-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, WEgE5MlxZN93qXAI5f6EvKldd15jIIW4Nz95BLrJPM39oX+8c+3hXfR+3Z2U7FBY dRsjIGEcQAtNIlDovE6/0A== 0000950123-08-010717.txt : 20080908 0000950123-08-010717.hdr.sgml : 20080908 20080908142000 ACCESSION NUMBER: 0000950123-08-010717 CONFORMED SUBMISSION TYPE: N-CSRS PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20080630 FILED AS OF DATE: 20080908 DATE AS OF CHANGE: 20080908 EFFECTIVENESS DATE: 20080908 FILER: COMPANY DATA: COMPANY CONFORMED NAME: MORGAN STANLEY CALIFORNIA TAX-FREE INCOME FUND CENTRAL INDEX KEY: 0000745992 IRS NUMBER: 000000000 STATE OF INCORPORATION: MA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: N-CSRS SEC ACT: 1940 Act SEC FILE NUMBER: 811-04020 FILM NUMBER: 081060599 BUSINESS ADDRESS: STREET 1: 522 FIFTH AVENUE CITY: NEW YORK STATE: NY ZIP: 10036 BUSINESS PHONE: 800-869-6397 MAIL ADDRESS: STREET 1: 522 FIFTH AVENUE CITY: NEW YORK STATE: NY ZIP: 10036 FORMER COMPANY: FORMER CONFORMED NAME: MORGAN STANLEY CALIFORNIA TAX FREE INCOME FUND DATE OF NAME CHANGE: 20010618 FORMER COMPANY: FORMER CONFORMED NAME: MORGAN STANLEY DEAN WITTER CALIFORNIA TAX FREE INCOME FUND DATE OF NAME CHANGE: 19980622 FORMER COMPANY: FORMER CONFORMED NAME: DEAN WITTER CALIFORNIA TAX FREE INCOME FUND DATE OF NAME CHANGE: 19920703 0000745992 S000002430 Morgan Stanley California Tax-Free Income Fund C000006491 A CLFAX C000006492 B CLFBX C000006493 C CLFCX C000006494 I CLFDX N-CSRS 1 y62927nvcsrs.txt FORM N-CSRS UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM N-CSR CERTIFIED SHAREHOLDER REPORT OF REGISTERED MANAGEMENT INVESTMENT COMPANIES Investment Company Act file number: 811-04020 Morgan Stanley California Tax-Free Income Fund (Exact name of registrant as specified in charter) 522 Fifth Avenue, New York, New York 10036 (Address of principal executive offices) (Zip code) Ronald E. Robison 522 Fifth Avenue, New York, New York 10036 (Name and address of agent for service) Registrant's telephone number, including area code: 212-296-6990 Date of fiscal year end: December 31, 2008 Date of reporting period: June 30, 2008 Item 1 - Report to Shareholders INVESTMENT MANAGEMENT [MORGAN STANLEY LOGO]
Welcome, Shareholder: In this report, you'll learn about how your investment in Morgan Stanley California Tax-Free Income Fund performed during the semiannual period. We will provide an overview of the market conditions, and discuss some of the factors that affected performance during the reporting period. In addition, this report includes the Fund's financial statements and a list of Fund investments. This material must be preceded or accompanied by a prospectus for the fund being offered. Market forecasts provided in this report may not necessarily come to pass. There is no assurance that the Fund will achieve its investment objective. The Fund is subject to market risk, which is the possibility that market values of securities owned by the Fund will decline and, therefore, the value of the Fund's shares may be less than what you paid for them. Accordingly, you can lose money investing in this Fund. Please see the prospectus for more complete information on investment risks. FUND REPORT For the six months ended June 30, 2008 TOTAL RETURN FOR THE 6 MONTHS ENDED JUNE 30, 2008
LIPPER LEHMAN CALIFORNIA BROTHERS MUNICIPAL CALIFORNIA DEBT EXEMPT FUNDS CLASS A CLASS B CLASS C CLASS I(+) INDEX(1) INDEX(2) -0.88% -0.89% -1.10% -0.75% -0.19% -1.00%
+ Formerly Class D shares. Renamed Class I shares effective March 31, 2008. The performance of the Fund's four share classes varies because each has different expenses. The Fund's total returns assume the reinvestment of all distributions but do not reflect the deduction of any applicable sales charges. Such costs would lower performance. See Performance Summary for standardized performance and benchmark information. MARKET CONDITIONS The fixed income market was tremendously volatile throughout the six-month reporting period. In the first quarter of 2008, credit and liquidity remained constrained, the housing market continued to weaken and fears of an economic recession emerged, all of which took a toll on investor confidence. As a result, investors shunned risky assets in favor of the relatively safe haven of high- quality government securities, fueling the performance of U.S. Treasuries while driving spreads in other sectors considerably wider. The Federal Reserve (the "Fed") stepped in several times during the quarter to help boost liquidity and the economy, reducing the target federal funds rates by 225 basis points while also taking the unprecedented steps of granting primary brokerage firms access to its discount window, loosening its collateral requirements, and extending loans of Treasury securities in exchange for lower quality, less liquid securities. In what was decidedly the biggest headline event, the Fed facilitated JPMorgan Chase's purchase of troubled Bear Stearns -- once the country's fifth largest investment bank -- in mid-March, which was viewed by many as necessary to avoid serious market repercussions had the firm failed. Early in the second quarter, market liquidity began to improve and investor appetite for risk returned, spurring a rebound in spread sector performance that lasted through mid-June. Citing the need to maintain a balance between supporting the economy while limiting inflationary pressures, the Fed held the target federal funds rate steady at 2.0 percent in June, where it had stood since the last rate cut in April. In the final weeks of the quarter, the market retreated again as investors paused to consider new credit concerns in the market as well as the possibility that the Fed might begin to raise rates in order to fight inflation. As a result, for the overall period Treasuries outperformed all other sectors of the fixed income market. After a difficult first quarter, the municipal bond market regained ground versus Treasuries in April and May as investors recognized the relative "cheapness" of municipals versus taxable products. However, some of that outperformance was given back late in the quarter. Overall, investment-grade municipal bonds outperformed high-yield municipals. Investment-grade municipals also outperformed their taxable counterparts. As of period end, municipal yields remained higher than at the start of the year, except on the front end of the yield curve. The California municipal market underperformed the broad municipal market for the period. The state continues to struggle with a growing budget deficit and deteriorating housing 2 market. California remained one of the largest issuers of municipal bonds in the country, with the majority of new issuance occurring in the development and energy sectors. PERFORMANCE ANALYSIS All share classes of Morgan Stanley California Tax-Free Income Fund underperformed the Lehman Brothers California Exempt Index, while Class A, B and I shares outperformed and Class C shares underperformed the Lipper California Municipal Debt Funds Index for the six months ended June 30, 2008, assuming no deduction of applicable sales charges. Over the course of the period, we added to the Fund's holdings in zero-coupon municipal bonds as they have become cheaper relative to their coupon-bearing counterparts. Unfortunately, zero-coupon issues underperformed during the period and holdings here held back performance. Overweight exposures to the hospital/life care and tobacco sectors also hindered performance as spreads in both sectors widened, causing their performance to wane. Other positions, however, were additive to performance. An overweight to the public utility sector, particularly water and sewer bonds, enhanced returns as the flight to quality that took place during the early part of the period helped boost the performance of the more solid infrastructure sectors such as these. Given the outperformance of the higher-rated segment of the municipal market, the Fund's overall emphasis on higher-quality securities was also additive. The Fund's yield-curve positioning was beneficial as well. We underweighted longer-dated issues and overweighted intermediate-dated issues through the use of interest rate swaps. This strategy helped enhance returns as the spread between intermediate- and long-dated yields widened in the first quarter of the year. There is no guarantee that any sectors mentioned will continue to perform as discussed herein or that securities in such sectors will be held by the Fund in the future. 3
TOP FIVE SECTORS AS OF 06/30/08 Appropriation 16.2% Water/Sewer 15.9 Education 9.8 General obligation 9.7 Hospital 9.6
LONG-TERM CREDIT ANALYSIS AS OF 06/30/08 Aaa/AAA 39.8% Aa/AA 24.6 A/A 18.9 Baa/BBB 14.5 Ba/BB or Less 2.2
Subject to change daily. Provided for informational purposes only and should not be deemed as a recommendation to buy or sell the securities mentioned or securities in the sectors shown above. Top five sectors are as a percentage of total investments. Long-term credit analysis are as a percentage of long-term investments. Securities are classified by sectors that represent broad groupings of related industries. Morgan Stanley is a full-service securities firm engaged in securities trading and brokerage activities, investment banking, research and analysis, financing and financial advisory services. Rating allocations based upon ratings as issued by Standard and Poor's and Moody's, respectively. INVESTMENT STRATEGY THE FUND WILL NORMALLY INVEST AT LEAST 80 PERCENT OF ITS NET ASSETS IN SECURITIES THAT PAY INTEREST EXEMPT FROM FEDERAL AND CALIFORNIA STATE INCOME TAXES. THE FUND'S "INVESTMENT ADVISER," MORGAN STANLEY INVESTMENT ADVISORS INC., GENERALLY INVESTS THE FUND'S ASSETS IN INVESTMENT GRADE, CALIFORNIA MUNICIPAL OBLIGATIONS. MUNICIPAL OBLIGATIONS ARE BONDS, NOTES OR SHORT-TERM COMMERCIAL PAPER ISSUED BY STATE GOVERNMENTS, LOCAL GOVERNMENTS OR THEIR RESPECTIVE AGENCIES. FOR MORE INFORMATION ABOUT PORTFOLIO HOLDINGS EACH MORGAN STANLEY FUND PROVIDES A COMPLETE SCHEDULE OF PORTFOLIO HOLDINGS IN ITS SEMIANNUAL AND ANNUAL REPORTS WITHIN 60 DAYS OF THE END OF THE FUND'S SECOND AND FOURTH FISCAL QUARTERS. THE SEMIANNUAL REPORTS AND THE ANNUAL REPORTS ARE FILED ELECTRONICALLY WITH THE SECURITIES AND EXCHANGE COMMISSION (SEC) ON FORM N-CSRS AND FORM N-CSR, RESPECTIVELY. MORGAN STANLEY ALSO DELIVERS THE SEMIANNUAL AND ANNUAL REPORTS TO FUND SHAREHOLDERS AND MAKES THESE REPORTS AVAILABLE ON ITS PUBLIC WEB SITE, WWW.MORGANSTANLEY.COM. EACH MORGAN STANLEY FUND ALSO FILES A COMPLETE SCHEDULE OF PORTFOLIO HOLDINGS WITH THE SEC FOR THE FUND'S FIRST AND THIRD FISCAL QUARTERS ON FORM N-Q. MORGAN STANLEY DOES NOT DELIVER THE REPORTS FOR THE FIRST AND THIRD FISCAL QUARTERS TO SHAREHOLDERS, NOR ARE THE REPORTS POSTED TO THE MORGAN STANLEY PUBLIC WEB SITE. YOU MAY, HOWEVER, OBTAIN THE FORM N-Q FILINGS (AS WELL AS THE FORM N-CSR AND N-CSRS FILINGS) BY ACCESSING THE SEC'S WEB SITE, HTTP://WWW.SEC.GOV. YOU MAY ALSO REVIEW AND COPY THEM AT THE SEC'S PUBLIC REFERENCE ROOM IN WASHINGTON, DC. 4 INFORMATION ON THE OPERATION OF THE SEC'S PUBLIC REFERENCE ROOM MAY BE OBTAINED BY CALLING THE SEC AT (800) SEC-0330. YOU CAN ALSO REQUEST COPIES OF THESE MATERIALS, UPON PAYMENT OF A DUPLICATING FEE, BY ELECTRONIC REQUEST AT THE SEC'S E-MAIL ADDRESS (PUBLICINFO@SEC.GOV) OR BY WRITING THE PUBLIC REFERENCE SECTION OF THE SEC, WASHINGTON, DC 20549-0102. HOUSEHOLDING NOTICE TO REDUCE PRINTING AND MAILING COSTS, THE FUND ATTEMPTS TO ELIMINATE DUPLICATE MAILINGS TO THE SAME ADDRESS. THE FUND DELIVERS A SINGLE COPY OF CERTAIN SHAREHOLDER DOCUMENTS, INCLUDING SHAREHOLDER REPORTS, PROSPECTUSES AND PROXY MATERIALS, TO INVESTORS WITH THE SAME LAST NAME WHO RESIDE AT THE SAME ADDRESS. YOUR PARTICIPATION IN THIS PROGRAM WILL CONTINUE FOR AN UNLIMITED PERIOD OF TIME UNLESS YOU INSTRUCT US OTHERWISE. YOU CAN REQUEST MULTIPLE COPIES OF THESE DOCUMENTS BY CALLING (800) 869-NEWS, 8:00 A.M. TO 8:00 P.M., ET. ONCE OUR CUSTOMER SERVICE CENTER HAS RECEIVED YOUR INSTRUCTIONS, WE WILL BEGIN SENDING INDIVIDUAL COPIES FOR EACH ACCOUNT WITHIN 30 DAYS. 5 PERFORMANCE SUMMARY AVERAGE ANNUAL TOTAL RETURNS -- PERIOD ENDED JUNE 30, 2008
CLASS A SHARES* CLASS B SHARES** CLASS C SHARES+ CLASS I SHARES++ (since 07/28/97) (since 07/11/84) (since 07/28/97) (since 07/28/97) SYMBOL CLFAX CLFBX CLFCX CLFDX 1 YEAR 0.98% (3) 0.94% (3) 0.50% (3) 1.16% (3) (3.31) (4) (3.89) (4) (0.47) (4) -- 5 YEARS 2.89 (3) 2.99 (3) 2.37 (3) 3.12 (3) 2.00 (4) 2.67 (4) 2.37 (4) -- 10 YEARS 4.03 (3) 4.03 (3) 3.52 (3) 4.29 (3) 3.58 (4) 4.03 (4) 3.52 (4) -- SINCE INCEPTION 4.16 (3) 6.51 (3) 3.66 (3) 4.41 (3) 3.75 (4) 6.51 (4) 3.66 (4) --
Performance data quoted represents past performance, which is no guarantee of future results and current performance may be lower or higher than the figures shown. For most recent month-end performance figures, please visit www.morganstanley.com/msim or speak with your Financial Advisor. Investment returns and principal value will fluctuate and fund shares, when redeemed, may be worth more or less than their original cost. The table does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Performance for Class A, Class B, Class C, and Class I shares will vary due to differences in sales charges and expenses. * The maximum front-end sales charge for Class A is 4.25%. ** The maximum contingent deferred sales charge (CDSC) for Class B is 5.0%. The CDSC declines to 0% after six years. For periods greater than eight years, returns do not reflect conversion to Class A shares eight years after the end of the calendar month in which shares were purchased. The conversion feature is currently suspended because the total annual operating expense ratio of Class B is currently lower than that of Class A. See "Conversion Feature" for Class B shares in "Share Class Arrangements" of the Prospectus for more information. + The maximum contingent deferred sales charge for Class C is 1.0% for shares redeemed within one year of purchase. ++ Class I (formerly Class D) has no sales charge. (1) The Lehman Brothers California Exempt Index tracks the performance of California issued municipal bonds rated at least Baa or BBB by Moody's Investors Service, Inc. or Standard & Poor's Corporation, respectively and with maturities of 2 years or greater. The Index is unmanaged and its returns do not include any sales charges or fees. Such costs would lower performance. It is not possible to invest directly in an index. (2) The Lipper California Municipal Debt Funds Index is an equally weighted performance index of the largest qualifying funds (based on net assets) in the Lipper California Municipal Debt Funds classification. The Index, which is adjusted for capital gains distributions and income dividends, is unmanaged and should not be considered an investment. There are currently 30 funds represented in this Index. The Fund is in the Lipper California Municipal Debt Funds classification as of the date of this report. (3) Figure shown assumes reinvestment of all distributions and does not reflect the deduction of any sales charges. (4) Figure shown assumes reinvestment of all distributions and the deduction of the maximum applicable sales charge. See the Fund's current prospectus for complete details on fees and sales charges. 6 EXPENSE EXAMPLE As a shareholder of the Fund, you incur two types of costs: (1) transaction costs, including sales charges (loads) on purchase payments and redemption fees; and (2) ongoing costs, including advisory fees; distribution and service (12b-1) fees; and other Fund expenses. This example is intended to help you understand your ongoing costs (in dollars) of investing in the Fund and to compare these costs with the ongoing costs of investing in other mutual funds. The example is based on an investment of $1,000 invested at the beginning of the period and held for the entire period 01/01/08 - 06/30/08. ACTUAL EXPENSES The first line of the table below provides information about actual account values and actual expenses. You may use the information in this line, together with the amount you invested, to estimate the expenses that you paid over the period. Simply divide your account value by $1,000 (for example, an $8,600 account value divided by $1,000 = 8.6), then multiply the result by the number in the first line under the heading entitled "Expenses Paid During Period" to estimate the expenses you paid on your account during this period. HYPOTHETICAL EXAMPLE FOR COMPARISON PURPOSES The second line of the table below provides information about hypothetical expenses based on the Fund's actual expense ratio and an assumed rate of return of 5% per year before expenses, which is not the Fund's actual return. The hypothetical account values and expenses may not be used to estimate the actual ending account balance or expenses you paid for the period. You may use this information to compare the ongoing cost of investing in the Fund and other funds. To do so, compare this 5% hypothetical example with the 5% hypothetical examples that appear in the shareholder reports of the other funds. Please note that the expenses shown in the table are meant to highlight your ongoing costs only and do not reflect any transactional costs, such as sales charges (loads) and redemption fees. Therefore, the second line of the table is useful in comparing ongoing costs, and will not help you determine the relative total cost of owning different funds. In addition, if these transactional costs were included, your costs would have been higher.
BEGINNING ENDING EXPENSES PAID ACCOUNT VALUE ACCOUNT VALUE DURING PERIOD@ ------------- ------------- -------------- 01/01/08 - 01/01/08 06/30/08 06/30/08 ------------- ------------- -------------- CLASS A Actual (-0.88% return)........................ $1,000.00 $ 991.20 $4.26 Hypothetical (5% annual return before expenses)................................... $1,000.00 $1,020.59 $4.32 CLASS B Actual (-0.89% return)........................ $1,000.00 $ 991.10 $4.11 Hypothetical (5% annual return before expenses)................................... $1,000.00 $1,020.74 $4.17 CLASS C Actual (-1.10% return)........................ $1,000.00 $ 989.00 $6.73 Hypothetical (5% annual return before expenses)................................... $1,000.00 $1,018.10 $6.82 CLASS I@@ Actual (-0.75% return)........................ $1,000.00 $ 992.50 $3.02 Hypothetical (5% annual return before expenses)................................... $1,000.00 $1,021.83 $3.07
- --------- @ Expenses are equal to the Fund's annualized expense ratios of 0.86%, 0.83%, 1.36% and 0.61% for Class A, Class B, Class C and Class I shares, respectively, multiplied by the average account value over the period, multiplied by 182/366 (to reflect the one-half year period). If the Fund had borne all of its expenses, the annualized expense ratios would have been 0.90%, 0.87%, 1.40% and 0.65% for Class A, Class B, Class C and Class I shares, respectively. Currently, the Distributor has agreed to waive the 12b-1 fee on Class B shares to the extent it exceeds 0.24% of the average daily net assets of such shares on an annualized basis. The Distributor may discontinue this waiver in the future. @@ Formerly Class D shares. Renamed Class I shares effective March 31, 2008. 7 INVESTMENT ADVISORY AGREEMENT APPROVAL NATURE, EXTENT AND QUALITY OF SERVICES The Board reviewed and considered the nature and extent of the investment advisory services provided by the Investment Adviser under the Advisory Agreement, including portfolio management, investment research and fixed income securities trading. The Board also reviewed and considered the nature and extent of the non-advisory, administrative services provided by the Fund's Administrator under the Administration Agreement, including accounting, clerical, bookkeeping, compliance, business management and planning, and the provision of supplies, office space and utilities at the Investment Adviser's expense. (The Investment Adviser and the Administrator together are referred to as the "Adviser" and the Advisory and Administration Agreements together are referred to as the "Management Agreement.") The Board also compared the nature of the services provided by the Adviser with similar services provided by non- affiliated advisers as reported to the Board by Lipper Inc. ("Lipper"). The Board reviewed and considered the qualifications of the portfolio managers, the senior administrative managers and other key personnel of the Adviser who provide the advisory and administrative services to the Fund. The Board determined that the Adviser's portfolio managers and key personnel are well qualified by education and/or training and experience to perform the services in an efficient and professional manner. The Board concluded that the nature and extent of the advisory and administrative services provided were necessary and appropriate for the conduct of the business and investment activities of the Fund. The Board also concluded that the overall quality of the advisory and administrative services was satisfactory. PERFORMANCE RELATIVE TO COMPARABLE FUNDS MANAGED BY OTHER ADVISERS On a regular basis, the Board reviews the performance of all funds in the Morgan Stanley Fund Complex, including the Fund, compared to their peers, paying specific attention to the underperforming funds. In addition, the Board specifically reviewed the Fund's performance for the one-, three- and five-year periods ended December 31, 2007, as shown in a report provided by Lipper (the "Lipper Report"), compared to the performance of comparable funds selected by Lipper (the "performance peer group"). The Board also discussed with the Adviser the performance goals and the actual results achieved in managing the Fund. The Board concluded that the Fund's performance was competitive with that of its performance peer group. FEES RELATIVE TO OTHER PROPRIETARY FUNDS MANAGED BY THE ADVISER WITH COMPARABLE INVESTMENT STRATEGIES The Board noted that the Adviser did not manage any other proprietary funds with investment strategies comparable to those of the Fund. 8 FEES AND EXPENSES RELATIVE TO COMPARABLE FUNDS MANAGED BY OTHER ADVISERS The Board reviewed the advisory and administrative fee (together, the "management fee") rate and total expense ratio of the Fund as compared to the average management fee rate and average total expense ratio for funds, selected by Lipper (the "expense peer group"), managed by other advisers with investment strategies comparable to those of the Fund, as shown in the Lipper Report. The Board noted that the management fee was lower and total expense ratio was higher but close to the expense peer group average. The Board concluded that the Fund's management fee rate and total expense ratio were competitive with those of its expense peer group. BREAKPOINTS AND ECONOMIES OF SCALE The Board reviewed the structure of the Fund's management fee schedule under the Management Agreement and noted that it includes breakpoints. The Board also reviewed the level of the Fund's management fee and noted that the fee, as a percentage of the Fund's net assets, would decrease as net assets increase because the management fee includes breakpoints. The Board concluded that the Fund's management fee would reflect economies of scale as assets increase. PROFITABILITY OF THE ADVISER AND AFFILIATES The Board considered information concerning the costs incurred and profits realized by the Adviser and affiliates during the last year from their relationship with the Fund and during the last two years from their relationship with the Morgan Stanley Fund Complex and reviewed with the Adviser the cost allocation methodology used to determine the profitability of the Adviser and affiliates. Based on its review of the information it received, the Board concluded that the profits earned by the Adviser and affiliates were not excessive in light of the advisory, administrative and other services provided to the Fund. FALL-OUT BENEFITS The Board considered so-called "fall-out benefits" derived by the Adviser and affiliates from their relationship with the Fund and the Morgan Stanley Fund Complex, such as sales charges on sales of Class A shares and "float" benefits derived from handling of checks for purchases and sales of Fund shares, through a broker-dealer affiliate of the Adviser. The Board also considered that a broker-dealer affiliate of the Adviser receives from the Fund 12b-1 fees for distribution and shareholder services. The Board concluded that the float benefits were relatively small and the sales charges and 12b-1 fees were competitive with those of other broker-dealers. 9 SOFT DOLLAR BENEFITS The Board considered whether the Adviser realizes any benefits from commissions paid to brokers who execute securities transactions for the Fund ("soft dollars"). The Board noted that the Fund invests only in fixed income securities, which do not generate soft dollars. ADVISER FINANCIALLY SOUND AND FINANCIALLY CAPABLE OF MEETING THE FUND'S NEEDS The Board considered whether the Adviser is financially sound and has the resources necessary to perform its obligations under the Management Agreement. The Board concluded that the Adviser has the financial resources necessary to fulfill its obligations under the Management Agreement. HISTORICAL RELATIONSHIP BETWEEN THE FUND AND THE ADVISER The Board also reviewed and considered the historical relationship between the Fund and the Adviser, including the organizational structure of the Adviser, the policies and procedures formulated and adopted by the Adviser for managing the Fund's operations and the Board's confidence in the competence and integrity of the senior managers and key personnel of the Adviser. The Board concluded that it is beneficial for the Fund to continue its relationship with the Adviser. OTHER FACTORS AND CURRENT TRENDS The Board considered the controls and procedures adopted and implemented by the Adviser and monitored by the Fund's Chief Compliance Officer and concluded that the conduct of business by the Adviser indicates a good faith effort on its part to adhere to high ethical standards in the conduct of the Fund's business. GENERAL CONCLUSION After considering and weighing all of the above factors, the Board concluded that it would be in the best interest of the Fund and its shareholders to approve renewal of the Management Agreement for another year. 10 Morgan Stanley California Tax-Free Income Fund PORTFOLIO OF INVESTMENTS - JUNE 30, 2008 (UNAUDITED)
PRINCIPAL AMOUNT IN COUPON MATURITY THOUSANDS RATE DATE VALUE - ------------------------------------------------------------------------------------------ Tax-Exempt Municipal Bonds (98.0%) California (94.4%) $ 750 Alameda County Joint Powers Authority, 2008 Ser A (FSA Insd)......................... 5.00% 12/01/25 $ 779,677 1,325 Alameda County Joint Powers Authority, 2008 Ser A (FSA Insd)......................... 5.00 12/01/26 1,372,276 1,590 Alvord Unified School District, 2007 Election, Ser 2008 A (FSA Insd).......... 5.00 08/01/28 1,643,392 4,000 Anaheim Public Financing Authority, 1997 Ser C (FSA Insd)......................... 6.00 09/01/16 4,542,160 8,000 Antelope Valley Healthcare District, Refg Ser 1997 A (FSA Insd).................... 5.20 01/01/20 8,171,520 5,000 California County Tobacco Securitization Agency, Los Angeles County Securitization Corp Ser 2006............................ 0.00(a) 06/01/28 3,600,600 19,730 California Department of Water Resources, Center Valley Ser Y (FGIC Insd).......... 5.00 12/01/25 20,142,752 2,000 California Educational Facilities Authority, California College of Arts Ser 2005..................................... 5.00 06/01/35 1,738,040 3,000 California Educational Facilities Authority, Mills College Ser 2005 A...... 5.00 09/01/29 2,972,730 2,000 California Educational Facilities Authority, Pitzer College Ser 2005 A..... 5.00 04/01/35 1,936,780 2,000 California Educational Facilities Authority, University of Redlands Ser 2005 A................................... 5.00 10/01/35 1,925,000 5,000 California Educational Facilities Authority, University of San Diego Ser 1998 (AMBAC Insd)........................ 5.00 10/01/22 5,045,200 4,000 California Health Facilities Financing Authority, Cedars-Sinai Medical Center Ser 2005................................. 5.00 11/15/27 3,950,880 5,000 California Health Facilities Financing Authority, Cedars-Sinai Medical Center Ser 2005................................. 5.00 11/15/34 4,750,450 2,000 California Health Facilities Financing Authority, Kaiser Permanente Ser 2006 A.. 5.25 04/01/39 1,928,920 2,000 California Infrastructure & Economic Development Bank, California Science Center Foundation Phase II Ser 2006 B (FGIC Insd).............................. 5.00 05/01/31 1,931,200 5,000 California Infrastructure & Economic Development Bank, Kaiser Hospital Ser 2001 A................................... 5.55 08/01/31 5,054,600 1,000 California Municipal Finance Authority, American Heritage Education Foundation Ser 2006 A............................... 5.25 06/01/26 918,800 5,000 California Pollution Control Finance Authority, San Diego Gas & Electric Co 1996 Ser A............................... 5.90 06/01/14 5,247,450 2,000 California Public Works Board, Butterfield State Office 2005 Ser A.................. 5.25 06/01/30 2,019,540 10,000 California Public Works Board, Department of Corrections Refg 1993 Ser A (AMBAC Insd).................................... 5.00 12/01/19 10,285,600 495 California State, Ser 1993 (FSA Insd)...... 5.50 04/01/19 498,208 5,000 California Statewide Communities Development Authority, Adventist Healthwest 2005 Ser A.................... 5.00 03/01/30 4,795,300 1,260 California Statewide Communities Development Authority, Cedars-Sinai Medical Center Ser 1992 (COPs)........... 6.50 08/01/12 1,338,460
See Notes to Financial Statements 11 Morgan Stanley California Tax-Free Income Fund PORTFOLIO OF INVESTMENTS - JUNE 30, 2008 (UNAUDITED) continued
PRINCIPAL AMOUNT IN COUPON MATURITY THOUSANDS RATE DATE VALUE - ------------------------------------------------------------------------------------------ $ 3,000 California Statewide Communities Development Authority, Daughters of Charity Health Ser 2005 A................ 5.25 % 07/01/30 $ 2,814,060 2,650 California, Ser 1996 (AMBAC Insd).......... 5.25 06/01/21 2,656,625 5,000 California, Various Purpose Dtd 04/01/02... 6.00 04/01/19 5,647,050 2,000 California, Veterans Ser AT................ 9.50 02/01/10 2,202,460 14,000 Duarte, City of Hope National Medical Center Ser 1999 A (COPs)................. 5.25 04/01/19 14,077,140 8,000 Eastern Municipal Water District, Water & Sewer Refg Ser 1998 A (COPs) (FGIC Insd).................................... 4.75 07/01/23 8,004,560 9,445 Fontana Unified School District, Election of 2006, Ser B (FSA Insd)................ 0.00 02/01/33 2,530,127 1,500 Fontana Public Financing Authority, Ser 2003 A (AMBAC Insd)...................... 5.375 09/01/25 1,550,160 14,000 Foothill/Eastern Transportation Corridor Agency, Toll Road Ser 1999............... 0.00(a) 01/15/23 13,130,460 5,000 Foothill/Eastern Transportation Corridor Agency, Toll Road Ser 1999 (MBIA Insd)... 5.125 01/15/19 5,047,050 10,000 Golden State Tobacco Securitization Corporation, Asset Backed Ser 2007 A-1... 5.75 06/01/47 8,510,300 3,000 Golden State Tobacco Securitization Corporation, Enhanced Asset Backed Ser 2005 A................................... 5.00 06/01/45 2,759,520 4,000 Golden State Tobacco Securitization Corporation, Enhanced Asset Backed Ser 2007 A-1................................. 5.125 06/01/47 3,057,080 6,750 Grossmont Union High School District, Election of 2004, Ser 2006 (MBIA Insd)... 0.00 08/01/24 2,960,415 3,000 Huntington Beach Union High School District, Ser 2004 (FSA Insd)............ 5.00 08/01/27 3,058,170 2,000 Independent Cities Lease Financing Authority, San Juan Mobile Estates Ser 2006 A................................... 5.125 05/15/41 1,748,680 780 Indio Redevelopment Agency, Tax Allocation Ser 2008 A............................... 5.25 08/15/27 771,599 470 Indio Redevelopment Agency, Tax Allocation Ser 2008 A............................... 5.25 08/15/28 461,380 2,100 Kern County Water Agency Improvement District No. 4, Ser 2008 A (COPs) (AGC Insd).................................... 5.00 05/01/28 2,144,058 5,000 Loma Linda, Loma Linda University Medical Center Ser 2005 A........................ 5.00 12/01/20 4,927,100 20,000 Long Beach Financing Authority, Ser 1992 (AMBAC Insd)............................. 6.00 11/01/17 22,054,800 20,000 Los Angeles Department of Water & Power, Ser 2001-A (FSA Insd).................... 5.25 07/01/22 20,815,600 5,000 Los Angeles Department of Water & Power, Ser 2001 A............................... 5.125 07/01/41 5,032,450 3,000 Los Angeles Municipal Improvement Corporation, Police Headquarters Ser 2006 - A (FGIC Insd)..................... 4.75 01/01/31 2,810,820 20,000 Los Angeles Wastewater, Refg Ser 2003 B (FSA Insd) (c)........................... 5.00 06/01/22 20,592,600 5,000 Los Angeles, Ser 2004 (MBIA Insd).......... 5.00 09/01/24 5,146,650 7,500 Madera County, Valley Children's Hospital Ser 1995 (COPs) (MBIA Insd).............. 6.50 03/15/15 8,311,575 850 Oakland Joint Powers Financing Authority, Oakland Administration Buildings Refg 2008 Ser B (AGC Insd).................... 5.00 08/01/25 870,264 1,215 Oakland Joint Powers Financing Authority, Oakland Administration Buildings Refg 2008 Ser B (AGC Insd).................... 5.00 08/01/26 1,239,069
See Notes to Financial Statements 12 Morgan Stanley California Tax-Free Income Fund PORTFOLIO OF INVESTMENTS - JUNE 30, 2008 (UNAUDITED) continued
PRINCIPAL AMOUNT IN COUPON MATURITY THOUSANDS RATE DATE VALUE - ------------------------------------------------------------------------------------------ $ 2,155 Placer County Water Agency, Refg Ser 2008 (COPs) (FSA Insd)........................ 4.75 % 07/01/29 $ 2,124,011 2,530 Poway Uniform School District Public Financing Authority, Ser 2007 (AMBAC Insd).................................... 4.625 09/15/42 2,318,340 3,100 Redding Electric System, 2008 Ser A (COPs) (FSA Insd)............................... 5.00 06/01/27 3,180,352 2,515 Roseville Joint Union High School District, Election of 2004, Ser 2007 C (FSA Insd).. 0.00 08/01/24 1,118,697 1,970 Roseville Joint Union High School District, Election of 2004, Ser 2007 C (FSA Insd).. 0.00 08/01/25 828,267 1,350 Roseville Joint Union High School District, Election of 2004, Ser 2007 C (FSA Insd).. 0.00 08/01/26 534,600 2,000 San Diego County, Burnham Institute for Medical Research Ser 2006 (COPs)......... 5.00 09/01/34 1,760,160 2,080 San Diego County Water Authority, Ser 2008 A (COPs) (FSA Insd)...................... 5.00 05/01/28 2,143,440 5,000 San Francisco Airports Commission, San Francisco Int'l Airport Second Ser Refg Issue 27 B (FGIC Insd)................... 5.125 05/01/26 5,043,600 9,500 San Francisco Bay Area Rapid Transit District, Sales Tax Ser 1998 (AMBAC Insd).................................... 4.75 07/01/23 9,557,665 4,000 San Francisco City & County, City Buildings Ser 2007 A (COPs) (FGIC Insd)............ 4.50 09/01/37 3,554,320 5,000 San Francisco City & County, Laguna Honda Hospital (FSA Insd) (d).................. 5.00 06/15/30 5,127,440 4,000 San Francisco Public Utilities Commission, Water 2002 Ser A (MBIA Insd)............. 5.00 11/01/20 4,080,120 6,000 San Joaquin Hills Transportation Corridor Agency, Toll Road Refg Ser 1997 A (MBIA Insd).................................... 0.00 01/15/15 4,432,680 10,000 San Joaquin Hills Transportation Corridor Agency, Toll Road Senior Lien Ser 1993... 5.00 01/01/33 8,537,100 10,000 San Jose Airport, Ser 2001 A (FGIC Insd)... 5.00 03/01/25 10,068,800 1,385 Santa Monica Community College District, 2002 Election 2007 Ser A (FGIC Insd)..... 0.00 08/01/22 668,276 1,385 Santa Monica Community College District, 2002 Election 2007 Ser A (FGIC Insd)..... 0.00 08/01/23 629,482 1,385 Santa Monica Community College District, 2002 Election 2007 Ser A (FGIC Insd)..... 0.00 08/01/24 593,403 1,380 Santa Monica Community College District, 2002 Election 2007 Ser A (FGIC Insd)..... 0.00 08/01/25 556,361 1,745 School Facilities Financing Authority, Grant Joint Union High School District Ser 2008 A (FSA Insd).................... 0.00 08/01/30 548,419 2,040 School Facilities Financing Authority, Grant Joint Union High School District Ser 2008 A (FSA Insd).................... 0.00 08/01/31 607,022 6,395 School Facilities Financing Authority, Grant Joint Union High School District Ser 2008 A (FSA Insd).................... 0.00 08/01/32 1,801,344 4,770 School Facilities Financing Authority, Grant Joint Union High School District Ser 2008 A (FSA Insd).................... 0.00 08/01/33 1,268,534
See Notes to Financial Statements 13 Morgan Stanley California Tax-Free Income Fund PORTFOLIO OF INVESTMENTS - JUNE 30, 2008 (UNAUDITED) continued
PRINCIPAL AMOUNT IN COUPON MATURITY THOUSANDS RATE DATE VALUE - ------------------------------------------------------------------------------------------ $ 3,500 Southern California Public Power Authority, Mead-Adelanto 1994 Ser A (AMBAC Insd).... 6.42(e)% 07/01/15 $ 4,098,675 2,500 Southern California Public Power Authority, Mead-Phoenix 1994 Ser A (AMBAC Insd)..... 6.27(e) 07/01/15 2,927,625 2,750 Southern California Public Power Authority, Transmission Refg Ser 2002 A (FSA Insd).. 5.25 07/01/18 2,884,805 5,000 Tobacco Securitization Authority of Northern California, Sacramento County Tobacco Securitization Corporation Ser 2005 A-1................................. 5.50 06/01/45 4,084,950 4,000 Tobacco Securitization Authority of Northern California, Sacramento County Tobacco Securitization Corporation Ser 2006 A-1................................. 5.00 06/01/37 3,148,440 2,050 Tustin Unified School District, School Facilities Improvement District No 2002- 1, 2002 Election Ser 2008 C (FSA Insd)... 5.00 06/01/28 2,112,997 10,000 University of California, Ser 2007 J (FSA Insd).................................... 4.50 05/15/31 9,479,300 10,000 University of California, Ser 2007 J (FSA Insd).................................... 4.50 05/15/35 9,334,700 5,000 West Basin Municipal Water District, Refg Ser 2003 A (COPs) (MBIA Insd)............ 5.00 08/01/30 4,993,150 4,685 Yosemite Community College District, Election of 2004 Ser 2008 C (FSA Insd)... 0.00 08/01/24 2,083,935 ------------ 387,752,367 ------------ Puerto Rico (3.6%) 1,635 Puerto Rico Commonwealth, Ser 1998......... 4.75 07/01/08(b) 1,651,481 6,365 Puerto Rico Commonwealth, Ser 1998......... 4.75 07/01/23 5,986,983 3,680 Puerto Rico Public Buildings Authority, 2002 Ser D (AMBAC Insd).................. 0.00(a) 07/01/17(b) 3,289,662 1,320 Puerto Rico Public Buildings Authority, 2002 Ser D (AMBAC Insd).................. 0.00(a) 07/01/31 1,105,883 3,000 Puerto Rico, Public Improvement Ser 1999 (Secondary MBIA Insd).................... 4.875 07/01/08(b) 3,030,270 ------------ 15,064,279 ------------ Total Tax-Exempt Municipal Bonds (Cost $400,415,491)............ 402,816,646 ------------ Short-Term California Tax-Exempt Municipal Obligations (1.8%) 780 California Housing Finance Agency Multifamily Housing, Ser 2000 D (Demand 07/01/08)................................ 2.85(f) 02/01/31 780,000 1,700 California Infrastructure & Economic Development Bank, The J. Paul Getty Trust Ser 2004 B (Demand 07/01/08)............. 1.45(f) 10/01/23 1,700,000 4,000 Metropolitan Water District of Southern California, Ser 2000 B-3 (Demand 07/01/08)................................ 2.16(f) 07/01/35 4,000,000 1,000 Tustin Improvement Bond Act of 1915, Reassessment District No. 95-2 Ser 1996 A (Demand 07/01/08)........................ 1.60(f) 09/02/13 1,000,000 ------------ Total Short-Term California Tax-Exempt Municipal Obligations (Cost $7,480,000)............................................... 7,480,000 ------------ Total Investments (Cost $407,895,491)........................... 410,296,646 ------------
See Notes to Financial Statements 14 Morgan Stanley California Tax-Free Income Fund PORTFOLIO OF INVESTMENTS - JUNE 30, 2008 (UNAUDITED) continued
PRINCIPAL AMOUNT IN THOUSANDS VALUE - ------------------------------------------------------------------------------------------ Floating Rate Note and Dealer Trust Obligation Related to Security Held (-0.7%) $(3,000) Note with interest rate of 1.53% at June 30, 2008 and contractual maturity of collateral at 06/15/30 (See Note 1D) (g) (Cost $(3,000,000))...................... $ (3,000,000) ------------ Total Net Investments (Cost $404,895,491) (h) (i).... 99.1% 407,296,646 Other Assets In Excess of Liabilities................ 0.9 3,571,983 -------- ------------ Net Assets........................................... 100.0% $410,868,629 ======== ============
- ----------
COPs Certificates of Participation. (a) Security is a "step-up" bond where the coupon increases on a predetermined future date. (b) Prerefunded to call date shown. (c) A portion of this security has been physically segregated in connection with open futures and swap contracts in the amount of $382,786. (d) Underlying security related to inverse floaters entered into by the Fund (See Note 1D). (e) Current coupon rate for an inverse floating rate municipal obligation (See Note 6). This rate resets periodically as the auction rate on the related security changes. Position in an inverse floating rate municipal obligation has a total value of $7,026,300 which represents 1.7% of net assets. (f) Current coupon of variable rate demand obligation. (g) Floating rate note and dealer trust obligation related to security held. The interest shown reflects the rate in effect at June 30, 2008. (h) Securities have been designated as collateral in the amount equal to $81,059,158 in connection with open futures and swap contracts. (i) The aggregate cost for federal income tax purposes approximates the aggregate cost for book purposes. The aggregate gross unrealized appreciation is $11,588,409 and the aggregate gross unrealized depreciation is $8,943,010 resulting in net unrealized appreciation of $2,645,399. Bond Insurance: - --------------- AGC Assured Guaranty Corporation. AMBAC AMBAC Assurance Corporation. FGIC Financial Guaranty Insurance Company. FSA Financial Security Assurance Inc. MBIA Municipal Bond Investors Assurance Corporation.
See Notes to Financial Statements 15 Morgan Stanley California Tax-Free Income Fund PORTFOLIO OF INVESTMENTS - JUNE 30, 2008 (UNAUDITED) continued FUTURES CONTRACTS OPEN AT JUNE 30, 2008:
UNREALIZED NUMBER OF DESCRIPTION, DELIVERY UNDERLYING FACE APPRECIATION CONTRACTS LONG/SHORT MONTH AND YEAR AMOUNT AT VALUE (DEPRECIATION) - ------------------------------------------------------------------------------------------------- 416 Long Swap Future 5 Year September 2008 $ 44,642,000 $ (72,669) 213 Long Swap Future 10 Year September 2008 23,420,017 124,984 1 Long U.S. Treasury Note Future 2 Year September 2008 211,203 1,279 149 Short U.S. Treasury Note Future 10 Year September 2008 (16,974,360) (69,336) 204 Short U.S. Treasury Bond Future 20 Year September 2008 (23,581,125) (355,957) 280 Short U.S. Treasury Note Future 5 Year September 2008 (30,955,313) (10,823) --------- Net Unrealized Depreciation......................... $(382,522) =========
INTEREST RATE SWAP CONTRACTS OPEN AT JUNE 30, 2008:
NOTIONAL UNREALIZED AMOUNT PAYMENTS RECEIVED TERMINATION APPRECIATION COUNTERPARTY (000'S) MADE BY FUND BY FUND DATE (DEPRECIATION) - ------------------------------------------------------------------------------------------------------------------------ JPMorgan Chase Bank $28,810 Floating Rate 0.00% # Fixed Rate 5.385% February 14, 2018 $ 215,787 Bank of America N.A. 7,198 Floating Rate 0.00 # Fixed Rate 5.580 February 28, 2018 103,291 Bank of America N.A. 8,240 Floating Rate 0.00 # Fixed Rate 5.070 April 14, 2018 (35,597) Bank of America N.A. 7,540 Floating Rate 0.00 # Fixed Rate 4.982 April 15, 2018 (56,022) Merrill Lynch & Co. 10,060 Floating Rate 0.00 # Fixed Rate 5.000 April 15, 2018 (68,509) JPMorgan Chase Bank 36,680 Fixed Rate 5.831 Floating Rate 0.00 # February 14, 2023 (473,906) Bank of America N.A. 9,073 Fixed Rate 5.990 Floating Rate 0.00 # February 28, 2023 (156,509) Bank of America N.A. 10,550 Fixed Rate 5.470 Floating Rate 0.00 # April 14, 2023 (29,645) Bank of America N.A. 9,170 Fixed Rate 5.380 Floating Rate 0.00 # April 15, 2023 (3,118) Merrill Lynch & Co. 12,880 Fixed Rate 5.395 Floating Rate 0.00 # April 15, 2023 (9,660) --------- Net Unrealized Depreciation................................................... $(513,888) =========
- ----------
# Floating rate represents USD-3 months LIBOR.
See Notes to Financial Statements 16 Morgan Stanley California Tax-Free Income Fund FINANCIAL STATEMENTS Statement of Assets and Liabilities June 30, 2008 (unaudited) Assets: Investments in securities, at value (cost $407,895,491)......... $410,296,646 Cash............................................................ 76,070 Unrealized appreciation on open swap contracts.................. 319,078 Receivable for: Interest..................................................... 4,911,988 Shares of beneficial interest sold........................... 440,122 Variation margin............................................. 103,671 Receivable from Distributor..................................... 315,979 Prepaid expenses and other assets............................... 32,720 ------------ Total Assets................................................. 416,496,274 ------------ Liabilities: Floating rate note and dealer trust obligation.................. 3,000,000 Unrealized depreciation on open swap contracts.................. 832,966 Payable for: Shares of beneficial interest redeemed....................... 1,054,150 Distribution fee............................................. 224,330 Dividends to shareholders.................................... 195,222 Investment advisory fee...................................... 155,090 Administration fee........................................... 28,211 Transfer agent fee........................................... 7,891 Accrued expenses and other payables............................. 129,785 ------------ Total Liabilities............................................ 5,627,645 ------------ Net Assets................................................... $410,868,629 ============ Composition of Net Assets: Paid-in-capital................................................. $405,615,640 Net unrealized appreciation..................................... 1,504,745 Accumulated undistributed net investment income................. 384,849 Accumulated undistributed net realized gain..................... 3,363,395 ------------ Net Assets................................................... $410,868,629 ============ Class A Shares: Net Assets...................................................... $ 25,639,018 Shares Outstanding (unlimited authorized, $.01 par value)....... 2,234,096 Net Asset Value Per Share.................................... $11.48 ====== Maximum Offering Price Per Share, (net asset value plus 4.44% of net asset value).............. $11.99 ====== Class B Shares: Net Assets...................................................... $318,709,111 Shares Outstanding (unlimited authorized, $.01 par value)....... 27,589,518 Net Asset Value Per Share.................................... $11.55 ====== Class C Shares: Net Assets...................................................... $ 20,726,862 Shares Outstanding (unlimited authorized, $.01 par value)....... 1,795,087 Net Asset Value Per Share.................................... $11.55 ====== Class I Shares: @@ Net Assets...................................................... $ 45,793,638 Shares Outstanding (unlimited authorized, $.01 par value)....... 3,978,052 Net Asset Value Per Share.................................... $11.51 ======
- --------- @@ Formerly Class D shares. Renamed Class I shares effective March 31, 2008. See Notes to Financial Statements 17 Morgan Stanley California Tax-Free Income Fund FINANCIAL STATEMENTS continued Statement of Operations For the six months ended June 30, 2008 (unaudited) Net Investment Income: Interest Income................................................. $ 10,727,562 ------------ Expenses Investment advisory fee......................................... 1,002,786 Distribution fee (Class A shares)............................... 31,262 Distribution fee (Class B shares)............................... 363,936 Distribution fee (Class C shares)............................... 84,195 Administration fee.............................................. 170,687 Transfer agent fees and expenses................................ 71,977 Shareholder reports and notices................................. 38,199 Professional fees............................................... 34,804 Custodian fees.................................................. 21,123 Registration fees............................................... 6,598 Trustees' fees and expenses..................................... 6,586 Interest and residual trust expenses............................ 98 Other........................................................... 26,134 ------------ Total Expenses............................................... 1,858,385 Less: amounts waived/reimbursed................................. (78,131) Less: expense offset............................................ (20,611) ------------ Net Expenses................................................. 1,759,643 ------------ Net Investment Income........................................ 8,967,919 ------------ Realized and Unrealized Gain (Loss): Realized Gain (Loss) on: Investments..................................................... 4,103,265 Futures contracts............................................... (858,470) Swap contracts.................................................. (142,589) ------------ Net Realized Gain............................................ 3,102,206 ------------ Change in Unrealized Appreciation/Depreciation on: Investments..................................................... (14,963,652) Futures contracts............................................... (117,614) Swap contracts.................................................. (513,888) ------------ Net Change in Unrealized Appreciation/Depreciation........... (15,595,154) ------------ Net Loss..................................................... (12,492,948) ------------ Net Decrease.................................................... $ (3,525,029) ============
See Notes to Financial Statements 18 Morgan Stanley California Tax-Free Income Fund FINANCIAL STATEMENTS continued Statements of Changes in Net Assets
FOR THE SIX FOR THE YEAR MONTHS ENDED ENDED JUNE 30, 2008 DECEMBER 31, 2007 ------------- ----------------- (unaudited) Increase (Decrease) in Net Assets: Operations: Net investment income.............................. $ 8,967,919 $ 19,586,718 Net realized gain.................................. 3,102,206 959,407 Net change in unrealized appreciation/depreciation........................ (15,595,154) (13,209,931) ------------ ------------ Net Increase (Decrease)......................... (3,525,029) 7,336,194 ------------ ------------ Dividends and Distributions to Shareholders from: Net investment income Class A shares.................................. (520,197) (4,607,758) Class B shares.................................. (7,100,050) (11,856,006) Class C shares.................................. (411,368) (834,721) Class I shares@@................................ (1,043,325) (2,230,782) Net realized gain Class A shares.................................. (20,879) (62,447) Class B shares.................................. (263,071) (847,603) Class C shares.................................. (17,155) (53,295) Class I shares@@................................ (37,773) (118,103) ------------ ------------ Total Dividends and Distributions............... (9,413,818) (20,610,715) ------------ ------------ Net decrease from transactions in shares of beneficial interest.............................. (17,267,398) (54,500,585) ------------ ------------ Net Decrease.................................... (30,206,245) (67,775,106) Net Assets: Beginning of period................................ 441,074,874 508,849,980 ------------ ------------ End of Period (Including accumulated undistributed net investment income of $384,849 and $491,870, respectively)... $410,868,629 $441,074,874 ============ ============
- ---------- @@ Formerly Class D shares. Renamed Class I shares effective March 31, 2008. See Notes to Financial Statements 19 Morgan Stanley California Tax-Free Income Fund NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2008 (UNAUDITED) 1. Organization and Accounting Policies Morgan Stanley California Tax-Free Income Fund (the "Fund") is registered under the Investment Company Act of 1940, as amended (the "Act"), as a diversified, open-end management investment company. The Fund's investment objective is to provide a high level of current income which is exempt from federal and California income tax, consistent with the preservation of capital. The Fund was organized as a Massachusetts business trust on April 9, 1984 and commenced operations on July 11, 1984. On July 28, 1997, the Fund converted to a multiple class share structure. The Fund offers Class A shares, Class B shares, Class C shares and Class I shares. The four classes are substantially the same except that most Class A shares are subject to a sales charge imposed at the time of purchase and some Class A shares, and most Class B shares and Class C shares are subject to a contingent deferred sales charge imposed on shares redeemed within eighteen months, six years and one year, respectively. Class I shares are not subject to a sales charge. Additionally, Class A shares, Class B shares and Class C shares incur distribution expenses. Effective March 31, 2008, Class D shares were renamed Class I shares. The Fund will assess a 2% redemption fee on Class A shares, Class B shares, Class C shares, and Class I shares, which is paid directly to the Fund, for shares redeemed or exchanged within seven days of purchase, subject to certain exceptions. The redemption fee is designed to protect the Fund and its remaining shareholders from the effects of short-term trading. The following is a summary of significant accounting policies: A. Valuation of Investments -- (1) portfolio securities are valued by an outside independent pricing service approved by the Trustees. The pricing service uses both a computerized grid matrix of tax-exempt securities and evaluations by its staff, in each case based on information concerning market transactions and quotations from dealers which reflect the mean between the last reported bid and asked price. The portfolio securities are thus valued by reference to a combination of transactions and quotations for the same or other securities believed to be comparable in quality, coupon, maturity, type of issue, call provisions, trading characteristics and other features deemed to be relevant. The Trustees believe that timely and reliable market quotations are generally not readily available for purposes of valuing tax-exempt securities and that the valuations supplied by the pricing service are more likely to approximate the fair value of such securities; (2) futures are valued at the latest sale price on the commodities exchange on which they trade unless it is determined that such price does not reflect their market value, in which case they will be valued at their fair value as determined in good faith under procedures established by and under the supervision of the Trustees; (3) interest rate swaps are mark-to-market daily based upon quotations from market makers; and 20 Morgan Stanley California Tax-Free Income Fund NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2008 (UNAUDITED) continued (4) short-term debt securities having a maturity date of more than sixty days at time of purchase are valued on a mark-to-market basis until sixty days prior to maturity and thereafter at amortized cost based on their value on the 61st day. Short-term debt securities having a maturity date of sixty days or less at the time of purchase are valued at amortized cost. B. Accounting for Investments -- Security transactions are accounted for on the trade date (date the order to buy or sell is executed). Realized gains and losses on security transactions are determined by the identified cost method. Discounts are accreted and premiums are amortized over the life of the respective securities and are included in interest income. Interest income is accrued daily. C. Multiple Class Allocations -- Investment income, expenses (other than distribution fees), and realized and unrealized gains and losses are allocated to each class of shares based upon the relative net asset value on the date such items are recognized. Distribution fees are charged directly to the respective class. D. Floating Rate Note and Dealer Trust Obligation Related to Security Held -- The Fund enters into transactions in which it transfers to a Dealer Trust ("Dealer Trust"), fixed rate bonds in exchange for cash and residual interests in the Dealer Trust's assets and cash flows, which are in the form of inverse floating rate investments. The Dealer Trust funds the purchases of the fixed rate bonds by issuing floating rate notes to third parties and allowing the Fund to retain residual interest in the bonds. The Fund enters into shortfall agreements with the Dealer Trust which commit the Fund to pay the Dealer Trust, in certain circumstances, the difference between the liquidation value of the fixed rate bonds held by the Dealer Trust and the liquidation value of the floating rate notes held by third parties, as well as any shortfalls in interest cash flows. The residual interests held by the Fund (inverse floating rate investments) include the right of the Fund (1) to cause the holders of the floating rate notes to tender their notes at par at the next interest rate reset date, and (2) to transfer the municipal bond from the Dealer Trust to the Fund, thereby collapsing the Dealer Trust. The Fund accounts for the transfer of bonds to the Dealer Trust as secured borrowings, with the securities transferred remaining in the Fund's investment assets, and the related floating rate notes reflected as Fund liabilities under the caption "Floating rate note and dealer trust obligation" on the Statement of Assets and Liabilities. The Fund records the interest income from the fixed rate bonds under the caption "Interest Income" and records the expenses related to floating rate note obligations and any administrative expenses of the Dealer Trust under the caption "Interest and residual trust expenses" on the Statement of Operations. The note issued by the Dealer Trust has an interest rate that resets weekly and the floating rate note holders have the option to tender their notes to the Dealer Trust for redemption at par at each reset date. At June 30, 2008, Fund investments with a value of $5,127,440 are held by the Dealer Trust and serve as collateral for the $3,000,000 in floating rate 21 Morgan Stanley California Tax-Free Income Fund NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2008 (UNAUDITED) continued note obligations outstanding at that date. Contractual maturity of the floating rate note obligation and interest rate in effect at June 30, 2008 are presented in the Portfolio of Investments. E. Futures Contracts -- A futures contract is an agreement between two parties to buy and sell financial instruments or contracts based on financial indices at a set price on a future date. Upon entering into such a contract, the Fund is required to pledge to the broker cash, U.S. Government securities or other liquid portfolio securities equal to the minimum initial margin requirements of the applicable futures exchange. Pursuant to the contract, the Fund agrees to receive from or pay to the broker an amount of cash equal to the daily fluctuation in the value of the contract. Such receipts or payments known as variation margin are recorded by the Fund as unrealized gains and losses. Upon closing of the contract, the Fund realizes a gain or loss equal to the difference between the value of the contract at the time it was opened and the value at the time it was closed. F. Interest Rate Swaps -- Interest rate swaps involve the exchange of commitments to pay and receive interest based on a notional principal amount. Net periodic interest payments to be received or paid are accrued daily and are recorded as realized gains or losses in the Statement of Operations. The Fund may pay or receive cash to collateralize interest rate swap contracts. This cash collateral is recorded as assets/liabilities on the Fund's books. G. Federal Income Tax Policy -- It is the Fund's policy to comply with the requirements of Subchapter M of the Internal Revenue Code applicable to regulated investment companies and to distribute substantially all of its taxable and nontaxable income to its shareholders. Therefore, no provision for federal income taxes is required. The Fund files tax returns with the U.S. Internal Revenue Service, New York State and New York City. The Fund adopted the provisions of the Financial Accounting Standards Board ("FASB") Interpretation No. 48 ("FIN 48") Accounting for Uncertainty in Income Taxes on June 27, 2008. FIN 48 sets forth a minimum threshold for financial statement recognition of the benefit of a tax position taken or expected to be taken in a tax return. The implementation of FIN 48 did not result in any unrecognized tax benefits in the accompanying financial statements. If applicable, the Fund recognizes interest accrued related to unrecognized tax benefits in interest expense and penalties in other expenses in the Statement of Operations. Each of the tax years in the four year period ended June 30, 2008, remains subject to examination by taxing authorities. H. Dividends and Distributions to Shareholders -- Dividends and distributions to shareholders are recorded on the ex-dividend date. I. Use of Estimates -- The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts and disclosures. Actual results could differ from those estimates. 22 Morgan Stanley California Tax-Free Income Fund NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2008 (UNAUDITED) continued 2. Investment Advisory/Administration Agreements Pursuant to an Investment Advisory Agreement with Morgan Stanley Investment Advisors Inc. (the "Investment Adviser") the Fund pays the Investment Adviser an advisory fee, accrued daily and payable monthly, by applying the following annual rates to the Fund's net assets determined as of the close of each business day: 0.47% to the portion of the daily net assets not exceeding $500 million; 0.445% to the portion of the daily net assets exceeding $500 million but not exceeding $750 million; 0.42% to the portion of the daily net assets exceeding $750 million but not exceeding $1 billion; 0.395% to the portion of the daily net assets exceeding $1 billion but not exceeding $1.25 billion; and 0.37% to the portion of the daily net assets in excess of $1.25 billion. Pursuant to an Administration Agreement with Morgan Stanley Services Company Inc. (the "Administrator"), an affiliate of the Investment Adviser, the Fund pays an administration fee, accrued daily and payable monthly, by applying the annual rate of 0.08% to the Fund's daily net assets. Under an agreement between the Administrator and State Street Bank and Trust Company ("State Street"), State Street provides certain administrative services to the Fund. For such services, the Administrator pays State Street a portion of the fee the Administrator receives from the Fund. The Investment Adviser has agreed to cap the Fund's operating expenses (except for brokerage and 12b-1 fees) by assuming the Fund's "other expenses" and/or waiving the Fund's advisory fees, and the Administrator has agreed to waive the Fund's administrative fees, to the extent such operating expenses exceed 0.60% of the average daily net assets of the Fund on an annualized basis. Such voluntary waivers may be terminated at any time without notice. 3. Plan of Distribution Shares of the Fund are distributed by Morgan Stanley Distributors Inc. (the "Distributor"), an affiliate of the Investment Adviser and Administrator. The Fund has adopted a Plan of Distribution (the "Plan") pursuant to Rule 12b-1 under the Act. The Plan provides that the Fund will pay the Distributor a fee which is accrued daily and paid monthly at the following annual rates: (i) Class A -- up to 0.25% of the average daily net assets of Class A shares; (ii) Class B -- up to 0.75 of the lesser of: (a) the average daily aggregate gross sales of the Class B shares since the inception of the Fund (not including reinvestment of dividend or capital gain distributions) less the average daily aggregate net asset value of the Class B shares redeemed since the Fund's inception upon which a contingent deferred sales charge has been imposed or waived; or (b) the average daily net assets of Class B shares; and (iii) Class C -- up to 0.75% of the average daily net assets of Class C shares. 23 Morgan Stanley California Tax-Free Income Fund NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2008 (UNAUDITED) continued In the case of Class B shares, provided that the Plan continues in effect, any cumulative expenses incurred by the Distributor but not yet recovered may be recovered through the payment of future distribution fees from the Fund pursuant to the Plan and contingent deferred sales charges paid by investors upon redemption of Class B shares. Although there is no legal obligation for the Fund to pay expenses incurred in excess of payments made to the Distributor under the Plan and the proceeds of contingent deferred sales charges paid by investors upon redemption of shares, if for any reason the Plan is terminated, the Trustees will consider at that time the manner in which to treat such expenses. The Distributor has advised the Fund that there were no excess expenses as of June 30, 2008. At June 30, 2008, included in the Statement of Assets and Liabilities, is a receivable from the Fund's Distributor which represents payments due to be reimbursed to the Fund under the Plan. Because the Plan is what is referred to as a "reimbursement plan", the Distributor reimburses to the Fund any 12b-1 fees collected in excess of the actual distribution expenses incurred. This receivable represents this excess amount as of June 30, 2008. The Distributor has agreed to waive the 12b-1 fee on Class B shares to the extent it exceeds 0.24% of the average daily net assets of such shares on an annualized basis. The Distributor may discontinue this waiver in the future. For the six months ended June 30, 2008, the Distribution fee was accrued for Class B shares at the annual rate of 0.22%. In the case of Class A shares and Class C shares, expenses incurred pursuant to the Plan in any calendar year in excess of 0.25% or 0.75% of the average daily net assets of Class A or Class C, respectively, will not be reimbursed by the Fund through payments in any subsequent year, except that expenses representing a gross sales credit to Morgan Stanley Financial Advisors and other authorized financial representatives at the time of sale may be reimbursed in the subsequent calendar year. For the six months ended June 30, 2008, the distribution fee was accrued for Class A shares and Class C shares at the annual rate of 0.25% and 0.75%, respectively. The Distributor has informed the Fund that for the six months ended June 30, 2008, it received contingent deferred sales charges from certain redemptions of the Fund's Class A shares, Class B shares and Class C shares of $4, $50,077 and $1,130, respectively and received $37,074 in front- end sales charges from sales of the Fund's Class A shares. The respective shareholders pay such charges which are not an expense of the Fund. 24 Morgan Stanley California Tax-Free Income Fund NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2008 (UNAUDITED) continued 4. Security Transactions and Transactions with Affiliates The cost of purchases and proceeds from sales of portfolio securities, excluding short-term investments, for the six months ended June 30, 2008 aggregated $35,233,534 and $55,662,453, respectively. Morgan Stanley Trust, an affiliate of the Investment Adviser, Administrator and Distributor, is the Fund's transfer agent. The Fund has an unfunded noncontributory defined benefit pension plan covering certain independent Trustees of the Fund who will have served as independent Trustees for at least five years at the time of retirement. Benefits under this plan are based on factors which include years of service and compensation. The Trustees voted to close the plan to new participants and eliminate the future benefits growth due to increases to compensation after July 31, 2003. Aggregate pension costs for the six months ended June 30, 2008, included in Trustees' fees and expenses in the Statement of Operations amounted to $2,961. At June 30, 2008, the Fund had an accrued pension liability of $59,212 which is included in accrued expenses in the Statement of Assets and Liabilities. The Fund has an unfunded Deferred Compensation Plan (the "Compensation Plan") which allows each independent Trustee to defer payment of all, or a portion, of the fees he or she receives for serving on the Board of Trustees. Each eligible Trustee generally may elect to have the deferred amounts credited with a return equal to the total return on one or more of the Morgan Stanley funds that are offered as investment options under the Compensation Plan. Appreciation/depreciation and distributions received from these investments are recorded with an offsetting increase/decrease in the deferred compensation obligation and do not affect the net asset value of the Fund. 5. Expense Offset The expense offset represents a reduction of the fees and expenses for interest earned on cash balances maintained by the Fund with the transfer agent and custodian. 6. Purposes of and Risks Relating to Certain Financial Instruments The Fund may invest a portion of its assets in inverse floating rate instruments, either through outright purchases of inverse floating rate securities or through the transfer of bonds to a Dealer Trust in exchange for cash and residual interests in the Dealer Trust. These investments are typically used by the Fund in seeking to enhance the yield of the portfolio. These instruments typically involve greater risks than a fixed rate municipal bond. In particular, these instruments are acquired through leverage or may have leverage embedded in them and therefore involve many of the risks associated with 25 Morgan Stanley California Tax-Free Income Fund NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2008 (UNAUDITED) continued leverage. Leverage is a speculative technique that may expose the Fund to greater risk and increased costs. Leverage may cause the Fund's net asset value to be more volatile than if it had not been leveraged because leverage tends to magnify the effect of any increases or decreases in the value of the Fund's portfolio securities. The use of leverage may also cause the Fund to liquidate portfolio positions when it may not be advantageous to do so in order to satisfy its obligations with respect to inverse floating rate instruments. To hedge against adverse interest rate changes, the Fund may invest in financial futures, municipal bond index futures and interest rate swap futures contracts ("futures contracts"). These futures contracts involve elements of market risk in excess of the amount reflected in the Statement of Assets and Liabilities. The Fund bears the risk of an unfavorable change in the value of the underlying securities. Risks may also arise upon entering into these contracts from the potential inability of the counterparties to meet the terms of their contracts. The Fund may enter into interest rate swaps and may purchase or sell interest rate caps, floors and collars. The Fund expects to enter into these transactions primarily to manage interest rate risk, hedge portfolio positions and preserve a return or spread on a particular investment or portion of its portfolio. The Fund may also enter into these transactions to protect against any increase in the price of securities the Fund anticipates purchasing at a later date. Interest rate swap transactions are subject to market risk, risk of default by the other party to the transaction, risk of imperfect correlation and manager risk. Such risks may exceed the related amounts shown in the Statement of Assets and Liabilities. 7. Federal Income Tax Status The amount of dividends and distributions from net investment income and net realized capital gains are determined in accordance with federal income tax regulations which may differ from generally accepted accounting principles. These "book/tax" differences are either considered temporary or permanent in nature. To the extent these differences are permanent in nature, such amounts are reclassified within the capital accounts based on their federal tax-basis treatment; temporary differences do not require reclassification. Dividends and distributions which exceed net investment income and net realized capital gains for tax purposes are reported as distributions of paid-in-capital. As of December 31, 2007, the Fund had temporary book/tax differences primarily attributable to book amortization of discounts on debt securities and mark-to- market of open futures contracts. 26 Morgan Stanley California Tax-Free Income Fund NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2008 (UNAUDITED) continued 8. Shares of Beneficial Interest Transactions in shares of beneficial interest were as follows:
FOR THE SIX FOR THE YEAR MONTHS ENDED ENDED JUNE 30, 2008 DECEMBER 31, 2007 ------------------------- --------------------------- SHARES AMOUNT SHARES AMOUNT ---------- ------------ ----------- ------------- (unaudited) Class A Shares Sold................................... 261,543 $ 3,058,383 361,602 $ 4,341,159 Conversion to Class B.................. -- -- (21,312,264) (257,677,039) Reinvestment of dividends and distributions ....................... 41,878 484,942 212,821 2,567,682 Redeemed............................... (152,961) (1,784,074) (1,796,927) (21,656,577) ---------- ------------ ----------- ------------- Net increase (decrease) -- Class A..... 150,460 1,759,251 (22,534,768) (272,424,775) ---------- ------------ ----------- ------------- Class B Shares Sold................................... 202,974 2,401,534 334,223 4,022,842 Conversion from Class A................ -- -- 21,172,173 257,677,039 Reinvestment of dividends and distributions ....................... 548,974 6,401,004 538,675 6,447,234 Redeemed............................... (2,097,366) (24,608,640) (3,907,522) (46,833,087) ---------- ------------ ----------- ------------- Net increase (decrease) -- Class B..... (1,345,418) (15,806,102) 18,137,549 221,314,028 ---------- ------------ ----------- ------------- Class C Shares Sold................................... 92,645 1,100,532 193,583 2,326,500 Reinvestment of dividends and distributions ....................... 32,785 381,944 41,889 502,976 Redeemed............................... (246,621) (2,890,340) (225,524) (2,712,498) ---------- ------------ ----------- ------------- Net increase (decrease) -- Class C..... (121,191) (1,407,864) 9,948 116,978 ---------- ------------ ----------- ------------- Class I Shares@ Sold................................... 109,343 1,298,717 278,435 3,333,721 Reinvestment of dividends and distributions ....................... 82,742 961,390 115,275 1,380,112 Redeemed............................... (346,125) (4,072,790) (684,615) (8,220,649) ---------- ------------ ----------- ------------- Net decrease -- Class I................ (154,040) (1,812,683) (290,905) (3,506,816) ---------- ------------ ----------- ------------- Net decrease in Fund................... (1,470,189) $(17,267,398) (4,678,176) $ (54,500,585) ========== ============ =========== =============
- ---------- @ Formerly Class D shares. Renamed Class I shares effective March 31, 2008. 9. Fair Valuation Measurements The Fund adopted Financial Accounting Standards Board Statement of Financial Accounting Standards No. 157, "Fair Value Measurements" ("FAS 157"), effective December 1, 2007. In accordance with FAS 157, fair value is defined as the price that the Fund would receive to sell an investment or pay to 27 Morgan Stanley California Tax-Free Income Fund NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2008 (UNAUDITED) continued transfer a liability in a timely transaction with an independent buyer in the principal market, or in the absence of a principal market the most advantageous market for the investment or liability. FAS 157 establishes a three-tier hierarchy to distinguish between (1) inputs that reflect the assumptions market participants would use in pricing an asset or liability developed based on market data obtained from sources independent of the reporting entity (observable inputs) and (2) inputs that reflect the reporting entity's own assumptions about the assumptions market participants would use in pricing an asset or liability developed based on the best information available in the circumstances (unobservable inputs) and to establish classification of fair value measurements for disclosure purposes. Various inputs are used in determining the value of the Fund's investments. The inputs are summarized in the three broad levels listed below. - Level 1 -- quoted prices in active markets for identical investments - Level 2 -- other significant observable inputs (including quoted prices for similar investments, interest rates, prepayment speeds, credit risk, etc.) - Level 3 -- significant unobservable inputs (including the Fund's own assumptions in determining the fair value of investments) The inputs or methodology used for valuing securities are not necessarily an indication of the risk associated with investing in those securities. The following is a summary of the inputs used as of June 30, 2008 in valuing the Fund's investments carried at value:
FAIR VALUE MEASUREMENTS AT JUNE 30, 2008 USING ------------------------------------------------------------ SIGNIFICANT SIGNIFICANT QUOTED PRICES IN OTHER OBSERVABLE UNOBSERVABLE ACTIVE MARKET FOR INPUTS INPUTS TOTAL IDENTICAL ASSETS (LEVEL 1) (LEVEL 2) (LEVEL 3) ----- -------------------------- ---------------- ------------ Investments in Securities $407,296,646 -- $407,296,646 -- Other financial instruments* (896,410) $(382,522) (513,888) -- ------------ --------- ------------ Total $406,400,236 $(382,522) $406,782,758 -- ============ ========= ============
- ---------- * Other financial instruments include futures, forwards, and swap contracts.
10. Accounting Pronouncement On March 19, 2008, FASB released Statement of Financial Accounting Standards No. 161, Disclosures about Derivative Instruments and Hedging Activities ("SFAS 161"). SFAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures 28 Morgan Stanley California Tax-Free Income Fund NOTES TO FINANCIAL STATEMENTS - JUNE 30, 2008 (UNAUDITED) continued about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit- risk-related contingent features in derivative agreements. The application of SFAS 161 is required for fiscal years beginning after November 15, 2008 and interim periods within those fiscal years. At this time, management is evaluating the implications of SFAS 161 and its impact on the financial statements has not yet been determined. 29 Morgan Stanley California Tax-Free Income Fund FINANCIAL HIGHLIGHTS Selected ratios and per share data for a share of beneficial interest outstanding throughout each period:
FOR THE SIX FOR THE YEAR ENDED DECEMBER 31, MONTHS ENDED ----------------------------------------------------------------- JUNE 30, 2008 2007 2006 2005 2004 2003 --------------------- ----------- ------------ ------------ ----------- ------- (unaudited) Class A Shares Selected Per Share Data: Net asset value, beginning of period............................ $11.83 $12.16 $12.16 $12.46 $12.58 $12.68 ------- ------- ------- ------- ------- ------- Income (loss) from investment operations: Net investment income........... 0.24 0.50 0.49 0.52 0.54 0.55 Net realized and unrealized gain (loss)........................... (0.34) (0.31) 0.06 (0.10) (0.02) (0.01) ------ ------ ----- ------ ------ ------ Total income (loss) from investment operations........................ (0.10) 0.19 0.55 0.42 0.52 0.54 ------ ----- ----- ----- ----- ----- Less dividends and distributions from: Net investment income........... (0.24) (0.49) (0.49) (0.51) (0.53) (0.55) Net realized gain............... (0.01) (0.03) (0.06) (0.21) (0.11) (0.09) ------ ------ ------ ------ ------ ------ Total dividends and distributions.. (0.25) (0.52) (0.55) (0.72) (0.64) (0.64) ------ ------ ------ ------ ------ ------ Net asset value, end of period..... $11.48 $11.83 $12.16 $12.16 $12.46 $12.58 ====== ====== ====== ====== ====== ====== Total Return(1).................... (0.88)%(5) 1.62% 4.64% 3.44% 4.26% 4.31% Ratios To Average Net Assets(2) : Total expenses (before expense offset)........................... 0.86 %(3)(4)(6) 1.00%(3) 0.86%(3) 0.86%(3) 0.81% 0.78% Total expenses (before expense offset, exclusive of interest and residual trust expenses).......... 0.86 %(4)(6) 0.84% 0.85% 0.86% 0.81% 0.78% Net investment income.............. 4.17 %(3)(4)(6) 4.12%(3) 4.06%(3) 4.11%(3) 4.29% 4.34% Supplemental Data: Net assets, end of period, in thousands......................... $25,639 $24,645 $299,414 $329,938 $19,203 $17,422 Portfolio turnover rate............ 9 %(5) 5% 5% 23% 10% 11%
- ---------- (1) Does not reflect the deduction of sales charge. Calculated based on the net asset value as of the last business day of the period. (2) Reflects overall Fund ratios for investment income and non-class specific expenses. (3) If the Fund had borne all of its expenses that were reimbursed or waived by the Investment Adviser and Administrator, the annualized expense and net investment income ratios, before expense offset, would have been as follows:
EXPENSE NET INVESTMENT PERIOD ENDED: RATIO INCOME RATIO - ------------- ------- -------------- June 30, 2008 0.90% 4.13% December 31, 2007 1.04 4.08 December 31, 2006 0.89 4.02 December 31, 2005 0.87 4.10
(4) Does not reflect the effect of expense offset of $0.01%. (5) Not annualized. (6) Annualized.
See Notes to Financial Statements 30 Morgan Stanley California Tax-Free Income Fund FINANCIAL HIGHLIGHTS continued
FOR THE SIX FOR THE YEAR ENDED DECEMBER 31, MONTHS ENDED ------------------------------------------------------------------- JUNE 30, 2008 2007 2006 2005 2004 2003 ---------------------- ----------- ----------- ----------- ----------- ----------- (unaudited) Class B Shares Selected Per Share Data: Net asset value, beginning of period......................... $11.91 $12.24 $12.24 $12.52 $12.65 $12.75 --------- ------ ------ ------ ------ ------ Income (loss) from investment operations: Net investment income........ 0.25 0.50 0.52 0.54 0.54 0.55 Net realized and unrealized gain (loss)................... (0.35) (0.30) 0.05 (0.08) (0.02) (0.02) ------ ------ ----- ------ ------ ------ Total income (loss) from investment operations.......... (0.10) 0.20 0.57 0.46 0.52 0.53 ------ ----- ----- ----- ----- ------ Less dividends and distributions from: Net investment income........ (0.25) (0.50) (0.51) (0.53) (0.54) (0.54) Net realized gain............ (0.01) (0.03) (0.06) (0.21) (0.11) (0.09) ------ ------ ------ ------ ------ ------ Total dividends and distributions.................. (0.26) (0.53) (0.57) (0.74) (0.65) (0.63) ------ ------ ------ ------ ------ ------ Net asset value, end of period.. $11.55 $11.91 $12.24 $12.24 $12.52 $12.65 ====== ====== ====== ====== ====== ====== Total Return(1)................. (0.89)%(6) 1.65% 4.81% 3.74% 4.22% 4.27% Ratios To Average Net Assets(2): Total expenses (before expense offset)........................ 0.83 %(4)(5)(7) 0.97%(4) 0.69%(4) 0.68%(4) 0.78%(3) 0.83%(3) Total expenses (before expense offset, exclusive of interest and residual trust expenses)... 0.83 %(5)(7) 0.81% 0.68% 0.68% 0.78%(3) 0.83%(3) Net investment income........... 4.20 %(4)(5)(7) 4.15%(4) 4.23%(4) 4.29%(4) 4.32%(3) 4.29%(3) Supplemental Data: Net assets, end of period, in thousands...................... $318,709 $344,606 $132,162 $159,221 $526,026 $599,737 Portfolio turnover rate......... 9 %(6) 5% 5% 23% 10% 11%
- ---------- (1) Does not reflect the deduction of sales charge. Calculated based on the net asset value as of the last business day of the period. (2) Reflects overall Fund ratios for investment income and non-class specific expenses. (3) If the Fund had borne all of its expenses that were reimbursed by the Distributor, the annualized expense and net investment income ratios, before expense offset, would have been as follows:
EXPENSE NET INVESTMENT PERIOD ENDED RATIO INCOME RATIO - ------------ ------- -------------- December 31, 2004 1.03% 4.07% December 31, 2003 1.35 3.77
(4) If the Fund had borne all of its expenses that were reimbursed or waived by the Investment Adviser and Administrator, the annualized expense and net investment income ratios, before expense offset, would have been as follows:
EXPENSE NET INVESTMENT PERIOD ENDED: RATIO INCOME RATIO - ------------- ------- -------------- June 30, 2008 0.87% 4.16% December 31, 2007 1.01 4.11 December 31, 2006 0.72 4.19 December 31, 2005 0.69 4.28
(5) Does not reflect the effect of expense offset of $0.01%. (6) Not annualized. (7) Annualized.
See Notes to Financial Statements 31 Morgan Stanley California Tax-Free Income Fund FINANCIAL HIGHLIGHTS continued
FOR THE SIX FOR THE YEAR ENDED DECEMBER 31, MONTHS ENDED ----------------------------------------------------------- JUNE 30, 2008 2007 2006 2005 2004 2003 ---------------------- ----------- ----------- ----------- ------- ------- (unaudited) Class C Shares Selected Per Share Data: Net asset value, beginning of period.............................. $11.90 $12.23 $12.23 $12.52 $12.65 $12.74 ------ ------ ------ ------ ------ ------ Income (loss) from investment operations: Net investment income............. 0.21 0.44 0.43 0.45 0.47 0.48 Net realized and unrealized gain (loss)............................. (0.34) (0.30) 0.06 (0.08) (0.02) 0.00 ------ ------ ----- ------ ------ ----- Total income (loss) from investment operations.......................... (0.13) 0.14 0.49 0.37 0.45 0.48 ------ ----- ----- ----- ----- ----- Less dividends and distributions from: Net investment income............. (0.21) (0.44) (0.43) (0.45) (0.47) (0.48) Net realized gain................. (0.01) (0.03) (0.06) (0.21) (0.11) (0.09) ------ ------ ------ ------ ------ ------ Total dividends and distributions.... (0.22) (0.47) (0.49) (0.66) (0.58) (0.57) ------ ------ ------ ------ ------ ------ Net asset value, end of period....... $11.55 $11.90 $12.23 $12.23 $12.52 $12.65 ====== ====== ====== ====== ====== ====== Total Return(1)...................... (1.10)%(5) 1.14% 4.12% 2.97% 3.61% 3.80% Ratios To Average Net Assets(2): Total expenses (before expense offset)............................. 1.36 %(3)(4)(6) 1.50%(3) 1.36%(3) 1.36%(3) 1.36% 1.35% Total expenses (before expense offset, exclusive of interest and residual trust expenses)............ 1.36 %(4)(6) 1.34% 1.35% 1.36% 1.36% 1.35% Net investment income................ 3.67 %(3)(4)(6) 3.62%(3) 3.56%(3) 3.61%(3) 3.74% 3.77% Supplemental Data: Net assets, end of period, in thousands........................... $20,727 $22,800 $23,320 $26,385 $27,519 $26,435 Portfolio turnover rate.............. 9 %(5) 5% 5% 23% 10% 11%
- ---------- (1) Does not reflect the deduction of sales charge. Calculated based on the net asset value as of the last business day of the period. (2) Reflects overall Fund ratios for investment income and non-class specific expenses. (3) If the Fund had borne all of its expenses that were reimbursed or waived by the Investment Adviser and Administrator, the annualized expense and net investment income ratios, before expense offset, would have been as follows:
EXPENSE NET INVESTMENT PERIOD ENDED: RATIO INCOME RATIO - ------------- ------- -------------- June 30, 2008 1.40% 3.63% December 31, 2007 1.54 3.58 December 31, 2006 1.39 3.52 December 31, 2005 1.37 3.60
(4) Does not reflect the effect of expense offset of $0.01%. (5) Not annualized. (6) Annualized.
See Notes to Financial Statements 32 Morgan Stanley California Tax-Free Income Fund FINANCIAL HIGHLIGHTS continued
FOR THE SIX FOR THE YEAR ENDED DECEMBER 31, MONTHS ENDED ----------------------------------------------------------- JUNE 30, 2008 2007 2006 2005 2004 2003 --------------------- ----------- ----------- ----------- ------- ------- (unaudited) Class I Shares @@ Selected Per Share Data: Net asset value, beginning of period......... $11.86 $12.20 $12.20 $12.49 $12.61 $12.71 ------ ------ ------ ------ ------ ------ Income (loss) from investment operations: Net investment income..................... 0.26 0.53 0.53 0.54 0.56 0.57 Net realized and unrealized gain (loss)... (0.34) (0.32) 0.05 (0.08) (0.01) (0.01) ------ ------ ----- ------ ------ ------ Total income (loss) from investment operations.................................. (0.08) 0.21 0.58 0.46 0.55 0.56 ------ ----- ----- ----- ----- ----- Less dividends and distributions from: Net investment income..................... (0.26) (0.52) (0.52) (0.54) (0.56) (0.57) Net realized gain......................... (0.01) (0.03) (0.06) (0.21) (0.11) (0.09) ------ ------ ------ ------ ------ ------ Total dividends and distributions............ (0.27) (0.55) (0.58) (0.75) (0.67) (0.66) ------ ------ ------ ------ ------ ------ Net asset value, end of period............... $11.51 $11.86 $12.20 $12.20 $12.49 $12.61 ====== ====== ====== ====== ====== ====== Total Return(1).............................. (0.75)%(5) 1.80% 4.90% 3.74% 4.48% 4.50% Ratios To Average Net Assets(2): Total expenses (before expense offset)....... 0.61 %(3)(4)(6) 0.76%(3) 0.61%(3) 0.61%(3) 0.61% 0.60% Total expenses (before expense offset, exclusive of interest and residual trust expenses)................................... 0.61 %(4)(6) 0.60% 0.60% 0.61% 0.61% 0.60% Net investment income........................ 4.42 %(3)(4)(6) 4.36%(3) 4.31%(3) 4.36%(3) 4.49% 4.52% Supplemental Data: Net assets, end of period, in thousands...... $45,794 $49,024 $53,954 $53,857 $58,399 $66,143 Portfolio turnover rate...................... 9 %(5) 5% 5% 23% 10% 11%
- ---------- @@ Formerly Class D shares. Renamed Class I shares effective March 31, 2008. (1) Calculated based on the net asset value as of the last business day of the period. (2) Reflects overall Fund ratios for investment income and non-class specific expenses. (3) If the Fund had borne all of its expenses that were reimbursed or waived by the Investment Adviser and Administrator, the annualized expense and net investment income ratios, before expense offset, would have been as follows:
EXPENSE NET INVESTMENT PERIOD ENDED: RATIO INCOME RATIO - ------------- ------- -------------- June 30, 2008 0.65% 4.38% December 31, 2007 0.80 4.32 December 31, 2006 0.64 4.27 December 31, 2005 0.62 4.35
(4) Does not reflect the effect of expense offset of $0.01%. (5) Not annualized. (6) Annualized.
See Notes to Financial Statements 33 (This Page Intentionally Left Blank) (This Page Intentionally Left Blank) TRUSTEES Frank L. Bowman Michael Bozic Kathleen A. Dennis James F. Higgins Dr. Manuel H. Johnson Joseph J. Kearns Michael F. Klein Michael E. Nugent W. Allen Reed Fergus Reid OFFICERS Michael E. Nugent Chairperson of the Board Ronald E. Robison President and Principal Executive Officer Kevin Klingert Vice President Dennis F. Shea Vice President Amy R. Doberman Vice President Carsten Otto Chief Compliance Officer Stefanie V. Chang Yu Vice President Francis J. Smith Treasurer and Chief Financial Officer Mary E. Mullin Secretary TRANSFER AGENT Morgan Stanley Trust Harborside Financial Center, Plaza Two Jersey City, New Jersey 07311 INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Deloitte & Touche LLP Two World Financial Center New York, New York 10281 LEGAL COUNSEL Clifford Chance US LLP 31 West 52nd Street New York, NY 10019 COUNSEL TO THE INDEPENDENT TRUSTEES Kramer Levin Naftalis & Frankel LLP 1177 Avenue of the Americas New York, NY 10036 INVESTMENT ADVISER Morgan Stanley Investment Advisors Inc. 522 Fifth Avenue New York, New York 10036 The financial statements included herein have been taken from the records of the Fund without examination by the independent auditors and accordingly they do not express an opinion thereon. This report is submitted for the general information of the shareholders of the Fund. For more detailed information about the Fund, its fees and expenses and other pertinent information, please read its Prospectus. The Fund's Statement of Additional Information contains additional information about the Fund, including its trustees. It is available, without charge, by calling (800) 869-NEWS. This report is not authorized for distribution to prospective investors in the Fund unless preceded or accompanied by an effective Prospectus. Read the Prospectus carefully before investing. Morgan Stanley Distributors Inc., member FINRA. (c) 2008 Morgan Stanley [MORGAN STANLEY LOGO] [MORGAN STANLEY LOGO] INVESTMENT MANAGEMENT Morgan Stanley California Tax-Free Income Fund CLFSAN IU08-04315P-Y06/08 Item 2. Code of Ethics. Not applicable for semiannual reports. Item 3. Audit Committee Financial Expert. Not applicable for semiannual reports. Item 4. Principal Accountant Fees and Services Not applicable for semiannual reports. Item 5. Audit Committee of Listed Registrants. Not applicable for semiannual reports. Item 6. (a) Refer to Item 1. (b) Not applicable. Item 7. Disclosure of Proxy Voting Policies and Procedures for Closed-End Management Investment Companies. Not applicable for semiannual reports. Item 8. Portfolio Managers of Closed-End Management Investment Companies Applicable only to reports filed by closed-end funds. Item 9. Closed-End Fund Repurchases Applicable to reports filed by closed-end funds. Item 10. Submission of Matters to a Vote of Security Holders Not applicable. Item 11. Controls and Procedures (a) The Fund's principal executive officer and principal financial officer have concluded that the Fund's disclosure controls and procedures are sufficient to ensure that information required to be disclosed by the Fund in this Form N-CSR was recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms, based upon such officers' evaluation of these controls and procedures as of a date within 90 days of the filing date of the report. (b) There were no changes in the registrant's internal control over financial reporting that occurred during the second fiscal quarter of the period covered by this report that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting. Item 12. Exhibits (a) Code of Ethics - Not applicable for semiannual reports. (b) A separate certification for each principal executive officer and principal financial officer of the registrant are attached hereto as part of EX-99.CERT. 2 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Morgan Stanley California Tax-Free Income Fund /s/ Ronald E. Robison Ronald E. Robison Principal Executive Officer August 15, 2008 Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment Company Act of 1940, this report has been signed by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /s/ Ronald E. Robison Ronald E. Robison Principal Executive Officer August 15, 2008 /s/ Francis Smith Francis Smith Principal Financial Officer August 15, 2008 3 EX-99.CERT 2 y62927exv99wcert.txt EX-99.CERT: CERTIFICATIONS EXHIBIT 12 B1 CERTIFICATION OF PRINCIPAL EXECUTIVE OFFICER CERTIFICATIONS I, Ronald E. Robison, certify that: 1. I have reviewed this report on Form N-CSR of Morgan Stanley California Tax-Free Income Fund; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements and other financial information included in this report, fairly present in all material respects the financial condition, results of operations, changes in net assets, and cash flows (if the financial statements are required to include a statement of cash flows) of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Rule 30a-3(c) under the Investment Company Act of 1940) and internal control over financial reporting (as defined in Rule 30a-3(d) under the Investment Company Act of 1940) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of a date within 90 days prior to the filing date of this report based on such evaluation; and d) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the second fiscal quarter of the period covered by this report that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): 4 a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize, and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Date: August 15, 2008 /s/ Ronald E. Robison Ronald E. Robison Principal Executive Officer 5 EXHIBIT 12 B2 CERTIFICATION OF PRINCIPAL FINANCIAL OFFICER CERTIFICATIONS I, Francis Smith, certify that: 1. I have reviewed this report on Form N-CSR of Morgan Stanley California Tax-Free Income Fund; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements and other financial information included in this report, fairly present in all material respects the financial condition, results of operations, changes in net assets, and cash flows (if the financial statements are required to include a statement of cash flows) of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Rule 30a-3(c) under the Investment Company Act of 1940) and internal control over financial reporting (as defined in Rule 30a-3(d) under the Investment Company Act of 1940) for the registrant and have: a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of a date within 90 days prior to the filing date of this report based on such evaluation; and d) disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the second fiscal quarter of the period covered by this report that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer(s) and I have disclosed to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): 6 a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize, and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls over financial reporting. Date: August 15, 2008 /s/ Francis Smith Francis Smith Principal Financial Officer 7 EX-99.906CERT 3 y62927exv99w906cert.txt EX-99.906CERT: CERTIFICATIONS SECTION 906 CERTIFICATION Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Morgan Stanley California Tax-Free Income Fund In connection with the Report on Form N-CSR (the "Report") of the above-named issuer for the period ended June 30, 2008 that is accompanied by this certification, the undersigned hereby certifies that: 1. The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Issuer. Date: August 15, 2008 /s/ Ronald E. Robison ---------------------------------------- Ronald E. Robison Principal Executive Officer A signed original of this written statement required by Section 906 has been provided to Morgan Stanley California Tax-Free Income Fund and will be retained by Morgan Stanley California Tax-Free Income Fund and furnished to the Securities and Exchange Commission or its staff upon request. 8 SECTION 906 CERTIFICATION Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 Morgan Stanley California Tax-Free Income Fund In connection with the Report on Form N-CSR (the "Report") of the above-named issuer for the period ended June 30, 2008 that is accompanied by this certification, the undersigned hereby certifies that: 1. The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and 2. The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Issuer. Date: August 15, 2008 /s/ Francis Smith ---------------------------------------- Francis Smith Principal Financial Officer A signed original of this written statement required by Section 906 has been provided to Morgan Stanley California Tax-Free Income Fund and will be retained by Morgan Stanley California Tax-Free Income Fund and furnished to the Securities and Exchange Commission or its staff upon request. 9 -----END PRIVACY-ENHANCED MESSAGE-----