Exhibit 17(b)
STATEMENT OF ADDITIONAL INFORMATION
Merrill Lynch Bond Fund, Inc.
P.O. Box 9011, Princeton, New Jersey 08543-9011 o Phone No. (609) 282-2800
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Merrill Lynch Bond Fund, Inc. (the "Fund") is a diversified open-end
investment company consisting of three separate portfolios, the High Income
Portfolio, the Core Bond Portfolio and the Intermediate Term Portfolio (each,
a "Portfolio"). The main goal of each Portfolio is to obtain the highest level
of current income as is consistent with the investment policies of such
Portfolio and with prudent investment management. As a secondary objective,
each Portfolio seeks capital appreciation when consistent with its primary
objective. Each Portfolio seeks to achieve its objectives by investing in a
diversified portfolio of fixed-income securities, such as corporate bonds and
notes, convertible securities, preferred stocks and government obligations.
Under normal circumstances, more than 90% of the net assets of each Portfolio
will be invested in fixed-income securities, including convertible and
nonconvertible debt securities and preferred stocks. There can be no assurance
that the investment objectives of a Portfolio will be achieved. Each Portfolio
may employ a variety of instruments and techniques to enhance income and to
hedge against market and currency risk.
Pursuant to the Merrill Lynch Select Pricing(SM) System, each Portfolio of
the Fund offers four classes of shares, each with a different combination of
sales charges, ongoing fees and other features. The Merrill Lynch Select
Pricing(SM) System permits an investor to choose the method of purchasing
shares that the investor believes is most beneficial given the amount of the
purchase, the length of time the investor expects to hold the shares and other
relevant circumstances. See "Purchase of Shares."
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This Statement of Additional Information of the Fund is not a
prospectus and should be read in conjunction with the Prospectus of the Fund,
dated January 24, 2002 (the "Prospectus"), which has been filed with the
Securities and Exchange Commission (the "Commission") and can be obtained,
without charge, by calling (800) MER-FUND or by writing to the Fund at the
above address. The Prospectus is incorporated by reference into this Statement
of Additional Information, and this Statement of Additional Information is
incorporated by reference into the Prospectus. The Fund's audited financial
statements are incorporated in this Statement of Additional Information by
reference to its 2001 Annual Report. You may request a copy of the Annual
Report at no charge by calling 800-637-3863 between 8:00 a.m. and 8:00 p.m.
Eastern time on any business day.
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Fund Asset Management, L.P.--Investment Adviser
FAM Distributors, Inc.--Distributor
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The date of this Statement of Additional Information is January 24, 2002.
TABLE OF CONTENTS
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Investment Objectives and Policies......................................3
High Income Portfolio.............................................3
Core Bond Portfolio...............................................5
Intermediate Term Portfolio.......................................5
Maturity of Fixed Income Investments..............................5
Risk Factors and Special Considerations.................................6
Risk Factors in Transactions in Junk Bonds........................6
Risk Factors in Transactions in Distressed Securities.............7
Risk Factors in Transactions in Corporate Loans...................7
Risk Factors in Transactions in Foreign Securities................7
Risk Factors in Transactions in Futures and Options Thereon.......9
European Economic and Monetary Union.............................11
Other Portfolio Strategies.............................................12
Investment Restrictions................................................16
Management of the Fund.................................................17
Directors and Officers...........................................17
Compensation of Directors........................................19
Management and Advisory Arrangements.............................20
Duration and Termination.........................................21
Code of Ethics...................................................22
Purchase of Shares.....................................................23
Initial Sales Charge Alternatives--Class A and Class D Shares... 27
Reduced Initial Sales Charges--Class A and Class D Shares....... 29
Deferred Sales Charge Alternatives--Class B and Class C Shares.. 33
Distribution Plans.............................................. 37
Employer-Sponsored Retirement or Savings Plans and Certain
Other Arrangements...............................................39
Limitations on the Payment of Deferred Sales Charges.............39
Redemption of Shares...................................................41
Redemption.......................................................41
Repurchase.......................................................42
Reinstatement Privilege--Class A and Class D Shares..............43
Pricing of Shares......................................................43
Determination of Net Asset Value.................................43
Computation of Offering Price Per Share..........................44
Portfolio Transactions and Brokerage...................................45
Portfolio Turnover...............................................46
Shareholder Services...................................................47
Investment Account...............................................47
Automatic Investment Plans.......................................47
Fee-Based Programs...............................................48
Automatic Reinvestment of Dividends and Capital Gains
Distribution.....................................................48
Systematic Withdrawal Plan.......................................48
Retirement and Education Savings Plans...........................49
Exchange Privilege...............................................50
Dividends and Taxes....................................................52
Dividends........................................................52
Taxes............................................................52
Tax Treatment of Options Transactions............................55
Performance Data.......................................................55
Additional Information.................................................59
Page
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Organization of the Fund.........................................59
Custodian........................................................60
Transfer Agency Services Arrangements............................60
Counsel and Auditor..............................................61
Accounting Services Provider.....................................61
Shareholder Reports..............................................61
Shareholder Inquiries............................................61
Additional Information...........................................62
Financial Statements...................................................63
Appendix A--Interest Rate Futures, Options Thereon and Options on Debt
Securities.......................................................64
Appendix B--Description of Bond Ratings................................66
2
INVESTMENT OBJECTIVES AND POLICIES
The primary investment objective of each Portfolio of the Fund is to
obtain the highest level of current income as is consistent with the
investment policies of such Portfolio and with prudent investment management.
As a secondary objective, each Portfolio seeks capital appreciation when
consistent with its primary objective. These investment objectives are a
fundamental policy of each Portfolio of the Fund and may not be changed
without a vote of the majority of the outstanding voting securities of such
Portfolio. See "Investment Restrictions." Each Portfolio seeks to achieve its
objectives by investing in a diversified portfolio of fixed-income securities,
such as corporate bonds and notes, mortgage-backed securities, asset-backed
securities, convertible securities, preferred stocks and government
obligations. There can be no assurance that the objective of any Portfolio can
be attained.
The securities in each Portfolio of the Fund will be varied from time to
time depending upon the judgment of management as to prevailing conditions in
the economy and the securities markets and the prospects for interest rate
changes among different categories of fixed-income securities. Under normal
circumstances, each Portfolio invests more than 90% of its net assets (defined
to include net assets plus borrowings for investment purposes) in fixed-income
securities, including convertible and nonconvertible debt securities and
preferred stocks. This investment policy may not be changed without providing
shareholders of the relevent Portfolio at least 60 days prior written notice.
The Portfolios of the Fund do not intend to invest in common stocks, rights or
other equity securities, but the Portfolios may acquire or hold such
securities (if consistent with their objectives) when such securities are
acquired in unit offerings with fixed-income securities or in connection with
an actual or proposed conversion or exchange of fixed-income securities.
Each Portfolio is permitted to use derivatives including, indexed and
inverse securities, options, futures, options on futures and swaps for hedging
purposes, as well as to increase the return on its portfolio investments. For
a more complete description of futures and options transactions, see "Risk
Factors in Transactions in Futures and Options Thereon" below and "Other
Portfolio Strategies--Options on Debt Securities" below.
Each Portfolio pursues its investment objectives through the separate
investment policies described below:
High Income Portfolio: The High Income Portfolio seeks high current
income by investing at least 80% of its net assets in fixed-income securities
that are rated in the lower rating categories of the established rating
services (Baa or lower by Moody's Investors Service, Inc. ("Moody's") and BBB
or lower by Standard & Poor's ("S&P") or Fitch, Inc. ("Fitch")), or in unrated
securities of comparable quality. Securities rated below Baa by Moody's or
below BBB by S&P or Fitch, and unrated securities of comparable quality, are
commonly known as "junk bonds." See Appendix B: Description of Bond Ratings
attached hereto for additional information concerning rating categories. Junk
bonds may constitute as much as 100% of the Portfolio's investments. Although
junk bonds can be expected to provide higher yields, such securities may be
subject to greater market fluctuations and risk of loss of income and
principal than lower-yielding, higher-rated fixed-income securities. See "Risk
Factors in Transactions in Junk Bonds." Because investment in such junk bonds
entails relatively greater risk of loss of income or principal, an investment
in the High Income Portfolio may not constitute a complete investment program
and may not be appropriate for all investors. Purchasers should carefully
assess the risks associated with an investment in this Portfolio.
Selection and supervision by the management of the High Income Portfolio
of portfolio investments involve continuous analysis of individual issuers,
general business conditions and other factors that may be too time-consuming
or too costly for the average investor. The furnishing of these services does
not, of course, guarantee successful results. Fund Asset Management, L.P.'s
("FAM" or the "Investment Adviser") analysis of issuers includes, among other
things, historic and current financial conditions, current and anticipated
cash flow and borrowing requirements, value of assets in relation to
historical cost, strength of management, responsiveness to business
conditions, credit standing, and current and anticipated results of
operations. Analysis of general business conditions and other factors may
include anticipated change in economic activity and interest rates, the
availability of new investment opportunities, and the economic outlook for
specific industries. While the Investment Adviser considers as one factor in
its credit analysis the ratings assigned by the rating services, the
Investment Adviser performs its own independent credit analysis of issuers and
consequently, the Portfolio may invest, without limit,
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in unrated securities. As a result, the High Income Portfolio's ability to
achieve its investment objective may depend to a greater extent on the
Investment Adviser's own credit analysis than mutual funds that invest in
higher-rated securities. Although the High Income Portfolio will invest
primarily in lower-rated securities, other than with respect to Distressed
Securities (which are discussed below) it will not invest in securities in the
lowest rating categories (Ca or below for Moody's and CC or below for S&P or
Fitch) unless the Investment Adviser believes that the financial condition of
the issuer or the protection afforded to the particular securities is stronger
than would otherwise be indicated by such low ratings. Securities that are
subsequently downgraded may continue to be held and will be sold only if, in
the judgment of the Investment Adviser, it is advantageous to do so.
The High Income Portfolio may invest up to 15% of its net assets in
secondary market purchases of loans extended to corporate borrowers by
commercial banks and other financial institutions ("Corporate Loans"). As in
the case of junk bonds, the Corporate Loans in which the High Income Portfolio
may invest may be rated in the lower rating categories of the established
rating services (Baa or lower by Moody's and BBB or lower by S&P or Fitch), or
may be unrated investments of comparable quality. As in the case of junk
bonds, such Corporate Loans can be expected to provide higher yields than
higher-rated fixed-income securities but may be subject to greater risk of
loss of principal and income. As discussed below under "Risk Factors in
Transactions in Corporate Loans," however, there are some significant
differences between Corporate Loans and junk bonds.
The High Income Portfolio may also from time to time invest up to 10% of
its net assets in securities which are the subject of bankruptcy proceedings
or otherwise in default or in significant risk of being in default
("Distressed Securities"). Distressed Securities that are in default or in
risk of being in default but not yet in bankruptcy proceedings may be the
subject of a pre-bankruptcy exchange offer pursuant to which holders of the
Distressed Securities receive securities or assets in exchange for the
Distressed Securities. Holders of Distressed Securities that are the subject
of bankruptcy proceedings may, following approval of a plan of reorganization
by the bankruptcy court, receive securities or assets in exchange for the
Distressed Securities. Generally, the Portfolio will invest in Distressed
Securities when the Investment Adviser anticipates that it is reasonably
likely that the securities will be subject to such an exchange offer or plan
of reorganization, as to which there can be no assurance. Normally, the
Portfolio will invest in Distressed Securities at a price that represents a
significant discount from the principal amount due on maturity of the
securities. The Portfolio will invest in Distressed Securities when the
Investment Adviser believes that, based on its analysis of the asset values of
the issuer of the Distressed Securities and the issuer's overall business
prospects, upon completion of an exchange offer or plan of reorganization with
respect to the Distressed Securities the Portfolio would receive, in exchange
for its Distressed Securities, securities or assets with terms and credit
characteristics which offer the Portfolio significant opportunities for
capital appreciation and future high rates of current income. See "Risk
Factors in Transactions in Distressed Securities."
When changing economic conditions and other factors cause the yield
difference between lower-rated and higher-rated securities to narrow, the High
Income Portfolio may purchase higher-rated securities if the Investment
Adviser believes that the risk of loss of income and principal may be
substantially reduced with only a relatively small reduction in yield. In
addition, under unusual market or economic conditions, the High Income
Portfolio, for temporary defensive or other purposes, may invest up to 100% of
its assets in securities issued or guaranteed by the United States Government
or its instrumentalities or agencies, certificates of deposit, bankers'
acceptances and other bank obligations, commercial paper rated in the highest
category by an established rating agency, or other fixed-income securities
deemed by the Investment Adviser to be consistent with a defensive posture, or
may hold its assets in cash. The yield on such securities may be lower than
the yield on lower-rated fixed-income securities.
Investments in high yield debt instruments, including high yield bonds,
Corporate Loans or other privately placed securities, may result in the High
Income Portfolio receiving material nonpublic information ("inside
information") concerning the borrower or issuer. Accordingly, the High Income
Portfolio has established certain procedures reasonably designed to prevent
the unauthorized access, dissemination or use of such inside information.
Receipt of inside information concerning a borrower or issuer may, under
certain circumstances, prohibit the High Income Portfolio or other funds or
accounts managed by the same portfolio managers, from trading in the public
securities of the borrower or issuer. Conversely, the portfolio managers for
the High Income Portfolio may, under certain circumstances, decline to receive
inside information made available by the borrower
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or issuer in order to allow the High Income Portfolio or other funds or
accounts managed by the same portfolio managers, to continue to trade in the
public securities of such borrower or issuer.
Core Bond Portfolio: The Core Bond Portfolio invests at least 80% of its
net assets in fixed-income securities rated in the four highest rating
categories of either S&P, Fitch or Moody's. Bonds rated in the lowest of these
categories are considered to have some speculative characteristics. The
Portfolio may invest up to 10% of its net assets in securities that are rated
below the four highest rating categories of S&P, Fitch and Moody's (i.e., junk
bonds) or in unrated securities of equivalent credit quality. The financial
risk of the Portfolio should be minimized by the quality of the bonds in which
it will invest, but the long maturities that typically provide the best yields
will subject the Portfolio to possible substantial price changes resulting
from market yield fluctuations. Portfolio management strategy will attempt to
mitigate adverse price changes and optimize favorable price changes through
active trading that shifts the maturity and/or quality structure of the
Portfolio within the Portfolio's overall investment guidelines. Under unusual
market or economic conditions, the Portfolio, for temporary defensive or other
purposes, may invest up to 100% of its net assets in obligations issued or
guaranteed by the United States Government or its instrumentalities or
agencies, certificates of deposit, bankers' acceptances and other bank
obligations, commercial paper rated in the highest category by an established
rating agency or other fixed-income securities deemed by the Investment
Adviser to be consistent with the objectives of the Portfolio, or the
Portfolio may hold its assets in cash.
Intermediate Term Portfolio: The Intermediate Term Portfolio invests at
least 80% of its net assets in bonds rated in the four highest rating
categories of either S&P, Fitch or Moody's. Bonds rated in the lowest of these
categories are considered to have some speculative characteristics. The
Portfolio may invest up to 10% of its net assets in securities that are rated
below the four highest rating categories of S&P, Fitch and Moody's (i.e., junk
bonds) or in unrated securities of equivalent credit quality. Under normal
circumstances, the average maturity of the Portfolio will be between three and
ten years. Because of the securities in which this Portfolio invests may on
average have shorter maturities, changes in the general level of interest
rates could result in less change in the net asset value per share of the
Intermediate Term Portfolio than for the other two Portfolios. In addition,
the Intermediate Term Portfolio may offer a lower yield than the other two
Portfolios.
Despite the inherently greater defensive characteristics of the shorter
average maturity of the Intermediate Term Portfolio, during periods of
unusually high yields on money market instruments the prices of
intermediate-term maturity securities may be adversely affected to a
substantial degree. Therefore, management will seek to mitigate the effect of
any such interest rate development by shortening the average maturity of
securities held by the Portfolio during such periods. Active management
strategy within the overall investment guidelines will thus seek to provide an
attractive total return. As in the other two Portfolios, under unusual market
or economic conditions, the Intermediate Term Portfolio, for temporary
defensive or other purposes, may invest up to 100% of its net assets in
obligations issued or guaranteed by the United States Government or its
instrumentalities or agencies, certificates of deposit, bankers' acceptances
and other bank obligations, commercial paper rated in the highest category by
an established rating agency or other fixed-income securities deemed by the
Investment Adviser to be consistent with the objectives of the Portfolio, or
the Portfolio may hold its assets in cash.
Each Portfolio of the Fund may invest in securities issued by foreign
governments (or political subdivisions or instrumentalities thereof) or
foreign companies (collectively, "Foreign Securities"). A Portfolio may only
invest in Foreign Securities if, at the time of acquisition, no more than 25%
(30% in the case of the High Income Portfolio) of the net assets of such
Portfolio (taken at market value at the time of the investment) would be
invested in Foreign Securities following such investment. Investments in
Foreign Securities may involve additional risks beyond those of securities
issued by U.S. companies. See "Risk Factors in Transactions in Foreign
Securities."
Maturity of Fixed Income Investments
The Intermediate Term Portfolio has a target range for the average
remaining maturity of the portfolio. For purposes of applying this target, the
Portfolio will consider a fixed-income security's maturity to be its stated
maturity (the date the issuer is scheduled to make its final payment of
principal), except that
o for a security with an unconditional put entitling the Portfolio to
receive the security's approximate amortized cost, the maturity will
be considered to be the next put date;
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o for mortgage-backed and other amortizing securities, the maturity
will be considered to be the average life remaining (the length of
time it is expected to take to retire half of the remaining
principal through amortizing payments) based on prepayment
assumptions that the Portfolio's manager believes to be reasonable;
and
o for a variable or floating rate investment grade security that the
Portfolio manager reasonably believes will have a market value
approximating amortized cost on the next interest reset date, the
maturity will be considered to be the next reset date.
RISK FACTORS AND SPECIAL CONSIDERATIONS
Risk Factors in Transactions in Junk Bonds
The High Income Portfolio intends to invest at least 80% of its net
assets in junk bonds. The Core Bond and Intermediate Term Portfolios each may
invest up to 10% of its net assets in junk bonds. Junk bonds are regarded as
being predominantly speculative as to the issuer's ability to make payments of
principal and interest. Investment in such securities involves substantial
risk. Issuers of junk bonds may be highly leveraged and may not have available
to them more traditional methods of financing. Therefore, the risks associated
with acquiring the securities of such issuers generally are greater than is
the case with higher rated securities. For example, during an economic
downturn or a sustained period of rising interest rates, issuers of junk bonds
may be more likely to experience financial stress, especially if such issuers
are highly leveraged. In addition, the market for junk bonds is relatively new
and has not weathered a major economic recession, and it is unknown what
effects such a recession might have on such securities. During such periods,
such issuers may not have sufficient revenues to meet their interest payment
obligations. The issuer's ability to service its debt obligations also may be
adversely affected by specific issuer developments, or the issuer's inability
to meet specific projected business forecasts, or the unavailability of
additional financing. The risk of loss due to default by the issuer is
significantly greater for the holders of junk bonds because such securities
may be unsecured and may be subordinated to other creditors of the issuer.
While most of the junk bonds in which the High Income Portfolio may invest do
not include securities that, at the time of investment, are in default or the
issuers of which are in bankruptcy, there can be no assurance that such events
will not occur after the Portfolio purchases a particular security, in which
case the Portfolio may experience losses and incur costs.
Junk bonds frequently have call or redemption features that would permit
an issuer to repurchase the security from a Portfolio. If a call were
exercised by the issuer during a period of declining interest rates, the
Portfolio likely would have to replace such called security with a lower
yielding security, thus decreasing the net investment income to the Portfolio
and dividends to shareholders.
Junk bonds tend to be more volatile than higher rated fixed-income
securities, so that adverse economic events may have a greater impact on the
prices of junk bonds than on higher rated fixed-income securities. Like higher
rated fixed-income securities, junk bonds are generally purchased and sold
through dealers who make a market in such securities for their own accounts.
However, there are fewer dealers in the junk bond market, which may be less
liquid than the market for higher rated fixed-income securities, even under
normal economic conditions. Also, there may be significant disparities in the
prices quoted for junk bonds by various dealers.
Adverse economic conditions or investor perceptions (whether or not based
on economic fundamentals) may impair the liquidity of this market, and may
cause the prices a Portfolio receives for its junk bonds to be reduced, or the
Portfolio may experience difficulty in liquidating a portion of its portfolio
when necessary to meet the Portfolio's liquidity needs or in response to a
specific economic event such as a deterioration in the creditworthiness of the
issuer. Under such conditions, judgment may play a greater role in valuing
certain of the Portfolio's portfolio securities than in the case of securities
trading in a more liquid market. Adverse publicity and investor perceptions,
which may not be based on fundamental analysis, also may decrease the value
and liquidity of junk bonds, particularly in a thinly traded market. Factors
adversely affecting the market value of such securities are likely to affect
adversely a Portfolio's net asset value. In addition, a Portfolio may incur
additional expenses to the extent that it is required to seek recovery upon a
default on a portfolio holding or to participate in the restructuring of the
obligation.
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Risk Factors in Transactions in Distressed Securities
Investment in Distressed Securities involves significant risk. The High
Income Portfolio will make such investments only when the Investment Adviser
believes it is reasonably likely that the issuer of the securities will make
an exchange offer or will be the subject of a bankruptcy plan of
reorganization; however, there can be no assurance that such an exchange offer
will be made or that such a plan of reorganization will be adopted. In
addition, a significant period of time may pass between the time at which the
Portfolio makes its investment in Distressed Securities and the time that any
such exchange offer or plan of reorganization is completed. During this
period, it is unlikely that the Portfolio will receive any interest payments
on the Distressed Securities, the Portfolio will be subject to significant
uncertainty as to whether or not the exchange offer or plan of reorganization
will be completed, and the Portfolio may be required to bear certain expenses
to protect its interest in the course of negotiations surrounding any
potential exchange offer or plan of reorganization. In addition, even if an
exchange offer is made or a plan of reorganization is adopted with respect to
Distressed Securities held by the Portfolio, there can be no assurance that
the securities or other assets received by the Portfolio in connection with
such exchange offer or plan of reorganization will not have a lower value or
income potential than anticipated when the investment was made. Moreover, any
securities received by the Portfolio upon completion of an exchange offer or
plan of reorganization may be restricted as to resale. In addition, as a
result of the Portfolio's participation in negotiations with respect to any
exchange offer or plan of reorganization with respect to an issue of
Distressed Securities, the Portfolio may be precluded from disposing of such
securities.
Risk Factors in Transactions in Corporate Loans
As in the case of junk bonds, the Corporate Loans in which the High
Income Portfolio may invest can be expected to provide higher yields than
higher-rated fixed income securities but may be subject to greater risk of
loss of principal and income. There are, however, some significant differences
between Corporate Loans and junk bonds. Corporate Loans are frequently secured
by pledges of liens and security interests in the assets of the borrower, and
the holders of Corporate Loans are frequently the beneficiaries of debt
service subordination provisions imposed on the borrower's bondholders. These
arrangements are designed to give Corporate Loan investors preferential
treatment over junk bond investors in the event of a deterioration in the
credit quality of the issuer. Even when these arrangements exist, however,
there can be no assurance that the principal and interest owed on the
Corporate Loans will be repaid in full. Corporate Loans generally bear
interest at rates set at a margin above a generally recognized base lending
rate that may fluctuate on a day-to-day basis, in the case of the Prime Rate
of a U.S. bank, or that may be adjusted on set dates, typically 30 days but
generally not more than one year, in the case of the London Interbank Offered
Rate ("LIBOR"). Consequently, the value of Corporate Loans held by the High
Income Portfolio may be expected to fluctuate significantly less than the
value of fixed rate junk bond instruments as a result of changes in the
interest rate environment. On the other hand, the secondary dealer market for
Corporate Loans is not as well developed as the secondary dealer market for
junk bonds, and therefore presents increased market risk relating to liquidity
and pricing concerns.
The High Income Portfolio may acquire interests in Corporate Loans by
means of a novation, assignment or participation. In a novation, the High
Income Portfolio would succeed to all the rights and obligations of the
assigning institution and become a contracting party under the credit
agreement with respect to the debt obligation. As an alternative, the High
Income Portfolio may purchase an assignment, in which case the High Income
Portfolio may be required to rely on the assigning institution to demand
payment and enforce its rights against the borrower but would otherwise
typically be entitled to all of such assigning institution's rights under the
credit agreement. Participation interests in a portion of a debt obligation
typically result in a contractual relationship only with the institution
participating out the interest and not with the borrower. In purchasing a loan
participation, the High Income Portfolio generally will have no right to
enforce compliance by the borrower with the terms of the loan agreement, nor
any rights of set-off against the borrower, and the High Income Portfolio may
not directly benefit from the collateral supporting the debt obligation in
which it has purchased the participation. As a result, the High Income
Portfolio will assume the credit risk of both the borrower and the institution
selling the participation to the High Income Portfolio.
Risk Factors in Transactions in Foreign Securities
Investments in foreign securities, particularly those of nongovernmental
issuers, involve considerations which are not ordinarily associated with
investing in U.S. issuers. These considerations include changes in currency
rates,
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currency exchange control regulations, the possibility of expropriation, the
unavailability of financial information or the difficulty of interpreting
financial information prepared under foreign accounting standards, less
liquidity and more volatility in foreign securities markets, the impact of
political, social or diplomatic developments, and the difficulty of assessing
economic trends in foreign countries. If it should become necessary, the
Portfolios could encounter greater difficulties in invoking legal processes
abroad than would be the case in the U.S. Transaction costs in foreign
securities may be higher. With respect to certain foreign countries, there is
the possibility of expropriation of assets, confiscatory taxation, political or
social instability or diplomatic developments which could affect investment in
those countries. There may be less publicly available information about a
foreign security than about a comparable U.S. instrument issued by a U.S.
entity, and foreign entities may not be subject to accounting, auditing and
financial reporting standards and requirements comparable to those of U.S.
entities. In addition, certain foreign securities may be subject to non-U.S.
withholding taxes. The Investment Adviser will consider these and other factors
before investing in foreign securities, and will not make such investments
unless, in its opinion, such investments will meet the Portfolio's standards
and objectives. No Portfolio will concentrate its investments in any particular
foreign country. Each Portfolio may purchase securities issued in dollar or
foreign currency denominations. In the case of any such investment in a
security denominated in a foreign currency, the Portfolio making the investment
would be subject to the risk of changes in currency exchange rates.
Risk Factors in Transactions in Mortgage-Backed and Asset-Backed Securities
Asset-Backed Securities. Each Portfolio may invest in asset-backed
securities. Asset-backed securities are "pass through" securities, meaning
that principal and interest payments made by the borrower on the underlying
assets (such as credit card receivables) are passed through to the Portfolio.
The value of asset-backed securities, like that of traditional fixed income
securities, typically increases when interest rates fall and decreases when
interest rates rise. However, asset-backed securities differ from traditional
fixed income securities because of their potential for prepayment. The price
paid by a Portfolio for its asset-backed securities, the yield the Portfolio
expects to receive from such securities and the average life of the securities
are based on a number of factors, including the anticipated rate of prepayment
of the underlying assets. In a period of declining interest rates, borrowers
may prepay the underlying assets more quickly than anticipated, thereby
reducing the yield to maturity and the average life of the asset-backed
securities. Moreover, when a Portfolio reinvests the proceeds of a prepayment
in these circumstances, it will likely receive a rate of interest that is
lower than the rate on the security that was prepaid. To the extent that a
Portfolio purchases asset-backed securities at a premium, prepayments may
result in a loss to the extent of the premium paid. If a Portfolio buys such
securities at a discount, both scheduled payments and unscheduled prepayments
will increase current and total returns and will accelerate the recognition of
income which, when distributed to shareholders, will be taxable as ordinary
income. In a period of rising interest rates, prepayments of the underlying
assets may occur at a slower than expected rate, creating maturity extension
risk. This particular risk may effectively change a security that was
considered short or intermediate term at the time of purchase into a long term
security. Since longer term securities generally fluctuate more widely in
response to changes in interest rates than shorter term securities, maturity
extension risk could increase the inherent volatility of a Portfolio. Certain
asset-backed securities may be illiquid.
Mortgage-Backed Securities. Mortgage-backed securities are "pass through"
securities, meaning that principal and interest payments made by the borrower
on the underlying mortgages are passed through to a Portfolio. The value of
mortgage-backed securities, like that of traditional fixed income securities,
typically increases when interest rates fall and decreases when interest rates
rise. However, mortgage-backed securities differ from traditional fixed income
securities because of their potential for prepayment without penalty. The
price paid by a Portfolio for its mortgage-backed securities, the yield the
Portfolio expects to receive from such securities and the average life of the
securities are based on a number of factors, including the anticipated rate of
prepayment of the underlying mortgages. In a period of declining interest
rates, borrowers may prepay the underlying mortgages more quickly than
anticipated, thereby reducing the yield to maturity and the average life of
the mortgage-backed securities. Moreover, when a Portfolio reinvests the
proceeds of a prepayment in these circumstances, it will likely receive a rate
of interest that is lower than the rate on the security that was prepaid.
To the extent that a Portfolio purchases mortgage-backed securities at a
premium, mortgage foreclosures and principal prepayments may result in a loss
to the extent of the premium paid. If a Portfolio buys such securities at
8
a discount, both scheduled payments of principal and unscheduled prepayments
will increase current and total returns and will accelerate the recognition of
income which, when distributed to shareholders, will be taxable as ordinary
income. In a period of rising interest rates, prepayments of the underlying
mortgages may occur at a slower than expected rate, creating maturity extension
risk. This particular risk may effectively change a security that was
considered short or intermediate term at the time of purchase into a long-term
security. Since long term securities generally fluctuate more widely in
response to changes in interest rates than do short term securities, maturity
extension risk could increase the inherent volatility of a Portfolio.
Risk Factors in Transactions in Futures and Options Thereon
Each Portfolio may engage in transactions in interest rate, bond and bond
index futures contracts and options thereon. Each Portfolio will limit
transactions in futures and options on futures to financial futures contracts
(i.e., contracts for which the underlying commodity is a bond, bond index or
interest rate index). In order to comply with current applicable regulations
of the Commodity Futures Trading Commission ("CFTC") pursuant to which the
Fund avoids being deemed a "commodity pool operator", each Portfolio is
limited in its futures trading activities to positions which constitute "bona
fide hedging" positions within the meaning and intent of applicable CFTC
rules, or to non-hedging positions for which the aggregate initial margin and
premiums will not exceed 5% of the liquidation value of such Portfolio's
assets.
Futures. Each Portfolio may engage in transactions in futures contracts
and options thereon. Futures are standardized, exchange-traded derivatives
contracts which obligate a purchaser to take delivery, and a seller to make
delivery, of a specific amount of a commodity at a specified future date at a
specified price. Options on futures are options to either buy (call) or sell
(put) a futures contract at a specified price prior to a specified date. No
price is paid upon entering into a futures contract (although a fee, or option
premium, is generally paid to the seller of an option on a futures contract at
the initiation of the transaction). Rather, upon purchasing or selling a
futures contract a Portfolio is required to deposit collateral ("margin")
equal to a percentage (generally less than 10%) of the contract value. Each
day thereafter until the futures position is closed, the Portfolio will pay
additional margin representing any loss experienced as a result of the futures
position the prior day or be entitled to a payment representing any profit
experienced as a result of the futures position the prior day.
A Portfolio may sell futures contracts or purchase a put option on
futures contracts in anticipation of an increase in interest rates. Generally,
as interest rates rise, the market value of the fixed-income securities held
by the Portfolio will fall, reducing the net asset value of the Portfolio. The
sale of futures contracts may limit the Portfolio's risk of loss through a
decline in the market value of portfolio holdings correlated with the futures
contracts prior to the futures contracts' expiration date. In the event the
market value of the portfolio holdings correlated with the futures contracts
increases rather than decreases, however, the Portfolio will realize a loss on
the futures position and a lower overall return than would have been realized
without the purchase of the futures contracts.
A Portfolio may purchase futures contracts or purchase a call option on
futures contracts in anticipation of a decrease in interest rates. Generally,
as interest rates decrease, the market value of fixed-income securities which
the Portfolio may be considering purchasing will increase. The purchase of
futures contracts may protect a Portfolio from having to pay more for such
securities when it identifies specific securities it wishes to purchase. In
the event that such securities decline in value or the Portfolio determines
not to purchase any additional securities, however, the Portfolio may realize
a loss relating to the futures position.
Each Portfolio may purchase and sell interest rate, bond and bond index
futures contracts ("futures contracts"), including, but not limited to, for
the purpose of hedging its portfolio of fixed-income securities against the
adverse effects of anticipated movements in interest rates. The Portfolios may
also purchase and sell exchange-traded call and put options on such futures
contracts. Set forth below is information concerning options and futures
contracts. Reference is made to Appendix A "Interest Rate Futures, Options
Thereon and Options on Debt Securities" attached hereto for a more complete
description of options and futures transactions.
Call Options on Futures Contracts. As set forth in Appendix A, a call
option on a futures contract provides the purchaser with the right, but not
the obligation, to enter into a "long" position in the underlying futures
contract at any time up to the expiration of the option. The purchase of an
option on a futures contract presents
9
more limited risk than the trading of the underlying futures contract,
although, depending on the price of the option compared to either the futures
contract upon which it is based, or the underlying debt securities, exercise of
the option may or may not be less risky than ownership of the futures contract
or underlying debt securities. Like the purchase of a futures contract, a
Portfolio may purchase a call option on a futures contract for the purposes
including, but not limited to, hedging against a market advance resulting from
declining interest rates when the Portfolio is not fully invested.
The writing of a call option on a futures contract may constitute a
partial hedge against declining prices of fixed-income securities of the
Portfolios, if the futures price at expiration is below the exercise price of
the option. In such event, the Portfolio will retain the full amount of the
option premium, which provides a partial hedge against any decline that may
have occurred in the Portfolio's fixed-income investments. Conversely, if the
futures price is above the exercise price at any point prior to expiration,
the option may be exercised and the Portfolio would be required to enter into
the underlying futures contract at an unfavorable price.
Put Options on Futures Contracts. As set forth in Appendix A, a put
option on a futures contract provides the purchaser with the right, but not
the obligation, to enter into a "short" position in the futures contract at
any time up to the expiration of the option. A Portfolio will purchase a put
option on a futures contract to hedge its securities against the risk of a
decline in market value as a result of rising interest rates.
The writing of a put option on a futures contract may constitute a
partial hedge against increasing prices of fixed-income securities which a
Portfolio intends to purchase, if the futures price at expiration is higher
than the exercise price. In such event, the Portfolio will retain the full
amount of the option premium, which provides a partial hedge against any
increase in the price of fixed-income securities which the Portfolio intends
to purchase. Conversely, if the futures price is below the exercise price at
any point prior to expiration, the option may be exercised and the Portfolio
would be required to enter into the underlying futures contract at an
unfavorable price.
The trading of futures contracts and options thereon involves the risk of
imperfect correlation between movements in the price of the futures contracts
or option and the price of the security being hedged. The hedge will not be
fully effective where there is imperfect correlation between the movements in
the two financial instruments. For example, if the price of the option or
futures contract moves more than the price of the hedged security, the
Portfolio would experience either a loss or gain on the option or future which
is not completely offset by movements in the price of the hedged securities.
To compensate for imperfect correlations, the Portfolio may purchase or sell
options or futures contracts in a greater dollar amount than the hedged
securities if the volatility of the hedged securities is historically greater
than the volatility of the futures contracts. Conversely, the Portfolio may
purchase or sell fewer futures contracts if the volatility of the price of the
hedged securities is historically less than that of the futures contracts,
although such transactions will in any event be entered into solely for
hedging purposes.
The Portfolio may also purchase futures contracts or options thereon to
hedge against a possible increase in the price of securities before the
Portfolio is able to invest its cash in fixed-income securities. In such
instances, it is possible that the market may instead decline. If the
Portfolio does not then invest in such securities because of concern as to
possible further market decline or for other reasons, the Portfolio may
realize a loss on the futures or option contract that is not offset by a
reduction in the price of securities purchased.
Because of low initial margin deposits made upon the opening of a futures
position, futures transactions involve substantial leverage. As a result,
relatively small movements in the price of the futures contract can result in
substantial unrealized gains or losses.
The anticipated offsetting movements between the price of the futures or
option contracts and the hedged security may be distorted due to differences
in the nature of the markets, such as differences in initial and variation
margin requirements, the liquidity of such markets and the participation of
speculators in such markets.
The amount of risk the Portfolio assumes when it purchases an option on a
futures contract is the premium paid for the option plus related transaction
costs. In order to profit from an option purchased, however, it may be
necessary to exercise the option and to liquidate the underlying futures
contract, subject to the risks of the availability of a liquid offset market.
In addition to the correlation risks discussed above, the purchase of an
option also entails the risk that changes in the value of the underlying
futures contract will not be fully reflected in the value of the option
purchased. The writer of an option on a futures contract is subject to the
risks of commodity
10
futures trading, including the requirement of variation margin payments, as
well as the additional risk that movements in the price of the option may not
correlate with movements in the price of the underlying security or futures
contract.
"Trading Limits" may also be imposed on the maximum number of contracts
which any person may trade on a particular trading day. A contract market may
order the liquidation of positions found to be in violation of these limits
and it may impose other sanctions or restrictions. The Investment Adviser does
not believe that trading limits will have any adverse impact on the portfolio
strategies for hedging a Portfolio's investments.
The trading of futures contracts and options thereon also is subject to
certain market risks, such as trading halts, suspensions, exchange or clearing
house equipment failures, government intervention, insolvency of a brokerage
firm or clearing corporation or other disruptions of normal trading activity,
which could at times make it difficult or impossible to liquidate existing
positions.
The successful use of transactions in futures contracts and options
thereon also depends on the ability of the management of the Portfolio
correctly to forecast the direction and extent of interest rate movements
within a given time frame. To the extent interest rates remain stable during
the period in which a futures contract or option is held by the Portfolio or
such rates move in a direction opposite to that anticipated, the Portfolio may
realize a loss on the hedging transaction which is not fully or partially
offset by an increase in the value of portfolio securities. As a result, the
Portfolio's total return for such period may be less than if it had not
engaged in the hedging transaction.
The Fund has obtained an order from the Commission exempting it from
certain provisions of the Investment Company Act of 1940, as amended (the
"Investment Company Act"), in connection with its transactions in interest
rate futures contracts and related options. In applying for this exemptive
order, the Fund made a number of representations to the Commission regarding
the manner in which such trading will be conducted.
European Economic and Monetary Union
For a number of years, certain European countries have been seeking
economic unification that would, among other things, reduce barriers between
countries, increase competition among companies, reduce government subsidies
in certain industries, and reduce or eliminate currency fluctuations among
these European countries. The Treaty on European Union (the "Maastricht
Treaty") sets out a framework for the European Economic and Monetary Union
("EMU") among the countries that comprise the European Union ("EU"). EMU
established a single common European currency (the "euro") that was introduced
on January 1, 1999 and is expected to replace the existing national currencies
of all EMU participants by July 1, 2002. EMU took effect for the initial EMU
participants on January 1, 1999. Certain securities issued in participating EU
countries (beginning with government and corporate bonds) will be
redenominated in the euro, and, are listed, traded, and make dividend and
other payments only in euros.
No assurance can be given that EMU will take effect, that the changes
planned for EMU can be successfully implemented, or that these changes will
result in the economic and monetary unity and stability intended. There is a
possibility that EMU will not be completed, or will be completed but then
partially or completely unwound. Because any participating country may opt out
of EMU within the first three years, it is also possible that a significant
participant could choose to abandon EMU, which would diminish its credibility
and influence. Any of these occurrences could have adverse effects on the
markets of both participating and non-participating countries, including sharp
appreciation or depreciation of the participants' national currencies and a
significant increase in exchange rate volatility, a resurgence in economic
protectionism, an undermining of confidence in the European markets, an
undermining of European economic stability, the collapse or slowdown of the
drive toward European economic unity, and/or reversion of the attempts to
lower government debt and inflation rates that were introduced in anticipation
of EMU. Also, withdrawal from EMU by an initial participant could cause
disruption of the financial markets as securities redenominated in euros are
transferred back into that country's national currency, particularly if the
withdrawing country is a major economic power. Such developments could have an
adverse impact on a Portfolio's investments in Europe generally or in specific
countries participating in EMU. Gains or losses from euro conversion may be
taxable to Portfolio shareholders under foreign or, in certain limited
circumstances, U.S. tax laws.
11
OTHER PORTFOLIO STRATEGIES
Each Portfolio may engage in the additional Portfolio strategies
described below.
Repurchase Agreements. Each Portfolio may invest in repurchase
agreements. Repurchase agreements may be entered into only with a member bank
of the Federal Reserve System or primary dealer in U.S. government securities
or an Affiliate thereof. Under such agreements, the seller agrees, upon
entering into the contract, to repurchase the security at a mutually
agreed-upon time and price, thereby determining the yield during the term of
the agreement. This results in a fixed rate of return for the Portfolio
insulated from market fluctuations during such period. Such agreements usually
cover short periods, such as under one week. Repurchase agreements may be
construed to be collateralized loans by the purchaser to the seller secured by
the securities transferred to the purchaser. The Portfolio will require the
seller to provide additional collateral if the market value of the securities
falls below the repurchase price at any time during the term of the repurchase
agreement. In the event of default by the seller under a repurchase agreement
construed to be a collateralized loan, the underlying securities are not owned
by the Portfolio but only constitute collateral for the seller's obligation to
pay the repurchase price. Therefore, the Portfolio may suffer time delays and
incur costs or possible losses in connection with the disposition of the
collateral. Instead of the contractual fixed rate of return, the rate of
return to the Portfolio will be dependent upon intervening fluctuations of the
market value of such security and the accrued interest on the security. In
such event, the Portfolio would have rights against the seller for breach of
contract with respect to any losses arising from market fluctuations following
the failure of the seller to perform. From time to time, each Portfolio also
may invest in securities pursuant to purchase and sale contracts. While the
substance of purchase and sale contracts is similar to repurchase agreements,
because of the different treatment with respect to accrued interest and
additional collateral, management believes that purchase and sale contracts
are not repurchase agreements as such term is understood in the banking and
brokerage community. As a matter of operating policy, a Portfolio will not
enter into repurchase agreements or purchase and sale contracts with greater
than seven days to maturity if, at the time of such investment, more than 10%
of the total assets of the Portfolio would be so invested.
Forward Commitments. Each Portfolio may purchase securities on a
when-issued basis or forward commitment basis, and may purchase or sell
securities for delayed delivery. These transactions occur when securities are
purchased or sold by the Portfolio with payment and delivery taking place in
the future to secure what is considered an advantageous yield and price to the
Portfolio at the time of entering into the transaction. The value of the
security on the delivery date may be more or less than its purchase price. A
Portfolio will establish a segregated account in connection with such
transactions in which the Portfolio will deposit liquid securities with a
value at least equal to the Portfolio's exposure, on a mark-to-market basis,
to the transaction (as calculated pursuant to requirements of the Commission).
Such segregation will ensure that the Portfolio has assets available to
satisfy its obligations with respect to the transaction, but will not limit
the Portfolio's exposure to loss).
U.S. Government securities and corporate debt obligations may be
purchased on a forward commitment basis at fixed purchase terms with periods
of up to 45 days between the commitment and settlement dates. The purchase
will be recorded on the date the Portfolio enters into the commitment and the
value of the security will thereafter be reflected in the calculation of the
Portfolio's net asset value. Although the Portfolio will generally enter into
forward commitments with the intention of acquiring securities for its
portfolio, the Portfolio may dispose of a commitment prior to settlement if
the Investment Adviser deems it appropriate to do so. There can, of course, be
no assurance that the judgments upon which these techniques are based will be
accurate or that such techniques when applied will be effective. The Portfolio
will enter into forward commitment arrangements only with respect to
securities in which it may otherwise invest pursuant to its investment
objectives and policies.
Restricted Securities. From time to time, a Portfolio may invest in
securities the disposition of which is subject to legal restrictions, such as
restrictions imposed by the Securities Act of 1933, as amended (the
"Securities Act"), on the resale of securities acquired in private placements.
If registration of such securities under the Securities Act is required, such
registration may not be readily accomplished, and if such securities may be
resold without registration, such resale may be permissible only in limited
quantities. In either event, a Portfolio may not be able to sell its
restricted securities at a time which, in the judgment of the Investment
Adviser, would be most opportune.
12
Standby Commitment Agreements. The High Income Portfolio may from time to
time enter into standby commitment agreements. Such agreements commit the
Portfolio, for a stated period of time, to purchase a stated amount of a
fixed-income security, which may be issued and sold to the Portfolio at the
option of the issuer. The price and coupon of the security is fixed at the
time of the commitment. At the time of entering into the agreement, the
Portfolio may be paid a commitment fee, regardless of whether or not the
security is ultimately issued, which is typically approximately 0.5% of the
aggregate purchase price of the security which the Portfolio has committed to
purchase. The Portfolio will enter into such agreements only for the purpose
of investing in the security underlying the commitment at a yield and price
which is considered advantageous to the Portfolio. The Portfolio will not
enter into a standby commitment with a remaining term in excess of 45 days and
will limit its investment in such commitments so that the aggregate purchase
price of the securities subject to such commitments, together with the value
of portfolio securities subject to legal restrictions on resale, will not
exceed 10% of its assets taken at the time of acquisition of such commitment
or security. The Portfolio will at all times maintain a segregated account
with its custodian of cash or liquid securities in an amount equal to the
purchase price of the securities underlying the commitment.
There can be no assurance that the securities subject to a standby
commitment will be issued and the value of the security, if issued, on the
delivery date may be more or less than its purchase price. Since the issuance
of the security underlying the commitment is at the option of the issuer, the
Portfolio may bear the risk of a decline in the value of such security and may
not benefit from an appreciation in the value of the security during the
commitment period.
The purchase of a security subject to a standby commitment agreement and
the related commitment fee will be recorded on the date on which the security
can reasonably be expected to be issued and the value of the security will
thereafter be reflected in the calculation of the Portfolio's net asset value.
The cost basis of the security will be adjusted by the amount of the
commitment fee. In the event the security is not issued, the commitment fee
will be recorded as income on the expiration date of the standby commitment.
Lending of Portfolio Securities. Each Portfolio from time to time may
lend securities from its portfolio to brokers, dealers and financial
institutions and receive as collateral cash or securities issued or guaranteed
by the U.S. Government which will be maintained at all times in an amount
equal to at least 100% of the current market value of the loaned securities.
Where a Portfolio receives securities as collateral for the loaned securities,
the Portfolio typically receives the income on both the loaned securities and
the collateral and, as a result, the Portfolio's yield may increase. Where a
Portfolio receives cash collateral, it may invest such collateral and retain
the amount earned on such investment, net of any amount rebated to the
borrower. The Portfolio may receive a fee for its loans. Loans of securities
are terminable at any time and the borrower, after notice, is required to
return borrowed securities within five business days. The Portfolio 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 Portfolio could experience delays and costs in gaining
access to the collateral. The Portfolio 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.
Options on Debt Securities. The Portfolios may write call and put options
on securities in order to increase the return on their investments and in
order to hedge optionable securities held by the Portfolios. The Portfolios
will write only covered call options on debt securities (i.e., options in
which it owns the underlying security) or fully funded put options on debt
securities (i.e., options in which an amount of cash or short-term securities
equal to the exercise price of the put has been segregated with the Fund's
custodian). By writing covered options on securities, a Portfolio will be able
to increase its return on the underlying securities by the amount of the
premium, if the option expires unexercised, or by the amount of any profits
earned by closing out the option position. The Portfolio may be required,
however, to forego benefits which could have been obtained from an increase in
the value of securities on which a call is written or a decrease in the value
of securities on which a put is written. As a result, the Portfolio may
receive less total return, and at other times greater total return, than if it
had not written options.
13
The Portfolios also may purchase put options on optionable securities
held in a Portfolio and, under certain limited circumstances, call options on
such instruments. Purchases of put options may enable the Portfolios to limit
the risk of declines in the value of the portfolio security underlying the
put, until the expiration of the option or the closing of the option
transaction. By purchasing a put, however, a Portfolio will be required to pay
the premium, which will reduce the benefits obtained from the transaction.
Although options written by a Portfolio may be terminated prior to
exercise or expiration by entering into an offsetting transaction, the ability
to do so depends upon the presence of a liquid secondary market on the
exchange on which the option is traded. If no such market is available, the
Portfolio may be unable to terminate existing positions and may be subject to
exercise of the option under unfavorable circumstances. The Portfolios will
enter into transactions in options on debt securities only when the management
of the Fund believes that a liquid secondary market for such options is
available. See Appendix A "Interest Rate Futures, Options Thereon and Options
on Debt Securities attached hereto."
A Portfolio may write call options which give the holder the right to buy
the underlying security covered by the option from the Portfolio at the stated
exercise price. A Portfolio also may write put options that give the holder
the right to sell the underlying security to the Portfolio at the stated
exercise price. A Portfolio will write only covered options, which means that
so long as the Portfolio is obligated as the writer of a call option, it will
own the underlying securities subject to the options and, in the case of put
options, that the Portfolio will, through its Custodian, have deposited and
maintained short-term U.S. Treasury obligations with a securities depository
with a value equal to or greater than the exercise price of the underlying
securities. The writer of a covered call option has no control over when he
may be required to sell his securities since he may be assigned an exercise
notice at any time prior to the termination of his obligation as a writer. If
an option expires unexercised, the writer realizes a gain in the amount of the
premium. Such a gain, of course, may be offset by a decline in the market
value of the underlying security during the option period. If a call option is
exercised, the writer realizes a gain or loss from the sale of the underlying
security.
A Portfolio will receive a premium from writing a put or call option,
which increases the Portfolio's return on the underlying security in the event
the option expires unexercised or is closed out at a profit. In the former
instance, the Portfolio increases its return by retaining the premium without
being required to purchase or sell the underlying security. In the latter
case, the Portfolio increases its return by liquidating the option position at
a profit. The amount of the premium will reflect, among other factors, the
current market price of the underlying security, the relationship of the
exercise price to the market price, the time period until the expiration of
the option and interest rates. By writing a call, the Portfolio limits its
opportunity to profit from an increase in the market value of the underlying
security above the exercise price of the option for so long as the Portfolio's
obligation as a writer continues. By writing a put, the Portfolio will be
obligated to purchase the underlying security at a price that may be higher
than the market value of that security at the time of exercise for as long as
the option is outstanding. In addition, in closing out an option position, the
Fund may incur a loss. Thus, in some periods the Portfolio will receive less
total return and in other periods greater total return from its option
positions than it otherwise would have received from the underlying
securities. To the extent that such transactions are engaged in for hedging
purposes, any gain (or loss) thereon may offset, in whole or in part, gains
(or losses) on securities held in a Portfolio or increases in the value of
securities the Portfolio intends to acquire. The Portfolio will attempt to
achieve, through the receipt of premiums on covered options, a more consistent
average total return than it would otherwise realize from holding the
underlying securities alone. To facilitate closing transactions, as described
below, the Portfolio will ordinarily only write options for which a liquid
secondary market appears to exist.
A Portfolio may engage in closing transactions in order to terminate
outstanding options that it has written. To effect a closing transaction, the
Portfolio purchases, prior to the exercise of an outstanding option that it
has written, an option of the same series as that on which it desires to
terminate its obligation. Profit or loss from a closing purchase transaction
will depend on whether the cost of the transaction is more or less than the
premium received on the sale of the option plus the related transaction costs.
A Portfolio will typically purchase a call option only where the market
price of the underlying security declines substantially following the writing
of a call option, and the Portfolio either re-hedges the security by writing a
second call option at a lower exercise price or disposes of the security. In
such event, the Portfolio would
14
usually enter into a closing transaction in connection with the first option it
wrote. However, if the first option has been held less than three months, the
Portfolio may desire not to enter into a closing transaction in order to comply
with certain provisions of the Internal Revenue Code. In such circumstances,
the Portfolio may purchase a call option in an opening transaction with the
same exercise price and expiration date as the option it sold.
Swaps. Each Portfolio may enter into swap agreements, including interest
rate and index swap agreements, for purposes of attempting to obtain a
particular desired return at a lower cost to the Portfolio than if the
Portfolio had invested directly in an instrument that yielded the desired
return. Swap agreements are two party contracts entered into primarily by
institutional investors for periods ranging from a few weeks to more than one
year. In a standard "swap" transaction, two parties agree to exchange the
returns (or differentials in rates of return) earned or realized on particular
predetermined investments or instruments. The gross returns to be exchanged or
"swapped" between the parties are calculated with respect to a "notional
amount," i.e., the dollar amount invested at a particular interest rate, in a
particular foreign currency, or in a "basket" of securities representing a
particular index. The "notional amount" of the swap agreement is only a
fictive basis on which to calculate the obligations which the parties to a
swap agreement have agreed to exchange. Each Portfolio's obligations (or
rights) under a swap agreement will generally be equal only to the net amount
to be paid or received under the agreement based on the relative values of the
positions held by each party to the agreement (the "net amount"). Each
Portfolio's obligations under a swap agreement will be accrued daily (offset
against any amounts owing to the Portfolio) and any accrued but unpaid net
amounts owed to a swap counter-party will be covered by marking as segregated
cash, U.S. government securities, equity securities or other liquid,
unencumbered assets, marked-to-market daily, to avoid any potential leveraging
of the Portfolio's portfolio. No Portfolio will enter into a swap agreement
with any single party if the net amount owed or to be received under existing
contracts with that party would exceed 5% of the Portfolio's assets.
Each Portfolio may also enter into credit default swap agreements. The
"buyer" in a credit default contract is obligated to pay the "seller" a
periodic stream of payments over the term of the contract provided that no
credit event with respect to any underlying reference obligation has occurred.
If a credit event occurs, the seller typically must pay the buyer the "par
value" (full notional value) of the reference obligation in exchange for the
reference obligation. The Portfolio may either be the buyer or the seller in
the transaction. If a Portfolio is a buyer and no credit event occurs, the
Portfolio loses its investment and recovers nothing. However, if a credit
event occurs, the buyer receives full notional value for a reference
obligation that may have little or no value. As a seller, the Portfolio
typically receives a fixed rate of income throughout the term of the contract,
which typically is between six months and three years, provided a credit event
does not occur. If a credit event occurs, the seller typically must pay the
buyer the full notional amount of the reference obligation. Credit default
swaps involve more risk than if the Portfolio had invested in the reference
obligation directly.
Whether each Portfolio's use of swap agreements will be successful in
furthering its investment objective will depend on the Investment Adviser's
ability to correctly predict whether certain types of investments are likely
to produce greater returns than other investments. Because they are two party
contracts and because they may have terms of greater than seven days, swap
agreements may be considered to be illiquid. Moreover, the Portfolio bears the
risk of loss of the amount expected to be received under a swap agreement in
the event of the default or bankruptcy of a swap agreement counterparty.
Restrictions imposed by the Internal Revenue Code of 1986, as amended (the
"Code"), may limit the Fund's ability to use swap agreements. The swaps market
is largely unregulated. It is possible that development in the swap market,
including potential government regulation, could adversely affect each
Portfolio's ability to terminate existing swap agreements or to realize
amounts to be received under such agreements.
Indexed and Inverse Securities. Each Portfolio may invest in securities
whose potential returns are directly related to changes in an underlying index
or interest rate, known as indexed securities. The return on indexed
securities will rise when the underlying index or interest rate rises and fall
when the index or interest rate falls. Each Portfolio may also invest in
securities whose return is inversely related to changes in an interest rate
("inverse floaters"). In general, inverse floaters change in value in a manner
that is opposite to most bonds -- that is, interest rates on inverse floaters
will decrease when short-term rates increase and increase when short-term
rates decrease. Investments in indexed securities and inverse floaters may
subject each Portfolio to the risk of reduced or eliminated interest payments.
Investments in indexed securities also may subject each Portfolio to loss of
15
principal. In addition, certain indexed securities and inverse floaters may
increase or decrease in value at a greater rate than the underlying interest
rate, which effectively leverages each Portfolio's investment. As a result,
the market value of such securities will generally be more volatile than that
of fixed rate securities. Both indexed securities and inverse floaters can be
derivative securities and can be considered speculative.
INVESTMENT RESTRICTIONS
The Fund has adopted the following fundamental and non-fundamental
restrictions and policies relating to the investment of the Portfolios' assets
and their activities. The fundamental policies set forth below may not be
changed without the approval of the holders of a majority of the Fund's
outstanding voting securities, including a majority of the shares of each
Portfolio affected (which for this purpose and under the Investment Company
Act means the lesser of (i) 67% of the shares represented at a meeting at
which more than 50% of the outstanding shares are represented or (ii) more
than 50% of the outstanding shares).
Under the fundamental investment restrictions, none of the Portfolios
may:
1. Make any investment inconsistent with the Fund's classification
as a diversified company under the Investment Company Act.
2. Invest more than 25% of its total assets, taken at market value,
in the securities of issuers in any particular industry (excluding the
U.S. Government and its agencies and instrumentalities).
3. Make investments for the purpose of exercising control or
management.
4. Purchase or sell real estate, except that, to the extent
permitted by applicable law, each Portfolio of the Fund may invest in
securities directly or indirectly secured by real estate or interests
therein or issued by companies which invest in real estate or interests
therein.
5. Make loans to other persons, except that the acquisition of
bonds, debentures or other corporate debt securities and investment in
government obligations, commercial paper, pass-through instruments,
certificates of deposit, bankers' acceptances, repurchase agreements or
any similar instruments shall not be deemed to be the making of a loan,
and except further that each Portfolio of the Fund may lend its portfolio
securities, provided that the lending of portfolio securities may be made
only in accordance with applicable law and the guidelines set forth in
the Fund's Prospectus and Statement of Additional Information, as they
may be amended from time to time. (For purposes of this restriction,
corporate debt securities includes corporate loans purchased in the
secondary market).
6. Issue senior securities to the extent such issuance would violate
applicable law.
7. Borrow money, except that (i) each Portfolio of the Fund may
borrow from banks (as defined in the Investment Company Act) in amounts
up to 33-1/3% of its total assets (including the amount borrowed), (ii)
each Portfolio of the Fund may borrow up to an additional 5% of its total
assets for temporary purposes, (iii) each Portfolio of the Fund may
obtain such short-term credit as may be necessary for the clearance of
purchases and sales of portfolio securities, and (iv) each Portfolio of
the Fund may purchase securities on margin to the extent permitted by
applicable law. The Fund may not pledge its assets other than to secure
such borrowings or, to the extent permitted by the Fund's investment
policies as set forth in its Prospectus and Statement of Additional
Information, as they may be amended from time to time, in connection with
hedging transactions, short sales, when-issued and forward commitment
transactions and similar investment strategies.
8. Underwrite securities of other issuers except insofar as a
Portfolio of the Fund technically may be deemed an underwriter under the
Securities Act in selling portfolio securities.
9. Purchase or sell commodities or contracts on commodities, except
to the extent that a Portfolio of the Fund may do so in accordance with
applicable law and the Fund's Prospectus and Statement of Additional
Information, as they may be amended from time to time, and without
registering as a commodity pool operator under the Commodity Exchange
Act.
16
Under the Fund's non-fundamental investment restrictions, none of the
Portfolios may:
a. Change its investment strategy to invest at least 80% of its net
assets in certain fixed-income securities without providing shareholders
with at least 60 days prior notice of such change.
b. Purchase securities of other investment companies, except to the
extent such purchases are permitted by applicable law. As a matter of
policy, however, the Fund will not purchase shares of any registered
open-end investment company or registered unit investment trust, in
reliance on Section 12(d)(1)(F) or (G) (the "fund of funds" provisions)
of the Investment Company Act at any time the Fund's shares are owned by
another investment company that is part of the same group of investment
companies as the Fund.
c. Make short sales of securities or maintain a short position,
except to the extent permitted by applicable law. The Fund currently does
not intend to engage in short sales, except short sales "against the
box."
d. Invest in securities which cannot be readily resold because of
legal or contractual restrictions or which cannot otherwise be marketed,
redeemed or put to the issuer or a third party, if at the time of
acquisition more than 15% of its total assets would be invested in such
securities. This restriction shall not apply to securities which mature
within seven days or securities which the Board of Directors of the Fund
has otherwise determined to be liquid pursuant to applicable law.
Securities purchased in accordance with Rule 144A under the Securities
Act (a "Rule 144A Security") and determined to be liquid by the Fund's
Board of Directors are not subject to the limitations set forth in this
investment restriction.
e. Notwithstanding fundamental investment restriction (7) above, the
Fund will not borrow amounts in any Portfolio in excess of 5% of the
total assets of such Portfolio, taken at market value, and then only from
banks as a temporary measure for extraordinary or emergency purposes such
as the redemption of Fund shares. In addition, the Fund will not purchase
securities while borrowings are outstanding.
Because of the affiliation of Merrill Lynch, Pierce, Fenner & Smith
Incorporated ("Merrill Lynch") with the Fund, the Fund is prohibited from
engaging in certain transactions involving Merrill Lynch except pursuant to an
exemptive order or otherwise in compliance with the provisions of the
Investment Company Act and the rules and regulations thereunder. Included
among such restricted transactions are (i) purchases from or sales to Merrill
Lynch of securities in transactions in which Merrill Lynch acts as principal,
and (ii) purchases of securities from underwriting syndicates of which Merrill
Lynch is a member.
MANAGEMENT OF THE FUND
Directors and Officers
The Board of Directors of the Fund consist of eight individuals, seven of
whom are not "interested persons" of the Fund as defined in the Investment
Company Act (the "non-interested Directors"). The Directors are responsible
for the overall supervision of the operations of the Fund and perform the
various duties imposed on the directors of investment companies by the
Investment Company Act.
Information about the Directors, executive officers and portfolio
managers of the Fund, including their ages and their principal occupations for
at least the last five years, is set forth below. Unless otherwise noted, the
address of each Director, officer and portfolio manager is P.O. Box 9011,
Princeton, New Jersey 08543-9011.
TERRY K. GLENN (61)--President and Director(1)(2)--Chairman (Americas
Region) since 2001 and Executive Vice President of the Investment Adviser and
its affiliate, Merrill Lynch Investment Managers, L.P. ("MLIM") (which terms
as used herein include their corporate predecessors) since 1983; President,
Merrill Lynch Mutual Funds since 1999; President of FAM Distributors, Inc.
("FAMD" or the "Distributor") since 1986 and Director thereof since 1991;
Executive Vice President and Director of Princeton Services, Inc. ("Princeton
Services") since 1993; President of Princeton Administrators, L.P. since 1988;
Director of Financial Data Services ("FDS") since 1985.
17
RONALD W. FORBES (61)--Director(2)(3)--1400 Washington Avenue, Albany,
New York 12222. Professor Emeritus of Finance, School of Business, State
University of New York at Albany, since 2000 and Professor thereof from 1989
to 2000. International Consultant, Urban Institute, Washington, D.C. from 1995
to 1999.
CYNTHIA A. MONTGOMERY (49)--Director(2)(3)--Harvard Business School,
Soldiers Field Road, Boston, Massachusetts 02613. Professor, Harvard Business
School, since 1989; Associate Professor, J.L. Kellogg Graduate School of
Management, Northwestern University from 1985 to 1989; Assistant Professor,
Graduate School of Business Administration, The University of Michigan from
1979 to 1985; Director, Unum Provident Corporation since 1990 and Director,
Newell Rubbermaid Inc. since 1995.
CHARLES C. REILLY (70)--Director(2)(3)--9 Hampton Harbor Road, Hampton
Bays, New York 11946. Self-employed financial consultant since 1990; President
and Chief Investment Officer of Verus Capital, Inc. from 1979 to 1990; Senior
Vice President of Arnhold and S. Bleichroeder, Inc. from 1973 to 1990; Adjunct
Professor, Columbia University Graduate School of Business from 1990 to 1991;
Adjunct Professor, Wharton School, University of Pennsylvania from 1989 to
1990; Partner, Small Cities Cable Television from 1986 to 1997.
KEVIN A. RYAN (69)--Director(2)(3)--127 Commonwealth Avenue, Chestnut
Hill, Massachusetts 02467. Founder and currently Director Emeritus of the
Boston University Center for the Advancement of Ethics and Character and
Director thereof from 1989 to 1999; Professor from 1982 to 1999 and currently
Professor Emeritus of Education at Boston University; formerly taught on the
faculties of The University of Chicago, Stanford University and Ohio State
University.
ROSCOE S. SUDDARTH (66)--Director(2)(3)--7403 MacKenzie Court, Bethesda,
Maryland 20817. Former President, Middle East Institute from 1995 to 2001;
Foreign Service Officer, United States Foreign Service from 1961 to 1995;
Career Minister from 1989 to 1995; Deputy Inspector General, U.S. Department
of State from 1991 to 1994; U.S. Ambassador to the Hashemite Kingdom of Jordan
from 1987 to 1990.
RICHARD R. WEST (63)--Director(2)(3)--Box 604, Genoa, Nevada 89411.
Professor of Finance since 1984, Dean from 1984 to 1993 and currently Dean
Emeritus of New York University Leonard N. Stern School of Business
Administration; Director of Bowne & Co., Inc. (financial printers), Vornado
Realty Trust, Inc. (real estate holding company) and Alexander's Inc. (real
estate company).
EDWARD D. ZINBARG (67)--Director(2)(3)--5 Hardwell Road, Short Hills, New
Jersey 07078-2117. Self-employed financial consultant since 1994; Executive
Vice President of The Prudential Insurance Company of America from 1988 to
1994; former Director of Prudential Reinsurance Company and former Trustee of
The Prudential Foundation.
CHRISTOPHER G. AYOUB (45)--Senior Vice President and Portfolio
Manager(1)(2)--Managing Director of MLIM since 1997; Vice President of MLIM
from 1985 to 1997; Assistant Vice President from 1984 to 1985.
B. DANIEL EVANS (57)--Portfolio Manager(1)(2)--Director of MLIM since
2000; Vice President of MLIM from 1995 to 2000.
VINCENT T. LATHBURY, III (60)--Senior Vice President and Portfolio
Manager(1)(2)--Managing Director of MLIM since 1997; Vice President of MLIM
from 1982 to 1997; Portfolio Manager of the Investment Adviser and MLIM since
1982.
JAMES J. PAGANO (39)--Portfolio Manager(1)(2)--Vice President of MLIM
since 1997.
DONALD C. BURKE (41)--Vice President and Treasurer(1)(2)--First Vice
President of the Investment Adviser and MLIM since 1997 and Treasurer thereof
since 1999; Senior Vice President and Treasurer of Princeton Services since
1999; Vice President of FAMD since 1999; Vice President of the Investment
Adviser and MLIM from 1990 to 1997; Director of Taxation of MLIM since 1990.
18
PHILLIP S. GILLESPIE (37)--Secretary(1)(2)--First Vice President of MLIM
since 2001; Director of MLIM from 1999 to 2000; Vice President of MLIM in
1999; attorney associated with the Investment Adviser and MLIM from 1998 to
1999; Assistant General Counsel of Chancellor LGT Asset Management, Inc. from
1997 to 1998; Senior Counsel and Attorney in the Division of Investment
Management and the Office of General Counsel at the U.S. Securities and
Exchange Commission from 1993 to 1997.
- -------------
(1) Interested person, as defined in the Investment Company Act, of the
Fund.
(2) The Directors and officers of the Fund are Directors and officers of certain
other investment companies for which the Investment Adviser or MLIM acts as
investment adviser.
(3) Member of the Fund's Audit and Nominating Committee, which is responsible
for the selection of the independent auditors and the selection and
nomination of non-interested Directors.
At January 4, 2002, the Directors and officers of the Fund as a group (14
persons) owned an aggregate of less than 1% of the outstanding shares of the
Fund. At that date, Mr. Glenn, a Director and officer of the Fund, and the
other officers of the Fund, owned less than 1% of the outstanding shares of
common stock of Merrill Lynch & Co., Inc. ("ML & Co.").
Compensation of Directors
Pursuant to the terms of the investment advisory agreement between FAM
and the Fund (the "Investment Advisory Agreement"), the Investment Adviser
pays all compensation of officers and employees of the Fund as well as the
fees of all Directors of the Fund who are affiliated persons of ML & Co. or
its subsidiaries.
The Fund pays each Director not affiliated with the Investment Adviser
(each a "non-interested Director") an annual fee of $2,950 plus a fee of $200
per Audit and Board meeting attended, together with such Director's actual
out-of-pocket expenses relating to attendance at meetings. The Fund also
compensates members of its Audit and Nominating Committee (the "Committee"),
which consists of all of the non-interested Directors with a fee of $2,950 per
year. The Co-Chairmen of the Committee each receives an additional annual fee
of $1,000.
The following table shows the compensation earned by the non-interested
Directors for the Fund's fiscal year ended September 30, 2001 and the
aggregate compensation paid to them by all registered investment companies
advised by the Investment Adviser and its affiliate, MLIM ("MLIM/FAM-advised
funds") for the calendar year ended December 31, 2001:
Aggregate
Pension or Compensation
Retirement Benefits from Fund and
Compensation Accrued as Part of Other MLIM/FAM-
Name from Fund Fund Expense Advised Funds(1)
- ---- ------------ ------------------- ----------------
Ronald W. Forbes(3)......... $7,900 None $293,400
Cynthia A. Montgomery....... $7,000 None $234,567
Charles C. Reilly(3)........ $7,900 None $293,400
Kevin A. Ryan.............. $7,400 None $261,067
Roscoe E. Suddarth(2)....... $7,400 None $250,633
Richard R. West............. $7,400 None $261,067
Edward D. Zinbarg(2)........ $7,400 None $250,633
- ----------------
(1) The Directors serve on the boards of MLIM/FAM-advised funds as follows:
Mr. Forbes (46 registered investment companies consisting of 55
portfolios); Ms. Montgomery (46 registered investment companies
consisting of 55 portfolios); Mr. Reilly (46 registered investment
companies consisting of 55 portfolios); Mr. Ryan (46 registered
investment companies consisting of 55 portfolios); Mr. Suddarth (46
registered investment companies consisting of 55 portfolios); Mr. West
(49 registered investment companies consisting of 66 portfolios); and Mr.
Zinbarg (46 registered investment companies consisting of 55 portfolios).
(2) Mr. Suddarth and Mr. Zinbarg were elected Directors of the Fund on July 10,
2000. Mr. Zinbarg was elected a director of certain other
MLIM/FAM-advised funds in January 2000.
(3) Effective June 2001, Mr. Forbes and Mr. Reilly are Co-Chairmen of the
Committee, each receiving $1,000 annually.
19
Management and Advisory Arrangements
Pursuant to the Investment Advisory Agreement, Fund Asset Management,
L.P., a subsidiary of ML & Co., acts as the investment adviser for the Fund
and provides the Fund with management services. Subject to the supervision of
the Board of Directors of the Fund, FAM is responsible for the actual
management of each Portfolio and constantly reviews the holdings of each
Portfolio in light of its own research analysis and analyses from other
relevant sources. The responsibility for making decisions to buy, sell or hold
a particular security rests with FAM. FAM provides the portfolio managers for
each Portfolio, who consider analyses from various sources, make the necessary
investment decisions and place transactions accordingly. FAM is also obligated
to perform certain administrative management services for the Fund and
provides all the office space, facilities, equipment and personnel necessary
to perform its duties under the Agreement.
The Investment Adviser is a limited partnership, the partners of which
are ML & Co. and Princeton Services. ML & Co. and Princeton Services are
"controlling persons" of the Investment Adviser as defined under the
Investment Company Act because of their ownership of its voting securities or
their power to exercise a controlling influence over its management or
policies. Similarly, the following entities may be considered "controlling
persons" of Merrill Lynch Asset Management U.K. ("MLAM U.K."): Merrill Lynch
Europe Limited (MLAM U.K.'s parent), a subsidiary of ML International
Holdings, a subsidiary of Merrill Lynch International, Inc., a subsidiary of
ML & Co.
The Investment Adviser has entered into a sub-advisory agreement (the
"Sub-Advisory Agreement") with MLAM U.K., an indirect, wholly owned subsidiary
of ML & Co. and an affiliate of the Investment Adviser, pursuant to which the
Investment Adviser pays MLAM U.K. a fee for providing investment advisory
services to the Investment Adviser with respect to the Fund in an amount to be
determined from time to time by the Investment Adviser and MLAM U.K. but in no
event in excess of the amount that the Investment Adviser actually receives
for providing services to the Fund pursuant to the Investment Advisory
Agreement. For the fiscal years ended September 30, 2001, 2000 and 1999 the
Investment Adviser did not pay any fees to MLAM U.K. pursuant to this
agreement. The address of MLAM U.K. is Milton Gate, 1 Moore Lane, London EC2Y
9MA, England.
Vincent T. Lathbury III serves as Portfolio Manager of the High Income
Portfolio, and Christopher G. Ayoub serves as Portfolio Manager of the Core
Bond Portfolio and Intermediate Term Portfolio. They are primarily responsible
for the day to day management of the Fund. Vincent T. Lathbury III has served
as First Vice President of MLIM since 1997, Vice President of MLIM from 1982
to 1997 and Portfolio Manager of the Investment Adviser and MLIM since 1982.
Christopher G. Ayoub has served as Director (Fixed Income Fund Management) of
MLIM since 1997, Vice President of MLIM from 1985 to 1997 and Assistant Vice
President from 1984 to 1985.
Securities held by the Fund may also be held by other funds for which FAM
or MLIM acts as an adviser or by investment advisory clients of MLIM. If
purchases or sales of securities for the Fund or other funds for which FAM or
MLIM acts as investment adviser or for their advisory clients arise for
consideration at or about the same time, transactions in such securities will
be made, insofar as feasible, for the respective funds and clients in a manner
deemed equitable to all. To the extent that transactions on behalf of more
than one client of the Investment Adviser or MLIM during the same period may
increase the demand for securities being purchased or the supply of securities
being sold, there may be an adverse effect on price.
Advisory Fee. As compensation for its services to the Portfolios, the
Investment Adviser receives at the end of each month a fee with respect to
each Portfolio. The fee for each Portfolio is determined based on the annual
advisory fee rates for that Portfolio set forth in the table below. These fee
rates are applied to the average daily net assets of each Portfolio, with the
reduced rates shown below applicable to portions of the assets of each
Portfolio to the extent that the aggregate of the average daily net assets of
the three combined Portfolios exceeds $250 million, $500 million and $750
million (each such amount being a "breakpoint level"). The portion of the
assets of a Portfolio to which the rate at each breakpoint level applies will
be determined on a "uniform percentage" basis. The uniform percentage
applicable to a breakpoint level is determined by dividing the amount of the
aggregate of the average daily net assets of the three combined Portfolios
that falls within that breakpoint
20
level by the aggregate of the average daily net assets of the three combined
Portfolios. The amount of the fee for a Portfolio at each breakpoint level is
determined by multiplying the average daily net assets of that Portfolio by the
uniform percentage applicable to that breakpoint level and multiplying the
product by the advisory fee rate.
Rates of Advisory Fee
--------------------------------------------------
Aggregate of average daily net assets High Income Core Bond Intermediate Term
of the three combined Portfolios Portfolio Portfolio Portfolio
------------------------------------- ----------- --------- -----------------
Up to $250 million 0.55% 0.50% 0.50%
Over $250 million up to $500 million 0.50 0.45 0.45
Over $500 million up to $750 million 0.45 0.40 0.40
Over $750 million 0.40 0.35 0.35
For the fiscal year ended September 30, 2001, FAM received advisory fees
from the Fund in the amount of $17,145,308 of which $11,183,440 was received
with respect to the High Income Portfolio (representing 0.42% of its average
daily net assets), $4,449,922 was received with respect to the Core Bond
Portfolio (representing 0.37% of its average daily net assets) and $1,511,946
was received with respect to the Intermediate Term Portfolio (representing
0.37% of its average daily net assets). The Investment Advisory Agreement
obligates each Portfolio to pay certain expenses incurred in its operation and
a portion of the Fund's general administrative expenses allocated on the basis
of the asset size of the respective Portfolios. The Fund's total expenses for
the year ended September 30, 2001 were $48,046,302 of which $31,769,880 was
attributable to the High Income Portfolio, $12,041,800 was attributable to the
Core Bond Portfolio, and $4,234,622 was attributable to the Intermediate Term
Portfolio, respectively.
For the fiscal years ended September 30, 1999 and 2000 the advisory fees
paid by the Fund to the Investment Adviser totaled $30,667,096 and 22,458,938,
respectively. The Investment Adviser did not reimburse any portion of its
advisory fee for the fiscal year ended September 30, 1999, 2000 and 2001.
Payment of Expenses. The Investment Advisory Agreement obligates FAM to
provide investment advisory services and to pay all compensation of and
furnish office space for officers and employees of the Fund connected with
investment and economic research, trading and investment management of the
Fund, as well as the fees of all Directors of the Fund who are affiliated
persons of ML & Co. or any of its affiliates. Each Portfolio pays all other
expenses incurred in its operation and a portion of the Fund's general
administrative expenses allocated on the basis of the asset size of the
respective Portfolios. Expenses that will be borne directly by the Portfolios
include redemption expenses, expenses of portfolio transactions, shareholder
servicing costs, expenses of registering the shares under Federal, state or
foreign laws, pricing costs (including the daily calculation of net asset
value), interest, certain taxes, charges of the custodian and Transfer Agent
and other expenses attributable to a particular Portfolio. Expenses that will
be allocated on the basis of size of the respective Portfolios include
Directors' fees, legal expenses, state franchise taxes, auditing services,
costs of preparing, printing and mailing proxies, stock certificates,
shareholder reports and prospectuses (except to the extent paid by FAMD),
Securities and Exchange Commission ("SEC") fees, accounting costs and other
expenses properly payable by the Fund and allocable on the basis of the size
of the respective Portfolios. Depending upon the nature of the lawsuit,
litigation costs may be directly applicable to the Portfolios or allocated on
the basis of the size of the respective Portfolios. The Board of Directors has
determined that this is an appropriate method of allocation of expenses.
Certain accounting services are provided for the Fund by State Street Bank and
Trust Company ("State Street") pursuant to an agreement between State Street
and the Fund. The Fund pays a fee for these services. In addition, the Fund
reimburses the Investment Adviser for the cost of other accounting services.
The Distributor will pay certain promotional expenses of each Portfolio
incurred in connection with the offering of shares of each Portfolio,
including the expenses of printing the prospectuses used in connection with
the continuous offering of shares by each Portfolio. See "Purchase of
Shares--Distribution Plans."
Duration and Termination. Continuation of the Investment Advisory
Agreement and the Sub-Advisory Agreement for the period March 1, 2002 to March
1, 2003 was approved by the Board of Directors, including a majority of the
disinterested directors, on November 28, 2001. Unless earlier terminated as
described herein, the Investment Advisory Agreement and Sub-Advisory Agreement
will continue in effect until March 1, 2003 and thereafter will continue in
effect from year to year if approved annually (a) by the Board of Directors of
the Fund
21
or by a majority of the outstanding voting shares of the Fund and (b) by a
majority of the Directors who are not parties to such contract or interested
persons (as defined in the Investment Company Act) of any such party. Such
contract terminates upon assignment and may be terminated without penalty on 60
days' written notice at the option of either party thereto or by the vote of
the shareholders of the Fund.
Transfer Agency Services. Financial Data Services, Inc. (the "Transfer
Agent"), a subsidiary of ML & Co., acts as the Fund's Transfer Agent pursuant
to a Transfer Agency, Dividend Disbursing Agency and Shareholder Servicing
Agency Agreement (the "Transfer Agency Agreement"). Pursuant to the Transfer
Agency Agreement, the Transfer Agent is responsible for the issuance, transfer
and redemption of shares and the opening and maintenance of shareholder
accounts. Pursuant to the Transfer Agency Agreement, the Transfer Agent
receives a fee of $16.00 per Class A or Class D account and $23.00 per Class B
or Class C account and is entitled to reimbursement for certain transaction
charges and out-of-pocket expenses incurred by the Transfer Agent under the
Transfer Agency Agreement. For purposes of the Transfer Agency Agreement, the
term "account" includes a shareholder account maintained directly by the
Transfer Agent and any other account representing the beneficial interest of a
person in the relevant share class on a recordkeeping system, provided the
recordkeeping system is maintained by a subsidiary of ML & Co.
Accounting Services. The Fund entered into an agreement with 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. Prior
to January 1, 2001, the Investment Adviser provided accounting services to
each Portfolio and was reimbursed by the Portfolio at its cost in connection
with such services.
The Investment Adviser continues to provide certain accounting services
to each Portfolio and each Portfolio reimburses the Investment Adviser for the
cost of these services.
The table below shows the amounts paid by each Portfolio to State Street
and to the Investment Adviser for the periods indicated:
1999 2000 2001
------------------- --------------------- ---------------------
Paid to Paid to Paid to Paid to Paid to Paid to
State Investment State Investment State Investment
Street Adviser Street Adviser Street* Adviser
-------- ----------- --------- ----------- --------- -----------
High Income Portfolio N/A $422,772 N/A $270,958 $536,375 $251,877
Core Bond Portfolio N/A $133,078 N/A $100,752 $244,725 $139,888
Intermediate Term Portfolio N/A $ 45,616 N/A $ 30,390 $ 83,407 $ 49,696
- -------------------
* Represents payments pursuant to the agreement with State Street commencing January 1, 2001.
Distribution Expenses. The Fund entered into a distribution agreement
with the Distributor in connection with the continuous offering of shares of
the Fund (the "Distribution Agreement"). The Distribution Agreement obligates
the Distributor to pay certain expenses in connection with the offering of
each class of shares of the Fund. After the prospectuses, statements of
additional information and periodic reports have been prepared, set in type
and mailed to shareholders, the Distributor pays for the printing and
distribution of copies thereof used in connection with the offering to dealers
and investors. The Distributor also pays for other supplementary sales
literature and advertising costs. The Distribution Agreement is subject to the
same renewal requirements and termination provisions as the Investment
Advisory Agreement described above.
Code of Ethics
The Board of Directors of the Fund has approved a Code of Ethics under
Rule 17j-1 of the Investment Company Act that covers the Fund, the Investment
Adviser, MLAM U.K. and the Distributor. The Code of Ethics significantly
restricts the personal investing activities of all employees of the Investment
Adviser and Distributor and, as described below, imposes additional, more
onerous, restrictions on Fund investment personnel.
The Code of Ethics requires that all employees of the Investment Adviser
and Distributor preclear any personal securities investments (with limited
exceptions such as mutual funds, high-quality short term securities and direct
obligations of the U.S. government). The preclearance requirement and
associated procedures are designed to identify any substantive prohibition or
limitation applicable to the proposed investment. The
22
substantive restrictions applicable to all employees of the Investment Adviser
and Distributor include a ban on acquiring any securities in a "hot" initial
public offering and investment personnel are prohibited from profiting on
short-term trading in securities. In addition, no employee may purchase or sell
any security that at the time is being purchased or sold (as the case may be),
or to the knowledge of the employee is being considered for purchase or sale,
by any fund advised by the Investment Adviser. Furthermore, the Code of Ethics
provides for trading "blackout periods" which prohibit trading by investment
personnel of the Fund within seven calendar days before or after trading by the
Fund in the same or an equivalent security.
PURCHASE OF SHARES
Reference is made to "Your Account--How to Buy, Sell, Transfer and
Exchange Shares" in the Prospectus.
Each Portfolio offers four classes of shares under the Merrill Lynch
Select Pricing(SM) System. Class A and Class D shares are sold to investors
choosing the initial sales charge alternatives and Class B and Class C shares
are sold to investors choosing the deferred sales charge alternative. Class C
shares of the Intermediate Term Portfolio are available only through the
Exchange Privilege and may not be purchased except through exchange of Class C
shares of another Portfolio or another fund.
The Merrill Lynch Select Pricing(SM) System is used by more than 50
registered investment companies advised by the Investment Advisor or its
affiliate, MLIM. Funds advised by the Investment Adviser or MLIM that use the
Merrill Lynch Select Pricing(SM) System are referred to herein as "Select
Pricing Funds".
Each Portfolio offers its shares at a public offering price equal to the
next determined net asset value per share plus any sales charge applicable to
the class of shares selected by the investor. The applicable offering price
for purchase orders is based upon the net asset value of the Portfolio next
determined after receipt of the purchase order by the Distributor. As to
purchase orders received by securities dealers or other financial
intermediaries prior to the close of business on the New York Stock Exchange
(the "NYSE") (generally 4:00 p.m., Eastern time) which includes orders
received after the determination of net asset value on the previous day, the
applicable offering price will be based on the net asset value on the day the
order is placed with the Distributor, provided that the orders are received by
the Distributor prior to 30 minutes after the close of business on the NYSE on
that day. If the purchase orders are not received prior to 30 minutes after
the close of business on the NYSE on that day, such orders shall be deemed
received on the next business day. Dealers or other financial intermediaries
have the responsibility of submitting purchase orders to the Fund not later
than 30 minutes after the close of business on the NYSE in order to purchase
Portfolio shares at that day's offering price.
Shares may be purchased directly from the Distributor or from other
securities dealers, including Merrill Lynch, with whom the Distributor has
entered into selected dealer agreements. The minimum initial purchase in each
Portfolio is $1,000 and the minimum subsequent purchase in each Portfolio is
$50, except that for retirement plans the minimum initial purchase in each
Portfolio is $100 and the minimum subsequent purchase is $1, and for
participants in certain fee-based programs the minimum initial purchase is
$250 and the minimum subsequent purchase is $50. Merrill Lynch charges its
customers a processing fee (currently $5.35) to confirm a sale of shares to
such customers.
The alternate sales arrangements of the Fund permit investors in the
Portfolios to choose the method of purchasing shares that they believe is most
beneficial given the amount of their purchase, the length of time the investor
expects to hold his shares and other relevant circumstances. Investors should
determine whether under their particular circumstances it is more advantageous
to incur an initial sales charge, as discussed below, or to have the entire
initial purchase price invested in one of the Portfolios with the investment
thereafter being subject to ongoing account maintenance and distribution fees.
A discussion of the factors that investors should consider in determining the
method of purchasing shares under the Merrill Lynch Select Pricing(SM) System
is set forth under "Merrill Lynch Select Pricing(SM) System" on page [26] of
the Prospectus.
Each Class A, Class B, Class C and Class D share of a Portfolio
represents identical interests in the Portfolio and has the same rights,
except that Class B, Class C and Class D shares bear the expenses of the
ongoing account maintenance fees, and Class B and Class C shares bear the
expenses of the ongoing distribution fees and the
23
additional incremental transfer agency costs resulting from the deferred sales
charge arrangements. The deferred sales charges and account maintenance fees
that are imposed on Class B and Class C shares, as well as the account
maintenance fees that are imposed on Class D shares, will be imposed directly
against those classes and not against all assets of the Portfolio and,
accordingly, such charges will not affect the net asset value of any other
class or have any impact on investors choosing another sales charge option.
Dividends paid by a Portfolio for each class of shares will be calculated in
the same manner at the same time and will differ only to the extent that
account maintenance and distribution fees and any incremental transfer agency
costs relating to a particular class are borne exclusively by that class. Class
B, Class C and Class D shares of a Portfolio each have exclusive voting rights
with respect to the Rule 12b-1 distribution plan adopted with respect to such
class pursuant to which account maintenance and/or distribution fees are paid
(except that Class B shareholders may vote upon any material changes to
expenses charged under the Class D Distribution Plan). See "Distribution Plans"
on page 37. Each class has different exchange privileges. See "Shareholder
Services--Exchange Privilege" on page 49.
Investors should understand that the purpose and function of the initial
sales charges with respect to Class A and Class D shares are the same as those
of the CDSC and distribution fees with respect to Class B and Class C shares
in that the sales charges and distribution fees applicable to each class
provide for the financing of the distribution of the shares of the Fund. The
distribution-related revenues paid with respect to a class will not be used to
finance the distribution expenditures of another class. Sales personnel may
receive different compensation for selling different classes of shares.
Investors are advised that only Class A and Class D shares may be available
for purchase through securities dealers, other than Merrill Lynch, that are
eligible to sell shares.
The following tables set forth a summary of the distribution arrangements
for each class of shares under the Merrill Lynch Select Pricing(SM) System.
24
High Income Portfolio and Core Bond Portfolio
Account
Maintenance Distribution Conversion
Class Sales Charge(1) Fee Fee Feature
- ----- --------------- ------------ ------------ -----------
A Maximum 4.00% initial sales No No No
charge(2)(3)
B CDSC for a period of four 0.25% 0.50% B Shares convert to
years, at a rate of 4.0% D shares automatically
during the first year, after approximately ten
decreasing 1.0% annually to years(5)
0.0%(4)
C 1.0% CDSC for one year 0.25% 0.55% No
decreasing to 0.0% after the
first year(6)
D Maximum 4.0% initial sales 0.25% No No
charge(3)
- ------------------
(1) Initial sales charges are imposed at the time of purchase as a percentage of the offering price. Contingent deferred sales
charges ("CDSCs") are imposed if the redemption occurs within the applicable CDSC time period. The charge will be assessed
on an amount equal to the lesser of the proceeds of redemption or the cost of the shares being redeemed.
(2) Offered only to eligible investors. See "Purchase of Shares--Initial Sales Charge Alternatives--Class A and Class D
Shares--Eligible Class A Investors" on page 24.
(3) Reduced for purchases of $25,000 or more and waived for purchases of Class A shares by certain retirement plans and
participants in connection with certain fee-based programs. Class A and Class D share purchases of $1,000,000 or more may
not be subject to an initial sales charge but, instead may be subject to a 1.0% CDSC if redeemed within one year. Such CDSC
may be waived in connection with certain fee-based programs. A 0.75% sales charge for 401(k) purchases over $1,000,000 will
apply.
(4) The CDSC may be modified in connection with certain fee-based programs.
(5) The conversion period for dividend reinvestment shares and the conversion and holding periods for certain retirement plans
were modified. Also, Class B shares of certain other MLIM-advised mutual funds into which exchanges may be made have an
eight year conversion period. If Class B shares of a Portfolio of the Fund are exchanged for Class B shares of another
Select Pricing Fund, the conversion period applicable to the Class B shares acquired in the exchange will apply, and the
holding period for the shares exchanged will be tacked onto the holding period for the shares acquired.
(6) The CDSC may be waived in connection with certain fee-based programs.
25
Intermediate Term Portfolio
Account
Maintenance Distribution Conversion
Class Sales Charge(1) Fee Fee Feature
----- ------------------------------ ------------ ------------- -----------------------
A Maximum 1.00% initial sales No No No
charge(2)(3)
B CDSC for one year, at a rate 0.25% 0.25% B shares convert to
of 1.0% during the first year, D shares automatically
decreasing to 0.0% after the after approximately ten
first year(4) years(5)
C 1.0% CDSC for one year 0.25% 0.25% No
decreasing to 0.0% after the
first year(6)
D Maximum 1.00% initial sales 0.10% No No
charge(3)
- -------------
(1) Initial sales charges are imposed at the time of purchase as a percentage
of the offering price. Contingent deferred sales charges ("CDSCs") are
imposed if the redemption occurs within the applicable CDSC time period.
The charge will be assessed on an amount equal to the lesser of the
proceeds of redemption or the cost of the shares being redeemed.
(2) Offered only to eligible investors. See "Purchase of Shares--Initial
Sales Charge Alternatives--Class A and Class D Shares--Eligible Class A
Investors" on page 24.
(3) Reduced for purchases of $100,000 or more and waived for purchases of
Class A shares by certain retirement plans and participants in connection
with certain fee-based programs. Class A and Class D share purchases of
$1,000,000 or more may not be subject to an initial sales charge but, if
the initial sales charge is waived, may be subject to a 0.20% CDSC if
redeemed within one year. A 0.30% sales charge for 401(k) purchases over
$1,000,000 will apply.
(4) The CDSC may be modified in connection with certain fee-based programs.
(5) The conversion period for dividend reinvestment shares and the conversion
and holding periods for certain retirement plans were modified. Also,
Class B shares of certain other MLIM-advised mutual funds into which
exchanges may be made have an eight year conversion period. If Class B
shares of a Portfolio of the Fund are exchanged for Class B shares of
another Select Pricing Fund, the conversion period applicable to the
Class B shares acquired in the exchange will apply, and the holding
period for the shares exchanged will be tacked onto the holding period
for the shares acquired.
(6) The CDSC may be waived in connection with certain fee-based programs.
26
Initial Sales Charge Alternatives--Class A and Class D Shares
Investors choosing the initial sales charge alternatives who are eligible
to purchase Class A shares should purchase Class A shares rather than Class D
shares because there is an account maintenance fee imposed on Class D shares.
Sales charges for purchases of Class A and Class D shares of the
Portfolios, computed as indicated below, are reduced on larger purchases. The
Distributor may reallow as a discount all or a part of such sales charge to
securities dealers with whom it has agreements and will retain any portion of
the sales charge not reallowed. If 90% or more of the sales charge is
reallowed to a dealer, such dealer may be deemed to be an underwriter within
the meaning of the Securities Act and subject to liability as such. The
Distributor will retain the entire sales charge on orders placed directly with
it. The sales charges applicable to the Portfolios, expressed as a percentage
of the gross public offering price and the net amount invested, and expected
dealer discounts, expressed as a percentage of the gross public offering
price, are as follows:
Class A and Class D shares of
High Income Portfolio and Core Bond Portfolio
-------------------------------------------------------------------
Discount to
Sales Load as Sales Load as Select Dealers as
a Percentage of a Percentage of a Percentage of
Amount of Purchase Offering Price Net Amount Invested* Offering Price
- ------------------ ---------------- -------------------- -------------------
Less than $25,000........................ 4.00% 4.17% 3.75%
$25,000 but less than $50,000............ 3.75 3.90 3.50
$50,000 but less than $100,000........... 3.25 3.36 3.00
$100,000 but less than $250,000.......... 2.50 2.56 2.25
$250,000 but less than $1,000,000........ 1.50 1.52 1.25
$1,000,000 and more**.................... 0.00 0.00 0.00
Class A and Class B shares of
Intermediate Term Portfolio
-------------------------------------------------------------------
Discount to
Sales Load as Sales Load as Select Dealers as
a Percentage of a Percentage of a Percentage of
Amount of Purchase Offering Price Net Amount Invested* Offering Price
- ------------------ ---------------- -------------------- -------------------
Less than $100,000....................... 1.00% 1.01% 0.95%
$100,000 but less than $250,000.......... 0.75 0.76 0.70
$250,000 but less than $500,000.......... 0.50 0.50 0.45
$500,000 but less than $1,000,000........ 0.30 0.30 0.27
$1,000,000 or more**..................... 0.00 0.00 0.00*
- ----------
* Rounded to the nearest one-hundredth percent.
** The initial sales charge may be waived on Class A and Class D
purchases of $1,000,000 or more, and on Class A purchases by certain
retirement plan investors and participants in certain fee-based
programs. If the sales charge is waived in connection with a purchase of
$1,000,000 or more, such purchases may be subject to a CDSC of 1.0% for
the High Income Portfolio and Core Bond Portfolio or 0.20% for the
Intermediate Term Portfolio if the shares are redeemed within one year
after purchase. Such CDSC may be waived in connection with certain
fee-based programs. The charge will be assessed on an amount equal to
the lesser of the proceeds of redemption or the cost of the shares being
redeemed. A sales charge of 0.75% (with respect to the High Income
Portfolio and Core Bond Portfolio) or 0.30% (with respect to the
Intermediate Term Portfolio) will be imposed on purchases of $1 million
or more of Class A or Class D shares by certain 401(k) plans.
The Distributor may reallow discounts to selected dealers and retain the
balance over such discounts. At times the Distributor may reallow the entire
sales charge to such dealers. Since securities dealers selling Class A and
Class D shares of the Fund will receive a concession equal to most of the
sales charge, they may be deemed to be underwriters under the Securities Act.
The proceeds from the account maintenance fees are used to compensate the
Distributor and Merrill Lynch (pursuant to a sub-agreement) for providing
continuing account maintenance activities.
27
Class A and Class D Sales Charge Information
Class A Shares
Gross Sales Sales Charges Sales Charges CDCSs Received on
Charges Retained by Paid to Redemption of
For the fiscal year ended September 30, Collected Distributor Merrill Lynch Load-Waived Shares
--------------------------------------- ------------- -------------- -------------- ------------------
High Income Portfolio
1999............................................. $144,887 $14,365 $130,522 $32,999
2000............................................. $ 63,894 $ 7,140 $ 56,754 $ 556
2001............................................. $ 64,685 $ 6,506 $ 58,179 $ 0
Core Bond Portfolio
1999............................................. $ 24,458 $ 2,709 $ 21,749 $ 0
2000............................................. $ 8,587 $ 855 $ 7,732 $ 515
2001............................................. $ 12,623 $ 1,133 $ 11,490 $ 0
Intermediate Term Portfolio
1999............................................. $ 3,404 $ 380 $ 3,024 $ 0
2000............................................. $ 877 $ 42 $ 835 $ 4,151
2001............................................. $ 1,251 $ 103 $ 1,148 $ 78
Class D Shares
Gross Sales Sales Charges Sales Charges CDCSs Received on
Charges Retained by Paid to Redemption of
For the fiscal year ended September 30, Collected Distributor Merrill Lynch Load-Waived Shares
--------------------------------------- ------------- -------------- -------------- ------------------
High Income Portfolio
1999............................................. $ 99,255 $10,195 $ 89,060 $ 0
2000............................................. $ 89,486 $ 9,550 $ 79,936 $ 1,231
2001............................................. $408,887 $39,389 $369,499 $58,153
Core Bond Portfolio
1999............................................. $131,083 $11,712 $119,371 $24,725
2000............................................. $ 30,406 $ 3,118 $ 27,288 $ 8,094
2001............................................. $134,588 $10,195 $123,673 $30,000
Intermediate Term Portfolio
1999............................................. $ 9,138 $ 837 $ 8,301 $ 108
2000............................................. $ 3,192 $ 202 $ 2,990 $ 1,552
2001............................................. $ 6,903 $ 302 $ 6,601 $ 4,000
Eligible Class A Investors. Class A shares are offered to a limited group
of investors and also will be issued upon reinvestment of dividends from
outstanding Class A shares. Investors that currently own Class A shares of a
Portfolio in a shareholder account, including participants in the Merrill
Lynch Blueprint(SM) Program, are entitled to purchase additional Class A shares
of that Portfolio in that account. Class A shares are available at net asset
value to corporate insurance reserve fund programs and U.S. warranty branches
of foreign banking institutions, provided that the program or branch has $3
million or more initially invested in MLIM/FAM-advised funds. Also eligible to
purchase Class A shares at net asset value are participants in certain
investment programs, including TMA(SM) Managed Trusts to which Merrill Lynch
Trust Company provides discretionary trustee services, collective investment
trusts for which Merrill Lynch Trust Company serves as trustee, certain
Merrill Lynch investment programs that offer pricing alternatives for
securities transactions and purchases made in connection with certain
fee-based programs. In addition, Class A shares will be offered at net asset
value to ML & Co. and its subsidiaries and their directors and employees and
to members of the Board of MLIM/FAM-advised funds, including the Fund. Certain
persons who acquired shares of certain MLIM/FAM-advised closed-end funds in
their initial offerings who wish to reinvest the net proceeds from a sale of
their closed-end fund shares of common stock in shares of the Fund also may
purchase Class A or Class D shares of a Portfolio if certain conditions set
forth below are met (for closed-end funds that commenced operations prior to
October 21, 1994). In addition, Class A shares of the Fund and certain other
MLIM/FAM-advised funds are offered at net asset value to shareholders of
Merrill Lynch Senior
28
Floating Rate Fund, Inc. and, if certain conditions are met to shareholders of
Merrill Lynch Municipal Strategy Fund, Inc. and Merrill Lynch High Income
Municipal Bond Fund, Inc. who wish to reinvest the net proceeds from a sale of
certain of their shares of common stock pursuant to a tender offer conducted
by such funds in shares of the Fund and certain other MLIM/FAM-advised funds.
As to purchase orders received by securities dealers prior to the close
of the New York Stock Exchange ("NYSE") (generally 4:00 p.m. Eastern time) on
the day the order is placed with the Distributor, including orders received
after the close on the previous day, the applicable offering price will be
based on the net asset value determined prior to the close of the NYSE on the
day the order is placed with the Distributor, provided the order is received
by the Distributor not later than 30 minutes after the close of business on
the NYSE (generally 4:00 p.m., Eastern time), on that day. If the purchase
orders are not received by the Distributor as of 30 minutes after the close of
business on the NYSE such orders will be deemed received on the next business
day. Any order may be rejected by the Distributor or the Fund. Neither the
Distributor nor securities dealers are permitted to withhold placing orders to
benefit themselves by a price change. The Fund reserves the right to suspend
the sale of its shares to the public in response to conditions in the
securities markets, or otherwise.
Reduced Initial Sales Charges. Reductions in or exemptions from the
imposition of a sales load are due to the nature of the investors and/or the
reduced sales effort that will be needed to obtain such investments. No
initial sales charges are imposed upon Class A and Class D shares issued as a
result of the automatic reinvestment of dividends. Class A and Class D sales
charges also may be reduced under a Right of Accumulation and a Letter of
Intention. Class A shares are offered at net asset value to certain eligible
Class A investors as set forth above under "Eligible Class A Investors" on
page 28. See "Shareholder Services--Fee Based Programs" on page 46.
Provided applicable threshold requirements are met, either Class A and
Class D shares are offered at net asset value to Employee Access(SM) Accounts
available through authorized employers. Subject to certain conditions Class A
and Class D shares are offered at net asset value to shareholders of Municipal
Strategy Fund and High Income Fund and Class A shares are offered at net asset
value to shareholders of Senior Floating Rate Fund who wish to reinvest in
shares of the Fund the net proceeds from a sale of certain of their shares of
common stock, pursuant to tender offers conducted by those funds.
Class D shares are offered at net asset value, without sales charge, to
an investor who has a business relationship with a Merrill Lynch Financial
Consultant if certain conditions described below are met.
Class D shares may be offered at net asset value in connection with the
acquisition of assets of other investment companies. Class D shares are
offered with reduced sales charges and, in certain circumstances, at net asset
value, to participants in the Merrill Lynch Blueprint(SM) Program.
Reduced Initial Sales Charges--Class A and Class D Shares
A reduced sales charge is available for any purchase of Class A or Class
D shares of the High Income Portfolio or Core Bond Portfolio in excess of
$25,000 and Class A or Class D shares of the Intermediate Term Portfolio in
excess of $100,000. The term "purchase," as used in this Statement of
Additional Information in connection with an investment in Class A and Class D
shares of the Fund, refers to a single purchase by an individual, or to
concurrent purchases, which in the aggregate are at least equal to the
prescribed amounts, by an individual, his spouse and their children under the
age of 21 years purchasing shares for his or their own account and to single
purchases by a trustee or other fiduciary purchasing shares for a single trust
estate or single fiduciary account (including a pension, profit-sharing or
other employee benefit trust created pursuant to a plan qualified under
Section 401 of the Code) although more than one beneficiary is involved. The
term "purchase" also includes purchases by any "company," as that term is
defined in the Investment Company Act, but does not include purchases by any
such company that has not been in existence for at least six months or that
has no purpose other than the purchase of shares of the Fund or shares of
other registered investment companies at a discount; provided, however that it
shall not include purchases by any group of individuals whose sole
organizational nexus is that the participants therein are credit cardholders
of a company, policyholders of an
29
insurance company, customers of either a bank or broker-dealer or clients of
an investment adviser. The term "purchase" also includes purchases by employee
benefit plans not qualified under Section 401 of the Code, including purchases
by employees or by employers on behalf of employees, by means of a payroll
deduction plan or otherwise, of shares of the Fund. Purchases by such a
company or non-qualified employee benefit plan will qualify for the quantity
discounts discussed above only if the Fund and the Distributor are able to
realize economies of scale in sales effort and sales related expense by means
of the company, employer or plan making the Fund's Prospectus available to
individual investors or employees and forwarding investments by such persons
to the Fund and by any such employer or plan bearing the expense of any
payroll deduction plan.
The Distributor may reallow as a discount all or a part of the sales
charge to securities dealers with whom it has agreements and will retain any
portion of the sales charge not reallowed. If 90% or more of the sales charge
is reallowed to a dealer, such dealer may be deemed to be an underwriter
within the meaning of the Securities Act and subject to liability as such. The
Distributor will retain the entire sales charge on orders placed directly with
it.
Right of Accumulation. Reduced sales charges are applicable through a
right of accumulation under which eligible investors are permitted to purchase
Class A or Class D shares of any of the three Portfolios subject to initial
sales charge at the offering price applicable to the total of (a) the public
offering price of the shares then being purchased plus (b) an amount equal to
the then-current net asset value or cost, whichever is higher, of the
purchaser's combined holdings of all classes of shares of the Funds and of
other MLIM/FAM-Advised Funds. For any such right of accumulation to be made
available, the Distributor must be provided at the time of purchase, by the
purchaser or the purchaser's securities dealer or other financial
intermediary, with sufficient information to permit confirmation of
qualification, and acceptance of the purchase order is subject to such
confirmation. The right of accumulation may be amended or terminated at any
time. Shares held in the name of a nominee or custodian under pension,
profit-sharing or other employee benefit plans may not be combined with other
shares to qualify for the right of accumulation.
Letter of Intent. Reduced sales charges are applicable to purchases
through any dealer aggregating $25,000 or more of Class A or Class D shares of
the High Income Portfolio or the Core Bond Portfolio and $100,000 or more of
Class A shares of the Intermediate Term Portfolio or other MLIM/FAM-Advised
Funds made within a 13-month period starting with the first purchase pursuant
to a Letter of Intent in the form provided by the Distributor. The Letter of
Intent is available only to investors whose accounts are maintained at the
Fund's Transfer Agent. The Letter of Intent is not a binding obligation to
purchase any amount of Class A or Class D shares, but its execution will
result in the purchaser's paying a lower sales charge at the appropriate
quantity purchase level. A purchase not originally made pursuant to a Letter
of Intent may be included under a subsequent Letter executed within 90 days of
such purchase if the Distributor is informed in writing of this intent within
such 90-day period. The value of Class A and Class D shares of any of the
three Portfolios or other MLIM/FAM-Advised Funds presently held, at cost or
maximum offering price (whichever is higher), on the date of the first
purchase under the Letter of Intent, may be included as a credit toward the
completion of such Letter. The reduced sales charge applicable to the amount
covered by the Letter of Intent will be applied only to new purchases. If the
total amount of shares purchased does not equal the amount stated in the
Letter of Intent, the investor will be notified and must pay, within 20 days
of the expiration of such Letter, the difference between the sales charge on
Class A or Class D shares of the Portfolio purchased at the reduced rate and
the sales charge applicable to the shares actually purchased through the
Letter. Class A or Class D shares equal to five percent of the intended amount
will be held in escrow during the 13-month period (while remaining registered
in the name of the purchaser). The first purchase under the Letter of Intent
must be five percent of the dollar amount of such Letter. If, during the term
of such Letter, a purchase brings the total amount invested to an amount equal
to or in excess of the amount indicated in the Letter, the purchaser will be
entitled on that purchase and subsequent purchases to the reduced percentage
sales charge which would be applicable to a single purchase equal to the total
dollar value of the Class A or Class D shares of the Portfolio then being
purchased under such Letter, but there will be no retroactive reduction of the
sales charges on any previous purchase.
The value of any shares redeemed or otherwise disposed of by the
purchaser prior to termination or completion of the Letter of Intent will be
deducted from the total purchases made under such Letter. An exchange from a
MLIM-advised money market fund into any Portfolio that creates a sales charge
will count toward completing a new or existing Letter of Intent in any
Portfolio.
30
TMA(SM) Managed Trusts. Class A shares are offered to TMA(SM) Managed
Trusts to which Merrill Lynch Trust Company provides discretionary trustee
services at net asset value.
Merrill Lynch Blueprint(SM) Program. Class D shares of any of the three
Portfolios are offered to participants in the Merrill Lynch Blueprint(SM)
Program ("Blueprint"). Class B shares of all three Portfolios are offered to
certain participants in Blueprint. In addition, participants in Blueprint who
own Class A shares of the Fund may purchase additional Class A shares of the
Fund through Blueprint. Blueprint is directed to small investors, Group IRAs
and participants in certain affinity groups such as benefit plans, credit
unions and trade associations. Class B shares are offered through Blueprint
only to certain affinity groups. The contingent deferred sales charge is
waived for shareholders who are members of certain affinity groups at the time
orders to purchase Class B shares are placed through Blueprint. However,
services (including the exchange privilege) available to Class B shareholders
through Blueprint may differ from those available to other Class B investors.
Orders for purchases and redemptions of Class B shares may be grouped for
execution purposes which, in some circumstances, may involve the execution of
such orders two business days following the day such orders are placed. The
minimum initial purchase price is $100 with a $50 minimum for subsequent
purchases through Blueprint. Minimum investment amounts are waived in
connection with automatic investment plans for Blueprint participants.
Investors placing orders to purchase Class A or Class D shares of the
Portfolios through Blueprint will acquire such Class A or Class D shares at
net asset value plus a sales charge calculated in accordance with the
Blueprint sales charge schedule (i.e., up to $5,000 at 3.5% for the High
Income and Core Bond Portfolios and 0.80% for the Intermediate Term
Portfolios. Purchases greater than $5,000 will be at the standard sales charge
rate disclosed in the Prospectus). In addition, Class D shares of the
Portfolios are being offered at net asset value plus a sales charge of 0.50%
for participants in corporate or group IRA programs placing orders to purchase
their shares through Blueprint. However, services (including the exchange
privilege) available to Class A and Class D shareholders through Blueprint may
differ from those available to other investors in Class A or Class D shares.
Class A and Class D shares are offered at net asset value to participants in
the Merrill Lynch Blueprint(SM) Program through the Merrill Lynch Directed IRA
Rollover Program ("IRA Rollover Program") available from Merrill Lynch
Business Financial Services, a business unit of Merrill Lynch. The IRA
Rollover Program is available to custodian rollover assets from
employer-sponsored retirement and savings plans whose Trustee and/or Plan
Sponsor offers the Merrill Lynch Directed IRA Rollover Program Service
Agreement. Orders for purchases and redemptions of Class A or Class D shares
of the Fund may be grouped for execution purposes which, in some
circumstances, may involve the execution of such orders two business days
following the day such orders are placed. The minimum initial purchase price
is $100 with a $50 minimum for subsequent purchases through Blueprint. Minimum
initial or subsequent purchase requirements are waived in connection with
automatic investment plans for Blueprint participants. Additional information
concerning purchases through Blueprint, including any annual fees and
transaction charges, is available from Merrill Lynch, Pierce, Fenner & Smith
Incorporated, The Blueprint(SM) Program, P.O. Box 30441, New Brunswick, New
Jersey 08989-0441.
Purchase Privileges of Certain Persons. Directors of the Fund, directors
and trustees of other MLIM/FAM-advised funds, ML & Co. and its subsidiaries
(the term "subsidiaries," when used herein with respect to ML & Co., includes
the Investment Advisor, MLIM, FAM and certain other entities directly or
indirectly wholly owned and controlled by ML & Co.), and their directors or
employees, and any trust, pension, profit-sharing or other benefit plan for
such persons, may purchase Class A shares of the Fund at net asset value. The
Fund realizes economies of scale and reduction of sales-related expenses by
virtue of the familiarity of these persons with the Fund. Employees and
directors or trustees wishing to purchase shares of the Fund must satisfy the
Fund's suitability standards.
Class A shares of the Fund and other Select Pricing Funds are offered at
net asset value to shareholders of Senior Floating Rate Fund (formerly known
as the Merrill Lynch Prime Fund, Inc.) who wish to reinvest the net proceeds
from a sale of certain of their shares of common stock of Senior Floating Rate
Fund in shares of the Fund. In order to exercise this investment option,
Senior Floating Rate Fund shareholders must sell their Senior Floating Rate
Fund shares to the Senior Floating Rate Fund in connection with a tender offer
conducted by the Senior Floating Rate Fund and reinvest the proceeds
immediately in the Fund. This investment option is available only with respect
to the proceeds of Senior Floating Rate Fund shares as to which no Early
Withdrawal Charge (as defined in the Senior Floating Rate Fund prospectus) is
applicable. Purchase orders from Senior Floating Rate
31
Fund shareholders wishing to exercise this investment option will be accepted
only on the day that the related Senior Floating Rate Fund tender offer
terminates and will be effected at the net asset value of the Fund at such
day.
Employee Access(SM) Accounts. Provided applicable threshold requirements
are met, either Class A or Class D shares are offered at net asset value to
Employee Access(SM) Accounts available through authorized employers. The
initial minimum for such accounts is $500, except that the initial minimum for
shares purchased for such accounts pursuant to the Automatic Investment
Program is $50.
Closed-End Fund Investment Option. Class A shares of the Fund and other
MLIM-advised mutual funds ("Eligible Class A Shares") are offered at net asset
value to shareholders of certain closed-end funds advised by the Investment
Adviser or MLIM who purchased such closed-end fund shares prior to October 21,
1994 (the date the Merrill Lynch Select Pricing(SM) System commenced
operations) and wish to reinvest the net proceeds from a sale of their
closed-end fund shares of common stock in Eligible Class A Shares of the Fund.
Alternatively, closed-end fund shareholders who purchased such shares on or
after October 21, 1994 and wish to reinvest the net proceeds from a sale of
their closed-end fund shares are offered Class A shares (if eligible to buy
Class A shares) or Class D shares of the Fund and other MLIM-advised mutual
funds ("Eligible Class D Shares"). In order to exercise this investment
option, closed-end fund shareholders must (i) sell their closed-end fund
shares through Merrill Lynch and reinvest the proceeds immediately in the
Eligible Class A or Class D Shares of the Fund, (ii) either have acquired the
shares in the closed-end fund's initial public offering or through
reinvestment of dividends earned on shares purchased in such offering, (iii)
have maintained their closed-end fund shares continuously in a Merrill Lynch
account, and (iv) purchase a minimum of $250 worth of Fund shares. Similarly,
Class D shares of the Portfolio are offered at a net asset value to
shareholders of Merrill Lynch Municipal Strategy Fund, Inc. ("Municipal
Strategy Fund") and Merrill Lynch High Income Municipal Bond Fund, Inc. ("High
Income Fund") who wish to purchase shares of the Fund with the net proceeds
from a sale of certain of their shares of common stock of Municipal Strategy
Fund and High Income Fund pursuant to a tender offer by Municipal Strategy
Fund or High Income Fund. This investment option is available only with
respect to the proceeds of Municipal Strategy Fund shares as to which no CDSC
(as defined in the Municipal Strategy Fund prospectus) is applicable, or with
respect to the proceeds of High Income Fund shares as to which no Early
Withdrawal Charge (as defined in the High Income Fund prospectus) is
applicable.
Class D shares of the Fund are offered at the net asset value, without
sales charge, to an investor who has a business relationship with a Merrill
Lynch Financial Advisor and who has invested in a mutual fund for which
Merrill Lynch has not served as a selected dealer if the following conditions
are satisfied: First, the investor must advise Merrill Lynch that he or she
will purchase Class D shares of a Portfolio with proceeds from a redemption of
such shares of other mutual funds and that such shares have been outstanding
for a period of no less than six months. Second, such purchase of Class D
shares must be made within 60 days after the redemption and the proceeds from
the redemption must have been maintained in the interim in cash or a money
market fund.
Class D shares of the Portfolios are also offered at net asset value,
without sales charge, to an investor who has a business relationship with a
Merrill Lynch Financial Advisor and who has invested in a mutual fund
sponsored by a non-Merrill Lynch company for which Merrill Lynch has served as
a selected dealer and where Merrill Lynch has either received or given notice
that such arrangement will be terminated ("notice"), if the following
conditions are satisfied: First, the investor must purchase Class D shares of
the Portfolio with proceeds from a redemption of shares of such other mutual
fund and such fund was subject to a sales charge either at the time of
purchase or on a deferred basis. Second, such purchase of Class D shares must
be made within 90 days after such notice.
Class D shares of the Portfolios are offered at net asset value, without
sales charge, to an investor who has a business relationship with a Merrill
Lynch Financial Advisor who joined Merrill Lynch from another investment firm
within six months prior to the date of purchase by such investor, if the
following conditions are satisfied. First, the investor must advise Merrill
Lynch that it will purchase Class D shares with proceeds from a redemption of
shares of a mutual fund that was sponsored by the Financial Consultant's
previous firm and imposed a sales charge either at the time of purchase or on
a deferred basis. Second, the investor also must establish that such
32
redemption had been made within 60 days prior to the investment in a
Portfolio, and the proceeds from the redemption had been maintained in the
interim in cash or a money market fund.
Acquisition of Certain Investment Companies. Class D shares may be
offered at net asset value in connection with the acquisition of the assets of
or merger or consolidation with a personal holding company or a public or
private investment company.
Purchases Through Certain Financial Intermediaries. Reduced sales charges
may be applicable for purchases of Class A or Class D shares of the Fund
through certain financial advisers, selected securities dealers and other
financial intermediaries that meet and adhere to standards established by the
Manager from time to time.
Deferred Sales Charge Alternatives--Class B and Class C Shares
Investors choosing the deferred sales charge alternatives should consider
Class B shares if they intend to hold their shares for an extended period of
time and Class C shares if they are uncertain as to the length of time they
intend to hold their assets in Select Pricing Funds.
The public offering price of Class B and Class C shares for investors
choosing the deferred sales charge alternatives is the next determined net
asset value per share without the imposition of a sales charge at the time of
purchase. As discussed below, Class B shares of the High Income Portfolio and
Core Bond Portfolio are subject to a four-year CDSC and Class B shares of the
Intermediate Term Portfolio are subject to a one year CDSC, while Class C
shares are subject only to a one-year CDSC. On the other hand, approximately
ten years after Class B shares are issued, such Class B shares, together with
shares issued upon dividend reinvestment with respect to those shares, are
automatically converted into Class D shares of the same Portfolio and
thereafter will be subject to lower continuing fees. Class C shares of the
Intermediate Term Portfolio are available only through the Exchange Privilege.
See "Conversion of Class B Shares to Class D Shares" on page 33. Both Class B
and Class C shares of each Portfolio are subject to an account maintenance fee
of 0.25% of net assets. Class B and Class C shares of the High Income
Portfolio and Core Bond Portfolio are subject to distribution fees of 0.50%
and 0.55%, respectively, of net assets. Both Class B and Class C shares of the
Intermediate Term Portfolio are subject to distribution fees of 0.25% of net
assets. See "Distribution Plans" on page 34. The proceeds from the account
maintenance fees are used to compensate the Distributor and Merrill Lynch
(pursuant to a sub-agreement) for providing continuing account maintenance
activities.
Class B and Class C shares are sold without an initial sales charge so
that the Fund will receive the full amount of the investor's purchase payment.
Merrill Lynch compensates its Financial Consultants for selling Class B and
Class C shares at the time of purchase from its own funds. See "Distribution
Plans" on page 34.
Proceeds from the CDSC and the distribution fee are paid to the
Distributor and are used in whole or in part by the Distributor to defray the
expenses of dealers (including Merrill Lynch) related to providing
distribution-related services to the Fund in connection with the sale of the
Class B and Class C shares, such as the payment of compensation to Financial
Consultants for selling Class B and Class C shares, from its own funds. The
combination of the CDSC and the ongoing distribution fee facilitates the
ability of the Fund to sell the Class B and Class C shares without a sales
charge being deducted at the time of purchase. Approximately ten years after
issuance, Class B shares of a Portfolio will convert automatically into Class
D shares of that Portfolio, which are subject to an account maintenance fee
but no distribution fee; Class B shares of certain other MLIM/FAM-advised
funds into which exchanges may be made convert into Class D shares
automatically after approximately eight years. If Class B shares of the Fund
are exchanged for Class B shares of another MLIM-advised mutual fund, the
conversion period applicable to the Class B shares acquired in the exchange
will apply, and the holding period for the shares exchanged will be tacked
onto the holding period for the shares acquired.
Imposition of the CDSC and the distribution fee on Class B and Class C
shares is limited by the NASD asset-based sales charge rule. See "Limitations
on the Payment of Deferred Sales Charges" on page 37. The proceeds from the
ongoing account maintenance fee are used to compensate Merrill Lynch for
providing continuing account maintenance activities. Class B shareholders of
the Fund exercising the exchange privilege described under "Shareholder
Services--Exchange Privilege" on page 48 will continue to be subject to the
Fund's CDSC schedule
33
if such schedule is higher than the CDSC schedule relating to the Class B
shares acquired as a result of the exchange.
Contingent Deferred Sales Charges--Class B Shares. Class B shares that
are redeemed within four years of purchase for the High Income Portfolio and
Core Bond Portfolio, or within one year of purchase for the Intermediate Term
Portfolio, may be subject to a CDSC at the rates set forth below charged as a
percentage of the dollar amount subject thereto. The charge will be assessed
on an amount equal to the lesser of the proceeds of redemption or the cost of
the shares being redeemed. Accordingly, no CDSC will be imposed on increases
in net asset value above the initial purchase price. In addition, no CDSC will
be assessed on shares derived from reinvestment of dividends.
The following table sets forth the rates of the CDSC on Class B shares:
High Income Portfolio and Core Bond Portfolio:
CDSC as a Percentage
of Dollar Amount
Year Since Purchase Payment Made Subject to Charge*
-------------------------------- --------------------
0-1.......................................... 4.0%
1-2.......................................... 3.0%
2-3.......................................... 2.0%
3-4.......................................... 1.0%
4 and thereafter............................. 0.0%
For the fiscal year ended September 30, 1999, the Distributor received
$9,950,119 in CDSCs with respect to redemptions of Class B shares, amounting
to $8,576,134 and $1,373,985 in the High Income Portfolio and the Core Bond
Portfolio, respectively, all of which were paid to Merrill Lynch. For the
fiscal year ended September 30, 2000, the Distributor received $6,425,638 in
CDSCs with respect to redemptions of Class B shares, amounting to $5,187,490,
and $1,238,148 and in the High Income Portfolio and Core Bond Portfolio,
respectively, all of which were paid to Merrill Lynch. For the fiscal year
ended September 30, 2001, the Distributor received $1,982,450 in CDSC's with
respect to redemptions of Class B shares amounting to $1,423,913 and $558,537
in the High Income Portfolio and the Core Bond Portfolio, respectively, all of
which were paid to Merrill Lynch. Additional CDSC's payable to the Distributor
may have been waived or converted to a contingent obligation in connection
with a shareholder's participation in certain fee-based programs.
Intermediate Term Portfolio:
Contingent Deferred
Sales Charge as a
Percentage of
Dollar Amount
Year Since Purchase Payment Made Subject to Charge
--------------------------------- -----------------------
0-1........................................ 1.0%
Thereafter................................. 0.0%
For the fiscal year ended September 30, 1999, the Distributor received
$130,178 in CDSCs with respect to redemptions of Class B shares with respect
to the Intermediate Term Portfolio. For the fiscal year ended September 30,
2000, the Distributor received CDSCs of $91,717 for the Intermediate Term
Portfolio with respect to redemptions of Class B shares all of which were paid
to Merrill Lynch. For the fiscal year ended September 30, 2001, the
Distributor received $43,999 in CDSCs with respect to redemptions of Class B
shares in the Intermediate Term Portfolio all of which were paid to Merrill
Lynch. Additional CDSCs payable to the Distributor may have been waived or
converted to a contingent obligation in connection with a shareholder's
participation in certain fee-based programs.
In determining whether a CDSC is applicable to a redemption, the
calculation will be determined in the manner that results in the lowest
possible applicable rate being charged. Therefore, with respect to the High
Income Portfolio and Core Bond Portfolio, it will be assumed that the
redemption is first of shares held for over
34
four years or shares acquired pursuant to reinvestment of dividends or
distributions and then of shares held longest during the four-year period. It
will be assumed, with respect to the Intermediate Term Portfolio, that the
redemption is of shares held for over one year or shares acquired pursuant to
reinvestment of dividends or distributions and then of shares held longest
during the one-year period. The CDSC will not be applied to dollar amounts
representing an increase in the net asset value since the time of purchase. A
transfer of shares from a shareholder's account to another account will be
assumed to be made in the same order as a redemption.
To provide an example, assume an investor purchased 100 Class B shares of
the High Income Portfolio at $10 per share (at a cost of $1,000) and in the
third year after purchase, the net asset value per share is $12 and, during
such time, the investor has acquired 10 additional shares upon dividend
reinvestment. If at such time the investor makes his first redemption of 50
shares (proceeds of $600), 10 shares will not be subject to charge because of
dividend reinvestment. With respect to the remaining 40 shares, the CDSC is
applied only to the original cost of $10 per share and not to the increase in
net asset value of $2 per share. Therefore, $400 of the $600 redemption
proceeds will be charged a CDSC at a rate of 2.0% (the applicable rate in the
third year after purchase) for shares purchased on or after October 21, 1994.
The Class B CDSC is waived on redemptions of shares made in connection
with certain post-retirement withdrawals from an Individual Retirement Account
("IRA") or other retirement plan or following the death or disability (as
defined in the Code) of a shareholder. The Class B CDSC also is waived on
redemptions of shares in connection with certain group plans through the
Merrill Lynch Blueprint(SM) Program. See "Shareholder Services--Merrill Lynch
Blueprint(SM) Program." The contingent deferred sales charge is waived on
redemption of shares by certain eligible 401(a) and eligible 401(k) plans. The
CDSC may also be waived for any Class B shares which are purchased by an
eligible 401(k) or eligible 401(a) plan and are rolled over into a Merrill
Lynch or Merrill Lynch Trust Company custodied Individual Retirement Account
and held in such account at the time of redemption and for any Class B shares
that were acquired and held at the time of the redemption in an Employee
Access(SM) Account available through employers providing eligible 401(k) plans.
The Class B CDSC may also be waived for any Class B shares that are purchased
within qualifying Employee Access(SM) Accounts. Additional information
concerning the waiver of the Class B CDSC described below. The terms of the
CDSC may be modified for redemptions made in connection with certain fee-based
programs. See "Shareholder Services--Fee Based Programs."
Redemptions for which the waiver applies in the case of such withdrawals
are: (a) any partial or complete redemption in connection with a distribution
following retirement under a tax-deferred retirement plan or attaining age 59
1/2 in the case of an IRA or other retirement plan, or part of a series of
equal periodic payments (not less frequently than annually) made for the life
(or life expectancy) or any redemption resulting from the tax-free return of
an excess contribution to an IRA; or (b) any partial or complete redemption
following the death or disability (as defined in the Internal Revenue Code) of
a Class B shareholder (including one who owns the Class B shares as joint
tenant with his or her spouse), provided the redemption is requested within
one year of the death or initial determination of disability.
Contingent Deferred Sales Charges--Class C Shares. Class C shares which
are redeemed within one year of purchase may be subject to a 1.0% CDSC charged
as a percentage of the dollar amount subject thereto. The charge will be
assessed on an amount equal to the lesser of the proceeds of redemption or the
cost of the shares being redeemed. Accordingly, no Class C CDSC will be
imposed on increases in net asset value above the initial purchase price. In
addition, no Class C CDSC will be assessed on shares derived from reinvestment
of dividends. The Class C CDSC may be waived in connection with certain
fee-based programs. See "Shareholder Services--Fee-Based Programs" on page 46.
The following table sets forth the rates of the contingent deferred sales
charge on Class C shares of the High Income Portfolio, Core Bond Portfolio and
Intermediate Term Portfolio:
Contingent Deferred
Sales Charge as a
Percentage of
Dollar Amount
Year Since Purchase Payment Made Subject to Charge
-------------------------------- --------------------
0-1...................................... 1.0%
Thereafter............................... 0.0%
35
For the fiscal year ended September 30, 1999, the Distributor received
CDSCs of $83,009 for the High Income Portfolio, $61,415 for the Core Bond
Portfolio, and $3,536 for the Intermediate Term Portfolio with respect to
redemptions of Class C shares, all of which were paid to Merrill Lynch. For
the fiscal year ended September 30, 2000, the Distributor received CDSCs of
$14,085 for the High Income Portfolio, $27,697 for the Core Bond Portfolio and
$748 for the Intermediate Term Portfolio with respect to redemptions of Class
C shares, all of which were paid to Merrill Lynch. For the fiscal year ended
September 30, 2001, the Distributor received CDSCs of $39,649 for the High
Income Portfolio, $16,681 for the Core Bond Portfolio and $1,384 for the
Intermediate Term Portfolio with respect to redemptions of Class C shares, all
of which were paid to Merrill Lynch.
In determining whether a Class C CDSC is applicable to a redemption, the
calculation will be determined in the manner that results in the lowest
possible rate being charged. Therefore, it will be assumed that the redemption
is first of shares held for over one year or shares acquired pursuant to
reinvestment of dividends or distributions and then of shares held longest
during the one-year period. The charge will not be applied to dollar amounts
representing an increase in the net asset value since the time of purchase. A
transfer of shares from a shareholder's account to another account will be
assumed to be made in the same order as a redemption.
Conversion of Class B Shares to Class D Shares. After approximately ten
years (the "Conversion Period"), Class B shares will be converted
automatically into Class D shares of the relevant Portfolio. Class D shares
are subject to an ongoing account maintenance fee of 0.25% of average daily
net assets for the High Income Portfolio and Core Bond Portfolio and 0.10% of
net assets for the Intermediate Term Portfolio, but are not subject to the
distribution fee that is borne by Class B shares. Automatic conversion of
Class B shares into Class D shares will occur at least once each month (on the
"Conversion Date") on the basis of the relative net asset values of the shares
of the two classes on the Conversion Date, without the imposition of any sales
load, fee or other charge. Conversion of Class B shares to Class D shares will
not be deemed a purchase or sale of the shares for federal income tax
purposes.
In addition, shares purchased through reinvestment of dividends on Class
B shares also will convert automatically to Class D shares. The Conversion
Date for dividend reinvestment shares will be calculated taking into account
the length of time the shares underlying such dividend reinvestment shares
were outstanding. If at a Conversion Date the conversion of Class B shares to
Class D shares of a Portfolio in a single account will result in less than $50
worth of Class B shares being left in the account, all of the Class B shares
of that Portfolio held in the account on the Conversion Date will be converted
to Class D shares of the same Portfolio.
Class B shareholders holding share certificates must deliver such
certificates to the Transfer Agent at least one week prior to the Conversion
Date applicable to those shares. Shares evidenced by certificates that are not
received by the Transfer Agent at least one week prior to the Conversion Date
will be converted into Class D shares on the next scheduled Conversion Date
after such certificates are delivered.
In general, Class B shares of MLIM-advised equity mutual funds will
convert approximately eight years after initial purchase, and Class B shares
of MLIM-advised taxable and tax-exempt fixed-income mutual funds will convert
approximately ten years after initial purchase. If, during the Conversion
Period, a shareholder exchanges Class B shares with an eight-year Conversion
Period for Class B shares with a ten-year Conversion Period, or vice versa,
the Conversion Period applicable to the Class B shares acquired in the
exchange will apply, and the holding period for the shares exchanged will be
tacked onto the holding period for the shares acquired.
The Conversion Period is modified for shareholders who purchased Class B
shares through certain retirement plans which qualified for a waiver of the
CDSC normally imposed on purchases of Class B shares ("Class B Retirement
Plans"). When the first share of any MLIM-advised mutual fund purchased by a
Class B Retirement Plan has been held for ten years (i.e., ten years from the
date the relationship between MLIM-advised mutual funds and the Class B
Retirement Plan was established), all Class B shares of all MLIM-advised
mutual funds held in that Class B Retirement Plan will be converted into Class
D shares of the appropriate funds. Subsequent to such conversion, that Class B
Retirement Plan will be sold Class D shares of the appropriate funds at net
asset value per share.
36
In the event that all Class B shares of a Portfolio held in a single
account are converted to Class D shares on a Conversion Date, shares
representing reinvestment of declared but unpaid dividends on those Class B
shares also will be converted to Class D shares; otherwise, only Class B
shares purchased through reinvestment of dividends paid will convert to Class
D shares on the Conversion Date.
The Conversion Period may also be modified for retirement plan investors
who participate in certain fee-based programs. See "Shareholder
Services--Fee-Based Programs" on page 46.
Distribution Plans
The Fund has adopted separate distribution plans for Class B, Class C and
Class D shares pursuant to Rule 12b-1 under the Investment Company Act (each a
"Distribution Plan") with respect to the account maintenance and/or
distribution fees paid by the Fund to the Distributor with respect to such
classes. The Class B and Class C Distribution Plans provide for the payment of
account maintenance fees and distribution fees, and the Class D Distribution
Plan provides for the payment of account maintenance fees.
The Distribution Plans for Class B, Class C and Class D shares each
provide that the Fund pays the Distributor an account maintenance fee relating
to the shares of the relevant class of a Portfolio, accrued daily and paid
monthly, at the annual rate of 0.25% of average daily net assets of the
relevant class and Portfolio for Class B, Class C and Class D shares of the
High Income Portfolio and Core Bond Portfolio, and for Class B and Class C
shares of the Intermediate Term Portfolio, and 0.10% of average daily net
assets attributable to the relevant class and Portfolio for Class D shares of
the Intermediate Term Portfolio in order to compensate the Distributor,
Merrill Lynch, a selected securities dealer or other financial intermediary
(pursuant to a sub-agreement) in connection with account maintenance
activities.
Payments of the account maintenance fees and/or distribution fees are
subject to the provisions of Rule 12b-1 under the Investment Company Act.
Among other things, each Distribution Plan provides that the Distributor shall
provide and the directors shall review quarterly reports of the disbursement
of the account maintenance fees and/or distribution fees paid to the
Distributor. In their consideration of each Distribution Plan, the directors
must consider all factors they deem relevant, including information as to the
benefits of the Distribution Plan to the Fund and its related class of
shareholders of the relevant Portfolio. Each Distribution Plan further
provides that, so long as the Distribution Plan remains in effect, the
selection and nomination of directors who are not "interested persons" of the
Fund, as defined in the Investment Company Act (the "Independent Directors"),
shall be committed to the discretion of the Independent Directors then in
office. In approving each Distribution Plan in accordance with Rule 12b-1, the
Independent Directors concluded that there is reasonable likelihood that such
Distribution Plan will benefit the Fund and its related class of shareholders
of the relevant Portfolio. Each Distribution Plan can be terminated at any
time, without penalty, by the vote of a majority of the Independent Directors
or by the vote of the holders of a majority of the outstanding related class
of voting securities of any Portfolio. A Distribution Plan cannot be amended
to increase materially the amount to be spent by any Portfolio without the
approval of the related class of shareholders of that Portfolio, and all
material amendments are required to be approved by the vote of directors,
including a majority of the Independent Directors who have no direct or
indirect financial interest in such Distribution Plan, cast in person at a
meeting called for that purpose. Rule 12b-1 further requires that the Fund
preserve copies of each Distribution Plan and any report made pursuant to such
plan for a period of not less than six years from the date of such
Distribution Plan or such report, the first two years in an easily accessible
place.
The Distribution Plans for Class B and Class C shares each provide that
the Fund also pays the Distributor a distribution fee relating to the shares
of the relevant class, accrued daily and paid monthly, at the annual rate of
0.50% and 0.55%, respectively, of average daily net assets attributable to the
relevant class and Portfolio for Class B and Class C shares of the High Income
Portfolio and Core Bond Portfolio, and 0.25% of average daily net assets
attributable to the relevant class and Portfolio for Class B and Class C
shares of the Intermediate Term Portfolio, in order to compensate the
Distributor and Merrill Lynch (pursuant to a sub-agreement) for providing
shareholder and distribution services, and bearing certain
distribution-related expenses of the Fund, including payments to financial
advisors or other financial intermediaries for selling Class B and Class C
shares of the Portfolio. The Distribution Plans relating to Class B and Class
C shares are designed to permit an investor to
37
purchase Class B and Class C shares through selected securities dealers and
other financial intermediaries without the assessment of an initial sales
charge and at the same time permit the dealer to compensate its financial
advisors, selected securities dealers or other financial intermediaries in
connection with the sale of the Class B and Class C shares. In this regard,
the purpose and function of the ongoing distribution fees and the CDSC are the
same as those of the initial sales charge with respect to the Class A and
Class D shares of the Fund in that the CDSC and ongoing distribution fees
provide for the financing of the distribution of the Fund's Class B and Class
C shares.
Prior to July 6, 1993, the Fund paid the Distributor an ongoing
distribution fee, accrued daily and paid monthly, at the annual rate of 0.75%
(in the case of the High Income Portfolio and Core Bond Portfolio) and 0.50%
(in the case of the Intermediate Term Portfolio) of the average daily net
assets for the Class B shares of the respective Portfolios (the "Prior Plan")
to compensate the Distributor and Merrill Lynch for providing account
maintenance and distribution-related activities and services to Class B
shareholders. The fee rate payable and the services provided under the Prior
Plan are identical to the aggregate fee rate payable and the services provided
under the Distribution Plan, the difference being that the account maintenance
and distribution services have been unbundled.
For the fiscal year ended September 30, 2001, the High Income Portfolio,
Core Bond Portfolio and Intermediate Term Portfolio paid the Distributor
$12,902,416, $3,593,967 and $622,961, respectively, pursuant to the Class B
Distribution Plan (based on average daily net assets subject to such Class B
Distribution Plan of approximately $1.7 billion, $480.6 million and $124.9
million, respectively), all of which were paid to Merrill Lynch for providing
account maintenance and distribution-related activities and services in
connection with Class B shares. For the fiscal year ended September 30, 2001,
the High Income Portfolio, the Core Bond Portfolio and the Intermediate Term
Portfolio, paid the Distributor $1,594,639, $518,440 and $18,662,
respectively, pursuant to the Class C Distribution Plan (based on average
daily net assets subject to such Class C Distribution Plan of approximately
$199.9 million, $65.0 million and $3.7 million, respectively) all of which
were paid to Merrill Lynch for providing account maintenance and
distribution-related activities and services in connection with Class C
shares. For the fiscal year ended September 30, 2001, the High Income
Portfolio, the Core Bond Portfolio and the Intermediate Term Portfolio, paid
the Distributor $664,566, $420,769 and $128,938, respectively, pursuant to the
Class D Distribution Plan (based on average daily net assets subject to such
Class D Distribution Plan of approximately $266.6 million, $168.8 million and
$129.3 million, respectively), all of which were paid to Merrill Lynch for
providing account maintenance activities in connection with Class D shares.
The payments under the Distribution Plans, as was the case with the Prior
Plan, are based on a percentage of average daily net assets attributable to
the relevant shares regardless of the amount of expenses incurred and,
accordingly, distribution-related revenues from the Distribution Plans may be
more or less than distribution-related expenses. Information with respect to
the distribution-related revenues and expenses is presented to the Directors
for their consideration in connection with their deliberations as to the
continuance of the Class B and Class C Distribution Plans. This information is
presented annually as of December 31 of each year on a "fully allocated
accrual" basis and quarterly on a "direct expense and revenue/cash" basis. On
the fully allocated accrual basis, revenues consist of the account maintenance
fees, distribution fees, CDSCs and certain other related revenues, and
expenses consist of financial consultant compensation, branch office and
regional operation center selling and transaction processing expenses,
advertising, sales promotion and marketing expenses, corporate overhead and
interest expense. On the direct expense and revenue/cash basis, revenues
consist of the account maintenance fees, distribution fees and CDSCs and the
expenses consist of financial consultation compensation.
As of September 30, 2001, direct cash revenues received with respect to
the Class B shares of the High Income Portfolio for the period since October
21, 1988 (commencement of operations) exceeded direct cash expenses by
$156,131,039 (representing 11.23% of High Income Portfolio's Class B net
assets at that date). As of September 30, 2001, direct cash revenues received
with respect to the Class B shares of the Core Bond Portfolio for the period
since October 21, 1988 (commencement of operations) exceeded direct cash
expenses by $33,779,566 (representing 6.60% of Core Bond Portfolio's Class B
net assets at that date). As of September 30, 2001, direct cash revenues
received with respect to the Class B shares of the Intermediate Term Portfolio
for the period since November 13, 1992 (commencement of operations) exceeded
direct cash expenses by $5,289,277 (representing 4.09% of Intermediate Term
Portfolio's Class B net assets at that date).
38
As of September 30, 2001, direct cash revenues received with respect to
the Class C shares of the High Income Portfolio for the period since October
21, 1994 (commencement of operations) exceeded direct cash expenses by
$13,166,387 (representing 7.45% of High Income Portfolio's Class C net assets
at that date). As of September 30, 2001, direct cash revenues received with
respect to the Class C shares of the Core Bond Portfolio for the period since
October 21, 1994 (commencement of operations) exceeded direct cash expenses by
$2,217,920 (representing 2.89% of Core Bond Portfolio's Class C net assets at
that date). As of September 30, 2001, direct cash revenues received with
respect to the Class C shares of the Intermediate Term Portfolio for the
period since October 21, 1994 (commencement of operations) exceeded direct
cash expenses by $140,622 (representing 3.06% of Intermediate Term Portfolio's
Class C net assets at that date).
The Fund has no obligation with respect to distribution and/or account
maintenance-related expenses incurred by the Distributor and Merrill Lynch in
connection with the Class B, Class C and Class D shares, and there is no
assurance that the Board of Directors of the Fund will approve the continuance
of the Distribution Plans from year to year. However, the Distributor intends
to seek annual continuation of the Distribution Plans. In their review of the
Distribution Plans, the Directors will be asked to take into consideration
expenses incurred in connection with the account maintenance and/or
distribution of each class of shares separately. The initial sales charges,
the account maintenance fee, the distribution fee and/or the CDSCs received
with respect to one class will not be used to subsidize the sale of shares of
another class. Payments of the distribution fee on Class B shares will
terminate upon conversion of those Class B shares into Class D shares as set
forth under "Deferred Sales Charge Alternatives--Class B and Class C
Shares--Conversion of Class B Shares to Class D Shares" on page 33.
The Fund has entered into separate distribution agreements (the
"Distribution Agreements") with the Distributor in connection with the
continuous offering of each class of shares of the three Portfolios. The
Distribution Agreements obligate the Distributor to pay certain expenses in
connection with the offering of each class of shares of the Fund. After the
prospectuses, statements of additional information and periodic reports have
been prepared, set in type and mailed to shareholders, the Distributor pays
for the printing and distribution of copies thereof used in connection with
the offering to dealers and investors. The Distributor also pays for other
supplementary sales literature and advertising costs. The Distribution
Agreements are subject to the same renewal requirements and termination
provisions as the Investment Advisory Agreement described above.
Employer-Sponsored Retirement or Savings Plans and Certain Other Arrangements
Certain employer-sponsored retirement or savings plans and certain other
arrangements may purchase Class A or Class D shares at net asset value, based
on the number of employees or number of employees eligible to participate in
the plan, the aggregate amount invested by the plan in specified investments
and/or the services provided by Merrill Lynch to the plan. Certain other plans
may purchase Class B shares with a waiver of the CDSC upon redemption, based
on similar criteria. Such Class B shares will convert into Class D shares
approximately ten years after the plan purchases the first share of any
MLIM-advised mutual fund. Minimum purchase requirements may be waived or
varied for such plans. Additional information regarding purchases by
employer-sponsored retirement or savings plans and certain other arrangements
is available toll-free from Merrill Lynch Business Financial Services at (800)
237-7777.
Limitations on the Payment of Deferred Sales Charges
The maximum sales charge rule in the NASD Conduct Rules of the National
Association of Securities Dealers, Inc. ("NASD") imposes a limitation on
certain asset-based sales charges, such as the distribution fee and the CDSC
borne by the Class B and Class C shares but not the account maintenance fees.
The maximum sales charge rule is applied separately by each class of a
Portfolio. As applicable to the Fund, the maximum sales charge rule limits the
aggregate of distribution fee payments and CDSCs payable by a Portfolio to the
sum of (1) 6.25% of eligible gross sales of Class B shares and Class C shares
of that Portfolio, computed separately (defined to exclude shares issued
pursuant to dividend reinvestment and exchanges) and (2) interest on the
unpaid balance for the respective class and portfolio computed separately at
the prime rate plus 1% (the unpaid balance being the maximum amount payable
minus amounts received from the payment of the distribution fee and the CDSC).
In connection with the Class B shares, the Distributor has voluntarily agreed
to waive interest charges on the unpaid
39
balance in excess of 0.50% of eligible gross sales. Consequently, the maximum
amount payable to the Distributor (referred to as the "voluntary maximum") in
connection with Class B shares in each Portfolio is 6.75% of eligible gross
sales. The Distributor retains the right to stop waiving the interest charge
at any time. To the extent payments would exceed the voluntary maximum, the
Fund will not make further payments of the distribution fee with respect to
Class B shares, and any CDSCs will be paid to the Fund rather than to the
Distributor; however, the Fund will continue to make payments of the account
maintenance fees. In certain circumstances the amount payable pursuant to the
voluntary maximum may exceed the amount payable under the NASD formula. In
such circumstances, payment in excess of the amount payable under the NASD
formula will not be made.
The following tables set forth comparative information as of September
30, 2001 with respect to the Class B and Class C shares of each Portfolio
indicating the maximum allowable payments that can be made under the NASD
maximum sales charge rule and the Distributor's voluntary maximum for the
period October 21, 1988 (commencement of Class B operations) to September 30,
2001 for the High Income Portfolio and Core Bond Portfolio, for the period
November 13, 1992 (commencement of Class B operations) to September 30, 2001
for the Intermediate Term Portfolio, and for the period October 21, 1994
(commencement of operations) to September 30, 2001 for Class C shares of each
Portfolio.
Data Calculated as of September 30, 2001
-------------------------------------------------------------------------------------------------
High Income Portfolio
-------------------------------------------------------------------------------------------------
(in thousands)
Annual
Distribution
Allowable Allowable Amounts Fee at
Eligible Aggregate Interest Maximum Previously Aggregate Current
Gross Sales on Unpaid Amount Paid to Unpaid Net Asse
Sales Charges Balance(2) Payable Distributor(3) Balance Level(4)
------------ ---------- ----------- -------- -------------- --------- ----------
Class B
Under NASD Rule as Adopted $6,510,768 $403,506 $215,548 $619,054 $197,948 $421,106 $6,950
Under Distributor's Voluntary
Waiver $6,510,768 $403,506 $ 35,970 $439,476 $197,948 $241,528 $6,950
Class C
Under NASD Rule as Adopted $ 940,291 $ 58,441 $ 27,071 $ 85,512 $ 14,313 $ 71,199 $ 972
Core Bond Portfolio
-------------------------------------------------------------------------------------------------
(in thousands)
Annual
Distribution
Allowable Allowable Amounts Fee at
Eligible Aggregate Interest Maximum Previously Aggregate Current
Gross Sales on Unpaid Amount Paid to Unpaid Net Asse
Sales Charges Balance(2) Payable Distributor(3) Balance Level(4)
------------ ---------- ----------- -------- -------------- --------- ----------
Class B
Under NASD Rule as Adopted $1,403,031 $ 87,114 $ 44,043 $131,157 $ 42,195 $ 88,962 $2,560
Under Distributor's Voluntary
Waiver $1,403,031 $ 87,114 $ 7,590 $ 94,704 $ 42,195 $ 52,509 $2,560
Class C
Under NASD Rule as Adopted $ 174,834 $ 10,889 $ 3,981 $ 14,870 $ 2,438 $ 12,432 $ 422
Intermediate Term Portfolio
-------------------------------------------------------------------------------------------------
(in thousands)
Annual
Distribution
Allowable Allowable Amounts Fee at
Eligible Aggregate Interest Maximum Previously Aggregate Current
Gross Sales on Unpaid Amount Paid to Unpaid Net Asse
Sales Charges Balance(2) Payable Distributor(3) Balance Level(4)
------------ ---------- ----------- -------- -------------- --------- ----------
Class B
Under NASD Rule as Adopted $ 308,578 $ 19,138 $ 9,159 $ 28,297 $ 5,127 $ 23,170 $ 323
Under Distributor's Voluntary
Waiver $ 308,578 $ 19,138 $ 1,691 $ 20,829 $ 5,127 $ 15,702 $ 323
Class C
Under NASD Rule as Adopted $ 5,574 $ 340 $ 193 $ 533 $ 95 $ 438 $ 11
40
- ---------------
(1) Purchase price of all eligible Class B shares sold since October 21, 1988
(commencement of Class B operations) other than shares acquired through
dividend reinvestment and the exchange privilege.
(2) Interest is computed on a monthly average Prime Rate basis based upon the
prime rate, as reported in The Wall Street Journal, plus 1.0%, as
permitted under the NASD Rule.
(3) Consists of CDSC payments, distribution fee payment and accruals. Of
these distribution fee payments made on Class B shares prior to July 3,
1993 under the Prior Plan at the 0.75% rate, 0.50% of average daily net
assets has been treated as a distribution fee and 0.25% of average daily
net assets has been deemed to have been a service fee and not subject to
the NASD maximum sales charge rule. See "Key Facts--Fees and Expenses" in
the Prospectus. This figure may include CDSCs that were deferred when a
shareholder redeemed shares prior to the expiration of the applicable
CDSC period and invested the proceeds, without the imposition of a sales
charge, in Class A shares in conjunction with the shareholder's
participation in the Merrill Lynch Mutual Funds Advisor ("MFA") program.
The CDSC is booked as a contingent obligation that may be payable if the
shareholder terminates participation in the MFA program.
(4) Provided to illustrate the extent to which the current level of
distribution fee payments (not including any CDSC payments) is amortizing
the unpaid balance. No assurance can be given that payments of the
distribution fee will reach either the voluntary maximum or the NASD
maximum.
(5) Purchase price of all eligible Class B shares sold since November 13,
1992 (commencement of Class B operations) other than shares acquired
through dividend reinvestment and the exchange privilege.
(6) Consists of CDSC payments, distribution fee payments and accruals. Of
these distribution fee payments made prior to July 6, 1993 on Class B
shares under the Prior Plan at the 0.50% rate, 0.25% of average daily net
assets has been treated as a distribution fee and 0.25% of average daily
net assets has been deemed to have been a service fee and not subject to
the NASD maximum sales charge rule.
REDEMPTION OF SHARES
Reference is made to "Your Account--How to Buy, Sell, Transfer and
Exchange Shares" in the Prospectus.
The Fund is required to redeem for cash all shares of each Portfolio upon
receipt of a written request in proper form. The redemption price is the net
asset value per share next determined after the initial receipt of proper
notice of redemption in the case of Class A or Class D shares of the
Portfolios, and is the net asset value per share next determined after the
initial receipt of proper notice of redemption, less the applicable CDSC, if
any, in the case of Class B or Class C shares of the Portfolios. Except for
any contingent deferred sales load which may be applicable to Class B or Class
C shares of the Portfolios, there will be no charge for redemption if the
redemption request is sent directly to the Transfer Agent. Shareholders
liquidating their total holdings also will receive upon redemption all
dividends declared through the date of redemption. If a shareholder redeems
all of the shares in his account, he will receive, in addition to the net
asset value of the shares redeemed, a separate check representing all
dividends declared but unpaid. If a shareholder redeems a portion of the
shares in his account, the dividends declared but unpaid on the shares
redeemed will be distributed on the next dividend payment date.
The value of shares at the time of redemption may be more or less than
the shareholder's cost, depending on the market value of the securities held
by each Portfolio at such time.
The Fund has entered into a joint committed line of credit with other
investment companies advised by the Investment Adviser and its affiliates and
a syndicate of banks that is intended to provide the Fund with a temporary
source of cash to be used to meet redemption requests from Fund shareholders
in extraordinary or emergency circumstances.
Redemption
A shareholder wishing to redeem shares held with the Transfer Agent may
do so by tendering the shares directly to the Transfer Agent, Financial Data
Services, Inc., P.O. Box 45289, Jacksonville, Florida 32232-5289. Redemption
requests delivered other than by mail should be delivered to Financial Data
Services, Inc., 4800 Deer Lake Drive East, Jacksonville, Florida 32246-6484.
Proper notice of redemption in the case of shares deposited with the Transfer
Agent may be accomplished by a written letter requesting redemption. Proper
notice of redemption in the case of shares for which certificates have been
issued may be accomplished by a written letter as noted above accompanied by
certificates for the shares to be redeemed. The notice in either event
requires the signature(s) of all persons in whose name(s) the shares are
registered, signed exactly as their name(s) appears on the Transfer Agent's
register. The signature(s) on the redemption request must be guaranteed by an
"eligible guarantor institution" as such is defined in Rule 17Ad-15 under the
Securities Exchange Act of 1934 (the "Exchange Act"), the existence and
validity of which may be verified by the Transfer Agent through the use of
41
industry publications. In the event a signature guarantee is required,
notarized signatures are not sufficient. In general, signature guarantees are
waived on redemptions of less than $50,000 as long as the following
requirements are met: (i) all requests require the signature(s) of all persons
in whose name(s) shares are recorded on the Transfer Agent's register; (ii)
all checks must be mailed to the address of record on the Transfer Agent's
register; and (iii) the address must not have changed within 30 days. Certain
rules may apply regarding certain account types such as but not limited to
UGMA/UTMA accounts, Joint Tenancies With Rights of Survivorship, contrabroker
transactions, and institutional accounts. In certain instances, the Transfer
Agent may require additional documents such as, but not limited to, trust
instruments, death certificates, appointments as executor or administrator, or
certificates of corporate authority. For shareholders redeeming directly with
the Transfer Agent, payment will be mailed within seven days after receipt of
a proper notice of redemption.
At various times the Fund may be requested to redeem shares of a
Portfolio for which it has not yet received good payment. The Fund may delay
or cause to be delayed the mailing of a redemption check until such time, not
exceeding ten days, as it has assured itself that good payment (e.g., cash,
Federal funds or certified check drawn on a U.S. bank) has been collected for
the purchase of such shares will usually not exceed 10 days.
The right to redeem shares or to receive payment with respect to any
redemption may only be suspended for any period during which trading on the
New York Stock Exchange (the "NYSE") is restricted as determined by the
Commission or such Exchange is closed (other than customary weekend and
holiday closings), for any period during which an emergency exists as defined
by the Commission as a result of which disposal of portfolio securities or
determination of the net asset value of any Portfolio is not reasonably
practicable, and for such other periods as the Commission may by order permit
for the protection of shareholders of each Portfolio.
A shareholder may also redeem shares held with the Transfer Agent by
telephone request. To request a redemption from your account, call the
Transfer Agent at 1-800-MER-FUND. The request must be made by the shareholder
of record and be for an amount less than $50,000. Before telephone requests
will be honored, signature approval from all shareholders of record on the
account must be obtained. The shares being redeemed must have been held for at
least 15 days. Telephone redemption requests will not be honored in the
following situations: the accountholder is deceased, the proceeds are to be
sent to someone other than the shareholder of record, funds are to be wired to
the client's bank account, a systematic withdrawal plan is in effect, the
request is by an individual other than the accountholder of record, the
account is held by joint tenants who are divorced, the address on the account
has changed within the last 30 days or share certificates have been issued on
the account.
Since this account feature involves a risk of loss from unauthorized or
fraudulent transactions, the Transfer Agent will take certain precautions to
protect your account from fraud. Telephone redemption may be refused if the
caller is unable to provide: the account number, the name and address
registered on the account and the social security number registered on the
account. The Fund or the Transfer Agent may temporarily suspend telephone
transactions at any time.
Repurchase
The Fund will also repurchase shares of each Portfolio through a selected
securities dealer or other financial intermediary. The Fund will normally
accept orders to repurchase shares by wire or telephone from dealers for their
customers at the net asset value next computed after receipt of the order by
the selected securities dealer or other financial intermediary, provided that
the request for repurchase is received by the selected securities dealer or
other financial intermediary prior to the close of business on the New York
Stock Exchange (generally 4:00 p.m. Eastern time) on the day received and is
received by the Fund from the selected securities dealer or other financial
intermediary not later than 30 minutes after the close of business on the NYSE
on the same day. Dealers have the responsibility of submitting such repurchase
requests to the Fund not later than 30 minutes after the close of business on
the NYSE in order to obtain that day's closing price. These repurchase
arrangements are for the convenience of shareholders and do not involve a
charge by the Fund (other than any applicable CDSC). Securities dealers that
do not have selected dealer agreements with the Distributor may impose a
charge on the shareholder for transmitting the notice of repurchase to the
Fund. Merrill Lynch, selected securities dealers or other financial
intermediaries may charge customers a processing fee (Merrill Lynch currently
charges $5.35) to confirm a repurchase of shares. Redemptions made directly
through the Fund's Transfer Agent are not subject to the
42
processing fee. The Fund reserves the right to reject any order for
repurchase. The exercise of this right of rejection might adversely affect
shareholders seeking redemption through the repurchase procedure.
For shareholders redeeming through their listed securities dealer,
payment for full and fractional shares will be made by the securities dealer
within seven days of the proper tender of the certificates, if any, and stock
power or letter requesting redemption, in each instance with signatures
guaranteed as noted above.
Reinstatement Privilege--Class A and Class D Shares
Shareholders who have redeemed Class A or Class D shares of any
Portfolio, including redemption through repurchase by the Fund, have a
privilege to reinstate their accounts by purchasing Class A or Class D shares,
as the case may be, of such Portfolio at the net asset value of such shares
without a sales charge up to the dollar amount redeemed. The reinstatement
privilege may be exercised as follows. A notice to exercise this privilege
along with a check for the amount to be reinstated must be received by the
Transfer Agent within 30 days after the date the request for redemption was
accepted by the Transfer Agent or the Distributor. The reinstatement will be
made at the net asset value per share next determined after the notice of
reinstatement is received and cannot exceed the amount of the redemption
proceeds. A redemption resulting in a gain is a taxable event whether or not
the reinstatement privilege is exercised. A redemption resulting in a loss
will not be a taxable event to the extent the reinstatement privilege is
exercised, and an adjustment will be made to the shareholder's tax basis in
shares acquired pursuant to the reinstatement to reflect the disallowed loss.
If a shareholder disposes of shares within 90 days of their acquisition
and subsequently reacquires shares of the Fund pursuant to the reinstatement
privilege, then the shareholder's tax basis in those shares disposed of will
be reduced to the extent the load charge paid to the Fund upon the
shareholder's initial purchase reduces any load charge such shareholder would
have been required to pay on the subsequent acquisition in absence of the
reinstatement privilege. Instead, such load charge will be treated as an
amount paid for the subsequently acquired shares and will be included in the
shareholder's tax basis for such shares.
PRICING OF SHARES
Determination of Net Asset Value
Reference is made to "Your Account--How Shares are Priced" in the
Prospectus.
The net asset value of the shares of all classes of each Portfolio is
determined once daily Monday through Friday as of the close of business on the
NYSE on each day the NYSE is open for trading based on prices at the time of
closing. The NYSE generally closes at 4:00 p.m., Eastern time. Any assets or
liabilities initially expressed in terms of non-U.S. dollar currencies are
translated into U.S. dollars at the prevailing market rates as quoted by one
or more banks or dealers on the day of valuation. The NYSE is not open for
business on the following holidays: New Year's Day, Martin Luther King, Jr.
Day, Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day,
Thanksgiving Day and Christmas Day. The net asset value per share of a
Portfolio is computed by dividing the sum of the value of the securities held
by such Portfolio plus any cash or other assets minus all liabilities by the
total number of shares of such Portfolio outstanding at such time, rounded to
the nearest cent. Expenses, including the investment advisory fee payable to
the Investment Adviser and any account maintenance and/or distribution fees
payable to the Distributor, are accrued daily. The Fund employs Merrill Lynch
Securities Pricing Service ("MLSPS"), an affiliate of the Investment Adviser,
to provide certain securities prices for the Fund. For the fiscal year ended
September 30, 2001, the Fund paid MLSPS $25,255 for securities price
quotations to compute the net asset value of the Portfolios.
The per share net asset value of Class A shares generally will be higher
than the per share net asset value of Class B, Class C and Class D shares of
that Portfolio, reflecting the daily expense accruals of the account
maintenance, distribution and higher transfer agency fees applicable with
respect to Class B and Class C shares and the daily expense accruals of the
account maintenance fees applicable with respect to Class D shares. Moreover,
the per share net asset value of Class D shares generally will be higher than
the per share net asset value of Class B and Class C shares, reflecting the
daily expense accruals of the distribution and higher transfer
43
agency fees applicable with respect to Class B and Class C shares. It is
expected, however, that the per share net asset value of the classes will tend
to converge (although not necessarily meet) immediately after the payment of
dividends which will differ by approximately the amount of the expense accrual
differentials between the classes.
Portfolio securities that are traded on stock exchanges are valued at the
last sale price as of the close of business on the day the securities are
being valued, or, lacking any sales, at the mean between closing bid and asked
prices. Securities traded in the over-the-counter ("OTC") market are valued at
the most recent bid prices (in the case of the Core Bond Portfolio and
Intermediate Term Portfolio) or at the mean of the most recent bid and ask
prices (in the case of the High Income Portfolio) as obtained from one or more
dealers that make markets in the securities. 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, and it is expected that for debt
securities this ordinarily will be the OTC market. Options on debt securities,
which are traded on exchanges, are valued at the last asked price for options
written and the last bid price for options purchased. Interest rate futures
contracts and options thereon, which are traded on exchanges, are valued at
their closing price at the close of such exchanges. 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 Board of Directors
of the Fund, including valuations furnished by a pricing service retained by
the Fund which may use a matrix system for valuations. These procedures of the
pricing service and its valuations are reviewed by the officers of the Fund
under the general supervision of the Directors.
Computation of Offering Price Per Share
The offering price for Class A, Class B, Class C and Class D shares of
the High Income Portfolio, Core Bond and Intermediate Term Portfolios, based
on the value of each Portfolio's net assets and number of shares outstanding
as of September 30, 2001, is calculated as set forth below.
High Income Portfolio:
Class A Class B Class C Class D
------------ -------------- ------------ ------------
Net Assets....................................... $438,383,229 $1,387,523,033 $177,235,945 $268,633,142
============ ============== ============ ============
Number of Shares Outstanding..................... 92,586,147 292,977,650 37,398,168 56,699,871
============ ============== ============ ============
Net Asset Value Per Share (net assets divided
by number of shares outstanding)............... $ 4.73 $ 4.74 $ 4.74 $ 4.74
Sales Charge* (for Class A and Class D shares:
4.00% of offering price (4.17% of net asset
value per share)).............................. .20 ** ** .20
------------ -------------- ------------ ------------
Offering Price................................... $ 4.93 $ 4.74 $ 4.74 $ 4.94
============ ============== ============ ============
- --------------
* Rounded to the nearest one-hundredth percent, assumes maximum sales charge
is applicable.
** Class B and Class C shares are not subject to an initial sales charge but
may be subject to a CDSC on redemption of shares. See "Purchase of
Shares--Deferred Sales Charge Alternatives--Class B and Class C Shares"
herein.
Core Bond Portfolio:
Class A Class B Class C Class D
------------ ------------ ----------- ------------
Net Assets....................................... $519,815,581 $511,165,747 $76,962,911 $201,269,134
============ ============ =========== ============
Number of Shares Outstanding..................... 46,381,399 45,608,926 6,864,636 17,946,678
============ ============ =========== ============
Net Asset Value Per Share (net assets divided by
number of shares outstanding).................. $ 11.21 $ 11.21 $ 11.21 $ 11.21
Sales Charge* (for Class A and Class D shares:
4.00% of offering price (4.17% of net asset
value per share))............................. .47 ** ** .47
------------ ------------ ---------- -------------
Offering Price................................... $ 11.68 $ 11.21 $ 11.21 $ 11.68
============ ============ =========== =============
44
- ---------
* Rounded to the nearest one-hundredth percent, assumes maximum sales
charge is applicable.
** Class B and Class C shares are not subject to an initial sales charge but
may be subject to a CDSC on redemption of shares. See "Purchase of
Shares--Deferred Sales Charge Alternatives--Class B and Class C Shares"
herein.
Intermediate Term Portfolio:
Class A Class B Class C Class D
------------ ------------ ---------- ------------
Net Assets....................................... $176,588,729 $129,161,800 $4,599,581 $130,116,525
============ ============ ========== ============
Number of Shares Outstanding..................... $ 15,399,133 $ 11,262,457 $ 401,050 $ 11,346,265
============ ============ ========== ============
Net Asset Value Per Share (net assets divided by
number of shares outstanding).................. $ 11.47 $ 11.47 $ 11.47 $ 11.47
Sales Charge* (for Class A and Class D shares:
1.00% of offering price (1.01% of net asset
value per share)).............................. $ .12 $ ** $ ** $ .12
------------ ------------ ---------- ------------
Offering Price................................... $ 11.59 $ 11.47 $ 11.47 $ 11.59
============ ============ =========== ============
- ---------
* Rounded to the nearest one-hundredth percent, assumes maximum sales
charge is applicable.
** Class B and Class C shares are not subject to an initial sales charge but
may be subject to a CDSC on redemption of shares. See "Purchase of
Shares--Deferred Sales Charge Alternatives--Class B and Class C Shares"
herein.
PORTFOLIO TRANSACTIONS AND BROKERAGE
Subject to policies established by the Board of Directors of the Fund,
the Investment Adviser is responsible for the portfolio decisions of each
Portfolio and the placing of its portfolio transactions. With respect to such
transactions, the Investment Adviser seeks to obtain the best net results for
the Portfolio, taking into account such factors as price (including the
applicable brokerage commission or dealer spread), size of order, difficulty
of execution and operational facilities of the firm involved and the firm's
risk in positioning a block of securities. While the Investment Adviser
generally seeks reasonably competitive commission rates, the Portfolio will
not necessarily be paying the lowest commission or spread available. No
Portfolio has any obligation to deal with any broker or group of brokers in
the execution of transactions in portfolio securities and does not use any
particular broker or dealer. In executing transactions with brokers and
dealers, the Investment Adviser seeks to obtain the best net results for the
Fund, taking into account such factors as price (including the applicable
brokerage commission or dealer spread), size of order, difficulty of execution
and operational facilities of the firm and the firm's risk in positioning a
block of securities. While the Investment Adviser generally seeks reasonably
competitive commission rates, the Fund does not necessarily pay the lowest
spread or commission available. In addition, consistent with the Conduct Rules
of the NASD and policies established by the Board of Directors of the Fund,
the Investment Adviser may consider sales of shares of the Fund as a factor in
the selection of brokers or dealers to execute portfolio transactions for the
Fund; however, whether or not a particular broker or dealer sells shares of
the Fund neither qualifies nor disqualifies such broker or dealer to execute
transactions for the Fund.
Under the Investment Company Act, persons affiliated with the Portfolios
are prohibited from dealing with the Portfolios as a principal in the purchase
and sale of securities unless such trading is permitted by an exemptive order
issued by the Commission. Since over-the-counter ("OTC") transactions are
usually principal transactions, affiliated persons of the Portfolios,
including Merrill Lynch, may not serve as dealer in connection with
transactions with the Portfolios. Affiliated persons of the Fund may serve as
broker for the Portfolios in over-the-counter transactions conducted on an
agency basis. Certain court decisions have raised questions as to the extent
to which investment companies should seek exemptions under the Investment
Company Act in order to seek to recapture underwriting and dealer spreads from
affiliated entities. The Board of Directors have considered all factors deemed
relevant, and have made a determination not to seek such recapture at this
time. The Board of Directors will reconsider this matter from time to time.
The Portfolios may not purchase securities, during the existence of any
underwriting syndicate of which Merrill Lynch is a member or in a private
placement in which Merrill Lynch serves as placement agent except pursuant to
procedures approved by the Board of Directors of the Fund which either comply
with rules adopted
45
by the Commission or with interpretations of the Commission Staff. Rule 10f-3
under the Investment Company Act sets forth conditions under which the
Portfolios may purchase corporate bonds or other securities from an
underwriting syndicate of which Merrill Lynch is a member. The rule sets forth
requirements relating to, among other things, the terms of an issue of
corporate bonds or other securities purchased by the Portfolios, the amount of
corporate bonds or other securities which may be purchased in any one issue
and the assets of the Portfolios which may be invested in a particular issue.
The securities in which each Portfolio invests are traded primarily in
the over-the-counter market. Where possible, each Portfolio will deal directly
with the dealers who make a market in the securities involved unless better
prices and execution are available elsewhere. Such dealers usually act as
principals for their own account. On occasion, securities may be purchased
directly from the issuer. Bonds and money market securities are generally
traded on a net basis and do not normally involve either brokerage commissions
or transfer taxes. The cost of portfolio securities transactions of each
Portfolio will consist primarily of dealer or underwriter spreads.
While the Investment Adviser seeks to obtain the best price and execution
in effecting transactions in the portfolio securities of each Portfolio,
brokers who provide supplemental investment research services to the
Investment Adviser may receive orders for transactions by a Portfolio. Such
supplemental research services ordinarily consist of assessments and analyses
of the business or prospects of a company, industry, or economic sector. If,
in the judgment of the Investment Adviser, a Portfolio will be benefited by
such supplemental research services, the Investment Adviser is authorized to
pay commissions to brokers furnishing such services which are in excess of
commissions which another broker may charge for the same transaction.
Information so received will be in addition to and not in lieu of the services
required to be performed by the Investment Adviser under its Investment
Advisory Agreement. The expenses of the Investment Adviser will not
necessarily be reduced as a result of the receipt of such supplemental
information. In some cases, the Investment Adviser may use such supplemental
research in providing investment advice to its other investment advisory
accounts.
The Fund anticipates that its brokerage transactions involving securities
of issuers domiciled in countries other than the United States generally will
be conducted primarily on the principal stock exchanges of such countries.
Brokerage commissions and other transaction costs on foreign stock exchange
transactions generally are higher than in the United States, although the Fund
will endeavor to achieve the best net results in effecting its portfolio
transactions. There generally is less government supervision and regulation of
foreign stock exchanges and brokers than in the United States. The Fund's
ability and decision to purchase and sell portfolio securities may be affected
by foreign laws and regulations relating to the convertability and
repatriation of assets.
For the fiscal year ended September 30, 1999, the Fund paid total
brokerage commissions of $26,766, of which $26,250 (98.1%) was paid to Merrill
Lynch. For the fiscal year ended September 30, 2000, the Fund paid total
brokerage commissions of $52,079, of which $17,909 (34.4%) was paid to Merrill
Lynch. For the fiscal year ended September 30, 2001, the Fund did not pay any
brokerage commissions to Merrill Lynch.
Portfolio Turnover
The rate of portfolio turnover is not a limiting factor when Fund
management deems it appropriate to purchase or sell securities held by the
Portfolios. The Fund expects that the annual turnover rate for each of the
Portfolios should not generally exceed 100%; however, during periods when
interest rates fluctuate significantly, as they have during the past few
years, the portfolio turnover rates for each of the Portfolios may be
substantially higher. In any particular year, however, market conditions could
result in portfolio activity of a Portfolio at a greater or lesser rate than
anticipated. High portfolio turnover involves correspondingly greater
transaction costs in the form of commissions and dealer spreads, which are
borne directly by the Fund. The calculation of the rate of portfolio turnover
does not include the purchase or sale of money market securities. High
portfolio turnover can be expected to result in the recognition of capital
gains and losses. To the extent the Fund distributes short-term capital gains,
such distributions will be taxable as dividends. The Fund's ability to enter
into certain short-term transactions will be limited by the requirement that
gains on certain securities held by the Fund for less than three months may
not exceed 30% of its annual gross income for federal income tax purposes.
The Fund intends to continue to comply with the various requirements of
the Internal Revenue Code so as to qualify as a "regulated investment company"
thereunder. See "Dividends, Distributions and Taxes" on page 49.
46
Among such requirements is a limitation to less than 30% on the amount of its
gross income which the Fund may derive from gain on the sale or other
disposition of securities held for less than three months. Accordingly, the
Fund's ability to effect certain portfolio transactions may be limited.
SHAREHOLDER SERVICES
The Fund offers a number of shareholder services described below which
are designed to facilitate investment in the shares of the Portfolios. Full
details as to each of such services and copies of the various plans described
below can be obtained from the Fund, the Distributor, Merrill Lynch, a
selected securities dealer or other financial intermediary. Certain of these
services are available only to U.S. investors and certain of these services
are not available to investors who place purchase orders for the Fund's shares
through the Merrill Lynch Blueprint(SM) Program.
Investment Account
Each shareholder whose account is maintained at the Transfer Agent has an
Investment Account and will receive statements at least quarterly, from the
Transfer Agent. These statements will serve as transaction confirmations for
automatic investment purchases and the reinvestment of income dividends. These
statements will also show any other activity in the account since the previous
statement. Shareholders will receive separate transaction confirmations for
each purchase or sale transaction other than automatic investment purchases
and the reinvestments of income dividends. A shareholder may make additions to
his Investment Account at any time by mailing a check directly to the Transfer
Agent. Upon the transfer of shares out of a Merrill Lynch brokerage account or
an account maintained with a securities dealer or other financial
intermediary, an Investment Account in the transferring shareholder's name
will be opened automatically, at the Transfer Agent.
Share certificates are issued only for full shares and only upon the
specific request of the shareholder. Issuance of certificates representing all
or only part of the full shares in an Investment Account may be requested by a
shareholder directly from the Transfer Agent.
Shareholders also may maintain their accounts through Merrill Lynch. Upon
the transfer of shares out of a Merrill Lynch brokerage account, an Investment
Account in the transferring shareholder's name will be opened automatically,
without charge, at the Transfer Agent. Shareholders considering transferring
their Class A shares from Merrill Lynch to another brokerage firm or financial
institution should be aware that, if the firm to which the Class A or Class D
shares are to be transferred will not take delivery of shares of the Fund, a
shareholder either must redeem the Class A or Class D shares (paying any
applicable CDSC) so that the cash proceeds can be transferred to the account
at the new firm or such shareholder must continue to maintain an Investment
Account at the transfer agent for those Class A or Class D shares.
Shareholders interested in transferring their Class B or Class C shares from
Merrill Lynch and who do not wish to have an Investment Account maintained for
such shares at the Transfer Agent may request their new brokerage firm to
maintain such shares in an account registered in the name of the brokerage
firm for the benefit of the shareholder at the transfer agent. If the new
brokerage firm is willing to accommodate the shareholder in this manner, the
shareholder must request that he or she be issued certificates for his shares,
and then must turn the certificates over to the new firm for re-registration
as described in the preceding sentence. Shareholders considering transferring
a tax-deferred retirement account such as an individual retirement account
from Merrill Lynch to another brokerage firm or financial institution should
be aware that, if the firm to which the retirement account is to be
transferred will not take delivery of shares of the Fund, a shareholder must
either redeem the shares (paying any applicable CDSC) so that the cash
proceeds can be transferred to the account at the new firm, or such
shareholder must continue to maintain a retirement account with Merrill Lynch
for those shares.
Automatic Investment Plans
A shareholder may make additions to an Investment Account at any time by
purchasing Class A shares (if he or she is an eligible Class A investor as
described in the Prospectus) or Class B, Class C or Class D shares at the
applicable public offering price either through the shareholder's securities
dealer or by mail directly to the Fund's
47
Transfer Agent, acting as agent for such securities dealer. Voluntary
accumulation also can be made through a service known as the Fund's Automatic
Investment Plan. Under the Automatic Investment Plan, the Fund is authorized
through pre-authorized checks or automated clearing house debits of $50 or
more to charge the regular bank account of the shareholder on a regular basis
to provide systematic additions to the Investment Account of such shareholder.
For investors who buy shares of the fund through Blueprint, no minimum charge
to the investors' bank accounts is required. An investor whose shares of the
Fund are held within a CMA(R) or CBA(R) Accounts may arrange to have periodic
investments made in the Fund in amounts of $100 or more ($1 for retirement
accounts) through the CMA(R) or CBA(R) Automatic Investment Program.
Fee-Based Programs
Certain fee-based programs offered by Merrill Lynch and other financial
intermediaries, including pricing alternatives for securities transactions
(each referred to in this paragraph as a "Program"), may permit the purchase
of Class A shares at net asset value. Under specified circumstances,
participants in certain Programs may deposit other classes of shares which
will be exchanged for Class A shares. Initial or deferred sales charges
otherwise due in connection with such exchanges may be waived or modified, as
may the Conversion Period applicable to the deposited shares. Termination of
participation in a Program may result in the redemption of shares held therein
or the automatic exchange thereof to another class at net asset value, which
may be shares of a money market fund. In addition, upon termination of
participation in a Program, shares that have been held for less than specified
periods within such Program may be subject to a fee based upon the current
value of such shares. These Programs also generally prohibit such shares from
being transferred to another account at Merrill Lynch, to another financial
intermediary to another broker-dealer or to the Transfer Agent. Except in
limited circumstances (which may also involve an exchange as described above),
such shares must be redeemed and another class of shares purchased (which may
involve the imposition of initial or deferred sales charges and distribution
and account maintenance fees) in order for the investment not to be subject to
Program fees. Additional information regarding a specific Program (including
charges and limitations on transferability applicable to shares that may be
held in such Program) is available in such Program's client agreement and from
the Transfer Agent at 1-800-MER-FUND or 1-800-637-3863.
Automatic Reinvestment of Dividends and Capital Gains Distributions
Unless specific instructions are given as to the method of payment of
dividends and capital gains distributions, dividends and distributions will be
reinvested automatically in additional shares of the Portfolio in which the
shareholder is invested. Such reinvestment will be at the net asset value of
shares of Portfolios, without a sales charge, determined as of the close of
business on the NYSE on the ex-dividend date of such dividend. Shareholders
may elect in writing to receive either their dividends or capital gains
distributions, or both, in cash, in which event payment will be mailed or
direct deposited on or about the payment date.
Shareholders may, at any time, notify Merrill Lynch in writing if the
shareholder's account is maintained with Merrill Lynch or notify the Transfer
Agent in writing or by telephone only if the shareholder account is maintained
at the Transfer Agent (1-800-MER-FUND) that they no longer wish to have their
dividends and/or distributions reinvested in shares of a Portfolio or vice
versa, and commencing ten days after receipt by the Transfer Agent of such
notice, those instructions will be effected, except that any dividend or
distribution of less than $10 payable to an account maintained directly with
the Fund's Transfer Agent will not be paid in cash but will be reinvested in
shares of the Fund. If the shareholder's account is maintained with the
Transfer Agent, he or she may contact the Transfer Agent in writing or by
telephone (1-800-MER-FUND). For other accounts, the shareholder should contact
his or her Merrill Lynch Financial Consultant, selected securities dealer or
other financial intermediary. The Fund is not responsible for any failure of
delivery to the shareholder's address of record and no interest will accrue on
amounts represented by uncashed distribution or redemption checks. Cash
payments can also be directly deposited to the shareholder's bank account. No
CDSC will be imposed on redemptions of shares issued as a result of the
automatic reinvestment of dividends or capital gains distributions.
Systematic Withdrawal Plan
A shareholder of any of the Portfolios may elect to make systematic
withdrawals from an Investment Account of Class A, Class B, Class C or Class D
shares in the form of payments by check or through automatic payment
48
by direct deposit to such shareholder's bank account on either a monthly or
quarterly basis as provided below. Quarterly withdrawals are available for
shareholders who have acquired shares of the Portfolios having a value, based
on cost or upon the current net asset value, of $5,000 or more, and monthly
withdrawals are available for shareholders with shares having a value of
$10,000 or more.
At the time of each withdrawal payment, sufficient shares are redeemed
from those on deposit in the shareholder's account to provide the withdrawal
payment specified by the shareholder. The shareholder may specify the dollar
amount and class of shares to be redeemed. Redemptions will be made at net
asset value as determined once daily by FAM immediately after the declaration
of dividends as of the close of business on the NYSE (generally 4:00 p.m.
Eastern time) on the 24th day of each month or the 24th day of the last month
of each quarter, whichever is applicable. If the NYSE is not open for business
on that day, the shares will be redeemed at the net asset value determined as
of the close of business on the following business day. The check for the
withdrawal payment will be mailed or the direct deposit for withdrawal payment
will be made on the next business day following redemption. When a shareholder
is making systematic withdrawals, dividends on all shares in the Investment
Account are reinvested automatically in shares of the applicable Portfolio. A
shareholder's systematic withdrawal plan may be terminated at any time,
without charge or penalty, by the shareholder, the Fund, the Transfer Agent or
the Distributor.
Withdrawal payments should not be considered as dividends, yields or
income. Each withdrawal is a taxable event. If periodic withdrawals
continuously exceed reinvested dividends, the shareholder's original
investment may be correspondingly reduced. Purchases of additional shares
concurrent with withdrawals are ordinarily disadvantageous to the shareholder
because of sales charges and tax liabilities. The Fund will not knowingly
accept purchase orders for shares of the Fund from investors who maintain a
systematic withdrawal plan unless such purchase is equal to at least one
year's scheduled withdrawals or $1,200, whichever is greater. Periodic
investments may not be made into an Investment Account from which the
shareholder has elected to make systematic withdrawals.
Alternatively, a shareholder whose shares are held within a CMA(R) or
CBA(R) may elect to have shares redeemed on a monthly, bimonthly, quarterly,
semiannual or annual basis through the CMA(R)/CBA(R) Systematic Redemption
Program. The minimum fixed dollar amount redeemable is $50. The proceeds of
systematic redemptions will be posted to the shareholder's account five
business days after the date the shares are redeemed. All redemptions are made
at net asset value. A shareholder may elect to have his or her shares redeemed
on the first, second, third or fourth Monday of each month, in the case of
monthly redemptions, or of every other month, in the case of bimonthly
redemptions. For quarterly, semiannual or annual redemptions, the shareholder
may select the month in which the shares are to be redeemed and may designate
whether the redemption is to be made on the first, second or fourth Monday of
the month. If the Monday selected is not a business day, the redemption will
be processed at net asset value on the next business day. The CMA(R) or CBA(R)
Systematic Redemption Program is not available if shares are being purchased
within the account pursuant to the Automatic Investment Program. For more
information on the CMA(R) or CBA(R) Systematic Redemption Program, eligible
shareholders should contact their Merrill Lynch Financial Advisor.
With respect to redemptions of Class B and Class C shares pursuant to a
systematic withdrawal plan, the maximum number of Class B or Class C shares
that can be redeemed from an account annually shall not exceed 10% of the
value of shares of such class in that account at the time the election to join
the systematic withdrawal plan was made. Clients affected by a conversion from
Class B shares to Class D shares, must re-elect the systematic withdrawal
plan. Any CDSC that otherwise might be due on such redemption of Class B or
Class C shares will be waived. Shares redeemed pursuant to a systematic
withdrawal plan will be redeemed in the same order as Class B or Class C
shares are otherwise redeemed.
Retirement and Education Savings Plans
Self-directed individual retirement accounts and other retirement and
education savings plans are available from Merrill Lynch. Under these plans,
investments may be made in the Fund and certain of the other mutual funds
sponsored by Merrill Lynch as well as in other securities. Merrill Lynch may
charge an initial establishment fee and an annual custodial fee for each
account. There may be fees associated with investing through these plans.
Information with respect to these plans is available upon request from Merrill
Lynch.
49
Dividends received in each of the plans referred to above are exempt from
Federal taxation until distributed from the plans and in the case of Roth IRA
plans and education savings plans may be exempt from taxation when distributed
as well. Investors considering participation in any retirement or education
savings plan should review specific tax laws relating thereto and should
consult their attorneys or tax advisers with respect to the establishment and
maintenance of any such plan.
Any retirement plan which does not meet the qualifications to purchase
Class A or Class D shares at net asset value may purchase Class B shares with
a waiver of the CDSC upon redemption if the following qualifications are met.
The CDSC is waived for any Eligible 401(k) Plan redeeming Class B shares and
is also waived for Class B redemptions from a 401(a) plan qualified under the
Code, provided that each such plan has the same or an affiliated sponsoring
employer as an Eligible 401(k) Plan purchasing Class B shares ("Eligible
401(a) Plan"). Other tax qualified retirement plans within the meaning of
Section 401(a) and 403(b) of the Code which are provided specialized services
(e.g., plans whose participants may direct on a daily basis their plan
allocations among a menu of investments) by independent administration firms
contracted through Merrill Lynch may also purchase Class B shares with a
waiver of the CDSC. The CDSC is also waived for any Class B shares which are
purchased by an Eligible 401(k) Plan or Eligible 401(a) Plan and are rolled
over into a Merrill Lynch or Merrill Lynch Trust Company custodied IRA and
held in such account at the time of redemption. The Class B CDSC is also
waived for shares purchased by a Merrill Lynch rollover IRA that was funded by
a rollover from a terminated 401(k) plan managed by the MLIM Private Portfolio
Group and held in such account at the time of redemption. The minimum initial
and subsequent purchase requirements are waived in connection with all the
above-referenced retirement plans.
Exchange Privilege
U.S. shareholders of each class of shares of a Portfolio of the Fund have
an exchange privilege with other Portfolios of the Fund and with certain other
MLIM/FAM-advised funds listed below. There is an exchange privilege available
with Summit, which is a Merrill Lynch sponsored money market fund specifically
designated as available for exchange by holders of Class A, Class B, Class C
and Class D shares of Select Pricing Funds. There is currently no limitation
on the number of times a shareholder may exercise the exchange privilege. The
exchange privilege may be modified or terminated in accordance with the rules
of the Commission.
Under the Merrill Lynch Select Pricing(SM) System, Class A shareholders
may exchange Class A shares of a Portfolio for Class A shares of another
Portfolio or a second MLIM/FAM-advised fund if the shareholder holds any Class
A shares of the other Portfolio or second fund in his account in which the
exchange is made at the time of the exchange or is otherwise eligible to
purchase Class A shares of the second fund. If the Class A shareholder wants
to exchange Class A shares for shares of the other Portfolio or a second
MLIM/FAM-advised fund, and the shareholder does not hold Class A shares of the
other Portfolio or second fund in his account at the time of the exchange and
is not otherwise eligible to acquire Class A shares of the other Portfolio or
second fund, the shareholder will receive Class D shares of the other
Portfolio or the second fund as a result of the exchange. Class D shares also
may be exchanged for Class A shares of another Portfolio or a second
MLIM/FAM-advised fund at any time as long as, at the time of the exchange, the
shareholder holds Class A shares of the second fund in the account in which
the exchange is made or is otherwise eligible to purchase Class A shares of
the other Portfolio or second fund. Class B, Class C and Class D of a
Portfolio shares will be exchangeable with shares of the same class of other
MLIM/FAM-advised funds. For purposes of computing the CDSC that may be payable
upon a disposition of the shares acquired in the exchange, the holding period
for the previously owned shares of the Portfolio is "tacked" to the holding
period of the newly acquired shares of the other Portfolio or other Fund as
more fully described below. Shares with a net asset value of at least $100 are
required to qualify for the exchange privilege, and any shares utilized in an
exchange must have been held by the shareholder for at least 15 days. It is
contemplated that the exchange privilege may be applicable to other new mutual
funds whose shares may be distributed by the Distributor.
Exchanges of Class A or Class D shares outstanding ("outstanding Class A
or Class D shares") for Class A or Class D shares of another MLIM/FAM-advised
fund ("new Class A or Class D shares") are transacted on the basis of relative
net asset value per Class A or Class D share, respectively, plus an amount
equal to the difference, if any, between the sales charge previously paid on
the outstanding Class A or Class D shares and the sales charge
50
payable at the time of the exchange on the new Class A or Class D shares. With
respect to outstanding Class A or Class D shares as to which previous
exchanges have taken place, the "sales charge previously paid" shall include
the aggregate of the sales charge paid with respect to such Class A or Class D
shares in the initial purchase and any subsequent exchange. Class A or Class D
shares issued pursuant to dividend reinvestment are sold on a no-load basis in
each of the funds offering Class A or Class D shares. For purposes of the
exchange privilege, Class A and Class D shares acquired through dividend
reinvestment shall be deemed to have been sold with a sales charge equal to
the sales charge previously paid on the Class A or Class D shares on which the
dividend was paid. In addition, each of the funds with Class B and Class C
shares outstanding ("outstanding Class B or Class C shares") offers to
exchange its Class B or Class C shares for Class B or Class C shares,
respectively, ("new Class B or Class C shares") of another MLIM/FAM-advised
fund on the basis of relative net asset value per Class B or Class C share,
without the payment of any CDSC that might otherwise be due on redemption of
the outstanding shares. Class B shareholders of the fund exercising the
exchange privilege will continue to be subject to the fund's CDSC schedule if
such schedule is higher than the CDSC relating to the new Class B shares
acquired through use of the exchange privilege. In addition, Class B shares of
the fund acquired through use of the exchange privilege will be subject to the
higher of the fund's CDSC schedule or the CDSC relating to the Class B shares
of the fund from which the exchange has been made. For purposes of computing
the sales load that may be payable on a disposition of the new Class B or
Class C shares, the holding period for the outstanding Class B or Class C
shares is "tacked" to the holding period of the new Class B or Class C shares.
For example, an investor may exchange Class B shares of the High Income
Portfolio of the Fund ("High Income Portfolio") for those of Merrill Lynch
Special Value Fund, Inc. ("Special Value Fund") after having held the High
Income Portfolio's Class B shares for two and a half years. The 2% sales load
that generally would apply to a redemption would not apply to the exchange.
Two years later the investor may decide to redeem the Class B shares of
Special Value Fund and receive cash. There will be no CDSC due on this
redemption, since by "tacking" the two and a half year holding period of High
Income Portfolio Class B shares to the two year holding period for the special
Value Fund Class B shares, the investor will be deemed to have held the new
Class B shares for more than four years.
Class A and Class D shares are exchangeable for Class A shares of Select
Pricing Funds and Summit, and Class B and Class C shares are exchangeable for
Class B shares of Summit. Class A shares of Summit have an exchange privilege
back into Class A or Class D shares of Select Pricing Funds; Class B shares of
Summit have an exchange privilege back into Class B or Class C shares of
Select Pricing Funds and, in the event of such an exchange, the period of time
that Class B shares of Summit are held will count toward satisfaction of the
holding period requirement for purposes of reducing any CDSC and toward
satisfaction of any Conversion Period with respect to Class B shares. Class B
shares of Summit will be subject to a distribution fee at an annual rate of
0.75% of average daily net assets of such Class B shares. This exchange
privilege does not apply with respect to certain Merrill Lynch fee-based
programs for which alternative exchange arrangements may exist. Please contact
your Merrill Lynch Financial Advisor for further information.
To exercise the exchange privilege, shareholders should contact their
Merrill Lynch Financial Advisor who will advise the Fund of the exchange.
Before effecting an exchange, shareholders should obtain a currently effective
prospectus of the fund into which the exchange is to be made. Shareholders of
the Fund, and shareholders of the other funds described above with shares for
which certificates have not been issued, may exercise the Exchange Privilege
by wire through their securities dealers or other financial intermediaries.
The Fund reserves the right to require a properly completed Exchange
Application. This exchange privilege may be modified or terminated in
accordance with the rules of the Commission.
Telephone exchange requests are also available in accounts held with the
Transfer Agent for amounts up to $50,000. To request an exchange from your
account, call the Transfer Agent at 1-800-MER-FUND. The request must be from
the shareholder of record. Before telephone requests will be honored,
signature approval from all shareholders of record must be obtained. The
shares being exchanged must have been held for at least 15 days. Telephone
requests for an exchange will not be honored in the following situations: the
account holder is deceased, the request is by an individual other than the
account holder of record, the account is held by joint tenants who are
divorced or the address on the account has changed within the last 30 days.
Telephone exchanges may be refused if the caller is unable to provide: the
account number, the name and address registered on the account and the social
security number registered on the account. The Fund or the Transfer Agent may
temporarily suspend telephone transactions at any time.
51
The Exchange Privilege may be modified or terminated at any time on 60
days' notice. The Fund reserves the right to limit the number of times an
investor may exercise the Exchange Privilege. The exchange privilege is
available only to U.S. shareholders in states where the exchange legally may
be made.
DIVIDENDS AND TAXES
Dividends
The Fund intends to distribute substantially all of the net investment
income of each Portfolio, monthly, if any. The net investment income of each
Portfolio is declared as dividends daily immediately prior to the
determination of the net asset value of each Portfolio on that day and is
reinvested monthly in additional full and fractional shares of each Portfolio
at net asset value unless the shareholder elects to receive such dividends in
cash. The net investment income of each Portfolio for dividend purposes
consists of interest and dividends earned on portfolio securities, less
expenses, in each case computed since the most recent determination of net
asset value. Expenses of each Portfolio, including the advisory fee and any
account maintenance and/or distribution fees (if applicable), are accrued
daily. Shares will accrue dividends as long as they are issued and
outstanding. From time to time, the Fund may declare a special dividend at or
about the end of the calendar year in order to comply with Federal tax
requirements that certain percentages of its ordinary income and capital gains
be distributed during the year. If in any fiscal year, the Fund has net income
from certain foreign currency transactions, such income will be distributed at
least annually.
See "Shareholder Services--Automatic Dividend Reinvestment Plan" for
information concerning the manner in which dividends may be reinvested
automatically in shares of the Fund. A shareholder whose account is maintained
at the Transfer Agent or whose account is maintained through Merrill Lynch may
elect in writing to receive any such dividends in cash. Dividends are taxable
to shareholders, as discussed below, whether they are reinvested in shares of
the Fund or received in cash. The per share dividends on Class B and Class C
shares will be lower than the per share dividends on Class A and Class D
shares as a result of the account maintenance, distribution and higher
transfer agency fees applicable with respect to the Class B and Class C
shares; similarly, the per share dividends on Class D shares will be lower
than the per share dividends on Class A shares as a result of the account
maintenance fees applicable with respect to the Class D shares. See "Pricing
of Shares--Determination of Net Asset Value."
Taxes
The Fund intends to continue to qualify for the special tax treatment
afforded regulated investment companies ("RICs") under the Internal Revenue
Code of 1986, as amended (the "Code"). As long as it so qualifies, the Fund
(but not its shareholders) will not be subject to Federal income tax on the
part of its net ordinary income and net realized capital gains which it
distributes to Class A, Class B, Class C and Class D shareholders (together,
the "shareholders"). The Fund intends to distribute substantially all of such
income. If in any taxable year a Portfolio does not qualify as a regulated
investment company, all of its taxable income will be taxed to the Portfolio
at corporate rates. Under the Code, each Portfolio of the Fund is treated as a
separate corporation for federal income tax purposes and, thus, each Portfolio
will be required to satisfy the qualification requirements under the Code for
regulated investment company treatment.
The Code requires a RIC to pay a non-deductible 4% excise tax to the
extent the RIC does not distribute during each calendar year, 98% of its
ordinary income, determined on a calendar year basis, and 98% of its capital
gains, determined, in general, on an October 31 year end, plus certain
undistributed amounts from previous years. While the Fund intends to
distribute its income and capital gains in the manner necessary to minimize
imposition of the 4% excise tax, there can be no assurance that sufficient
amounts of the Fund's taxable income and capital gains will be distributed to
avoid entirely the imposition of the tax. In such event, the Fund will be
liable for the tax only on the amount by which it does not meet the foregoing
distribution requirements.
The Fund contemplates declaring as dividends substantially all of its net
investment income. Dividends paid by the Fund from a Portfolio's investment
income and net realized short term capital gains are taxable to shareholders
as ordinary income. Dividends will be taxable to shareholders as ordinary
income or capital gains, whether received in cash or reinvested in additional
shares of the Fund. The Transfer Agent will send each
52
shareholder a monthly dividend statement which will include the amount of
dividends paid and identify whether such dividends represent ordinary income
or capital gains. Dividends paid by the Fund from its ordinary income or from
an excess of net short term capital gains over net long term capital losses
(together referred to hereafter as "ordinary income dividends") are taxable to
shareholders as ordinary income. Distributions made from an excess of net long
term capital gains over net short term capital losses ("capital gain
dividends") are taxable to shareholders as long term capital gains, regardless
of the length of time the shareholder has owned Fund shares. Any loss upon the
sale or exchange of Fund shares held for six months or less, however, will be
treated as long term capital loss to the extent of any capital gain dividends
received by the shareholder. Distributions in excess of the Fund's earnings
and profits will first reduce the adjusted tax basis of a holder's shares and,
after such adjusted tax basis is reduced to zero, will constitute capital
gains to such holder (assuming the shares are held as a capital asset).
Although the Fund may invest in certain municipal securities, it is not
anticipated that any portion of the dividends paid by the Fund will qualify
for tax-exempt treatment to shareholders.
Upon sales or exchange or shares of a Portfolio, a shareholder will
realize short- or long-term capital gain or loss, depending upon the
shareholder's holding period in the Portfolio shares. However, if a
shareholder's holding period in his shares is six months or less, any capital
loss realized from a sale or exchange of such shares must be treated as
long-term capital loss to the extent of capital gains dividends received with
respect to such shares. Currently, the maximum tax rates applicable to net
capital gains recognized by individuals and other non-corporate taxpayers are
(i) the same as ordinary income rates for capital assets held for one year or
less, and (ii) 20% for capital assets held for more than one year.
Shareholders should consult their tax advisers regarding the availability and
effect of a certain tax election to mark-to-market shares of a Portfolio held
on January 1, 2001. Capital gains or losses recognized by corporate
shareholders are subject to tax at the ordinary income tax rates applicable to
corporations. The new tax rates for capital gains described above apply to
distributions of capital gain dividends by regulated investment companies
("RICs") such as the Fund as well as to sales and exchanges of shares in RICs
such as the Fund.
A Portfolio may recognize interest attributable to it from holding zero
coupon securities. Current federal law requires that, for most zero coupon
securities, the Portfolio must accrue a portion of the discount at which the
security was purchased as income each year even though the Portfolio receives
no interest payment in cash on the security during the year. In addition, the
Fund may invest in pay-in-kind securities on which payments of interest
consist of securities rather than cash. As an investment company, each
Portfolio must pay out substantially all of its net investment income each
year. Accordingly, a Portfolio may be required to pay out as an income
distribution each year an amount which is greater than the total amount of
cash interest the Fund actually received. Such distributions will be made from
the cash assets of the Fund or by sales of portfolio securities, if necessary.
The Fund may realize a gain or loss from such sales.
Ordinary income dividends paid to shareholders who are nonresident aliens
or foreign entities will be subject to a 30% United States withholding tax
under existing provisions of the Code applicable to foreign individuals and
entities unless a reduced rate of withholding or a withholding exemption is
provided under applicable treaty law. Nonresident shareholders are urged to
consult their own tax advisors concerning the applicability of the United
States withholding tax.
Some shareholders may be subject to a 31% withholding tax on reportable
dividends, capital gains distributions and redemption payments ("backup
withholding"). Generally, shareholders subject to backup withholding will be
those for whom a certified taxpayer identification number is not on file with
the Fund or who, to the Fund's knowledge, have furnished an incorrect number.
When establishing an account, an investor must certify under penalties of
perjury that such number is correct and that he is not otherwise subject to
backup withholding.
Dividends and interest received by the Fund may give rise to withholding
and other taxes imposed by foreign countries. Tax conventions between certain
countries and the United States may reduce or eliminate such taxes. Dividends
to shareholders who are nonresident aliens, trusts, estates, partnerships or
corporations may be subject to a 30% United States withholding tax unless a
reduced rate of withholding is provided under an applicable treaty.
Shareholders who are nonresident aliens or foreign entities are urged to
consult their own tax advisers concerning the applicability of the United
States withholding tax.
53
No gain or loss will be recognized by Class B shareholders on the
conversion of their Class B shares into Class D shares. A shareholder's basis
in the Class D shares acquired will be the same as such shareholder's basis in
the Class B shares converted, and the holding period of the acquired Class D
shares will include the holding period of the converted Class B shares.
If a shareholder exercises an exchange privilege within 90 days of
acquiring the shares, then the loss the shareholder can recognize on the
exchange will be reduced (or the gain increased) to the extent any sales
charge paid to the Fund on the exchanged shares reduces any sales charge the
shareholder would have owed upon the purchase of the new shares in the absence
of the exchange privilege. Instead, such load charge will be treated as an
amount paid for the new shares.
Under another provision of the Code, any dividend declared by the Fund to
shareholders of record in October, November, or December of any year and made
payable to shareholders of record in such a month will be deemed to have been
received on December 31 of such year if actually paid during the following
January.
Ordinary income and capital gains dividends may also be subject to state
and local taxes.
A loss realized on a sale or exchange of shares of the Fund will be
disallowed if other Fund shares are acquired (whether through the automatic
reinvestment of dividends or otherwise) within a 61-day period beginning 30
days before and ending 30 days after the date that the shares are disposed of.
In such case, the basis of the shares acquired will be adjusted to reflect the
disallowed loss.
The Code imposes a 4% nondeductible excise tax on a regulated investment
company, such as the Fund, if it does not distribute to its shareholders
during the calendar year an amount equal to 98% of the Fund's investment
company income, with certain adjustments, for such calendar year, plus 98% of
the Fund's capital gain net income for the one-year period ending on October
31, of such calendar year. In addition, an amount equal to any undistributed
investment company taxable income or capital gain net income from the previous
calendar year must also be distributed to avoid the excise tax. While the Fund
intends to distribute its income and capital gains in the manner necessary to
avoid imposition of the 4% excise tax, there can be no assurance that
sufficient amounts of the Fund's taxable income and capital gains will be
distributed to avoid entirely the imposition of the tax. The excise tax is
imposed on the amount by which the regulated investment company does not meet
the foregoing distribution requirements.
Only dividends paid by the Fund which are attributable to dividends
received by the Fund will qualify for the 70% dividends-received deduction for
corporations. In addition, corporate shareholders must have held their shares
in the Fund for more than 45 days to qualify for the deduction on dividends
paid by the Fund. Because most of the income of each Portfolio will be
interest income, rather than dividends on common or preferred stock, it is
unlikely that any substantial proportion of its distributions will be eligible
for the dividends-received deduction available for corporations under the
Code.
At September 30, 2001, the Fund had a capital loss carryforward of
approximately $85,080,000 in the Core Bond Portfolio of which $21,203,000
expires in 2003, $2,604,000 expires in 2005, $305,000 expires in 2007,
$28,410,000 expires in 2008, and $32,558,000 expires in 2009 and approximately
$22,654,000 in the Intermediate Term Portfolio of which $6,608,000 expires in
2003, $276,000 expires in 2005 and $7,450,000 expires in 2008 and $8,320,000
expires in 2009, and approximately $523,135,000 in the High Income Portfolio
of which $74,969,000 expires in 2007, $60,400,000 expires in 2008 and
$387,766,000 expires in 2009. These amounts will be available to offset like
amounts of any future taxable gains.
Dividends to shareholders who are nonresident aliens, trusts, estates,
partnerships or corporations may be subject to a 30% U.S. withholding tax
unless a reduced rate of withholding is provided under an applicable tax
treaty. Shareholders who are nonresident aliens or foreign entities are urged
to consult their own tax advisers concerning the applicability of the U.S.
withholding tax.
The foregoing is a general and abbreviated summary of the applicable
provisions of the Code and Treasury Regulations presently in effect. For the
complete provisions, reference should be made to the pertinent sections of the
Code and the Treasury Regulations promulgated thereunder. The Code and
Regulations are subject to change
54
by legislative or administrative action. Investors are urged to consult their
attorneys or tax advisers regarding specific questions as to federal, foreign,
state or local taxes.
Tax Treatment of Options Transactions
Each Portfolio of the Fund may purchase and sell interest rate futures
contracts and may write and purchase call and put options on such futures
contracts and on certain debt securities. The Portfolios may write or purchase
options which will be classified as "nonequity options" under the Code.
Generally, gain and loss resulting from transactions in options on debt
securities, as well as gain and loss from transactions in futures contracts
and options thereon, will be treated as long term capital gain or loss to the
extent of 60 percent thereof and short term capital gain or loss to the extent
of 40 percent thereof (hereinafter "blended gain or loss"). In the case of the
exercise or assignment of an option on a debt security, the premium paid or
received by the Fund generally will adjust the gain or loss on disposition of
the underlying security.
Any option or futures contract held by a Portfolio on the last day of a
fiscal year will be treated as sold for market value on that date, and gain or
loss recognized as a result of such deemed sale will be blended gain or loss.
The capital gains and losses of each Portfolio will be combined in each fiscal
year to determine the capital gains and losses of the Fund, as described
above.
In addition, the Portfolio's trading strategies may constitute "straddle"
transactions with futures contracts, options thereon and options on debt
securities. "Straddles" may affect the taxation of futures contracts and
options, and may cause the postponement of recognition of losses incurred in
certain closing transactions.
The requirements for classification as a regulated investment company may
restrict the Fund's ability to engage in certain options and futures contract
transactions. The Fund has obtained a private letter ruling from the Internal
Revenue Service providing the Fund with relief from certain provisions of the
Code which might otherwise affect its ability to engage in such transactions.
PERFORMANCE DATA
From time to time the Fund may include a Portfolio's average annual total
return and other total return data, as well as yield, in advertisements or
information furnished to present or prospective shareholders. Total return and
yield figures are based on a Portfolio's historical performance and are not
intended to indicate future performance. Average annual total return and yield
are determined separately for Class A, Class B, Class C and Class D shares of
each Portfolio in accordance with formulas specified by the Commission and
take into account the maximum applicable sales charge.
Average annual total return quotations for the specified periods are
computed by finding the average annual compounded rates of return (based on
net investment income and any realized and unrealized capital gains or losses
on portfolio investments over such periods) that would equate the initial
amount invested to the redeemable value of such investment at the end of each
period. Average annual total return is computed assuming all dividends and
distributions are reinvested and taking into account all applicable recurring
and nonrecurring expenses, including the maximum sales charge in the case of
Class A and Class D shares and the CDSC that would be applicable to a complete
redemption of the investment at the end of the specified period in the case of
Class B and Class C shares and the maximum sales charge in the case of Class A
and D shares. Dividends paid by the Fund with respect to all shares, to the
extent any dividends are paid, will be calculated in the same manner at the
same time on the same day and will be in the same amount, except that account
maintenance and distribution charges and any incremental transfer agency costs
relating to each class of shares, will be borne exclusively by that class. The
Fund will include performance data for all classes of shares of the Fund in
any advertisement or information including performance data of the Fund.
Dividends paid by a Portfolio with respect to all shares, to the extent
any dividends are paid, will be calculated in the same manner at the same time
on the same day and will be in the same amount, except that account
maintenance fees and distribution charges and any incremental transfer agency
costs relating to each class of shares will be borne exclusively by that
class. Each Portfolio of the Fund will include performance data for all
classes of shares of that Portfolio in any advertisement or information
including performance data of the Fund.
55
The Fund also may quote annual, average annual and annualized total
return and aggregate total return performance data, both as a percentage and
as a dollar amount based on a hypothetical investment of $1,000 or some other
amount, for various periods other than those noted below. Such data will be
computed as described above, except that (1) the rates of return calculated
will not be average annual rates, but rather, actual annual, annualized or
aggregate rate of return and (2) the maximum applicable sales charge will not
be included with respect to annual or annualized rates of return calculations.
Aside from the impact on the performance data calculations of including or
excluding the maximum applicable sales charge, actual annual or annualized
total return data generally will be lower than average annual total return
data since the average rates of return reflect compounding of return;
aggregate total return data generally will be higher than average annual total
return data since the aggregate rates of return reflect compounding over a
longer period of time. In advertisements distributed to investors whose
purchases are subject to waiver of the CDSC in the case of Class B and Class C
shares (such as investors in certain retirement plans) or to reduced sales
charges in the case of Class A and Class D shares, performance data may take
into account the reduced, and not the maximum, sales charge or may not take
into account the contingent deferred sales charges and therefore may reflect
greater total return since, due to the reduced sales charges or waiver of the
CDSC, a lower amount of expenses is deducted. See "Purchase of Shares." A
Portfolio's total return may be expressed either as a percentage or as a
dollar amount in order to illustrate such total return on a hypothetical
investment in that Portfolio at the beginning of each specified period.
Yield quotations will be computed based on a 30-day period by dividing
(a) the net income based on the yield to maturity of each security earned
during the period by (b) the average daily number of shares outstanding during
the period that were entitled to receive dividends multiplied by the maximum
offering price per share on the last day of the period.
Set forth below is total return and yield information for the Class A,
Class B, Class C and Class D shares of the High Income Portfolio, the Core
Bond Portfolio and the Intermediate Term Portfolio for the periods indicated.
HIGH INCOME PORTFOLIO
Class A Shares
---------------------------
Average Annual Total Return
(including maximum
Period applicable sales charges)
------ ----------------------------
One Year Ended September 30, 2001.......................... (15.44%)
Five Years Ended September 30, 2001........................ (0.26%)
Ten Years Ended September 30, 2001......................... 6.37%
Yield
30 days ended September 30, 2001........................... 13.92%
Tax Equivalent Yield*
30 days ended September 30, 2001........................... 19.33%
----------
* Based on a Federal income tax rate of 28%.
Class B Shares
---------------------------
Average Annual Total Return
(including maximum
Period applicable sales charges)
------ ----------------------------
One Year Ended September 30, 2001.......................... (15.65%)
Five Years Ended September 30, 2001........................ (0.17%)
Ten Years Ended September 30, 2001......................... 6.02%
Yield
30 days ended September 30, 2001........................... 13.64%
Tax Equivalent Yield*
30 days ended September 30, 2001........................... 18.94%
----------
* Based on a Federal income tax rate of 28%.
56
Class C Shares
---------------------------
Average Annual Total Return
(including maximum
Period applicable sales charges)
------ ----------------------------
One Year Ended September 30, 2001.......................... (13.37%)
Five Years Ended September 30, 2001........................ (0.24%)
Inception (October 21, 1994) to September 30, 2001......... 3.13%
Yield
30 days ended September 30, 2001........................... 13.59%
Tax Equivalent Yield*
30 days ended September 30, 2001........................... 18.88%
----------
* Based on a Federal income tax rate of 28%.
Class D Shares
---------------------------
Average Annual Total Return
(including maximum
Period applicable sales charges)
------ ----------------------------
One Year Ended September 30, 2001.......................... (15.62%)
Five Years Ended September 30, 2001........................ (0.49%)
Inception (October 21, 1994) to September 30, 2001......... 3.11%
Yield
30 days ended September 30, 2001........................... 13.60%
Tax Equivalent Yield*
30 days ended September 30, 2001........................... 18.89%
----------
* Based on a Federal income tax rate of 28%.
CORE BOND PORTFOLIO
Class A Shares
---------------------------
Average Annual Total Return
(including maximum
Period applicable sales charges)
------ ----------------------------
One Year Ended September 30, 2001.......................... 6.98%
Five Years Ended September 30, 2001........................ 5.84%
Ten Years Ended September 30, 2001......................... 6.72%
Yield
30 days ended September 30, 2001........................... 4.76%
Tax Equivalent Yield*
30 days ended September 30, 2001........................... 6.61%
----------
* Based on a Federal income tax rate of 28%.
Class B Shares
---------------------------
Average Annual Total Return
(including maximum
Period applicable sales charges)
------ ----------------------------
One Year Ended September 30, 2001.......................... 6.59%
Five Years Ended September 30, 2001........................ 5.90%
Ten Years Ended September 30, 2001......................... 6.34%
Yield
30 days ended September 30, 2001........................... 4.19%
Tax Equivalent Yield*
30 days ended September 30, 2001........................... 5.82%
----------
* Based on a Federal income tax rate of 28%.
57
Class C Shares
---------------------------
Average Annual Total Return
(including maximum
Period applicable sales charges)
------ ----------------------------
One Year Ended September 30, 2001.......................... 9.53%
Five Years Ended September 30, 2001........................ 5.82%
Inception (October 21, 1994) to September 30, 2001......... 6.66%
Yield
30 days ended September 30, 2001........................... 4.14%
Tax Equivalent Yield*
30 days ended September 30, 2001........................... 5.75%
----------
* Based on a Federal income tax rate of 28%.
Class D Shares
---------------------------
Average Annual Total Return
(including maximum
Period applicable sales charges)
------ ----------------------------
One Year Ended September 30, 2001.......................... 6.72%
Five Years Ended September 30, 2001........................ 5.56%
Inception (October 21, 1994) to September 30, 2001......... 6.63%
Yield
30 days ended September 30, 2001........................... 4.52%
Tax Equivalent Yield*
30 days ended September 30, 2001........................... 6.28%
----------
* Based on a Federal income tax rate of 28%.
INTERMEDIATE TERM PORTFOLIO
Class A Shares
---------------------------
Average Annual Total Return
(including maximum
Period applicable sales charges)
------ ----------------------------
One Year Ended September 30, 2001.......................... 10.24%
Five Years Ended September 30, 2001........................ 6.58%
Ten Years Ended September 30, 2001......................... 7.05%
Yield
30 days ended September 30, 2001........................... 4.78%
Tax Equivalent Yield*
30 days ended September 30, 2001........................... 6.64%
----------
* Based on a Federal income tax rate of 28%.
Class B Shares
---------------------------
Average Annual Total Return
(including maximum
Period applicable sales charges)
------ ----------------------------
One Year Ended September 30, 2001.......................... 9.79%
Five Years Ended September 30, 2001........................ 6.25%
Inception (November 13, 1992) to September 30, 2001........ 6.26%
Yield
30 days ended September 30, 2001........................... 4.32%
Tax Equivalent Yield*
30 days ended September 30, 2001........................... 6.00%
----------
* Based on a Federal income tax rate of 28%.
58
Class C Shares
---------------------------
Average Annual Total Return
(including maximum
Period applicable sales charges)
------ ----------------------------
One Year Ended September 30, 2001.......................... 9.78%
Five Years Ended September 30, 2001........................ 6.24%
Inception (October 21, 1994) to September 30, 2001......... 6.94%
Yield
30 days ended September 30, 2001........................... 4.31%
Tax Equivalent Yield*
30 days ended September 30, 2001........................... 5.99%
----------
* Based on a Federal income tax rate of 28%.
Class D Shares
---------------------------
Average Annual Total Return
(including maximum
Period applicable sales charges)
------ ----------------------------
One Year Ended September 30, 2001.......................... 10.13%
Five Years Ended September 30, 2001........................ 6.48%
Inception (October 21, 1994) to September 30, 2001......... 7.24%
Yield
30 days ended September 30, 2001........................... 4.68%
Tax Equivalent Yield*
30 days ended September 30, 2001........................... 6.50%
----------
* Based on a Federal income tax rate of 28%.
In order to reflect the reduced sales charges in the case of Class A or
Class D shares, or the waiver of the CDSC in the case of Class B or Class C
shares applicable to certain investors, as described under "Purchase of
Shares," the total return data quoted by the Fund in advertisements directed
to such investors may take into account the reduced, and not the maximum,
sales charge or may not take into account the waiver of the CDSC, and
therefore may reflect greater total return since, due to the reduced sales
charges or the waiver of CDSCs, a lower amount of expenses may be deducted.
Total return and yield figures are based on a Portfolio's historical
performance and are not intended to indicate future performance. A Portfolio's
total return and yield will vary depending on market conditions, the
securities held by that Portfolio, that Portfolio's operating expenses and the
amount of realized and unrealized net capital gains or losses during the
period. The value of an investment in a Portfolio will fluctuate and an
investor's shares, when redeemed, may be worth more or less than their
original cost.
On occasion, the Fund may compare the performance of the Portfolios to
various indices, including the Standard & Poor's 500 Index, the Value Line
Composite Index, the Dow Jones Industrial Average, or performance data
contained in publications such as Lipper Analytical Services, Inc.,
Morningstar Publications, Inc., Money Magazine, U.S. News & World Report,
Business Week, CDA Investment Technology, Inc., Forbes Magazine or Fortune
Magazine. In addition, from time to time the Fund may include the
risk-adjusted performance ratings assigned by Morningstar Publications, Inc.
to the Portfolios in advertising or supplemental sales literature. As with
other performance data, performance comparisons should not be considered
indicative of a Portfolio's relative performance for any future period.
ADDITIONAL INFORMATION
Organization of the Fund
The Fund is a diversified, open-end management investment company
organized under the laws of the state of Maryland that commenced operations on
November 10, 1978 as the Merrill Lynch High Income Fund, Inc., consisting
solely of the High Income Portfolio. The Fund was reorganized on September 8,
1980 to change its name from the Merrill Lynch High Income Fund, Inc. to the
Merrill Lynch Corporate Bond Fund, Inc. and to add the High Quality Portfolio
and the Intermediate Term Portfolio. The High Quality Portfolio and the
Intermediate
59
Term Portfolio commenced operations on October 31, 1980. The Fund changed its
name to Merrill Lynch Bond Fund, Inc. on January 22, 2001. The High Quality
Portfolio changed its name to Core Bond Portfolio on January 22, 2001.
The authorized capital stock of the Fund consists of three billion six
hundred fifty million (3,650,000,000) shares of Common Stock, having a par
value $0.10 per share. The shares of Common Stock are divided as follows: High
Income Portfolio Series Common Stock which is divided into four classes
designated "Class A Common Stock," "Class B Common Stock," "Class C Common
Stock" and "Class D Common Stock" which consist of 500,000,000 shares,
1,500,000,000 shares, 200,000,000 shares and 500,000,000 shares, respectively,
Core Bond Portfolio Common Stock which is divided into four classes designated
"Class A Common Stock," "Class B Common Stock," "Class C Common Stock" and
"Class D Common Stock" which consists of 250,000,000, 250,000,000, 100,000,000
and 100,000,000, respectively, and the Intermediate Term Portfolio Series
Common Stock, which is divided into four classes designated "Class A Common
Stock," "Class B Common Stock," "Class C Common Stock" and "Class D Common
Stock" which consists of 100,000,000, 50,000,000, 50,000,000 and 50,000,000
shares, respectively. Each of the Fund's shares has equal dividend,
distribution, liquidation and voting rights, except that only shares of the
respective Portfolios are entitled to vote on matters concerning only that
Portfolio and Class B, Class C and Class D Shares bear certain account
maintenance expenses and expenses related to the distribution of such shares
and have exclusive voting rights with respect to matters relating to such
account maintenance and distribution expenditures. The shares of each
Portfolio, when issued, will be fully paid and nonassessable, have no
preference, preemptive, conversion, exchange or similar rights, and will be
freely transferable. Stock certificates will be issued by the Transfer Agent
only on specific request. Certificates for fractional shares are not issued in
any case. Holders of shares of any Portfolio are entitled to redeem their
shares as set forth under "Redemption of Shares."
Shareholders are entitled to one vote for each share held and fractional
votes for fractional shares held and will vote on the election of Directors
and any other matter submitted to a shareholder vote. The Fund does not intend
to hold meetings of shareholders unless under the Investment Company Act
shareholders are required to act upon any of the following matters: (i)
election of Directors; (ii) approval of an investment advisory agreement;
(iii) approval of a distribution agreement; and (iv) ratification of selection
of independent accountants. Voting rights for Directors are not cumulative.
Each share is entitled to participate equally in dividends and distributions
declared by the Fund and in the net assets of the Fund upon liquidation or
dissolution after satisfaction of outstanding liabilities except that, as
noted above, Class B, Class C and Class D shares bear certain additional
expenses.
The Investment Adviser provided the initial capital for the Fund by
purchasing 10,417 shares for $100,003. Such shares were acquired for
investment and can only be disposed of by redemption. The organizational
expenses of the Fund have been fully amortized.
Under a separate agreement Merrill Lynch has granted the Fund the right
to use the "Merrill Lynch" name and has reserved the right to withdraw its
consent to the use of such name by the Fund at any time, or to grant the use
of such name to any other company, and the Fund has granted Merrill Lynch,
under certain conditions, the use of any other name it might assume in the
future, with respect to any corporation organized by Merrill Lynch.
Custodian
State Street Bank and Trust Company (the "Custodian"), One Heritage Drive
P2N, North Quincy, Massachusetts 02171, is the Fund's Custodian. Under its
contract with the Fund, the Custodian is authorized to establish separate
accounts in foreign currencies and to cause foreign securities owned by the
Fund to be held in its offices outside the United States and with certain
foreign banks and securities depositories. The Custodian is responsible for
maintaining, safeguarding and controlling each Portfolio's cash and
securities, handling receipt and delivery of securities and collecting
interest and dividends on the investments.
Transfer Agency Services Arrangements
Financial Data Services, Inc. 4800 Deer Lake Drive East, Jacksonville,
Florida 32246-6484, acts as the Fund's Transfer Agent. The Transfer Agent is
responsible for the issuance, transfer and redemption of shares and
60
the opening, maintenance and servicing of shareholder accounts. The Transfer
Agent, which is a subsidiary of ML & Co. and an affiliate of both the
Investment Adviser and Merrill Lynch, acts as the Fund's transfer agent
pursuant to a Transfer Agency, Dividend Disbursing Agency and Shareholder
Servicing Agency Agreement (the "Transfer Agency Agreement"). Pursuant to the
Transfer Agency Agreement, the Transfer Agent is responsible for the issuance,
transfer and redemption of shares and the opening and maintenance of
shareholder accounts. Pursuant to the Transfer Agency Agreement, the Transfer
Agent receives an annual fee of up to $11.00 per Class A or Class D account
and up to $14.00 per Class B or Class C account and is entitled to
reimbursement for certain transaction charges and out-of-pocket expenses
incurred by the Transfer Agent under the Transfer Agency Agreement.
Additionally, a $.20 monthly closed account charge will be assessed on all
accounts which close during the calendar year. Application of this fee will
commence the month following the month the account is closed. At the end of
the calendar year, no further fees will be due. For purposes of the Transfer
Agency Agreement, the term "account" includes a shareholder account maintained
directly by the Transfer Agent and any other account representing the
beneficial interest of a person in the relevant share class on a recordkeeping
system, provided the recordkeeping system is maintained by a subsidiary of ML
& Co.
Counsel and Auditor
Clifford Chance Rogers & Wells LLP, counsel to the Fund, passes upon
legal matters for the Fund in connection with the shares offered by this
Prospectus. Deloitte & Touche LLP, independent auditors, are auditors of the
Fund.
Accounting Services Provider
State Street Bank and Trust Company, 500 College Road East, Princeton,
New Jersey, 08540, provides certain accounting services for the Fund.
Shareholder Reports
The Fund issues to its shareholders report, at least semi-annually,
containing unaudited financial statements and annual reports containing
financial statements examined by auditors approved annually by the Directors.
Only one copy of each shareholder report and certain shareholder
communications will be mailed to each identified shareholder regardless of the
number of accounts such shareholder has. If a shareholder wishes to receive
separate copies of each report and communication for each of the shareholder's
related accounts the shareholder should notify in writing:
Financial Data Services, Inc.
P.O. Box 45289
Jacksonville, Florida 32232-5289
The written notification should include the shareholder's name, address,
tax identification number and Merrill Lynch, Pierce, Fenner & Smith
Incorporated and/or mutual fund account numbers.
Shareholder Inquiries
Shareholder inquiries may be addressed to the Fund at the address or
telephone number set forth on the cover page of this Statement of Additional
Information.
61
Additional Information
The Prospectus and this Statement of Additional Information do not
contain all the information set forth in the Registration Statement and the
exhibits relating thereto, which the Fund has filed with the Securities and
Exchange Commission, Washington, D.C., under the Securities Act and the
Investment Company Act, to which reference is hereby made.
To the knowledge of the Fund, no person or entity owned beneficially 5%
or more of the Fund's shares as of January 4, 2002 with the exception of:
CLASS A
-------
High Income Portfolio
MERRILL LYNCH TRUST COMPANY.............................. 26.73%
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
MERRILL LYNCH TRUST COMPANY, FSB......................... 7.07%
TRUSTEE FBO DAIMLER CHRYSLER CORP. SALARIED
ATTN: EAST REGION
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
MERRILL LYNCH TRUST COMPANY, FSB.......................... 5.98%
TRUSTEE FBO MERRILL LYNCH
ATTN: EAST REGION
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
CLASS A
-------
Core Bond Portfolio
MERRILL LYNCH TRUST COMPANY............................... 67.65%
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
MERRILL LYNCH TRUST COMPANY, FSB........................... 8.13%
TRUSTEE FBO MERRILL LYNCH
ATTN: EAST REGION
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
CLASS D
-------
MERRILL LYNCH TRUST COMPANY............................... 13.00%
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
NEXTGEN 75 EQUITY PORTFOLIO................................ 6.09%
FINANCE AUTHORITY OF MAINE
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
MLIM FIXED INCOME.......................................... 5.33%
FINANCE AUTHORITY OF MAINE
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
62
CLASS A
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Intermediate Term Portfolio
MERRILL LYNCH TRUST COMPANY............................... 70.29%
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
MERRILL LYNCH TRUST COMPANY, FSB.......................... 8.12%
TRUSTEE FBO DAIMLER CHRYSLER CORP. SALARIED
ATTN: EAST REGION
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
MERRILL LYNCH TRUST COMPANY, FSB.......................... 5.36%
TTEE FBO MERRILL LYNCH
ATT: EAST REGION
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
MERRILL LYNCH TRUST COMPANY, FSB.......................... 5.34%
TRUSTEE FBO DEUTSCHE BANK
NORTH AMERICA HOLDING CORPORATION
ATTN: EAST REGION
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
MERRILL LYNCH TRUST COMPANY, FSB.......................... 5.18%
TRUSTEE FBO
NEXTEL COMMUNICATIONS, INC.
ATTN: BIS
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
CLASS C
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ROBERT S. ORENSTEIN AND NANCY E. PFAU JTWROS.............. 8.76%
INVESTMENT ACCOUNT
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
CLASS D
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MERRILL LYNCH TRUST COMPANY............................... 65.89%
800 SCUDDERS MILL ROAD
PLAINSBORO, NJ 08536
FINANCIAL STATEMENTS
The Fund's audited financial statements are incorporated in this
Statement of Additional Information by reference to its 2001 Annual Report.
You may request a copy of the Annual Report at no charge by calling (800)
637-3863 between 8:00 a.m. and 8:00 p.m. Eastern time, on any business day.
63
APPENDIX A
Interest Rate Futures, Options Thereon and Options on Debt Securities
Each Portfolio may trade options on debt securities, purchase and sell
interest rate, bond and bond index futures contracts ("futures contracts") and
purchase and write call and put options on futures contracts. At the date
hereof, futures contracts (and options thereon) can be purchased and sold with
respect to U.S. Treasury notes and GNMA certificates on the Chicago Board of
Trade and with respect to U.S. Treasury bills on the International Monetary
Market at the Chicago Mercantile Exchange. Options directly on debt securities
are currently traded on the Chicago Board Options Exchange and the American
Stock Exchange.
Futures Contracts. A futures contract creates a binding obligation on the
purchaser (the "long") to accept delivery, and the seller (the "short") to
make delivery, of the face amount of the security underlying the futures
contract in a stated delivery month, at a price fixed in the contract or to
make a cash settlement in lieu of actual delivery. A majority of transactions
in futures contracts, however, do not result in actual delivery of the
underlying security, but are settled through liquidation, i.e., by entering
into an offsetting transaction. Futures contracts are traded only on commodity
exchanges--known as "contract markets"--approved for such trading by the
Commodity Futures Trading Commission ("CFTC"). Transactions in futures
contracts must be executed through a futures commission merchant ("FCM"), or
brokerage firm, which is a member of the relevant contract market.
The purchase or sale of a futures contract differs from the purchase or
sale of a security in that the total cash value reflected by the futures
contract is not paid. Instead, an amount of cash or securities acceptable to
each Portfolio's FCM and the relevant contract market, which varies, but may
be 5% or less of the contract amount, must be deposited with the FCM. This
amount is known as "initial margin," and represents a "good faith" deposit
assuring the performance of both the purchaser and the seller under the
futures contract. Subsequent payments to and from the FCM, known as
"maintenance" or "variation" margin, are required to be made on a daily basis
as the price of the futures contract fluctuates, making the long or short
positions in the futures contract more or less valuable, a process known as
"marking to the market." Prior to the settlement date of the futures contract,
the position may be closed out by taking an opposite position which will
operate to terminate the position in the futures contract. A final
determination of variation margin is then made, additional cash is required to
be paid to or released by the FCM, and the Portfolio realizes a loss or gain.
In addition, a commission is paid on each completed purchase and sale
transaction.
Each Portfolio will deal only in standardized contracts on recognized
exchanges. The clearing members of an exchange's clearing corporation
guarantee the performance of their futures contracts through the clearing
corporation, a nonprofit organization managed by the exchange membership which
is also responsible for handling daily accounting of deposits or withdrawals
of margin.
Options on Futures Contracts. An option on a futures contract gives the
purchaser (known as the "holder") the right, but not the obligation, to enter
into a long position in the underlying futures contract (i.e., purchase the
futures contract), in the case of a "call" option, or to enter into a short
position (i.e., sell the futures contract), in the case of a "put" option, at
a fixed price (the "exercise" or "strike" price) up to a stated expiration
date. The holder pays a non-refundable purchase price for the option, known as
the "premium." The maximum amount of risk the purchaser of the option assumes
is equal to the premium, the transaction costs and the unrealized profits, if
any, although this entire amount may be lost. Upon exercise of the option by
the holder, the contract market clearing corporation establishes a
corresponding short position for the seller, or "writer" of the option in the
case of a call option, or a corresponding long position in the case of a put
option, at the strike price. In the event that an option is exercised, the
holder will be subject to all the risks associated with the trading of futures
contracts. An option becomes worthless when it expires.
The writer of an option on a futures contract is required to deposit
initial and variation margin pursuant to requirements similar to those
applicable to futures contracts. Premiums received from the holder of the
option may be included in initial margin. The writing of an option on a
futures contract involves risks similar to those relating to futures
contracts, which are described beginning on page 9.
64
A position in an option may be terminated by the purchaser or seller
prior to its expiration by effecting a closing purchase or sale transaction,
which requires the purchase or writing of an option of the same series (i.e.,
the same exercise price and expiration date) as the option previously written
or purchased. The premium received from the holder on the closing transaction
may be more or less than the premium paid for the option, resulting in a gain
or loss on the transactions.
Exercise prices of options are set at specified intervals in relation to
the price of the underlying futures contract by the exchange on which they are
traded. Exercise prices are initially established when a new expiration cycle
commences and additional exercise prices may subsequently be introduced as the
futures contract price fluctuates. The expiration of an option is generally
based on the expiration of the underlying futures contract.
The holder of an option exercises it by notifying his broker of his
intention to exercise. The broker tenders the exercise notice to the clearing
house of the applicable exchange which assigns the notice on a random basis to
a broker with a customer who has written and outstanding an option of the same
series. That broker then assigns the exercise notice to such customer,
generally on a random basis, and the customer is then obligated to enter into
the underlying futures contract upon exercise. At that time, the contract
market clearing house establishes appropriate long and short futures positions
for the holder and writer. A corresponding short position for the writer would
be established in the case of a call option, or a corresponding long position
would be established in the case of a put option. The parties will then be
subject to initial and variation margin requirements with respect to the
underlying futures contract. By interposing itself between options writers and
purchasers, the clearing house in effect guarantees the performance of the
other side to each option purchased or sold.
Options on Debt Securities. An option on a U.S. Government security gives
the holder the right, but not the obligation, to purchase the underlying
security, in the case of a call option, or to sell the underlying security, in
the case of a put option, at the specified strike price up to a stated
expiration date. The holder pays a non-refundable premium upon purchasing the
option. The maximum amount of risk assumed by the holder is equal to the
premium, transaction costs and unrealized profits, if any, although this
entire amount may be lost. Upon exercise of the option, the holder purchases
or sells the underlying security at the strike price. Options on debt
instruments to be traded by the Fund may be traded on national securities
exchanges regulated by the Securities and Exchange Commission. The Options
Clearing Corporation is interposed between the clearing members which are the
parties to each such option, thereby assuring the performance of the parties.
If a liquid market exists, a position in an option may be terminated by
the purchaser or seller prior to expiration by entering into an offsetting
purchase or sale transaction in an option of the same series (i.e., the same
exercise price and expiration date) as the option previously purchased or
written. The premium paid or received by the trader on the closing transaction
may be more or less than the premium paid or received for the option,
resulting in a gain or loss on the transaction. If an option is not exercised,
it expires worthless to the holder.
Exercise prices of options are set at specified intervals in relation to
the price of the underlying security by the exchange on which they are traded.
Exercise prices are initially established when a new expiration cycle
commences and additional exercise prices may subsequently be introduced as the
price of the security fluctuates.
The holder of an option exercises it by notifying his broker of his
intention to exercise. The broker tenders the exercise notice to the clearing
house, which assigns the notice on a random basis to a broker with a customer
who has written and outstanding an option of the same series. That broker then
assigns the exercise notice to its customer, generally on a random basis. As a
call or put writer, the customer is obligated to sell or purchase the
underlying security.
65
APPENDIX B
DESCRIPTION OF BOND RATINGS
Ratings of Bonds
Description of Bond Ratings of Moody's:
Aaa Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally referred
to as "gilt-edge." Interest payments are protected by a large or by an
exceptionally stable margin and principal is secure. While the various
protective elements are likely to change, such changes as can be
visualized are most unlikely to impair the fundamentally strong position
of such issues.
Aa Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally
known as high grade bonds. They are rated lower than the best bonds
because margins of protection may not be as large as in Aaa securities or
fluctuation of protective elements may be of greater amplitude or there
may be other elements present which make the long-term risks appear
somewhat larger than in Aaa securities.
A Bonds which are rated A possess many favorable investment attributes and
are to be considered as upper medium-grade obligations. Factors giving
security to principal and interest are considered adequate but elements
may be present which suggest a susceptibility to impairment sometime in
the future.
Baa Bonds which are rated Baa are considered medium-grade obligations, i.e.,
they are neither highly protected nor poorly secured. Interest payments
and principal security appear adequate for the present but certain
protective elements may be lacking or may be characteristically
unreliable over any great length of time. Such bonds lack outstanding
investment characteristics and in fact have speculative characteristics
as well.
Ba Bonds which are rated Ba are judged to have speculative elements; their
future cannot be considered as well assured. Often the protection of
interest and principal payments may be very moderate and thereby not well
safeguarded during both good and bad times over the future. Uncertainty
of position characterizes bonds in this class.
B Bonds which are rated B generally lack characteristics of a desirable
investment. Assurance of interest and principal payments or of
maintenance of other terms of the contract over any long period of time
may be small.
Caa Bonds which are rated Caa are of poor standing. Such issues may be in
default or there may be present elements of danger with respect to
principal or interest.
Ca Bonds which are rated Ca represent obligations that are speculative in a
high degree. Such issues are often in default or have other marked
shortcomings.
C Bonds which are rated C are the lowest rated class of bonds and issues so
rated can be regarded as having extremely poor prospects of ever
attaining any real investment standing.
The modifier 1 indicates that the bond ranks in the higher end of its
generic rating category; the modifier 2 indicates a mid-range ranking; and the
modifier 3 indicates that the issue ranks in the lower end of its rating
category.
Description of Bond Ratings of Standard & Poor's:
AAA Bonds rated AAA have the highest rating assigned by Standard & Poor's.
Capacity to pay interest and repay principal is extremely strong.
AA Bonds rated AA have a very strong capacity to pay interest and repay
principal and differ from the higher rated issues only in small degree.
66
A Bonds rated A have a strong capacity to pay interest and repay principal
although they are somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than bonds in higher
rated categories.
BBB Bonds rated BBB are regarded as having an adequate capacity to pay
interest and repay principal. Whereas they normally exhibit adequate
protection parameters, adverse economic conditions or changing
circumstances are more likely to lead to a weakened capacity to pay
interest and repay principal for bonds in this category than in higher
rated categories.
BB Bonds rated BB, B, CCC and CC are regarded, on balance, as predominantly
speculative with respect to the B issuer's capacity to pay interest and
repay principal in accordance with the terms of the obligation. BB
indicates the lowest degree of speculation and CC the highest degree of
speculation and CC the highest degree of speculation. While such bonds
will likely have some quality and protective characteristics, these are
outweighed by large uncertainties or major risk exposures to adverse
conditions.
C The C rating is reserved for income bonds on which no interest is being
paid.
D Bonds rated D are in default, and payment of interest and/or repayment of
principal is in arrears.
NR Indicates that no rating has been requested, that there is insufficient
information on which to base a rating, or that S&P does not rate a
particular type of bond as a matter of policy.
Plus (+) or Minus (-): The ratings from "AA" to "B" may be modified by
the addition of a plus or minus sign to show relative standing within the
major rating categories.
Description of Bond Ratings of Fitch
AAA Bonds rated AAA are considered to be investment grade and of the highest
credit quality. The obligor has an exceptionally strong ability to pay
interest and repay principal, which is unlikely to be affected by
reasonably foreseeable events.
AA Bonds rated AA are considered to be investment grade and of very high
credit quality. The obligor's ability to pay interest and repay principal
is very strong, although not quite as strong as bonds rated AAA. Because
bonds rated in the AAA and AA categories are not significantly vulnerable
to foreseeable future developments, short-term debt of these issuers is
generally rated F1+.
A Bonds rated A are considered to be investment grade and of high credit
quality. The obligor's ability to pay interest and repay principal is
considered to be strong, but may be more vulnerable to adverse changes in
economic conditions and circumstances than bonds with higher ratings.
BBB Bonds rated BBB are considered to be investment grade and of satisfactory
credit quality. The obligor's ability to pay interest and repay principal
is considered to be adequate. Adverse changes in economic conditions and
circumstances, however, are more likely to have an adverse impact on
these bonds and, therefore, impair timely payment. The likelihood that
the ratings of these bonds will fall below investment grade is higher
than for bonds with higher ratings.
BB Bonds rated BB are considered speculative. The obligor's ability to pay
interest and repay principal may be affected over time by adverse
economic changes. However, business and financial alternatives can be
identified which could assist the obligor in satisfying its debt service
requirements.
B Bonds rated B are considered highly speculative. While bonds in this
class are currently meeting debt service requirements, the probability of
continued timely payment of principal and interest reflects the obligor's
limited margin of safety and the need for reasonable business and
economic activity throughout the life of the issue.
CCC Bonds rated CCC have certain identifiable characteristics, which, if not
remedied, may lead to default. The ability to meet obligations requires
an advantageous business and economic environment.
67
CC Bonds rated CC are minimally protected. Default in payment of interest
and/or principal seems probable over time.
C Bonds rated C are in imminent default in payment of interest or
principal.
DDD Bonds rated DDD, DD and D are in actual default of interest and/or
DD principal payments. Such bonds are extremely speculative and should be
D valued on the basis of their ultimate recovery value in liquidation or
reorganization of the obligor. DDD represents the highest potential for
recovery on these bonds and D represents the lowest potential for
recovery.
Plus (+) and minus (-) signs are used with a rating symbol to indicate
the relative position of a credit within the rating category. Plus and minus
signs, however, are not used in the AAA category covering 12-36 months.