financial pacific - june update, beyond qe (third party), may 27.2011

Wealth Management Research 26 May 2011

US fixed incomeJune update: Beyond QE

• We look for credit segments of the bond market to continueto generate positive total returns, as incremental credit spreadimprovement can offset, to some extent, the price declinesresulting from a moderate rise in rates.

• We recommend investors utilize recent market strength toupgrade portfolios in the municipal and preferred securitiessectors.

• Municipal investors may wish to use recent strength to diversifyportfolios at a reasonable cost. Preferred security holders canlimit interest rate induced price loss by reducing exposure tohigh duration preferreds with a low probability of being called.

The Fed is scheduled to complete its QE2 Treasury purchase programat the end of June, thereby removing a substantial buyer of Treasurybonds from the market. Yet nominal bond yields have continued todecline from their early April highs rather than moving higher, as wemight expect the natural reaction of the bond market to be. We viewthe path towards lower nominal rates as primarily a function of thecurrent economic soft patch, as well as global macro and geopoliticalrisk factors that have contributed towards a safety bid for Treasuries.

Continued headlines regarding European sovereign debt concerns, aswell as moderating economic data are poised to weigh on yields inthe near-term. Nonetheless, we view rate action during May as anovershoot and expect rates to revert to ranges that were establishedin the December 2010 through April 2011 timeframe. Despite theupcoming end of Fed purchases, we discount the potential for a"cliff effect" and believe foreign demand at Treasury auctions remainssufficient to provide a bid for Treasury supply after the Fed buyingstops.

Across fixed income, performance in May was driven almost entirelyby the dramatic rally in Treasuries over the past few weeks. As aresult, longer duration segments which are more sensitive to rateincreases outperformed shorter duration segments. In a less volatileenvironment, we believe valuation and fundamentals will be thedifferentiators, rather than rates.

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

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

Michael Tagliaferro, CFA, analyst, UBS [email protected], +1 212 713 9191

USD taxable fixed income strategyTactical deviations from benchmark, in %

2.0

1.0

1.0

0.0

-1.0

-1.0

-1.0

-1.0

High yield

Investment grade corporate

Preferred securities

Emerging market

Agency

TIPS

Treasuries

Mortgages

Source: UBS WMR, as of 26 May 2011This 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 see 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 12.

What will the post QE2 bond market bring? Moderate growth should support fixed income Wealth Management Research forecasts a self-sustaining moderate economic recovery scenario. While we believe this recovery will ultimately drive Treasury rates towards historical norms, our recommendations are based on the belief that rates may remain lower for longer with the front end of the curve anchored at extremely low levels. This provides support for our continued call for a neutral duration positioning. In the absence of a dramatic move in rates, a scenario that we deem unlikely in the near-term given the aforementioned concerns, taxable bonds with maturities in the 4 to 7 year range will perform the best, in our opinion, given the steepness of the curve. The winding down of QE2 signifies the end of the Fed’s easing campaign and a move to quantitative neutrality. As we look forward to the progression into the next monetary tightening cycle, we look for long-term Treasury yields to only gradually edge higher over time, rather than explode upwards. Provided that the bond market adjusts to this environment and the credit backdrop remains strong, we believe credit segments of the bond market can continue to generate positive total returns, as incremental credit spread improvement can offset, to some extent, the price declines resulting from a rise in rates. Given the post-crisis credit spread contraction that has already taken place, markets could demonstrate greater differentiation in bond sector returns should rates move higher. Within credit, investment grade (IG) corporate bonds and preferreds, as a longer duration segments, will be more sensitive to rising rates relative to high yield (HY) corporates. However, the ability for credit spread compression as an offset to higher rates will be a key return driver. In the IG bond market, we foresee only perhaps 25bps of additional spread compression as available to help absorb higher rates. Preferreds and HY exhibit greater spread tightening cushion, with the potential for perhaps 50bps and 75bps of additional spread compression, respectively.Therefore these sectors could outperform if credit fundamentals remain strong for Financials and lower-rated issuers, the primary components of preferreds and HY. Lower for longer fuels muni rally Lower supply, combined with a recent sharp drop in Treasury yields helped fuel a sharp rally in the municipal bond sector, particularly at the front and mid-section of the yield curve, making munis the best performing fixed income segment in May. Whereas the yield on the 10-year Treasury benchmark bond has fallen roughly 45bps in recent weeks, the yield decline occurring on comparably maturing munis was even greater given continued light new issue supply. The AAA municipal market data curve at the 10-year maturity spot stands at 2.65%, a decline of 62bps from the 3.27% level offered in mid-April. Barry McAlinden, CFA, Strategist, UBS FS Inc. Kathleen McNamara, CFA, CFP®, Strategist, UBS FS Inc. Michael Tagliaferro, CFA, Strategist, UBS FS Inc.

Nominal Treasury yields rose when QE2 began in the fall of 2010, but have recently retreated

2-year and 10-year Treasury yields, in %

0.00

0.501.00

1.502.00

2.503.00

3.504.00

4.50

Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Apr-11 Jul-11

2-year Treasury yield 10-year Treasury yield Source: Bloomberg, UBS WMR, as of 25 May 2011

Manufacturing still firm, services soft

Institute for Supply Management Purchasing Managers Index

30

35

40

45

50

55

60

65

2005 2006 2007 2008 2009 2010 2011

Manufacturing Non-manufacturing

Source: Bloomberg, UBS WMR, as of 25 May 2011 Monthly changes in 10-year Treasury yields are well correlated to monthly IG total returns

Monthly change in 10-year Treasury and monthly IG total

returns since 1980, in %

R2 = 0.4887

(10.00)

(8.00)

(6.00)

(4.00)

(2.00)

0.00

2.00

4.00

6.00

8.00

10.00

-100 -75 -50 -25 0 25 50 75 100

monthly change in 10yr Treasurymonthly change in 10yr Treasurymonthly change in 10yr Treasurymonthly change in 10yr Treasury

monthly IG total return




Source: Yield Book, UBS WMR, as of 25 May 2011

US fixed income

Wealth Management Research 26 May 2011 2

US interest rate forecast (%)

26-May in 3

months

in 6

months in 9

months

in 12

months

3-month

Libor 0.25 0.30 0.40 0.50 0.60

2-year

Treasury 0.49 1.00 1.10 1.20 1.30

5-year

Treasury 1.73 2.25 2.50 2.63 2.70

10-year

Treasury 3.06 3.75 4.00 4.13 4.25

30-Year

Treasury 4.22 4.75 5.00 5.00 5.00

Source: UBS WMR, as of 25 May 2011

Monthly changes in 10-year Treasury yields show less correlation to monthly HY returns

Monthly changes in 10-year Treasury and monthly HY total

returns since 1989, in %

R2 = 0.0156

(20.00)

(15.00)

(10.00)

(5.00)

0.00

5.00

10.00

15.00

20.00

-100 -75 -50 -25 0 25 50 75 100

monthly change in 10yr Treasurymonthly change in 10yr Treasurymonthly change in 10yr Treasurymonthly change in 10yr Treasury

monthly HY total return




Source: Yield Book, UBS WMR, as of 25 May 2011

Recommendations

US fixed income


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

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

Treasuries With the Fed unlikely to tighten until 1Q 2012, the yield curve should remain steep. If the curve stays steep and yields rise as we forecast, bonds with maturities in the 4 to 7-year range should outperform shorter and longer maturities.

4 to 7 years

Emerging markets We like exposure to emerging markets via investment-grade rated credits, including quasi-sovereign oil conglomerates, and large mining companies.

See the Corporate Bond Valuation Report

High yield corporates An improving default rate and strong investor appetite for HY is likely to provide continued support. However, the pace totals returns thus far through 2011 is unsustainable, in our opinion.

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

Investment grade corporates Given the steepness of the yield curve, bonds that mature in 4 to 7 years should outperform both shorter and longer-dated bonds, despite the likely upward trajectory of Treasury rates. We also favor bonds in the BBB-rating category.

See the Corporate Bond Valuation Report

Preferred securities To reduce longer term interest rate risk, focus on securities likely to be called such as US bank trust preferreds (be mindful of extension risk and regulatory call risk), high coupon DRDs, and floaters.

See the Preferred Securities Valuation Report

Municipal bonds:

Tax exempt We prefer the 7 to 12 year maturity range (previously 5 to 10 years). Since the market consensus began to shift in mid-April towards much lower tax-exempt issuance for 2011, investor demand increased, and did so dramatically at the 5-year spot helping push the AAA muni-to-Treasury ratio (M/T) ratio at that maturity to below 70%.

7 to 12 years

Taxable Build America Bonds Spreads on taxable BABs continue to improve since the program’s expiration on 31 December 2010. Most BABs are long-duration securities and thus are longer than our recommended maturity target. However, they can be suitable for income buyers with long-term time horizons who are not concerned about price volatility.

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 26 May 2011

US fixed income


Emerging markets: Remain neutral Emerging markets continue to boast sound fundamentals, in our view. While rising inflation remains a major source of concern, encouraging growth prospects have fueled a rebound in investor flows in recent weeks providing support to prices. Furthermore, visibility in Peru’s presidential elections has improved, as the market-friendlier option now seems likely to win the 5 June run-off. However, a possible deterioration beyond market expectations in the sovereign debt situation in peripheral Eurozone, and/or the ongoing political crisis in the Middle East and North Africa may hurt appetite for risk, diverting crossover investor flowsaway from emerging markets. Under this scenario, total returns for emerging markets bonds are likely to rely on dedicated investors only, which may not be strong enough to support valuations and avoid underperformance. In addition, on 24 May, the US government imposed sanctions on Venezuela’s state-owned oil company for doing business with Iran. US sanctions are not expected to affect oil flows, but will likely constrain the Venezuelan oil company’s –and possibly Venezuela’s– access to US credit and capital markets. We note that Venezuela’s weight in some of the most broadly followed emerging market indices ranges between 6% and 8%. We therefore maintain our recommendation for a neutral allocation to emerging markets. Donald McLauchlan

Corporate bonds: Mind the gap Corporate bonds generated positive total returns in May as the strong rally in Treasuries bolstered performance of both investment grade (IG) and high yield (HY) bonds. As we have discussed in the past, we believe that at current low yields, the directionality of credit spreads is largely a function of interest rates, with credit spreads unlikely to tighten further until there is a backup in rates. Accordingly, credit spreads widened a touch in recent weeks - a move that we see driven by exceedingly low yields, rather than any deterioration in fundamentals. Our continued preference for credit segments over non-credit segments recognizes that opportunities for relative price appreciation are more limited going forward given the strong performance of credit segments over the past two years. Still, the incremental yield that credit segments offer will continue to generate outperformance in our opinion. We therefore continue to overweight HY (+2) and IG (+1). Investor appetite for corporate bonds remains insatiable, with strong new issue activity in May. Fundamentals continue to be supportive. In consideration of the steepness of the yield curve, as well as

Emerging markets spreads are wide relative to US high grade Spreads in basis points

0

200

400

600

800

1,000

1,200

2002 2004 2006 2008 2010

All EM EM HG All US HG

Source: Barclays Capital bond indices, 24 May 2011

IG corporate bonds with intermediate maturities have outperformed post-crisis Total return, in %

(2)

-

2

4

6

8

10

12

14

16

Nov09 Jan10 Mar10 May10 Jul10 Sep10 Nov10 Jan11 Mar11 May11

1-3 Yr 3-5 years 5-7 years 7-10 years Source: Barclays Capital, UBS WMR, as of 23 May 2011

US fixed income


our forecast for the Fed to remain on hold until early 2012, we continue to recommend investors focus their attention on bonds with maturities of 4 to 7 years. Despite persistent chatter about rising rates, which by our estimation has been a concern for well over a year, we reiterate our belief that interest rates will remain lower for longer. Against this backdrop, we believe there is a significant cost associated with shortening portfolio durations too much. In the past, we have discussed “gap analysis”, which demonstrated that by remaining in cash while waiting for better buying opportunities (after interest rates rise), investors might forego positive performance that would be difficult to later recoup.While rising interest rates would indeed lead to negative price returns on bonds with longer durations, we believe that the incremental income generated by these bonds would more than offset this price action. Demonstrating this, the total return of bonds in the 5 to 7 year maturity bucket has more than doubled that of bonds in the 1 to 3 year bucket over the past 18 months. Other recommendations include preferences for ‘BBB’-rated corporates, due to their improving fundamentals and valuation advantage versus higher rated securities. In addition, bonds of Financial sector issuers, offer attractive yield pick-up versus Industrials, though may be more volatile in consideration of European sovereign debt concerns and potential settlements with states Attorneys General regarding mortgage servicing issues. HY bonds continue to show improving fundamentals with the default rates now forecast to be below 2% for the full-year 2011. As the primary risk for HY bonds, such a low default rate is an indicator of continued strong performance. For most investors, exposure to HY should be taken in a diversified manner through an investment vehicle such as a fund, in our opinion. Michael Tagliaferro, CFA

Preferred securities: regulatory calls Fifth Third Bancorp (FITB) announced on 18 May that it will redeem FTB pr C (8.875%) at par plus accrued on 15 June 2011 through the use of a regulatory par call, which caught the market by surprise based on the premium trading price prior to the announcement. FITB was able to call this security due to the fact that the regulatory call language in its prospectus did not have a "90-day window" clause, so it allowed FITB to call it anytime following the Dodd-Frank Act. As a result of FITB’s announcement, the prices of premium trust preferreds (TruPS) repriced lower, though many continue to trade above par. The fact that premium priced TruPS will be gradually pulled to par is to be expected, but the rapid move was likely due to increased market awareness that the possibility of early regulatory calls exists and also the fact that

The rate and credit environments remain supportive for preferreds

Preferred price changes, in %

(1.0)0.01.02.03.04.05.06.07.08.09.0

Dec-31 Jan-31 Feb-28 Mar-31 Apr-30 May-31

REIT Preferreds Trust Preferreds Non-US QDIDRD-Eligible Floating-Rate

Source: Bloomberg, UBS WMR, as of 24 May 2011

The declining default rate could drive HY spreads tighter Default rates, in % and HY credit spreads, in basis points

0%

2%

4%

6%

8%

10%

12%

14%

2011200920072005200320011999

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

TTM Default Rate (2011 projected) OAS Source: Moody's, Barclays Capital, UBS WMR, as of 23 May 2011

Credit spreads have gradually improved thus far through 2011 Credit Spreads, in basis points

0

100

200

300

400

500

600

700

800

900

2001 2003 2005 2007 2009 2011

0

300

600

900

1,200

1,500

1,800

2,100

IG (LHS) 10-yr Avg IG HY (RHS) 10-yr Avg HY Source: Barclays Capital, UBS WMR, as of 23 May 2011

US fixed income


some TruPS do not contain 90-day window language. We view FITB’s announcement as a unique situation, and we continue to believe that most banks will refrain from calling their TruPS until 2012 or early 2013 since they will continue to receive full Tier 1 treatment until 2013. However, the possibility of regulatory calls is a risk factor that investors should consider when holding premium TruPS. For those securities with 90 day window language, it remains unclear what may constitute another capital treatment event prior to the beginning of the Tier 1 phase-out on 1 January 2013. Citigroup recently stated during their fixed-income investor call that the Fed’s notice of proposed rulemaking (NPRM) that is scheduled for release later this year may open up a regulatory call window, but that they will continue to review this with their legal team. While a window must be open to call those TruPS with 90-day window language, those with more flexible “anytime” call language exhibit greater early call risk due to the flexibility that they provide issuers for early regulatory calls. For further details, see our report titled Uncertainty of regulatory calls, 23 May 2011. We maintain our overweight allocation to preferreds based on our view that preferred credit spreads remain wide enough to absorb a moderate move higher in benchmark Treasury rates. Over the longer-term, however, we believe that many preferreds that are not called will likely experience some degree of interest-rate related price loss relative to current levels. Preferred security holders who may be sensitive to price fluctuation may utilize the current low rate environment to assess the duration risk of individual preferred holdings, using the coupon type and size and the security’s structure to assess its likelihood of being called. To lower potential interest rate induced price loss, investors may consider reducing exposure to high duration preferreds with a low probability of being called. Barry McAlinden, CFA

Municipal bonds: Lower for longer fuels rally In the recent bond market rally, munis followed the direction of Treasuries to lower yields while the supply factor (or lack thereof) led to notable outperformance by the sector. Municipal-to-Treasury ratios at the 5-, 10- and 30-year maturity points stand at 69.4%, 84.6% and 100.5%, down from 77.8%, 91.6% and 104.7%, respectively, in mid-April. In addition to the direction of Treasury rates, the performance of the municipal market hinges heavily on technical factors of supply relative to demand. We note that the continued absence of significant buyers of long-term munis has limited the level of outperformance arising at that segment of the curve. Despite the recent rally, yields on high quality 30-year munis are still in excess of Treasury yields with comparable maturities.

Supply continues to surprise on the downside

Total monthly municipal issuance, in USD millions

0

10

20

30

40

50

Jan-10 May-10 Sep-10 Jan-11 May-11Total Issuance

Source: Bond Buyer, UBS WMR, as of 23 May 2011

Spreads hover above their historical average and have moderate room for improvement, in our view Preferred credit spreads vs long-term Treasuries (bps)

0

200

400

600

800

1000

1200

1400

1600

1999 2001 2003 2005 2007 2009 2011

YTM spread vs long Treasuries Pre-crisis averageCrisis average

Source: BofA Merrill Lynch, UBS WMR, 24 May 2011

US fixed income


Rally too far to fast? Last month we wrote about our expectation for technical factors related to high anticipated seasonal redemptions in June to provide some near-term price support to the market. That said, we did not expect the magnitude of the bond rally that ensued. In our Municipal Bond Market Chartbook dated 2 May 2011, we cited an industry survey conducted by Municipal Market Data (MMD) that showed market participants were reducing their bearish views on the sector yet few were outright bullish. At this stage, it is evident that some confidence has returned to the sector. Yet risks remain. On the credit side, federal stimulus aid to US states ceases at the end of next month, coinciding with the majority of states finalizing FY 2012 budgets. Also, Moody’s cautioned in a recent special report that letter-of-credit expirations in the municipal market will create some rollover risk. As a result of these factors and a variety of other challenges facing state and local governments, we expect to see credit rating downgrades to be more common than upgrades and greater stress at the local level than for state governments. For our risk assessment and trends to watch, see page 40 in our new research report: Exchange: The municipal bond market: A whole new world, Spring 2011. Investors should be prepared for technical factors to weaken after Labor Day. A potential rise in Treasury yields from their current low levels combined with some supply returning to the muni market could pressure muni yields higher. Offsetting factors that could keep municipal yields lower for longer include: a structural shift to a prolonged period of lower issuance and Treasury rates not rising significantly. Key Portfolio Themes • Use the recent municipal bond market rally as an opportunity to take profits and diversify portfolios at a reasonable cost. While it is possible for muni yields to fall further in the near-term, we believe that recent price gains have occurred in the midst of a longer-term secular shift to higher interest rates that will pull muni yields along. Given the positive municipal market performance over the past few months, valuations on a significant portion of the market have risen, producing potential capital gains. Returns on the broad muni index by BofA/ML are up 4.1% year-to-date through 23May 2011. • Upgrade sectors. We continue to advocate the high quality sectors of the muni market such as essential purpose revenue bonds in the water/sewer and public utility sector, broad based sales tax bonds with ample coverage and a conservative additional bonds test, major established transportation agency issuers, and voted general obligation bonds. Exercise caution when a local government is overly reliant on state-shared revenue. With that said, payment defaults are still concentrated in the riskiest segments of the muni market, specifically, land-based finance, multi-family housing and long-term care.

M/T ratios fall sharply at front part of the curve

AAA Municipal-to-Treasury ratio, in %

50

75

100

125

150

175

200

2007 2008 2009 2010 2011

AAA GO 30 Year AAA GO 10 Year AAA GO 5 Year

Source: MMD, UBS WMR, as of 23 May 2011

Tax-exempt curve is still steep

AAA yield curve change, in %

0

1

2

3

4

5

5 10 15 20 25 305/24/10 4/23/10 5/23/11

Source: MMD, UBS WMR, as of 23 May 2011

US fixed income


• Focus on the 7-to-12 year maturity range for new money purchases. We view this range as the best compromise between the attractiveness of earning extra yield by extending maturities, given the steep tax-exempt yield curve, while seeking to limit exposure to rising yields should the Treasury market sell-off. Yields on AA and AAA high quality munis in this segment of the yield curve range from 1.93% to 3.22%, compared to less than 1.00% on shorter-dated 1- to 3-year munis. We previously preferred the 5-to-10-year range. However, with the 5-year AAA muni-to-Treasury ratio now at just 69%, we believe this maturity is overvalued. Since the market consensus began to shift in mid-April towards much lower tax-exempt issuance for 2011, investor demand increased, and did so dramatically at the 5-year spot. Kathleen M. McNamara, CFA, CFP®

US fixed income


Appendix Snapshot: Asset allocation, returns and yield tables

US fixed income sector returns (%)

2010201020102010 YTDYTDYTDYTD MTDMTDMTDMTD 6666----MonthMonthMonthMonth

YieldYieldYieldYields Ups Ups Ups Up

50 bp50 bp50 bp50 bpssss****

6666----MonthMonthMonthMonth

Yields DownYields DownYields DownYields Down

50 50 50 50 bpbpbpbpssss****

EffectiveEffectiveEffectiveEffective

DurationDurationDurationDuration

Treasuries 5.9 2.1 1.1 -1.1 3.9 5.3

TIPS 6.3 4.7 0.1 -0.3 5.1 5.1

Agencies 4.7 1.7 0.5 -0.4 2.1 3.3

Investment grade corporates 9.5 3.7 1.0 -0.6 5.4 6.3

High yield corporates 15.1 5.9 0.4 1.9 5.5 4.3

Preferred securities 13.7 5.5 0.7 N/A N/A 5.2

Mortgages 5.7 2.5 0.9 N/A N/A 4.1

Emerging Market sovereign bonds (USD)

12.5 3.5 1.3 -0.4 6.2 7.2

Municipals 2.3 4.2 1.9 N/A N/A 7.9

Taxable Fixed Income 6.8 2.6 1.0 N/A N/A 5.0

*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 25 May 2011

US fixed income asset allocation

BencBencBencBenchhhhmark mark mark mark allocallocallocallocaaaationtiontiontion1111

(%)(%)(%)(%)

Tactical Tactical Tactical Tactical devidevidevideviaaaationtiontiontion2222

(%)(%)(%)(%)

Current Current Current Current allallallalloooocationcationcationcation3333

(%)(%)(%)(%)

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 1.0 23.0

High yield corporates 10.0 2.0 12.0

Preferred securities 4.0 1.0 5.0

Mortgages 20.0 -1.0 19.0

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 26 May 2011

Economic snapshot

IndIndIndIndiiiicatorcatorcatorcator (%)(%)(%)(%) 1Q1Q1Q1Q

10101010

2Q2Q2Q2Q

10101010

3Q3Q3Q3Q

10101010

4Q4Q4Q4Q

10101010

1Q1Q1Q1Q

11111111

2Q2Q2Q2Q

11111111

3Q3Q3Q3Q

11111111

4Q4Q4Q4Q

11111111

Ann.Ann.Ann.Ann.

2011201120112011

Real GDP 3.73.73.73.7 1.71.71.71.7 2.62.62.62.6 3.3.3.3.1111 1.8 3.5 3.0 3.0 2.7

CPI-U 1.51.51.51.5 ----0.70.70.70.7 1.1.1.1.4444 2.62.62.62.6 5.2 2.8 0.8 0.3 2.6

Core CPI-U 0.00.00.00.0 0.90.90.90.9 1.1.1.1.1111 0.0.0.0.6666 1.7 1.4 1.2 1.3 1.2

Unemployment 9.79.79.79.7 9.79.79.79.7 9.69.69.69.6 9.69.69.69.6 8.9 8.7 8.6 8.5 8.7

Federal funds rate 0.130.130.130.13 0.130.130.130.13 0.130.130.130.13 0.130.130.130.13 0.130.130.130.13 0-0.25

0-0.25

0-0.25

0.18

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

Source: UBS, as of 26 May 2011

US money market rates (%)

MuniMuniMuniMuni

SwapSwapSwapSwap

IndexIndexIndexIndex

TreasuryTreasuryTreasuryTreasury

BillBillBillBill

Discount Discount Discount Discount NotesNotesNotesNotes

CommercialCommercialCommercialCommercial

PaperPaperPaperPaper

CertificatesCertificatesCertificatesCertificates

ofofofof

DepositDepositDepositDeposit

7-day 0.20 N/A N/A N/A N/A

30-day N/A 0.04 0.04 0.16 0.15

60-day N/A 0.02 0.05 0.20 N/A

90-day N/A 0.04 0.06 0.22 0.15

120-day N/A 0.05 0.08 0.24 N/A

180-day N/A 0.08 0.11 0.27 0.55

Note: Rates shown are discount yields on T-bill, discount notes, and commercial paper. CD rates are annual percentage yields (APY).

Source: Bloomberg and UBS as of 26 May 2011

US fixed income


Appendix

US fixed income yields (%)

MaturityMaturityMaturityMaturity TreaTreaTreaTreasurysurysurysury TIPSTIPSTIPSTIPS STRIPSSTRIPSSTRIPSSTRIPS AgenciesAgenciesAgenciesAgencies MorMorMorMorttttgagegagegagegage IG CorpIG CorpIG CorpIG Corpooooraterateraterate SingleSingleSingleSingle----AAAA

HY Corporate HY Corporate HY Corporate HY Corporate

DoubleDoubleDoubleDouble----BBBB

BABsBABsBABsBABs MunicMunicMunicMuniciiiipalpalpalpal AAAAAAAAAAAA

MunicMunicMunicMuniciiiipal TEY pal TEY pal TEY pal TEY 35%35%35%35%

Municipal Municipal Municipal Municipal

TEY 28%TEY 28%TEY 28%TEY 28%

PrPrPrPreeeeferredferredferredferred aaaaSingleSingleSingleSingle----AAAA

2-year 0.42 -1.48 0.58 0.50 N/A 1.42 2.97 1.50 0.46 0.71 0.64 N/A

5-year 1.65 -0.45 1.83 1.85 3.15 2.82 4.68 2.81 1.33 2.05 1.85 N/A

10-year 3.06 0.76 3.26 2.87 3.97 4.46 6.12 4.17 2.84 4.37 3.94 N/A

20-year 3.96 1.46 4.12 4.35 N/A 5.51 6.79 5.91 4.21 6.48 5.85 N/A

30-year 4.25 1.78 4.32 4.40 N/A 5.58 7.14 6.36 4.40 6.77 6.11 6.71

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 26 May 2011

Highlighted securities

Highlighted Treasury Inflation Protected Securities (TIPS)

Issuer NameIssuer NameIssuer NameIssuer Name CoCoCoCouuuuponponponpon MMMMaaaaturityturityturityturity CUSIPCUSIPCUSIPCUSIP Yield to Mat. (YTM)*Yield to Mat. (YTM)*Yield to Mat. (YTM)*Yield to Mat. (YTM)* Current factor**Current factor**Current factor**Current factor** DurationDurationDurationDuration

TIPS 0.125 4/15/2016 912828QD5 -0.38 1.01082 4.88

TIPS 2.500 7/15/2016 912828FL9 -0.37 1.10481 4.84

TIPS 2.375 1/15/2017 912828GD6 -0.13 1.10639 5.29

TIPS 2.625 7/15/2017 912828GX2 -0.07 1.07654 5.69

TIPS 1.625 1/15/2018 912828HN3 0.12 1.06502 6.29

TIPS 1.375 7/15/2018 912828JE1 0.18 1.03468 6.79

TIPS 2.125 1/15/2019 912828JX9 0.32 1.03921 7.06

TIPS 1.875 7/15/2019 912828LA6 0.39 1.04496 7.55

TIPS 1.375 1/15/2020 912828MF4 0.53 1.03178 8.13

TIPS 1.250 7/15/2020 912828NM8 0.61 1.02308 8.61

TIPS 1.125 01/15/2021 912828PP9 0.73 1.01996 9.09

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 26 May 2011 and will change daily.

Source: UBS WMR, as of 26 May 2011

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Appendix

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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.

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Appendix

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