Item 1: Report to Shareholders| Institutional High Yield Fund | May 31, 2007 |
The views and opinions in this report were current as of May 31, 2007. They are not guarantees of performance or investment results and should not be taken as investment advice. Investment decisions reflect a variety of factors, and the managers reserve the right to change their views about individual stocks, sectors, and the markets at any time. As a result, the views expressed should not be relied upon as a forecast of the fund’s future investment intent. The report is certified under the Sarbanes-Oxley Act, which requires mutual funds and other public companies to affirm that, to the best of their knowledge, the information in their financial reports is fairly and accurately stated in all material respects.
Manager’s Letter
T. Rowe Price Institutional High Yield Fund
Dear Investors
Six months ago, we wrote in our midyear shareholder report, “the past six months may well have been the best overall environment for high-yield bonds that we have seen in two decades.” To our surprise, the high-yield market environment got even better. High-yield bonds were the best-performing domestic fixed-income asset class for the past six-month and one-year periods, and your fund posted solid gains.
PORTFOLIO PERFORMANCE AND
MARKET ENVIRONMENT
The Institutional High Yield Fund generated excellent returns that outperformed its Lipper peer group average and were generally in line with the J.P. Morgan Global High Yield Index for the past six and 12 months. The market environment for investment-grade bonds turned more challenging in the back half of our fiscal year, while the conditions for below investment-grade “junk” bonds improved, largely due to the minimal number of defaults (just three in the high-yield market over the past six months) and tighter spreads (the yield difference between comparable-maturity high-yield bonds and Treasuries). In this environment, the fund’s share price rose $0.25 for the past six months. During that period, the portfolio also earned $0.43 of dividend income, for a 6.72% total return. Our 12.48% return for the past 12 months was $0.39 of appreciation and $0.82 of income.
We do not expect to benefit from additional appreciation in the near term because we believe the high-yield market is already fully valued.
The primary reasons the portfolio performed so well over the past six months were strong credit selection and the scarcity of bonds that declined. The fund’s 20 largest detractors in the second half of the fiscal year cost the fund only six basis points of performance (100 basis points equal 1.00%). Conversely, on top of the ledger, the 20 companies that generated the best contributions added 202 basis points.
Credit Nirvana Revisited
The outperformance of high-yield versus investment-grade bonds this year has been dramatic. Corporate profits and cash flow remained strong, and investors displayed tremendous demand for higher-yielding instruments. Although the economy slowed significantly in the first quarter, it was largely overshadowed by the sense of euphoria surrounding private-equity activity—most of the securities issued in conjunction with recent buyouts have performed well. The average yield across the high-yield market currently is about 7.5%, and almost every new issue with a 9% or higher coupon has rallied out of the gate.
For all these reasons, capital appreciation within the asset class has been abundant, and because there have been virtually no credit problems over the past year, we were able to keep most of the incremental income that is paid to compensate investors for the additional risk of investing in high-yield securities. It seemed that over the past six months, investor demand for additional yield was greater than concern about rising interest rates, tight credit spreads, and the economic outlook. Perhaps the reason for this optimistic view is that investors believe that defaults will remain low for the next six to 12 months. We agree with that sentiment and think the high-yield market environment remains positive overall, even though we are concerned that valuations are stretched, which could lead to a modest correction.
• High-yield bonds were the best-performing domestic fixed-income asset class for the past six and 12 months.
• Investor demand for additional yield was greater than concern about rising interest rates, tight credit spreads, and a slowing economy.
• We were focused on total return but, as the period progressed, we reined in the fund’s risk profile.
• We expect the portfolio to generate more modest returns in the future than we have enjoyed in the recent past.
PORTFOLIO REVIEW
As noted in the Quality Diversification chart, the portfolio is focused on the middle and upper tiers of the junk bond market (69% of assets are invested in BB, BB/B and B rated issues). We were surprised by the outperformance of CCC rated bonds over the past six months. Given that the credit and economic cycles are growing long in the tooth, the strong performance of lower-quality credits, from already lofty levels, was unexpected.
The chart above shows our allocation across the credit spectrum and includes our 3% position in common stock and equity-linked holdings, including convertible preferred, preferred stock, and warrants. In addition, your fund, unlike its benchmark, has holdings in bank loans (approximately 9% of assets on May 31), floating-rate debt (7%), and cash and short-term holdings (6%). At the end of the reporting period, more than at any time in our history, the fund is invested in non-benchmark securities. The reason for this unconventional investment approach is our view that the asset class is fundamentally overvalued. We own correlated assets but we are not exclusively invested in high-yield bonds that make up the benchmark. Over the past six months, this creative management style has worked very well.
Home Runs in Common and Preferred Stock
Our outlook for the performance of common stocks was positive, and we took advantage of equity-linked securities. During the past six months, we increasingly focused on total return such as a huge opportunity in Freeport-McMoRan Copper & Gold. In addition to establishing large positions in its new issue bonds and bank debt, we opportunistically added the common and convertible-preferred stock of the world’s largest publicly traded copper company. While we normally focus on hitting singles and doubles in our investment strategy, Freeport turned out to be a home run. The company was a new position in the fund during the last six months, the portfolio’s best contributor, and our largest holding at the end of the period. (Please refer to our portfolio of investments for a complete listing of holdings and the amount each represents in the portfolio.)
Freeport-McMoRan issued $6 billion of new high-yield bonds and bank loans in the spring (the largest high-yield new issue ever) to complete its merger with Phelps Dodge. It was our largest purchase this year and one of the largest positions we have ever taken in the fund. We invested in the bonds for current income and their appreciation potential, and we liked the floating-rate bank loans for their defensive characteristics. If rates continue to trend higher, the yield on the bank debt will adjust higher, too. We took modest positions in the convertible-preferred stock (which pays a 5.5% dividend) and common stock because our equity analysts were excited about its potential. They believed the prospects for this Phoenix-based company were excellent due to its long-term earnings growth potential, the strong demand for metals in Asia, and the likelihood of higher copper prices. Freeport is an example of how our credit analysts work with our equity analysts when assessing a company’s pro spects. We added 33 basis points of performance with our Freeport position.
Independent power producers NRG Energy and Reliant Energy were among the fund’s best contributors. In both cases we supplemented sizable holdings in bonds and bank debt with common or preferred stock. Among our other large holdings, General Motors, Citizens Communications, and Cablevision Systems were strong contributors due in part to our investments in equity-linked securities. In the case of Cablevision, a long-term position in the fund, we thought it would be acquired in a leveraged buyout (LBO), so we bought the stock at $30. After it announced the LBO two months later, we sold the stock at $35 for a tidy 17% gain. However, we didn’t win on every equity-linked securities trade, and we suffered modest losses on Delta Airlines and XM Satellite Radio.
While our opportunistic approach yielded windfall gains in the early part of the year, we decided to rein in the fund’s risk profile as the period progressed. We reduced our common stock and convertible holdings significantly and added the proceeds to less risky bank loans, which are safer than bonds in a rising rate environment. Our common stock exposure, which was less than 2% at the end of November, ranged as high as 3% over the past six months, but by the end of the period was trimmed back to less than 2%. Similarly, we’ve pared our convertibles. Overall, we thought it was a good time to lock in the profits we’d earned through our strong security selection.
Bank Loans and Floating-Rate Debt: What’s Not to Like?
At the end of the reporting period we held 9% of assets in bank loans, significantly more than our 5% weight six months ago. This is because we see better relative value in the loans than in the bonds for many of our companies. Bank loans typically yield more than BB rated bonds, and their yield adjusts based on changes in the London Interbank Offered Rate (Libor), which, until recently, yielded about a full percentage point more than 10-year Treasuries. Over the past six months, our average BB bond yielded approximately 6.5%, and our average bank loan yielded about 7.5% . However, the clincher for us is that the loans have better covenants and are more senior in the capital structure, which means we are more likely to collect our interest and recover our principal in case of trouble.
We also added to our holdings in floating-rate bonds over the past six months. Floaters now account for about 7% of the portfolio. Bank loans plus floaters currently represent approximately 16% of the fund, which is a significant increase since our midyear report.
In the same time frame, we added our cash position. When the high-yield market spread went below 300 basis points, we felt valuations were simply too expensive. Although nobody rings a bell at market peaks, we began aggressively reducing the portfolio’s risk characteristics in April. The fund has provided a double-digit annualized return for the past five years (10.63% for the five-year period ended May 31, 2007), and while we are elated, we have become more cautious than in a long time.
OUTLOOK
We anticipate the largest wave of buyout activity in the history of our asset class in the coming year. Although we are sure the size of the asset class will grow, we are not sure it is going to get better. Several of the mega deals on the drawing board include Texas Utilities (TXU), the largest regulated utility ever to be taken private; and the buyout of First Data will be even bigger, including around $8 billion in high-yield bonds—the largest high-yield offering ever. Two of the “Big Three” auto manufacturers came into the asset class as fallen angels, and Chrysler, the third, is being sold from Daimler-Benz as an LBO. Sallie Mae, Harrah’s, Station Casinos, Alltel, and Tribune are all going to create a large splash when their high-yield bonds hit the market, and there are lots of smaller offerings in the works.
We don’t know if the volume of new debt will be good for the market, but we are acutely aware that we will need to be cautious about where we invest. If we are not sure about a new issue, we intend to take the conservative approach by owning senior bank loans issued by the company, or we will simply say, “No thanks.” Until now, the vast majority of new issues have performed well, the high-yield market has done a good job of absorbing new supply, and we have made good profits. The danger, we fear, is that the deals are becoming more speculative and highly leveraged.
We are cautious about the high-yield market’s short-term performance. After such a long and strong period of outperformance, investors need to remember that returns of this magnitude are unlikely to be sustained. We recommend that investors take a close look at their allocation to high-yield bonds, and if the position has grown beyond a “normal” portfolio weighting, consider rebalancing into an asset class that is at or below your target allocation. As we have said in previous shareholder letters, we expect the portfolio to generate more modest absolute returns in the future than we have enjoyed in the recent past.
We appreciate your confidence and thank you for investing with T. Rowe Price.
Respectfully submitted,
Mark J. Vaselkiv
Chairman of the fund’s Investment Advisory Committee
June 15, 2007
The committee chairman has day-to-day responsibility for managing the portfolio and works with committee members in developing and executing the fund’s investment program.
Bonds are subject to interest rate risk, the decline in bond prices that usually accompanies a rise in interest rates, and credit risk, the chance that any fund holding could have its credit rating downgraded, or that a bond issuer will default (fail to make timely payments of interest or principal), potentially reducing the fund’s income level and share price. High-yield corporate bonds could have greater price declines than funds that invest primarily in high-quality bonds. Companies issuing high-yield bonds are not as strong financially as those with higher credit ratings, so the bonds are usually considered speculative investments.
Duration: A measure of a bond or bond fund’s sensitivity to changes in interest rates. For example, a fund with a four-year duration would fall about 4% in response to a one-percentage-point rise in interest rates, and vice versa.
Federal funds rate: The interest rate charged on overnight loans of reserves by one financial institution to another in the United States. The Federal Reserve sets a target federal funds rate to affect the direction of interest rates.
J.P. Morgan Global High Yield Index: Tracks the performance of domestic and overseas noninvestment-grade corporate bonds; all are denominated in U.S. dollars.
Lehman Brothers U.S. Aggregate Index: An unmanaged index that tracks domestic investment-grade bonds, including corporate, government, and mortgage-backed securities.
Lipper averages: Consist of all mutual funds in a particular category as tracked by Lipper Inc.
London Interbank Offered Rate (Libor): The interest rate that banks loan money to each other in the London wholesale market, which is also known as the interbank market.
Weighted average maturity: The weighted average of the stated maturity dates of the portfolio’s securities. In general, the longer the average maturity, the greater the fund’s sensitivity to interest rate changes. A shorter average maturity usually means less interest rate sensitivity and therefore a less volatile portfolio.
Portfolio Highlights
Performance and Expenses
T. Rowe Price Institutional High Yield Fund
This chart shows the value of a hypothetical $1 million investment in the fund over the past 10 fiscal year periods or since inception (for funds lacking 10-year records). The result is compared with benchmarks, which may include a broad-based market index and a peer group average or index. Market indexes do not include expenses, which are deducted from fund returns as well as mutual fund averages and indexes.
This table shows how the fund would have performed each year if its actual (or cumulative) returns for the periods shown had been earned at a constant rate.
Fund Expense Example
As a mutual fund shareholder, you may incur two types of costs: (1) transaction costs, such as redemption fees or sales loads, and (2) ongoing costs, including management fees, distribution and service (12b-1) fees, and other fund expenses. The following 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 most recent six-month period and held for the entire period.
Actual Expenses
The first line of the following table (“Actual”) provides information about actual account values and actual expenses. You may use the information in this line, together with your account balance, 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 $1,000 = 8.6), then multiply the result by the number in the first line under the heading “Expenses Paid During Period” to estimate the expenses you paid on your account during this period.
Hypothetical Example for Comparison Purposes
The information on the second line of the table (“Hypothetical”) is based on hypothetical account values and expenses derived from the fund’s actual expense ratio and an assumed 5% per year rate of return before expenses (not the fund’s actual return). You may compare the ongoing costs of investing in the fund with other funds by contrasting this 5% hypothetical example and the 5% hypothetical examples that appear in the shareholder reports of the other funds. The hypothetical account values and expenses may not be used to estimate the actual ending account balance or expenses you paid for the period.
You should also be aware that the expenses shown in the table highlight only your ongoing costs and do not reflect any transaction costs, such as redemption fees or sales loads. Therefore, the second line of the table is useful in comparing ongoing costs only and will not help you determine the relative total costs of owning different funds. To the extent a fund charges transaction costs, however, the total cost of owning that fund is higher.
Financial Highlights
T. Rowe Price Institutional High Yield Fund
The accompanying notes are an integral part of these financial statements.
Portfolio of Investments (†)
T. Rowe Price Institutional High Yield Fund
May 31, 2007
The accompanying notes are an integral part of these financial statements.
Statement of Assets and Liabilities
T. Rowe Price Institutional High Yield Fund
May 31, 2007
(In thousands except shares and per share amounts)
The accompanying notes are an integral part of these financial statements.
Statement of Operations
T. Rowe Price Institutional High Yield Fund
($ 000s)
The accompanying notes are an integral part of these financial statements.
Statement of Changes in Net Assets
T. Rowe Price Institutional High Yield Fund
($ 000s)
The accompanying notes are an integral part of these financial statements.
Notes to Financial Statements
T. Rowe Price Institutional High Yield Fund
May 31, 2007
NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES
T. Rowe Price Institutional Income Funds, Inc. (the corporation), is registered under the Investment Company Act of 1940 (the 1940 Act). The Institutional High Yield Fund (the fund), a diversified, open-end management investment company, is one portfolio established by the corporation. The fund commenced operations on May 31, 2002. The fund seeks high current income and, secondarily, capital appreciation.
The accompanying financial statements were prepared in accordance with accounting principles generally accepted in the United States of America, which require the use of estimates made by fund management. Fund management believes that estimates and security valuations are appropriate; however, actual results may differ from those estimates, and the security valuations reflected in the financial statements may differ from the value the fund ultimately realizes upon sale of the securities.
Valuation The fund values its investments and computes its net asset value per share at the close of the New York Stock Exchange (NYSE), normally 4 p.m. ET, each day that the NYSE is open for business. Debt securities are generally traded in the over-the-counter market. Securities with original maturities of one year or more are valued at prices furnished by dealers who make markets in such securities or by an independent pricing service, which considers yield or price of bonds of comparable quality, coupon, maturity, and type, as well as prices quoted by dealers who make markets in such securities. Securities with original maturities of less than one year are valued at amortized cost in local currency, which approximates fair value when combined with accrued interest.
Equity securities listed or regularly traded on a securities exchange or in the over-the-counter (OTC) market are valued at the last quoted sale price or, for certain markets, the official closing price at the time the valuations are made, except for OTC Bulletin Board securities, which are valued at the mean of the latest bid and asked prices. A security that is listed or traded on more than one exchange is valued at the quotation on the exchange determined to be the primary market for such security. Listed securities not traded on a particular day are valued at the mean of the latest bid and asked prices for domestic securities and the last quoted sale price for international securities.
Investments in mutual funds are valued at the mutual fund’s closing net asset value per share on the day of valuation. Swap agreements are valued at prices furnished by dealers who make markets in such securities.
Other investments, including restricted securities, and those for which the above valuation procedures are inappropriate or are deemed not to reflect fair value are stated at fair value as determined in good faith by the T. Rowe Price Valuation Committee, established by the fund’s Board of Directors.
Most foreign markets close before the close of trading on the NYSE. If the fund determines that developments between the close of a foreign market and the close of the NYSE will, in its judgment, materially affect the value of some or all of its portfolio securities, which in turn will affect the fund’s share price, the fund will adjust the previous closing prices to reflect the fair value of the securities as of the close of the NYSE, as determined in good faith by the T. Rowe Price Valuation Committee, established by the fund’s Board of Directors. A fund may also fair value securities in other situations, such as when a particular foreign market is closed but the fund is open. In deciding whether to make fair value adjustments, the fund reviews a variety of factors, including developments in foreign markets, the performance of U.S. securities markets, and the performance of instruments trading in U.S. markets that represent foreign securities and baskets of foreign securities. The fund uses outside pricing services to provide it with closing market prices and information used for adjusting those prices. The fund cannot predict when and how often it will use closing prices and when it will adjust those prices to reflect fair value. As a means of evaluating its fair value process, the fund routinely compares closing market prices, the next day’s opening prices in the same markets, and adjusted prices.
Currency Translation Assets, including investments, and liabilities denominated in foreign currencies are translated into U.S. dollar values each day at the prevailing exchange rate, using the mean of the bid and asked prices of such currencies against U.S. dollars as quoted by a major bank. Purchases and sales of securities, income, and expenses are translated into U.S. dollars at the prevailing exchange rate on the date of the transaction. The effect of changes in foreign currency exchange rates on realized and unrealized security gains and losses is reflected as a component of security gains and losses.
Redemption Fees A 1% fee is assessed on redemptions of fund shares held for 90 days or less to deter short-term trading and to protect the interests of long-term shareholders. Redemption fees are withheld from proceeds that shareholders receive from the sale or exchange of fund shares. The fees are paid to the fund, and are recorded as an increase to paid-in capital. The fees may cause the redemption price per share to differ from the net asset value per share.
In-Kind Subscriptions Under certain circumstances and when considered in the best interest of the fund, the fund may accept portfolio securities rather than cash as payment for the purchase of fund shares (in-kind subscription). For financial reporting and tax purposes, the cost basis of contributed securities is equal to the market value of the securities on the date of contribution. In-kind subscriptions result in no gain or loss and no tax consequences for the fund. During the year ended May 31, 2007, the fund accepted $93,719,000 of in-kind subscriptions from other T. Rowe Price funds.
Investment Transactions, Investment Income, and Distributions Income and expenses are recorded on the accrual basis. Premiums and discounts on debt securities are amortized for financial reporting purposes. Dividends received from mutual fund investments are reflected as dividend income; capital gain distributions are reflected as realized gain/loss. Dividend income and capital gain distributions are recorded on the ex-dividend date. Investment transactions are accounted for on the trade date. Realized gains and losses are reported on the identified cost basis. Net periodic receipts or payments required by swaps are accrued daily and recorded as realized gain or loss in the accompanying financial statements. Fluctuations in the fair value of swaps are reflected in the change in net unrealized gain or loss and are reclassified to realized gain or loss upon termination prior to maturity. Paydown gains and losses are recorded as an adjustment to interest income. Distributions to shareholders are recorded on the ex-dividend date. Income distributions are declared on a daily basis and paid monthly. Capital gain distributions, if any, are declared and paid by the fund, typically on an annual basis.
”
New Accounting Pronouncements In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes, a clarification of FASB Statement No. 109, Accounting for Income Taxes. FIN 48 establishes financial reporting rules regarding recognition and measurement of tax positions taken or expected to be taken on a tax return. Management is evaluating the anticipated impact, if any, that FIN 48 will have on the fund upon adoption, which, pursuant to a delay granted by the U.S. Securities and Exchange Commission, is expected to be on the last business day of the fund’s semiannual period, November 30, 2007.
In September 2006, the FASB released the Statement of Financial Accounting Standard No. 157 (“FAS 157”), Fair Value Measurements. FAS 157 clarifies the definition of fair value and establishes the framework for measuring fair value, as well as proper disclosure of this methodology in the financial statements. It will be effective for the fund’s fiscal year beginning June 1, 2008. Management is evaluating the effects of FAS 157; however, it is not expected to have a material impact on the fund’s net assets or results of operations.
NOTE 2 - INVESTMENT TRANSACTIONS
Consistent with its investment objective, the fund engages in the following practices to manage exposure to certain risks or to enhance performance. The investment objective, policies, program, and risk factors of the fund are described more fully in the fund’s prospectus and Statement of Additional Information.
Noninvestment-Grade Debt Securities At May 31, 2007, approximately 90% of the fund’s net assets were invested in noninvestment-grade debt securities, commonly referred to as “high-yield” or “junk” bonds. A real or perceived economic downturn or higher interest rates could adversely affect the liquidity or value, or both, of such securities because such events could lessen the ability of issuers to make principal and interest payments.
Restricted Securities The fund may invest in securities that are subject to legal or contractual restrictions on resale. Although certain of these securities may be readily sold, for example, under Rule 144A, others may be illiquid, their sale may involve substantial delays and additional costs, and prompt sale at an acceptable price may be difficult.
Swaps During the year ended May 31, 2007, the fund was a party to credit default swaps under which it buys or sells credit protection against a defined-issuer credit event. Upon a defined-issuer credit event, the fund is required to either deliver the notional amount of the contract in cash and take delivery of the relevant credit or deliver cash approximately equal to the notional amount of the contract less market value of the relevant credit at the time of the credit event. Risks arise from the possible inability of counterparties to meet the terms of their agreements and from changes in creditworthiness of the relevant underlying issuer.
Other Purchases and sales of portfolio securities, other than short-term securities, aggregated $392,521,000 and $260,867,000, respectively, for the year ended May 31, 2007.
NOTE 3 - FEDERAL INCOME TAXES
No provision for federal income taxes is required since the fund intends to continue to qualify as a regulated investment company under Subchapter M of the Internal Revenue Code and distribute to shareholders all of its taxable income and gains. Federal income tax regulations differ from generally accepted accounting principles; therefore, distributions determined in accordance with tax regulations may differ significantly in amount or character from net investment income and realized gains for financial reporting purposes. Financial reporting records are adjusted for permanent book/tax differences to reflect tax character. Financial records are not adjusted for temporary differences.
Distributions during the year ended May 31, 2007, totaled $30,095,000 and were characterized as ordinary income for tax purposes. At May 31, 2007, the tax-basis components of net assets were as follows:
For federal income tax purposes, market discount is recognized as income at the time of sale in the amount of the lesser of gain or scheduled amortization. Accordingly, at May 31, 2007, amortization of $813,000 that has been recognized as income for financial reporting purposes is treated as unrealized appreciation for tax purposes.
For the year ended May 31, 2007, the fund recorded the following permanent reclassifications to reflect tax character. Reclassifications to paid-in capital relate primarily to a tax practice that treats a portion of the proceeds from each redemption of capital shares as a distribution of taxable net investment income and/or realized capital gain. Reclassifications between income and gain relate primarily to differences between book/tax amortization policies. Results of operations and net assets were not affected by these reclassifications.
At May 31, 2007, the cost of investments for federal income tax purposes was $442,860,000.
NOTE 4 - RELATED PARTY TRANSACTIONS
The fund is managed by T. Rowe Price Associates, Inc. (the manager or Price Associates), a wholly owned subsidiary of T. Rowe Price Group, Inc. The investment management and administrative agreement between the fund and the manager provides for an all-inclusive annual fee equal to 0.50% of the fund’s average daily net assets. The fee is computed daily and paid monthly. The agreement provides that investment management, shareholder servicing, transfer agency, accounting, custody services, and directors’ fees and expenses are provided to the fund, and interest, taxes, brokerage commissions, and extraordinary expenses are paid directly by the fund.
The fund may invest in the T. Rowe Price Reserve Investment Fund and the T. Rowe Price Government Reserve Investment Fund (collectively, the T. Rowe Price Reserve Investment Funds), open-end management investment companies managed by Price Associates and affiliates of the fund. The T. Rowe Price Reserve Investment Funds are offered as cash management options to mutual funds, trusts, and other accounts managed by Price Associates and/or its affiliates, and are not available for direct purchase by members of the public. The T. Rowe Price Reserve Investment Funds pay no investment management fees. During the year ended May 31, 2007, dividend income from the T. Rowe Price Reserve Investment Funds totaled $785,000, and the value of shares of the T. Rowe Price Reserve Investment Funds held at May 31, 2007, and May 31, 2006, was $21,135,000 and $5,011,000, respectively.
Mutual funds and other accounts managed by T. Rowe Price and its affiliates may invest in the fund; however, no T. Rowe Price fund may invest for the purpose of exercising management or control over the fund. At May 31, 2007, approximately 46% of the fund’s outstanding shares were held by T. Rowe Price funds.
Report of Independent Registered Public Accounting Firm
To the Board of Directors of T. Rowe Price Institutional Income Funds, Inc. and
Shareholders of T. Rowe Price Institutional High Yield Fund
In our opinion, the accompanying statement of assets and liabilities, including the portfolio of investments, and the related statements of operations and of changes in net assets and the financial highlights present fairly, in all material respects, the financial position of T. Rowe Price Institutional High Yield Fund (one of the portfolios comprising T. Rowe Price Institutional Income Funds, Inc., hereafter referred to as the “Fund”) at May 31, 2007, the results of its operations for the year then ended, the changes in its net assets for each of the two years in the period then ended and the financial highlights for each of the five years in the period then ended, in conformity with accounting principles generally accepted in the United States of America. These financial statements and financial highlights (hereafter referred to as “financial statements”) are the responsibility of the Fund’s management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these financial statements in accordance with the auditing standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits, which included confirmation of securities at May 31, 2007 by correspondence with the custodian and brokers, and by agreement to the underlying ownership records for T. Rowe Price Reserve Investment Fund, provide a reasonable basis for our opinion.
PricewaterhouseCoopers LLP
Baltimore, Maryland
July 12, 2007
| Tax Information (Unaudited) for the Tax Year Ended 5/31/07 |
We are providing this information as required by the Internal Revenue Code. The amounts shown may differ from those elsewhere in this report because of differences between tax and financial reporting requirements.
The fund’s distributions to shareholders included:
• $13,000 from short-term capital gains,
• $1,000 from long-term capital gains, which were subject to the 15% rate gains category.
For taxable non-corporate shareholders, $473,000 of the fund’s income represents qualified dividend income subject to the 15% rate category.
For corporate shareholders, $454,000 of the fund’s income qualifies for the dividends-received deduction.
| Information on Proxy Voting Policies, Procedures, and Records |
A description of the policies and procedures used by T. Rowe Price funds and portfolios to determine how to vote proxies relating to portfolio securities is available in each fund’s Statement of Additional Information, which you may request by calling 1-800-225-5132 or by accessing the SEC’s Web site, www.sec.gov. The description of our proxy voting policies and procedures is also available on our Web site, www.troweprice.com. To access it, click on the words “Company Info” at the top of our homepage for individual investors. Then, in the window that appears, click on the “Proxy Voting Policy” navigation button in the top left corner.
Each fund’s most recent annual proxy voting record is available on our Web site and through the SEC’s Web site. To access it through our Web site, follow the directions above, then click on the words “Proxy Voting Record” at the bottom of the Proxy Voting Policy page.
| How to Obtain Quarterly Portfolio Holdings |
The fund files a complete schedule of portfolio holdings with the Securities and Exchange Commission for the first and third quarters of each fiscal year on Form N-Q. The fund’s Form N-Q is available electronically on the SEC’s Web site (www.sec.gov); hard copies may be reviewed and copied at the SEC’s Public Reference Room, 450 Fifth St. N.W., Washington, DC 20549. For more information on the Public Reference Room, call 1-800-SEC-0330.
| Approval of Investment Management Agreement |
On March 7, 2007, the fund’s Board of Directors (Board) unanimously approved the investment advisory contract (Contract) between the fund and its investment manager, T. Rowe Price Associates, Inc. (Manager). The Board considered a variety of factors in connection with its review of the Contract, also taking into account information provided by the Manager during the course of the year, as discussed below:
Services Provided by the Manager
The Board considered the nature, quality, and extent of the services provided to the fund by the Manager. These services included, but were not limited to, management of the fund’s portfolio and a variety of related activities, as well as financial and administrative services, reporting, and communications. The Board also reviewed the background and experience of the Manager’s senior management team and investment personnel involved in the management of the fund. The Board concluded that it was satisfied with the nature, quality, and extent of the services provided by the Manager.
Investment Performance of the Fund
The Board reviewed the fund’s average annual total return over the one- and three-year periods as well as the fund’s year-by-year returns and compared these returns with a wide variety of previously agreed upon comparable performance measures and market data, including those supplied by Lipper and Morningstar, which are independent providers of mutual fund data. On the basis of this evaluation and the Board’s ongoing review of investment results, the Board concluded that the fund’s performance was satisfactory.
Costs, Benefits, Profits, and Economies of Scale
The Board reviewed detailed information regarding the revenues received by the Manager under the Contract and other benefits that the Manager (and its affiliates) may have realized from its relationship with the fund, including research received under “soft dollar” agreements. The Board noted that soft dollars were not used to pay for third-party, non-broker research. The Board also received information on the estimated costs incurred and profits realized by the Manager and its affiliates from advising T. Rowe Price mutual funds, as well as estimates of the gross profits realized from managing the fund in particular. The Board concluded that the Manager’s profits were reasonable in light of the services provided to the fund. The Board also considered whether the fund or other funds benefit under the fee levels set forth in the Contract from any economies of scale realized by the Manager. The Board noted that, under the Contract, the fund pays the Manager a single fee based on the fund’s net assets and the Manager, in turn, pays all expenses of the fund, with certain exceptions. The Board concluded that, based on the profitability data it reviewed and consistent with this single fee structure, the Contract provided for a reasonable sharing of any benefits from economies of scale with the fund.
Fees
The Board reviewed the fund’s single fee structure and compared the rate with fees and expenses of other comparable funds based on information and data supplied by Lipper. The information provided to the Board showed that the fund’s single fee rate was below the median management fee rate and expense ratio for comparable funds. The Board also reviewed the fee schedules for comparable privately managed accounts of the Manager and its affiliates. Management informed the Board that the Manager’s responsibilities for privately managed accounts are more limited than its responsibilities for the fund and other T. Rowe Price mutual funds that it or its affiliates advise. On the basis of the information provided, the Board concluded that the fees paid by the fund under the Contract were reasonable.
Approval of the Contract
As noted, the Board approved the continuation of the Contract. No single factor was considered in isolation or to be determinative to the decision. Rather, the Board concluded, in light of a weighting and balancing of all factors considered, that it was in the best interests of the fund to approve the continuation of the Contract, including the fees to be charged for services thereunder.
| About the Fund’s Directors and Officers |
Your fund is governed by a Board of Directors (Board) that meets regularly to review a wide variety of matters affecting the fund, including performance, investment programs, compliance matters, advisory fees and expenses, service providers, and other business affairs. The Board elects the fund’s officers, who are listed in the final table. At least 75% of Board members are independent of T. Rowe Price Associates, Inc. (T. Rowe Price), and T. Rowe Price International, Inc. (T. Rowe Price International); “inside” or “interested” directors are employees or officers of T. Rowe Price. The business address of each director and officer is 100 East Pratt Street, Baltimore, Maryland 21202. The Statement of Additional Information includes additional information about the fund directors and is available without charge by calling a T. Rowe Price representative at 1-800-225-5132.
| Independent Directors | |
| |
| |
| |
| Name (Year of Birth) | |
| Year Elected* | Principal Occupation(s) During Past 5 Years and Directorships of Other Public Companies |
| |
| Jeremiah E. Casey (1940) | Director, National Life Insurance (2001 to 2005); Director, The Rouse Company, real estate developers (1990 to |
| 2006 | 2004); Director, Allfirst Financial Inc. (previously First Maryland Bancorp) (1983 to 2002) |
| |
| Anthony W. Deering (1945) | Chairman, Exeter Capital, LLC, a private investment firm (2004 to present); Director, Vornado Real Estate Investment |
| 2002 | Trust (3/04 to present); Director, Mercantile Bankshares (4/03 to present); Member, Advisory Board, Deutsche Bank |
| | North America (2004 to present); Director, Chairman of the Board, and Chief Executive Officer, The Rouse Company, |
| | real estate developers (1997 to 2004) |
| |
| Donald W. Dick, Jr. (1943) | Principal, EuroCapital Advisors, LLC, an acquisition and management advisory firm; Chairman, The Haven Group, a |
| 2002 | custom manufacturer of modular homes (1/04 to present) |
| |
| David K. Fagin (1938) | Chairman and President, Nye Corporation (6/88 to present); Director, Canyon Resources Corp. (5/00 to present); |
| 2002 | Director, Golden Star Resources Ltd. (5/92 to present); Director, Pacific Rim Mining Corp. (2/02 to present) |
| |
| Karen N. Horn (1943) | Director, Federal National Mortgage Association (9/06 to present); Managing Director and President, Global Private |
| 2003 | Client Services, Marsh Inc. (1999 to 2003); Managing Director and Head of International Private Banking, Bankers |
| | Trust (1996 to 1999); Director, Georgia Pacific (5/04 to 12/05), Eli Lilly and Company, and Simon Property Group |
| |
| Theo C. Rodgers (1941) | President, A&R Development Corporation (1977 to present) |
| 2005 | |
| |
| John G. Schreiber (1946) | Owner/President, Centaur Capital Partners, Inc., a real estate investment company; Partner, Blackstone Real Estate |
| 2002 | Advisors, L.P. |
| |
| *Each independent director oversees 119 T. Rowe Price portfolios and serves until retirement, resignation, or election of a successor. |
| Inside Directors | |
| |
| Name (Year of Birth) | |
| Year Elected* [Number of | |
| T. Rowe Price Portfolios | |
| Overseen] | Principal Occupation(s) During Past 5 Years and Directorships of Other Public Companies |
| |
| Edward C. Bernard (1956) | Director and Vice President, T. Rowe Price; Vice Chairman of the Board, Director, and Vice President, T. Rowe Price |
| 2006 [119] | Group, Inc.; Chairman of the Board, Director, and President, T. Rowe Price Investment Services, Inc., and T. Rowe |
| | Price Retirement Plan Services, Inc.; Chairman of the Board and Director, T. Rowe Price Services, Inc., T. Rowe Price |
| | Savings Bank, T. Rowe Price Global Asset Management Limited, and T. Rowe Price Global Investment Services Limited; |
| | Director, T. Rowe Price International, Inc.; Chief Executive Officer, Chairman of the Board, Director, and President, |
| | T. Rowe Price Trust Company; Chairman of the Board, all funds |
| |
| Mary J. Miller, CFA (1955) | Director, T. Rowe Price Trust Company; Director and Vice President, T. Rowe Price; Vice President, T. Rowe Price |
| 2004 [37] | Group, Inc.; President, Institutional Income Funds |
| |
| *Each inside director serves until retirement, resignation, or election of a successor. |
| Officers | |
| |
| Name (Date of Birth) | |
| Title and Fund(s) Served | Principal Occupation(s) |
| |
| Connice A. Bavely, CFA (1951) | Vice President, T. Rowe Price and T. Rowe Price Group, Inc. |
| Vice President, Institutional Income Funds | |
| |
| David C. Beers, CFA (1970) | Assistant Vice President, T. Rowe Price; formerly, High Yield Analyst, |
| Assistant Vice President, Institutional Income Funds | Chartwell Investment Partners and Business Analyst/Software Developer, |
| | Morgan Stanley Investment Management (to 2004) |
| |
| Brian J. Brennan, CFA (1964) | Vice President, T. Rowe Price, T. Rowe Price Group, Inc., and T. Rowe Price |
| Executive Vice President, Institutional Income Funds | Trust Company |
| |
| Andrew M. Brooks (1956) | Vice President, T. Rowe Price and T. Rowe Price Group, Inc. |
| Vice President, Institutional Income Funds | |
| |
| Joseph A. Carrier, CPA (1960) | Vice President, T. Rowe Price, T. Rowe Price Group, Inc., T. Rowe Price |
| Treasurer, Institutional Income Funds | Investment Services, Inc., and T. Rowe Price Trust Company |
| |
| Michael J. Conelius, CFA (1964) | Vice President, T. Rowe Price, T. Rowe Price Group, Inc., and T. Rowe Price |
| Vice President, Institutional Income Funds | International, Inc. |
| |
| Roger L. Fiery III, CPA (1959) | Vice President, T. Rowe Price, T. Rowe Price Group, Inc., T. Rowe Price |
| Vice President, Institutional Income Funds | International, Inc., and T. Rowe Price Trust Company |
| |
| Justin T. Gerbereux, CFA (1975) | Vice President, T. Rowe Price; formerly student, Mary Washington College |
| Assistant Vice President, Institutional Income Funds | and Darden School of Business Administration, University of Virginia (to |
| | 2003); Equity Research Intern, Mellon Growth Advisors, LLC (to 2002) |
| |
| John R. Gilner (1961) | Chief Compliance Officer and Vice President, T. Rowe Price; Vice President, |
| Chief Compliance Officer, Institutional Income Funds | T. Rowe Price Group, Inc., and T. Rowe Price Investment Services, Inc. |
| |
| |
| Gregory S. Golczewski (1966) | Vice President, T. Rowe Price and T. Rowe Price Trust Company |
| Vice President, Institutional Income Funds | |
| Henry H. Hopkins (1942) | Director and Vice President, T. Rowe Price Investment Services, Inc., |
| Vice President, Institutional Income Funds | T. Rowe Price Services, Inc., and T. Rowe Price Trust Company; Vice |
| | President, T. Rowe Price, T. Rowe Price Group, Inc., T. Rowe Price |
| | International, Inc., and T. Rowe Price Retirement Plan Services, Inc. |
| |
| Paul A. Karpers, CFA (1967) | Vice President, T. Rowe Price and T. Rowe Price Group, Inc. |
| Vice President, Institutional Income Funds | |
| |
| Ian D. Kelson (1956) | Vice President, T. Rowe Price, T. Rowe Price Group, Inc., and T. Rowe Price |
| Vice President, Institutional Income Funds | International, Inc. |
| |
| Patricia B. Lippert (1953) | Assistant Vice President, T. Rowe Price and T. Rowe Price Investment |
| Secretary, Institutional Income Funds | Services, Inc. |
| |
| Kevin P. Loome, CFA (1967) | Vice President, T. Rowe Price and T. Rowe Price Group, Inc. |
| Vice President, Institutional Income Funds | |
| |
| Paul M. Massaro, CFA (1975) | Vice President, T. Rowe Price; formerly student, The Wharton Business |
| Assistant Vice President, Institutional Income Funds | School, University of Pennsylvania (to 2003); Equity Research Employee, |
| | Banc of America Securities and J.P. Morgan Chase (to 2002) |
| |
| Michael J. McGonigle (1966) | Vice President, T. Rowe Price and T. Rowe Price Group, Inc. |
| Vice President, Institutional Income Funds | |
| |
| Brian A. Rubin, CPA (1974) | Assistant Vice President, T. Rowe Price |
| Assistant Vice President, Institutional Income Funds | |
| |
| Daniel O. Shackelford, CFA (1958) | Vice President, T. Rowe Price, T. Rowe Price Group, Inc., and T. Rowe Price |
| Vice President, Institutional Income Funds | Trust Company |
| |
| Walter P. Stuart III, CFA (1960) | Vice President, T. Rowe Price and T. Rowe Price Group, Inc. |
| Vice President, Institutional Income Funds | |
| |
| Thomas E. Tewksbury (1961) | Vice President, T. Rowe Price and T. Rowe Price Group, Inc. |
| Vice President, Institutional Income Funds | |
| |
| David A. Tiberii, CFA (1965) | Vice President, T. Rowe Price and T. Rowe Price Group, Inc. |
| Vice President, Institutional Income Funds | |
| |
| Mark J. Vaselkiv (1958) | Vice President, T. Rowe Price and T. Rowe Price Group, Inc. |
| Executive Vice President, Institutional Income Funds | |
| |
| Julie L. Waples (1970) | Vice President, T. Rowe Price |
| Vice President, Institutional Income Funds | |
| |
| Thea N. Williams (1961) | Vice President, T. Rowe Price and T. Rowe Price Group, Inc. |
| Vice President, Institutional Income Funds | |
| |
| Unless otherwise noted, officers have been employees of T. Rowe Price or T. Rowe Price International for at least five years. |
Item 2. Code of Ethics.
The registrant has adopted a code of ethics, as defined in Item 2 of Form N-CSR, applicable to its principal executive officer, principal financial officer, principal accounting officer or controller, or persons performing similar functions. A copy of this code of ethics is filed as an exhibit to this Form N-CSR. No substantive amendments were approved or waivers were granted to this code of ethics during the period covered by this report.
Item 3. Audit Committee Financial Expert.
The registrant’s Board of Directors/Trustees has determined that Mr. Donald W. Dick Jr. qualifies as an audit committee financial expert, as defined in Item 3 of Form N-CSR. Mr. Dick is considered independent for purposes of Item 3 of Form N-CSR.
Item 4. Principal Accountant Fees and Services.
(a) – (d) Aggregate fees billed to the registrant for the last two fiscal years for professional services rendered by the registrant’s principal accountant were as follows:
Audit fees include amounts related to the audit of the registrant’s annual financial statements and services normally provided by the accountant in connection with statutory and regulatory filings. Audit-related fees include amounts reasonably related to the performance of the audit of the registrant’s financial statements and specifically include the issuance of a report on internal controls and, if applicable, agreed-upon procedures related to fund acquisitions. Tax fees include amounts related to services for tax compliance, tax planning, and tax advice. The nature of these services specifically includes the review of distribution calculations and the preparation of Federal, state, and excise tax returns. All other fees include the registrant’s pro-rata share of amounts for agreed-upon procedures in conjunction with service contract approvals by the registrant’s Board of Directors/Trustees.
(e)(1) The registrant’s audit committee has adopted a policy whereby audit and non-audit services performed by the registrant’s principal accountant for the registrant, its investment adviser, and any entity controlling, controlled by, or under common control with the investment adviser that provides ongoing services to the registrant require pre-approval in advance at regularly scheduled audit committee meetings. If such a service is required between regularly scheduled audit committee meetings, pre-approval may be authorized by one audit committee member with ratification at the next scheduled audit committee meeting. Waiver of pre-approval for audit or non-audit services requiring fees of a de minimis amount is not permitted.
(2) No services included in (b) – (d) above were approved pursuant to paragraph (c)(7)(i)(C) of Rule 2-01 of Regulation S-X.
(f) Less than 50 percent of the hours expended on the principal accountant’s engagement to audit the registrant’s financial statements for the most recent fiscal year were attributed to work performed by persons other than the principal accountant’s full-time, permanent employees.
(g) The aggregate fees billed for the most recent fiscal year and the preceding fiscal year by the registrant’s principal accountant for non-audit services rendered to the registrant, its investment adviser, and any entity controlling, controlled by, or under common control with the investment adviser that provides ongoing services to the registrant were $1,201,000 and $883,000, respectively, and were less than the aggregate fees billed for those same periods by the registrant’s principal accountant for audit services rendered to the T. Rowe Price Funds.
(h) All non-audit services rendered in (g) above were pre-approved by the registrant’s audit committee. Accordingly, these services were considered by the registrant’s audit committee in maintaining the principal accountant’s independence.
Item 5. Audit Committee of Listed Registrants.
Not applicable.
Item 6. Schedule of Investments.
Not applicable. The complete schedule of investments is included in Item 1 of this Form N-CSR.
Item 7. Disclosure of Proxy Voting Policies and Procedures for Closed-End Management Investment Companies.
Not applicable.
Item 8. Portfolio Managers of Closed-End Management Investment Companies.
Not applicable.
Item 9. Purchases of Equity Securities by Closed-End Management Investment Company and Affiliated Purchasers.
Not applicable.
Item 10. Submission of Matters to a Vote of Security Holders.
Not applicable.
Item 11. Controls and Procedures.
(a) The registrant’s principal executive officer and principal financial officer have evaluated the registrant’s disclosure controls and procedures within 90 days of this filing and have concluded that the registrant’s disclosure controls and procedures were effective, as of that date, in ensuring that information required to be disclosed by the registrant in this Form N-CSR was recorded, processed, summarized, and reported timely.
(b) The registrant’s principal executive officer and principal financial officer are aware of no change in the registrant’s internal control over financial reporting that occurred during the registrant’s second fiscal quarter 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)(1) The registrant’s code of ethics pursuant to Item 2 of Form N-CSR is attached.
(2) Separate certifications by the registrant's principal executive officer and principal financial officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 and required by Rule 30a-2(a) under the Investment Company Act of 1940, are attached.
(3) Written solicitation to repurchase securities issued by closed-end companies: not applicable.
(b) A certification by the registrant's principal executive officer and principal financial officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and required by Rule 30a-2(b) under the Investment Company Act of 1940, is attached.
| | |
| | |
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. |
| |
| T. Rowe Price Institutional Income Funds, Inc. |
| |
| |
| By | /s/ Edward C. Bernard |
| | Edward C. Bernard |
| | Principal Executive Officer |
| |
| Date | July 23, 2007 |
| |
| |
| | Pursuant to the requirements of the Securities Exchange Act of 1934 and the Investment |
| Company Act of 1940, this report has been signed below by the following persons on behalf of |
| the registrant and in the capacities and on the dates indicated. |
| |
| |
| By | /s/ Edward C. Bernard |
| | Edward C. Bernard |
| | Principal Executive Officer |
| |
| Date | July 23, 2007 |
| |
| |
| |
| By | /s/ Joseph A. Carrier |
| | Joseph A. Carrier |
| | Principal Financial Officer |
| |
| Date | July 23, 2007 |
