Exhibit 17(b)
(BULL LOGO)
Merrill Lynch Investment Managars
Annual Report
August 31, 2001
Merrill Lynch
U.S. Government
Mortgage Fund
www.mlim.ml.com
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.
Merrill Lynch
U.S. Government
Mortgage Fund
Box 9011
Princeton, NJ
08543-9011
Printed on post-consumer recycled paper
Merrill Lynch U.S. Government Mortgage Fund
DEAR SHAREHOLDER
Economic Review
During the six months ended August 31, 2001, the economy remained weak. Second
quarter gross domestic product growth is likely to be revised from an
initially reported annualized growth rate of 0.7% to flat or even negative.
Third-quarter growth is also expected to be slow as the economy struggles to
recover. We anticipate a U-shaped recovery and not a quick bounce to the
strong growth seen during recent years. As we believe economic growth is
currently at, or near bottoming, we expect third-quarter economic data to
continue to give conflicting signals. However, there are signs that indicate a
muted recovery may take hold sometime in the fourth quarter.
Monetary and fiscal policy stimulus have been put in place. The Federal
Reserve Board has cut interest rates seven times as of August 31, 2001, for a
total of 300 basis points (3.00%). There have been tax cuts and rebate checks
that are putting more money into the hands of the consumer. Consumer
confidence remains high even in the face of rising unemployment and consumer
spending is strong even without the impact of the rebate checks. Housing is
strong and leading economic indicators have moved higher for four consecutive
months. But again, the recovery will be slow in coming and it will not measure
up to the previous period of robust growth.
Fiscal Year in Review
The fiscal year ended August 31, 2001 was marked with significant changes in
both the economic environment and the resulting effect on the term structure
of interest rates. Early in the fiscal year, the technology bubble burst,
causing valuations in the stock market to plummet. The Federal Reserve Board
responded by making a series of short-term interest rate cuts. In addition,
there was a general flight to quality. The yield curve was inverted at the
start of the fiscal year with three-month Treasury bills yielding 63 basis
points more than 30-year Treasury bonds at 5.67%. By fiscal year-end that
relationship changed dramatically, with the three-month Treasury bill
declining 294 basis points to 3.36% while 30-year interest rates declined just
31 basis points to 5.36%.
The effect on price for a given interest rate change is greater on longer-term
securities. Even though interest rate declines were greater at the front end
of the yield curve, the price movement, and therefore total return, was
greater at the longer end of the yield curve. The optimal part of the yield
curve was in the five-year area where interest rates declined by 160 basis
points and the total return for the year ended August 31, 2001 was +11.89%. By
comparison, three-month Treasury bills, two-year notes, and 30-year bonds
returned +5.26%, +9.18%, and +8.38%, respectively for the same period.
For the fiscal year ended August 31, 2001, the Fund's Class A, Class B, Class
C and Class D Shares had total returns of +11.77%, +10.91%, +10.86% and
+11.49%, respectively. The unmanaged benchmark Salomon Smith Barney Mortgage
Index had a return of +11.87% for the same 12-month period. (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 3 - 5 of this
report to shareholders.) The Fund provided good relative total returns for the
fiscal year ended August 31, 2001. Our strategy to overweight mortgage
securities proved to be correct. Also correct was our focus on securities that
offered some prepayment protection. In a declining interest rate environment,
where many mortgages trade at premium prices, prepayment on mortgage
securities can hurt total return. We avoided significant prepayment risk by
weighting the portfolio in lower coupon securities that traded at a discount
price. We also kept a large portion of the portfolio in multi-family
securities, where there are contractual prohibitions against early prepayment.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
Going forward, we are still quite positive on the mortgage-backed securities
(MBS) market even though interest rates have declined to the point where
refinancing risk again becomes an important factor. For example, five-year and
ten-year Treasury notes ended the period trading at yields of 4.38% and 4.83%,
respectively. By comparison, a Fannie Mae 6% coupon MBS was trading at a
dollar price of $98.25 or a discount of 1.75%. A Fannie Mae 6.5% coupon was
only slightly over par at $101.12. This demonstrates that the coupon and
yields are attractive with little, if any, prepayment risk at this time.
Even though interest rates are quite low, there is still opportunity for
improved performance. First, interest rates probably will drift a little lower
as it becomes apparent that the economic recovery is not immediate and far
from robust. Second, as we mentioned, the coupon flow is quite attractive
compared to Treasury securities. Third, the yield curve is quite steep
allowing for the potential of rolling down the curve for positive price gains.
Last, we believe that the yield spreads on MBS will tighten closer to
historical norms. This tightening of yield spreads typically has the same
impact on price and total return as a general decline in interest rates.
In Conclusion
We thank you for your continued investment in Merrill Lynch U.S. Government
Mortgage Fund, and we look forward to discussing our outlook and strategy with
you in our next report to shareholders.
Sincerely,
(Terry K. Glenn)
Terry K. Glenn
President and Trustee
(Gregory Mark Maunz)
Gregory Mark Maunz
Senior Vice President and Portfolio Manager
September 25, 2001
The Fund's transfer agency fee schedule has been amended. Under the revised
schedule, the fees payable to Financial Data Services, Inc., the transfer
agent for the Fund, now range from $16 to $23 per shareholder account
(depending upon the level of service required) or 0.10% of account assets for
certain accounts that participate in certain fee-based programs.
A Special Message to Shareholders
Merrill Lynch Investment Managers, L.P. ("MLIM") and its employees join the
nation in mourning the victims and supporting the families of those so deeply
affected by the tragic events that occurred on September 11. As the United
States recovers from this devastating act of terrorism, we would like to
assure our shareholders that client assets are safe and MLIM stands strong,
capable and ready to serve our shareholders. Our company continues to be
financially sound with a strong and liquid balance sheet. Our systems have
remained fully operable, and our portfolio managers and their investment teams
are on the job managing your Fund's investments. While we cannot predict
financial market activity in the weeks and months ahead, we ask you to remain
confident that your Fund is managed by highly qualified investment
professionals who have experience managing portfolios in a variety of market
conditions.
Although uncertainty has been injected into the financial markets, history has
shown the resilience of our financial system in times of crisis. We should not
underestimate the resolve of our business leaders, our government, and most of
all, the spirit of our people to prevail and go forward with renewed strength.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
PERFORMANCE DATA
About Fund Performance
Investors are able to purchase shares of the Fund through the Merrill Lynch
Select PricingSM System, which offers four pricing alternatives:
* Class A Shares incur a maximum initial sales charge (front-end load) of 4%
and bear no ongoing distribution or account maintenance fees. Class A Shares
are available only to eligible investors, as detailed in the Fund's
prospectus. If you were a Class A shareholder prior to October 21, 1994, your
Class A Shares were redesignated to Class D Shares on October 21, 1994.
However, in the case of certain eligible investors, the shares were
simultaneously exchanged for Class A Shares.
* Class B Shares are subject to a maximum contingent deferred sales charge of
4% if redeemed during the first year, decreasing 1% each year thereafter to 0%
after the fourth year. 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 D Shares after approximately 10 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 D Shares incur a maximum initial sales charge of 4% and an account
maintenance fee of 0.25% (but no distribution fee).
None of the past results shown should be considered a representation of future
performance. 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 the "Recent Performance Results" and "Average Annual Total
Return" tables assume reinvestment of all dividends and capital gains
distributions 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.
Recent Performance Results*
Ten Years/
6-Month 12-Month Since Inception Standardized
As of August 31, 2001 Total Return Total Return Total Return 30-Day Yield
ML U.S. Government Mortgage Fund Class A Shares +4.20% +11.77% +67.74% 5.46%
ML U.S. Government Mortgage Fund Class B Shares +3.90 +10.91 +71.73 4.91
ML U.S. Government Mortgage Fund Class C Shares +3.88 +10.86 +58.62 4.87
ML U.S. Government Mortgage Fund Class D Shares +4.18 +11.49 +89.57 5.22
*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 Trust's ten-year/inception periods are from 10/21/94 for
Class A & Class C Shares, from 12/23/91 for Class B Shares; and ten years for
Class D Shares.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
PERFORMANCE DATA (continued)
Total Return Based on a $10,000 Investment
A line graph illustrating the growth of a $10,000 investment in Merrill Lynch
U.S. Government Mortgage Fund++ Class A and Class C Shares* compared to a
similar investment in Salomon Brothers Mortgage Index++++. Values illustrated
are as follows:
Merrill Lynch U.S. Government Mortgage Fund++
Class A Shares*
Date Value
10/21/1994** $ 9,600.00
August 1995 $10,709.00
August 1996 $11,196.00
August 1997 $12,278.00
August 1998 $13,273.00
August 1999 $13,438.00
August 2000 $14,410.00
August 2001 $16,106.00
Merrill Lynch U.S. Government Mortgage Fund++
Class C Shares*
Date Value
10/21/1994** $10,000.00
August 1995 $11,080.00
August 1996 $11,487.00
August 1997 $12,482.00
August 1998 $13,384.00
August 1999 $13,439.00
August 2000 $14,309.00
August 2001 $15,863.00
Salomon Brothers Mortgage Index++++.
Date Value
10/21/1994** $10,000.00
August 1995 $11,248.00
August 1996 $11,815.00
August 1997 $13,041.00
August 1998 $14,158.00
August 1999 $14,427.00
August 2000 $15,598.00
August 2001 $17,449.00
A line graph illustrating the growth of a $10,000 investment in Merrill Lynch
U.S. Government Mortgage Fund++ Class B Shares* compared to a similar
investment in Salomon Brothers Mortgage Index++++. Values illustrated are as
follows:
Merrill Lynch U.S. Government Mortgage Fund++
Class B Shares*
Date Value
12/23/1991** $10,000.00
August 1992 $10,454.00
August 1993 $11,269.00
August 1994 $10,982.00
August 1995 $11,960.00
August 1996 $12,405.00
August 1997 $13,485.00
August 1998 $14,467.00
August 1999 $14,534.00
August 2000 $15,483.00
August 2001 $17,172.00
Salomon Brothers Mortgage Index++++.
Date Value
12/23/1991** $10,000.00
August 1992 $10,572.00
August 1993 $11,379.00
August 1994 $11,432.00
August 1995 $12,683.00
August 1996 $13,322.00
August 1997 $14,705.00
August 1998 $15,965.00
August 1999 $16,269.00
August 2000 $17,590.00
August 2001 $19,677.00
A line graph illustrating the growth of a $10,000 investment in Merrill Lynch
U.S. Government Mortgage Fund++ Class D Shares* compared to a similar
investment in Salomon Brothers Mortgage Index++++. Values illustrated are as
follows:
Merrill Lynch U.S. Government Mortgage Fund++
Class D Shares*
Date Value
August 1991** $9,600.00
August 1992 $10,575.00
August 1993 $11,458.00
August 1994 $11,222.00
August 1995 $12,286.00
August 1996 $12,812.00
August 1997 $14,000.00
August 1998 $15,098.00
August 1999 $15,246.00
August 2000 $16,325.00
August 2001 $18,201.00
Salomon Brothers Mortgage Index++++.
Date Value
August 1991** $10,000.00
August 1992 $11,252.00
August 1993 $12,111.00
August 1994 $12,168.00
August 1995 $13,500.00
August 1996 $14,181.00
August 1997 $15,653.00
August 1998 $16,994.00
August 1999 $17,317.00
August 2000 $18,723.00
August 2001 $20,945.00
*Assuming maximum sales charge, transaction costs and other operating
expenses, including advisory fees.
**Commencement of operations.
++The Trust invests primarily in US Government and Government agency
securities, including GNMA mortgage-backed certificates and other
mortgage-backed Government securities.
++++This unmanaged Index reflects the performance of a capital market
weighting of the outstanding agency-issued mortgage-backed securities. The
starting date for the Index in the Class A & Class C Shares' graph is from
10/31/94 and in the Class B Shares' graph is from 12/31/91.
Past performance is not predictive of future performance.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
PERFORMANCE DATA (concluded)
Average Annual Total Return
% Return Without % Return With
Sales Charge Sales Charge**
Class A Shares*
One Year Ended 6/30/01 +10.79% +6.36%
Five Years Ended 6/30/01 +7.01 +6.14
Inception (10/21/94) through 6/30/01 +7.59 +6.93
*Maximum sales charge is 4%. **Assuming maximum sales charge.
% Return % Return
Without CDSC With CDSC**
Class B Shares*
One Year Ended 6/30/01 +9.95% +5.95%
Five Years Ended 6/30/01 +6.19 +6.19
Inception (12/23/91) through 6/30/01 +5.55 +5.55
*Maximum contingent deferred sales charge is 4% and is reduced to 0% after 4
years. **Assuming payment of applicable contingent deferred sales charge.
% Return % Return
Without CDSC With CDSC**
Class C Shares*
One Year Ended 6/30/01 +9.79% +8.79%
Five Years Ended 6/30/01 +6.14 +6.14
Inception (10/21/94) through 6/30/01 +6.70 +6.70
*Maximum contingent deferred sales charge is 1% and is reduced to 0% after 1
year. **Assuming payment of applicable contingent deferred sales charge.
% Return Without % Return With
Sales Charge Sales Charge**
Class D Shares*
One Year Ended 6/30/01 +10.52% +6.10%
Five Years Ended 6/30/01 +6.77 +5.90
Ten Years Ended 6/30/01 +6.66 +6.23
*Maximum sales charge is 4%. **Assuming maximum sales charge.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
SCHEDULE OF INVESTMENTS
Face Interest Original Maturity
Issue Amount Rate Date(s) Value
US Government Agency Mortgage-Backed Obligations*--93.7%
Fannie Mae $ 2,807,494 6.00% 6/01/2028 - 4/01/2031(9) $ 3,101,285
213,755,202 6.50 12/01/2008 - 7/01/2031(9) 216,714,923
13,792,118 7.00 11/01/2013 - 8/01/2029 14,246,464
259 7.50 1/01/2025 270
432,678 8.00 9/01/2024 - 9/01/2027 453,218
326,550 8.50 5/01/2010 - 8/01/2012 344,849
8,631,844 8.50(3) 7/15/2023 9,209,948
5,650,796 9.50 3/01/2020 5,989,844
9,139,780 11.00 2/01/2011 - 11/01/2020 10,398,703
11,716 11.50 6/01/2015 13,163
712,000 13.00 8/01/2010 - 4/01/2015 839,318
Fannie Mae #0384046 10,000,000 5.67(10) 9/01/2006 10,184,375
Mortgage-Backed Securities-- #0160465 32,655,593 6.16(8) 8/01/2013 33,687,317
Multi-Family++ #0380332 9,296,184 6.195(7) 6/01/2005 9,634,501
#0375610 13,439,201 6.465(7) 6/01/2004 13,867,872
#0380021 6,050,963 6.49(2) 1/01/2008 6,341,338
#0073894 950,247 6.525(7) 12/01/2003 980,437
#0073885 856,321 6.545(2) 1/01/2007 898,396
#0073873 738,711 6.625(2) 2/01/2007 777,439
#0073221 1,406,038 6.715(7) 10/01/2005 1,480,392
#0375015 18,398,170 6.79(7) 4/01/2004 19,148,140
#0073915 1,444,147 6.87(2) 1/01/2007 1,532,429
#0073910 11,405,075 6.875(2) 1/01/2007 12,107,641
#0375043 3,449,648 6.895(2) 4/01/2007 3,667,060
#0375007 11,667,739 6.94(2) 3/01/2007 12,420,713
#0375012 3,163,540 6.95(2) 4/01/2007 3,370,513
#0073944 13,368,845 6.96(2) 1/01/2007 14,239,680
#0073952 2,646,407 6.96(2) 1/01/2007 2,818,337
#0073946 5,169,180 6.97(2) 2/01/2007 5,507,836
#0073969 7,600,422 7.05(2) 2/01/2007 8,122,463
#0073962 4,530,363 7.085(2) 2/01/2007 4,850,105
#0073967 4,402,316 7.105(2) 2/01/2007 4,716,701
#0073992 2,502,735 7.115(2) 2/01/2007 2,682,553
#0375069 1,029,164 7.122(2) 4/01/2007 1,103,401
#0073943 1,368,478 7.18(4) 2/01/2019 1,463,222
#0073608 4,681,588 7.49(2) 8/01/2006 5,078,325
#0375052 4,581,391 7.50(2) 3/01/2027 5,075,107
#0109076 2,074,610 7.59(2) 8/01/2006 2,257,162
#0160024 4,929,864 7.625(2) 11/01/2003 5,116,835
#0160095 6,898,751 7.66(2) 3/01/2004 7,193,857
Fannie Mae 98-M1-IO2 90,630,291 0.68635(1) 2/25/2013 4,021,719
Mortgage-Backed Securities-- 94-M1-IO 62,755,813 0.87(1) 10/25/2003 972,715
REMICs**--Multi-Family++ 98-M3-B 10,960,597 6.45 8/17/2013 11,263,172
97-M8-A2 19,135,000 7.16 1/25/2022 20,358,641
96-M3-A2 40,500,000 7.41 3/25/2021 43,257,839
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
SCHEDULE OF INVESTMENTS (continued)
Face Interest Original Maturity
Issue Amount Rate Date(s) Value
US Government Agency Mortgage-Backed Obligations* (concluded)
Fannie Mae 94-56-TB $ 5,239,230 6.50(1)% 7/25/2022 $ 947,142
REMICs** Trust 273 3,139,576 7.00(1) 7/01/2026 553,182
96-W1-AL 7,514,728 7.25 3/25/2026 7,756,777
Freddie Mac 485 10.00 7/01/2019 537
Participation Certificates 4,626,903 10.50 9/01/2010 - 9/01/2020 5,160,780
1,050,656 11.00 8/01/2010 - 9/01/2020 1,185,733
1,232,683 11.50 12/01/2011 - 6/01/2020 1,414,839
586,493 12.00 5/01/2010 - 6/01/2020 676,918
831,662 12.50 9/01/2014 - 7/01/2019 964,269
1,462,185 13.00 11/01/2009 - 2/01/2016 1,686,740
Freddie Mac 170,370 6.00 4/01/2009 173,905
Participation Certificates-- 249,986,937 6.00 6/01/2029 - 5/01/2031(9) 246,250,790
Gold Program 137,616 6.50 9/01/2013 141,165
202,537,568 6.50 10/01/2028 - 8/01/2031(9) 203,920,525
7,516,360 7.00 8/01/2011 - 2/01/2013 7,790,056
58,293,989 7.00 9/01/2028 - 12/01/2030 59,783,151
9,146,437 7.50 5/01/2009 - 10/01/2011 9,532,937
290,644 7.50 8/01/2017 302,391
8,506,465 8.00 1/01/2007 - 7/01/2012 8,883,451
68,778 8.00 10/01/2027 72,054
2,473,512 8.50 1/01/2025 - 7/01/2025 2,617,993
1,283,966 10.50 10/01/2020 - 12/01/2020 1,443,818
Freddie Mac REMICs** Trust 134 535,543 9.00(1) 4/01/2022 91,106
Trust 1220 2,487,338 10.00 2/15/2022 2,458,069
Government National Mortgage 68,656,986 6.50 10/15/2023 - 7/15/2029 69,419,304
Association 145,967,931 7.00 4/15/2023 - 5/15/2029 150,045,337
45,684,457 7.50 1/15/2007 - 2/15/2030(9) 47,625,988
4,888,015 8.00 1/15/2024 - 8/15/2026(9) 5,258,584
13,664,959 10.00 12/15/2015 - 12/15/2021 15,267,940
49,465 10.50 1/15/2016 - 4/15/2021 55,034
80 11.00 1/15/2016 90
1,059 11.50 8/15/2013 1,193
Total US Government Agency Mortgage-Backed Obligations (Cost--$1,365,786,968) 1,392,992,016
US Government Obligations--2.8%
US Treasury Notes 40,000,000 5.75 11/15/2005 42,112,400
Total US Government Obligations (Cost--$41,968,750) 42,112,400
Face
Amount Issue Value
Repurchase Agreements***--1.7%
$25,000,000 Morgan Stanley & Company, Inc., purchased on 8/31/2001 to yield 3.63% to 9/04/2001 25,000,000
Total Repurchase Agreements (Cost--$25,000,000) 25,000,000
Total Investments (Cost--$1,432,755,718)--98.2% 1,460,104,416
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
SCHEDULE OF INVESTMENTS (concluded)
Nominal Value Strike Notification
Covered by Options Price Date
Options Purchased--0.1%
Call Options 15,602,752 Government National Mortgage Association, 100 9/20/2011(5) $ 12,482
Purchased Purchased 30-Year, 6.75% Adjustable Rate
Mortgage(5)(6)
29,600,000 United States Treasury Notes, 5% due 2/15/2011 97.563 9/10/2001(11) 989,735
Total Options Purchased (Cost--$425,500) 1,002,217
Options Written--(0.1)%
Call Options 50,000,000 Government National Mortgage Association, 98.578 9/10/2001(11) (937,500)
Written 30-Year, 6.75% Adjustable Rate Mortgage(5)(6)
Put Options 15,602,752 Fannie Mae, 6.50%(9) 100 9/20/2011(5) (15,603)
Written
Total Options Written (Premiums Received--$425,781) (953,103)
Total Investments, Net of Options Written (Cost--$1,432,755,437)--98.2% 1,460,153,530
Other Assets Less Liabilities--1.8% 27,050,296
---------------
Net Assets--100.0% $1,487,203,826
===============
(1)Represents the interest only portion of a mortgage-backed obligation.
(2)Represents balloon mortgages that amortize on a 25-year or 30-year schedule
and have 10-year original maturities.
(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 European style options which can be exercised only on the
notification date. These options, when combined, represent a standby purchase
commitment whereby the Fund is obligated to purchase the outstanding principal
amount of specific Government National Mortgage Association, 30-year, 6.75%
Adjustable Rate Mortgage pools as of September 20, 2011. For this commitment,
the Fund receives a net .12% per annum based on the nominal value covered by
the options.
(6)Adjustable Rate Security. The interest rate resets annually at the 1-year
Constant Maturing Treasury rate plus 1.5%, subject to a 1% annual adjustment
cap and an 11% life cap.
(7)Represents balloon mortgages that amortize on a 30-year schedule and have
7-year original maturities.
(8)Represents a mortgage that amortizes on a 15-year schedule and has a
15-year original maturity.
(9)Represents or includes a "to-be-announced" (TBA) transaction. The Fund has
committed to purchasing or selling securities for which all specific
information is not available at this time.
(10)Represents a balloon mortgage that amortizes on a 30-year schedule and has
a 5-year original maturity.
(11)Represents European style options which can be exercised only on the
notification date.
++Underlying multi-family loans have prepayment protection by means of lockout
periods and/or yield maintenance premiums.
*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 (REMICs).
***Repurchase Agreements are fully collateralized by US Government Agency
Obligations.
See Notes to Financial Statements.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
FINANCIAL INFORMATION
Statement of Assets and Liabilities as of August 31, 2001
Assets: Investments, at value (identified cost--$1,432,755,718) $ 1,460,104,416
Options purchased, at value (cost--$425,500) 1,002,217
Receivables:
Securities sold $ 150,177,084
Interest 11,178,066
Beneficial interest sold 4,357,025
Principal paydowns 354,744 166,066,919
------------
Prepaid registration fees and other assets 134,552
---------------
Total assets 1,627,308,104
---------------
Liabilities: Options written, at value (premiums received--$425,781) 953,103
Payables:
Securities purchased 129,183,975
Beneficial interest redeemed 4,739,117
Custodian 1,867,044
Dividends to shareholders 1,522,539
Investment adviser 553,822
Distributor 525,138 138,391,635
------------
Accrued expenses and other liabilities 759,540
---------------
Total liabilities 140,104,278
---------------
Net Assets: Net assets $ 1,487,203,826
Net Assets Class A Shares of beneficial interest, $.10 par value,
Consist of: unlimited number of shares authorized $ 2,360,741
Class B Shares of beneficial interest, $.10 par value,
unlimited number of shares authorized 4,688,398
Class C Shares of beneficial interest, $.10 par value,
unlimited number of shares authorized 570,023
Class D Shares of beneficial interest, $.10 par value,
unlimited number of shares authorized 7,328,816
Paid-in capital in excess of par 1,646,857,447
Accumulated realized capital losses on investments--net (201,999,692)
Unrealized appreciation on investments--net 27,398,093
---------------
Net assets $ 1,487,203,826
===============
Net Asset Class A--Based on net assets of $234,929,682 and 23,607,412
Value: shares of beneficial interest outstanding $ 9.95
===============
Class B--Based on net assets of $466,432,519 and 46,883,981
shares of beneficial interest outstanding $ 9.95
===============
Class C--Based on net assets of $56,706,036 and 5,700,232
shares of beneficial interest outstanding $ 9.95
===============
Class D--Based on net assets of $729,135,589 and 73,288,158
shares of beneficial interest outstanding $ 9.95
===============
See Notes to Financial Statements.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
FINANCIAL INFORMATION (continued)
Statement of Operations for the Year Ended August 31, 2001
Investment Interest and discount earned $ 93,070,184
Income:
Expenses: Investment advisory fees $ 6,734,054
Account maintenance and distribution fees--Class B 3,134,219
Account maintenance fees--Class D 1,853,739
Transfer agent fees--Class D 1,379,818
Transfer agent fees--Class B 857,941
Transfer agent fees--Class A 401,043
Accounting services 370,431
Account maintenance and distribution fees--Class C 301,617
Custodian fees 287,671
Printing and shareholder reports 146,734
Professional fees 136,820
Trustees' fees and expenses 79,240
Registration fees 77,236
Transfer agent fees--Class C 76,548
Pricing fees 65,638
Other 52,512
------------
Total expenses 15,955,261
---------------
Investment income--net 77,114,923
---------------
Realized & Realized gain on investments--net 3,784,133
Unrealized Change in unrealized appreciation/depreciation 68,774,825
Gain on on investments--net ---------------
Investments-- Net Increase in Net Assets Resulting from Operations $ 149,673,881
Net: ===============
See Notes to Financial Statements.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
FINANCIAL INFORMATION (continued)
Statements of Changes in Net Assets
For the Year Ended August 31,
2001 2000
Increase (Decrease) in Net Assets:
Operations: Investment income--net $ 77,114,923 $ 85,948,520
Realized gain (loss) on investments--net 3,784,133 (8,076,919)
Change in unrealized appreciation/depreciation on investments--net 68,774,825 17,073,004
---------------- ---------------
Net increase in net assets resulting from operations 149,673,881 94,944,605
---------------- ---------------
Dividends to Investment income--net:
Shareholders: Class A (12,568,680) (12,162,473)
Class B (21,183,948) (26,575,702)
Class C (1,885,812) (2,070,304)
Class D (41,476,483) (45,140,041)
---------------- ---------------
Net decrease in net assets resulting from dividends to
shareholders (77,114,923) (85,948,520)
---------------- ---------------
Beneficial Net increase (decrease) in net assets derived from
Interest beneficial interest transactions 65,775,375 (286,654,061)
Transactions: ---------------- ---------------
Net Assets: Total increase (decrease) in net assets 138,334,333 (277,657,976)
Beginning of year 1,348,869,493 1,626,527,469
---------------- ---------------
End of year $ 1,487,203,826 $1,348,869,493
================ ===============
See Notes to Financial Statements.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
FINANCIAL INFORMATION (continued)
Financial Highlights
The following per share data and ratios
have been derived from information
provided in the financial statements. Class A
For the Year Ended August 31,
Increase (Decrease) in Net Asset Value: 2001 2000 1999 1998 1997
Per Share Net asset value, beginning of year $ 9.44 $ 9.37 $ 9.80 $ 9.64 $ 9.40
Operating ------------- ---------- ------------ ---------- -----------
Performance: Investment income--net .57 .58 .55 .60 .64
Realized and unrealized gain (loss)
on investments--net .51 .07 (.43) .16 .24
------------- ---------- ------------ ---------- -----------
Total from investment operations 1.08 .65 .12 .76 .88
------------- ---------- ------------ ---------- -----------
Less dividends from investment
income--net (.57) (.58) (.55) (.60) (.64)
------------- ---------- ------------ ---------- -----------
Net asset value, end of year $ 9.95 $ 9.44 $ 9.37 $ 9.80 $ 9.64
============= ========== ============ ========== ===========
Total Based on net asset value per share 11.77% 7.23% 1.24% 8.10% 9.66%
Investment ============= ========== ============ ========== ===========
Return:**
Ratios to Expenses .75% .75% .70% .68% .65%
Average ============= ========== ============ ========== ===========
Net Assets: Investment income--net 5.84% 6.23% 5.71% 6.18% 6.73%
============= ========== ============ ========== ===========
Supplemental Net assets, end of year
Data: (in thousands) $ 234,930 $ 192,119 $ 212,131 $ 277,568 $ 278,103
============= ========== ============ ========== ===========
Portfolio turnover 199.30% 37.28% 58.16% 301.88% 349.05%
============= ========== ============ ========== ===========
The following per share data and ratios
have been derived from information
provided in the financial statements. Class B
For the Year Ended August 31,
Increase (Decrease) in Net Asset Value: 2001 2000 1999 1998 1997
Per Share Net asset value, beginning of year $ 9.44 $ 9.36 $ 9.79 $ 9.63 $ 9.40
Operating ------------- ---------- ------------ ---------- -----------
Performance: Investment income--net .50 .51 .48 .53 .57
Realized and unrealized gain (loss)
on investments--net .51 .08 (.43) .16 .23
------------- ---------- ------------ ---------- -----------
Total from investment operations 1.01 .59 .05 .69 .80
------------- ---------- ------------ ---------- -----------
Less dividends from investment
income--net (.50) (.51) (.48) (.53) (.57)
------------- ---------- ------------ ---------- -----------
Net asset value, end of year $ 9.95 $ 9.44 $ 9.36 $ 9.79 $ 9.63
============= ========== ============ ========== ===========
Total Based on net asset value per share 10.91% 6.53% .46% 7.28% 8.71%
Investment ============= ========== ============ ========== ===========
Return:**
Ratios to Expenses 1.52% 1.52% 1.46% 1.45% 1.42%
Average ============= ========== ============ ========== ===========
Net Assets: Investment income--net 5.07% 5.47% 4.95% 5.42% 5.98%
============= ========== ============ ========== ===========
Supplemental Net assets, end of year
Data: (in thousands) $ 466,432 $ 405,846 $ 571,969 $ 627,818 $ 672,541
============= ========== ============ ========== ===========
Portfolio turnover 199.30% 37.28% 58.16% 301.88% 349.05%
============= ========== ============ ========== ===========
*Total investment returns exclude the effects of sales charges.
See Notes to Financial Statements.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
FINANCIAL INFORMATION (concluded)
Financial Highlights (concluded)
The following per share data and ratios
have been derived from information
provided in the financial statements. Class C
For the Year Ended August 31,
Increase (Decrease) in Net Asset Value: 2001 2000 1999 1998 1997
Per Share Net asset value, beginning of year $ 9.44 $ 9.36 $ 9.79 $ 9.63 $ 9.40
Operating ------------- ---------- ------------ ---------- -----------
Performance: Investment income--net .49 .51 .48 .52 .56
Realized and unrealized gain (loss)
on investments--net .51 .08 (.43) .16 .23
------------- ---------- ------------ ---------- -----------
Total from investment operations 1.00 .59 .05 .68 .79
------------- ---------- ------------ ---------- -----------
Less dividends from investment
income--net (.49) (.51) (.48) (.52) (.56)
------------- ---------- ------------ ---------- -----------
Net asset value, end of year $ 9.95 $ 9.44 $ 9.36 $ 9.79 $ 9.63
============= ========== ============ ========== ===========
Total Based on net asset value per share 10.86% 6.47% .41% 7.23% 8.66%
Investment ============= ========== ============ ========== ===========
Return:**
Ratios to Expenses 1.57% 1.57% 1.51% 1.51% 1.47%
Average ============= ========== ============ ========== ===========
Net Assets: Investment income--net 5.00% 5.43% 4.90% 5.35% 5.91%
============= ========== ============ ========== ===========
Supplemental Net assets, end of year
Data: (in thousands) $ 56,706 $ 30,593 $ 46,614 $ 43,038 $ 28,723
============= ========== ============ ========== ===========
Portfolio turnover 199.30% 37.28% 58.16% 301.88% 349.05%
============= ========== ============ ========== ===========
The following per share data and ratios
have been derived from information
provided in the financial statements. Class D
For the Year Ended August 31,
Increase (Decrease) in Net Asset Value: 2001 2000 1999 1998 1997
Per Share Net asset value, beginning of year $ 9.44 $ 9.36 $ 9.79 $ 9.63 $ 9.40
Operating ------------- ---------- ------------ ---------- -----------
Performance: Investment income--net .55 .56 .53 .58 .62
Realized and unrealized gain (loss)
on investments--net .51 .08 (.43) .16 .23
------------- ---------- ------------ ---------- -----------
Total from investment operations 1.06 .64 .10 .74 .85
------------- ---------- ------------ ---------- -----------
Less dividends from investment
income--net (.55) (.56) (.53) (.58) (.62)
------------- ---------- ------------ ---------- -----------
Net asset value, end of year $ 9.95 $ 9.44 $ 9.36 $ 9.79 $ 9.63
============= ========== ============ ========== ===========
Total Based on net asset value per share 11.49% 7.08% .98% 7.84% 9.27%
Investment ============= ========== ============ ========== ===========
Return:**
Ratios to Expenses 1.00% 1.00% .95% .93% .90%
Average ============= ========== ============ ========== ===========
Net Assets: Investment income--net 5.59% 5.99% 5.47% 5.94% 6.49%
============= ========== ============ ========== ===========
Supplemental Net assets, end of year
Data: (in thousands) $ 729,136 $ 720,311 $ 795,813 $ 866,013 $ 927,756
============= ========== ============ ========== ===========
Portfolio turnover 199.30% 37.28% 58.16% 301.88% 349.05%
============= ========== ============ ========== ===========
*Total investment returns exclude the effects of sales charges.
See Notes to Financial Statements.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
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 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. The Fund
offers four classes of shares under the Merrill Lynch Select Pricing SM
System. Shares of Class A and Class D are sold with a front-end sales charge.
Shares of Class B and Class C may be subject to a contingent deferred sales
charge. All classes of shares have identical voting, dividend, liquidation and
other rights and the same terms and conditions, except that Class B, Class C
and Class D Shares bear certain expenses related to the account maintenance of
such shares, and Class B and Class C 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. The following is a summary of significant accounting policies
followed by the Fund.
(a) Valuation of investments--Securities traded in the over-the-counter market
are valued at the last available bid price in the over-the-counter market or
on the basis of yield equivalents as obtained from one or more dealers that
make markets in the securities. The Fund employs Merrill Lynch Securities
Pricing Service ("MLSPS"), an affiliate of Merrill Lynch, Pierce, Fenner &
Smith Incorporated ("MLPF&S"), to provide mortgage-backed securities prices
for the Fund. Options written or purchased are valued at the last sale price
in the case of exchange-traded options. In the case of options traded in the
over-the-counter market, valuation is the last asked price (options written)
or the last bid price (options purchased). Financial futures contracts and
options thereon, which are traded on exchanges, are valued at their last sale
price as of the close of such exchanges. Securities with a remaining maturity
of sixty days or less are valued on an amortized cost basis, which
approximates market value. 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.
(b) Repurchase agreements--The Fund invests in US 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 to increase or decrease the level of risk to which the
Fund is exposed more quickly and efficiently than transactions in other types
of instruments. Losses may arise due to changes in the value of the contract
or if the counterparty does not perform under the contract.
* Futures contracts--The Fund may purchase or sell financial futures
contracts. 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 is authorized to 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.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
(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. Interest income and extended delivery fees are
recognized on the accrual basis. The Fund will adopt the provisions to
amortize all premiums and discounts on debt securities effective September 1,
2001, as now required under the new AICPA Audit and Accounting Guide for
Investment Companies. The cumulative effect of this accounting change will
have no impact on the total net assets of the Fund, but will result in a
$13,811 decrease to the cost of securities and a corresponding $13,811
increase to net unrealized appreciation, based on debt securities held as of
August 31, 2001.
(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) Dollar rolls--The Fund sells 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.
As of August 31, 2001, no dollar rolls were in effect.
(i) Custodian bank--The Fund recorded an amount payable to the custodian bank
reflecting an overnight overdraft which resulted from a failed trade which
settled the next day.
2. Investment Advisory Agreement and Transactions with Affiliates:
The Fund has entered into an Investment Advisory Agreement with 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:
Account Distribution
Maintenance Fee Fee
Class B .25% .50%
Class C .25% .55%
Class D .25% --
Pursuant to a sub-agreement with the Distributor, 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 B, Class C and Class D
shareholders. The ongoing distribution fee compensates the Distributor and
MLPF&S for providing shareholder and distribution-related services to Class B
and Class C shareholders.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
NOTES TO FINANCIAL STATEMENTS (continued)
For the year ended August 31, 2001, FAMD earned underwriting discounts and
direct commissions and MLPF&S earned dealer concessions on sales of the Fund's
Class A and Class D Shares as follows:
FAMD MLPF&S
Class A $ 136 $ 1,741
Class D $ 18,145 $ 221,115
For the year ended August 31, 2001, MLPF&S received contingent deferred sales
charges of $429,175 and $12,236 relating to transactions in Class B and Class
C Shares, respectively. Furthermore, MLPF&S received contingent deferred sales
charges of $31,473 relating to transactions subject to front-end sales charge
waivers in Class D Shares.
Financial Data Services, Inc. ("FDS"), a wholly-owned subsidiary of ML & Co.,
is the Fund's transfer agent.
For the year ended August 31, 2001, the Fund paid MLSPS, an affiliate of
MLPF&S, $178 for security price quotations to compute the net asset value of
the Fund.
Prior to January 1, 2001, FAM provided accounting services to the Fund at its
cost and the Fund reimbursed FAM for these services. FAM continues to provide
certain accounting services to the Fund. The Fund reimburses FAM at its cost
for such services. For the year ended August 31, 2001, the Fund reimbursed FAM
an aggregate of $106,729 for the above-described services. The Fund entered
into an agreement with State Street Bank and Trust Company ("State Street"),
effective January 1, 2001, pursuant to which State Street provides certain
accounting services to the Fund. The Fund pays a fee for these 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
year ended August 31, 2001 were $2,922,266,884 and $2,726,634,418,
respectively.
Net realized gains for the year ended August 31, 2001 and net unrealized gains
(losses) as of August 31, 2001 were as follows:
Realized Unrealized
Gains Gains
(Losses) (Losses)
Long-term investments $ 2,554,967 $ 27,348,698
Options purchased -- 576,717
Options written -- (527,322)
Financial futures contracts 1,229,166 --
----------- ------------
Total $ 3,784,133 $ 27,398,093
As of August 31, 2001, net unrealized appreciation for Federal income tax
purposes aggregated $27,395,506, of which $34,046,314 related to appreciated
securities and $6,650,808 related to depreciated securities. The aggregate
cost of investments, including options, at August 31, 2001 for Federal income
tax purposes was $1,432,758,024.
Transactions in options written for the year ended August 31, 2001 were as
follows:
Nominal Value
Covered by Premiums
Put Options Written Options Received
Outstanding put options written,
beginning of year. 25,826,059 $ --
Options expired (10,223,307) --
----------- -----------
Outstanding put options
written, end of year 15,602,752 $ --
=========== ===========
Nominal Value
Covered by Premiums
Call Options Written Options Received
Outstanding call options written,
beginning of year. -- $ --
Options sold 50,000,000 425,781
----------- -----------
Outstanding call options
written, end of year 50,000,000 $ 425,781
=========== ===========
4. Shares of Beneficial Interest:
Net increase (decrease) in net assets derived from beneficial interest
transactions was $65,775,375 and $(286,654,061) for the years ended August 31,
2001 and August 31, 2000, respectively.
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
Transactions in shares of beneficial interest for each class were as follows:
Class A Shares for the Year Dollar
Ended August 31, 2001 Shares Amount
Shares sold 11,486,006 $112,213,653
Shares issued to shareholders
in reinvestment of dividends 162,431 1,583,430
------------ --------------
Total issued 11,648,437 113,797,083
Shares redeemed (8,390,750) (81,877,918)
------------ --------------
Net increase 3,257,687 $ 31,919,165
============ ==============
Class A Shares for the Year Dollar
Ended August 31, 2000 Shares Amount
Shares sold 8,590,023 $ 80,009,133
Shares issued to shareholders
in reinvestment of dividends 135,971 1,268,220
------------ --------------
Total issued 8,725,994 81,277,353
Shares redeemed (11,027,002) (102,751,609)
------------ --------------
Net increase (2,301,008) $(21,474,256)
============ ==============
Class B Shares for the Year Dollar
Ended August 31, 2001 Shares Amount
Shares sold 18,912,495 $ 185,104,145
Shares issued to shareholders
in reinvestment of dividends 1,163,858 11,346,482
------------ --------------
Total issued 20,076,353 196,450,627
Automatic conversion of shares (3,369,741) (32,877,221)
Shares redeemed (12,822,475) (124,664,599)
------------ --------------
Net increase 3,884,137 $ 38,908,807
============ ==============
Class B Shares for the Year Dollar
Ended August 31, 2000 Shares Amount
Shares sold 8,212,152 $ 76,667,166
Shares issued to shareholders
in reinvestment of dividends 1,533,575 14,294,974
------------ --------------
Total issued 9,745,727 90,962,140
Automatic conversion of shares (2,434,813) (22,718,458)
Shares redeemed (25,398,785) (236,675,449)
------------ --------------
Net increase (18,087,871) $(168,431,767)
============ ==============
Class C Shares for the Year Dollar
Ended August 31, 2001 Shares Amount
Shares sold 3,629,627 $ 35,584,338
Shares issued to shareholders
in reinvestment of dividends 125,177 1,221,385
------------ --------------
Total issued 3,754,804 36,805,723
Shares redeemed (1,296,164) (12,624,766)
------------ --------------
Net increase 2,458,640 $ 24,180,957
============ ==============
Class C Shares for the Year Dollar
Ended August 31, 2000 Shares Amount
Shares sold 940,033 $ 8,790,180
Shares issued to shareholders
in reinvestment of dividends 144,606 1,348,178
------------ --------------
Total issued 1,084,639 10,138,358
Shares redeemed (2,822,028) (26,280,345)
------------ --------------
Net increase (1,737,389) $(16,141,987)
============ ==============
Class D Shares for the Year Dollar
Ended August 31, 2001 Shares Amount
Shares sold 13,133,960 $ 128,224,313
Automatic conversion of shares 3,369,741 32,877,221
------------ --------------
Shares issued to shareholders
in reinvestment of dividends 1,847,720 17,998,322
Total issued 18,351,421 179,099,856
Shares redeemed (21,381,997) (208,333,410)
------------ --------------
Net increase (3,030,576) $(29,233,554)
============ ==============
Class D Shares for the Year Dollar
Ended August 31, 2000 Shares Amount
Shares sold 12,254,428 $ 114,481,013
Automatic conversion of shares 2,434,813 22,718,458
------------ --------------
Shares issued to shareholders
in reinvestment of dividends 2,068,822 19,279,824
Total issued 16,758,063 156,479,295
Shares redeemed (25,435,386) (237,085,346)
------------ --------------
Net increase (8,677,323) $(80,606,051)
============ ==============
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
NOTES TO FINANCIAL STATEMENTS (concluded)
5. Short-Term Borrowings:
On December 1, 2000, the Fund, along with certain other funds managed by FAM
and its affiliates, renewed and amended a $1,000,000,000 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 facility. Amounts borrowed under the facility 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. The Fund did not
borrow under the facility during the year ended August 31, 2001.
6. Capital Loss Carryforward:
At August 31, 2001, the Fund had a net capital loss carryforward of
approximately $200,903,000, of which $175,708,000 expires in 2003, $16,733,000
expires in 2004, $4,697,000 expires in 2008 and $3,765,000 expires in 2009.
This amount will be available to offset like amounts of any future taxable
gains.
INDEPENDENT AUDITORS' REPORT
The Board of Trustees and Shareholders, Merrill Lynch U.S. Government Mortgage
Fund:
We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of Merrill Lynch U.S. Government
Mortgage Fund as of August 31, 2001, the related statements of operations for
the year then ended, and changes in net assets for each of the years in the
two-year period then ended, and the financial highlights for each of the years
presented. These financial statements and the financial highlights are the
responsibility of the Fund's management. Our responsibility is to express an
opinion on these financial statements and the financial highlights based on
our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
financial statements and the financial highlights are free of material
misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. Our
procedures included confirmation of securities owned at August 31, 2001 by
correspondence with the custodian and brokers; where replies were not received
from brokers, we performed other auditing procedures.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion. In our opinion, such financial statements
and financial highlights present fairly, in all material respects, the
financial position of Merrill Lynch U.S. Government Mortgage Fund as of August
31, 2001, the results of its operations, the changes in its net assets, and
the financial highlights for the respective stated periods in conformity with
accounting principles generally accepted in the United States of America.
Deloitte & Touche LLP
New York, New York
October 12, 2001
Merrill Lynch U.S. Government Mortgage Fund, August 31, 2001
OFFICERS AND TRUSTEES
Terry K. Glenn, President and Trustee
Joe Grills, Trustee
Walter Mintz, Trustee
Robert S. Salomon Jr., Trustee
Melvin R. Seiden, Trustee
Stephen B. Swensrud, Trustee
Gregory Mark Maunz, Senior Vice President
Jeffrey B. Hewson, Vice President
Donald C. Burke, Vice President and Treasurer
Phillip S. Gillespie, Secretary
Custodian
The Bank of New York
90 Washington Street, 12th Floor
New York, NY 10286
Transfer Agent
Financial Data Services, Inc.
4800 Deer Lake Drive East
Jacksonville, FL 32246-6484
(800) 637-3863