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<TABLE>
<S> <C>
DIRECTORS OFFICERS
Barton M. Biggs James W. Grisham
CHAIRMAN OF THE BOARD VICE PRESIDENT
Chairman and Director, Morgan Stanley Michael F. Klein
Asset Management Inc. and Morgan Stanley VICE PRESIDENT
Asset Management Limited; Managing Harold J. Schaaff,
Director, Morgan Stanley & Co. Jr.
Incorporated; Director, Morgan Stanley VICE PRESIDENT
Group Inc. Joseph P. Stadler
Frederick B. Whittemore VICE PRESIDENT
VICE-CHAIRMAN OF THE BOARD Valerie Y. Lewis
Advisory Director, Morgan Stanley & Co. SECRETARY
Incorporated Karl O. Hartmann
Warren J. Olsen ASSISTANT SECRETARY
DIRECTOR AND PRESIDENT James R. Rooney
Principal, Morgan Stanley Asset TREASURER
Management Inc. and Morgan Stanley & Co. Joanna M. Haigney
Incorporated ASSISTANT TREASURER
John D. Barrett II
Chairman and Director,
Barrett Associates, Inc.
Gerard E. Jones
Partner, Richards & O'Neil LLP
Andrew McNally IV
Chairman and Chief Executive Officer, Rand
McNally
Samuel T. Reeves
Chairman of the Board and CEO, Pinacle
L.L.C.
Fergus Reid
Chairman and Chief Executive Officer,
LumeLite Corporation
Frederick O. Robertshaw
Of Counsel, Bryan, Cave
</TABLE>
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INVESTMENT ADVISER AND ADMINISTRATOR
Morgan Stanley Asset Management Inc.
1221 Avenue of the Americas
New York, New York 10020
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DISTRIBUTOR
Morgan Stanley & Co. Incorporated
1251 Avenue of the Americas
New York, New York 10020
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CUSTODIANS
The Chase Manhattan Bank
770 Broadway
New York, New York 10003
Morgan Stanley Trust Company
One Pierrepont Plaza
Brooklyn, New York 11210
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LEGAL COUNSEL
Morgan, Lewis & Bockius LLP
2000 One Logan Square
Philadelphia, Pennsylvania 19103
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INDEPENDENT ACCOUNTANTS
Price Waterhouse LLP
1177 Avenue of the Americas
New York, New York 10036
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For current performance, current net asset value, or for assistance with your
account, please contact the Fund at (800) 548-7786. This report is authorized
for distribution only when preceded or accompanied by prospectuses of the Morgan
Stanley Institutional Fund, Inc.
[LOGO] MORGAN STANLEY
INSTITUTIONAL FUND, INC.
P.O. Box 2798
Boston, MA 02208-2798
[LOGO] MORGAN STANLEY
INSTITUTIONAL FUND, INC.
FIXED INCOME PORTFOLIO
THIRD QUARTER REPORT
SEPTEMBER 30, 1996
<PAGE>
LETTER TO SHAREHOLDERS
- -------
The Fixed Income Portfolio invests primarily in a diversified portfolio of U.S.
Government securities, corporate bonds (including competitively priced
Eurodollar bonds), mortgage-backed securities and other fixed income securities.
Targeted rates of return for the Portfolio are based on current and projected
market and economic conditions and on a conservative investment management
approach.
For the nine month period ended September 30, 1996, the Portfolio had a total
return of 1.47% for the Class A shares and 1.33% for the Class B shares as
compared to a total return of 0.60% for the Lehman Agregate Bond Index. The
average annual total return for the twelve months and five years ended September
30, 1996 and for the period from inception on May 15, 1991
PERFORMANCE COMPARED TO THE LEHMAN AGGREGATE BOND INDEX(1)
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<TABLE>
<CAPTION>
TOTAL RETURNS(2)
----------------------------------------------
AVERAGE AVERAGE
ANNUAL ANNUAL
ONE FIVE SINCE
YTD YEAR YEARS INCEPTION
--------- ----------- --------- -----------
<S> <C> <C> <C> <C>
PORTFOLIO--CLASS A...... 1.47% 5.97% 7.58% 8.14%
PORTFOLIO--CLASS B(3)... 1.33 N/A N/A N/A
INDEX................... 0.60 4.89 7.46 8.12
</TABLE>
1. The Lehman Aggregate Bond Index is an unmanaged index made up of the
Government/Corporate Index, the Mortgage-Backed Securities Index and the
Asset-Backed Securities Index.
2. Total returns for the Portfolio reflect expenses waived and reimbursed, if
applicable, by the Adviser. Without such waiver and reimbursement, total
returns would be lower.
3. The Portfolio began offering Class B shares on January 2, 1996.
PAST PERFORMANCE IS NOT PREDICTIVE OF FUTURE PERFORMANCE.
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THE PERFORMANCE RESULTS PROVIDED ARE FOR INFORMATIONAL PURPOSES ONLY AND SHOULD
NOT BE CONSTRUED AS A GUARANTEE OF THE PORTFOLIO'S FUTURE PERFORMANCE. PAST
PERFORMANCE SHOWN IS NOT PREDICTIVE OF FUTURE PERFORMANCE. INVESTMENT RETURN AND
PRINCIPAL VALUE WILL FLUCTUATE SO THAT AN INVESTOR'S SHARES, WHEN REDEEMED, MAY
BE WORTH MORE OR LESS THAN THEIR ORIGINAL COST. YIELDS WILL FLUCTUATE AS MARKET
CONDITIONS CHANGE.
through September 30, 1996 was 5.97%, 7.58%, and 8.14% respectively, for the
Class A shares as compared to 4.89%, 7.46% and 8.12%, respectively, for the
Index. As of September 30, 1996, the Portfolio had an SEC 30-day yield of 6.59%
for the Class A shares and 6.44% for the Class B shares.
While bond market returns for the third quarter of 1996 did not approach some of
the stellar quarterly returns seen last year, they did improve noticeably over
those of the first half of 1996. With bond yields finishing the quarter at
basically the same levels at which they began, the Lehman Aggregate Bond Index
returned 1.85% and the Lehman Government Corporate Index returned 1.76% for the
quarter. The quarterly returns were sufficient to move the year-to-date returns
of the Aggregate Index into positive territory, but not sufficient to do the
same for the Government/Corporate Index, where returns remain slightly negative
on a year-to-date basis. For all practical purposes, the positive return for the
quarter occurred entirely during September, as returns over the July/August
period were essentially flat.
Interest rate behavior over the quarter can best be characterized as fluctuating
within a narrow trading range. Rates seldom deviated by more than twenty basis
points from the levels at which they began the quarter and there was little
variation with respect to yield curve shape, as well. This lack of a strong
interest rate trend reflected both a lack of market conviction with respect to
the likely future strength of the economy and a lack of market conviction
regarding the likelihood of a Federal Reserve tightening.
Unlike the first half of the year, in which a consensus developed that the
economy was growing rapidly, the third quarter was characterized by considerable
debate over the strength of the economy. While most investors anticipated some
slowing of growth from the rapid pace of the second quarter, there was far less
agreement as to the timing and magnitude of any slowdown. This timing and
magnitude issue was thought to be key in assessing if, when and by how much the
Federal Reserve
2
<PAGE>
might raise short-term interest rates. Even though there were few signs of
inflationary pressures, market participants generally agreed that without a
slowdown in growth, the Fed would tighten to prevent such pressures from
emerging. With each economic release, market participants tended to reassess
their expectations of a Fed tightening, increasing these expectations and
causing the market to sell off on releases that showed strength in the economy,
while decreasing these expectations and causing the market to rally on releases
that showed weakness. The market reacted in a similar fashion to various
statements made by Federal Reserve officials during the quarter.
In the end, this debate was not resolved over the quarter. While the Federal
Reserve put a tightening bias in place at its July meeting, it chose not to
raise the Federal Funds target rate at its subsequent two meetings. Thus, market
participants were left in the same position entering the fourth quarter as they
had been in entering the third-- seeking more information to help clarify the
strength of the economy and uncertain as to the future course of Fed policy.
From a sector standpoint, the narrow trading range over the quarter tended to
benefit the major non-Treasury sectors, as investors sought to enhance return
through adding yield spread product. Corporate spreads tightened across almost
all sectors, in some cases quite sharply, as credit trends remained favorable
and market technicals extremely strong. On a broad basis, corporate spreads are
now at their tightest levels of the year. Mortgage securities also performed
well over the quarter as the narrow interest rate range reduced the impact of
the prepayment risk usually associated with this sector. Asset-backed securities
likewise outperformed comparable duration Treasuries over the quarter.
Foreign bond markets continued their exceptional performance relative to the
U.S. market. For example, 10-year German yields fell more than 40 basis points
on the quarter, richening by a like amount relative to 10-year Treasuries. As
has been the case all year, other foreign bond markets produced even better
returns, particularly the higher yielding European markets.
REVIEW
Because we have not believed that the interest rate environment has been
conducive to taking interest rate risk, we have maintained a basically neutral
duration position over the last nine months. In our view, sector allocation
presented a better risk/reward tradeoff and we focused on these opportunities
for the portfolio. We held an overweighted position in discount mortgage-backed
securities throughout the year. The combination of yield enhancement, liquidity,
quality and low dollar prices all contributed to the appeal of this sector. As
opportunities arose, we continued to fine-tune the maturity of our mortgage
holdings to position ourselves more favorably within the mortgage sector. Our
corporate weightings remained fairly stable over the last three quarters. While
tight spreads limited opportunities to find attractive new holdings, we were not
anxious to reduce our corporate weighting because we did not expect a reversal
in the fundamental and technical forces that have been driving corporate spreads
tighter. Finally, we continued to see opportunity in hedged foreign bonds. We
capitalized on a period of spread weakness in early August to increase our
holdings of hedged German bonds, before somewhat reducing our weighting as
spreads richened sharply later in the quarter. Despite substantial year-to-date
outperformance, we believe fundamentals continue to favor German over U.S.
bonds.
OUTLOOK
Our Portfolio begins the fourth quarter relatively neutral to its benchmarks
in duration. We do not view the current environment as an attractive one for
taking interest rate risk, given the narrowness of the recent trading range.
Instead, we expect to continue our focus on sector opportunities to add value to
the Portfolio. Currently, our emphasis remains on discount mortgages, which
offer attractive yield spreads relative to
3
<PAGE>
corporate bonds. In past years, corporate bond spreads have shown a tendency to
widen during the fourth quarter. While we do not anticipate that happening this
year, we will be alert for any opportunities to purchase attractively valued
corporate bonds should such a widening occur. Finally, we expect to continue our
use of hedged foreign bonds, given that total return opportunities remain
favorable relative to the U.S. markets
Warren Ackerman, III
PORTFOLIO MANAGER
October 1996
4
<PAGE>
INVESTMENTS (UNAUDITED)
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SEPTEMBER 30, 1996
<TABLE>
<CAPTION>
FACE
AMOUNT VALUE
(000) (000)
- --------------- ---------
<C> <S> <C>
FIXED INCOME SECURITIES (93.7%)
U.S. GOVERNMENT AND AGENCY OBLIGATIONS (60.7%)
U.S. TREASURY BONDS (2.9%)
$ 4,000 8.125%, 8/15/19 $ 4,473
---------
U.S. TREASURY NOTES (24.1%)
17,000 6.25%, 5/31/00 16,926
20,000 7.25%, 8/15/04 20,718
---------
37,644
---------
FEDERAL HOME LOAN MORTGAGE CORPORATION (0.0%)
12 13.00%, 9/01/10 13
---------
FEDERAL NATIONAL MORTGAGE ASSOCIATION (16.9%)
4,747 6.00%, 9/01/10 4,523
5,702 6.00%, 2/01/11 5,434
3,915 7.00%, 3/01/11 3,871
1,672 6.00%, 5/01/11 1,586
2,281 6.00%, 5/01/11 2,163
9,382 6.50%, 4/01/24 8,888
---------
26,465
---------
GOVERNMENT NATIONAL MORTGAGE ASSOCIATION (16.8%)
7,580 6.00%, 2/15/24 6,928
9,042 7.00%, 5/15/24 8,745
7,949 7.00%, 3/15/26 7,651
3,008 7.50%, 5/15/26 2,971
---------
26,295
---------
TOTAL U.S. GOVERNMENT AND AGENCY OBLIGATIONS 94,890
---------
FOREIGN GOVERNMENT AND AGENCY OBLIGATIONS (9.7%)
3,000 United Mexican States 7.688%,
8/06/01 3,004
13,500 Treuhandanstalt 6.75%, 5/13/04 9,340
3,000 Quebec Province (Yankee) 7.50%,
7/15/23 2,875
---------
TOTAL FOREIGN GOVERNMENT AND AGENCY
OBLIGATIONS 15,219
---------
CORPORATE BONDS AND NOTES (17.8%)
BROADCAST-RADIO & TELEVISION (1.5%)
2,500 News America Holdings 7.75%,
12/01/45 2,288
---------
FINANCE (16.3%)
2,000 Capital One Bank 6.47%, 7/31/98 1,990
5,000 Ford Motor Credit Co. 6.25%,
11/08/00 4,888
5,000 General Motors Acceptance Corp.
7.375%, 6/22/00 5,088
5,000 Goldman Sachs Group 6.25%, 2/01/03 4,798
3,215 Lehman Brothers Holdings, Inc.
5.75%, 2/15/98 3,181
3,000 Lehman Brothers Holdings, Inc.
7.25%, 4/15/03 2,975
<CAPTION>
FACE
AMOUNT VALUE
(000) (000)
- --------------- ---------
<C> <S> <C>
$ 2,500 Lumbermens Mutual Casualty Co.,
Series AI, 9.15%, 7/01/26 $ 2,611
---------
25,531
---------
TOTAL CORPORATE BONDS AND NOTES 27,819
---------
ASSET BACKED SECURITIES (5.5%)
14 Federal National Mortgage
Association, REMIC 92-59F,
(Floating Rate), 5.925%, 8/25/06 14
18 ML Asset Backed Corporation,
Series 1993-1, Class A2, 5.125%,
7/15/98 18
3,404 Resolution Trust Corp., Series
1991-M5, Class A, 9.00%, 3/25/17 3,542
5,000 Standard Credit Card Trust 6.75%,
6/07/00 5,033
---------
TOTAL ASSET BACKED SECURITIES 8,607
---------
TOTAL FIXED INCOME SECURITIES (93.7%)
(Cost $146,152) 146,535
---------
SHORT-TERM INVESTMENT (5.1%)
REPURCHASE AGREEMENT (5.1%)
8,005 Goldman Sachs & Co., 5.625%, dated
9/30/96, due 10/01/96, to be
repurchased at $8,006,
collateralized by $8,195 U.S.
Treasury Notes, 6.50%, due
8/15/05, valued at $8,091 (Cost
$8,005) 8,005
---------
TOTAL INVESTMENTS (98.8%) (Cost $154,157) 154,540
---------
OTHER ASSETS AND LIABILITIES (1.2%)
Other Assets 25,080
Liabilities (23,165)
---------
1,915
---------
NET ASSETS (100%) $ 156,455
---------
---------
CLASS A:
NET ASSETS $ 155,065
NET ASSET VALUE, OFFERING AND REDEMPTION
PRICE PER SHARE
Applicable to 14,721,770 outstanding $0.001 par
value shares (authorized 500,000,000 shares) $10.53
---------
---------
CLASS B:
NET ASSETS $1,390
NET ASSET VALUE, OFFERING AND REDEMPTION
PRICE PER SHARE
Applicable to 132,024 outstanding $0.001 par
value shares (authorized 500,000,000 shares) $10.53
---------
---------
</TABLE>
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REMIC -- Real Estate Mortgage Investment Conduit
Floating Rate Security -- Interest rate changes on these instruments are based
on changes in a designated base rate. The rates shown are those in effect on
September 30, 1996.
5
