Financial Pacific - Reconfiguring the play book (third party)

Wealth Management Research 2 September 2011

US fixed incomeReconfiguring the play book

• Uncertainty over the strength of the economy and theEuropean debt crisis are twin concerns. We recommend afurther dialing down of credit risk by moving to neutral on USDdenominated emerging market sovereign debt.

• Within the investment grade segment, we favor non-Financialsversus Financials.

• To hedge against the risk of recession and an unanticipateddrop in bond yields, we have extended the recommendedmaturity range on taxable bonds to the four to ten year area,up from the four to seven year range.

What a difference a month makesA month ago, the markets were focused on the debt ceilingdebate, the potential for a default on Treasury securities, and S&P'sdowngrade of the US sovereign credit rating to AA+ from AAA.Now, however, uncertainty over the strength of the economy and theEuropean debt crisis are the twin concerns for investors. With growthhovering at stall speed, a key question is whether the US economywill manage to muddle through or will it lose altitude and slip intorecession.

The data have sent mixed signals, with survey based measuresshowing a sharp deterioration in sentiment that has yet to becorroborated by the hard data. For example, the Philadelphia Fedmanufacturing index fell to -30.7 in August, a level that has historicallybeen associated with recession. Other manufacturing surveys by theregional Federal Reserve banks have also fallen, although not assharply. Meanwhile, the University of Michigan consumer confidenceindex, which slipped to 55.7, stands at a level last seen duringthe 2008 to mid-2009 recession. Although we expect a rebound ingrowth 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 on

Anne Briglia, CFA, strategist, UBS [email protected], +1 212 713 3149

Barry McAlinden, CFA, strategist, UBS [email protected], +1 212 713 3261

Donald McLauchlan, analyst, UBS [email protected], +1 212 713 3771

David Wang, associate, UBS [email protected], +1 212 713 9295

Kathleen McNamara, CFA, CFP®, strategist, UBS [email protected], +1 212 713 3310

USD taxable fixed income strategyTactical deviations from benchmark, in %

2.0

1.0

0.0

0.0

0.0

-1.0

-1.0

-1.0

Investment grade corporate

Mortgage

Emerging market

High Yield

Preferred securities

Agencies

TIPS

Treasuries

Source: UBS WMR, as of 1 September 2011

This table presents the recommended asset allocationfor the US Fixed Income portion of a portfolio. It isdeveloped by UBS Wealth Management Research for ahypothetical, average US investor with a moderate risktolerance, intermediate investment horizon, and totalreturn objective. The weights may not be suitable for allinvestors or investment goals and should not be used asthe sole basis of any investment decision. Please consultyour UBS financial advisor to learn how these weightingsshould be applied to your individual investment goals.

This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosuresbegin on page 13.

10-year Italian and Spanish government debt, which previouslyspiked above 6%, only fell to the 5% area after the ECB steppedin to support the market. Given the tight linkages betweensovereigns and banks, a key concern is that a sovereign debtcrisis morphs into a full-fledged European-wide banking crisis. Time to play defense In view of these risks, we recommend a further dialing down ofcredit risk by moving to neutral on USD denominated emergingmarket sovereign debt, and increasing the overweight oninvestment grade corporate (IG) bonds. Maintain a neutralallocation to high yield (HY) and preferred securities, which arethe higher beta plays within the credit segment. Within IG, wefavor non-financials versus financials. As the recent roller coasterin the spreads on Bank of America bonds and preferred securitiesdemonstrate, US banks are not immune to negative headlinerisk. Should the sovereign debt contagion spread to theEuropean banking system, we believe spreads on US bankswould widen in sympathy. Finally, to hedge against the risk ofrecession and an unanticipated drop in bond yields, we haveextended the recommended maturity range on taxable bonds tothe four to ten year area, up from the four to seven year range. Slower growth, sovereign debt fears should anchor yields On 16 August, we lowered our Treasury yield forecasts, a changepredicated on several developments. The first was the FOMC’sannouncement at the 9 August meeting that it intends to holdthe target fed funds rate at zero to 25bps until mid-2013. We believe this policy change will shift the interest rate pathdownward 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 suggest. As a result, we believe the odds of recession haveincreased. Finally, we view the ongoing sovereign debt crisis inEurope with concern. The inability of the political establishmentto tackle the debt crisis has eroded investor confidence at the same time the contagion appears to be spreading. Thus, theTreasury market should continue to benefit from flight-to-quality flows during those time periods when sovereign debt concernsflair anew. Against this backdrop, we continue to recommend investors maintain a neutral duration allocation. Anne Briglia, CFA

Regional manufacturing indices trend lower Federal Reserve regional bank surveys, index level

(60)

(40)

Jul-01 Jul-03 Jul-05 Jul-07 Jul-09 Jul-11

20

30

(20)

0

20

40

60

40

50

60

70

80

Empire State (lhs) Philly Fed (lhs) Richmond (lhs)Kansas City (lhs) Dallas (lhs) Chicago (rhs)

Another soft patch or genuine weakness?

Source: Bloomberg, UBS WMR, as of 1 September 2011 ECB buying has lowered yields to around 5% 10-year government bond yields, in %

4.50

4.75

5.00

5.25

5.50

5.75

6.00

6.25

6.50

Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-1110-year Italian government bond 10-year Spanish governement bond

Source: Bloomberg, UBS WMR, as of 1 September 2011

US interest rate forecast (%) 1 Sept. in 3

months in 6

months in 12

monthsEnd 11

3-month Libor

0.33 0.3 0.3 0.3 0.6

2-year Treasury

0.18 0.3 0.4 0.6 0.3

5-year Treasury

0.90 1.0 1.3 1.8 1.1

10-year Treasury

2.13 2.3 2.5 3.0 2.4

30-Year Treasury

3.50 3.8 3.8 4.3 3.8


US fixed income

Wealth Management Research 2 September 2011 2

Recommendations

Sector Comment Implementation

US Fixed Income:

Taxable:

Agency securities Callable agencies offer incremental income and could outperform non-callable bonds should Treasury yields remain range bound to slightly higher over the next 12 months.

3nc6m-1x; 3nc1y-1x; 5nc6m-1x; 5nc1y-1x

USD Emerging markets (EM) We move from overweight to neutral as we don’t expect EM to perform as well as it did in August should risk aversion pick-up again. We generally recommend exposure to EM via diversified bond 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.

See the Corporate Bond Valuation Report

High yield corporates (HY) HY credit spreads have widened meaningfully, making valuations attractive relative to forecasted twelve month default rates. However, given the uncertain economic outlook, we maintain a neutral allocation that was established on 19 August.

Diversified exposure, through a mutual fund or closed-end fund.

Investment grade corporates (IG) IG bonds are now our only credit sector overweight as we believe IG offers the best upside/downside qualities in different potential market environments. Given the Fed’s 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.

See the Corporate Bond Valuation Report

Mortgage backed securities We believe agency MBS offer attractive carry versus Treasury securities.

Mutual funds

Preferred securities European financial preferreds will likely remain sensitive to sovereign concerns. We recommend these securities only for investors who can tolerate equity-like price volatility. We favor preferreds likely to be called such as US bank trust preferreds (be mindful of extension risk and regulatory call risk) and high coupon DRDs.

See the Preferred Securities Valuation Report

TIPS Rising real yields would hurt TIPS prices and result in poor absolute performance; we therefore recommend investors plan to hold TIPS to maturity.

5 to 10 years

Municipal bonds:

Tax exempt We maintain our preference for intermediate-term maturities for new money purchases. Income-oriented investors with an ability to withstand a higher degree of price risk can be rewarded by allocating a small portion of a municipal bond portfolio to longer maturities selectively.

7 to 12 years; add longer maturities selectively

Taxable Build America Bonds Spreads on taxable BABs widened recently along with other credit-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.

20 to 30 years

Note: Bold text in the comment and implementation columns indicate changes from last month’s report. Source: UBS WMR, as of 1 September 2011

US fixed income


Corporate bonds: Spreads correct Throughout much of this year, our fixed incomerecommendations have largely favored corporate credit,including investment grade (IG) and high yield (HY) bonds thatwe believed would likely continue to deliver positive excessreturns over Treasuries in most scenarios. One scenario wherecorporate credit could underperform would be if market eventswere to spark strong selling across all risk assets. Although thiswas not our base case outlook, this was exactly what transpiredin August as a classic credit market selloff ensued. The reaction from the credit segments of the bond market waslargely a reflection of the degree of credit risk each sectorexhibits. IG credit spreads, as measured by the Barclay’sCorporate Index, widened to 208bps from 150bps, an enormous move for IG. The widening was led by Financials, which gappedout by nearly 100bps, while Industrials and Utilities were roughly45bps and 35bps wider, respectively. However, lower Treasuryyields helped to cushion the blow and yields on IG moved only modestly higher. The yield-to-worst (YTW) of the index increasedto 3.66% from 3.53% and IG total returns were mostly flat forthe month. We continue to believe that the direction of IG credit spreads willlargely be a function of moves in rates and that spreads will re-main at the wider end of recent ranges should lower Treasuryrates persist, as we expect. Nonetheless, at current spread levels,we believe IG valuations are attractive. Spreads remain wellabove their pre-crisis average of 130bps despite the strongfundamental shape of the corporate sector. We thereforeincrease our IG tactical weighting to +2 from +1 this month,making it our largest credit segment overweight. In anenvironment where returns are more likely to be driven by creditrisk premiums rather than interest rate risk, we believe IG offersthe best upside/downside qualities in different possible marketenvironments. Should the economy turn out weaker then weexpect, any widening of IG spreads will likely be lower than whatHY, EM and preferreds may experience. IG would probablybenefit from a further decline in Treasury yields that would likelyaccompany another recession. However, should the economymuddle through and investor risk taking resume, we believe IGwill also likely perform relatively well. Despite the wider credit spread differential between financial andnon-financial bonds, we believe that further spreaddecompression would likely occur on any further market volatilitydriven by US growth concerns or the European debt crisis. US banks 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 universal banks is extremely low at the present time. However, we believefinancial spreads will continue to be higher beta relative to non-

IG and HY excess returns over Treasuries IG and HY index return less Treasury index return, in %

-8.0

Jan-11 Feb-11 Mar-11 Apr-11 May- Jun-11 Jul-11 Aug-11 Sep-11

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

IG less Treasuries HY less Treasuries

Source: BofA Merrill Lynch, UBS WMR, 30 August 2011

IG and HY spreads now trade above 10-year averages Credit spreads, in basis points

0

150

300

450

600

750

900

0

400

800

1,200

1,600

2,000

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Barclays Corporate Index (LHS) IG Average (LHS)Barclays HY Index (RHS) HY Average (RHS)

Source: Barclays Capital, UBS WMR, as of 30 August 2011

The yield differential between Financial and Industrial sector bonds widened in August Credit spreads, in basis points

(200)

0

200

400

600

800

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 201

Finance OAS Industrial OAS Difference


US fixed income


financials and we therefore generally favor non-Financial positions for investors putting new money to work in thecorporate bond market. Within non-Financials, we continue toprefer BBB-rated credits in the managed care, insurance, miningand communications sectors. Given the Fed’s commitment tokeep the funds rate low into mid-2013, we have extended outour recommended maturity range to 4 to 10 years, from 4 to 7years. Moving down into riskier credit sectors, we observed muchhigher spread volatility in HY and preferreds during August. HYspreads gapped to 708bps from 540bps at the beginning ofAugust and the YTW of the Barclay’s HY Index increased to8.5% from 7.15%. Preferreds exhibited a similar trend as thintrading conditions and investor risk aversion towards Financialscontributed to a highly volatile and choppy trading environment.Preferred spreads increased to 385bps over long-maturity Treasuries from 300bps, and the sector exhibited intra-month price swings of nearly 10%. Despite being the highest yielding segments of the bond market,we remain neutral on HY and Preferreds. After being overweightsince the beginning of the year, we established this neutralallocation on 19 August to reflect WMR’s more cautious view onrisk assets stemming from continued financial stress in theEurozone and higher risk of a US recession. Valuations of HYbond spreads are attractive relative to the low level of forecastedcorporate default rates over the next year. However, we believeeconomic uncertainty will keep HY spreads elevated in the near-term and we continue to observe a very high correlationbetween HY spreads and equities. Barry McAlinden, CFA

Preferred securities: Correlated to equities Following 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 market continues to demonstrate heightened sensitivity to the recentexodus from risky assets, driven by concerns of anaemiceconomic recovery both in the US and Europe. A weakeningeconomy is not likely to provide banks in these regions thebackdrop to build or maintain margins and capital at levelsnecessary to absorb losses in a scenario of further macro shocks.In the US, the impact of disappointing survey-based economic data and S&P’s downgrade of the US AAA-rating resulted in heightened risk attitudes towards the large US banks, and BACin particular. Furthermore, we have seen accelerated concernsabout the ability of European leaders to contain the sovereigndebt crisis on their side of the Atlantic. This caused widespreadflight-to-quality buying, causing a rally in US Treasuries and aflight from those fixed income sectors that contain the highestdegree of credit risk, including preferreds. The trading

Within the Banking sector, the senior/subordinated yield differential also widened Credit spreads, in basis points

(100)0

100

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 201 2012

200300400500600700800900

Senior Subordinated Difference


HY credit spreads remain correlated to equities Credit spreads, in basis points and S&P 500 Index level

300

350400

450500

550

600650

700750

800

Aug 10 Nov 10 Feb 11 May 11 Aug 11

1,050

1,100

1,150

1,200

1,250

1,300

1,350

1,400

HY OAS (LHS) S&P 500 Index (RHS, reverse order)

Source: Barclays Capital, Bloomberg, UBS WMR, as of 30 August 2011

Preferred prices plummeted in early August Year-to-date price change, in %

(20.0)

(15.0)

(10.0)

(5.0)

0.0

5.0

10.0

Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May- Jun-11 Jul-11 Aug-11

REIT Preferreds Trust Preferreds Non-US QDI

DRD-Eligible Floating-Rate

Source: Bloomberg, UBS WMR, as of 31 August 2011

US fixed income


environment in preferreds has also been characterized by thinmarkets and reduced liquidity. Preferreds abruptly corrected by roughly 10% on 5 August and 8August before snapping back somewhat, but returning close tonothing in price terms for the year. With prices suppressed,preferred credit spreads versus long-term Treasuries have gappednear 400bps, a level not seen since early to mid 2009. Withspreads nearly double their pre-crisis levels, we believe that theyprovide sufficient cushion against any moderate rise in Treasuryrates that may occur. However, we see credit risk as the maindriver of preferred security prices in the near term rather thaninterest rate risk. Credit sensitivity will likely remain high whilemacro pressures persist, and we look for the preferred asset classto continue to exhibit equity-like correlation while investor risk aversion 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 in July 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 Wong Barry McAlinden, CFA

Emerging markets: Adopt a neutral allocation This month we also reduce our emerging markets (EM) allocationto neutral from +1. We established an overweight position lastmonth based on the improving fundamentals of many EMsovereigns, which we believe could lead to positive ratingsactions relative to developed markets. In fact, S&P upgraded Peruto BBB from BBB- on 30 August. However, while our positiveview has not changed, we do not expect EM to perform as wellas it did in August should risk aversion pick up again. Despiterelatively strong fundamentals in most EM countries, foreign debt fund managers reported USD 506mn in outflows over thelast four weeks, as investors continue to shun riskier asset

Preferreds have recently demonstrated equity-like price volatility Trend in preferreds’ daily absolute price change, in %

0.0

0.5

1.0

1.5

2.0

2.5

3.0

Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11

REIT Preferreds Trust Preferreds Non-US QDI

DRD-Eligible Floating-Rate

Source: Bloomberg, UBS WMR, as of 31 August 2011 Note: chart shows 20-day moving average to smooth out results

Emerging markets look attractive relative to IG corporates Spreads, in basis points

0

200

400

600

800

1,000

1,200

2001 2004 2007 2010

All EM EM IG IG corporates

Source: Barclays Capital bond indices, UBS WMR, as of 29 August 2011

US fixed income


classes. Although supply is expected to be limited (the consensusview is for negative net sovereign bond issuance through year end), 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 broadly followed EM indices are rated below investment grade. Economic growth 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 to neutral from +1, and increasing the overweight to investmentgrade bonds to +2 from +1. Donald McLauchlan

Agency MBS: Play the carry Since we moved to an overweight (+1) in June, investors’ lack offocus on the mortgage sector, the shift to “risk off” mode, andunwarranted fears of a pre-pay spike have sent spreads on 30-year current coupon agency MBS approximately 20bps wider.Yet, there are several reasons we believe agency MBS valuationsare attractive at current levels. In a low yield environment, with the Fed likely to remain on hold until mid-2013, investors arehard pressed to find fixed income investments that offer anattractive combination of incremental income and high creditquality. At 175bps versus the 5/10-year blended Treasury yield, the spread on the current coupon is at the widest level in twoand a half years. Some of this widening is due to fears of a spike in pre-pays. While previous government efforts to prop up the housing sectorhave been disappointing, recent press reports indicate that theObama administration is considering several new proposals toassist struggling borrowers. Headline risk around the president’supcoming “jobs” speech on 8 September could trigger someadditional widening. However, we believe Congress is in no mood to pay for additional costly measures to stimulate thehousing sector, and think the chances of a substantial, expensivenew housing program are slim. Moreover, capacity constraints inthe mortgage industry and stricter underwriting standards have created a more muted refi response than the absolute level ofmortgage rates would suggest. We think this trend will persist,which suggests that the market may be overestimating theamount of prepay risk faced by MBS investors. In addition, the technical mix looks constructive. Demand formortgages by institutional investors such as banks and mortgageREITs 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.

Agency MBS spreads have widened 30-year FNMA current coupon spread, in basis points

100

125

150

175

Aug-09 Feb-10 Aug-10 Feb-11 Aug-1130-Yr FNMA current coupon vs 5/10 Treasury


While refis have increased, the response has been less pronounced than in the past Mortgage Bankers Association refi index (lhs) and 30-year commitment rate, in %

2501,2502,2503,2504,2505,2506,2507,2508,2509,250

1998 2000 2002 2004 2006 2008 2010

4.00

5.00

6.00

7.00

8.00

9.00

Refi index (lhs) 30-yr committment rate (rhs)


US fixed income


Anne Briglia, CFA

Municipal bonds: yields hit lows, yet M/T ratios attract buyers Absolute muni yields are now at historic lows at most segmentsof the curve. And yet, on a relative basis to Treasuries, munisoffer value, in our view. Over the past month, exceedingly strongout-performance of Treasury securities drove AAA muni-to-Treasury (M/T) ratios to levels over 110% all along the curve. Atthese levels, municipals attracted some crossover buyers. Asmany market participants will undoubtedly recall, lacklusterdemand from traditional buyers in January drove M/T ratioshigher and attracted similar interest from non-traditional investors. As we go to press, AAA tax-exempt muni yields are stillat or above 100% all along the curve with the exception of the 5-year spot. The 5-year M/T ratio is at 95%, while the 10-year and 30-year ratio stands at 102% and 108% respectively. Austin retains its triple-A ratings Standard and Poor’s downgrade of the United States sovereigndebt 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 AugustUS Municipal Bond Market Chartbook, we indicated that S&P’sapproach to municipal ratings left room for the affirmation ofAAA ratings on some states and local governments. The ratingsagency subsequently reaffirmed its view that a state or localgovernment can exhibit stronger credit characteristics than thesovereign even during times of economic or political stress. As if to demonstrate its commitment to this point of view, S&Phas reaffirmed its AAA rating on the general obligation debt ofAustin, Texas. In assigning the gilt-edged rating, S&P cited thecity’s diversified economy and tax base, strong financial management, and moderate debt burden. The capital city’sjobless rate was substantially lower than the state and nationalaverage as employment in state government and at theUniversity of Texas provided a degree of economic stability. Dell Computer Corp. is the third largest employer in the area. Notsurprisingly, Moody’s and Fitch also reaffirmed Austin’s triple-A ratings. Modest supply increase expected We look for new issue volume to increase modestly in the fourthquarter, pressuring yields slightly higher as is consistent withhistorical trends when there is a rise in the muni calendar. Thatsaid, we are not looking for a repeat of the sharp rise in ratesthat 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.

M/T ratios are volatile from Treasury bond swings AAA Municipal-to-Treasury ratio, in %

60

70

80

90

100

Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11

110

120

5 yr 10 yr 30 yr

Source: MMD, UBS WMR, as of 30 August, 2011

M/T yield curve comparison

Maturity AAA Muni Yield

Treasury Yield

Muni/ Treasuries

1 year 0.22 0.1 2.20 5 year 0.89 0.94 0.95 10 year 2.25 2.21 1.02 15 year 3.07 2.9 1.06 20 year 3.56 3.24 1.10 30 year 3.89 3.59 1.08

Source: MMD, UBS WMR as of 31 August 2011 Yields are near historic lows AAA yield curve change, in %

0

1

2

3

4

5

5 10 15 20 25 308/27/10 8/29/11 7/29/11

Source: MMD, UBS WMR, as of 30 August 2011

US fixed income


For more information on developments in the municipal marketincluding Vallejo, CA, Harrisburg, PA and Jefferson County, AL,see WMR’s August Municipal Update, 27 August 2011. Key Portfolio Themes Use the municipal bond market rally to take profits and

diversify portfolios at a reasonable cost. Given the strong municipal market performance over the past several months,valuations on a significant portion of the market have risen,producing potential capital gains. Returns on the broad muniindex by BofA/ML are up 7.5% year to date through 31August 2011. Also, some yields along the curve are at thelowest point of the year. This may afford investors theopportunity to capture gains and rebalance portfolios as necessary.

Maintain intermediate-term maturity preference for new

money purchases; add longer maturities selectively. We maintain our view that the intermediate term maturity rangeof 7 to 12 years offers investors an adequate balancebetween risk and reward for core new money purchases.Given the steepness, particularly at the front section of themunicipal curve, an incremental 1.00% return is available bymoving to the 7 year maturity on the high grade curve from4 year maturities. Another 1.00% to 1.15% can be earnedby extending to a 12 year maturity. On average, the 7 to 12year segment offers 55% of the maximum yield available onthe curve. Income-oriented investors with longer-term holding periods and an ability to withstand a higher degreeof interest rate risk can be rewarded by allocating a smallportion of a muni portfolio to the 18 to 20 year maturityrange where 90% of the maximum yield available on thecurve can be attained. Beyond 20 years, incremental yieldopportunities are more limited and do not justify theassociated 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 increasecurrent yield (coupon income divided by purchase price) andprovide some price protection in a portfolio against risinginterest rates. Premium bonds have shorter durations thanbonds priced at par or at a discount with the same maturitydate. Also, high coupon bonds that are now trading on a yield-to-call basis because interest rates have fallen since thebonds were originally issued are apt to have higher yieldsthan bonds of similar credit quality with lower coupon ratesand valued near par. The rationale for cheaper offer yields of premium priced bonds relative to par priced bonds is oftenexplained by the individual investor’s aversion to bondspriced above par. Many individual investors are notcomfortable receiving more coupon interest over time (asoccurs with premium bonds) as a trade off for a reduction inprincipal at maturity. As a result, investors who will onlypurchase bonds priced near par value are forced tosignificantly extend maturities and/or go down in credit

Taxable BABs and Industrial corporate bond spreads widened in August BABs versus Industrial corporate spreads, in basis points

150

165

180

195

210

225

Aug-10 Oct-10 Dec-10 Feb-11 Apr-11 Jun-11 Aug-11US Industrial Corp 10+yr OASBuild America Bond Index OAS

Source: BofA/ML, UBS WMR, as of 30 August 2011 Credit quality spreads moved modestly higher Credit quality spreads, In basis points

0

75

150

225

300

375

Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11BAA GO 10 yr - AAA GO 10 yrA GO 10 yr - AAA GO 10 yrAA GO 10 yr - AAA GO 10 yr

Source: MMD UBS WMR as of 30 August 2011

US fixed income


quality in search of higher yields. In our view, this is not necessarily the best approach.

Kathleen M. McNamara, CFA, CFP

US fixed income


Appendix Snapshot: Asset allocation, returns and yield tables

US fixed income sector returns (%)

2010 YTD MTD 6-MonthYields Up50 bps*

6-Month Yields Down

50 bps*

Effective Duration

Treasuries 5.9 7.1 2.8 -1.6 3.6 5.7

TIPS 6.3 11.1 0.9 -1.5 4.2 6.1

Agencies 4.7 4.1 1.4 -0.3 1.7 3.5

Investment grade corporates 9.5 5.8 0.1 -0.8 5.3 6.4

High yield corporates 15.1 2.0 -4.0 2.5 6.1 4.6

Preferred securities 13.7 4.8 0.4 N/A N/A 6.1

Mortgages 5.7 5.2 1.3 N/A N/A 2.6

Emerging Market sovereign bonds (USD)

12.5 7.5 0.8 -0.6 6.1 7.3

Municipals 2.3 7.5 1.5 N/A N/A 7.8

Taxable Fixed Income 6.8 5.9 1.5 N/A N/A 4.8 *Note: Columns represent forecasted total returns of the respective index based on parallel up and down yield curve shifts of 50bps over a six month time horizon. Source: BofA Merrill Lynch Indices, Yield Book, UBS WMR, as of 31 August 2011

US fixed income asset allocation

Benchmark allocation1

(%)

Tactical deviation2

(%)

Current allocation3

(%)

Treasuries 12.0 -1.0 11.0

TIPS 5.0 -1.0 4.0

Agencies 22.0 -1.0 21.0

Investment grade corporates 22.0 2.0 24.0

High yield corporates 10.0 0.0 10.0

Preferred securities 4.0 0.0 4.0

Mortgages 20.0 1.0 21.0

Emerging Market sovereign bonds (USD)

5.0 0.0 5.0

1 The benchmark allocation refers to a moderate risk profile. See “Sources of Benchmark Allocations and Investor Risk Profiles” in the Appendix of the Investment Strategy Guide for an explanation regarding the source of benchmark allocations and their suitability. 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 2011

Economic snapshot

Indicator (%) 1Q 10

2Q 10

3Q 10

4Q 10

1Q 11

2Q 11

3Q 11

4Q 11

Ann. 2011

Real GDP 3.9 3.8 2.5 2.3 0.4 1.0 2.5 2.0 1.8

CPI-U 1.5 -0.7 1.4 2.6 5.2 4.1 1.2 0.6 2.9

Core CPI-U 0.0 0.9 1.1 0.6 1.7 2.5 2.0 1.7 1.5

Unemployment 9.7 9.7 9.6 9.6 8.9 9.1 9.0 8.8 8.9

Federal funds rate 0.13 0.13 0.13 0.13 0.13 0.13 0-0.25

0-0.25

0.13

Note: Bolded values are actual; non-bolded values are forecasts. Values are quarter-over-quarter annualized, except as noted.

Source: UBS, as of 31 August 2011

US money market rates (%)

Muni Swap Index

Treasury Bill

Discount Notes

CommercialPaper

Certificatesof

Deposit

7-day 0.21 N/A N/A N/A N/A

30-day N/A 0.01 0.01 0.22 N/A

60-day N/A 0.00 0.02 0.28 N/A

90-day N/A 0.00 0.03 0.32 0.25

120-day N/A 0.00 0.04 0.35 N/A

180-day N/A 0.02 0.08 0.42 0.30 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

US fixed income


Appendix

US fixed income yields (%)

Maturity Treasury TIPS STRIPS Agencies Mortgage IG CorporateSingle-A

HY Corporate Double-B

BABs MunicipalAAA

Municipal TEY 35%

Municipal TEY 28%

Preferred 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 6.87

Note: 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 2011

Highlighted securities

Highlighted Treasury Inflation Protected Securities (TIPS)

Issuer Name Coupon Maturity CUSIP Yield to Mat. (YTM)* Current factor** Duration

TIPS 2.500 7/15/2016 912828FL9 -0.82 1.11774 4.64

TIPS 2.375 1/15/2017 912828GD6 -0.63 1.11933 5.10

TIPS 2.625 7/15/2017 912828GX2 -0.60 1.08913 5.52

TIPS 1.625 1/15/2018 912828HN3 -0.44 1.07748 6.10

TIPS 1.375 7/15/2018 912828JE1 -0.39 1.04678 6.60

TIPS 2.125 1/15/2019 912828JX9 -0.28 1.05137 6.90

TIPS 1.875 7/15/2019 912828LA6 -0.20 1.05719 7.39

TIPS 1.375 1/15/2020 912828MF4 -0.09 1.04385 7.95

TIPS 1.250 7/15/2020 912828NM8 -0.02 1.03505 8.44

TIPS 1.125 1/15/2021 912828PP9 0.06 1.03189 8.93

TIPS 0.625 7/15/2021 912828QV5 0.12 1.00153 9.58

Note: *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 consider transaction 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

US fixed income


Appendix

For 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.

US fixed income


Appendix

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US fixed income
