UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM N-CSRS
CERTIFIED SHAREHOLDER REPORT OF REGISTERED MANAGEMENT INVESTMENT
COMPANIES
Investment Company Act file number 811-4077
Name of Fund: Merrill Lynch U.S. Government Mortgage Fund
Fund Address: P.O. Box 9011
Princeton, NJ 08543-9011
Name and address of agent for service: Terry K. Glenn, President,
Merrill Lynch U.S. Government Mortgage Fund, 800 Scudders Mill Road,
Plainsboro, NJ, 08536. Mailing address: P.O. Box 9011, Princeton,
NJ, 08543-9011
Registrant's telephone number, including area code: (609) 282-2800
Date of fiscal year end: 08/31/04
Date of reporting period: 09/01/03 - 02/29/04
Item 1 - Report to Stockholders
(BULL LOGO)
Merrill Lynch Investment Managers
www.mlim.ml.com
Merrill Lynch
U.S. Government
Mortgage Fund
Semi-Annual Report
February 29, 2004
This report is not authorized for use as an offer of sale or a
solicitation of an offer to buy shares of the Fund unless
accompanied or preceded by the Fund's current prospectus. Past
performance results shown in this report should not be considered a
representation of future performance. Investment return and
principal value of shares will fluctuate so that shares, when
redeemed, may be worth more or less than their original cost.
Statements and other information herein are as dated and are subject
to change.
A description of the policies and procedures that the Fund uses to
determine how to vote proxies relating to portfolio securities is
available (1) without charge, upon request, by calling toll-free
1-800-MER-FUND (1-800-637-3863); (2) on www.mutualfunds.ml.com; and
(3) on the Securities and Exchange Commission's website at
http://www.sec.gov.
Merrill Lynch U.S. Government Mortgage Fund
Box 9011
Princeton, NJ
08543-9011
A Letter From the President
Dear Shareholder
As I write to you at February month-end, fixed income markets in the
United States continued to reward those investors willing to accept
greater risk. The high yield market, as measured by the Credit
Suisse First Boston High Yield Index, provided a return of +10.88%
over the past six months and +25.17% for the 12-month period ended
February 29, 2004. In other areas of fixed income, investment grade
corporate bonds, as measured by the Merrill Lynch Corporate Master
Index, returned +6.59% and +8.11% for the six-month and 12-month
periods ended February 29, 2004, respectively. U.S. Treasury issues,
as measured by the Merrill Lynch U.S. Treasuries 1-10 Years Index,
returned +3.16% and +2.73% for the six-month and 12-month periods
ended February 29, 2004, respectively.
At the same time, equity markets maintained their positive momentum
from year-end 2003. For the six-month and 12-month periods ended
February 29, 2004, the Standard & Poor's (S&P) 500 Index returned
+14.59% and +38.52%, respectively. Much of the boost came from
improving economic conditions in the United States.
The major signposts indicate that we are seeing a shift from
economic growth fueled primarily by fiscal and monetary stimulus to
a broader-based, self-sustaining economic expansion. Gross domestic
product growth, which peaked at an annualized rate of 8.2% in the
third quarter of 2003, was 4.1% in the fourth quarter. A similar
level of growth is expected in the first quarter of 2004. For its
part, the Federal Reserve Board has reiterated its willingness to
keep short-term interest rates at current low levels to ensure the
economy's strength.
Accompanying the increase in economic activity was an improvement
in corporate earnings. By February 10, 2004, 392 of the S&P 500
companies had reported their fourth-quarter 2003 results, and
67.6% of those exceeded expectations. In the meantime, the American
consumer, who continued to spend despite the faltering economy, may
get further incentive from another round of Federal tax refunds this
year.
At Merrill Lynch Investment Managers, we believe the events and
efforts of 2003 leave us with a much stronger economy and that
recent optimism suggests it is time for investors to consider what
can go right in 2004. We encourage you to revisit your portfolio and
your asset allocation strategy to ensure you are well positioned to
take advantage of the opportunities that lie ahead.
We thank you for trusting Merrill Lynch Investment Managers with
your investment assets, and we look forward to serving you in the
months and years ahead.
Sincerely,
(Terry K. Glenn)
Terry K. Glenn
President and Trustee
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
We are pleased to present to you the management team of
Merrill Lynch U.S. Government Mortgage Fund
Senior Portfolio Manager Frank Viola joined Merrill Lynch Investment
Managers in 1997 and heads the Merrill Lynch U.S. Government
Mortgage Fund team. Mr. Viola received a bachelor's degree from The
Pennsylvania State University and is a CFA R charterholder. He is
also an associate of the Society of Actuaries and a member of the
American Academy of Actuaries. In addition to Mr. Viola, the
investment team includes Co-Portfolio Manager Teresa Giacino,
Jeffrey Hewson, Ted Magnani and Tom Musmanno. Ms. Giacino earned a
bachelor's degree from Rider University. Mr. Hewson received a
bachelor's degree and an MBA from Rutgers University. Mr. Magnani
has a bachelor's degree from Rutgers University. Mr. Musmanno
received a bachelor's degree from Siena College and an MBA from St.
John's University. He is a CFA charterholder and a member of the
Association for Investment Management and Research and the New York
Society of Security Analysts. The team has a combined 81 years of
investment experience.
Frank Viola
Senior Portfolio Manager
Table of Contents
A Letter From the President 2
A Discussion With Your Fund's Portfolio Managers 4
Performance Data 6
Schedule of Investments 9
Financial Statements 13
Financial Highlights 16
Notes to Financial Statements 21
Officers and Trustees 27
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
A Discussion With Your Fund's Portfolio Managers
We ended the period with an overweight position in mortgage-backed
securities and a conservative duration slightly shorter than that of
the Fund's benchmark.
How did the Fund perform during the period in light of the existing
market conditions?
For the six-month period ended February 29, 2004, the Fund's Class
A, Class B, Class C, Class I and Class R Shares had total returns of
+3.70%, +3.44%, +3.41%, +3.83% and +3.65%, respectively. (Fund
results shown do not reflect sales charges and would be lower if
sales charges were included. Complete performance information can be
found on pages 6 - 8 of this report to shareholders.) For the same
period, the unmanaged benchmark Citigroup Mortgage Index returned
+4.20% and the Lipper U.S. Mortgage Funds category posted an average
return of +3.68%. (Funds in this Lipper category invest primarily in
mortgages/securities issued or guaranteed as to principal and
interest by the U.S. government and certain Federal agencies.)
In July 2003, the ten-year Treasury note yield, a benchmark for
mortgage-backed securities (MBS) had moved higher from historic lows
reached in June 2003. This caused a moderation in the high levels of
mortgage-refinancing activity that characterized the prior period.
Although Treasury yields generally fell during this period,
volatility was more subdued than in the prior six months. This,
coupled with slowdowns in refinancing, compressed MBS spreads.
Nevertheless, the period saw an acceleration in economic growth.
Gross domestic product grew at an annualized rate of 8.2% in the
third quarter of 2003 and was 4.1% in the fourth quarter. The
improving economy fueled expectations for rising interest rates.
Despite the apparent strength, weak job creation continued to be a
drag on economic sentiment, providing further justification for some
to question the sustainability of the economic recovery. So, despite
the continued positive economic news and significant appreciation of
equity securities during the period, Treasury yields managed to end
the period lower than they started. Yields on two-year, five-year
and ten-year Treasury issues were respectively 33 (.33%), 53 (.53%)
and 49 basis points (.49%) lower at February 29, 2004 than on
September 1, 2003.
For its part, the Federal Reserve Board maintained its accommodative
monetary policy for the duration of the period, keeping the Federal
Funds rate at 1%. We expect short-term interest rates to remain at
this level for some time, as weak employment growth and scant signs
of inflation could keep the Federal Reserve Board from raising the
target rate until late in the year.
The portfolio ended the period with a duration slightly shorter than
that of its benchmark. This positioning was based on our belief that
interest rates would move higher, driving down prices on fixed
income securities, an effect that is magnified for longer durations.
However, interest rates declined across the board during the period,
detracting from the Fund's relative performance. In addition, the
portfolio was overweight in higher-coupon MBS, which we expected
would perform well in a rising interest rate environment. However,
the overall decline in Treasury yields negatively impacted the
relative performance of these holdings. Our precommitments to
forward purchases of MBS fared well, particularly early in the
fourth quarter of 2003 due to tightening spreads. (Forward purchases
are agreements to purchase MBS for a predetermined price on a
predetermined future date.)
What changes were made to the portfolio during the period?
Relative to our benchmark, the portfolio was overweight in MBS
during the period, although we reduced our exposure in response to
tightening mortgage spreads compared to Treasury securities. We
precommitted to future MBS purchases while keeping duration neutral
by selling equal duration Treasury securities. We were able to
finance much of the portfolio's collateral position at interest
rates that were lower than the effective yields of the securities,
thus improving overall performance.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
We increased our overweight to higher-coupon MBS during the period.
We made this move based on the belief that prepayment risk had
substantially declined with a rise in Treasury yields in July (after
bottoming at historic lows in June). As interest rates rise, the
prepayment risk on higher-coupon MBS lessens, since homeowners are
less likely to refinance their mortgages in a rising interest rate
environment. Mortgage prepayments result in principal being returned
at par sooner than expected, effectively lowering the yield on
premium-priced securities.
To enhance the Fund's performance on financed positions, we
increased allocations to floating rate and limited maturity
structured products, some with credit exposure to non-agency
AAA-rated MBS. Floating rate and limited maturity instruments
allowed us to increase return while not adding interest rate risk.
This complimented our ongoing strategy of exploiting what we
believed would be a lower volatility environment - one where yield
would outweigh price return. In addition, we continued to increase
holdings of structured agency product on collateralized mortgage
obligations.
How would you characterize the Fund's position at the close of the
period?
At the end of the period, the portfolio maintained a conservative
duration position - slightly short versus the benchmark - and was
overweight in higher-coupon MBS, based on our belief that the
economy will show continued improvement and that interest rates
eventually will rise. As a yield-enhancing strategy, the portfolio
also held 7.5% of net assets in mortgage product not issued by U.S.
government entities.
Given the amortizing cash flow characteristics of MBS in general, we
believe the Fund will perform relatively well in a rising yield
environment compared to other fixed income investment alternatives.
Frank Viola
Vice President and Portfolio Manager
Teresa L. Giacino
Vice President and Portfolio Manager
March 16, 2004
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Performance Data
About Fund Performance
Effective April 14, 2003, Class A Shares were redesignated Class I
Shares and Class D Shares were redesignated Class A Shares.
Investors are able to purchase shares of the Fund through multiple
pricing alternatives:
* Class A Shares incur a maximum initial sales charge of 4% and an
account maintenance fee of 0.25% (but no distribution fee).
* Class B Shares are subject to a maximum contingent deferred sales
charge of 4%, declining to 0% after six years. All Class B Shares
purchased prior to December 1, 2002 will maintain the four-year
schedule. In addition, Class B Shares are subject to a distribution
fee of 0.50% and an account maintenance fee of 0.25%. These shares
automatically convert to Class A Shares after approximately ten
years. (There is no initial sales charge for automatic share
conversions.)
* Class C Shares are subject to a distribution fee of 0.55% and an
account maintenance fee of 0.25%. In addition, Class C Shares are
subject to a 1% contingent deferred sales charge if redeemed within
one year of purchase.
* Class I Shares incur a maximum initial sales charge (front-end
load) of 4% and bear no ongoing distribution or account maintenance
fees. Class I Shares are available only to eligible investors, as
detailed in the Fund's prospectus.
* Class R Shares do not incur a maximum sales charge (front-end
load) or deferred sales charge. These shares are subject to a
distribution fee of 0.25% and an account maintenance fee of 0.25%.
Class R Shares are available only to certain retirement plans.
None of the past results shown should be considered a representation
of future performance. Current performance may be lower or higher
than the performance data quoted. Refer to www.mlim.ml.com to obtain
more current performance information. Performance results do not
reflect the deduction of taxes that a shareholder would pay on fund
distributions or the redemption of fund shares. Figures shown in
each of the following tables assume reinvestment of all dividends
and capital gain distributions, if any, at net asset value on the
payable date. Investment return and principal value of shares will
fluctuate so that shares, when redeemed, may be worth more or less
than their original cost. Dividends paid to each class of shares
will vary because of the different levels of account maintenance,
distribution and transfer agency fees applicable to each class,
which are deducted from the income available to be paid to
shareholders.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Performance Data (continued)
Recent Performance Results
10-Year/
6-Month 12-Month Since Inception Standardized
As of February 29, 2004 Total Return Total Return Total Return 30-Day Yield
ML U.S. Government Mortgage Fund Class A Shares* +3.70% +2.73% +80.52% 2.33%
ML U.S. Government Mortgage Fund Class B Shares* +3.44 +2.20 +71.43 1.91
ML U.S. Government Mortgage Fund Class C Shares* +3.41 +2.15 +77.78 1.86
ML U.S. Government Mortgage Fund Class I Shares* +3.83 +2.99 +91.86 2.57
ML U.S. Government Mortgage Fund Class R Shares* +3.65 +2.81 + 4.11 2.18
Citigroup Mortgage Index** +4.20 +3.62 +97.26/+101.81/+4.80 --
*Investment results shown do not reflect sales charges; results
shown would be lower if a sales charge was included. Total
investment returns are based on changes in net asset values for the
periods shown, and assume reinvestment of all dividends and capital
gains distributions at net asset value on the payable date. The
Fund's 10-year/inception periods are 10 years for Class A & Class B
Shares, from 10/21/94 for Class C & Class I Shares, and from 1/03/03
for Class R Shares.
**This unmanaged Index reflects the performance of a capital market
weighting of the outstanding agency-issued mortgage-backed
securities. Ten year/since inception total returns are for 10 years,
from 10/31/94 and from 1/03/03, respectively.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Performance Data (concluded)
Average Annual Total Return
Return Without Return With
Sales Charge Sales Charge**
Class A Shares*
One Year Ended 2/29/04 +2.73% -1.38%
Five Years Ended 2/29/04 +6.15 +5.28
Ten Years Ended 2/29/04 +6.08 +5.65
*Maximum sales charge is 4%.
**Assuming maximum sales charge.
Return Return
Without CDSC With CDSC**
Class B Shares*
One Year Ended 2/29/04 +2.20% -1.78%
Five Years Ended 2/29/04 +5.60 +5.28
Ten Years 2/29/04 +5.54 +5.54
*Maximum contingent deferred sales charge is 4% and is reduced to 0%
after six years.
**Assuming payment of applicable contingent deferred sales charge.
Return Return
Without CDSC With CDSC**
Class C Shares*
One Year Ended 2/29/04 +2.15% +1.16%
Five Years Ended 2/29/04 +5.55 +5.55
Inception (10/21/94)
through 2/29/04 +6.34 +6.34
*Maximum contingent deferred sales charge is 1% and is reduced to 0%
after one year.
**Assuming payment of applicable contingent deferred sales charge.
Return Without Return With
Sales Charge Sales Charge**
Class I Shares*
One Year Ended 2/29/04 +2.99% -1.13%
Five Years Ended 2/29/04 +6.39 +5.52
Inception (10/21/94)
through 2/29/04 +7.21 +6.75
*Maximum sales charge is 4%.
**Assuming maximum sales charge.
Return Without
Sales Charge
Class R Shares
One Year Ended 2/29/04 +2.81%
Inception (1/03/03) through 2/29/04 +3.55
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Schedule of Investments
Face Interest Original Maturity
Issue Amount Rate Date(s) Value
Non-U.S. Government Agency Asset-Backed & Mortgage-Backed Obligations*--7.5%
Centex Home Equity 04-B-AV1 $ 15,000,000 1.30 % 3/25/2034 $ 15,000,000
Countrywide Home Loans, Inc. 02-18-A10 2,510,615 5.50 11/25/2032 2,526,425
02-32-1A1 2,649,645 6.00 11/25/2032 2,703,787
Deutsche Mortgage Securities, Inc. 03-01-1A1 6,308,607 4.50 4/25/2033 6,436,629
Equity One ABS, Inc. 03-4-AF1 17,871,297 1.24 (8) 11/25/2033 17,867,789
GMAC Mortgage Corporation Loan Trust 03-J7-A10 29,412,756 5.50 11/25/2033 30,558,230
MASTR Asset Securitization Trust 03-10-3A1 41,166,333 5.50 11/25/2033 41,871,841
Residential Asset Mortgage Products, Inc. 03-RS7-AI1 18,700,876 1.22 (8) 6/25/2018 18,696,392
Securitized Asset-Backed Receivables, LLC 04-OP1-A2 20,000,000 1.50 (8) 2/25/2034 20,000,000
Total Non-U.S. Government Agency Asset-Backed & Mortgage-Backed Obligations (Cost--$153,484,156) 155,661,093
U.S. Government Agency Obligations - 4.1%
Fannie Mae 10,000,000 4.25 7/15/2007 10,544,370
Federal Home Loan Bank 50,000,000 1.40 10/01/2009 49,941,400
Freddie Mac Participation Certificates 25,000,000 5.75 4/29/2009 25,170,975
Total U.S. Government Agency Obligations (Cost--$85,881,067) 85,656,745
U.S. Government Agency Mortgage-Backed Obligations*--100.7%
Fannie Mae 17,983,703 3.968 8/01/2033 18,234,137
24,488,202 4.50 8/01/2018 - 12/01/2018 24,748,207
18,210,234 5.00 TBA (9) 18,693,934
773,946 5.50 3/01/2032 792,350
28,905,756 6.50 12/01/2008 - 2/01/2014 30,777,156
194,879,630 6.50 4/01/2026 - 3/15/2034 205,029,498
3,351,900 7.00 11/01/2013 - 11/01/2014 3,592,809
20,507 7.00 8/01/2029 21,786
19,208,422 7.50 7/01/2016 - 12/01/2032 20,879,579
92,226 8.00 9/01/2024 - 9/01/2027 100,446
116,465 8.50 5/01/2010 - 8/01/2012 126,951
2,342,554 8.50 (3) 7/15/2023 2,583,035
1,851,366 9.50 3/01/2020 1,980,962
685,863 11.00 10/01/2011 - 8/01/2020 772,194
330,135 13.00 9/01/2013 - 3/01/2015 383,989
Fannie Mae #0385872 5,346,028 4.28 (7) 2/01/2010 5,483,071
Mortgage-Backed Securities-- #0160465 31,612,973 6.16 (6) 8/01/2013 34,943,783
Multi-Family++ #0073943 1,271,412 7.18 (4) 2/01/2019 1,440,871
Fannie Mae 98-M1-IO2 78,938,590 1.0664 (1) 2/25/2013 2,717,382
Mortgage-Backed Securities-- 02-M2-N 165,850,768 1.34 (1) 8/25/2012 16,244,171
REMICs**--Multi-Family++ 97-M8-A2 16,552,036 7.16 1/25/2022 17,905,509
96-M3-A2 449,083 7.41 3/25/2021 449,083
Fannie Mae REMICS** 03-W16-AF1 36,734,813 1.18 (8) 2/25/2033 36,737,461
03-41-YF 25,000,000 1.39 (8) 6/25/2028 25,021,490
03-W19-1A1 22,406,633 2.01 11/25/2033 22,355,980
03-23-AB 15,660,918 4.00 3/25/2017 15,742,227
03-16-JB 20,016,478 5.00 3/25/2018 20,023,772
94-56-TB 262,959 6.50 (1) 7/25/2022 527
Trust 273 554,388 7.00 (1) 7/01/2026 88,499
96-W1-AL 2,670,923 7.25 3/25/2026 2,955,931
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Schedule of Investments (continued)
Face Interest Original Maturity
Issue Amount Rate Date(s) Value
U.S. Government Agency Mortgage-Backed Obligations (concluded)
Freddie Mac $ 10,000,000 1.597 % 5/15/2010 $ 9,980,511
Participation Certificates 365 10.00 7/01/2019 409
1,945,077 10.50 1/01/2010 - 9/01/2020 2,184,658
351,045 11.00 8/01/2010 - 9/01/2020 396,081
547,259 11.50 12/01/2011 - 6/01/2020 622,031
312,697 12.00 5/01/2010 - 6/01/2020 356,003
446,274 12.50 11/01/2014 - 7/01/2019 506,114
773,084 13.00 11/01/2009 - 2/01/2016 889,844
Freddie Mac 7,529,813 4.50 6/01/2018 - 9/01/2018 7,613,940
Participation Certificates-- 54,184,002 4.50 11/01/2033 - 1/01/2034 52,737,957
Gold Program 73,254,600 5.00 3/15/2019 75,177,533
198,797,723 5.00 5/01/2033 - 4/15/2034 199,090,081
53,140,246 5.50 3/01/2013 - 12/01/2017 55,420,185
378,153,920 5.50 TBA (9) 385,599,014
55,210,748 6.00 4/01/2009 - 10/01/2017 58,224,452
345,647,034 6.00 3/01/2029 - 3/15/2034 359,504,326
12,091,756 6.50 2/01/2029 - 7/01/2032 12,732,336
7,527,500 7.00 8/01/2011 - 6/01/2016 8,057,417
75,177,557 7.00 7/01/2028 - 7/01/2032 79,799,917
2,124,473 7.50 8/01/2009 - 10/01/2011 2,275,999
43,415,893 7.50 8/01/2017 - 12/01/2032 46,680,159
2,550,524 8.00 1/01/2008 - 7/01/2012 2,737,781
5,560,522 8.00 10/01/2027 - 8/01/2032 6,005,536
610,129 8.50 1/01/2025 - 7/01/2025 666,024
260,870 10.50 10/01/2020 - 12/01/2020 295,723
Freddie Mac REMICS** Trust 2677 10,000,000 4.00 3/15/2014 10,100,320
Trust 134 152,739 9.00 (1) 4/01/2022 4,196
Trust 1220-A 835,062 10.00 2/15/2022 836,457
Trust 1220-B 6,789,130 10.00 (1) 2/15/2022 67,891
Government National Mortgage Association 50,000,000 5.00 3/15/2019 51,562,500
626,839 5.50 3/15/2029 - 4/15/2029 645,341
4,576,820 6.00 5/15/2024 - 11/15/2031 4,789,363
41,373,346 6.50 10/15/2023 - 3/15/2032 43,726,214
37,800,837 7.00 4/15/2023 - 4/15/2032 40,291,632
13,047,906 7.50 2/15/2025 - 12/15/2031 14,048,109
6,830,345 8.00 1/15/2024 - 8/15/2026 7,478,027
4,908,353 10.00 12/15/2015 - 12/15/2021 5,528,619
31,233 10.50 1/15/2016 - 4/15/2021 35,395
67 11.00 1/15/2016 77
937 11.50 8/15/2013 1,075
Government National Mortgage Association
REMICS** 02-81B 10,000,000 5.042 1/16/2009 10,135,052
Total U.S. Government Agency Mortgage-Backed Obligations (Cost--$2,063,659,330) 2,087,631,089
Short-Term Securities--38.0%
U.S. Government Agency Obligations*** Fannie Mae 610,000,000 0.98 3/15/2004 (d) 609,769,739
Shares
Held
Merrill Lynch Premier Institutional Fund (a)(b) 110,640,000 110,640,000
Face
Amount Issue
Repurchase Agreements $67,400,000 Morgan Stanley & Company, Inc., purchased on 2/27/2004 to yield 1%
to 3/01/2004, repurchase price $67,405,617, collateralized by FNMA,
3.489% to 6.257%, due 7/01/2012 to 10/01/2033 67,400,000
Total Short-Term Securities (Cost--$787,809,739) 787,809,739
Total Investments (Cost--$3,090,834,292)--150.3% 3,116,758,666
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Schedule of Investments (continued)
Number of
Contracts++++ Issue Value
Options Written--(0.2%)
Call Options 12 Swaption, expiring 3/12/2004 at 3.90%, Broker, Morgan Stanley (2) $ (151,116)
Written 25 Swaption, expiring 12/13/2006 at 5.90%, Broker, Morgan Stanley (2) (1,431,950)
---------------
(1,583,066)
Put Options 12 Swaption, expiring 3/12/2004 at 3.90%, Broker, Morgan Stanley (2) (151,116)
Written 25 Swaption, expiring 12/13/2006 at 5.90%, Broker, Morgan Stanley (2) (1,431,950)
---------------
(1,583,066)
Total Options Written (Premiums Received--$3,256,700) (3,166,132)
Total Investments, Net of Options Written (Cost--$3,087,577,592)--150.1% 3,113,592,534
Unrealized Appreciation on Swaps (e)--0.1% 1,023,881
Variation Margin on Financial Futures Contracts (c)--0.0% (740,625)
Liabilities in Excess of Other Assets--(50.2%) (1,040,206,870)
---------------
Net Assets--100.0% $ 2,073,668,920
===============
(1)Represents the interest only portion of a mortgage-backed
obligation.
(2)This European style swaption, which can be exercised only to the
expiration date, represents a standby commitment whereby the Fund is
obligated to enter into a predetermined interest rate swap contract
upon exercise of the swaption.
(3)Federal Housing Administration/Veterans' Administration Mortgages
packaged by the Federal National Mortgage Association.
(4)Represents a balloon mortgage that amortizes on a 22-year
schedule and has a 22-year original maturity.
(5)Represents a balloon mortgage that amortizes on a 30-year
schedule and has a 30-year original maturity.
(6)Represents a mortgage that amortizes on a 15-year schedule and
has a 15-year original maturity.
(7)Represents a balloon mortgage that amortizes on a 30-year
schedule and has a 7-year original maturity.
(8)Floating rate note.
(9)Represents a "to-be-announced" (TBA) transaction. The Fund has
committed to purchasing securities for which all specific
information is not available at this time.
++Underlying multi-family loans have prepayment protection by means
of lockout periods and/or yield maintenance premiums.
++++One contract represents a notional amount of $1,000,000.
*Asset-Backed and Mortgage-Backed Obligations are subject to
principal paydowns as a result of prepayments or refinancings of the
underlying mortgage instruments. As a result, the average life may
be substantially less than the original maturity.
**Real Estate Mortgage Investment Conduits (REMIC).
***U.S. Government Agency Obligations are traded on a discount
basis; the interest rate shown reflects the discount rate paid at
the time of purchase by the Fund.
(a)Investments in companies considered to be an affiliate of the
Fund (such companies are defined as "Affiliated Companies" in
Section 2(a)(3) of the Investment Company Act of 1940) are as
follows:
Interest/
Net Dividend
Affiliate Activity Income
Merrill Lynch Liquidity Series, LLC
Money Market Series $ (5,082,000) $ 799
Merrill Lynch Premier Institutional
Fund 107,252,000 $44,452
(b)Security was purchased with the cash proceeds from securities
loans.
(c)Financial futures contracts sold as of February 29, 2004 were as
follows:
Number of Expiration Face Unrealized
Contracts Issue Date Value Losses
1,110 U.S. Treasury June
5-Year Notes 2004 $124,541,306 $ (229,631)
900 U.S. Treasury June
10-Year Notes 2004 $102,008,891 (478,609)
-----------
Total Unrealized Losses $ (708,240)
===========
(d)All or a portion of security held as collateral in connection
with open financial futures contracts.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Schedule of Investments (concluded)
(e)Swaps entered into as of February 29, 2004 were as follows:
Notional Unrealized
Amount Appreciation
Receive a variable return equal to
J.P. Morgan U.S. Agency Mortgage
Index Total Return and pay a floating
rate based on 1-month USD LIBOR,
minus .17%
Broker, J.P. Morgan Chase Bank
Expires February 2004 $ 72,000,000 --
Receive a variable return equal to
J.P. Morgan U.S. Agency Mortgage
Index Total Return and pay a
floating rate based on 1-month
USD LIBOR, minus .30%
Broker, J.P. Morgan Chase Bank
Expires April 2004 $ 50,000,000 --
Receive a variable return equal
to Mortgage-Backed Securities
Fixed Rate Index Total Return
and pay a floating rate based on
1-month USD LIBOR, minus .16%
Broker, UBS Warburg
Expires August 2004 $ 80,000,000 --
Receive a variable return equal
to Mortgage-Backed Securities
Fixed Rate Index Total Return
and pay a floating rate based on
1-month USD LIBOR, minus .15%
Broker, Lehman Brothers
Special Finance
Expires September 2004 $ 72,000,000 --
Receive a variable return equal to
3-month USD LIBOR and pay a
fixed rate of 2.2625%
Broker, Morgan Stanley
Capital Services Inc.
Expires December 2005 $ 28,200,000 $ 276,501
Receive a variable return equal to
3-month USD LIBOR and pay a
fixed rate of 4.7125%
Broker, Morgan Stanley
Capital Services Inc.
Expires December 2013 $ 20,200,000 747,380
-----------
Total $ 1,023,881
===========
See Notes to Financial Statements.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Statement of Assets and Liabilities
As of February 29, 2004
Assets
Investments, at value (including securities loaned of $108,435,440)
(identified cost--$3,090,834,292) $ 3,116,758,666
Cash 90,724
Unrealized appreciation on swaps 1,023,881
Receivables:
Securities sold $ 427,525,276
Interest 8,331,436
Beneficial interest sold 2,963,270
Swaps 1,525,347
Principal paydowns 88,245
Securities lending--net 12,182 440,445,756
---------------
Prepaid registration fees and other assets 314,674
---------------
Total assets 3,558,633,701
---------------
Liabilities
Collateral on securities loaned, at value 110,640,000
Options written, at value (premiums received--$3,256,700) 3,166,132
Payables:
Securities purchased 1,362,223,590
Beneficial interest redeemed 4,412,958
Dividends to shareholders 1,106,018
Other affiliates 1,030,420
Variation margin 740,625
Investment adviser 732,103
Distributor 688,148 1,370,933,862
---------------
Accrued expenses and other liabilities 224,787
---------------
Total liabilities 1,484,964,781
---------------
Net Assets
Net assets $ 2,073,668,920
===============
Net Assets Consist of
Class A Shares of beneficial interest, $.10 par value, unlimited number
of shares authorized $ 8,356,662
Class B Shares of beneficial interest, $.10 par value, unlimited number
of shares authorized 5,012,927
Class C Shares of beneficial interest, $.10 par value, unlimited number
of shares authorized 3,464,283
Class I Shares of beneficial interest, $.10 par value, unlimited number
of shares authorized 3,187,257
Class R Shares of beneficial interest, $.10 par value, unlimited number
of shares authorized 31,504
Paid-in capital in excess of par 2,045,514,372
Accumulated distributions in excess of investment income--net $ (3,970,818)
Accumulated realized capital losses on investments--net (14,257,850)
Unrealized appreciation on investments--net 26,330,583
---------------
Total accumulated earnings--net 8,101,915
---------------
Net Assets $ 2,073,668,920
===============
Net Asset Value
Class A--Based on net assets of $864,129,547 and 83,566,620 shares of
beneficial interest outstanding $ 10.34
===============
Class B--Based on net assets of $518,393,410 and 50,129,271 shares of
beneficial interest outstanding $ 10.34
===============
Class C--Based on net assets of $358,202,248 and 34,642,831 shares of
beneficial interest outstanding $ 10.34
===============
Class I--Based on net assets of $329,690,583 and 31,872,573 shares of
beneficial interest outstanding $ 10.34
===============
Class R--Based on net assets of $3,253,132 and 315,043 shares of beneficial
interest outstanding $ 10.33
===============
See Notes to Financial Statements.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Statement of Operations
For the Six Months Ended February 29, 2004
Investment Income
Interest $ 41,416,588
Securities lending--net 45,251
---------------
Total income 41,461,839
---------------
Expenses
Investment advisory fees $ 4,846,757
Account maintenance and distribution fees--Class B 2,052,695
Account maintenance and distribution fees--Class C 1,522,209
Account maintenance fees--Class A 1,073,190
Transfer agent fees--Class A 849,627
Transfer agent fees--Class B 594,615
Transfer agent fees--Class C 419,440
Transfer agent fees--Class I 323,113
Accounting services 274,826
Custodian fees 126,336
Professional fees 68,015
Pricing fees 60,870
Registration fees 57,751
Printing and shareholder reports 57,382
Trustees' fees and expenses 28,906
Account maintenance and distribution fees--Class R 2,278
Transfer agent fees--Class R 1,261
Other 38,211
---------------
Total expenses 12,397,482
---------------
Investment income--net 29,064,357
---------------
Realized & Unrealized Gain on Investments--Net
Realized gain on investments--net 24,002,752
Change in unrealized appreciation on investments--net 22,864,298
---------------
Total realized and unrealized gain on investments--net 46,867,050
---------------
Net Increase in Net Assets Resulting from Operations $ 75,931,407
===============
See Notes to Financial Statements.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Statements of Changes in Net Assets
For the Six For the
Months Ended Year Ended
February 29, August 31,
Increase (Decrease) in Net Assets: 2004 2003
Operations
Investment income--net $ 29,064,357 $ 66,455,314
Realized gain on investments--net 24,002,752 8,431,538
Change in unrealized appreciation on investments--net 22,864,298 (36,750,188)
--------------- ---------------
Net increase in net assets resulting from operations 75,931,407 38,136,664
--------------- ---------------
Dividends to Shareholders
Investment income--net:
Class A (13,810,272) (26,838,903)
Class B (7,358,652) (16,821,329)
Class C (5,012,082) (11,397,197)
Class I (5,662,679) (11,356,412)
Class R (20,672) (205)
--------------- ---------------
Net decrease in net assets resulting from dividends to shareholders (31,864,357) (66,414,046)
--------------- ---------------
Beneficial Interest Transactions
Net increase (decrease) in net assets derived from beneficial
interest transactions (160,400,209) 105,163,018
--------------- ---------------
Net Assets
Total increase (decrease) in net assets (116,333,159) 76,885,636
Beginning of period 2,190,002,079 2,113,116,443
--------------- ---------------
End of period* $ 2,073,668,920 $ 2,190,002,079
=============== ===============
*Accumulated distributions in excess of investment income--net $ (3,970,818) $ (1,170,818)
=============== ===============
See Notes to Financial Statements.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Financial Highlights
Class A
The following per share data and ratios have been derived For the Six
from information provided in the financial statements. Months Ended
February 29, For the Year Ended August 31,++
Increase (Decrease) in Net Asset Value: 2004 2003 2002 2001 2000
Per Share Operating Performance
Net asset value, beginning of period $ 10.13 $ 10.25 $ 9.95 $ 9.44 $ 9.36
---------- ---------- ---------- ---------- ----------
Investment income--net .15+++ .32 .43 .55 .56
Realized and unrealized gain (loss)
on investments--net .22 (.12) .30 .51 .08
---------- ---------- ---------- ---------- ----------
Total from investment operations .37 .20 .73 1.06 .64
---------- ---------- ---------- ---------- ----------
Less dividends from investment income--net (.16) (.32) (.43) (.55) (.56)
---------- ---------- ---------- ---------- ----------
Net asset value, end of period $ 10.34 $ 10.13 $ 10.25 $ 9.95 $ 9.44
========== ========== ========== ========== ==========
Total Investment Return**
Based on net asset value per share 3.70%+++++ 1.93% 7.54% 11.49% 7.08%
========== ========== ========== ========== ==========
Ratios to Average Net Assets
Expenses .97%* .95% .97% 1.00% 1.00%
========== ========== ========== ========== ==========
Investment income--net 2.94%* 3.09% 4.30% 5.59% 5.99%
========== ========== ========== ========== ==========
Supplemental Data
Net assets, end of period (in thousands) $ 864,130 $ 855,543 $ 819,410 $ 729,136 $ 720,311
========== ========== ========== ========== ==========
Portfolio turnover 248.59% 428.59% 426.77% 199.30% 37.28%
========== ========== ========== ========== ==========
*Annualized.
**Total investment returns exclude the effects of sales charges.
++Effective April 14, 2003, Class D Shares were redesignated Class A
Shares.
+++Based on average shares outstanding.
+++++Aggregate total investment return.
See Notes to Financial Statements.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Financial Highlights (continued)
Class B
The following per share data and ratios have been derived For the Six
from information provided in the financial statements. Months Ended
February 29, For the Year Ended August 31,
Increase (Decrease) in Net Asset Value: 2004 2003 2002 2001 2000
Per Share Operating Performance
Net asset value, beginning of period $ 10.13 $ 10.26 $ 9.95 $ 9.44 $ 9.36
---------- ---------- ---------- ---------- ----------
Investment income--net .12++ .26 .38 .50 .51
Realized and unrealized gain (loss)
on investments--net .23 (.13) .31 .51 .08
---------- ---------- ---------- ---------- ----------
Total from investment operations .35 .13 .69 1.01 .59
---------- ---------- ---------- ---------- ----------
Less dividends from investment income--net (.14) (.26) (.38) (.50) (.51)
---------- ---------- ---------- ---------- ----------
Net asset value, end of period $ 10.34 $ 10.13 $ 10.26 $ 9.95 $ 9.44
========== ========== ========== ========== ==========
Total Investment Return**
Based on net asset value per share 3.44%+++ 1.40% 6.99% 10.91% 6.53%
========== ========== ========== ========== ==========
Ratios to Average Net Assets
Expenses 1.49%* 1.47% 1.49% 1.52% 1.52%
========== ========== ========== ========== ==========
Investment income--net 2.42%* 2.58% 3.76% 5.07% 5.47%
========== ========== ========== ========== ==========
Supplemental Data
Net assets, end of period (in thousands) $ 518,393 $ 591,435 $ 613,282 $ 466,432 $ 405,846
========== ========== ========== ========== ==========
Portfolio turnover 248.59% 428.59% 426.77% 199.30% 37.28%
========== ========== ========== ========== ==========
*Annualized.
**Total investment returns exclude the effects of sales charges.
++Based on average shares outstanding.
+++Aggregate total investment return.
See Notes to Financial Statements.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Financial Highlights (continued)
Class C
The following per share data and ratios have been derived For the Six
from information provided in the financial statements. Months Ended
February 29, For the Year Ended August 31,
Increase (Decrease) in Net Asset Value: 2004 2003 2002 2001 2000
Per Share Operating Performance
Net asset value, beginning of period $ 10.13 $ 10.25 $ 9.95 $ 9.44 $ 9.36
---------- ---------- ---------- ---------- ----------
Investment income--net .12++ .26 .37 .49 .51
Realized and unrealized gain (loss)
on investments--net .22 (.12) .30 .51 .08
---------- ---------- ---------- ---------- ----------
Total from investment operations .34 .14 .67 1.00 .59
---------- ---------- ---------- ---------- ----------
Less dividends from investment income--net (.13) (.26) (.37) (.49) (.51)
---------- ---------- ---------- ---------- ----------
Net asset value, end of period $ 10.34 $ 10.13 $ 10.25 $ 9.95 $ 9.44
========== ========== ========== ========== ==========
Total Investment Return**
Based on net asset value per share 3.41%+++ 1.35% 6.94% 10.86% 6.47%
========== ========== ========== ========== ==========
Ratios to Average Net Assets
Expenses 1.54%* 1.52% 1.54% 1.57% 1.57%
========== ========== ========== ========== ==========
Investment income--net 2.37%* 2.52% 3.40% 5.00% 5.43%
========== ========== ========== ========== ==========
Supplemental Data
Net assets, end of period (in thousands) $ 358,202 $ 414,539 $ 384,119 $ 56,706 $ 30,593
========== ========== ========== ========== ==========
Portfolio turnover 248.59% 428.59% 426.77% 199.30% 37.28%
========== ========== ========== ========== ==========
*Annualized.
**Total investment returns exclude the effects of sales charges.
++Based on average shares outstanding.
+++Aggregate total investment return.
See Notes to Financial Statements.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Financial Highlights (continued)
Class I
The following per share data and ratios have been derived For the Six
from information provided in the financial statements. Months Ended
February 29, For the Year Ended August 31,++
Increase (Decrease) in Net Asset Value: 2004 2003 2002 2001 2000
Per Share Operating Performance
Net asset value, beginning of period $ 10.13 $ 10.26 $ 9.95 $ 9.44 $ 9.37
---------- ---------- ---------- ---------- ----------
Investment income--net .16+++ .34 .46 .57 .58
Realized and unrealized gain (loss)
on investments--net .23 (.13) .31 .51 .07
---------- ---------- ---------- ---------- ----------
Total from investment operations .39 .21 .77 1.08 .65
---------- ---------- ---------- ---------- ----------
Less dividends from investment income--net (.18) (.34) (.46) (.57) (.58)
---------- ---------- ---------- ---------- ----------
Net asset value, end of period $ 10.34 $ 10.13 $ 10.26 $ 9.95 $ 9.44
========== ========== ========== ========== ==========
Total Investment Return**
Based on net asset value per share 3.83%+++++ 2.08% 7.91% 11.77% 7.23%
========== ========== ========== ========== ==========
Ratios to Average Net Assets
Expenses .72%* .70% .72% .75% .75%
========== ========== ========== ========== ==========
Investment income--net 3.19%* 3.34% 4.53% 5.84% 6.23%
========== ========== ========== ========== ==========
Supplemental Data
Net assets, end of period (in thousands) $ 329,691 $ 328,408 $ 296,305 $ 234,930 $ 192,119
========== ========== ========== ========== ==========
Portfolio turnover 248.59% 428.59% 426.77% 199.30% 37.28%
========== ========== ========== ========== ==========
*Annualized.
**Total investment returns exclude the effects of sales charges.
++Effective April 14, 2003, Class A Shares were redesignated Class I
Shares.
+++Based on average shares outstanding.
+++++Aggregate total investment return.
See Notes to Financial Statements.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Financial Highlights (concluded)
Class R
For the For the
Six Period
The following per share data and ratios have been derived Months January 3,
from information provided in the financial statements. Ended 2003++ to
February 29, August 31,
Increase (Decrease) in Net Asset Value: 2004 2003
Per Share Operating Performance
Net asset value, beginning of period $ 10.12 $ 10.31
------------ ------------
Investment income--net .15+++ .24
Realized and unrealized gain (loss) on investments--net .22 (.19)
------------ ------------
Total from investment operations .37 .05
------------ ------------
Less dividends from investment income--net (.16) (.24)
------------ ------------
Net asset value, end of period $ 10.33 $ 10.12
============ ============
Total Investment Return**
Based on net asset value per share 3.65%+++++ .44%+++++
============ ============
Ratios to Average Net Assets
Expenses 1.22%* 1.23%*
============ ============
Investment income--net 2.69%* 2.81%*
============ ============
Supplemental Data
Net assets, end of period (in thousands) $ 3,253 $ 77
============ ============
Portfolio turnover 248.59% 428.59%
============ ============
*Annualized.
**Total investment returns exclude the effects of sales charges.
++Commencement of operations.
+++Based on average shares outstanding.
+++++Aggregate total investment return.
See Notes to Financial Statements.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Notes to Financial Statements
1. Significant Accounting Policies:
Merrill Lynch U.S. Government Mortgage Fund (the "Fund") is
registered under the Investment Company Act of 1940, as amended, as
a diversified, open-end management investment company. The Fund's
financial statements are prepared in conformity with accounting
principles generally accepted in the United States of America, which
may require the use of management accruals and estimates. These
unaudited financial statements reflect all adjustments, which are,
in the opinion of management, necessary to a fair statement of the
results for the interim period presented. All such adjustments are
of a normal, recurring nature. The Fund offers multiple classes of
shares. Shares of Class A and Class I are sold with a front-end
sales charge. Shares of Class B and Class C may be subject to a
contingent deferred sales charge. Class R Shares are sold only to
certain retirement plans. All classes of shares have identical
voting, dividend, liquidation and other rights and the same terms
and conditions, except that Class A, Class B, Class C and Class R
Shares bear certain expenses related to the account maintenance of
such shares, and Class B, Class C and Class R Shares also bear
certain expenses related to the distribution of such shares. Each
class has exclusive voting rights with respect to matters relating
to its account maintenance and distribution expenditures. Income,
expenses (other than expenses attributable to a specific class) and
realized and unrealized gains and losses on investments are
allocated daily to each class based on its relative net assets. The
following is a summary of significant accounting policies followed
by the Fund.
(a) Valuation of investments--Securities that are held by the Fund
that are traded on stock exchanges or the Nasdaq National Market are
valued at the last sale price or official close price on the
exchange on which such securities are traded, as of the close of
business on the day the securities are valued or, lacking any sales,
at the last available bid price for long positions, and at the last
available ask price for short positions. In cases where securities
are traded on more than one exchange, the securities are valued on
the exchange designated as the primary market by or under the
authority of the Board of the Fund. Long positions in securities
traded in the over-the-counter ("OTC") market, Nasdaq Small Cap or
Bulletin Board are valued at the last available bid price or yield
equivalent obtained from one or more dealers or pricing services
approved by the Board of Trustees of the Fund. Short positions in
securities traded in the OTC market are valued at the last available
ask price. Portfolio securities that are traded both in the OTC
market and on a stock exchange are valued according to the broadest
and most representative market. When the Fund writes an option, the
amount of the premium received is recorded on the books of the Fund
as an asset and an equivalent liability. The amount of the liability
is subsequently valued to reflect the current market value of the
option written, based on the last sale price in the case of exchange-
traded options or, in the case of options traded in the OTC market,
the last ask price. Options purchased by the Fund are valued at
their last sale price in the case of exchange-traded options or, in
the case of options traded in the OTC market, the last bid price.
The value of swaps, including interest rate swaps, caps, and floors,
will be determined by obtaining dealer quotations. Other
investments, including futures contracts and related options, are
stated at market value. Obligations with remaining maturities of
60 days or less are valued at amortized cost unless the Investment
Adviser believes that this method no longer produces fair
valuations. Repurchase agreements will be valued at cost plus
accrued interest. The Fund employs certain pricing services to
provide securities prices for the Fund. Securities and assets for
which market quotations are not readily available are valued at fair
value as determined in good faith by or under the direction of the
Trustees of the Fund, including valuations furnished by the pricing
services retained by the Fund, which may use a matrix system for
valuations. The procedures of a pricing service and its valuations
are reviewed by the officers of the Fund under the general
supervision of the Trustees. Such valuations and procedures will be
reviewed periodically by the Trustees.
Generally, trading in foreign securities, as well as U.S. government
securities and money market instruments, is substantially completed
each day at various times prior to the close of business on the New
York Stock Exchange ("NYSE"). The values of such securities used in
computing the net asset value of the Fund's shares are determined as
of such times. Foreign currency exchange rates also are generally
determined prior to the close of business on the NYSE. Occasionally,
events affecting the values of such securities and such exchange
rates may occur between the times at which they are determined and
the close of business on the NYSE that may not be reflected in the
computation of the Fund's net asset value. If events (for example, a
company announcement, market volatility or a natural disaster) occur
during such periods that are expected to materially affect the value
of such securities, those securities may be valued at the fair value
as determined in good faith by the Board of Trustees or by the
Investment Adviser using a pricing service and/or procedures
approved by the Board of Trustees.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Notes to Financial Statements (continued)
(b) Repurchase agreements--The Fund invests in U.S. government
securities pursuant to repurchase agreements. Under such agreements,
the counterparty agrees to repurchase the security at a mutually
agreed upon time and price. The Fund takes possession of the
underlying securities, marks to market such securities and, if
necessary, receives additional securities daily to ensure that the
contract is fully collateralized. If the counterparty defaults and
the fair value of the collateral declines, liquidation of the
collateral by the Fund may be delayed or limited.
(c) Derivative financial instruments--The Fund may engage in various
portfolio investment strategies both to increase the return of the
Fund and to hedge, or protect, its exposure to interest rate
movements and movements in the securities markets. Losses may arise
due to changes in the value of the contract or if the counterparty
does not perform under the contract.
* Financial futures contracts--The Fund may purchase or sell
financial futures contracts and options on such futures contracts.
Futures contracts are contracts for delayed delivery of securities
at a specific future date and at a specific price or yield. Upon
entering into a contract, the Fund deposits and maintains as
collateral such initial margin as required by the exchange on which
the transaction is effected. 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 value of the contract. Such receipts or
payments are known as variation margin and are recorded by the Fund
as unrealized gains or losses. When the contract is closed, the Fund
records a realized 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.
* Options--The Fund may write and purchase call and put options.
When the Fund writes an option, an amount equal to the premium
received by the Fund is reflected as an asset and an equivalent
liability. The amount of the liability is subsequently marked to
market to reflect the current market value of the option written.
When a security is purchased or sold through an exercise of an
option, the related premium paid (or received) is added to (or
deducted from) the basis of the security acquired or deducted from
(or added to) the proceeds of the security sold. When an option
expires (or the Fund enters into a closing transaction), the Fund
realizes a gain or loss on the option to the extent of the premiums
received or paid (or gain or loss to the extent the cost of the
closing transaction exceeds the premiums paid or received).
Written and purchased options are non-income producing investments.
* Swaps--The Fund may enter into swap agreements, which are over-the-
counter contracts in which the Fund and a counterparty agree to make
periodic net payments on a specified notional amount. The net
payments can be made for a set period of time or may be triggered by
a predetermined credit event. The net periodic payments may be based
on a fixed or variable interest rate; the change in market value of
a specified security, basket of securities, or index; or the return
generated by a security.
(d) Income taxes--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. Therefore, no Federal income tax
provision is required.
(e) Security transactions and investment income--Security
transactions are recorded on the dates the transactions are entered
into (the trade dates). Realized gains and losses on security
transactions are determined on the identified cost basis. Dividend
income is recorded on the ex-dividend dates. Interest income and
extended delivery fees are recognized on the accrual basis. The Fund
amortizes all premiums and discounts on debt securities.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Notes to Financial Statements (continued)
(f) Prepaid registration fees--Prepaid registration fees are charged
to expense as the related shares are issued.
(g) Dividends and distributions--Dividends from net investment
income are declared daily and paid monthly. Distributions of capital
gains are recorded on the ex-dividend dates.
(h) Securities lending--The Fund may lend securities to financial
institutions that provide cash or securities issued or guaranteed by
the U.S. government as collateral, which will be maintained at all
times in an amount equal to at least 100% of the current market
value of the loaned securities. The market value of the loaned
securities is determined at the close of business of the Fund and
any additional required collateral is delivered to the Fund on the
next business day. Where the Fund receives securities as collateral
for the loaned securities, it collects a fee from the borrower. The
Fund typically receives the income on the loaned securities but does
not receive the income on the collateral. Where the Fund receives
cash collateral, it may invest such collateral and retain the amount
earned on such investment, net of any amount rebated to the
borrower. Loans of securities are terminable at any time and the
borrower, after notice, is required to return borrowed securities
within five business days. The Fund may pay reasonable finder's,
lending agent, administrative and custodial fees in connection with
its loans. In the event that the borrower defaults on its obligation
to return borrowed securities because of insolvency or for any other
reason, the Fund could experience delays and costs in gaining access
to the collateral. The Fund also could suffer a loss where the value
of the collateral falls below the market value of the borrowed
securities, in the event of borrower default or in the event of
losses on investments made with cash collateral.
(i) Mortgage dollar rolls--The Fund may sell mortgage-backed
securities for delivery in the current month and simultaneously
contracts to repurchase substantially similar (same type, coupon and
maturity) securities on a specific future date.
2. Investment Advisory Agreement and Transactions with Affiliates:
The Fund has entered into an Investment Advisory Agreement with Fund
Asset Management, L.P. ("FAM"). The general partner of FAM is
Princeton Services, Inc. ("PSI"), an indirect, wholly-owned
subsidiary of Merrill Lynch & Co., Inc. ("ML & Co."), which is the
limited partner. The Fund has also entered into a Distribution
Agreement and Distribution Plans with FAM Distributors, Inc. ("FAMD"
or the "Distributor"), which is a wholly-owned subsidiary of Merrill
Lynch Group, Inc.
FAM is responsible for the management of the Fund's portfolio and
provides the necessary personnel, facilities, equipment and certain
other services necessary to the operations of the Fund. For such
services, the Fund pays a monthly fee based upon the average daily
value of the Fund's net assets at the following rate:
Portion of Average Daily Value of Net Assets: Rate
Not exceeding $500 million .500%
In excess of $500 million but not
exceeding $1 billion .475%
In excess of $1 billion but not
exceeding $1.5 billion .450%
In excess of $1.5 billion but not
exceeding $2 billion .425%
In excess of $2 billion but not
exceeding $2.5 billion .400%
In excess of $2.5 billion but not
exceeding $3.5 billion .375%
In excess of $3.5 billion but not
exceeding $5 billion .350%
In excess of $5 billion but not
exceeding $6.5 billion .325%
Exceeding $6.5 billion .300%
Pursuant to the Distribution Plans adopted by the Fund in accordance
with Rule 12b-1 under the Investment Company Act of 1940, the Fund
pays the Distributor ongoing account maintenance and distribution
fees. The fees are accrued daily and paid monthly at annual rates
based upon the average daily net assets of the shares as follows:
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Notes to Financial Statements (continued)
Account
Maintenance Distribution
Fee Fee
Class A .25% --
Class B .25% .50%
Class C .25% .55%
Class R .25% .25%
Pursuant to a sub-agreement with the Distributor, Merrill Lynch,
Pierce, Fenner & Smith Incorporated ("MLPF&S"), a subsidiary of
ML & Co., also provides account maintenance and distribution
services to the Fund. The ongoing account maintenance fee
compensates the Distributor and MLPF&S for providing account
maintenance services to Class A, Class B, Class C and Class R
shareholders. The ongoing distribution fee compensates the
Distributor and MLPF&S for providing shareholder and distribution-
related services to Class B, Class C and Class R shareholders.
For the six months ended February 29, 2004, FAMD earned underwriting
discounts and MLPF&S earned dealer concessions on sales of the
Fund's Class A and Class I Shares as follows:
FAMD MLPF&S
Class A $ 3,653 $ 27,220
Class I $ 36 $ 346
For the six months ended February 29, 2004, MLPF&S received
contingent deferred sales charges of $777,075 and $56,346 relating
to transactions in Class B and Class C Shares, respectively.
Furthermore, MLPF&S received contingent deferred sales charges of
$1,006 relating to transactions subject to front-end sales charge
waivers in Class A Shares.
The Fund has received an exemptive order from the Securities and
Exchange Commission permitting it to lend portfolio securities to
MLPF&S or its affiliates. Pursuant to that order, the Fund also
has retained Merrill Lynch Investment Managers, LLC ("MLIM, LLC"),
an affiliate of FAM, as the securities lending agent for a fee based
on a share of the returns on investment of cash collateral. MLIM,
LLC may, on behalf of the Fund, invest cash collateral received
by the Fund for such loans, among other things, in a private
investment company managed by MLIM, LLC or in registered money
market funds advised by FAM or its affiliates. For the six months
ended February 29, 2004, MLIM, LLC received $19,526 in securities
lending agent fees.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of
ML & Co., is the Fund's transfer agent.
For the six months ended February 29, 2004, the Fund reimbursed FAM
$20,910 for certain accounting services.
Certain officers and/or trustees of the Fund are officers and/or
directors of FAM, PSI, FAMD, FDS, and/or ML & Co.
3. Investments:
Purchases and sales of investments, excluding short-term securities,
for the six months ended February 29, 2004 were $5,898,189,417 and
$5,980,895,884, respectively.
Net realized gains (losses) for the six months ended February 29,
2004 and net unrealized gains (losses) as of February 29, 2004 were
as follows:
Realized Unrealized
Gains (Losses) Gains (Losses)
Long-term investments $ 23,547,036 $ 25,924,374
Short-term investments 131 --
Options purchased 328,856 --
Options written (642,013) 90,568
Swaps 7,541,728 1,023,881
Financial futures contracts (6,772,986) (708,240)
--------------- ---------------
Total $ 24,002,752 $ 26,330,583
=============== ===============
As of February 29, 2004, net unrealized appreciation for Federal
income tax purposes aggregated $25,756,161, of which $31,060,936
related to appreciated securities and $5,304,775 related to
depreciated securities. The aggregate cost of investments, net of
options written, at February 29, 2004 for Federal income tax
purposes was $3,087,836,373.
Transactions in options written for the six months ended February
29, 2004 were as follows:
Call Options Number of Premiums
Written Contracts Received
Outstanding call options written,
beginning of period 63 $ 2,723,075
Options sold 37 1,628,350
Options closed (50) (2,723,075)
Options expired (13) --
------------- ---------------
Outstanding call options
written, end of period 37 $ 1,628,350
============= ===============
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Notes to Financial Statements (continued)
Put Options Number of Premiums
Written Contracts Received
Outstanding put options written,
beginning of period 4,803 $ 2,764,325
Options sold 37 1,628,350
Options closed (3,898) (2,764,325)
Options expired (905) --
------------- ---------------
Outstanding put options
written, end of period 37 $ 1,628,350
============= ===============
4. Shares of Beneficial Interest:
Net increase (decrease) in net assets derived from beneficial
interest transactions was $(160,400,209) and $105,163,018 for the
six months ended February 29, 2004 and the year ended August 31,
2003, respectively.
Transactions in shares of beneficial interest for each class were as
follows:
Class A Shares for the
Six Months Ended Dollar
February 29, 2004 Shares Amount
Shares sold 9,808,379 $ 100,366,869
Automatic conversion of shares 1,085,404 11,113,527
Shares issued to shareholders
in reinvestment of dividends 596,922 6,126,591
------------- ---------------
Total issued 11,490,705 117,606,987
Shares redeemed (12,383,193) (126,860,688)
------------- ---------------
Net decrease (892,488) $ (9,253,701)
============= ===============
Class A Shares for the Year Dollar
Ended August 31, 2003 Shares Amount
Shares sold 24,830,194 $ 255,763,407
Automatic conversion of shares 3,615,714 37,226,405
Shares resulting from
reorganization 596,152 6,095,331
Shares issued to shareholders
in reinvestment of dividends 1,060,137 10,900,865
------------- ---------------
Total issued 30,102,197 309,986,008
Shares redeemed (25,547,897) (262,751,395)
------------- ---------------
Net increase 4,554,300 $ 47,234,613
============= ===============
Class B Shares for the
Six Months Ended Dollar
February 29, 2004 Shares Amount
Shares sold 3,240,101 $ 33,190,818
Shares issued to shareholders
in reinvestment of dividends 535,096 5,492,162
------------- ---------------
Total issued 3,775,197 38,682,980
Automatic conversion of shares (1,085,328) (11,113,527)
Shares redeemed (10,944,573) (112,088,050)
------------- ---------------
Net decrease (8,254,704) $ (84,518,597)
============= ===============
Class B Shares for the Year Dollar
Ended August 31, 2003 Shares Amount
Shares sold 18,176,359 $ 187,220,780
Shares resulting from
reorganization 4,826,184 49,346,327
Shares issued to shareholders
in reinvestment of dividends 1,158,460 11,913,503
------------- ---------------
Total issued 24,161,003 248,480,610
Automatic conversion of shares (3,615,196) (37,226,405)
Shares redeemed (21,964,595) (225,788,918)
------------- ---------------
Net decrease (1,418,788) $ (14,534,713)
============= ===============
Class C Shares for the
Six Months Ended Dollar
February 29, 2004 Shares Amount
Shares sold 1,657,544 $ 16,998,888
Shares issued to shareholders
in reinvestment of dividends 361,012 3,703,819
------------- ---------------
Total issued 2,018,556 20,702,707
Shares redeemed (8,301,651) (85,022,989)
------------- ---------------
Net decrease (6,283,095) $ (64,320,282)
============= ===============
Class C Shares for the Year Dollar
Ended August 31, 2003 Shares Amount
Shares sold 13,348,468 $ 137,411,546
Shares resulting from
reorganization 2,032,979 20,784,497
Shares issued to shareholders
in reinvestment of dividends 784,713 8,069,165
------------- ---------------
Total issued 16,166,160 166,265,208
Shares redeemed (12,700,515) (130,461,166)
------------- ---------------
Net increase 3,465,645 $ 35,804,042
============= ===============
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Notes to Financial Statements (concluded)
Class I Shares for the
Six Months Ended Dollar
February 29, 2004 Shares Amount
Shares sold 5,208,171 $ 53,430,449
Shares issued to shareholders
in reinvestment of dividends 25,878 265,576
------------- ---------------
Total issued 5,234,049 53,696,025
Shares redeemed (5,771,157) (59,154,020)
------------- ---------------
Net decrease (537,108) $ (5,457,995)
============= ===============
Class I Shares for the Year Dollar
Ended August 31, 2003 Shares Amount
Shares sold 17,831,397 $ 183,727,174
Shares resulting from
reorganization 519,193 5,310,013
Shares issued to shareholders
in reinvestment of dividends 73,598 757,179
------------- ---------------
Total issued 18,424,188 189,794,366
Shares redeemed (14,900,196) (153,212,760)
------------- ---------------
Net increase 3,523,992 $ 36,581,606
============= ===============
Class R Shares for the
Six Months Ended Dollar
February 29, 2004 Shares Amount
Shares sold 337,471 $ 3,459,283
Shares issued to shareholders
in reinvestment of dividends 1,854 19,063
------------- ---------------
Total issued 339,325 3,478,346
Shares redeemed (31,883) (327,980)
------------- ---------------
Net increase 307,442 $ 3,150,366
============= ===============
Class R Shares for the
Period January 3, 2003++ Dollar
to August 31, 2003 Shares Amount
Shares sold 7,588 $ 77,337
Shares issued to shareholders
in reinvestment of dividends 13 133
------------- ---------------
Net increase 7,601 $ 77,470
============= ===============
++Commencement of operations.
5. Short-Term Borrowings:
The Fund, along with certain other funds managed by FAM and its
affiliates, is a party to a $500,000,000 credit agreement with Bank
One, N.A. and certain other lenders. The Fund may borrow under the
credit agreement to fund shareholder redemptions and for other
lawful purposes other than for leverage. The Fund may borrow up to
the maximum amount allowable under the Fund's current prospectus and
statement of additional information, subject to various other legal,
regulatory or contractual limits. The Fund pays a commitment fee of
..09% per annum based on the Fund's pro rata share of the unused
portion of the credit agreement. Amounts borrowed under the credit
agreement bear interest at a rate equal to, at each fund's election,
the Federal Funds rate plus .50% or a base rate as determined by
Bank One, N.A. On November 28, 2003, the credit agreement was
renewed for one year under the same terms. The Fund did not borrow
under the credit agreement during the six months ended February 29,
2004.
6. Capital Loss Carryforward:
On August 31, 2003, the Fund had a net capital loss carryforward of
$25,195,353, of which $16,732,658 expires in 2004, $4,697,041
expires in 2008 and $3,765,654 expires in 2009. This amount will be
available to offset like amounts of any future taxable gains.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Officers and Trustees
Terry K. Glenn, President and Trustee
James H. Bodurtha, Trustee
Joe Grills, Trustee
Herbert I. London, Trustee
Andre F. Perold, Trustee
Roberta Cooper Ramo, Trustee
Robert S. Salomon, Jr., Trustee
Stephen B. Swensrud, Trustee
Frank Viola, Vice President
Teresa L. Giacino, Vice President
Donald C. Burke, Vice President and Treasurer
Phillip S. Gillespie, Secretary
Custodian
The Bank of New York
100 Church Street
New York, NY 10286
Transfer Agent
Financial Data Services, Inc.
4800 Deer Lake Drive East
Jacksonville, FL 32246-6484
800-637-3863
Electronic Delivery
The Fund offers electronic delivery of communications to its
shareholders. In order to receive this service, you must
register your account and provide us with e-mail information.
To sign up for this service, simply access this website
http://www.icsdelivery.com/live and follow the instructions.
When you visit this site, you will obtain a personal identification
number (PIN). You will need this PIN should you wish to update your
e-mail address, choose to discontinue this service and/or make any
other changes to the service. This service is not available for
certain retirement accounts at this time.
MERRILL LYNCH U.S. GOVERNMENT MORTGAGE FUND, FEBRUARY 29, 2004
Item 2 - Code of Ethics - Not Applicable to this semi-annual report
Item 3 - Audit Committee Financial Expert - Not Applicable to this
semi-annual report
Item 4 - Principal Accountant Fees and Services - Not Applicable to
this semi-annual report
Item 5 - Audit Committee of Listed Registrants - Not Applicable
Item 6 - Schedule of Investments - Not Applicable
Item 7 - Disclosure of Proxy Voting Policies and Procedures for
Closed-End Management Investment Companies - Not Applicable
Item 8 - Purchases of Equity Securities by Closed-End Management
Investment Company and Affiliated Purchasers - Not Applicable
Item 9 - Submission of Matters to a Vote of Security Holders - Not
Applicable
Item 10 - Controls and Procedures
10(a) - The registrant's certifying officers have reasonably
designed such disclosure controls and procedures to ensure material
information relating to the registrant is made known to us by others
particularly during the period in which this report is being
prepared. The registrant's certifying officers have determined that
the registrant's disclosure controls and procedures are effective
based on our evaluation of these controls and procedures as of a
date within 90 days prior to the filing date of this report.
10(b) - There were no changes in the registrant's internal control
over financial reporting (as defined in Rule 30a-3(d) under the Act
(17 CFR 270.30a-3(d)) that occurred during the last fiscal half-year
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 11 - Exhibits attached hereto
11(a)(1) - Code of Ethics - Not Applicable to this semi-annual
report
11(a)(2) - Certifications - Attached hereto
11(a)(3) - Not Applicable
11(b) - Certifications - Attached hereto
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.
Merrill Lynch U.S. Government Mortgage Fund
By: _/s/ Terry K. Glenn_______
Terry K. Glenn,
President of
Merrill Lynch U.S. Government Mortgage Fund
Date: April 16, 2004
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/ Terry K. Glenn________
Terry K. Glenn,
President of
Merrill Lynch U.S. Government Mortgage Fund
Date: April 16, 2004
By: _/s/ Donald C. Burke________
Donald C. Burke,
Chief Financial Officer of
Merrill Lynch U.S. Government Mortgage Fund
Date: April 16, 2004