentialgrowth rates to be lower and hence also lowering the neutralpolicy rate to which central banks look to raise rates over time.Easier monetary policy is required to achieve the same growthand inflation rates that prevailed pre-pandemic. Japanificationwould be an apt description, where household savings stayhigh. Governments drop helicopter money (think MMT) andhouseholds and corporates recycle it back into bank deposits.Real yields and inflation are low; government debt is high;employment is high, but wage growth is low and growth anemic.We do not think this is going to happen to the U.S., China or EM(Europe remains a work in progress) but vigilance is requiredto monitor developments on the policy and private sectorbehavior fronts to make sure, the policy rug is not pulled outfrom under economies and the private sector remains confidentenough about the future to increase spending and reduceabnormally high (by the standard of normal times) savings.10-year U.S. Treasury yields look too low at 1.2%, as do 10-yearGerman government bonds at yields lower than -0.4%. Durationmanagement in the second half of the year may be critical togenerating positive returns.The bottom line is that an investment strategy focused on acontinuation of low nominal (and in particular real) yields, stronggrowth (in output and incomes), rising vaccination rates, andstable policy remains intact. While it is difficult to believe thatglobal developed market yields will not go higher eventually,we should not count on it happening in the very short term,given technical and liquidity dynamics at work (summer liquidityand of course the August curse when things seem always togo haywire somewhere in the world). Credit spreads shouldremain well supported but higher quality bonds will struggleto tighten further; widening should be a buying opportunitygiven the medium term outlook. Cyclical assets should continueto outperform, as we have seen CCC rated bonds do in recentweeks and months. Selective emerging markets and securitizedcredit remain attractive. As we have discussed before, the dollarremains a bellwether of where the global economy is going:weaker is good/stronger is bad.The views and opinions expressed are those of the Portfolio Management team as of July 2021 and are subject to change based on market, economicand other conditions. Past performance is not indicative of future results.FIXED INCOME MORGAN STANLEY INVESTMENT MANAGEMENT3

GLOBAL FIXED INCOME BULLETINDevelopedMarket (DM)Rate/ForeignCurrency(FX)EmergingMarket(EM) Rate/FXMONTHLY REVIEWOUTLOOKIn June, 10-year yields fell across the developedmarkets, despite continued strong economic dataand muted volatility. In the U.S., the yield curveflattened meaningfully as rate hike expectationsare forecasted to be sooner than previouslythought following a hawkish shift in tone fromthe Fed at its June meeting, but the terminal,or neutral, policy rate is now being priced to belower. U.S. 10-year breakeven inflation fell overthe month, although investor concern aroundrising inflation remained. As vaccination roll-outcontinued to accelerate across the EU, the ECBpresented a more positive outlook to the region’seconomy at its June meeting. The ECB upgradedits GDP and inflation projections, while alsoviewing the increase in inflation as transitory. TheBank of England kept rates and asset purchasesunchanged at its June meeting, despite risinginflation and stronger than expected GDP growth;the market interpreted the meeting as dovish dueto the committee communicating it doesn’t planto raise rates for quite some time still.Falling infection rates, vaccine rollouts and strongefficacy results, massive U.S. fiscal stimulus,high savings rates, economic re-openings anddovish central banks are buttressing a verypositive outlook for economies for the secondhalf of this year. With the 1.9 trillion support/stimulus package being implemented, U.S. fiscalpolicy is on a trajectory to significantly improve2021/2022 growth globally, not just in the U.S.With a second, infrastructure package also likelyto be discussed in the fall, probably worth at leastanother 1 trillion, the tailwind for the U.S. andglobal economy is strong, even with an upwardtrend in yields seen so far this year.EM debt returns were mixed in June. Hardcurrency sovereigns delivered strong returns,predominantly driven by lower U.S. Treasuryyields. EM Corporates were also positive forthe month, according to the JPM CEMBI BroadDiversified Index, with high yield outperforminginvestment grade corporates Local currencybonds posted negative returns, due to weaker EMcurrencies versus the U.S. dollar. From a sectoralperspective, companies in the Transport, Oil &Gas, TMT and Utilities led the market, whilethose in the Real Estate, Financial, Industrial andConsumer sectors underperformed.We remain generally constructive on EM FixedIncome assets in the weeks ahead on the backof continued stability in UST yields, a steadymovement towards reopening in developedmarkets, and a pickup in vaccination rates inseveral EM economies.While we do not expect a dramatic sell-off ingovernment bond markets, we think the riskis skewed to yields rising, as valuations arenow considerably richer than they were twomonths’ ago. The recent price action only makesfundamental sense if one believes the neutralpolicy rate, r*, has shifted considerably lower postpandemic. While it is possible this has happened,it will take time for it to be proven one way orthe other, and we do not see what new data haveemerged to cause investors to become bearishabout long term growth. The current surge ininflation is expected to be transitory but there isa risk it becomes more persistent due to higherwages and inflation expectations. The fact thatreal yields remain close to all-time lows suggestsfinancial conditions remain very accommodative.The views and opinions expressed are those of the Portfolio Management team as of July 2021 and are subject to change based on market, economicand other conditions. Past performance is not indicative of future results.4MORGAN STANLEY INVESTMENT MANAGEMENT FIXED INCOME

WHERE IS ALL THE YIELD GOING?1MONTHLY REVIEWOUTLOOKCreditCredit spreads over the month ground tighter inEuro and U.S. IG. Credit markets also benefittedfrom slightly higher equities and lower volatility inthe month. Curves flattened as long-dated paperoutperformed. Supply picked up in the monthahead of the summer with 24bn in Corporatesand 30bn in Financials (of which 10bn was inREITs) taking gross issuance YTD to 327bn.1We remain constructive on credit, and see theasset class supported by a few key factors. Firstly,there remains expectations of an economicrebound in 2021. This will be facilitated bycontinued positive support from monetary andfiscal policy as rates stay accommodative and QEcreates strong demand. We expect corporatesto maintain conservative strategies until the realeconomy normalises. Finally, we expect continueddemand for credit in general, if risk-free assetscontinue to offer negative real and absolute yields.SecuritizedProductsJune experienced active new issuance, quietsecondary trading activity and relatively lowmarket volatility. Interest rates remainedlargely range-bound, and the curve flattenedmeaningfully as expectations of potential Fed ratehikes were pulled forward.Credit fundamentals remain strong in theresidential and consumer sectors of thesecuritized markets, while commercial real estatecontinues to face some remaining pandemicinduced stress. We continue to have a positiveoutlook on residential and consumer creditsectors and a more cautious view on commercialmortgage backed securities (CMBS).Source: Bloomberg, as of June 30, 2021The views and opinions expressed are those of the Portfolio Management team as of July 2021 and are subject to change based on market, economicand other conditions. Past performance is not indicative of future results.FIXED INCOME MORGAN STANLEY INVESTMENT MANAGEMENT5

GLOBAL FIXED INCOME BULLETINRisk ConsiderationsDiversification neither assures aprofit nor guarantees against loss in adeclining market.There is no assurance that a portfolio willachieve its investment objective. Portfoliosare subject to market risk, which isthe possibility that the market values ofsecurities owned by the portfolio willdecline and that the value of portfolioshares may therefore be less than whatyou paid for them. Market values canchange daily due to economic and otherevents (e.g. natural disasters, health crises,terrorism, conflicts and social unrest) thataffect markets, countries, companies orgovernments. It is difficult to predict thetiming, duration, and potential adverseeffects (e.g. portfolio liquidity) of events.Accordingly, you can lose money investingin a portfolio. Fixed-income securities aresubject to the ability of an issuer to maketimely principal and interest payments(credit risk), changes in interest rates(interest rate risk), the creditworthinessof the issuer and general market liquidity(market risk). In a rising interest-rateenvironment, bond prices may fall and mayresult in periods of volatility and increasedportfolio redemptions. In a declininginterest-rate environment, the portfoliomay generate less income. Longer-termsecurities may be more sensitive to interestrate changes. Certain U.S. governmentsecurities purchased by the strategy, suchas those issued by Fannie Mae and FreddieMac, are not backed by the full faith andcredit of the U.S. It is possible that theseissuers will not have the funds to meet theirpayment obligations in the future. Publicbank loans are subject to liquidity risk andthe credit risks of lower-rated securities.High-yield securities (junk bonds) arelower-rated securities that may have ahigher degree of credit and liquidity risk.Sovereign debt securities are subject todefault risk. Mortgage- and asset-backedsecurities are sensitive to early prepaymentrisk and a higher risk of default, andmay be hard to value and difficult to sell(liquidity risk). They are also subjectto credit, market and interest rate risks.The currency market is highly volatile.Prices in these markets are influencedby, among other things, changing supplyDEFINITIONSR* is the real short term interest rate that would occur when the economyis at equilibrium, meaning that unemployment is at the neutral rate andinflation is at the target rate. Basis point: One basis point 0.01%.INDEX DEFINITIONSThe indexes shown in this report are not meant to depict the performanceof any specific investment, and the indexes shown do not include anyexpenses, fees or sales charges, which would lower performance. Theindexes shown are unmanaged and should not be considered an investment.It is not possible to invest directly in an index.The Bloomberg Barclays Euro Aggregate Corporate Index (BloombergBarclays Euro IG Corporate) is an index designed to reflect the performanceof the euro-denominated investment-grade corporate bond market.The Bloomberg Barclays Global Aggregate Corporate Index is the corporatecomponent of the Barclays Global Aggregate index, which provides abroad-based measure of the global investment-grade fixed income markets.The Bloomberg Barclays U.S. Corporate Index (Bloomberg Barclays U.S.IG Corp) is a broad-based benchmark that measures the investment-grade,fixed-rate, taxable corporate bond market.The Bloomberg Barclays U.S. Corporate High Yield Index measures the marketof USD-denominated, non-investment grade, fixed-rate, taxable corporate bonds.Securities are classified as high yield if the middle rating of Moody’s, Fitch,and S&P is Ba1/BB /BB or below. The index excludes emerging market debt.The Bloomberg Barclays U.S. Corporate Index is a broad-based benchmarkthat measures the investment grade, fixed-rate, taxable, corporate bond market.and demand for a particular currency;trade; fiscal, money and domestic orforeign exchange control programs andpolicies; and changes in domestic andforeign interest rates. Investments inforeign markets entail special risks such ascurrency, political, economic and marketrisks. The risks of investing in emergingmarket countries are greater than therisks generally associated with foreigninvestments. Derivative instrumentsmay disproportionately increase losses andhave a significant impact on performance.They also may be subject to counterparty,liquidity, valuation, and correlation andmarket risks. Restricted and illiquidsecurities may be more difficult to selland value than publicly traded securities(liquidity risk). Due to the possibility thatprepayments will alter the cash flows oncollateralized mortgage obligations(CMOs), it is not possible to determine inadvance their final maturity date or averagelife. In addition, if the collateral securingthe CMOs or any third-party guaranteesare insufficient to make payments, theportfolio could sustain a loss.The Bloomberg Barclays U.S. Mortgage Backed Securities (MBS) Indextracks agency mortgage-backed pass-through securities (both fixed-rate andhybrid ARM) guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA) andFreddie Mac (FHLMC). The index is constructed by grouping individual TBAdeliverable MBS pools into aggregates or generics based on program, couponand vintage. Introduced in 1985, the GNMA, FHLMC and FNMA fixed-rateindexes for 30- and 15-year securities were backdated to January 1976, May 1977and November 1982, respectively. In April 2007, agency hybrid adjustable-ratemortgage (ARM) pass-through securities were added to the index.Consumer Price Index (CPI) is a measure that examines the weightedaverage of prices of a basket of consumer goods and services, such astransportation, food and medical care.Euro vs. USD – Euro total return versus U.S. dollar.German 10YR bonds – Germany Benchmark 10-Year Datastream GovernmentIndex; Japan 10YR government bonds – Japan Benchmark 10-Year DatastreamGovernment Index; and 10YR U.S. Treasury – U.S. Benchmark 10-YearDatastream Government Index.The ICE BofAML European Currency High-Yield Constrained Index (ICEBofAML Euro HY constrained) is designed to track the performance ofeuro- and British pound sterling-denominated below investment-gradecorporate debt publicly issued in the eurobond, sterlingThe ICE BofAML U.S. Mortgage-Backed Securities (ICE BofAML U.S.Mortgage Master) Index tracks the performance of U.S. dollar-denominated,fixed-rate and hybrid residential mortgage pass-through securities publiclyissued by U.S. agencies in the U.S. domestic market.The views and opinions expressed are those of the Portfolio Management team as of July 2021 and are subject to change based on market, economicand other conditions. Past performance is not indicative of future results.6MORGAN STANLEY INVESTMENT MANAGEMENT FIXED INCOME

WHERE IS ALL THE YIELD GOING?The ICE BofAML U.S. High Yield Master II Constrained Index (ICE BofAMLU.S. High Yield) is a market value-weighted index of all domestic and Yankeehigh-yield bonds, including deferred-interest bonds and payment-in-kindsecurities. Its securities have maturities of one year or more and a creditrating lower than BBB-/Baa3, but are not in default.The ISM Manufacturing Index is based on surveys of more than 300manufacturing firms by the Institute of Supply Management. The ISMManufacturing Index monitors employment, production inventories, new ordersand supplier deliveries. A composite diffusion index is created that monitorsconditions in national manufacturing based on the data from these surveys.Italy 10-Year Government Bonds – Italy Benchmark 10-Year DatastreamGovernment Index.The JP Morgan CEMBI Broad Diversified Index is a global, liquid corporateemerging markets benchmark that tracks U.S.-denominated corporate bondsissued by emerging markets entities.The JPMorgan Government Bond Index – emerging markets (JPM local EMdebt) tracks local currency bonds issued by emerging market governments.The index is positioned as the investable benchmark that includes onlythose countries that are accessible by most of the international investorbase (excludes China and India as of September 2013).The JPMorgan Government Bond Index Emerging Markets (JPM External EMDebt) tracks local currency bonds issued by emerging market governments.The index is positioned as the investable benchmark that includes onlythose countries that are accessible by most of the international investorbase (excludes China and India as of September 2013).The JP Morgan Emerging Markets Bond Index Global (EMBI Global) trackstotal returns for traded external debt instruments in the emerging marketsand is an expanded version of the EMBI . As with the EMBI , the EMBIGlobal includes U.S. dollar-denominated Brady bonds, loans and eurobondswith an outstanding face value of at least 500 million.The JP Morgan GBI-EM Global Diversified Index is a market-capitalizationweighted, liquid global benchmark for U.S.-dollar corporate emerging marketbonds representing Asia, Latin America, Europe and the Middle East/Africa.JPY vs. USD – Japanese yen total return versus U.S. dollar.The National Association of Realtors Home Affordability Index comparesthe median income to the cost of the median home.The Nikkei 225 Index (Japan Nikkei 225) is a price-weighted index of Japan’stop 225 blue-chip companies on the Tokyo Stock Exchange.The MSCI AC Asia ex-Japan Index (MSCI Asia ex-Japan) captures large- andmid-cap representation across two of three developed markets countries(excluding Japan) and eight emerging markets countries in Asia.The MSCI All Country World Index (ACWI, MSCI global equities) is a free floatadjusted market capitalization weighted index designed to measure the equitymarket performance of developed and emerging markets. The term “free float”represents the portion of shares outstanding that are deemed to be availablefor purchase in the public equity markets by investors. The performance ofthe Index is listed in U.S. dollars and assumes reinvestment of net dividends.MSCI Emerging Markets Index (MSCI emerging equities) captures largeand mid-cap representation across 23 emerging markets (EM) countries.The MSCI World Index (MSCI developed equities) captures large and midcap representation across 23 developed market (DM) countries.Purchasing Managers Index (PMI) is an indicator of the economic healthof the manufacturing sector.The Russell 2000 Index is an index that measures the performance ofthe 2,000 smallest companies in the Russell 3000 Index.The S&P 500 Index (U.S. S&P 500) measures the performance of thelarge-cap segment of the U.S. equities market, covering approximately75 percent of the U.S. equities market. The index includes 500 leadingcompanies in leading industries of the U.S. economy.The S&P/LSTA U.S. Leveraged Loan 100 Index (S&P/LSTA LeveragedLoan Index) is designed to reflect the performance of the largest facilitiesin the leveraged loan market.The S&P GSCI Copper Index (Copper), a sub-index of the S&P GSCI, providesinvestors with a reliable and publicly available benchmark for investmentperformance in the copper commodity market.The S&P GSCI Softs (GSCI soft commodities) Index is a sub-index of theS&P GSCI that measures the performance of only the soft commodities,weighted on a world production basis. In 2012, the S&P GSCI Softs Indexincluded the following commodities: coffee, sugar, cocoa and cotton.Spain 10-Year Government Bonds – Spain Benchmark 10-Year DatastreamGovernment Index.The Thomson Reuters Convertible Global Focus USD Hedged Index is amarket weighted index with a minimum size for inclusion of 500 million(U

The rally in government bonds is fast approaching levels which look too low relative to a sanguine view of the future. U.S. Treasury 10-year real yields are back near -1%, not far from lows seen in May or even during depths of despair in February 2