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: 811-07243 Morgan Stanley Balanced Income Fund (Exact name of registrant as specified in charter) 1221 Avenue of the Americas, New York, New York 10020 (Address of principal executive offices) (Zip code) Ronald E. Robison 1221 Avenue of the Americas, New York, New York 10020 (Name and address of agent for service) Registrant's telephone number, including area code: 212-762-4000 Date of fiscal year end: January 31, 2007 Date of reporting period: July 31, 2006 Item 1 - Report to Shareholders Welcome, Shareholder: In this report, you'll learn about how your investment in Morgan Stanley Balanced 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 July 31, 2006 TOTAL RETURN FOR THE 6 MONTHS ENDED JULY 31, 2006 <Table> <Caption> LIPPER MIXED-ASSET LEHMAN TARGET BROTHERS RUSSELL ALLOCATION LIPPER U.S. GOV'T./ 1000(R) CONSERVATIVE INCOME CREDIT VALUE FUNDS FUNDS CLASS A CLASS B CLASS C CLASS D INDEX(1) INDEX(2) INDEX(3) INDEX(4) 0.76% 0.44% 0.46% 0.96% 0.32% 5.07% 0.75% 1.53% </Table> 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 In the bond market, the six-month period provided few surprises. As was widely expected, the Federal Open Market Committee (the "Fed") continued to raise the target federal funds rate by 25 basis points at each of its meetings during the first half of the year, bringing the target rate to 5.25 percent at the end of June. In the Fed's view, the U.S. economy remains on solid footing, and core inflation is still relatively low, though most measures of core inflation are either at or above the high end of the range viewed as acceptable by the Fed. Within the government sector, U.S. Treasuries underperformed over the six-month period because of their high sensitivity to fluctuating interest rates and their relatively low yields. Given ongoing concerns over inflation and increased risk in the corporate market, the credit sector had trouble keeping pace with other fixed-income sectors, and posted its lowest six-month return since 1999. Within the investment-grade portion of the sector, lower-rated issues (BBB-and A-rated) outpaced higher-rated issues (AA-rated and above). Industrials posted the highest returns, followed by utilities and financials. Overall, longer dated corporate issues underperformed shorter-dated issues. The stock market produced flat results for the six-month period overall. Although 2006 began with a strong market rally, rising uncertainties about inflation and economic slowdown overshadowed the market's more positive influences. Against a backdrop of spiking commodity prices, the Fed continued to raise the federal funds rate and indicate that future rate increases were possible. With housing and consumer trends already showing initial signs of deceleration, investors grew increasingly anxious about the Fed's language. (Note: In August, after the close of the reporting period, the Fed paused its series of interest rate increases for the first time since it began monetary tightening in June 2004.) Although corporate profits had continued to be healthy for the most part, corporate managements began to downgrade their business outlooks in light of a potentially slowing economy. In May and June, stocks marked a level of price volatility not seen in several years, leading to a stock market correction that rippled across markets worldwide. By the end of the period, however, the markets recovered some of their lost ground. Value stocks -- in which the Fund invests -- fared better than the broad market, eking out a modest gain for the six months overall. 2 PERFORMANCE ANALYSIS Morgan Stanley Balanced Income Fund outperformed the Lehman Brothers U.S. Government/Credit Index, and underperformed the Russell 1000(R) Value Index and the Lipper Income Funds Index for the six months ended July 31, 2006, assuming no deduction of applicable sales charges. The Fund's Class A and D shares outperformed and Class B and C shares underperformed the Lipper Mixed-Asset Target Allocation Conservative Funds Index for the same period, assuming no deduction of applicable sales charges. Within the Fund's fixed income investments, we kept the Fund's overall duration* well below that of the Lehman Brothers U.S. Government/Credit Index during the period. This posture was beneficial to the Fund's performance as interest rates rose across the market, especially in the short- and intermediate-portions of the yield curve. Our focus on higher-coupon mortgage-backed securities with slow prepayments also added to performance, particularly in the second half of the period when higher-coupon issues outperformed low-coupon issues. Gains from these securities were partially offset, however, by a large underweight in lower- and current-coupon issues, which outperformed during the first half of the period. Within the credit section of the portfolio, we employed a defensive strategy with a focus on higher-quality securities, which enhanced relative performance, as did our strong security selection. In the stock portion of the portfolio, the consumer discretionary sector drove positive performance relative to the Russell 1000 Value Index during the period, particularly in our selection of retail and auto stocks. The Fund's basic materials exposure also contributed positively to relative gains due to company specific events. Another area of strength was the Fund's positioning in the technology sector. Although the Fund's technology holdings had a negative return overall, our investment process led us to avoid some of the broad market's weakest performing hardware and equipment stocks. In contrast, telecommunication services stocks detracted most from returns relative to the Russell 1000 Value Index. After several years of declining performance, the telecommunication services sector began to show signs of progress during the period. However, our selections did not perform as well as those stocks that led the sector's turnaround. Although the financials sector produced a positive return on an absolute basis, stock selection and an underweight allocation caused the Fund's performance to lag that of the benchmark sector, largely due to the Fund's lack of exposure to real estate investment trusts and minimal exposure to regional banks. In the consumer staples sector, stock selection in the food and staples retailing and beverage and tobacco industries proved disadvantageous. During the period, we maintained the Fund's asset allocation. As of the end of the reporting period, the Fund held 66 percent in bonds and 34 percent in stocks. 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. - ---------------------------------------------------- * A measure of the sensitivity of a bond's price to changes in interest rates, expressed in years. Each year of duration represents an expected 1 percent change in the price of a bond for every 1 percent change in interest rates. The longer a bond's duration, the greater the effect of interest-rate movements on its price. Typically, funds with shorter durations perform better in rising-interest-rate environments, while funds with longer durations perform better when rates decline. 3 <Table> <Caption> TOP 10 HOLDINGS U.S. Treasury Securities 20.3% Fed. Natl. Mtge. Assoc. 15.3 USAA Auto Owner Trust 1.5 American Express Credit Acct. 1.4 JPMorgan Chase & Co. 1.2 Bayer AG (ADR) (Germany) 1.1 Honda Auto Receivables Owner Trust 1.1 Harley-Davidson Motorcycle Trust 1.0 Citigroup, Inc. 1.0 CNH Equipment Trust 0.9 </Table> <Table> <Caption> PORTFOLIO COMPOSITION* Common Stocks 34.1% U.S. Government Agencies & Obligations 30.9 Corporate Bonds 15.5 Asset-Backed Securities 12.7 Short-Term Investments 6.8 Put Option Purchased 0.0 </Table> * Does not include open long futures contracts with an underlying face amount of $15,859,375 and unrealized appreciation of $92,842 and open short futures contracts with an underlying face amount of $13,412,313 and unrealized depreciation of $65,293. Data as of July 31, 2006. Subject to change daily. All percentages for top 10 holdings are as a percentage of net assets and all percentages for portfolio composition are as a percentage of total investments. These data are provided for informational purposes only and should not be deemed a recommendation to buy or sell the securities mentioned. 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. INVESTMENT STRATEGY THE FUND WILL NORMALLY INVEST AT LEAST 80 PERCENT OF ITS ASSETS IN INCOME-PRODUCING SECURITIES, CONSISTING OF (1) FIXED-INCOME SECURITIES AND (2) DIVIDEND PAYING COMMON STOCKS AND SECURITIES CONVERTIBLE INTO COMMON STOCKS. WITHIN THE LIMITATIONS DETAILED IN THE FUND'S PROSPECTUS, THE FUND'S "INVESTMENT ADVISER," MORGAN STANLEY INVESTMENT ADVISORS INC., MAY PURCHASE OR SELL SECURITIES IN ANY PROPORTION IT BELIEVES DESIRABLE BASED ON ITS ASSESSMENT OF BUSINESS, ECONOMIC AND INVESTMENT CONDITIONS. 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. INFORMATION ON THE OPERATION OF THE SEC'S PUBLIC REFERENCE ROOM MAY BE OBTAINED BY CALLING THE SEC AT 4 (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. PROXY VOTING POLICY AND PROCEDURES AND PROXY VOTING RECORD YOU MAY OBTAIN A COPY OF THE FUND'S PROXY VOTING POLICY AND PROCEDURES WITHOUT CHARGE, UPON REQUEST, BY CALLING TOLL FREE (800) 869-NEWS OR BY VISITING THE MUTUAL FUND CENTER ON OUR WEB SITE AT WWW.MORGANSTANLEY.COM. IT IS ALSO AVAILABLE ON THE SECURITIES AND EXCHANGE COMMISSION'S WEB SITE AT HTTP://WWW.SEC.GOV. YOU MAY OBTAIN INFORMATION REGARDING HOW THE FUND VOTED PROXIES RELATING TO PORTFOLIO SECURITIES DURING THE MOST RECENT TWELVE-MONTH PERIOD ENDED JUNE 30 WITHOUT CHARGE BY VISITING THE MUTUAL FUND CENTER ON OUR WEB SITE AT WWW.MORGANSTANLEY.COM. THIS INFORMATION IS ALSO AVAILABLE ON THE SECURITIES AND EXCHANGE COMMISSION'S WEB SITE AT HTTP://WWW.SEC.GOV. 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) 350-6414, 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 FUND PERFORMANCE AVERAGE ANNUAL TOTAL RETURNS -- PERIOD ENDED JULY 31, 2006 <Table> <Caption> CLASS A SHARES* CLASS B SHARES** CLASS C SHARES(+) CLASS D SHARES(++) (since 07/28/97) (since 07/28/97) (since 03/28/95) (since 07/28/97) SYMBOL BINAX BINBX BINCX BINDX 1 YEAR 3.22%(5) 2.50%(5) 2.52%(5) 3.56%(5) (2.20)(6) (2.17)(6) 1.59(6) -- 5 YEARS 4.13(5) 3.35(5) 3.38(5) 4.40(5) 3.01(6) 3.01(6) 3.38(6) -- 10 YEARS -- -- 6.15(5) -- -- -- 6.15(6) -- SINCE INCEPTION 5.56(5) 4.74(5) 6.79(5) 5.79(5) 4.93(6) 4.74(6) 6.79(6) -- </Table> 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 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 D shares will vary due to differences in sales charges and expenses. * The maximum front-end sales charge for Class A is 5.25%. ** The maximum contingent deferred sales charge (CDSC) for Class B is 5.0%. The CDSC declines to 0% after six years. + The maximum contingent deferred sales charge for Class C is 1.0% for shares redeemed within one year of purchase. ++ Class D has no sales charge. (1) The Lehman Brothers U.S. Government/Credit Index tracks the performance of government and corporate obligations, including U.S. government agency and Treasury securities and corporate and Yankee bonds. Indexes are unmanaged and their 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 Russell 1000(R) Value Index measures the performance of those companies in the Russell 1000(R) Index with lower price-to-book ratios and lower forecasted growth values. Indexes are unmanaged and their returns do not include any sales charges or fees. Such costs would lower performance. It is not possible to invest directly in an index. (3) The Lipper Mixed-Asset Target Allocation Conservative Funds Index is an equally-weighted performance index of the largest qualifying funds (based on net assets) in the Lipper Mixed-Asset Target Allocation Conservative 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 10 fund represented in this Index. The Fund is in the Lipper Mixed-Asset Target Allocation Conservative Funds classification as of 7/31/2006. (4) The Lipper Income Funds Index is an equally-weighted performance index of the largest qualifying funds (based on net assets) in the Lipper Income 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. (5) Figure shown assumes reinvestment of all distributions and does not reflect the deduction of any sales charges. (6) 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 02/01/06 - 07/31/06. 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. <Table> <Caption> BEGINNING ENDING EXPENSES PAID ACCOUNT VALUE ACCOUNT VALUE DURING PERIOD * ------------- ------------- --------------- 02/01/06 - 02/01/06 07/31/06 07/31/06 ------------- ------------- --------------- CLASS A Actual (0.76% return)....................................... $1,000.00 $1,007.60 $ 6.92 Hypothetical (5% annual return before expenses)............. $1,000.00 $1,017.90 $ 6.95 CLASS B Actual (0.44% return)....................................... $1,000.00 $1,004.40 $10.64 Hypothetical (5% annual return before expenses)............. $1,000.00 $1,014.18 $10.69 CLASS C Actual (0.46% return)....................................... $1,000.00 $1,004.60 $10.64 Hypothetical (5% annual return before expenses)............. $1,000.00 $1,014.18 $10.69 CLASS D Actual (0.96% return)....................................... $1,000.00 $1,009.60 $ 5.68 Hypothetical (5% annual return before expenses)............. $1,000.00 $1,019.14 $ 5.71 </Table> - ------------------ * Expenses are equal to the Fund's annualized expense ratios of 1.39%, 2.14%, 2.14% and 1.14% for Class A, Class B, Class C and Class D shares, respectively, multiplied by the average account value over the period, multiplied by 181/365 (to reflect the one-half year period). 7 Morgan Stanley Balanced Income Fund PORTFOLIO OF INVESTMENT - JULY 31, 2006 (UNAUDITED) <Table> <Caption> NUMBER OF SHARES VALUE - ------------------------------------------------------------------------------------------------------- Common Stocks (32.9%) Aerospace & Defense (0.7%) 7,740 Northrop Grumman Corp. ..................................................... $ 512,311 11,760 Raytheon Co. ............................................................... 530,023 ------------ 1,042,334 ------------ Beverages: Alcoholic (0.3%) 6,230 Diageo PLC (ADR) (United Kingdom)........................................... 438,094 ------------ Beverages: Non-Alcoholic (0.6%) 17,830 Coca-Cola Co. (The)......................................................... 793,435 ------------ Broadcasting (0.7%) 32,120 Clear Channel Communications, Inc. ......................................... 929,874 ------------ Cable/Satellite TV (0.2%) 9,000 Comcast Corp. (Class A)*.................................................... 309,420 ------------ Chemicals: Major Diversified (1.5%) 31,530 Bayer AG (ADR) (Germany).................................................... 1,552,222 13,500 Du Pont (E.I.) de Nemours & Co. ............................................ 535,410 ------------ 2,087,632 ------------ Computer Processing Hardware (0.1%) 4,555 Hewlett-Packard Co. ........................................................ 145,350 ------------ Department Stores (0.2%) 4,130 Kohl's Corp.*............................................................... 233,882 ------------ Discount Stores (0.5%) 15,630 Wal-Mart Stores, Inc. ...................................................... 695,535 ------------ Electric Utilities (1.2%) 12,750 American Electric Power Co., Inc. .......................................... 460,530 9,660 Entergy Corp. .............................................................. 744,786 9,970 FirstEnergy Corp. .......................................................... 558,320 ------------ 1,763,636 ------------ Finance/Rental/Leasing (0.6%) 15,380 Freddie Mac................................................................. 889,887 ------------ Financial Conglomerates (2.6%) 28,680 Citigroup, Inc. ............................................................ 1,385,531 38,376 JPMorgan Chase & Co. ....................................................... 1,750,713 9,140 State Street Corp. ......................................................... 548,948 ------------ 3,685,192 ------------ </Table> See Notes to Financial Statements 8 Morgan Stanley Balanced Income Fund PORTFOLIO OF INVESTMENT - JULY 31, 2006 (UNAUDITED) continued <Table> <Caption> NUMBER OF SHARES VALUE - ------------------------------------------------------------------------------------------------------- Food Retail (0.1%) 3,050 Kroger Co. ................................................................. $ 69,936 1,700 Safeway, Inc. .............................................................. 47,736 2,800 Supervalu, Inc. ............................................................ 75,908 ------------ 193,580 ------------ Food: Major Diversified (0.6%) 8,600 ConAgra Foods Inc. ......................................................... 184,900 29,040 Unilever N.V. (NY Registered Shares) (Netherlands).......................... 687,667 ------------ 872,567 ------------ Food: Specialty/Candy (0.4%) 13,340 Cadbury Schweppes PLC (ADR) (United Kingdom)................................ 523,728 ------------ Household/Personal Care (0.4%) 8,810 Procter & Gamble Co. (The).................................................. 495,122 ------------ Industrial Conglomerates (1.5%) 36,380 General Electric Co. ....................................................... 1,189,262 6,370 Ingersoll-Rand Co. Ltd. (Class A) (Bermuda)................................. 228,046 9,180 Siemens AG (ADR) (Germany).................................................. 741,101 ------------ 2,158,409 ------------ Insurance Brokers/Services (0.6%) 32,000 Marsh & McLennan Companies, Inc. ........................................... 864,960 ------------ Integrated Oil (2.0%) 9,700 BP PLC (ADR) (United Kingdom)............................................... 703,444 15,230 ConocoPhillips.............................................................. 1,045,387 5,170 Exxon Mobil Corp. .......................................................... 350,216 11,480 Royal Dutch Shell PLC (ADR) (Class A) (United Kingdom)...................... 812,784 ------------ 2,911,831 ------------ Investment Banks/Brokers (1.5%) 2,070 Goldman Sachs Group, Inc. (The)............................................. 316,192 15,570 Merrill Lynch & Co., Inc. .................................................. 1,133,807 47,100 Schwab (Charles) Corp. (The)................................................ 747,948 ------------ 2,197,947 ------------ Life/Health Insurance (0.1%) 12,510 Aegon N.V. (NY Registered Shares) (Netherlands)............................. 211,669 ------------ Major Banks (1.1%) 18,152 Bank of America Corp. ...................................................... 935,372 8,260 PNC Financial Services Group................................................ 585,138 ------------ 1,520,510 ------------ </Table> See Notes to Financial Statements 9 Morgan Stanley Balanced Income Fund PORTFOLIO OF INVESTMENT - JULY 31, 2006 (UNAUDITED) continued <Table> <Caption> NUMBER OF SHARES VALUE - ------------------------------------------------------------------------------------------------------- Major Telecommunications (2.0%) 5,723 Embarq Corp. ............................................................... $ 258,966 21,800 France Telecom S.A. (ADR) (France).......................................... 506,414 51,267 Sprint Nextel Corp. ........................................................ 1,015,087 30,457 Verizon Communications, Inc. ............................................... 1,030,056 ------------ 2,810,523 ------------ Managed Health Care (0.2%) 3,090 CIGNA Corp. ................................................................ 281,962 ------------ Media Conglomerates (1.7%) 24,500 Disney (Walt) Co. (The)..................................................... 727,405 66,240 Time Warner, Inc. .......................................................... 1,092,960 15,910 Viacom, Inc. (Class B)*..................................................... 554,464 ------------ 2,374,829 ------------ Medical Specialties (0.2%) 7,460 Applera Corp. - Applied Biosystems Group.................................... 239,839 ------------ Motor Vehicles (0.3%) 14,360 Honda Motor Co., Ltd. (ADR) (Japan)......................................... 473,162 ------------ Multi-Line Insurance (0.3%) 5,880 Hartford Financial Services Group, Inc. (The)............................... 498,859 ------------ Oil Refining/Marketing (0.1%) 1,900 Marathon Oil Corp. ......................................................... 172,216 ------------ Oilfield Services/Equipment (0.4%) 8,370 Schlumberger Ltd. (Netherlands Antilles).................................... 559,535 ------------ Other Consumer Services (0.0%) 1,200 Block (H.&R.), Inc. ........................................................ 27,300 ------------ Packaged Software (0.7%) 53,897 Symantec Corp.*............................................................. 936,191 ------------ Pharmaceuticals: Major (5.5%) 23,380 Abbott Laboratories......................................................... 1,116,863 44,600 Bristol-Myers Squibb Co. ................................................... 1,069,062 9,360 GlaxoSmithKline PLC (ADR) (United Kingdom).................................. 517,889 19,810 Lilly (Eli) & Co. .......................................................... 1,124,614 27,220 Pfizer, Inc. ............................................................... 707,448 12,080 Roche Holdings Ltd. (ADR) (Switzerland)..................................... 1,073,308 9,080 Sanofi-Aventis (ADR) (France)............................................... 430,301 54,670 Schering-Plough Corp. ...................................................... 1,117,455 15,800 Wyeth....................................................................... 765,826 ------------ 7,922,766 ------------ </Table> See Notes to Financial Statements 10 Morgan Stanley Balanced Income Fund PORTFOLIO OF INVESTMENT - JULY 31, 2006 (UNAUDITED) continued <Table> <Caption> NUMBER OF SHARES VALUE - ------------------------------------------------------------------------------------------------------- Precious Metals (0.4%) 11,650 Newmont Mining Corp. ....................................................... $ 596,830 ------------ Property - Casualty Insurers (1.6%) 1,380 ACE Ltd. (Cayman Islands)................................................... 71,111 15,540 Chubb Corp. (The)........................................................... 783,527 20,984 St. Paul Travelers Companies, Inc. (The).................................... 961,067 6,460 XL Capital Ltd. (Class A) (Cayman Islands).................................. 411,502 ------------ 2,227,207 ------------ Regional Banks (0.2%) 9,300 Fifth Third Bancorp......................................................... 354,702 ------------ Restaurants (0.2%) 7,070 McDonald's Corp. ........................................................... 250,207 ------------ Semiconductors (0.6%) 23,877 Intel Corp. ................................................................ 429,786 27,090 Micron Technology, Inc.*.................................................... 422,333 ------------ 852,119 ------------ Specialty Insurance (0.3%) 5,060 MGIC Investment Corp. ...................................................... 287,965 4,150 PMI Group, Inc. (The)....................................................... 176,209 ------------ 464,174 ------------ Specialty Stores (0.1%) 5,530 Office Depot, Inc.*......................................................... 199,357 ------------ Telecommunication Equipment (0.2%) 12,460 Motorola, Inc. ............................................................. 283,590 ------------ Tobacco (0.4%) 6,920 Altria Group, Inc. ......................................................... 553,392 ------------ Total Common Stocks (Cost $39,174,995)...................................... 47,043,354 ------------ </Table> <Table> <Caption> PRINCIPAL AMOUNT IN COUPON MATURITY THOUSANDS RATE DATE - --------- ------ -------- Corporate Bonds (16.5%) Advertising/Marketing Services (0.1%) $ 190 WPP Finance (UK) Corp. (United Kingdom)................... 5.875% 06/15/14 186,258 ------------ Aerospace & Defense (0.4%) 235 Northrop Grumman Corp. ................................... 4.079 11/16/06 233,993 370 Systems 2001 Asset Trust - 144A** (Cayman Islands)........ 6.664 09/15/13 384,731 ------------ 618,724 ------------ </Table> See Notes to Financial Statements 11 Morgan Stanley Balanced Income Fund PORTFOLIO OF INVESTMENT - JULY 31, 2006 (UNAUDITED) continued <Table> <Caption> PRINCIPAL AMOUNT IN COUPON MATURITY THOUSANDS RATE DATE VALUE - --------------------------------------------------------------------------------------------------------- Air Freight/Couriers (0.2%) $ 225 Fedex Corp. .............................................. 2.65 % 04/01/07 $ 220,437 ------------ Airlines (0.4%) 321 America West Airlines, Inc. (Series 01-1)................. 7.10 04/02/21 330,559 195 Southwest Airlines Co. (Series 01-1)...................... 5.496 11/01/06 195,133 ------------ 525,692 ------------ Apparel/Footwear Retail (0.1%) 75 Limited Brands, Inc. ..................................... 6.95 03/01/33 72,315 ------------ Beverages: Alcoholic (0.4%) 285 FBG Finance Ltd. - 144A** (Australia)..................... 5.125 06/15/15 265,166 290 Miller Brewing Co. - 144A**............................... 4.25 08/15/08 282,497 ------------ 547,663 ------------ Cable/Satellite TV (0.2%) 135 Comcast Cable Communications, Inc. ....................... 6.75 01/30/11 140,320 40 Lenfast Communications, Inc. ............................. 7.625 02/15/08 41,089 105 TCI Communications, Inc. ................................. 7.875 02/15/26 113,582 ------------ 294,991 ------------ Casino/Gaming (0.4%) 415 Harrah's Operating Co., Inc. ............................. 5.625 06/01/15 387,815 110 Harrah's Operating Co., Inc. ............................. 6.50 06/01/16 108,464 ------------ 496,279 ------------ Chemicals: Major Diversified (0.1%) 170 ICI Wilmington, Inc. ..................................... 4.375 12/01/08 165,029 ------------ Computer Processing Hardware (0.1%) 185 Hewlett-Packard Co. ...................................... 5.339+ 05/22/09 185,237 ------------ Containers/Packaging (0.1%) 145 Sealed Air Corp. - 144A**................................. 5.625 07/15/13 140,391 ------------ Department Stores (0.1%) 50 Federated Department Stores, Inc. ........................ 6.625 09/01/08 50,998 80 May Department Stores Co., Inc. .......................... 5.95 11/01/08 80,483 ------------ 131,481 ------------ Electric Utilities (2.2%) 280 Ameren Corp. ............................................. 4.263 05/15/07 277,165 280 Arizona Public Service Co. ............................... 5.80 06/30/14 273,677 75 Arizona Public Service Co. ............................... 6.75 11/15/06 75,229 265 Carolina Power & Light Co. ............................... 5.125 09/15/13 255,510 305 CC Funding Trust I........................................ 6.90 02/16/07 306,895 100 Cincinnati Gas & Electric Co. ............................ 5.70 09/15/12 98,907 </Table> See Notes to Financial Statements 12 Morgan Stanley Balanced Income Fund PORTFOLIO OF INVESTMENT - JULY 31, 2006 (UNAUDITED) continued <Table> <Caption> PRINCIPAL AMOUNT IN COUPON MATURITY THOUSANDS RATE DATE VALUE - --------------------------------------------------------------------------------------------------------- $ 140 Consolidated Natural Gas Co. ............................. 5.00 % 12/01/14 $ 129,928 230 Consolidated Natural Gas Co. (Series C)................... 6.25 11/01/11 234,265 180 Consumers Energy Co. ..................................... 4.80 02/17/09 176,220 130 Detroit Edison Co. (The).................................. 6.125 10/01/10 132,432 90 Entergy Gulf States, Inc. ................................ 3.60 06/01/08 86,497 195 Entergy Gulf States, Inc. ................................ 5.631+ 12/01/09 193,229 250 Ohio Power Company - IBC (Series K)....................... 6.00 06/01/16 250,453 70 Panhandle Eastern Pipe Line Co. (Series B)................ 2.75 03/15/07 68,738 165 Public Service Electric & Gas Co. (Series MTNB)........... 5.00 01/01/13 159,084 155 Texas Eastern Transmission, LP............................ 7.00 07/15/32 167,000 205 Wisconsin Electric Power Co. ............................. 3.50 12/01/07 199,955 ------------ 3,085,184 ------------ Electrical Products (0.3%) 240 Cooper Industries, Inc. .................................. 5.25 07/01/07 238,340 245 Cooper Industries, Inc. .................................. 5.25 11/15/12 239,843 ------------ 478,183 ------------ Electronics/Appliances (0.1%) 160 LG Electronics Inc. - 144A** (South Korea)................ 5.00 06/17/10 153,166 ------------ Finance/Rental/Leasing (1.5%) 240 CIT Group, Inc. .......................................... 2.875 09/29/06 239,048 190 CIT Group Inc. (Series MTN)............................... 4.75 08/15/08 187,424 350 Countrywide Home Loans, Inc. (Series MTN)................. 3.25 05/21/08 336,799 375 MBNA Corp. ............................................... 5.58+ 05/05/08 377,936 335 Nationwide Building Society - 144A** (United Kingdom)..... 4.25 02/01/10 321,591 485 Residential Capital Corp. ................................ 6.375 06/30/10 483,779 150 SLM Corp. ................................................ 4.00 01/15/10 142,872 ------------ 2,089,449 ------------ Financial Conglomerates (0.7%) 500 Associates Corp. of North America......................... 6.25 11/01/08 508,399 315 Chase Manhattan Corp. .................................... 6.00 02/15/09 318,498 80 Chase Manhattan Corp. .................................... 7.00 11/15/09 83,417 165 General Electric Capital Corp. ........................... 4.25 12/01/10 157,840 ------------ 1,068,154 ------------ Food Retail (0.2%) 210 Fred Meyer, Inc. ......................................... 7.45 03/01/08 215,458 ------------ </Table> See Notes to Financial Statements 13 Morgan Stanley Balanced Income Fund PORTFOLIO OF INVESTMENT - JULY 31, 2006 (UNAUDITED) continued <Table> <Caption> PRINCIPAL AMOUNT IN COUPON MATURITY THOUSANDS RATE DATE VALUE - --------------------------------------------------------------------------------------------------------- Food: Major Diversified (0.3%) $ 100 ConAgra Foods, Inc. ...................................... 7.00 % 10/01/28 $ 103,367 130 ConAgra Foods, Inc. ...................................... 8.25 09/15/30 152,959 115 Kraft Foods Inc. ......................................... 5.25 06/01/07 114,509 ------------ 370,835 ------------ Forest Products (0.0%) 19 Weyerhaeuser Co. ......................................... 6.125 03/15/07 19,022 ------------ Gas Distributors (0.3%) 195 NiSource Finance Corp. ................................... 5.764+ 11/23/09 195,456 180 Sempra Energy............................................. 4.621 05/17/07 178,727 ------------ 374,183 ------------ Home Furnishings (0.1%) 155 Mohawk Industries, Inc. (Series D)........................ 7.20 04/15/12 160,989 ------------ Hotels/Resorts/Cruiselines (0.2%) 305 Hyatt Equities LLC - 144A**............................... 6.875 06/15/07 307,090 ------------ Household/Personal Care (0.2%) 350 Clorox Co. (The).......................................... 5.444+ 12/14/07 350,611 ------------ Industrial Conglomerates (0.3%) 200 Textron Financial Corp. .................................. 4.125 03/03/08 195,591 250 Textron Financial Corp. (Series MTN)...................... 5.125 02/03/11 245,859 ------------ 441,450 ------------ Insurance Brokers/Services (0.4%) 570 Farmers Exchange Capital - 144A**......................... 7.05 07/15/28 554,175 ------------ Major Banks (0.7%) 120 Bank of New York Co., Inc. (The).......................... 5.20 07/01/07 119,610 250 Bank of New York Co., Inc. (The) (Series BKNT)............ 3.80 02/01/08 244,311 160 HSBC Finance Corp. ....................................... 6.75 05/15/11 167,538 250 Huntington National Bank (Series BKNT).................... 4.375 01/15/10 241,078 165 Popular North America Inc. (Series MTN)................... 5.65 04/15/09 164,591 ------------ 937,128 ------------ Major Telecommunications (1.1%) 150 Deutsche Telekom International Finance Corp. BV (Netherlands)........................................... 8.25+ 06/15/30 175,978 295 France Telecom S.A. (France).............................. 8.50+ 03/01/31 364,992 185 SBC Communications, Inc. ................................. 6.15 09/15/34 172,508 70 Sprint Capital Corp. ..................................... 8.75 03/15/32 85,506 125 Telecom Italia Capital SA (Luxembourg).................... 4.00 11/15/08 120,530 225 Telecom Italia Capital SA (Luxembourg).................... 4.00 01/15/10 211,944 </Table> See Notes to Financial Statements 14 Morgan Stanley Balanced Income Fund PORTFOLIO OF INVESTMENT - JULY 31, 2006 (UNAUDITED) continued <Table> <Caption> PRINCIPAL AMOUNT IN COUPON MATURITY THOUSANDS RATE DATE VALUE - --------------------------------------------------------------------------------------------------------- $ 140 Telefonica Europe BV (Netherlands)........................ 8.25 % 09/15/30 $ 162,497 300 Verizon New England, Inc. ................................ 6.50 09/15/11 304,104 ------------ 1,598,059 ------------ Media Conglomerates (0.3%) 90 News America Holdings, Inc. .............................. 7.75 02/01/24 96,468 115 News America, Inc. ....................................... 7.28 06/30/28 118,244 255 Viacom, Inc. - 144A**..................................... 6.875 04/30/36 245,307 ------------ 460,019 ------------ Motor Vehicles (0.1%) 145 DaimlerChrysler North American Holdings Co. .............. 8.50 01/18/31 167,925 ------------ Multi-Line Insurance (0.7%) 660 AIG Sun America Global Finance VI - 144A**................ 6.30 05/10/11 681,018 130 American General Finance Corp. (Series MTNH).............. 4.625 09/01/10 125,300 125 AXA Financial, Inc. ...................................... 6.50 04/01/08 126,491 135 International Lease Finance Corp. ........................ 3.75 08/01/07 132,510 ------------ 1,065,319 ------------ Oil & Gas Pipelines (0.2%) 95 Kinder Morgan Energy Partners, L.P. ...................... 5.125 11/15/14 88,481 260 Plains All American Pipeline L.P. - 144A**................ 6.70 05/15/36 258,138 ------------ 346,619 ------------ Other Metals/Minerals (0.2%) 260 Brascan Corp. (Canada).................................... 7.125 06/15/12 273,422 ------------ Property - Casualty Insurers (1.1%) 460 Mantis Reef Ltd. - 144A** (Australia)..................... 4.692 11/14/08 448,437 175 Platinum Underwriters Finance Inc. (Series B)............. 7.50 06/01/17 173,887 220 Platinum Underwriters Holdings, Ltd. (Series B) (Bahamas)............................................... 6.371 11/16/07 218,292 315 St. Paul Travelers Companies, Inc. (The).................. 5.01 08/16/07 311,797 420 XLLIAC Global Funding - 144A**............................ 4.80 08/10/10 406,947 ------------ 1,559,360 ------------ Pulp & Paper (0.1%) 95 Sappi Papier Holding AG - 144A** (Austria)................ 6.75 06/15/12 89,665 ------------ Railroads (0.4%) 190 Burlington North Santa Fe Railway Co. .................... 6.125 03/15/09 192,911 175 Norfolk Southern Corp. ................................... 7.35 05/15/07 177,286 35 Union Pacific Corp. ...................................... 6.625 02/01/08 35,545 110 Union Pacific Corp. (Series MTNE)......................... 6.79 11/09/07 111,488 ------------ 517,230 ------------ </Table> See Notes to Financial Statements 15 Morgan Stanley Balanced Income Fund PORTFOLIO OF INVESTMENT - JULY 31, 2006 (UNAUDITED) continued <Table> <Caption> PRINCIPAL AMOUNT IN COUPON MATURITY THOUSANDS RATE DATE VALUE - --------------------------------------------------------------------------------------------------------- Real Estate Development (0.5%) $ 375 World Financial Properties - 144A**....................... 6.91 % 09/01/13 $ 389,679 369 World Financial Properties - 144A**....................... 6.95 09/01/13 384,216 ------------ 773,895 ------------ Real Estate Investment Trusts (0.1%) 185 EOP Operating LP.......................................... 6.763 06/15/07 186,616 ------------ Regional Banks (0.3%) 420 Marshall & Ilsley Bank (Series BKNT)...................... 3.80 02/08/08 409,677 ------------ Restaurants (0.1%) 115 Tricon Global............................................. 8.875 04/15/11 128,924 ------------ Savings Banks (0.7%) 195 Household Finance Corp. .................................. 4.125 12/15/08 189,420 70 Household Finance Corp. .................................. 5.875 02/01/09 70,720 70 Household Finance Corp. .................................. 6.375 10/15/11 72,276 230 Household Finance Corp. .................................. 6.40 06/17/08 233,810 100 Sovereign Bank (Series CD)................................ 4.00 02/01/08 97,562 195 Washington Mutual Bank.................................... 5.50 01/15/13 191,326 180 Washington Mutual Inc. ................................... 8.25 04/01/10 194,143 ------------ 1,049,257 ------------ Trucks/Construction/Farm Machinery (0.3%) 70 Caterpillar Financial Services Corp. (Series MTNF)........ 3.625 11/15/07 68,373 340 Caterpillar Financial Services Corp. (Series MTNF)........ 5.259+ 08/20/07 340,407 ------------ 408,780 ------------ Wireless Telecommunications (0.2%) 285 Vodafone Group PLC (United Kingdom)....................... 5.59+ 12/28/07 285,101 ------------ Total Corporate Bonds (Cost $23,854,832)..................................... 23,509,442 ------------ U.S. Government Obligations (20.0%) U.S. Treasury Bonds 1,100 .......................................................... 6.125 08/15/29 1,243,259 5,350 .......................................................... 7.625 02/15/25 6,897,322 6,550 .......................................................... 8.125 08/15/21 8,559,009 U.S. Treasury Notes 1,250 .......................................................... 4.25 08/15/13 - 1,198,291 11/15/13 9,035 .......................................................... ++ 4.25 08/15/13 8,674,920 4,190 U.S. Treasury Strip....................................... 0.00 08/15/20 2,032,510 ------------ Total U.S. Government Obligations (Cost $28,499,371)......................... 28,605,311 ------------ </Table> See Notes to Financial Statements 16 Morgan Stanley Balanced Income Fund PORTFOLIO OF INVESTMENT - JULY 31, 2006 (UNAUDITED) continued <Table> <Caption> PRINCIPAL AMOUNT IN COUPON MATURITY THOUSANDS RATE DATE VALUE - --------------------------------------------------------------------------------------------------------- Mortgage-Backed Securities (14.5%) Federal Home Loan Mortgage Corp. Gold $ 144 .......................................................... 6.50 % 01/01/31 $ 147,005 371 .......................................................... 7.50 10/01/29 - 384,585 06/01/32 Federal National Mortgage Assoc. 546 .......................................................... 6.50 08/01/32 554,436 3,159 .......................................................... 7.00 01/01/32 - 3,244,035 02/01/36 400 .......................................................... 7.00 ++ 409,875 1,323 .......................................................... 7.50 08/01/23 - 1,371,206 09/01/35 486 .......................................................... 8.00 05/01/24 - 513,115 08/01/31 Federal National Mortgage Assoc. (ARM) 972 .......................................................... 1.354 07/01/36 1,004,949 651 .......................................................... 5.358 07/01/36 673,266 417 .......................................................... 5.663 07/01/33 422,939 977 .......................................................... 6.116 03/01/36 997,594 2,083 .......................................................... 6.164 01/01/36 2,143,175 2,078 .......................................................... 6.165 01/01/36 2,134,566 965 .......................................................... 6.17 03/01/36 991,727 1,027 .......................................................... 6.389 05/01/36 1,060,976 1,227 .......................................................... 6.406 04/01/36 1,268,483 1,000 .......................................................... 6.489 05/01/36 1,033,284 2,007 .......................................................... 6.671 04/01/36 2,097,147 94 Federal National Mortgage Assoc. Dwarf.................... 7.00 07/01/11 - 96,332 06/01/12 Government National Mortgage Assoc. 84 .......................................................... 7.50 08/15/25 - 87,597 10/15/26 63 .......................................................... 8.00 06/15/26 - 66,485 07/15/26 ------------ Total Mortgage-Backed Securities (Cost $20,797,594).......................... 20,702,777 ------------ Asset-Backed Securities (13.5%) Finance/Rental/Leasing 700 American Express Credit Account Master Trust 2002-3 A..... 5.479+ 12/15/09 701,085 1,275 American Express Credit Account Master Trust 2003-3 A..... 5.479+ 11/15/10 1,277,991 725 Banc of America Securities Auto Trust 2005-WF1 A3......... 3.99 08/18/09 715,379 425 Capital Auto Receivables Asset Trust 2004-2 A............. 3.35 02/15/08 422,026 725 Capital Auto Receivables Asset Trust 2005-1 A4............ 4.05 07/15/09 716,200 650 Caterpillar Financial Asset Trust 2005-A A3............... 3.90 02/25/09 642,380 </Table> See Notes to Financial Statements 17 Morgan Stanley Balanced Income Fund PORTFOLIO OF INVESTMENT - JULY 31, 2006 (UNAUDITED) continued <Table> <Caption> PRINCIPAL AMOUNT IN COUPON MATURITY THOUSANDS RATE DATE VALUE - --------------------------------------------------------------------------------------------------------- $ 184 CIT Equipment Collateral 2004-EF1 A3...................... 3.50 % 09/20/08 $ 181,621 475 CNH Equipment Trust 2005-A A3............................. 4.02 04/15/09 469,695 900 CNH Equipment Trust 2005-B A3............................. 4.27 01/15/10 884,811 575 DaimlerChrysler Auto Trust 2005-B A3...................... 4.04 09/08/09 568,628 475 Ford Credit Auto Owner Trust 2005-B A3.................... 4.17 01/15/09 471,179 425 Ford Credit Auto Owner Trust 2006-A A3.................... 5.05 03/15/10 422,868 700 GE Equipment Small Ticket LLC 2005-2A..................... 4.88 10/22/09 695,260 900 Harley-Davidson Motorcycle Trust 2005-1 A2................ 3.76 12/17/12 881,039 525 Harley-Davidson Motorcycle Trust 2005-2 A2................ 4.07 02/15/12 512,290 425 Hertz Vehicle Financing LLC 2005-2A A2.................... 4.93 02/25/10 420,052 400 Honda Auto Receivables Owner Trust 2005-2 A3.............. 3.93 01/15/09 395,660 650 Honda Auto Receivables Owner Trust 2005-3 A3.............. 3.87 04/20/09 640,464 575 Honda Auto Receivables Owner Trust 2005-6 A3.............. 4.85 10/19/09 571,227 450 Hyundai Auto Receivables Trust 2005-A A3.................. 3.98 11/16/09 442,435 140 MBNA Master Credit Card Trust 1999-B A.................... 5.90 08/15/11 142,234 800 Merrill Auto Trust Securitization 2005-1 A3............... 4.10 08/25/09 789,442 575 National City Auto Receivables Trust 2004-A A4............ 2.88 05/15/11 558,656 825 Nissan Auto Receivables Owner Trust 2005-B A3............. 3.99 07/15/09 814,733 175 TXU Electric Delivery Transition Bond Co. LLC 2004-1 A2... 4.81 11/17/14 169,645 950 USAA Auto Owner Trust 2004-2 A4........................... 3.58 02/15/11 931,903 645 USAA Auto Owner Trust 2004-3 A3........................... 3.16 02/17/09 638,060 563 USAA Auto Owner Trust 2005-1 A3........................... 3.90 07/15/09 557,491 500 Volkswagen Auto Lease Trust 2005-A A3..................... 3.82 05/20/08 496,657 750 Volkswagen Auto Loan Enhanced Trust 2005-1 A3............. 4.80 07/20/09 744,992 213 Wachovia Auto Owner Trust 2004-B A3....................... 2.91 04/20/09 210,607 400 Wachovia Auto Owner Trust 2005-A A3....................... 4.06 09/21/09 395,230 575 Wachovia Auto Owner Trust 2005-B A3....................... 4.79 04/20/10 570,656 189 World Omni Auto Receivables Trust 2004-A A3............... 3.29 11/12/08 187,707 ------------ Total Asset-Backed Securities (Cost $19,438,313)............................. 19,240,303 ------------ Collateralized Mortgage Obligations (1.8%) 725 Federal Home Loan Mortgage Corp. Whole Loan 2005-S001 2A2..................................................... 5.535+ 09/25/45 727,661 991 Federal National Mortgage Assoc. 2006-28 1A1.............. 5.495+ 03/25/36 991,599 11,463 Federal National Mortgage Assoc. 2006-28 1P (IO).......... 0.596+ 03/25/36 295,524 1,450 Federal National Mortgage Assoc. 2005-68 XI (IO).......... 6.00 08/25/35 569,321 ------------ Total Collateralized Mortgage Obligations (Cost $2,266,376).................. 2,584,105 ------------ </Table> See Notes to Financial Statements 18 Morgan Stanley Balanced Income Fund PORTFOLIO OF INVESTMENT - JULY 31, 2006 (UNAUDITED) continued <Table> <Caption> NUMBER OF CONTRACTS VALUE - ------------------------------------------------------------------------------------------------------- Put Option Purchased (0.0%) 247 90 day Euro $ June/2007 @ $94.25 (Cost $78,673)............................. $ 58,663 ------------ </Table> <Table> <Caption> PRINCIPAL AMOUNT IN COUPON MATURITY THOUSANDS RATE DATE - --------- ------ --------- Short-Term Investments (7.2%) U.S. Government Obligation (a) (0.3%) $ 400 U.S. Treasury Bill*** (Cost $390,782).................... 5.09 % 01/11/07 390,782 ------------ Repurchase Agreement (6.9%) 9,920 Joint repurchase agreement account (dated 07/31/06; proceeds $9,921,452) (b) (Cost $9,920,000)............. 5.27 08/01/06 9,920,000 ------------ Total Short-Term Investments (Cost $10,310,782).............................. 10,310,782 ------------ </Table> <Table> Total Investments (Cost $144,420,936) (c)(d)..................... 106.4% 152,054,737 Liabilities in Excess of Other Assets............................ (6.4) (9,088,205) ----- ------------ Net Assets....................................................... 100.0% $142,966,532 ===== ============ </Table> - --------------------- <Table> ADR American Depositary Receipt. ARM Adjustable Rate Mortgage. IO Interest Only Security. * Non-income producing security. ** Resale is restricted to qualified institutional investors. *** A portion of this security has been physically segregated in connection with open futures contracts in the amount of $380,000. + Floating rate security; rate shown is the rate in effect at July 31, 2006. ++ Security purchased on a forward commitment basis with an approximate principal amount and no definite maturity date; the actual principal amount and maturity date will be determined upon settlement. ++ Security purchased on a forward commitment basis. (a) Purchased on a discount basis. The interest rate shown has been adjusted to reflect a money market equivalent yield. (b) Collateralized by federal agency and U.S. Treasury obligations. (c) Securities have been designated as collateral in an amount equal to $38,240,597 in connection with open futures contracts and securities purchased on a forward commitment basis. (d) The aggregate cost for federal income tax purposes approximates the aggregate cost for book purposes. The aggregate gross unrealized appreciation is $10,796,868 and the aggregate gross unrealized depreciation is $3,163,067, resulting in net unrealized appreciation of $7,633,801. </Table> See Notes to Financial Statements 19 Morgan Stanley Balanced Income Fund PORTFOLIO OF INVESTMENT - JULY 31, 2006 (UNAUDITED) continued FUTURES CONTRACTS OPEN AT JULY 31, 2006: <Table> <Caption> UNREALIZED NUMBER OF DESCRIPTION, DELIVERY UNDERLYING FACE APPRECIATION CONTRACTS LONG/SHORT MONTH AND YEAR AMOUNT AT VALUE (DEPRECIATION) - ------------------------------------------------------------------------------------------------- 142 Long U.S. Treasury Notes 5 Year, $ 14,799,063 $ 78,338 September 2006 10 Long U.S. Treasury Notes 10 Year, 1,060,312 14,504 September 2006 13 Short U.S. Treasury Bonds 20 Year, (1,407,656) (26,130) September 2006 59 Short U.S. Treasury Notes 2 Year, (12,004,657) (39,163) September 2006 -------- Net Unrealized Appreciation............................ $ 27,549 ======== </Table> See Notes to Financial Statements 20 Morgan Stanley Balanced Income Fund FINANCIAL STATEMENTS Statement of Assets and Liabilities July 31, 2006 (unaudited) <Table> Assets: Investments in securities, at value (cost $144,420,936)....................................... $152,054,737 Cash........................................................ 929 Receivable for: Interest................................................ 1,089,722 Investments sold........................................ 424,584 Shares of beneficial interest sold...................... 77,699 Dividends............................................... 50,316 Variation margin........................................ 5,124 Prepaid expenses and other assets........................... 47,252 ------------ Total Assets............................................ 153,750,363 ------------ Liabilities: Payable for: Investments purchased................................... 9,977,504 Shares of beneficial interest redeemed.................. 395,931 Distribution fee........................................ 107,179 Investment advisory fee................................. 63,539 Administration fee...................................... 9,775 Transfer agent fee...................................... 3,373 Accrued expenses and other payables......................... 226,530 ------------ Total Liabilities....................................... 10,783,831 ------------ Net Assets.............................................. $142,966,532 ============ Composition of Net Assets: Paid-in-capital............................................. $133,333,789 Net unrealized appreciation................................. 7,661,350 Accumulated undistributed net investment income............. 3,043 Accumulated undistributed net realized gain................. 1,968,350 ------------ Net Assets.............................................. $142,966,532 ============ Class A Shares: Net Assets.................................................. $22,641,987 Shares Outstanding (unlimited authorized, $.01 par value)... 1,831,156 Net Asset Value Per Share............................... $12.36 ============ Maximum Offering Price Per Share, (net asset value plus 5.54% of net asset value)......... $13.04 ============ Class B Shares: Net Assets.................................................. $84,886,936 Shares Outstanding (unlimited authorized, $.01 par value)... 6,893,782 Net Asset Value Per Share............................... $12.31 ============ Class C Shares: Net Assets.................................................. $34,529,012 Shares Outstanding (unlimited authorized, $.01 par value)... 2,800,415 Net Asset Value Per Share............................... $12.33 ============ Class D Shares: Net Assets.................................................. $908,597 Shares Outstanding (unlimited authorized, $.01 par value)... 73,698 Net Asset Value Per Share............................... $12.33 ============ </Table> See Notes to Financial Statements 21 Morgan Stanley Balanced Income Fund FINANCIAL STATEMENTS continued Statement of Operations For the six months ended July 31, 2006 (unaudited) <Table> Net Investment Income: Income Interest.................................................... $ 2,576,666 Dividends (net of $22,872 foreign withholding tax).......... 614,356 ----------- Total Income............................................ 3,191,022 ----------- Expenses Distribution fee (Class A shares)........................... 28,258 Distribution fee (Class B shares)........................... 466,333 Distribution fee (Class C shares)........................... 186,286 Investment advisory fee..................................... 400,762 Shareholder reports and notices............................. 171,975 Transfer agent fees and expenses............................ 107,451 Administration fee.......................................... 61,656 Professional fees........................................... 58,565 Registration fees........................................... 29,255 Custodian fees.............................................. 27,644 Trustees' fees and expenses................................. 928 Other....................................................... 18,195 ----------- Total Expenses.......................................... 1,557,308 Less: expense offset........................................ (476) ----------- Net Expenses............................................ 1,556,832 ----------- Net Investment Income................................... 1,634,190 ----------- Net Realized and Unrealized Gain (Loss): Net Realized Gain on: Investments................................................. 3,988,455 Futures contracts........................................... 53,858 Options..................................................... 12,242 ----------- Net Realized Gain....................................... 4,064,555 ----------- Net Change in Unrealized Appreciation/Depreciation on: Investments................................................. (5,168,106) Futures contracts........................................... 28,059 Options..................................................... (20,010) ----------- Net Depreciation........................................ (5,160,057) ----------- Net Loss................................................ (1,095,502) ----------- Net Increase................................................ $ 538,688 =========== </Table> See Notes to Financial Statements 22 Morgan Stanley Balanced Income Fund FINANCIAL STATEMENTS continued Statements of Changes in Net Assets <Table> <Caption> FOR THE SIX FOR THE YEAR MONTHS ENDED ENDED JULY 31, 2006 JANUARY 31, 2006 ------------- ---------------- (unaudited) Increase (Decrease) in Net Assets: Operations: Net investment income....................................... $ 1,634,190 $ 3,339,217 Net realized gain........................................... 4,064,555 11,725,472 Net change in unrealized depreciation....................... (5,160,057) (5,507,219) ------------ ------------ Net Increase............................................ 538,688 9,557,470 ------------ ------------ Dividends and Distributions to Shareholders from: Net investment income Class A shares.......................................... (300,411) (538,035) Class B shares.......................................... (878,248) (2,361,571) Class C shares.......................................... (357,089) (889,437) Class D shares.......................................... (14,117) (41,670) Net realized gain Class A shares.......................................... (430,522) (1,182,901) Class B shares.......................................... (1,715,618) (5,804,185) Class C shares.......................................... (684,221) (2,188,127) Class D shares.......................................... (18,066) (64,026) ------------ ------------ Total Dividends and Distributions....................... (4,398,292) (13,069,952) ------------ ------------ Net decrease from transactions in shares of beneficial interest.................................................. (21,713,253) (26,657,384) ------------ ------------ Net Decrease............................................ (25,572,857) (30,169,866) Net Assets: Beginning of period......................................... 168,539,389 198,709,255 ------------ ------------ End of Period (Including accumulated undistributed net investment income of $3,043 and dividends in excess of net investment income of $81,282, respectively)............................................... $142,966,532 $168,539,389 ============ ============ </Table> See Notes to Financial Statements 23 Morgan Stanley Balanced Income Fund NOTES TO FINANCIAL STATEMENTS - JULY 31, 2006 (UNAUDITED) 1. Organization and Accounting Policies Morgan Stanley Balanced 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 current income and moderate capital growth. The Fund was organized as a Massachusetts business trust on November 23, 1994 and commenced operations on March 28, 1995. 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 D 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 D shares are not subject to a sales charge. Additionally, Class A shares, Class B shares and Class C shares incur distribution expenses. The Fund will assess a 2% redemption fee, on Class A shares, Class B shares, Class C shares, and Class D shares, which is paid directly to the Fund, for shares redeemed 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) an equity portfolio security listed or traded on the New York Stock Exchange ("NYSE") or American Stock Exchange or other exchange is valued at its latest sale price prior to the time when assets are valued; if there were no sales that day, the security is valued at the mean between the last reported bid and asked price; (2) an equity portfolio security listed or traded on the Nasdaq is valued at the Nasdaq Official Closing Price; if there were no sales that day, the security is valued at the mean between the last reported bid and asked price; (3) all other portfolio securities for which over-the-counter market quotations are readily available are valued at the mean between the last reported bid and asked price. In cases where a security is traded on more than one exchange, the security is valued on the exchange designated as the primary market; (4) for equity securities traded on foreign exchanges, the last reported sale price or the latest bid price may be used if there were no sales on a particular day; (5) listed options are valued at the latest sale price on the exchange on which they are listed unless no sales of such options have taken place that day, in which case they are valued at the mean between their latest bid and asked price; (6) futures are valued at the latest price published by the commodities exchange on which they trade; (7) when market quotations are not readily available including circumstances under which Morgan Stanley Investment Advisors Inc. (the "Investment Adviser") determines that the latest sale 24 Morgan Stanley Balanced Income Fund NOTES TO FINANCIAL STATEMENTS - JULY 31, 2006 (UNAUDITED) continued price, the bid price or the mean between the last reported bid and asked price do not reflect a security's market value, portfolio securities are valued at their fair value as determined in good faith under procedures established by and under the general supervision of the Fund's Trustees. Occasionally, developments affecting the closing prices of securities and other assets may occur between the times at which valuations of such securities are determined (that is, close of the foreign market on which the securities trade) and the close of business on the NYSE. If developments occur during such periods that are expected to materially affect the value of such securities, such valuations may be adjusted to reflect the estimated fair value of such securities as of the close of the NYSE, as determined in good faith by the Fund's Trustees or by the Investment Adviser using a pricing service and/or procedures approved by the Trustees of the Fund; (8) certain portfolio securities may be valued by an outside pricing service approved by the Fund's Trustees; and (9) 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. Dividend income and other distributions are recorded on the ex-dividend date. Discounts are accreted and premiums are amortized over the life of the respective securities. Interest income is accrued daily. C. Repurchase Agreements -- Pursuant to an Exemptive Order issued by the Securities and Exchange Commission, the Fund, along with other affiliated entities managed by the Investment Adviser, may transfer uninvested cash balances into one or more joint repurchase agreement accounts. These balances are invested in one or more repurchase agreements and are collateralized by cash, U.S. Treasury or federal agency obligations. The Fund may also invest directly with institutions in repurchase agreements. The Fund's custodian receives the collateral, which is marked-to-market daily to determine that the value of the collateral does not decrease below the repurchase price plus accrued interest. D. 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. 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 25 Morgan Stanley Balanced Income Fund NOTES TO FINANCIAL STATEMENTS - JULY 31, 2006 (UNAUDITED) continued 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. Options -- When the Fund writes a call or put option, an amount equal to the premium received is included in the Fund's Statement of Assets and Liabilities as a liability which is subsequently marked-to-market to reflect the current market value of the option written. If a written option either expires or the Fund enters into a closing purchase transaction, the Fund realizes a gain or loss without regard to any unrealized gain or loss on the underlying security or currency and the liability related to such option is extinguished. If a written call option is exercised, the Fund realizes a gain or loss from the sale of the underlying security and or currency and the proceeds from such sale are increased by the premium originally received. When the Fund purchases a call or put option, the premium paid is recorded as an investment and is subsequently marked-to-market to reflect the current market value. If a purchased option expires, the Fund will realize a loss to the extent of the premium paid. If the Fund enters into a closing sale transaction, a gain or loss is realized for the difference between the proceeds from the sale and the cost of the option. If a put option is exercised, the cost of the security or currency sold upon exercise will be increased by the premium originally paid. If a call option is exercised, the cost of the security purchased upon exercise will be increased by the premium originally paid. G. Federal Income Tax Policy -- It is the Fund's policy to comply with the requirements of the Internal Revenue Code applicable to regulated investment companies and to distribute substantially all of its taxable income to its shareholders. Accordingly, no federal income tax provision is required. 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. 26 Morgan Stanley Balanced Income Fund NOTES TO FINANCIAL STATEMENTS - JULY 31, 2006 (UNAUDITED) continued 2. Investment Advisory/Administration Agreements Pursuant to an Investment Advisory Agreement, the Fund pays the Investment Adviser an advisory fee, accrued daily and payable monthly, by applying the following annual rates to the net assets of the Fund determined as of the close of each business day: 0.52% to the portion of the daily net assets not exceeding $500 million and 0.495% to the portion of the daily net assets in excess of $500 million. 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. 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; (ii) Class B -- up to 1.0% of the average daily net assets of Class B; and (iii) Class C -- up to 1.0% of the average daily net assets of Class C. 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 such excess amounts totaled $5,774,985 at July 31, 2006. 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 1.0% 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 July 31, 2006, the distribution fee was accrued for Class A shares and Class C shares at the annual rate of 0.25% and 1.0%, respectively. 27 Morgan Stanley Balanced Income Fund NOTES TO FINANCIAL STATEMENTS - JULY 31, 2006 (UNAUDITED) continued The Distributor has informed the Fund that for the six months ended July 31, 2006, it received contingent deferred sales charges from certain redemptions of the Fund's Class B shares and Class C shares of $148,277 and $2,502, respectively and received $9,537 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. 4. Security Transactions and Transactions with Affiliates The cost of purchases and proceeds from sales, maturities and prepayments of portfolio securities, excluding short-term investments, for the six months ended July 31, 2006, aggregated $54,153,032 and $74,085,012, respectively. Included in the aforementioned are purchases and sales, maturities and prepayments of U.S. Government securities of $46,502,161 and $49,001,449, respectively. The Fund had purchases with other Morgan Stanley funds of $24,000. Morgan Stanley Trust, an affiliate of the Investment Adviser, Administrator and Distributor, is the Fund's transfer agent. 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 they receive for serving on the Board of Trustees. Each eligible Trustee generally may elect to have their 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. Purposes of and Risks Relating to Certain Financial Instruments The Fund may purchase and sell interest rate and index futures ("futures contracts") to facilitate trading; increase or decrease Fund's market exposure, seek higher investment returns, or to protect against a decline in the value of the Fund's securities or an increase in prices of securities that may be purchased. For hedging and investment purposes, the Fund may also engage in transactions in listed and over-the-counter options. These future and option 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. Risk may also arise upon entering into these contracts from the potential inability of the counterparties to meet the terms of their contracts. 28 Morgan Stanley Balanced Income Fund NOTES TO FINANCIAL STATEMENTS - JULY 31, 2006 (UNAUDITED) continued 6. Expense Offset The expense offset represents a reduction of the transfer agent fees and expenses for earnings on cash balances maintained by the Fund. 7. Shares of Beneficial Interest Transactions in shares of beneficial interest were as follows: <Table> <Caption> FOR THE SIX FOR THE YEAR MONTHS ENDED ENDED JULY 31, 2006 JANUARY 31, 2006 ------------------------- ------------------------- (unaudited) SHARES AMOUNT SHARES AMOUNT ---------- ------------ ---------- ------------ CLASS A SHARES Sold.............................................. 95,160 $ 1,187,180 264,863 $ 3,475,020 Conversion from Class B........................... 235,472 2,943,127 1,302,350 16,907,628 Reinvestment of dividends and distributions....... 46,915 571,338 105,157 1,336,171 Redeemed.......................................... (353,588) (4,420,005) (514,896) (6,743,161) ---------- ------------ ---------- ------------ Net increase - Class A............................ 23,959 281,640 1,157,474 14,975,658 ---------- ------------ ---------- ------------ CLASS B SHARES Sold.............................................. 146,794 1,834,474 951,941 12,432,158 Conversion to Class A............................. (236,412) (2,943,127) (1,307,463) (16,907,628) Reinvestment of dividends and distributions....... 161,358 1,955,714 483,645 6,120,943 Redeemed.......................................... (1,409,456) (17,555,910) (3,119,370) (40,679,978) ---------- ------------ ---------- ------------ Net decrease - Class B............................ (1,337,716) (16,708,849) (2,991,247) (39,034,505) ---------- ------------ ---------- ------------ CLASS C SHARES Sold.............................................. 62,813 788,917 323,214 4,214,224 Reinvestment of dividends and distributions....... 73,876 896,134 206,479 2,615,217 Redeemed.......................................... (531,023) (6,621,496) (678,101) (8,831,850) ---------- ------------ ---------- ------------ Net decrease - Class C............................ (394,334) (4,936,445) (148,408) (2,002,409) ---------- ------------ ---------- ------------ CLASS D SHARES Sold.............................................. 2,414 30,465 35,650 462,004 Reinvestment of dividends and distributions....... 2,298 27,913 6,628 84,009 Redeemed.......................................... (32,446) (407,977) (87,220) (1,142,141) ---------- ------------ ---------- ------------ Net decrease - Class D............................ (27,734) (349,599) (44,942) (596,128) ---------- ------------ ---------- ------------ Net decrease in Fund.............................. (1,735,825) $(21,713,253) (2,027,123) $(26,657,384) ========== ============ ========== ============ </Table> 8. 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 29 Morgan Stanley Balanced Income Fund NOTES TO FINANCIAL STATEMENTS - JULY 31, 2006 (UNAUDITED) continued 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 January 31, 2006, the Fund had temporary book/tax differences primarily attributable to capital loss deferrals on wash sales and straddles, mark-to-market of open futures contracts and book amortization of premiums on debt securities. 9. Legal Matters The Investment Adviser, certain affiliates of the Investment Adviser, certain officers of such affiliates and certain investment companies advised by the Investment Adviser or its affiliates, including the Fund, are named as defendants in a consolidated class action. This consolidated action also names as defendants certain individual Trustees and Directors of the Morgan Stanley funds. The consolidated amended complaint, filed in the United States District Court Southern District of New York on April 16, 2004, generally alleges that defendants, including the Fund, violated their statutory disclosure obligations and fiduciary duties by failing properly to disclose (i) that the Investment Adviser and certain affiliates of the Investment Adviser allegedly offered economic incentives to brokers and others to recommend the funds advised by the Investment Adviser or its affiliates to investors rather than funds managed by other companies, and (ii) that the funds advised by the Investment Adviser or its affiliates, including the Fund, allegedly paid excessive commissions to brokers in return for their efforts to recommend these funds to investors. The complaint seeks, among other things, unspecified compensatory damages, rescissionary damages, fees and costs. The defendants have moved to dismiss the action. On March 9, 2005, Plaintiffs sought leave to supplement their complaint to assert claims on behalf of other investors, which motion defendants opposed. On April 14, 2006, the Court granted defendants' motion to dismiss in its entirety. Additionally, the Court denied Plaintiff's motion to supplement their complaint. This matter is now concluded. 10. New Accounting Pronouncement In July 2006, the Financial Accounting Standards Board (FASB) issued Interpretation 48, Accounting for Uncertainty in Income Taxes -- an interpretation of FASB Statement 109 (FIN 48). FIN 48 clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position must meet before being recognized in the financial statements. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Fund will adopt FIN 48 during 2007 and the impact to the Fund's financial statements, if any, is currently being assessed. 30 Morgan Stanley Balanced Income Fund NOTES TO FINANCIAL STATEMENTS - JULY 31, 2006 (UNAUDITED) continued 11. Subsequent Event -- Fund Merger On September 18, 2006, the Fund was acquired by Morgan Stanley Balanced Growth Fund ("Balance Growth") based on the respective valuations as of the close of business on September 15, 2006 pursuant to a Plan of Reorganization approved by the shareholders of the fund on August 23, 2006. The acquisition was accomplished by a tax-free exchange of 2,415,880 Class A shares of Balanced Growth at a net asset of $14.52 per share for $35,074,372 Class A shares of the Fund; 4,914,367 Class B shares of Balanced Growth at a net asset value of $14.53 per share for $71,415,649 Class B shares of the Fund; 5,008,116 Class C shares of Balanced Growth at a net asset value of $14.54 per share for $72,798,275 Class C shares of the Fund; and 72,948 Class D shares of Balanced Growth at a net asset value of $14.51 per share for $1,058,382 Class D shares of the Fund. The net assets of Balanced Growth and the Fund immediately before the acquisition were $180,346,678 and $137,644,097, respectively, including unrealized appreciation of $7,514,281 for the Fund. Immediately after the acquisition, the combined net assets of Balanced Growth amounted to $317,990,775. 31 Morgan Stanley Balanced Income Fund FINANCIAL HIGHLIGHTS Selected ratios and per share data for a share of beneficial interest outstanding throughout each period: <Table> <Caption> FOR THE SIX FOR THE YEAR ENDED JANUARY 31, MONTHS ENDED -------------------------------------------------- JULY 31, 2006 2006 2005 2004 2003 2002 ------------- -------- -------- -------- -------- ------ (unaudited) Class A Shares: Selected Per Share Data: Net asset value, beginning of period.................. $12.68 $12.98 $12.66 $11.45 $12.35 $12.42 ------ ------ ------ ------ ------ ------ Income (loss) from investment operations: Net investment income++........................... 0.17 0.33 0.30 0.26 0.33 0.43 Net realized and unrealized gain (loss)........... (0.08) 0.44 0.39 1.28 (0.84) (0.06) ------ ------ ------ ------ ------ ------ Total income (loss) from investment operations........ 0.09 0.77 0.69 1.54 (0.51) 0.37 ------ ------ ------ ------ ------ ------ Less dividends and distributions from: Net investment income............................. (0.17) (0.37) (0.37) (0.33) (0.39) (0.44) Net realized gain................................. (0.24) (0.70) -- -- -- -- ------ ------ ------ ------ ------ ------ Total dividends and distributions..................... (0.41) (1.07) (0.37) (0.33) (0.39) (0.44) ------ ------ ------ ------ ------ ------ Net asset value, end of period........................ $12.36 $12.68 $12.98 $12.66 $11.45 $12.35 ====== ====== ====== ====== ====== ====== Total Return+......................................... 0.76%(1) 6.05% 5.55% 13.65% (4.19)% 3.13% Ratios to Average Net Assets(3): Total expenses (before expense offset)................ 1.39%(2) 1.15% 1.08% 1.09% 1.08% 1.16% Net investment income................................. 2.75%(2) 2.49% 2.39% 2.15% 2.79% 3.44% Supplemental Data: Net assets, end of period, in thousands............... $22,642 $22,918 $8,434 $7,318 $3,125 $2,216 Portfolio turnover rate............................... 36%(1) 78% 89% 174% 173% 99% </Table> - --------------------- <Table> ++ The per share amounts were computed using an average number of shares outstanding during the period. + Does not reflect the deduction of sales charge. Calculated based on the net asset value as of the last business day of the period. (1) Not annualized. (2) Annualized. (3) Reflects overall Fund ratios for investment income and non-class specific expenses. </Table> See Notes to Financial Statements 32 Morgan Stanley Balanced Income Fund FINANCIAL HIGHLIGHTS continued <Table> <Caption> FOR THE SIX FOR THE YEAR ENDED JANUARY 31, MONTHS ENDED ---------------------------------------------------- JULY 31, 2006 2006 2005 2004 2003 2002 ------------- -------- -------- -------- -------- -------- (unaudited) Class B Shares: Selected Per Share Data: Net asset value, beginning of period......... $12.63 $12.93 $12.61 $11.40 $12.31 $12.39 ------ ------ ------ ------ ------ ------ Income (loss) from investment operations: Net investment income++.................. 0.12 0.23 0.20 0.17 0.24 0.34 Net realized and unrealized gain (loss)................................... (0.08) 0.44 0.39 1.28 (0.85) (0.07) ------ ------ ------ ------ ------ ------ Total income (loss) from investment operations.................................. 0.04 0.67 0.59 1.45 (0.61) 0.27 ------ ------ ------ ------ ------ ------ Less dividends and distributions from: Net investment income.................... (0.12) (0.27) (0.27) (0.24) (0.30) (0.35) Net realized gain........................ (0.24) (0.70) -- -- -- -- ------ ------ ------ ------ ------ ------ Total dividends and distributions............ (0.36) (0.97) (0.27) (0.24) (0.30) (0.35) ------ ------ ------ ------ ------ ------ Net asset value, end of period............... $12.31 $12.63 $12.93 $12.61 $11.40 $12.31 ====== ====== ====== ====== ====== ====== Total Return+................................ 0.44%(1) 5.16% 4.83% 12.77% (4.98)% 2.32% Ratios to Average Net Assets(3): Total expenses (before expense offset)....... 2.14%(2) 1.91% 1.84% 1.86% 1.84% 1.91% Net investment income........................ 2.00%(2) 1.73% 1.63% 1.38% 2.03% 2.68% Supplemental Data: Net assets, end of period, in thousands...... $84,887 $103,938 $145,072 $169,135 $135,146 $101,957 Portfolio turnover rate...................... 36%(1) 78% 89% 174% 173% 99% </Table> - --------------------- <Table> ++ The per share amounts were computed using an average number of shares outstanding during the period. + Does not reflect the deduction of sales charge. Calculated based on the net asset value as of the last business day of the period. (1) Not annualized. (2) Annualized. (3) Reflects overall Fund ratios for investment income and non-class specific expenses. </Table> See Notes to Financial Statements 33 Morgan Stanley Balanced Income Fund FINANCIAL HIGHLIGHTS continued <Table> <Caption> FOR THE SIX FOR THE YEAR ENDED JANUARY 31, MONTHS ENDED -------------------------------------------------- JULY 31, 2006 2006 2005 2004 2003 2002 ------------- ---------- ------- ------- ------- ------- (unaudited) Class C Shares: Selected Per Share Data: Net asset value, beginning of period............ $12.65 $12.95 $12.63 $11.42 $12.33 $12.41 ------ ------ ------ ------ ------ ------ Income (loss) from investment operations: Net investment income++..................... 0.12 0.23 0.21 0.17 0.24 0.33 Net realized and unrealized gain (loss)..... (0.08) 0.45 0.38 1.28 (0.85) (0.05) ------ ------ ------ ------ ------ ------ Total income (loss) from investment operations..................................... 0.04 0.68 0.59 1.45 (0.61) 0.28 ------ ------ ------ ------ ------ ------ Less dividends and distributions from: Net investment income....................... (0.12) (0.28) (0.27) (0.24) (0.30) (0.36) Net realized gain........................... (0.24) (0.70) -- -- -- -- ------ ------ ------ ------ ------ ------ Total dividends and distributions............... (0.36) (0.98) (0.27) (0.24) (0.30) (0.36) ------ ------ ------ ------ ------ ------ Net asset value, end of period.................. $12.33 $12.65 $12.95 $12.63 $11.42 $12.33 ====== ====== ====== ====== ====== ====== Total Return+................................... 0.46%(1) 5.25% 4.84% 12.74% (5.00)% 2.32% Ratios to Average Net Assets(3): Total expenses (before expense offset).......... 2.14%(2) 1.89% 1.77% 1.85% 1.84% 1.91% Net investment income........................... 2.00%(2) 1.75% 1.70% 1.39% 2.03% 2.68% Supplemental Data: Net assets, end of period, in thousands......... $34,529 $40,401 $43,308 $43,092 $32,439 $33,321 Portfolio turnover rate......................... 36%(1) 78% 89% 174% 173% 99% </Table> - --------------------- <Table> ++ The per share amounts were computed using an average number of shares outstanding during the period. + Does not reflect the deduction of sales charge. Calculated based on the net asset value as of the last business day of the period. (1) Not annualized. (2) Annualized. (3) Reflects overall Fund ratios for investment income and non-class specific expenses. </Table> See Notes to Financial Statements 34 Morgan Stanley Balanced Income Fund FINANCIAL HIGHLIGHTS continued <Table> <Caption> FOR THE SIX FOR THE YEAR ENDED JANUARY 31, MONTHS ENDED ---------------------------------------------- JULY 31, 2006 2006 2005 2004 2003 2002 ------------- ---------- ------ ------ ------ ------ (unaudited) Class D Shares: Selected Per Share Data: Net asset value, beginning of period.................. $12.65 $12.95 $12.63 $11.42 $12.33 $12.40 ------ ------ ------ ------ ------ ------ Income (loss) from investment operations: Net investment income++........................... 0.19 0.36 0.33 0.29 0.34 0.45 Net realized and unrealized gain (loss)........... (0.09) 0.44 0.39 1.28 (0.83) (0.05) ------ ------ ------ ------ ------ ------ Total income (loss) from investment operations........ 0.10 0.80 0.72 1.57 (0.49) 0.40 ------ ------ ------ ------ ------ ------ Less dividends and distributions from: Net investment income............................. (0.18) (0.40) (0.40) (0.36) (0.42) (0.47) Net realized gain................................. (0.24) (0.70) -- -- -- -- ------ ------ ------ ------ ------ ------ Total dividends and distributions..................... (0.42) (1.10) (0.40) (0.36) (0.42) (0.47) ------ ------ ------ ------ ------ ------ Net asset value, end of period........................ $12.33 $12.65 $12.95 $12.63 $11.42 $12.33 ====== ====== ====== ====== ====== ====== Total Return+......................................... 0.96%(1) 6.24% 5.80% 13.94% (4.04)% 3.37% Ratios to Average Net Assets(3): Total expenses (before expense offset)................ 1.14%(2) 0.91% 0.84% 0.86% 0.84% 0.91% Net investment income................................. 3.00%(2) 2.73% 2.63% 2.38% 3.03% 3.68% Supplemental Data: Net assets, end of period, in thousands............... $909 $1,283 $1,895 $3,034 $1,476 $496 Portfolio turnover rate............................... 36%(1) 78% 89% 174% 173% 99% </Table> - --------------------- <Table> ++ The per share amounts were computed using an average number of shares outstanding during the period. + Calculated based on the net asset value as of the last business day of the period. (1) Not annualized. (2) Annualized. (3) Reflects overall Fund ratios for investment income and non-class specific expenses. </Table> See Notes to Financial Statements 35 TRUSTEES Michael Bozic Charles A. Fiumefreddo Edwin J. Garn Wayne E. Hedien James F. Higgins Dr. Manuel H. Johnson Joseph J. Kearns Michael E. Nugent Fergus Reid OFFICERS Michael E. Nugent Chairman of the Board Ronald E. Robison President and Principal Executive Officer J. David Germany Vice President Dennis F. Shea Vice President Barry Fink 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 INVESTMENT ADVISER Morgan Stanley Investment Advisors Inc. 1221 Avenue of the Americas New York, New York 10020 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. Investments and services offered through Morgan Stanley DW Inc., member SIPC. Morgan Stanley Distributors Inc., member NASD. (c) 2006 Morgan Stanley [MORGAN STANLEY LOGO] MORGAN STANLEY FUNDS Morgan Stanley Balanced Income Fund Semiannual Report July 31, 2006 [MORGAN STANLEY LOGO] BINSAR-38400RPT-RA06-00856P-Y07/06 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. Refer to Item 1. 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 Balanced Income Fund /s/ Ronald E. Robison Ronald E. Robison Principal Executive Officer September 21, 2006 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 September 21, 2006 /s/ Francis Smith Francis Smith Principal Financial Officer September 21, 2006 3