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Prospectus
April 30, 2003
The Municipal Fund Investment Accumulation Program
The Municipal Fund Investment Accumulation Program is only open to holders
of units of Municipal Investment Trust Fund and Defined Asset Funds --
Municipal Insured Series for reinvestment of distributions on those units.
This Prospectus contains information you should know before investing,
including information about risks. Please read it before you invest and keep
it for future reference.
The Securities and Exchange Commission has not approved or disapproved these
securities or passed upon the adequacy of this Prospectus. Any
representation to the contrary is a criminal offense.
Table of Contents
PAGE
KEY FACTS
[GRAPHIC] ---------------------------------------
The Municipal Fund Investment Accumulation Program at a Glance 3
Risk/ Return Bar Chart 5
Fees and Expenses 6
DETAILS ABOUT THE PROGRAM
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[GRAPHIC]
How the Program Invests 7
Investment Risks 8
[GRAPHIC] YOUR ACCOUNT
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Participation in the Program 13
How to Buy, Sell, Transfer and Exchange Shares 14
MANAGEMENT OF THE PROGRAM
[GRAPHIC] ---------------------------------------
Fund Asset Management 18
Financial Highlights 19
[Graphic] FOR MORE INFORMATION
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Shareholder Reports Back Cover
Statement of Additional Information Back Cover
THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM
[GRAPHIC]
Key Facts
In an effort to help you better understand the many concepts involved in making
an investment decision, we have defined the highlighted terms in this prospectus
in the sidebar.
Municipal Bond -- a debt obligation issued by or on behalf of a governmental
entity or other qualifying issuer that pays interest exempt from Federal income
tax.
Investment Grade -- any of the four highest debt obligation ratings by
recognized rating agencies, including Moody's Investors Service, Inc., Standard
& Poor's or Fitch Ratings.
THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM AT A GLANCE
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What is the Municipal Fund Investment Accumulation Program (the "Program")?
The Program invests distributions made to holders of units of Municipal
Investment Trust Fund Series and Defined Asset Funds -- Municipal Investment
Trust Fund Insured Series. Holders of units of these unit trust funds may elect
to have their distributions reinvested in shares of the Program rather than paid
in cash. The Program is not open to investment by persons who are not holders of
units of the participating unit trust funds, and investments in the Program are
limited to reinvestment of distributions.
What is the Program's investment objective?
The investment objective of the Program is to provide shareholders with
income exempt from Federal income tax through investment in a diversified
portfolio of interest bearing long- and intermediate-term municipal bonds, the
interest on which is, in the opinion of bond counsel to the issuing authorities,
exempt from Federal income tax.
What are the Program's main investment strategies?
Under normal circumstances, the Program invests at least 80% of its assets in
a portfolio of municipal bonds, the income from which is exempt from Federal
income tax. These may be obligations of a variety of issuers including states,
territories and possessions of the United States and the District of Columbia
and their political subdivisions, agencies and instrumentalities. The Program
invests primarily in long- and intermediate-term municipal bonds. The Program
will invest only in investment grade obligations and, measured at the time of
purchase, at least 75% of its total assets will be invested in municipal bonds
rated in the three highest rating categories. When choosing investments, Program
management considers various factors, including the credit quality of issuers,
yield analysis, diversification and call features of the obligations.
What are the main risks of investing in the Program? The Program cannot
guarantee that it will achieve its objective.
As with any fund, the value of the Program's investments -- and therefore the
value of the Program's shares -- may fluctuate. These changes may occur in
response to interest rate changes or in response to other factors, including
financial condition, that may affect the municipal bond market generally, or a
particular issuer or obligation. Generally, when interest rates go up, the value
of debt instruments like municipal bonds goes down. Also, Program management may
select securities that underperform the bond market or other
THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM 3
[GRAPHIC] Key Facts
funds with similar investment objectives and investment strategies. If the value
of the Program's investments goes down, you may lose money.
Prices of longer term securities generally change more in response to
interest rate changes than prices of shorter term securities.
Who should invest?
The Program allows for the automatic reinvestment of distributions made to
holders of units of certain unit trust funds. The Program may be an appropriate
investment for you if you:
. Want to automatically reinvest distributions you receive from a
participating unit trust fund
. Are looking for an investment that provides income that is exempt from
Federal income tax
. Want a professionally managed and diversified portfolio without the
administrative burdens of direct investments in municipal bonds
. Are looking for liquidity
. Can tolerate the risk of loss caused by changes in interest rates or
adverse changes in the price of municipal bonds in general
4 THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM
RISK/RETURN BAR CHART
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The bar chart and table shown below provide an indication of the risks of
investing in the Program. The bar chart shows changes in the Program's
performance for each of the past ten calendar years. The table compares the
average annual total returns of the Program's shares for the periods shown with
those of the Lehman Brothers Municipal Bond Index, a broad measure of market
performance. How the Program performed in the past (before and after taxes) is
not necessarily an indication of how the Program will perform in the future.
[CHART]
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
- ------ ------ ------ ----- ----- ----- ------ ------ ----- ------
11.93% -6.44% 15.88% 3.36% 8.29% 5.35% -6.77% 11.57% 2.81% 7.09%
During the ten-year period shown in the bar chart, the highest return for a
quarter was 6.27% (quarter ended March 31, 1995) and the lowest return for a
quarter was -5.95% (quarter ended March 31, 1994). The Program's year-to-date
return as of March 31, 2003 was 1.08%.
After-tax returns are calculated using the historical highest marginal Federal
individual income tax rate in effect during the periods measured and do not
reflect the impact of state and local taxes. Actual after-tax returns depend on
an investor's tax situation and may differ from those shown. The after-tax
returns shown are not relevant to investors who hold their Program shares
through tax-deferred arrangements, such as 401(k) plans or individual retirement
accounts or through tax advantaged education savings accounts.
Average Annual Total Returns
(For the Periods ended December 31, 2002) One Year Five Years Ten Years
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The Municipal Fund Accumulation Program, Inc.
Return Before Taxes* 7.09% 3.82% 5.06%
Return After Taxes on Distributions* 7.09% 3.53% 4.86%
Return After Taxes on Distributions and Sale of Program
Shares* 6.41% 3.90% 5.02%
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Lehman Brothers Municipal Bond Index** 9.60% 6.06% 6.71%
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* Includes all applicable fees and sales charges.
** This unmanaged index consists of long-term revenue bonds, general obligation
bonds and insured bonds, all of which mature within 30 years. Performance of
the index does not reflect the deduction of fees, expenses or taxes. Past
performance is not predictive of future performance.
THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM 5
[GRAPHIC] Key Facts
UNDERSTANDING EXPENSES
Fund investors pay various fees and expenses, either directly or indirectly.
Listed below are some of the main types of expenses that the Program may charge:
Expenses paid indirectly by the shareholder:
Annual Program Operating Expenses -- expenses that cover the costs of operating
the Program.
Management Fee -- a fee paid to the Investment Adviser for managing the Program.
FEES AND EXPENSES
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This table shows the different fees and expenses that you may pay if you buy
and hold shares of the Program. Future expenses may be greater or less than
those indicated below.
Shareholder Fees (fees paid directly from your investment):
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Maximum Sales Charge (Load) imposed on purchases (as a percentage of offering price) None
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Maximum Deferred Sales Charge (Load) (as a percentage of original purchase price or redemption
proceeds, whichever is lower) None
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Maximum Sales Charge (Load) imposed on Dividend Reinvestments None
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Redemption Fee None
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Exchange Fee None
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Annual Program Operating Expenses (expenses that are deducted from Program
assets):
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Management Fee 0.50%
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Distribution and/or Service (12b-1) Fees None
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Other Expenses 0.27%
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Total Annual Program Operating Expenses 0.77%
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Example:
This example is intended to help you compare the cost of investing in the
Program with the cost of investing in other mutual funds by illustrating the
costs to you if you redeem after one, three, five and ten years.
This example assumes that you invest $10,000 in the Program for the time
periods indicated, that dividends are reinvested, that your investment has a 5%
return each year and that the Program's operating expenses remain the same.
These assumptions are not meant to indicate you will receive a 5% annual rate of
return. Your annual return may be more or less than the 5% used in this example.
Although your actual costs may be higher or lower, based on these assumptions
your costs would be:
1 Year 3 Years 5 Years 10 Years
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$79 $246 $428 $954
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6 THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM
[GRAPHIC]
Details About
the Program
ABOUT THE PORTFOLIO MANAGER
Theodore R. Jaeckel, Jr. is the portfolio manager of the Program. Mr. Jaeckel
has been a Director (Municipal Tax-Exempt Fund Management) of Merrill Lynch
Investment Managers since 1997. Mr. Jaeckel has been primarily responsible for
the management of the Program since 2001.
ABOUT THE INVESTMENT ADVISER
The Program is managed by Fund Asset Management, L.P.
HOW THE PROGRAM INVESTS
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The Program's investment objective is to seek to provide shareholders with
income exempt from Federal income tax.
Outlined below are the main strategies the Program uses in seeking to achieve
its investment objective:
The Program invests primarily in long- and intermediate-term investment grade
municipal bonds. Municipal bonds may be obligations of a variety of issuers
including governmental entities or other qualifying issuers. Issuers may be
states, territories and possessions of the United States and the District of
Columbia and their political subdivisions, agencies and instrumentalities.
Municipal bonds may also include short term tax exempt obligations like
municipal notes and variable rate demand obligations. Because of its emphasis on
municipal bonds, the Program should be considered as a means of diversifying an
investment portfolio and not in itself a balanced investment program.
Under normal circumstances, the Program invests at least 80% of its assets in
municipal bonds, the income from which is exempt from Federal income tax.
The Program will purchase only investment grade obligations and, measured at
the time of purchase, at least 75% of its total assets will be invested in
municipal bonds rated in the three highest rating categories ("A" or better) by
recognized rating agencies. Under current market conditions, the Board of
Directors of the Program has determined that the Program will not purchase
municipal bonds if one or more of the recognized rating agencies has rated the
debt obligation below investment grade. However, the Program may continue to
hold municipal bonds that, after purchase, are downgraded to a rating below
investment grade. This policy is discretionary and may be changed from time to
time.
The Program's investments may include private activity bonds that may subject
certain shareholders to an alternative minimum tax.
Program management considers a variety of factors when choosing investments,
such as:
. Credit Quality of Issuers -- based on bond ratings and other factors
including economic and financial conditions.
. Yield Analysis -- takes into account factors such as the different yields
available on different types of obligations and
THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM 7
[GRAPHIC] Details About the Program
the shape of the yield curve (longer term obligations typically have
higher yields).
. Maturity Analysis -- the weighted average maturity of the portfolio will
be maintained within a desirable range as determined from time to time.
Factors considered include portfolio activity, maturity of the supply of
available bonds and the shape of the yield curve.
In addition, Program management considers the availability of features that
protect against an early call of a bond by the issuer.
Other Strategies. In addition to the main strategies discussed above, the
Program may use certain other investment strategies:
As a temporary measure for defensive purposes, or to provide liquidity, the
Program may invest without limitation in short-term tax-exempt obligations.
Short-term investments may limit the potential for income on your shares and may
limit the Program's ability to achieve its investment objective.
The Program may invest in fixed rate or variable rate obligations. The
Program may purchase municipal bonds on a when-issued or delayed delivery basis
and may enter into forward commitments.
The Program may use derivatives including futures, options, indexed
securities, inverse securities and swap agreements. Derivatives are financial
instruments whose value is derived from another security or an index such as the
Lehman Brothers Municipal Bond Index.
The Program may invest uninvested cash balances in affiliated money market
funds.
INVESTMENT RISKS
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This section contains a summary discussion of the general risks of investing
in the Program. As with any fund, there can be no guarantee that the Program
will meet its objective or that the Program's performance will be positive for
any period of time.
8 THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM
Set forth below are the main risks of investing in the Program:
Bond Market and Selection Risk -- Bond market risk is the risk that the bond
market will go down in value, including the possibility that the market will go
down sharply and unpredictably. Selection risk is the risk that the investments
that Program management selects will underperform the market or other funds with
similar investment objectives and investment strategies.
Credit Risk -- Credit risk is the risk that the issuer will be unable to pay
the interest or principal when due. The degree of credit risk depends on both
the financial condition of the issuer and the terms of the obligation.
Interest Rate Risk -- Interest rate risk is the risk that prices of municipal
bonds generally increase when interest rates decline and decrease when interest
rates increase. Prices of longer term securities generally change more in
response to interest rate changes than prices of shorter term securities.
Call and Redemption Risk -- A bond's issuer may call a bond for redemption
before it matures. If this happens to a bond the Program holds, the Program may
lose income and may have to invest the proceeds in bonds with lower yields.
The Program may also be subject to certain other risks associated with its
investments and investment strategies, including:
Borrowing and Leverage Risk -- The Program may borrow for temporary emergency
purposes, including to meet redemptions. Borrowing may exaggerate changes in the
net asset value of Program shares and in the yield on the Program's portfolio.
Borrowing will cost the Program interest expense and other fees. The cost of
borrowing may reduce the Program's return. Certain securities that the Program
buys may create leverage including, for example, when-issued securities and
forward commitments.
General Obligation Bonds -- The faith, credit and taxing power of the issuer
of a general obligation bond secures payment of interest and repayment of
principal. Timely payments depend on the issuer's credit quality, ability to
raise tax revenues and ability to maintain an adequate tax base.
Revenue Bonds -- Payments of interest and principal on revenue bonds are made
only from the revenues generated by a particular facility, class of facilities
or the proceeds of a special tax or other revenue source. These payments depend
on the money earned by the particular facility or class of facilities.
Industrial development bonds are one type of revenue bond.
THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM 9
[GRAPHIC] Details About the Program
Industrial Development Bonds -- Municipalities and other public authorities
issue industrial development bonds to finance development of industrial
facilities for use by a private enterprise. The private enterprise pays the
principal and interest on the bond, and the issuer does not pledge its faith,
credit and taxing power for repayment. If the private enterprise defaults on its
payments, the Program may not receive any income or get its money back from the
investment.
Moral Obligation Bonds -- Moral obligation bonds are generally issued by
special purpose public authorities of a state or municipality. If the issuer is
unable to meet its obligations, repayment of these bonds becomes a moral
commitment, but not a legal obligation, of the state or municipality.
Municipal Lease Obligations -- In a municipal lease obligation, the issuer
agrees to make payments when due on the lease obligation. The issuer will
generally appropriate municipal funds for that purpose, but is not obligated to
do so. Although the issuer does not pledge its unlimited taxing power for
payment of the lease obligation, the lease obligation is secured by the leased
property. However, it may be difficult to sell the property and the proceeds of
a sale may not cover the Program's loss.
Insured Municipal Bonds -- Bonds purchased by the Program may be covered by
insurance that guarantees timely interest payments and repayment of principal on
maturity. If a bond's insurer fails to fulfill its obligations or loses its
credit rating, the value of the bond could drop. Insured bonds are subject to
market risk.
When Issued Securities, Delayed Delivery Securities and Forward Commitments
- -- When issued and delayed delivery securities and forward commitments involve
the risk that the security the Program buys will lose value prior to its
delivery to the Program. There also is the risk that the security will not be
issued or that the other party will not meet its obligation, in which case the
Program loses the investment opportunity of the assets it has set aside to pay
for the security and any gain in the security's price.
Variable Rate Demand Obligations -- Variable rate demand obligations (VRDOs)
are floating rate securities that combine an interest in a long term municipal
bond with a right to demand payment before maturity from a bank or other
financial institution. If the bank or financial institution is unable to pay,
the Program may lose money.
Derivatives -- The Program may use derivative instruments including indexed
and inverse floating rate securities, options on portfolio positions, options on
10 THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM
securities or other financial indices, financial futures and options on such
futures and swap agreements. Derivatives allow the Program to increase or
decrease its risk exposure more quickly and efficiently than other types of
instruments.
Derivatives are volatile and involve significant risks, including:
Credit risk -- the risk that the counterparty (the party on the other side
of the transaction) on a derivative transaction will be unable to honor its
financial obligation to the Program.
Leverage risk -- the risk associated with certain types of investments or
trading strategies that relatively small market movements may result in large
changes in the value of an investment. Certain investments or trading
strategies that involve leverage can result in losses that greatly exceed the
amount originally invested.
Liquidity risk -- the risk that certain securities may be difficult or
impossible to sell at the time that the seller would like or at the price that
the seller believes the security is currently worth.
The Program may use derivatives for hedging purposes including anticipatory
hedges. Hedging is a strategy in which the Program uses a derivative to offset
the risks associated with other Program holdings. While hedging can reduce
losses, it can also reduce or eliminate gains or cause losses if the market
moves in a different manner than anticipated by the Program or if the cost of
the derivative outweighs the benefit of the hedge. Hedging also involves the
risk that changes in the value of the derivative will not match those of the
holdings being hedged as expected by the Program, in which case any losses on
the holdings being hedged may not be reduced and may be increased. There can be
no assurance that the Program's hedging strategy will reduce risk or that
hedging transactions will be either available or cost effective. The Program is
not required to use hedging and may choose not to do so.
Indexed and Inverse Floating Rate Securities -- The Program 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. The Program may also invest in
securities whose return is inversely related to changes in an interest rate
THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM 11
[GRAPHIC] Details About the Program
(inverse floaters). In general, income on inverse floaters will decrease when
short term interest rates increase and increase when short term interest rates
decrease. Investments in inverse floaters may subject the Program to the risks
of reduced or eliminated interest payments and losses of 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 the Program's investment. As a result, the market value of such
securities will generally be more volatile than that of fixed rate, tax
exempt securities. Indexed securities and inverse floaters are derivative
securities and can be considered speculative.
Illiquid Investments -- The Program may invest up to 15% of its net assets in
illiquid securities that it cannot easily sell within seven days at current
value or that have contractual or legal restrictions on resale. If the Program
buys illiquid securities it may be unable to quickly sell them or may be able to
sell them only at a price below current value.
STATEMENT OF ADDITIONAL INFORMATION
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If you would like further information about the Program, including how it
invests, please see the Statement of Additional Information.
12 THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM
[GRAPHIC]
Your Account
PARTICIPATION IN THE PROGRAM
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The purpose of the Program is to permit you to reinvest distributions you
receive on units you hold of various series of certain unit trust funds. The
unit trust funds include all series of Municipal Investment Trust Fund Series
and Defined Asset Funds -- Municipal Investment Trust Fund Insured Series.
Distributions on units held by you will be paid to you in cash unless you elect
to reinvest the distributions in shares of the Program by sending a notice in
writing to the program agent. The program agent is The Bank of New York, 100
Church Street, New York, New York 10007. You may also change an election you
have made to participate in the Program by notifying the Program agent in
writing. Your initial notice and notice of any change must be received by the
program agent at least 10 days prior to the record date of the first
distribution to which you want such change to apply.
Distributions on units of the unit trust funds may consist of interest
income, or capital gains or principal on the units. You may elect to have some
or all of these distributions reinvested in shares of the Program. Any
distribution that you elect to have reinvested in shares of the Program will be
automatically reinvested by the program agent on your behalf on the date the
distribution is made. On that date, the distribution will be applied to the
purchase of shares of the Program at net asset value, without a sales charge. If
you have elected to have distributions of principal on your units invested in
shares of the Program, the proceeds of redemption or payment at maturity of
securities held in the unit trust fund represented by your units will be
invested in shares of the Program, rather than being distributed to you in cash.
The program agent will mail to you a report of each distribution that is
reinvested in shares of the Program. Even though distributions are being
reinvested in shares of the Program, for Federal income tax purposes, you will
be considered to have received those distributions.
The Program may reject any order to buy shares. The Board of Directors of the
Program may decide to change the terms of investment in shares of the Program or
terminate the Program entirely without notice to you. In addition, the Board of
Directors of the Program may appoint a substitute program agent or an additional
program agent.
The administrators of the Program are Merrill Lynch, Pierce, Fenner & Smith
Incorporated, Prudential Securities Incorporated, Morgan Stanley Dean Witter
Inc. and Smith Barney Inc. The administrators are the sponsors of the unit trust
funds.
For further details of the terms and conditions of the Program see the
Statement of Additional Information.
THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM 13
[GRAPHIC] Your Account
HOW TO BUY, SELL, TRANSFER AND EXCHANGE SHARES
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The chart on the following pages summarizes how to buy, sell, transfer and
exchange shares of the Program.
If You Want To Your Choices Information Important for You to Know
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Buy Shares First, you decide whether you Refer to the description of the Program on page 13. Be sure to read this
want to participate in the prospectus carefully.
Program
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Next, determine what Distributions from the unit trust funds
may consist of interest income, capital distributions from
the unit trust gains or principal. You may reinvest the
distributions of interest income or of funds you want to
reinvest capital gains or of principal, or you may reinvest
all distributions.
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Notify the program agent of The notice must be in writing and received by the program agent at least ten
your election to reinvest some days before the record date for the first distribution you want to have
or all distributions you receive reinvested.
from the unit trust funds
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Decide whether your shares Consult with your securities
dealer. Under certain circumstances, your will be held in an
account with securities dealer may not be able to hold your
shares in your account with the your securities dealer or
with securities dealer.
the program agent
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Add to Your Purchase additional shares Once you have elected to participate in
the Program, distributions from the Investment unit trust funds that you have
elected to have reinvested in the Program will be automatically
reinvested. If you have
not already elected to
have all of your
distributions from the
unit trust funds
reinvested, you may
notify the program agent
that you wish to reinvest
more of your
distributions.
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Acquire additional shares All dividends on shares of the Program are automatically reinvested in
through the Program's additional shares of the Program without a sales charge.
automatic dividend
reinvestment plan
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Stop Reinvesting Notify the program agent in Your election to stop reinvesting
some or all distributions from the unit trust Distributions in writing funds in
shares of the Program will be effective for any distribution that has a Shares
of the record date that is more than ten days after the program agent receives
your
Program written notice.
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Transfer Shares to Transfer to a participating You may transfer your shares of
the Program only to another securities dealer Another Securities securities
dealer that has entered into an agreement with Merrill Lynch. All future trading
of Dealer these assets must be coordinated by the receiving firm.
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Transfer to a non-participating You must either:
securities dealer . Transfer your
shares to an account with
the Program Agent; or .
Sell your shares.
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Information Important for You to Know
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Refer to the description of the Program on page 13. Be sure to read this
prospectus carefully.
- --------------------------------------------------------------------------------
Distributions from the unit trust funds may consist of interest income, capital
gains or principal. You may reinvest the distributions of interest income or of
capital gains or of principal, or you may reinvest all distributions.
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The notice must be in writing and received by the program agent at least ten
days before the record date for the first distribution you want to have
reinvested.
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Consult with your securities dealer. Under certain circumstances, your
securities dealer may not be able to hold your shares in your account with the
securities dealer.
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Once you have elected to participate in the Program, distributions from the unit
trust funds that you have elected to have reinvested in the Program will be
automatically reinvested. If you have not already elected to have all of your
distributions from the unit trust funds reinvested, you may notify the program
agent that you wish to reinvest more of your distributions.
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All dividends on shares of the Program are automatically reinvested in
additional shares of the Program without a sales charge.
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Your election to stop reinvesting some or all distributions from the unit trust
funds in shares of the Program will be effective for any distribution that has a
record date that is more than ten days after the program agent receives your
written notice.
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You may transfer your shares of the Program only to another securities dealer
that has entered into an agreement with Merrill Lynch. All future trading of
these assets must be coordinated by the receiving firm.
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You must either:
.. Transfer your shares to an account with the Program Agent; or . Sell your
shares.
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14 THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM
If You Want To Your Choices Information Important for You to Know
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Sell Your Shares Have your securities dealer The price of your
shares is based on the next calculation of net asset value
submit your sales order to one of after your order is placed.
For your redemption request to be priced at the net the
Administrators asset value on the day of your request, you must
submit your request to your
dealer prior to that day's
close of business on the
New York Stock Exchange
(generally 4:00 p.m.
Eastern time). Any
redemption request placed
after that time will be
priced at the net asset
value as of the close of
business on the next
business day.
Securities dealers may
charge a fee to process a
redemption of shares. No
processing fee is charged
if you redeem shares held
by the Program Agent.
The Program may reject an
order to sell shares under certain circumstances.
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Sell through the Program Agent You may sell shares held at the Program Agent by writing to the Program
Agent at the address on the inside back cover of this prospectus. All
shareholders on the account must sign the letter. A signature guarantee will
generally be required but may be waived in certain limited circumstances.
You can obtain a signature guarantee from a bank, securities dealer,
securities broker, credit union, savings association, national securities
exchange or registered securities association. A notary public seal will not be
acceptable. If you hold stock certificates, return the certificates with the
letter. The Program Agent will normally mail redemption proceeds within
seven days following receipt of a properly completed request.
If you hold share
certificates, they must be
delivered to the Program
Agent before they can be
converted. Check with the
Program Agent or your
securities dealer for
details.
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Information Important for You to Know
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The price of your shares is based on the next calculation of net asset value
after your order is placed. For your redemption request to be priced at the net
asset value on the day of your request, you must submit your request to your
dealer prior to that day's close of business on the New York Stock Exchange
(generally 4:00 p.m. Eastern time). Any redemption request placed after that
time will be priced at the net asset value as of the close of business on the
next business day.
Securities dealers may charge a fee to process a redemption of shares. No
processing fee is charged if you redeem shares held by the Program Agent.
The Program may reject an order to sell shares under certain circumstances.
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You may sell shares held at the Program Agent by writing to the Program Agent at
the address on the inside back cover of this prospectus. All shareholders on the
account must sign the letter. A signature guarantee will generally be required
but may be waived in certain limited circumstances. You can obtain a signature
guarantee from a bank, securities dealer, securities broker, credit union,
savings association, national securities exchange or registered securities
association. A notary public seal will not be acceptable. If you hold stock
certificates, return the certificates with the letter. The Program Agent will
normally mail redemption proceeds within seven days following receipt of a
properly completed request.
If you hold share certificates, they must be delivered to the Program Agent
before they can be converted. Check with the Program Agent or your securities
dealer for details.
- -------------------------------------------------------------------------------
Because of the high cost of maintaining smaller shareholder accounts, the
Program may redeem the shares in your account if the net asset value of your
account falls below $500 due to redemptions you have made. You will be notified
that the value of your account is less than $500 before the Program makes an
involuntary redemption. You will then have 60 days to make an additional
investment to bring the value of your account to at least $500 before the
Program takes any action. This involuntary redemption does not apply to Uniform
Gifts or Transfers to Minors Act accounts.
THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM 15
[GRAPHIC] Your Account
Net Asset Value -- the market value of the Program's total assets after
deducting liabilities, divided by the number of shares outstanding.
Dividends -- exempt interest, ordinary income and capital gains paid to
shareholders. Dividends may be reinvested in additional Program shares as they
are paid.
HOW SHARES ARE PRICED
- --------------------------------------------------------------------------------
Each distribution on your units will automatically be applied to purchase
shares at net asset value. This is the offering price. Shares are also redeemed
at their net asset value. The Program calculates its net asset value (generally
by using market quotations) each day the New York Stock Exchange is open, as of
the close of business on the Exchange, based on prices at the time of closing.
The Exchange generally closes at 4:00 p.m. Eastern time. The net asset value
used in determining your price is the next one calculated after your purchase or
redemption order is placed.
DIVIDENDS AND TAXES
- --------------------------------------------------------------------------------
The Program will distribute net investment income, if any, monthly and net
realized capital gains, if any, at least annually. The Program may also pay a
special distribution at the end of the calendar year to comply with Federal
income tax requirements. If you would like to receive dividends in cash, contact
the Program Agent.
To the extent that the dividends distributed by the Program are from
municipal bond interest income, they are exempt from Federal income tax, but
they may be subject to state and local income taxes. Certain investors may be
subject to a Federal alternative minimum tax on dividends received from the
Program. Interest income from other investments may produce taxable dividends.
The Program may realize capital gains on the sale of its municipal bonds. These
capital gains will be taxable to you.
Generally, within 60 days after the end of the Program's taxable year, you
will be informed of the amount of exempt-interest dividends and capital gains
dividends you received that year. Capital gain dividends are generally taxable
as long-term capital gains to you, regardless of how long you have held your
shares. The tax treatment of dividends from the Program is the same whether you
choose to receive distributions in cash or to have them reinvested in shares of
the Program.
By law, your dividends will be subject to a withholding tax if you have not
provided a taxpayer identification number or social security number or if the
number you have provided is incorrect.
16 THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM
This section summarizes some of the consequences of an investment in the
Program under current Federal tax laws. It is not a substitute for personal tax
advice. You should consult your personal tax adviser about the potential tax
consequences to you of an investment in the Program under all applicable tax
laws.
ELECTRONIC DELIVERY
- --------------------------------------------------------------------------------
The Program is now offering electronic delivery of communications to its
shareholders. In order to receive this service, you must register your account
and provide us with e-mail information. To sign up for this service, simply
access this website http://www.icsdelivery.com/live/ and follow the
instructions. When you visit the site, you will obtain a personal identification
number (PIN). You will need this PIN should you wish to update your e-mail
address, choose to discontinue this service and/or make other changes to the
service.
THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM 17
[GRAPHIC]
Management of the Program
FUND ASSET MANAGEMENT
- --------------------------------------------------------------------------------
Fund Asset Management, L.P., the Program's Investment Adviser, manages the
Program's investments and its business operations under the overall supervision
of the Program's Board of Directors. The Investment Adviser has the
responsibility for making all investment decisions for the Program. For the
fiscal year ended December 31, 2002, the Investment Adviser received a fee at
the annual rate of 0.50% of the Program's average daily net assets.
Fund Asset Management was organized as an investment adviser in 1977 and
offers investment advisory services to more than 50 registered investment
companies. Fund Asset Management and its affiliates, including Merrill Lynch
Investment Managers, had approximately $442 billion in investment company and
other portfolio assets under management as of March, 2003. This amount includes
assets managed for Merrill Lynch affiliates.
The Investment Adviser, together with the Administrators of the Program,
Merrill Lynch, Pierce, Fenner & Smith Incorporated, Prudential Securities
Incorporated, Morgan Stanley Dean Witter Inc., and Smith Barney Inc., is also
responsible for the overall management of the Program's business operations.
The Administrators perform certain management services necessary for the
operation of the Program and provide office space, facilities and necessary
personnel for such services. For these services, the Investment Adviser pays
the Administrators an aggregate monthly fee at the annual rate of 0.20% of the
Program's average daily net assets.
18 THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM
FINANCIAL HIGHLIGHTS
- --------------------------------------------------------------------------------
The Financial Highlights table is intended to help you understand the
Program's financial performance for the past five years. Certain information
reflects the financial results for a single Program share. The total returns in
the table represent the rate that an investor would have earned or lost on an
investment in the Program (assuming reinvestment of all dividends). The
information has been audited by Deloitte & Touche LLP, whose report, along with
the Program's financial statements, is included in the Program's Annual Report,
which is available upon request.
For the Year Ended December 31,
-------------------------------------------------
Increase (Decrease) in Net Asset Value: 2002 2001 2000 1999 1998
Per Share Operating Performance:
- ------------------------------------------------------------------------------------------------------------
Net asset value, beginning of year $16.96 $17.33 $16.35 $18.50 $19.22
- ------------------------------------------------------------------------------------------------------------
Investment income -- net .88* .85 .85 .79 .88
- ------------------------------------------------------------------------------------------------------------
Realized and unrealized gain (loss) on investments -- net .29 (.37) .98 (2.00) .12
- ------------------------------------------------------------------------------------------------------------
Total from investment operations 1.17 .48 1.83 (1.21) 1.00
- ------------------------------------------------------------------------------------------------------------
Less dividends and distributions:
Investment income -- net (.88) (.85) (.85) (.79) (.88)
Realized gain on investments -- net --+ -- -- (.84)
In excess of realized gain on investments -- net -- -- -- (.15) --
- ------------------------------------------------------------------------------------------------------------
Total dividends and distributions (.88) (.85) (.85) (.94) (1.72)
- ------------------------------------------------------------------------------------------------------------
Net asset value, end of year $17.25 $16.96 $17.33 $16.35 $18.50
- ------------------------------------------------------------------------------------------------------------
Total Investment Return:
- ------------------------------------------------------------------------------------------------------------
Based on net asset value per share 7.09% 2.81% 11.57% (6.77%) 5.35%
- ------------------------------------------------------------------------------------------------------------
Ratios to Average Net Assets:
- ------------------------------------------------------------------------------------------------------------
Expenses, net of reimbursement .77% .82% .79% .79% .76%
- ------------------------------------------------------------------------------------------------------------
Expenses .77% .82% .79% .79% .76%
- ------------------------------------------------------------------------------------------------------------
Investment income -- net 5.16% 4.89% 5.06% 4.47% 4.54%
- ------------------------------------------------------------------------------------------------------------
Supplemental Data:
- ------------------------------------------------------------------------------------------------------------
Net assets, end of year (in thousands) $395,668 $405,385 $430,491 $432,433 $525,583
- ------------------------------------------------------------------------------------------------------------
Portfolio turnover 40% 76% 111% 222% 178%
- ------------------------------------------------------------------------------------------------------------
+ Amount is less than $.01 per share. * Based on average shares outstanding.
THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM 19
[FLOW CHART]
THE MUNICIPAL FUND INVESTMENT ACCUMULATION PROGRAM
For More Information
[Graphic]
Shareholder Reports
Additional information about the Program's investments is available in the
Program's Annual and Semi-Annual Reports. In the Program's annual report you
will find a discussion of the market conditions and investment strategies that
significantly affected the Program's performance during its last fiscal year.
You may obtain these reports at no cost by calling 1-800-MER-FUND.
The Program will send you one copy of each shareholder report and certain other
mailings, regardless of the number of Program accounts you have. To receive
separate shareholder reports for each account, write to the Program Agent at its
mailing address. Include your name, address, tax identification number and
brokerage or Program account number. If you have any questions, please call your
securities dealer or call the Program Agent at 1-800-221-7771. Statement of
Additional Information
The Statement of Additional Information contains further information about the
Program. The portions of the Statement of Additional Information relating to the
Program are incorporated by reference into (legally considered part of) this
Prospectus. The portions of the Statement of Additional Information that do not
relate to the Program are not incorporated by reference, are not part of this
Prospectus, and should not be relied on by investors in the Program. You may
request a free copy by writing the Program at The Bank of New York, 100 Church
Street, New York, New York 10007 or by calling 1-800-221-7771.
Information about the Program (including the Statement of Additional
Information) can be reviewed and copied at the SEC's Public Reference Room in
Washington, D.C. Call 1-202-942-8090 for information on the operation of the
public reference room. This information is also available on the SEC's Internet
site at http://www.sec.gov and copies may be obtained upon payment of a
duplicating fee by electronic request at the following e-mail address:
publicinfo@sec.gov, or by writing the Public Reference Section of the SEC,
Washington, D.C. 20549-0102.
You should rely only on the information contained in this Prospectus. No one is
authorized to provide you with information that is different from the
information contained in this Prospectus.
Investment Company Act file #811-2694
Code #19102-0403
(C)Fund Asset Management, L.P.
[LOGO]Merrill Lynch Investment Managers
Prospectus
April 30, 2003
The Municipal Fund
Investment Accumulation Program
This Prospectus contains information you should know before investing,
including information about risks. Please read it before you invest and keep it
for future reference.
The Securities and Exchange Commission has not approved or disapproved these
securities or passed upon the adequacy of this Prospectus. Any representation to
the contrary is a criminal offense.
www.mlim.ml.com
STATEMENT OF ADDITIONAL INFORMATION
THE MUNICIPAL FUND ACCUMULATION PROGRAM, INC.
P.O. Box 9011, Princeton, New Jersey 08543-9011. Phone No. (609) 282-2800
This Statement of Additional Information of The Municipal Fund Accumulation
Program, Inc. (the "Program") is not a prospectus and should be read in
conjunction with the Prospectus of the Program, dated April 30, 2003, which has
been filed with the Securities and Exchange Commission (the "Commission") and
can be obtained, without charge, by calling 1-800-MER-FUND or by writing to the
Program at the above address. The Program's Prospectus is incorporated by
reference into this Statement of Additional Information, and Part I of this
Statement of Additional Information and the portions of Part II of this
Statement of Additional Information that relate to the Program have been
incorporated by reference into the Program's Prospectus. The portions of Part II
of this Statement of Additional Information that do not relate to the Program do
not form a part of the Program's Statement of Additional Information, have not
been incorporated by reference into the Program's Prospectus and should not be
relied upon by investors in the Program. The Program's audited financial
statements are incorporated by reference into this Statement of Additional
Information by reference to the Program's 2002 Annual Report. You may request a
copy of the Annual Report at no charge by calling 1-800-637-3863 between 8:30
a.m. and 5:30 p.m. Eastern time on any business day.
Investment Adviser
Fund Asset Management, L.P.
Administrators
Merrill Lynch, Pierce, Fenner & Smith Incorporated
Prudential Securities Incorporated
Morgan Stanley Dean Witter Inc.
Smith Barney Inc.
The date of this Statement of Additional Information is April 30, 2003.
Table Of Contents
Part I
The Program I-1
Investment Objectives and Policies I-2 Investment Restrictions
I-3 Information on Trustees and Directors I-4 Management and
Arrangements I-8 Computation of Offering Price I-9 Portfolio
Transactions and Brokerage I-9 Fund Performance I-10 Additional
Information I-10 Financial Statements I-11
Part II
Investment Risks and Considerations II-1
Management and other Service Arrangements II-31
Purchase of Shares II-34
Redemption of Shares II-42
Shareholder Services II-43
Pricing of Shares II-48
Portfolio Transactions and Brokerage II-49
Dividends and Taxes II-52
Performance Data II-56
General Information II-58
Appendix A A-1
PART I: SPECIAL INFORMATION ABOUT THE MUNICIPAL FUND ACCUMULATION PROGRAM
Part I of this Statement of Additional Information sets forth information about
The Municipal Fund Accumulation Program (the "Program"). It includes information
about the Program's Board of Directors, the advisory services provided to and
the management fees paid by the Program, performance data for the Program, and
information about other fees paid by and services provided to the Program. This
Part I should be read in conjunction with the Program's Prospectus and those
portions of Part II of this Statement of Additional Information that pertain to
the Program.
I. The Program
In General
The investment objective of the Program is to provide shareholders with income
exempt from Federal income tax through investment in a diversified portfolio of
interest bearing long- and intermediate-term state, municipal and public
authority bonds, the interest on which is, in the opinion of bond counsel to the
issuing authorities, exempt from Federal income tax. This investment objective
is a fundamental policy of the Program and may not be changed without a vote of
the majority of the outstanding shares of the Program. The Program is classified
as a diversified fund under the Investment Company Act of 1940, as amended (the
"Investment Company Act").
The shares of capital stock, $.01 par value, of the Program ("Shares") are
offered without sales charge to the holders of units ("Units") of all series of
Municipal Investment Trust Fund (the "Unit Trust Funds") and Defined Asset Funds
- -- Municipal Insured Series. The Unit Trust Funds consist of a number of
different unit investment trusts holding portfolios of state, municipal and
public authority bonds. The Program has been formed to facilitate reinvestment
of distributions on units (the "Units") of the various series of the Unit Trust
Funds. Since the Program is an open-end investment company, the Shares are
redeemable by the holder at the net asset value next determined after the
receipt of the redemption request in proper form.
Terms and Conditions of Participation
All persons who are or who become registered holders of Units of series of the
Unit Trust Funds offering a reinvestment option are eligible to participate in
the Program and are herein called "Holders." Holders include brokers or nominees
of banks and other financial institutions that are or become registered holders
of Units. Such eligibility is subject to the terms and conditions of
participation (the "Terms and Conditions") set forth under this caption.
Distributions on Units of series of the Unit Trust Funds offering a reinvestment
option will be paid in cash unless Holders elect to reinvest such distributions
in the Program by sending a notice in writing to the Program agent. Each Holder
participating in the Program will receive a copy of the Program's Prospectus and
may request a copy of the Program's Statement of Additional Information; a
Holder not participating in the Program may request a copy of the Prospectus and
this Statement of Additional Information. Holders of Units may elect to
participate in the Program or to change a previous election by notice in writing
to the Program agent. Notice of any change in the basis of participation or of
election to participate in the Program must be received by the Program agent in
writing at least ten days prior to the record day for the first distribution to
which such notice is to apply.
Under these Terms and Conditions, both distributions of interest income and
distributions of capital gains, if any, and principal (or either such type of
distribution) on Units of Holders participating in the Program will be invested
without sales charge in Shares. Holders who are participating in the Program and
whose Units are therefore subject to these Terms and Conditions are herein
called "Shareholders" The Bank of New York (100 Church Street, New York, New
York 10007), will act as the Program agent (the "Agent") for the Shareholders.
All securities, cash and other similar assets of the Program will be held by the
Agent as custodian. The Agent also acts as the Program's dividend disbursing
agent, transfer agent and registrar and performs certain other services for the
Program.
Under these Terms and Conditions, each distribution of interest income and
capital gains, if any, and principal on a Shareholder's Units, will, on the date
of such distribution, automatically be received by the Agent on behalf of such
Shareholder and applied to purchase Shares at net asset value, without sales
charge. In the case of Holders of Units whose distributions of principal are
being invested in the Program, the proceeds of redemption or payment at maturity
of securities held in the unit investment trust represented by the Holder's
Units will be invested in Shares, rather than being distributed in cash to the
Holder. Net interest income, after expenses, received by the Program on
obligations in its portfolio will be distributed by the Program monthly and net
realized capital gains, if any, will be distributed at least annually. Such
distributions will be reinvested automatically in Shares of the Program unless
the Shareholder elects, by written notice to the Agent, not to have such
distributions reinvested in Shares.
The Program has qualified and intends to continue to qualify (i) for the tax
treatment applicable to "regulated investment companies" under the Internal
Revenue Code of 1986, as amended (the "Code") and (ii) to pay "exempt-interest"
dividends as permitted under the Code. Pursuant to such qualification, if the
Program distributes to Shareholders (without regard to designated capital gains
distributions) an amount equal to or in excess of the sum of 90% of its
investment company taxable income and 90% of its net tax-
I-1
exempt interest income, such "exempt-interest" dividends reflecting tax-exempt
interest received by the Program will be tax-exempt in the hands of
Shareholders, except possibly where a Shareholder might be deemed to be a
"substantial user" as defined in the Code, or subject to alternative minimum
tax. The Program will not be subject to Federal income tax on such part of its
net capital gains, if any, as it distributes to Shareholders, although it may be
subject to certain state and local taxes. For these purposes, any capital gains
of the Program which are re-invested are considered to have been distributed. In
addition to their right to redeem their Shares and receive a payment equal to
the net asset value thereof, Shareholders may at any time, by so notifying the
Agent in writing (the Agent will deliver a copy of such notice to the trustee
for the respective series of the Unit Trust Funds), elect to (i) terminate their
participation in the Program and thereafter receive all distributions on their
Units in cash, (ii) terminate their participation in part as to distributions of
capital gains and principal on their Units and thereafter receive distributions
in cash out of the principal accounts for the respective Unit Trust Funds or
(iii) terminate their participation in part as to distributions of interest on
their Units and thereafter receive future distributions in cash out of the
interest accounts for the respective series.
All the costs of establishing and administering the Program and these Terms and
Conditions are borne by the Program. The administrators of the Program (the
"Administrators") are Merrill Lynch, Pierce, Fenner & Smith Incorporated
("Merrill Lynch"), Prudential Securities Incorporated, Morgan Stanley Dean
Witter Inc., and Smith Barney Inc., which are sponsors of Unit Trust Funds. The
investment adviser to the Program is Fund Asset Management, L.P. (the
"Investment Adviser" or "FAM"), a registered investment adviser and an affiliate
of Merrill Lynch. The Investment Adviser receives as annual compensation,
payable monthly, for its services in connection with the Program a fee of 0.50%
of the average net assets of the Program. The Administrators receive from the
Investment Adviser as annual compensation, payable monthly, for their services
in connection with the Program a fee of 0.20% of the average net assets of the
Program.
The Agent will mail to each Shareholder a report of each transaction undertaken
for such Shareholder in receiving distributions and purchasing Shares.
Distributions on Units which are applied to purchase Shares are considered to
have been distributed to Shareholders for Federal income tax purposes, and all
taxes which are payable in respect to such distributions must be paid by
Shareholders regardless of participation in the Program.
On tender for redemption of any or all of his Shares, a Shareholder will be
entitled to receive within seven days a payment representing the net asset value
of the Shares (including fractional Shares), provided that such right of
redemption may be suspended or postponed under certain circumstances.
If the Holder is a broker or a nominee of a bank or another financial
institution, the trustee and Agent will apply these Terms and Conditions on the
basis of the respective numbers of Units certified from time to time by such
Holder to be the total numbers of Units registered in such Holder's name and
held for the accounts of beneficial owners who are to participate in the
Program, upon the several bases of participation offered by the Program at the
time. It is anticipated, however, that, due to administrative problems connected
with Units held in "street name" other than by Merrill Lynch, such Units will be
registered in the names of the beneficial owners thereof unless such owners
elect not to participate in the Program.
Merrill Lynch or its nominee holds in its name Program Shares for the accounts
of customers whose Unit Trust Funds are held in Merrill Lynch accounts and who
elect to reinvest in the Program. These Shares may be transferred to an account
in the customer's name with the Agent upon request. Merrill Lynch maintains
records identifying the names and addresses of these customers and their Share
balances, and will be compensated for these services by the Agent out of fees it
receives from the Program.
Experience may indicate that changes in these Terms and Conditions are desirable
or that this offering should be terminated. Such changes may be made or this
offering may be terminated at the direction of the Board of Directors of the
Program (the "Directors") without notice to any Shareholder. The Directors may
at any time appoint a substitute agent or an additional agent to act for the
Program.
II. Investment Objectives and Policies
The investment objective of the Program is to provide shareholders with income
exempt from Federal income tax through investment in a diversified portfolio of
interest bearing long- and intermediate-term state, municipal and public
authority bonds, the interest on which is, in the opinion of bond counsel to the
issuing authorities, exempt from Federal income tax ("Municipal Bonds"). The
Program invests, under normal circumstances, at least 80% of its net assets in
Municipal Bonds. For this purpose, net assets include any borrowings for
investment purposes. The Program's investment objective and policy of investing
at least 80% of its net assets in Municipal Bonds are fundamental policies of
the Program that may not be changed without approval of a majority of the
Program's outstanding shares.
In making the Program's investments in Municipal Bonds, the Investment Adviser
considers the following factors, among others:
(i) the quality of the Municipal Bonds: not less than 75% of the Program's
total assets will be invested in
I-2
Municipal Bonds that (a) will (determined on the basis of current value)
at the time of acquisition be rated "A" or better by a nationally
recognized statistical rating organization ("NRSRO"), including Standard
& Poor's ("Standard & Poor's"), Fitch Ratings ("Fitch") or Moody's
Investors Service, Inc. ("Moody's"), and all of which will at such time
be rated "BBB/ Baa" or better by a NRSRO or (b) will have, in the opinion
of the Adviser, similar credit characteristics. (Under current market and
other conditions, the Board has determined that all of the Municipal
Bonds in which the Program invests will at the time of acquisition be
rated "BBB" or "Baa" or better by the NRSROs or will have, in the opinion
of the Adviser, similar credit characteristics. No
split-rating below "BBB" or "Baa" by one or more of the NRSROs at the
time of the acquisition will be permitted.)
(ii) the yield and price of the Municipal Bonds relative to other Municipal
Bonds of comparable quality and maturity;
(iii) the maturity of the Municipal Bonds; and
(iv) the diversification of the Municipal Bonds as to purpose of issue and
location of issuer, taking into account the availability in the market of
issuers which meet the Program's quality, rating, yield and price
criteria.
While the Program will invest the proceeds of the sale of its Shares (and other
cash proceeds such as those generated by redemptions, maturities or sales of
portfolio securities) as promptly as possible, some short period of time may
elapse between the time the Program receives such proceeds and the time such
proceeds are invested by the Program. However, the Program reserves the right to
extend such period for defensive purposes. During such periods such proceeds may
be held in cash or invested in temporary investments (principally state,
municipal and public authority notes, bonds and commercial paper) ("Temporary
Investments") that have credit characteristics, in the opinion of the Investment
Adviser, similar to those provided for other portfolio securities and the
interest income on which is, in the opinion of counsel to the issuing
authorities, exempt from Federal income tax. The Program will not invest in
short-term obligations other than those on which the interest income is, in the
opinion of counsel to the issuing authorities, exempt from Federal income tax.
The Fund may also invest in variable rate demand obligations ("VRDOs") and VRDOs
in the form of participation interests ("Participating VRDOs") in variable rate
tax-exempt obligations held by a financial institution.
The fact that a Municipal Bond may cease to be rated or that its rating may be
reduced below the ratings referred to above will not require that it be
eliminated from the portfolio but will be considered by the Investment Adviser
in determining whether it should be retained or sold.
A portion of the Program's assets may be invested in Municipal Bonds rated BBB/
Baa by one or more NRSROs. Although Municipal Bonds rated BBB normally exhibit
adequate protection parameters, they entail a greater degree of risk and are of
a more speculative nature than obligations rated in the higher categories.
Therefore, adverse economic conditions or changing circumstances are more likely
to lead to a weakened capacity to pay interest and repay principal for debt
obligations in this category than in higher rated categories. Municipal Bonds
rated Baa are also speculative in nature and entail greater risks than those
rated in higher categories. Although interest payments and principal security
may appear adequate for the present, certain protective elements may be lacking
or may be characteristically unreliable over any great length of time.
At the time that Municipal Bonds are originally issued, opinions relating to the
validity of such Municipal Bonds and to the exemption of interest thereon from
Federal income taxes are rendered by counsel to the respective issuing
authorities. The Program, the Investment, the Administrators, the Agent, or
their counsel, will make any review of the proceedings relating to the issuance
of the . Municipal Bonds or the basis for such opinions.
The Program does not intend to concentrate its investments in obligations of
any one state.
III. Investment Restrictions
The Program has adopted a number of fundamental and non-fundamental investment
restrictions and policies relating to the investment of its assets and its
activities. The fundamental policies set forth below may not be changed without
the approval of the holders of a majority of the Program's outstanding voting
securities (which for this purpose and under the Investment 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).
Set forth below are the Program's fundamental restrictions. Unless otherwise
provided, all references below to the assets of a Program are in terms of
current market value.
Under its fundamental investment restrictions, the Program may not:
I-3
(1) invest in securities or other investments other than Municipal Bonds and
short-term tax exempt securities, the interest on which is, in the opinion
of counsel to the issuing authorities, exempt from Federal income tax;
(2) invest more than 25% of its assets, taken at market value at the time of
each investment, in the securities of issuers in any particular industry
(excluding the U. S. Government and its agencies and instrumentalities). For
purposes of this restriction, states, municipalities and their political
subdivisions are not considered part of any industry.
(3) purchase securities on margin (but the Program may obtain such short term
credits as may be necessary for the clearance of purchases and sales of
securities), make short sales of securities, maintain a short position or
write or purchase put or call options;
(4) borrow money, except from banks as a temporary measure for emergency
purposes, where such borrowings would not exceed 5% of its total assets
(taken at current value);
(5) pledge assets except to secure indebtedness permitted by (3) above, with
pledged assets to be no more than 10% of its total net assets (taken at
current value);
(6) purchase any security if as a result (a) more than 5% of the Program's total
assets (taken at current value) would be invested in securities of the
issuer thereof (other than securities issued or guaranteed by the United
States government) or (b) the Program would hold more than 10% of any class
of securities of the issuer thereof other than securities issued or
guaranteed by the United States government (taking all debt issued as a
single class) or more than 10% of the voting securities of the issuer
thereof;
(7) invest for the purpose of exercising control or management of any company;
(8) invest in securities of other investment companies, except as part of a
merger, consolidation, purchase of assets or similar transaction approved
by the Program's Shareholders;
(9) make investments in oil, gas or other mineral exploration programs,
commodities, commodity contracts or real estate, although the Program may
invest in securities secured by real estate or interests therein or issued
by companies, including real estate investment trusts, which deal in real
estate or interests therein;
(10) act as an underwriter except as it may be deemed such in a sale of
restricted securities;
(11) participate on a joint (or joint and advised or sponsored by the Adviser or
any of its affiliates to reduce brokerage commissions or otherwise to
achieve the best overall execution not being considered participation in a
trading account in securities);
(12) purchase or retain securities of an issuer if, to the knowledge of the
Program, an officer or director of the Program or the Adviser owns
beneficially more than 1/2 of 1% of such shares or securities of such
issuer and all such directors and officers owning more than 1/2 of 1% of
such shares or securities together own more than 5% of such shares or
securities; or
(13) make loans, except through the purchase of debt obligations.
Except in the case of the restriction set forth in clause (12), the foregoing
percentages will apply at the time of the purchase of a security and shall not
be considered violated unless an excess or deficiency occurs or exists
immediately after and as a result of a purchase of such security.
For purposes of the investment restrictions set forth in clause (9), the term
"exploration programs" includes oil, gas or other mineral leases, as well as
exploration programs.
The Program does not have a policy with respect to the issuance of senior
securities. However, the Program currently does not intend to issue any senior
securities.
For purposes of investment restriction (2) above, industry means any one or more
of the industry sub-classifications used by one or more widely recognized market
indices or ratings group indices, and/or as defined by Program management.
IV. Information on Trustees and Directors
The Board of Directors of the Program consists of eight individuals, seven of
whom are not "interested persons" of the Program as defined in the Investment
Company Act (the "non-interested Directors"). The Directors are responsible for
the overall supervision of the operations of the Program and perform the various
duties imposed on the directors or trustees of investment companies by the
Investment Company Act.
Each non-interested Director is a member of the Program's Audit and Oversight
Committee (the "Committee"). The principal responsibilities of the Committee are
the appointment, compensation and oversight of the Program's independent
accountants, including the resolution of disagreements regarding financial
reporting between Program management and such independent accountants. The
Committee's responsibilities include, without limitation, to (i) review with the
independent accountants the arrangements for and scope of annual and special
audits and any other services provided by the independent accountants to the
Program; (ii) discuss with the independent accountants certain matters relating
to the Program's financial statements, including any adjustment to such
financial statements recommended by such independent accountants or any other
results of any audit; (iii) ensure that the independent accountants submit on a
periodic basis a formal written statement with respect to their independence,
discuss
I-4
with the independent accountants any relationships or services disclosed in the
statement that may impact the objectivity and independence of the Program's
independent accountants and recommend that the Board take appropriate action in
response thereto to satisfy itself of the independent accountants' independence;
and (iv) consider the comments of the independent accountants with respect to
the quality and adequacy of the Program's accounting and financial reporting
policies and practices and internal controls and Program management's responses
thereto. The Board of the Program has adopted a written charter for the
Committee. The Committee also reviews and nominates candidates to serve as
non-interested Directors. The Committee generally will not consider nominees
recommended by shareholders. The Committee has retained independent legal
counsel to assist it in connection with these duties. The Committee met four
times during the fiscal year ended December 31, 2002.
Biographical Information
Certain biographical and other information relating to the non-interested
Directors of the Program is set forth below, including their ages, their
principal occupations for at least the last five years, the length of time
served, the total number of portfolios overseen in the complex of funds advised
by the Investment Adviser and its affiliate, Merrill Lynch Investment Managers,
L.P. ("MLIM") ("MLIM/FAM-advised funds") and other public directorships:
Number
of
Term of MLIM/
Position(s) Office** FAM-
Held with and Length Advised
Name, Address* and the of Time Principal Occupation During Funds
Age of Director Program Served Past Five Years Overseen
--------------- ----------- ---------- --------------------------- ----------
Ronald W. Forbes (62) Director Director Professor Emeritus of Finance, School of Business, 44
since State University of New York at Albany since 2000 registered
1977 and Professor thereof from 1989 to 2000; International investment
Consultant, Urban Institute, Washington, D.C. from companies
1995 to 1999. consisting
of
50
portfolios
Cynthia A. Montgomery (50) Director Director Professor, Harvard Business School since 1989; 44
since Associate Professor, J.L. Kellogg Graduate School of registered
1993 Management, Northwestern University from 1985 to investment
1989; Associate Professor, Graduate School of companies
Business Administration, the University of Michigan consisting
from 1979 to 1985. of
50
portfolios
Charles C. Reilly (71) Director Director Self-employed financial consultant since 1990; 44
since President and Chief Investment Officer of Verus registered
1991 Capital, Inc. from 1979 to 1990; Senior Vice President investment
of Armhold and S. Bleichroeder, Inc. from 1973 to companies
1990; Adjunct Professor, Columbia University consisting
Graduate School of Business from 1990 to 1991; of
Adjunct Professor, Wharton School, University of 50
Pennsylvania from 1989 to 1990; Partner, Small Cities portfolios
Cable Television from 1986 to 1997.
Kevin A. Ryan (70) Director Director Founder
and currently Director Emeritus of the
Boston 44 since University Center for
the Advancement of Ethics and registered
1992 Character and Director thereof from
1989 to 1999; investment
Professor from 1982 to 1999
and currently Professor
companies Emeritus of
Education of Boston
University; formerly
consisting taught on the
faculties of The University
Chicago, of Stanford
University and Ohio State
University. 50
portfolios
Roscoe S. Suddarth (67) Director Director President, Middle East Institute, from 1995 to 2001; 44
since Foreign Service Officer, United States Foreign registered
2000 Service, from 1961 to 1995; Career Minister, from investment
1989 to 1995; Deputy Inspector General, U.S. companies
Department of State, from 1991 to 1994; U.S. consisting
Ambassador to the Hashemite Kingdom of Jordan, of
from 1987 to 1990. 50
portfolios
Name, Address* and Public
Age of Director Directorships
--------------- -------------
Ronald W. Forbes (62) None
Cynthia A. Montgomery (50) Unum Provident
Corporation
(insurance products);
Newell Rubbermaid Inc
(manufacturing)
Charles C. Reilly (71) None
Kevin A. Ryan (70) None
Roscoe S. Suddarth (67) None
I-5
Number
of
Term of MLIM/
Position(s) Office** FAM-
Held with and Length Advised
Name, Address* and the of Time Principal Occupation During Funds
Age of Director Program Served Past Five Years Overseen
--------------- ----------- ---------- ---------------------------------------------------- ----------
Richard R. West (65) Director Director Professor of Finance from 1982 to 1994; Dean of New 44
since York University Leonard N. Stern School of Business registered
1981 from 1984 to 1993; Dean Emeritus since 1994. investment
companies
consisting
of
50
portfolios
Edward D. Zinbarg (68) Director Director Self-employed financial consultant since 1994; 44
since Executive Vice President of the Prudential Insurance registered
2000 Company of America from 1988 to 1994; Former investment
Director of Prudential companies
Reinsurance Company and former Trustee of the consisting
Prudential Foundation. of
50
portfolios
Name, Address* and Public
Age of Director Directorships
--------------- ---------------------------
Richard R. West (65) Bowne & Co., Inc.
(Financial printers);
Vornado Realty Trust, Inc.
(real estate holding
company); Alexander's,
Inc. (real estate company);
Vornado Operating
Company (real estate
company)
Edward D. Zinbarg (68) None
- --------
* The address of each non-interested Director is P.O. Box 9095, Princeton, New
Jersey 08543-9095.
** Each Director serves until his or her successor is elected and qualified,
until December 31 of the year in which he or she turns 72, or until his or
her death, resignation, or removal as provided in the Program's by-laws,
charter or by statute.
Certain biographical and other information relating to the Director who is an
officer and an "interested person" of the Program as defined in the Investment
Company Act (the "interested Director") and to the other officers of the Program
is set forth below, including their ages, their principal occupations for at
least the last five years, the length of time served, the total number of
portfolios overseen in MLIM/FAM-advised funds and public directorships held.
Number
of
MLIM/
Term of FAM-
Position(s) Office** Advised
Held with and Length Funds and
The of Time Principal Occupation(s) During Portfolios Public
Name, Address* and Age Program Served Past Five Years Overseen Directorships
---------------------- ----------- ------------ ----------------------------------------------------- ---------- -------------
Terry K. Glenn*** (62) President President President and Chairman of the MLIM/FAM-advised 117 None
and and funds since 1999; Chairman (Americas Region) of registered
Director Director**** MLIM from 2000 to 2002; Executive Vice President investment
since 1999 of MLIM and FAM (which terms as used herein companies
include their corporate predecessors) from 1983 to consisting
2002; President and Director of Princeton Services of 161
since 1993; President of FAM Distributors, Inc. portfolios
("FAMD") from 1986 to 2002 and Director thereof
from 1991 to 2002; Executive Vice President and
Director of Princeton Services, Inc. L.P. ("Princeton
Services") from 1988 to 2002; Director of Financial
Data Services, Inc. ("FDS") from 1985 to 2002
Robert C. Doll, Jr. (47) Senior Senior Vice President of MLIM and FAM since 2001; Co-Head 45 None
Vice President (Americas Region) thereof from 2000 to 2001 and registered
President since Senior Vice President thereof from 1999 to 2001; investment
1999 Director of Princeton Services since 2001; Chief companies
Investment Officer of OppenheimerFunds, Inc. in consisting
1999 and Executive Vice President thereof from 1991 of 69
to 1999. portfolios
I-6
Number
of
MLIM/
FAM-
Term of Advised
Position(s) Office** Funds
Held with and Length and
Name, Address* The of Time Principal Occupation(s) During Portfolios
and Age Program Served Past Five Years Overseen
-------------- ----------- ----------- ----------------------------------------------------- ----------
Donald C. Burke (42) Vice Vice First Vice President of FAM and MLIM since 1997 116
President President and the Treasurer thereof
since 1999; Senior Vice registered and since
1993, President and Treasurer of Princeton since
1999; Vice investment Treasurer Treasurer
President of FAMD since 1999. Vice President of
companies
since 1999 FAM and MLIM from 1990 to 1997; Director of consisting
Taxation of MLIM since 1990. of 160
portfolios
Kenneth A. Jacob (51) Senior Senior Vice Managing
Director of MLIM since 2000; First Vice 36 Vice
President President of MLIM from 1997 to 2000;
Vice President registered
President since 2002 of MLIM from 1984 to 1997; Portfolio Manager of investment
FAM and MLIM since 1997. companies
consisting
of 50
portfolios
John M. Loffredo (38) Senior Senior Vice Managing
Director of MLIM since 2000; First Vice 36 Vice
President President of MLIM from 1997 to 2000;
Vice President registered President since 2002 of
MLIM from 1991 to 1997; Portfolio Manager of
investment
FAM and MLIM since 1997. companies
consisting
of 50
portfolios
Theodore R. Jaeckel, Jr. (42) Vice Vice Director (Municipal Tax--Exempt Fund 6
President President Management) of the Adviser since 1997. Vice registered
and since 2001 President of the Adviser since 1991. investment
Portfolio companies
Manager consisting
of 6
portfolios
Brian D. Stewart (33) Secretary Secretary
Vice President (Legal Advisory) of
MLIM since 2002; 37 since 2002
Attorney associated with Reed Smith
LLP from 2001 registered
to 2002; Associate with Saul Ewing LLP from 1999 to investment
2001. companies
consisting
of 51
portfolios
Name, Address* Public
and Age Directorships
-------------- -------------
Donald C. Burke (42) None
Kenneth A. Jacob (51) None
John M. Loffredo (38) None
Theodore R. Jaeckel, Jr. (42) None
Brian D. Stewart (33) None
- --------
* Unless otherwise indicated, the address for each of officer listed in this
table is P.O. Box 9011, Princeton, New Jersey 08543-9011.
** Elected by and serves at the pleasure of the Board of Directors of the
Program.
*** Mr. Glenn is an "interested person" as defined in the Investment Company
Act, of the Program based on his former positions with MLIM, FAM, FAMD,
Princeton Services and Princeton Administrators, L.P.
**** As a Director, Mr. Glenn serves until his successor is elected and
qualified, until December 31 of the year in which he turns 72, or until his
death, resignation, or removal as provided in the Program's by-laws,
charter or by statute.
Share Ownership
Information relating to each Director's share ownership of the Program and in
all registered funds in the Merrill Lynch family of funds overseen by the
respective Director ("Supervised Merrill Lynch Funds") as of December 31, 2002
is set forth in the chart below:
Aggregate Dollar Range Aggregate Dollar Range of Securities in
Director of Equity in the Program All Supervised Merrill Lynch Funds
- -------- ------------------------ ---------------------------------------
Interested Director:
Terry K. Glenn Over
None $100,000
Non-Interested Directors:
Ronald W. Forbes Over
None $100,000
Cynthia A. Montgomery. $50,001-
None $100,000
Charles C. Reilly Over
None $100,000
Kevin A. Ryan Over
None $100,000
Roscoe S. Suddarth Over
None $100,000
Richard R. West Over
None $100,000
Edward D. Zinbarg Over
None $100,000
I-7
As of April 2, 2003, the Directors of the Program, as a group, owned an
aggregate of less than 1% of the outstanding shares of the Program. As of
December 31, 2002, none of the non-interested Directors or their immediate
family members owned beneficially or of record any securities issued by ML & Co.
Compensation of Directors
The Program pays each non-affiliated Director a combined fee for service on the
Board and the Committee of $1,100 per year plus $50 per Board in person meeting
attended. The Co-Chairmen of the Committee each receives an additional annual
fee of $1,000. The Program will also pay the out-of-pocket expenses of
Directors relating to attendance at meetings.
Set forth below is a chart showing the aggregate compensation paid by the
Program to each of its non-interested Directors for the fiscal year ended
December 31, 2002 and the total compensation paid to each Director from all
MLIM/FAM-advised funds for the calendar year ended December 31, 2002.
Pension or Retirement Aggregate
Benefits Accrued as Compensation
Compensation Part of from Program Fund
Director from the Program Program Expenses Complex(1)
-------- ---------------- --------------------- -----------------
Ronald W. Forbes* $2,500 None $308,400
Cynthia A. Montgomery $1,500 None $266,400
Charles C. Reilly* $2,500 None $308,400
Kevin A. Ryan $1,500 None $266,400
Roscoe S. Suddarth $1,500 None $266,400
Richard R. West $1,500 None $275,400
Edward D. Zinbarg $1,500 None $266,400
* Co-Chairman of the Committee.
(1) For information on the number of MLIM/FAM-advised funds from which each
Director receives compensation, see the chart on p.I-5.
IV. Management and Arrangements
The Program has entered into an investment advisory agreement with the
Investment Adviser ("the Investment Advisory Agreement"), pursuant to which the
Investment Adviser receives for its services to the Program monthly compensation
at the annual rate of 0.50% of the Program's average daily net assets.
The table below sets forth information about the total investment advisory fees
paid by the Program to the Investment Adviser for the periods indicated.
Fiscal Year Ended December 31, Management Fee
------------------------------ --------------
2002 $1,985,992
2001 $2,105,887
2000 $2,112,216
In connection with its consideration of the Investment Advisory Agreement, the
Board reviewed information derived from a number of sources and covering a range
of issues. The Board considered the services provided to the Program by the
Investment Adviser under the Investment Advisory Agreement, as well as other
services provided by the Investment Adviser and its affiliates under other
agreements, and the personnel who provide these services. In addition to
investment advisory services, the Investment Adviser and its affiliates provide
administrative services, shareholder services, oversight of fund accounting,
marketing services, assistance in meeting legal and regulatory requirements, and
other services necessary for the operation of the Program. The Board also
considered the Investment Adviser's costs of providing services, and the direct
and indirect benefits to the Investment Adviser from its relationship with the
Program. The benefits considered by the Board included not only the Investment
Adviser's compensation for investment advisory services and the Investment
Adviser's profitability under the Investment Adviser Agreement, but also
compensation paid to the Investment Adviser or its affiliates for other,
non-advisory services provided to the Program. In connection with its
consideration of the Investment Advisory Agreement, the Board also compared the
Program's advisory fee rate, expense ratios and historical performance to those
of comparable funds. Based in part on this comparison, and taking into account
the various services provided to the Program by the Investment Adviser and its
affiliates as well as the requirements of managing a municipal bond portfolio,
the Board concluded that the advisory fee rate was reasonable. The Board
considered whether there should be changes in the advisory fee rate or structure
in order to enable the Program to participate in any economies of scale that the
Investment Adviser may experience as result of growth in the Program's assets.
Based on the information reviewed and the discussions, the Board, including a
majority of the non-interested Directors, concluded that the advisory fee rate
was reasonable in relation to the services provided. The non-interested
Directors were represented by independent counsel who assisted them in their
deliberations.
I-8
Transfer Agency Services
The table below sets forth information about the total amounts paid by the Fund
to the transfer agent for the periods indicated.
Fiscal Year Ended December 31, Transfer Agent Fee*
------------------------------ -------------------
2002 $726,678
2001 $935,414
2000 $897,984
- --------
* During the fiscal year ended December 31, 2000 and the period January 1, 2001
to June 30, 2001, the Program paid fees to the transfer agent at lower rates
than the ones currently in effect. If the current rates had been in effect for
those periods, the fees paid may have been higher. The new rates became
effective July 1, 2001.
Accounting Services
The table below shows the amounts paid by the Fund to State Street Bank and
Trust Company ("State Street") and to the Investment Adviser for accounting
services for the periods indicated:
Paid to Paid to the
Fiscal Year Ended December 31, State Street Investment Adviser
------------------------------ ------------ ------------------
2002 $123,006 $ 12,486
2001 $125,686 * $ 14,650
2000 N/A $106,600
- --------
* Represents payments pursuant to the agreement with State Street effective
January 1, 2001.
VI. Computation of Offering Price
An illustration of the computation of the offering price for shares of the
Program based on the value of the Program's net assets and number of shares
outstanding as of December 31, 2002 is set forth below.
Net Assets $395,667,824
Number of Shares Outstanding 22,941,799
Net Asset Value Per Share (net assets Divided by number of shares Outstanding) $17.25
Offering Price $17.25
VII. Portfolio Transactions and Brokerage
See Part II "Portfolio Transactions and Brokerage" of this Statement of
Additional Information for more information.
Information about the brokerage commissions paid by the Program, including
commissions paid to Merrill Lynch, is set forth in the following table:
Aggregate Brokerage Commissions Paid
Fiscal year ended December 31, Commissions Paid to Merrill Lynch
------------------------------ ------------------- ----------------
2002 $19,680 $0
2001 $5,525 $0
2000 $ 0 $0
I-9
VIII. Fund Performance
Set forth below is information on the Program's average annual total return
expressed as a percentage based on a hypothetical $1000 investment (before and
after taxes) yield and tax-equivalent yield for the periods indicated:
Period Average Annual Total Return
------ ---------------------------------
One Year Ended December 31, 2002 7.09%
Five Years Ended December 31, 2002 4.06%
Ten Years Ended December 31, 2002. 11.57%
Average Annual Total Return
After Taxes on Dividends
---------------------------------
One Year Ended December 31, 2002 7.09%
Five Years Ended December 31, 2002 3.72%
Ten Years Ended December 31, 2002. 11.56%
Average Annual Total Return After
Taxes on Dividends and Redemption
---------------------------------
One Year Ended December 31, 2002 4.81%
Five Years Ended December 31, 2002 4.63%
Ten Years Ended December 31, 2002. 4.88%
Yield
---------------------------------
One Year Ended December 31, 2002 4.81%
Tax Equivalent Yield(a)
---------------------------------
30 Days Ended December 31, 2002 6.63%
(a) Based on a Federal income tax rate of 27.5%.
IX. Additional Information
Organization of the Program
The Program, an open-end diversified management investment company registered
under the Investment Company Act, was incorporated in Maryland on October 11,
1976. The Program does not intend to hold meetings of Shareholders unless under
the Investment Company Act Shareholders are required to act on any of the
following matters: (i) election of directors; (ii) approval of an investment
advisory agreement; (iii) approval of a distribution plan or (iv) ratification
of selection of independent accountants.
Description of Shares
The Program is authorized to issue a total of 100,000,000 Shares of $.01 par
value each. Shares are fully paid and non-assessable when issued, have no
pre-emptive, conversion or exchange rights and are transferable without
restriction. Each share entitles the holder to one vote at all meetings of
shareholders. Cumulative voting is not permitted. Thus the holders of more than
50% of the shares voting for the election of the Directors can elect all of the
Directors of the Program if they choose to do so and in such event the holders
of the remaining shares would not be able to elect any Directors. Holders of
Shares are entitled to participate equally in dividends and distributions, and,
in addition, in the event of the distribution or liquidation of the Program the
holders of Shares will be entitled to participate equally in any assets of the
Program. Unless requested to do so by a Shareholder, the Program will not
ordinarily issue certificates representing Shares but will instead establish for
each Shareholder through the Agent an account under which such Shares are held
for safekeeping.
Principal Shareholders
To the knowledge of the Program, no entity owned beneficially 5% or more of the
Program's shares as of April 11, 2003.
I-10
X. Financial Statements
The Program's audited financial statements are incorporated in the Program's
Statement of Additional Information by reference to its 2002 Annual Report. You
may request a copy of the Annual Report at no extra charge by calling
1-800-637-3863 between 8:30 a.m. and 5:30 p.m. Eastern time on any business day.
I-11
PART II
Part II of this Statement of Additional Information contains information about
the following funds: Core Bond Portfolio, High Income Portfolio and
Intermediate Term Portfolio of Merrill Lynch Bond Fund, Inc. ("Bond Fund");
Merrill Lynch California Insured Municipal Bond Fund of the Merrill Lynch
California Municipal Series Trust ("California Insured"); Merrill Lynch Low
Duration Fund of Merrill Lynch Investment Managers Funds, Inc. ("Low
Duration"); Insured Portfolio, National Portfolio and Limited Maturity
Portfolio of Merrill Lynch Municipal Bond Fund, Inc. ("Municipal Bond");
Merrill Lynch Municipal Intermediate Term Fund of Merrill Lynch Municipal
Series Trust ("Municipal Intermediate Term"); Merrill Lynch Florida Municipal
Bond Fund ("Florida Municipal Bond"), Merrill Lynch New Jersey Municipal Bond
Fund ("New Jersey Municipal Bond"), Merrill Lynch New York Municipal Bond Fund
("New York Municipal Bond") and Merrill Lynch Pennsylvania Municipal Bond Fund
("Pennsylvania Municipal Bond") of Merrill Lynch Multi-State Municipal Series
Trust;Merrill Lynch Short Term U.S. Government Fund, Inc. ("Short Term U.S.
Government"); Merrill Lynch U.S. Government Mortgage Fund ("U.S. Government
Mortgage"); Merrill Lynch U.S. High Yield Fund, Inc. ("U.S. High Yield");
Merrill Lynch World Income Fund, Inc. ("World Income"); and The Municipal Fund
Investment Accumulation Program ("Municipal Investment Accumulation").
Throughout this Statement of Additional Information, each of the above listed
funds may be referred to as a "Fund" or collectively as the "Funds." California
Insured, Municipal Bond, Municipal Intermediate Term, Florida Municipal Bond,
New Jersey Municipal Bond, New York Municipal Bond, Pennsylvania Municipal Bond
and Municipal Investment Accumulation are collectively referred to herein as the
"Municipal Funds."
Each Fund is organized either as a Maryland corporation or a Massachusetts
business trust. In each jurisdiction, nomenclature varies. For ease and clarity
of presentation, shares of common stock and shares of beneficial interest are
referred to herein as "shares" or "Common Stock," holders of shares or Common
Stock are referred to as "shareholders," the trustees or directors of each Fund
are referred to as "Directors," Merrill Lynch Investment Managers, L.P. ("MLIM")
or Fund Asset Management, L.P. ("FAM"), as applicable, is the investment adviser
or manager of each Fund and each is referred to as the "Manager," and the
investment advisory agreement or management agreement applicable to each Fund is
referred to as the "Management Agreement." Each Fund's Articles of Incorporation
or Declaration of Trust is referred to as its "charter." The Investment Company
Act of 1940, as amended, is referred to herein as the "Investment Company Act"
and the Securities and Exchange Commission is referred to as the "Commission."
Certain Funds are "feeder" funds (each, a "Feeder Fund") that invest all of
their assets in a corresponding "master" portfolio (each, a "Master Portfolio")
of a master trust (each, a "Master Trust"), a mutual fund that has the same
objective as the corresponding Feeder Fund. All investments will be made at the
level of the Master Trust. This structure is sometimes called a "master/feeder"
structure. A Feeder Fund's investment results will correspond directly to the
investment results of the underlying Master Trust in which it invests. For
simplicity, this Statement of Additional Information uses the term "Fund" to
include both a Feeder Fund and its Master Trust.
INVESTMENT RISKS AND CONSIDERATIONS
Set forth below are descriptions of some of the types of investments and
investment strategies that one or more of the Funds may use, and the risks and
considerations associated with those investments and investment strategies.
Please see each Fund's Prospectus and Part I, Section I "Investment Objectives
and Policies" of each Fund's Statement of Additional Information for a complete
description of each Fund's investment policies and risks. Information contained
in this section about the risks and considerations associated with a Fund's
investments and/or investment strategies applies only to those Funds
specifically identified as making each type of investment or using each
investment strategy (each, a "Covered Fund"). Information that does not apply to
a Covered Fund does not form a part of that Covered Fund's Statement of
Additional Information and should not be relied on by investors in the Covered
Fund. Only information that is clearly identified as applicable to a Covered
Fund is considered to form a part of that Covered Fund's Statement of Additional
Information.
II-1
Bond Bond Municipal
Fund- Fund- Bond Fund- Municipal Municipal Bond-
Core High Intermediate Bond- Bond- Limited Municipal
Bond Income Term California Low Insured National Maturity Intermediate
Portfolio Portfolio Portfolio Insured Duration Portfolio Portfolio Portfolio Term
--------- --------- ------------ ---------- -------- --------- --------- --------- ------------
Investment in
Other
Investment
Companies X X X X X X X X X
Securities
Lending X X X X
Convertible
Securities X X X X
Borrowing
and
Leverage X X X X X X X X X
When Issued
Securities,
Delayed
Delivery
Securities
and
Forward
Commitments X X X X X X X X X
Warrants X X X
Standby
Commitment
Agreements X X X
Repurchase
Agreements
and
Purchase
and Sale
Contracts X X X X X X X X X
Reverse
Repurchase
Agreements X
Dollar
Rolls X
Illiquid or
Restricted
Securities X X X X X X X X X
144A
Securities X X X X
Debt
Securities X X X X X X X X X
Junk
Bonds X X X X X X X X
Corporate
Loans X X X X X
Distressed
Securities X
Mortgage-
Related
Securities X X X X
Mortgage
Backed
Securities X X X X
Mortgage
Pass-
Through
Securities X X X X
Collateralized
Mortgage
Obligations
("CMOs") X X X X Adjustable
Rate
Mortgage
Securities X X X X
CMO
Residuals X X X X
Stripped
Mortgage
Backed
Securities X X X X
Tiered
Index
Bonds X X X X
Asset Backed
Securities X X X X
Foreign
Investment
Risks X X X X
Foreign
Market
Risk X X X X
Foreign
Economy
Risk X X X X
Currency
Risk
and
Exchange
Risk X X X X
Governmental
Supervision
and
Regulation/Accounting
Standards X X X X
Certain
Risks
of
Holding
Fund
Assets
Outside
the
U.S X X X X
Settlement
Risk X X X X
Investment in
Emerging
Markets X X X X
Restrictions
on
Certain
Investments
Supranational
Entities X
Sovereign
Debt X X X X
Short
Sales X X X
New
Florida Jersey New York Pennsylvania Short Term U.S. U.S. Municipal
Municipal Municipal Municipal Municipal U.S. Government High World Investment
Bond Bond Bond Bond Government Mortgage Yield Income Accumulation
--------- --------- --------- ------------ ---------- ---------- ----- ------ ------------
Investment in
Other
Investment
Companies X X X X X X X X X
Securities
Lending X X X X
Convertible
Securities X X
Borrowing
and
Leverage X X X X X X X X X
When Issued
Securities,
Delayed
Delivery
Securities
and
Forward
Commitments X X X X X X X X X
Warrants X X
Standby
Commitment
Agreements X
Repurchase
Agreements
and
Purchase
and Sale
Contracts X X X X X X X X X
Reverse
Repurchase
Agreements X
Dollar
Rolls X X
Illiquid or
Restricted
Securities X X X X X X X X X
144A
Securities X X X X
Debt
Securities X X X X X X X X X
Junk
Bonds X X X X X X
Corporate
Loans X
Distressed
Securities X
Mortgage-
Related
Securities X X X
Mortgage
Backed
Securities X X X
Mortgage
Pass-
Through
Securities X X X
Collateralized
Mortgage
Obligations
("CMOs") X X X Adjustable
Rate
Mortgage
Securities X X X
CMO
Residuals X X X
Stripped
Mortgage
Backed
Securities X X
Tiered
Index
Bonds X X X
Asset Backed
Securities X X X X
Foreign
Investment
Risks X X
Foreign
Market
Risk X X
Foreign
Economy
Risk X X
Currency
Risk
and
Exchange
Risk X X
Governmental
Supervision
and
Regulation/Accounting
Standards X X
Certain
Risks
of
Holding
Fund
Assets
Outside
the
U.S X X
Settlement
Risk X X
Investment in
Emerging
Markets X
Restrictions
on
Certain
Investments X
Supranational
Entities X
Sovereign
Debt X
Short
Sales X X
II-2
Bond Bond Bond Municipal
Fund- Fund- Fund- Municipal Municipal Bond-
Core High Intermediate Bond- Bond- Limited Municipal
Bond Income Term California Low Insured National Maturity Intermediate
Portfolio Portfolio Portfolio Insured Duration Portfolio Portfolio Portfolio Term
--------- --------- ------------ ---------- -------- --------- --------- --------- ------------
Derivatives X X X X X X X X X
Hedging X X X X X X X X X
Indexed
and
Inverse
Floating
Rate
Securities X X X X X X X X X
Swap
Agreements X X X X X X X X X
Options
on
Securities
and
Securities
Indices X X X X X X X X X
Purchasing
Put
Options X X X X X X X X X
Purchasing
Call
Options X X X X X X X X X
Options
on
Government
National
Mortgage
Association
("GNMA")
Certificates X X X X
Writing
Call
Options X X X X X X X X X
Writing
Put
Options X X X X X X X X X
Types of
Options X X X X X X X X X
Futures X X X X X X X X X
Foreign
Exchange
Transactions X X X X
Forward
Foreign
Exchange
Transactions X X X X
Currency
Futures X X X X
Currency
Options X X X X
Limitations
on
Currency
Hedging X X X X
Risk
Factors
in
Hedging
Foreign
Currency
Risks X X X X
Risk
Factors
in
Derivatives X X X X X X X X X
Credit
Risk X X X X X X X X X
Currency
Risk X X X X
Leverage
Risk X X X X X X X X X
Liquidity
Risk X X X X X X X X X
Additional
Risk
Factors
of
OTC
Transactions;
Limitations
on
the
Use
of
OTC
Derivatives X X X X X X X X X
Interest
Rate
Swaps,
Caps
and
Floors X X X X
Credit
Default
Swap
Agreements X X X X
Stripped
Securities X X X X
Real Estate
Investment
Trusts
("REITs") X X X X Zero Coupon
Securities X X X
Municipal
Investments X X X X X X
Risk
Factors
and
Special
Considerations
Relating
to
Municipal
Bonds X X X X X X
Description
of
Municipal
Bonds X X X X X X
General
Obligation
Bonds X X X X X X
Revenue
Bonds X X X X X X
IDBs and
PABs X X X X X X
Moral
Obligation
Bonds X X X X X X
Municipal
Notes X X X X X X
Municipal
Commercial
Paper X X X X X X
Municipal
Lease
Obligations X X X X X X
Yields X X X X X X
Variable
Rate
Demand
Obligations
("VRDOs")
and
Participating
VRDOs X X X X X X
Transactions
in
Financial
Futures
Contracts X X X X X X
Call
Rights X X X X X X
Municipal
Interest
Rate
Swap
Transactions X X X X X X
New
Florida Jersey New York Pennsylvania Short Term U.S. U.S. Municipal
Municipal Municipal Municipal Municipal U.S. Government High World Investment
Bond Bond Bond Bond Government Mortgage Yield Income Accumulation
--------- --------- --------- ------------ ---------- ---------- ----- ------ ------------
Derivatives X X X X X X X X X
Hedging X X X X X X X X X
Indexed
and
Inverse
Floating
Rate
Securities X X X X X X X X X
Swap
Agreements X X X X X X X X X
Options
on
Securities
and
Securities
Indices X X X X X X X X X
Purchasing
Put
Options X X X X X X X X X
Purchasing
Call
Options X X X X X X X X X
Options
on
Government
National
Mortgage
Association
("GNMA")
Certificates X X
Writing
Call
Options X X X X X X X X X
Writing
Put
Options X X X X X X X X X
Types of
Options X X X X X X X X X
Futures X X X X X X X X X
Foreign
Exchange
Transactions X X
Forward
Foreign
Exchange
Transactions X X
Currency
Futures X X
Currency
Options X X
Limitations
on
Currency
Hedging X X
Risk
Factors
in
Hedging
Foreign
Currency
Risks X X
Risk
Factors
in
Derivatives X X X X X X X X X
Credit
Risk X X X X X X X X X
Currency
Risk X X
Leverage
Risk X X X X X X X X X
Liquidity
Risk X X X X X X X X X
Additional
Risk
Factors
of
OTC
Transactions;
Limitations
on
the
Use
of
OTC
Derivatives X X X X X X X X X
Interest
Rate
Swaps,
Caps
and
Floors X X X X
Credit
Default
Swap
Agreements X X X X
Stripped
Securities X X
Real Estate
Investment
Trusts
("REITs") X X Zero Coupon
Securities X X X
Municipal
Investments X X X X X
Risk
Factors
and
Special
Considerations
Relating
to
Municipal
Bonds X X X X X
Description
of
Municipal
Bonds X X X X X
General
Obligation
Bonds X X X X X
Revenue
Bonds X X X X X
IDBs and
PABs X X X X X
Moral
Obligation
Bonds X X X X X
Municipal
Notes X X X X X
Municipal
Commercial
Paper X X X X X
Municipal
Lease
Obligations X X X X X
Yields X X X X X
Variable
Rate
Demand
Obligations
("VRDOs")
and
Participating
VRDOs X X X X X
Transactions
in
Financial
Futures
Contracts X X X X X
Call
Rights X X X X X
Municipal
Interest
Rate
Swap
Transactions X X X X X
II-3
Investment in Other Investment Companies. Each Fund may invest in other
investment companies whose investment objectives and policies are consistent
with those of the Fund. In accordance with the Investment Company Act, a Fund
may invest up to 10% of its total assets in securities of other investment
companies. In addition, under the Investment Company Act a Fund may not own more
than 3% of the total outstanding voting stock of any investment company and not
more than 5% of the value of the Fund's total assets may be invested in
securities of any investment company. (These limits do not restrict a Feeder
Fund from investing all of its assets in shares of its Master Portfolio.) Each
Fund has received an exemptive order from the Commission permitting it to
invest in affiliated registered money market funds and in an affiliated private
investment company without regard to such limitations, provided however, that in
all cases the Fund's aggregate investment of cash in shares of such investment
companies shall not exceed 25% of the Fund's total assets at any time. If a Fund
acquires shares in investment companies, shareholders would bear both their
proportionate share of expenses in the Fund (including management and advisory
fees) and, indirectly, the expenses of such investment companies (including
management and advisory fees). Investments by a Fund in wholly owned investment
entities created under the laws of certain countries will not be deemed an
investment in other investment companies.
Securities Lending. Each Fund may lend securities with a value not exceeding 33
1/3% of its total assets or the limit prescribed by applicable law to banks,
brokers and other financial institutions. In return, the Fund receives
collateral in 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. Each Fund maintains the ability
to obtain the right to vote or consent on proxy proposals involving material
events affecting securities loaned. A Fund receives the income on the loaned
securities. Where a Fund receives securities as collateral, the Fund receives a
fee for its loans from the borrower and does not receive the income on the
collateral. Where a Fund receives cash collateral, it may invest such collateral
and retain the amount earned, net of any amount rebated to the borrower. As a
result, the Fund's yield may increase. Loans of securities are terminable at any
time and the borrower, after notice, is required to return borrowed securities
within the standard time period for settlement of securities transactions. The
Fund is obligated to return the collateral to the borrower at the termination of
the loan. A Fund could suffer a loss in the event the Fund must return the cash
collateral and there are losses on investments made with the cash collateral. In
the event the borrower defaults on any of its obligations with respect to a
securities loan, a Fund could suffer a loss where there are losses on
investments made with the cash collateral or, where the value of the securities
collateral falls below the market value of the borrowed securities. A Fund could
also experience delays and costs in gaining access to the collateral. Each Fund
may pay reasonable finder's, lending agent, administrative and custodial fees in
connection with its loans. Each Fund has received an exemptive order from the
Commission permitting it to lend portfolio securities to Merrill Lynch, Pierce,
Fenner & Smith Incorporated or its affiliates and to retain an affiliate of the
Fund as lending agent.
Convertible Securities. Convertible securities entitle the holder to receive
interest payments paid on corporate debt securities or the dividend preference
on a preferred stock until such time as the convertible security matures or is
redeemed or until the holder elects to exercise the conversion privilege.
Synthetic convertible securities may be either (i) a debt security or preferred
stock that may be convertible only under certain contingent circumstances or
that may pay the holder a cash amount based on the value of shares of underlying
common stock partly or wholly in lieu of a conversion right (a "Cash-Settled
Convertible"), (ii) a combination of separate securities chosen by the Manager
in order to create the economic characteristics of a convertible security, i.e.,
a fixed income security paired with a security with equity conversion features,
such as an option or warrant (a "Manufactured Convertible") or (iii) a synthetic
security manufactured by another party.
The characteristics of convertible securities make them appropriate investments
for an investment company seeking a high total return from capital appreciation
and investment income. These characteristics include the potential for capital
appreciation as the value of the underlying common stock increases, the
relatively high yield received from dividend or interest payments as compared to
common stock dividends and decreased risks of decline in value relative to the
underlying common stock due to their fixed-income nature. As a result of the
conversion feature, however, the interest rate or dividend preference on a
convertible security is generally less than would be the case if the securities
were issued in nonconvertible form.
In analyzing convertible securities, the Manager will consider both the yield on
the convertible security relative to its credit quality and the potential
capital appreciation that is offered by the underlying common stock, among other
things.
II-4
Convertible securities are issued and traded in a number of securities markets.
Even in cases where a substantial portion of the convertible securities held by
a Fund are denominated in U.S. dollars, the underlying equity securities may be
quoted in the currency of the country where the issuer is domiciled. With
respect to convertible securities denominated in a currency different from that
of the underlying equity securities, the conversion price may be based on a
fixed exchange rate established at the time the security is issued. As a result,
fluctuations in the exchange rate between the currency in which the debt
security is denominated and the currency in which the share price is quoted will
affect the value of the convertible security. As described below, a Fund is
authorized to enter into foreign currency hedging transactions in which it may
seek to reduce the effect of such fluctuations.
Apart from currency considerations, the value of convertible securities is
influenced by both the yield of nonconvertible securities of comparable issuers
and by the value of the underlying common stock. The value of a convertible
security viewed without regard to its conversion feature (i.e., strictly on the
basis of its yield) is sometimes referred to as its "investment value." To the
extent interest rates change, the investment value of the convertible security
typically will fluctuate. However, at the same time, the value of the
convertible security will be influenced by its "conversion value," which is the
market value of the underlying common stock that would be obtained if the
convertible security were converted. Conversion value fluctuates directly with
the price of the underlying common stock. If, because of a low price of the
common stock the conversion value is substantially below the investment value of
the convertible security, the price of the convertible security is governed
principally by its investment value.
To the extent the conversion value of a convertible security increases to a
point that approximates or exceeds its investment value, the price of the
convertible security will be influenced principally by its conversion value. A
convertible security will sell at a premium over the conversion value to the
extent investors place value on the right to acquire the underlying common stock
while holding a fixed-income security. The yield and conversion premium of
convertible securities issued in Japan and the Euromarket are frequently
determined at levels that cause the conversion value to affect their market
value more than the securities' investment value.
Holders of convertible securities generally have a claim on the assets of the
issuer prior to the common stockholders but may be subordinated to other debt
securities of the same issuer. A convertible security may be subject to
redemption at the option of the issuer at a price established in the charter
provision, indenture or other governing instrument pursuant to which the
convertible security was issued. If a convertible security held by a Fund is
called for redemption, the Fund will be required to redeem the security, convert
it into the underlying common stock or sell it to a third party. Certain
convertible debt securities may provide a put option to the holder, which
entitles the holder to cause the security to be redeemed by the issuer at a
premium over the stated principal amount of the debt security under certain
circumstances.
As indicated above, synthetic convertible securities may include either
Cash-Settled Convertibles or Manufactured Convertibles. Cash-Settled
Convertibles are instruments that are created by the issuer and have the
economic characteristics of traditional convertible securities but may not
actually permit conversion into the underlying equity securities in all
circumstances. As an example, a private company may issue a Cash-Settled
Convertible that is convertible into common stock only if the company
successfully completes a public offering of its common stock prior to maturity
and otherwise pays a cash amount to reflect any equity appreciation.
Manufactured Convertibles are created by the Manager by combining separate
securities that possess one of the two principal characteristics of a
convertible security, i.e., fixed income ("fixed income component") or a right
to acquire equity securities ("convertibility component"). The fixed income
component is achieved by investing in nonconvertible fixed income securities,
such as nonconvertible bonds, preferred stocks and money market instruments. The
convertibility component is achieved by investing in call options, warrants, or
other securities with equity conversion features ("equity features") granting
the holder the right to purchase a specified quantity of the underlying stocks
within a specified period of time at a specified price or, in the case of a
stock index option, the right to receive a cash payment based on the value of
the underlying stock index.
A Manufactured Convertible differs from traditional convertible securities in
several respects. Unlike a traditional convertible security, which is a single
security having a unitary market value, a Manufactured Convertible is comprised
of two or more separate securities, each with its own market value. Therefore,
the total "market value "of such a Manufactured Convertible is the sum of the
values of its fixed income component and its convertibility component.
More flexibility is possible in the creation of a Manufactured Convertible than
in the purchase of a traditional convertible security. Because many corporations
have not issued convertible securities, the Manager may combine a fixed income
instrument and an equity feature with respect to the stock of the issuer of the
fixed income instrument to create a synthetic
II-5
convertible security otherwise unavailable in the market. The Manager may also
combine a fixed income instrument of an issuer with an equity feature with
respect to the stock of a different issuer when the Manager believes such a
Manufactured Convertible would better promote a Fund's objective than alternate
investments. For example, the Manager may combine an equity feature with respect
to an issuer's stock with a fixed income security of a different issuer in the
same industry to diversify the Fund's credit exposure, or with a U.S. Treasury
instrument to create a Manufactured Convertible with a higher credit profile
than a traditional convertible security issued by that issuer. A Manufactured
Convertible also is a more flexible investment in that its two components may be
purchased separately and, upon purchasing the separate securities, "combined" to
create a Manufactured Convertible. For example, the Fund may purchase a warrant
for eventual inclusion in a Manufactured Convertible while postponing the
purchase of a suitable bond to pair with the warrant pending development of more
favorable market conditions.
The value of a Manufactured Convertible may respond differently to certain
market fluctuations than would a traditional convertible security with similar
characteristics. For example, in the event a Fund created a Manufactured
Convertible by combining a short-term U.S. Treasury instrument and a call option
on a stock, the Manufactured Convertible would likely outperform a traditional
convertible of similar maturity that is convertible into that stock during
periods when Treasury instruments outperform corporate fixed income securities
and underperform during periods when corporate fixed-income securities
outperform Treasury instruments.
Borrowing and Leverage. Each Fund may borrow from banks as a temporary measure
for extraordinary or emergency purposes, including to meet redemptions or to
settle securities transactions. Most Funds will not purchase securities at any
time when borrowings exceed 5% of their total assets, except (a) to honor prior
commitments or (b) to exercise subscription rights when outstanding borrowings
have been obtained exclusively for settlements of other securities transactions.
Certain Funds may also borrow in order to make investments. The purchase of
securities while borrowings are outstanding will have the effect of leveraging
the Fund. Such leveraging increases the Fund's exposure to capital risk, and
borrowed funds are subject to interest costs that will reduce net income. The
use of leverage by a Fund creates an opportunity for greater total return, but,
at the same time, creates special risks. For example, leveraging may exaggerate
changes in the net asset value of Fund shares and in the yield on the Fund's
portfolio. Although the principal of such borrowings will be fixed, the Fund's
assets may change in value during the time the borrowings are outstanding.
Borrowings will create interest expenses for the Fund that can exceed the income
from the assets purchased with the borrowings. To the extent the income or
capital appreciation derived from securities purchased with borrowed funds
exceeds the interest the Fund will have to pay on the borrowings, the Fund's
return will be greater than if leverage had not been used. Conversely, if the
income or capital appreciation from the securities purchased with such borrowed
funds is not sufficient to cover the cost of borrowing, the return to the Fund
will be less than if leverage had not been used, and therefore the amount
available for distribution to shareholders as dividends will be reduced. In the
latter case, the Manager in its best judgment nevertheless may determine to
maintain the Fund's leveraged position if it expects that the benefits to the
Fund's shareholders of maintaining the leveraged position will outweigh the
current reduced return.
Certain types of borrowings by a Fund may result in the Fund being subject to
covenants in credit agreements relating to asset coverage, portfolio composition
requirements and other matters. It is not anticipated that observance of such
covenants would impede the Manager from managing a Fund's portfolio in
accordance with the Fund's investment objectives and policies. However, a breach
of any such covenants not cured within the specified cure period may result in
acceleration of outstanding indebtedness and require the Fund to dispose of
portfolio investments at a time when it may be disadvantageous to do so.
Each Fund may at times borrow from affiliates of the Manager, provided that the
terms of such borrowings are no less favorable than those available from
comparable sources of funds in the marketplace.
When Issued Securities, Delayed Delivery Securities and Forward Commitments. A
Fund may purchase or sell securities that it is entitled to receive on a when
issued basis. A Fund may also purchase or sell securities on a delayed delivery
basis or through a forward commitment. These transactions involve the purchase
or sale of securities by a Fund at an established price with payment and
delivery taking place in the future. The Fund enters into these transactions to
obtain what is considered an advantageous price to the Fund at the time of
entering into the transaction. No Fund has established any limit on the
percentage of its assets that may be committed in connection with these
transactions. When a Fund purchases securities in these transactions, the Fund
segregates liquid securities in an amount equal to the amount of its purchase
commitments.
II-6
There can be no assurance that a security purchased on a when issued basis will
be issued or that a security purchased or sold through a forward commitment will
be delivered. The value of securities in these transactions on the delivery date
may be more or less than the Fund's purchase price. The Fund may bear the risk
of a decline in the value of the security in these transactions and may not
benefit from an appreciation in the value of the security during the commitment
period.
Warrants. Warrants are securities permitting, but not obligating, the warrant
holder to subscribe for other securities. Buying a warrant does not make the
Fund a shareholder of the underlying stock. The warrant holder has no right to
dividends or votes on the underlying stock. A warrant does not carry any right
to assets of the issuer, and for this reason investment in warrants may be more
speculative than other equity-based investments.
Standby Commitment Agreements. A Fund may enter into standby commitment
agreements. These agreements commit a Fund, for a stated period of time, to
purchase a stated amount of securities that may be issued and sold to that Fund
at the option of the issuer. The price of the security is fixed at the time of
the commitment. At the time of entering into the agreement the Fund is paid a
commitment fee, regardless of whether or not the security is ultimately issued.
A Fund will enter into such agreements for the purpose of investing in the
security underlying the commitment at a price that is considered advantageous to
the Fund. A Fund will limit its investment in such commitments so that the
aggregate purchase price of securities subject to such commitments, together
with the value of portfolio securities subject to legal restrictions on resale
that affect their marketability, will not exceed 15% of its net assets taken at
the time of the commitment. A Fund segregates liquid assets in an aggregate
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 Fund may bear the
risk of a decline in the value of such security and may not benefit from any
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 thereafter
will be reflected in the calculation of a Fund'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.
Repurchase Agreements and Purchase and Sale Contracts. A Fund may invest in
securities pursuant to repurchase agreements or purchase and sale contracts.
Repurchase agreements and purchase and sale contracts may be entered into only
with financial institutions which have capital of at least $50 million or whose
obligations are guaranteed by an entity having capital of at least $50 million.
Under such agreements, the other party agrees, upon entering into the contract
with a Fund, to repurchase the security at a mutually agreed-upon time and price
in a specified currency, thereby determining the yield during the term of the
agreement. This results in a fixed rate of return insulated from market
fluctuations during such period, although such return may be affected by
currency fluctuations. In the case of repurchase agreements, the prices at which
the trades are conducted do not reflect accrued interest on the underlying
obligation; whereas, in the case of purchase and sale contracts, the prices take
into account accrued interest. 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. In the case of a repurchase agreement, as a purchaser, a Fund
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; the Fund does not have the right to seek additional
collateral in the case of purchase and sale contracts. 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 Fund but only constitute
collateral for the seller's obligation to pay the repurchase price. Therefore,
the Fund may suffer time delays and incur costs or possible losses in connection
with disposition of the collateral.
A purchase and sale contract differs from a repurchase agreement in that the
contract arrangements stipulate that securities are owned by the Fund. In the
event of a default under such a repurchase agreement or under a purchase and
sale contract, instead of the contractual fixed rate, the rate of return to the
Fund would be dependent upon intervening fluctuations of the market values of
such securities and the accrued interest on the securities. In such event, the
Fund 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. A Fund may not invest in repurchase agreements or purchase and sale
contracts maturing in more
II-7
than seven days if such investments, together with the Fund's other illiquid
investments, would exceed 15% of the Fund's net assets.
Reverse Repurchase Agreements. A Fund may enter into reverse repurchase
agreements with the same parties with whom it may enter into repurchase
agreements. Under a reverse repurchase agreement, a Fund sells securities and
agrees to repurchase them at a mutually agreed date and price. At the time a
Fund enters into a reverse repurchase agreement, it will establish and maintain
a segregated account with its approved custodian containing cash, cash
equivalents or liquid high grade debt securities having a value not less than
the repurchase price (including accrued interest). Reverse repurchase agreements
involve the risk that the market value of the securities retained in lieu of
sale by a Fund may decline below the price of the securities the Fund has sold
but is obligated to repurchase. In the event the buyer of securities under a
reverse repurchase agreement files for bankruptcy or becomes insolvent, such
buyer or its trustee or receiver may receive an extension of time to determine
whether to enforce a Fund's obligations to repurchase the securities and the
Fund's use of the proceeds of the reverse repurchase agreement may effectively
be restricted pending such decision.
Dollar Rolls. A Fund may enter into dollar rolls, in which the Fund will sell
securities for delivery in the current month and simultaneously contract to
repurchase substantially similar (the same type and coupon) securities on a
specified future date from the same party. During the roll period, a Fund
forgoes principal and interest paid on the securities sold. A Fund is
compensated by the difference between the current sales price and the forward
price for the future purchase (often referred to as the "drop") as well as by
the interest earned on the cash proceeds of the initial sale.
Dollar rolls involve the risk that the market value of the securities subject to
a Fund's forward purchase commitment may decline below the price of the
securities the Fund has sold. In the event the buyer of the securities files for
bankruptcy or becomes insolvent, a Fund's use of the proceeds of the current
sale portion of the transaction may be restricted pending a determination by the
other party, or its trustee or receiver, whether to enforce the Fund's
obligation to purchase the similar securities in the forward transaction. Dollar
rolls are speculative techniques that can be deemed to involve leverage. A Fund
will engage in dollar roll transactions to enhance return and not for the
purpose of borrowing. Each dollar roll transaction is accounted for as a sale of
a portfolio security and a subsequent purchase of a substantially similar
security in the forward market.
Illiquid or Restricted Securities. Each Fund may invest up to 15% of its net
assets in securities that lack an established secondary trading market or
otherwise are considered illiquid. Liquidity of a security relates to the
ability to dispose easily of the security and the price to be obtained upon
disposition of the security, which may be less than would be obtained for a
comparable more liquid security. Illiquid securities may trade at a discount
from comparable, more liquid investments. Investment of a Fund's assets in
illiquid securities may restrict the ability of the Fund to dispose of its
investments in a timely fashion and for a fair price as well as its ability to
take advantage of market opportunities. The risks associated with illiquidity
will be particularly acute where a Fund's operations require cash, such as when
the Fund redeems shares or pays dividends, and could result in the Fund
borrowing to meet short term cash requirements or incurring capital losses on
the sale of illiquid investments.
A Fund may invest in securities that are not registered ("restricted
securities") under the Securities Act of 1933, as amended (the "Securities
Act"). Restricted securities may be sold in private placement transactions
between issuers and their purchasers and may be neither listed on an exchange
nor traded in other established markets. In many cases, privately placed
securities may not be freely transferable under the laws of the applicable
jurisdiction or due to contractual restrictions on resale. As a result of the
absence of a public trading market, privately placed securities may be less
liquid and more difficult to value than publicly traded securities. To the
extent that privately placed securities may be resold in privately negotiated
transactions, the prices realized from the sales, due to illiquidity, could be
less than those originally paid by the Fund or less than their fair market
value. In addition, issuers whose securities are not publicly traded may not be
subject to the disclosure and other investor protection requirements that may be
applicable if their securities were publicly traded. If any privately placed
securities held by a Fund are required to be registered under the securities
laws of one or more jurisdictions before being resold, the Fund may be required
to bear the expenses of registration. Certain of the Fund's investments in
private placements may consist of direct investments and may include investments
in smaller, less seasoned issuers, which may involve greater risks. These
issuers may have limited product lines, markets or financial resources, or they
may be dependent on a limited management group. In making investments in such
securities, a Fund may obtain access to material nonpublic information, which
may restrict the Fund's ability to conduct portfolio transactions in such
securities.
II-8
144A Securities. A Fund may purchase restricted securities that can be offered
and sold to "qualified institutional buyers" under Rule 144A under the
Securities Act. The Directors have determined to treat as liquid Rule 144A
securities that are either freely tradable in their primary markets offshore or
have been determined to be liquid in accordance with the policies and procedures
adopted by the Fund's Directors. The Directors have adopted guidelines and
delegated to the Manager the daily function of determining and monitoring
liquidity of restricted securities. The Directors, however, will retain
sufficient oversight and be ultimately responsible for the determinations. Since
it is not possible to predict with assurance exactly how this market for
restricted securities sold and offered under Rule 144A will continue to develop,
the Directors will carefully monitor a Fund's investments in these securities.
This investment practice could have the effect of increasing the level of
illiquidity in a Fund to the extent that qualified institutional buyers become
for a time uninterested in purchasing these securities.
Initial Public Offering Risk. The volume of initial public offerings and the
levels at which the newly issued stocks trade in the secondary market are
affected by the performance of the stock market overall. If initial public
offerings are brought to the market, availability may be limited and the Fund
may not be able to buy any shares at the offering price, or if it is able to buy
shares, it may not be able to buy as many shares at the offering price as it
would like. In addition, the prices of securities involved in initial public
offerings are often subject to greater and more unpredictable price changes than
more established stocks.
Debt Securities. Debt securities, such as bonds, involve credit risk. This is
the risk that the issuer will not make timely payments of principal and
interest. The degree of credit risk depends on the issuer's financial condition
and on the terms of the bonds. This risk is reduced to the extent a Fund limits
its debt investments to U.S. Government securities. All debt securities,
however, are subject to interest rate risk. This is the risk that the value of
the security may fall when interest rates rise. In general, the market price of
debt securities with longer maturities will go up or down more in response to
changes in interest rates than the market price of shorter term securities.
Junk Bonds. Junk bonds are debt securities that are rated below investment grade
by the major rating agencies or are unrated securities that Fund management
believes are of comparable quality. Although junk bonds generally pay higher
rates of interest than investment grade bonds, they are high risk
investments that may cause income and principal losses for a Fund. The major
risks in junk bond investments include the following:
. Junk bonds may be issued by less creditworthy companies. These securities
are vulnerable to adverse changes in the issuer's industry and to general
economic conditions. Issuers of junk bonds may be unable to meet their
interest or principal payment obligations because of an economic
downturn, specific issuer developments or the unavailability of
additional financing.
. The issuers of junk bonds may have a larger amount of outstanding debt
relative to their assets than issuers of investment grade bonds. If the
issuer experiences financial stress, it may be unable to meet its debt
obligations. The issuer's ability to pay its debt obligations also may be
lessened by specific issuer developments, or the unavailability of
additional financing.
. Junk bonds are frequently ranked junior to claims by other creditors. If
the issuer cannot meet its obligations, the senior obligations are
generally paid off before the junior obligations.
. Junk bonds frequently have redemption features that permit an issuer to
repurchase the security from a Fund before it matures. If an issuer
redeems the junk bonds, a Fund may have to invest the proceeds in bonds
with lower yields and may lose income.
. Prices of junk bonds are subject to extreme price fluctuations. Negative
economic developments may have a greater impact on the prices of junk
bonds than on other higher rated fixed income securities.
. Junk bonds may be less liquid than higher rated fixed income securities
even under normal economic conditions. There are fewer dealers in the
junk bond market, and there may be significant differences in the prices
quoted for junk bonds by the dealers. Because they are less liquid,
judgment may play a greater role in valuing certain of a Fund's portfolio
securities than in the case of securities trading in a more liquid
market.
II-9
. A Fund may incur expenses to the extent necessary to seek recovery upon
default or to negotiate new terms with a defaulting issuer.
Corporate Loans. Certain Funds can invest in corporate loans. Commercial banks
and other financial institutions make corporate loans to companies that need
capital to grow or restructure. Borrowers generally pay interest on corporate
loans at rates that change in response to changes in market interest rates such
as the London Interbank Offered Rate ("LIBOR") or the prime rate of U.S. banks.
As a result, the value of corporate loan investments is generally less
responsive to shifts in market interest rates. Because the trading market for
corporate loans is less developed than the secondary market for bonds and notes,
a Fund may experience difficulties from time to time in selling its corporate
loans. Borrowers frequently provide collateral to secure repayment of these
obligations. Leading financial institutions often act as agent for a broader
group of lenders, generally referred to as a "syndicate." The syndicate's agent
arranges the corporate loans, holds collateral and accepts payments of principal
and interest. If the agent developed financial problems, a Fund may not recover
its investment, or there might be a delay in the Fund's recovery. By investing
in a corporate loan, a Fund becomes a member of the syndicate.
As in the case of junk bonds, the Corporate Loans in which a Fund 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 LIBOR. Consequently, the value of
Corporate Loans held by a Fund 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.
A Fund may acquire interests in Corporate Loans by means of a novation,
assignment or participation. In a novation, the a Fund 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, a Fund may purchase an assignment, in which case the Fund 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 selling the participation interest and
not with the borrower. In purchasing a loan participation, a Fund 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 Fund may not
directly benefit from the collateral supporting the debt obligation in which it
has purchased the participation. As a result, a Fund will assume the credit risk
of both the borrower and the institution selling the participation to the Fund.
Distressed Securities. A Fund may invest in securities, including corporate
loans purchased in the secondary market, which are the subject of bankruptcy
proceedings or otherwise in default as to the repayment of principal and/or
interest at the time of acquisition by the Fund or are rated in the lower rating
categories (Ca or lower by Moody's Investors Service, Inc. ("Moody's") and CC or
lower by Standard & Poor's ("S&P")) or which, if unrated, are in the judgment of
the Manager of equivalent quality ("Distressed Securities"). Investment in
Distressed Securities is speculative and involves significant risks. Distressed
Securities frequently do not produce income while they are outstanding and may
require a Fund to bear certain extraordinary expenses in order to protect and
recover its investment.
A Fund will generally make such investments only when the Manager believes it is
reasonably likely that the issuer of the Distressed Securities will make an
exchange offer or will be the subject of a plan of reorganization pursuant to
which the Fund will receive new securities. 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 a Fund 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 a Fund will receive any interest payments on the
Distressed Securities, the
II-10
Fund will be subject to significant uncertainty as to whether or not the
exchange offer or plan of reorganization will be completed and the Fund may be
required to bear certain extraordinary expenses to protect and recover its
investment. Even if an exchange offer is made or plan of reorganization is
adopted with respect to Distressed Securities held by a Fund, there can be no
assurance that the securities or other assets received by a Fund in connection
with such exchange offer or plan of reorganization will not have a lower value
or income potential than may have been anticipated when the investment was made.
Moreover, any securities received by a Fund upon completion of an exchange offer
or plan of reorganization may be restricted as to resale. As a result of a
Fund's participation in negotiations with respect to any exchange offer or plan
of reorganization with respect to an issuer of Distressed Securities, the Fund
may be restricted from disposing of such securities.
Mortgage-Related Securities
Mortgage-Backed Securities. Investing in mortgage-backed securities involves
certain unique risks in addition to those generally associated with investing in
the real estate industry in general. These unique risks include the failure of a
party to meet its commitments under the related operative documents, adverse
interest rate changes and the effects of prepayments on mortgage cash flows.
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 Fund. 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 Fund for its mortgage backed
securities, the yield the Fund 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 Fund 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 Fund 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 Fund buys such securities at 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 shorter-term securities, maturity extension risk could
increase the inherent volatility of the Fund. Under certain interest rate and
prepayment scenarios, a Fund may fail to recoup fully its investment in
mortgage-backed securities notwithstanding any direct or indirect governmental
or agency guarantee.
Mortgage Pass-Through Securities. Mortgage pass-through securities represent
interests in pools of mortgages in which payments of both principal and interest
on the securities are generally made monthly, in effect "passing through"
monthly payments made by borrowers on the residential or commercial mortgage
loans which underlie the securities (net of any fees paid to the issuer or
guarantor of the securities). Mortgage pass-through securities differ from other
forms of debt securities, which normally provide for periodic payment of
interest in fixed amounts with principal payments at maturity or specified call
dates. Early repayment of principal on mortgage pass-through securities (arising
from prepayments of principal due to the sale of underlying property,
refinancing, or foreclosure, net of fees and costs which may be incurred) may
expose a Fund to a lower rate of return upon reinvestment of principal. Also, if
a security subject to repayment has been purchased at a premium, in the event of
prepayment, the value of the premium would be lost.
There are currently three types of mortgage pass-through securities: (1) those
issued by the U.S. government or one of its agencies or instrumentalities, such
as the Government National Mortgage Association ("Ginnie Mae"), the Federal
National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage
Corporation ("Freddie Mac"); (2) those issued by private issuers that represent
an interest in or are collateralized by pass-through securities issued or
guaranteed by the U.S. government or one of its agencies or instrumentalities;
and (3) those issued by private issuers that represent an interest in or are
collateralized by whole mortgage loans or pass-through securities without a
government guarantee but usually having some form of private credit enhancement.
II-11
Ginnie Mae is a wholly-owned U.S. government corporation within the Department
of Housing and Urban Development. Ginnie Mae is authorized to guarantee, with
the full faith and credit of the U.S. government, the timely payment of
principal and interest on securities issued by the institutions approved by
Ginnie Mae (such as savings and loan institutions, commercial banks and mortgage
banks), and backed by pools of Federal Housing Administration ("FHA")-insured or
Veterans' Administration ("VA")-guaranteed mortgages.
Obligations of Fannie Mae and Freddie Mac are not backed by the full faith and
credit of the U. S. government. In the case of obligations not backed by the
full faith and credit of the U.S. government, the Fund must look principally to
the agency issuing or guaranteeing the obligation for ultimate repayment. Fannie
Mae and Freddie Mac may borrow from the U.S. Treasury to meet its obligations,
but the U.S. Treasury is under no obligation to lend to Fannie Mae or Freddie
Mac.
Private mortgage pass-through securities are structured similarly to Ginnie
Mae, Fannie Mae, and Freddie Mac mortgage pass-through securities and are issued
by originators of and investors in mortgage loans, including depository
institutions, mortgage banks, investment banks and special purpose subsidiaries
of the foregoing.
Pools created by private mortgage pass-through issuers generally offer a higher
rate of interest than government and government-related pools because there are
no direct or indirect government or agency guarantees of payments in the private
pools. However, timely payment of interest and principal of these pools may be
supported by various forms of insurance or guarantees, including individual
loan, title, pool and hazard insurance and letters of credit. The insurance and
guarantees are issued by governmental entities, private insurers and the
mortgage poolers. The insurance and guarantees and the creditworthiness of the
issuers thereof will be considered in determining whether a mortgage-related
security meets a Fund's investment quality standards. There can be no assurance
that the private insurers or guarantors can meet their obligations under the
insurance policies or guarantee arrangements. Private mortgage pass-through
securities may be bought without insurance or guarantees if, through an
examination of the loan experience and practices of the originator/ servicers
and poolers, the Manager determines that the securities meet a Fund's quality
standards.
Collateralized Mortgage Obligations ("CMOs"). CMOs are debt obligations
collateralized by residential or commercial mortgage loans or residential or
commercial mortgage pass-through securities. Interest and prepaid principal are
generally paid monthly. CMOs may be collateralized by whole mortgage loans or
private mortgage pass-through securities but are more typically collateralized
by portfolios of mortgage pass-through securities guaranteed by Ginnie Mae,
Freddie Mac, or Fannie Mae. The issuer of a series of CMOs may elect to be
treated as a Real Estate Mortgage Investment Conduit ("REMIC"). All future
references to CMOs also include REMICs.
CMOs are structured into multiple classes, each bearing a different stated
maturity. Actual maturity and average life will depend upon the prepayment
experience of the collateral, which is ordinarily unrelated to the stated
maturity date. CMOs often provide for a modified form of call protection through
a de facto breakdown of the underlying pool of mortgages according to how
quickly the loans are repaid. Monthly payment of principal received from the
pool of underlying mortgages, including prepayments, is first returned to
investors holding the shortest maturity class. Investors holding the longer
maturity classes usually receive principal only after the first class has been
retired. An investor may be partially protected against a sooner than desired
return of principal because of the sequential payments.
Certain issuers of CMOs are not considered investment companies pursuant to a
rule adopted by the Commission, and a Fund may invest in the securities of such
issuers without the limitations imposed by the Investment Company Act on
investments by a Fund in other investment companies. In addition, in reliance on
an earlier Commission interpretation, a Fund's investments in certain other
qualifying CMOs, which cannot or do not rely on the rule, are also not subject
to the limitation of the Investment Company Act on acquiring interests in other
investment companies. In order to be able to rely on the Commission's
interpretation, these CMOs must be unmanaged, fixed asset issuers, that: (1)
invest primarily in mortgage-backed securities; (2) do not issue redeemable
securities; (3) operate under general exemptive orders exempting them from all
provisions of the Investment Company Act; and (4) are not registered or
regulated under the Investment Company Act as investment companies. To the
extent that a Fund selects CMOs that cannot rely on the rule or do not meet the
above requirements, the Fund may not invest more than 10% of its assets in all
such entities and may not acquire more than 3% of the voting securities of any
single such entity.
A Fund may also invest in, among other things, parallel pay CMOs, Planned
Amortization Class CMOs ("PAC bonds"), sequential pay CMOs, and floating rate
CMOs. Parallel pay CMOs are structured to provide payments of principal on each
payment date to more than one class. PAC bonds generally require payments of a
specified amount of principal on each
II-12
payment date. Sequential pay CMOs generally pay principal to only one class
while paying interest to several classes. Floating rate CMOs are securities
whose coupon rate fluctuates according to some formula related to an existing
market index or rate. Typical indices would include the eleventh district
cost-of-funds index ("COFI"), LIBOR, one-year Treasury yields, and ten-year
Treasury yields.
Adjustable Rate Mortgage Securities. Adjustable rate mortgage securities
("ARMs") are pass-through securities collateralized by mortgages with adjustable
rather than fixed rates. ARMs eligible for inclusion in a mortgage pool
generally provide for a fixed initial mortgage interest rate for either the
first three, six, twelve, thirteen, thirty-six, or sixty scheduled monthly
payments. Thereafter, the interest rates are subject to periodic adjustment
based on changes to a designated benchmark index.
ARMs contain maximum and minimum rates beyond which the mortgage interest rate
may not vary over the lifetime of the security. In addition, certain ARMs
provide for additional limitations on the maximum amount by which the mortgage
interest rate may adjust for any single adjustment period. In the event that
market rates of interest rise more rapidly to levels above that of the ARM's
maximum rate, the ARM's coupon may represent a below market rate of interest. In
these circumstances, the market value of the ARM security will likely have
fallen.
Certain ARMs contain limitations on changes in the required monthly payment. In
the event that a monthly payment is not sufficient to pay the interest accruing
on an ARM, any such excess interest is added to the principal balance of the
mortgage loan, which is repaid through future monthly payments. If the monthly
payment for such an instrument exceeds the sum of the interest accrued at the
applicable mortgage interest rate and the principal payment required at such
point to amortize the outstanding principal balance over the remaining term of
the loan, the excess is then utilized to reduce the outstanding principal
balance of the ARM.
CMO Residuals. CMO residuals are derivative mortgage securities issued by
agencies or instrumentalities of the U.S. government or by private originators
of, or investors in, mortgage loans, including savings and loan associations,
homebuilders, mortgage banks, commercial banks, investment banks, and special
purpose entities of the foregoing. The cash flow generated by the mortgage
assets underlying a series of CMOs is applied first to make required payments of
principal and interest on the CMOs and second to pay the related administrative
expenses of the issuer. The residual in a CMO structure generally represents the
interest in any excess cash flow remaining after making the foregoing payments.
Each payment of such excess cash flow to a holder of the related CMO residual
represents income and/or a return of capital. The amount of residual cash flow
resulting from a CMO will depend on, among other things, the characteristics of
the mortgage assets, the coupon rate of each class of CMO, prevailing interest
rates, the amount of administrative expenses and the prepayment experience on
the mortgage assets. In part, the yield to maturity on the CMO residuals is
extremely sensitive to prepayments on the related underlying mortgage assets, in
the same manner as an interest-only ("IO") class of stripped mortgage-related
securities. In addition, if a series of a CMO includes a class that bears
interest at an adjustable rate, the yield to maturity on the related CMO
residual will also be extremely sensitive to changes in the level of the index
upon which interest rate adjustments are based. In certain circumstances a Fund
may fail to recoup fully its initial investment in a CMO residual.
CMO residuals are generally purchased and sold by institutional investors
through several investment banking firms acting as brokers or dealers. The CMO
residual market has recently developed and CMO residuals currently may not have
the liquidity of other more established securities trading in other markets.
Transactions in CMO residuals are generally completed only after careful review
of the characteristics of the securities in question. In addition, CMO residuals
may or, pursuant to an exemption therefrom, may not have been registered under
the Securities Act. CMO residuals, whether or not registered under the
Securities Act, may be subject to certain restrictions on transferability, and
may be deemed "illiquid" and subject to a Fund's limitations on investment in
illiquid securities.
Stripped Mortgage Backed Securities. A Fund may invest in stripped mortgage
backed securities ("SMBSs") issued by agencies or instrumentalities of the
United States. SMBSs are derivative multiclass mortgage backed securities. SMBS
arrangements commonly involve two classes of securities that receive different
proportions of the interest and principal distributions on a pool of mortgage
assets. A common variety of SMBS is where one class (the principal only or PO
class) receives some of the interest and most of the principal from the
underlying assets, while the other class (the interest only or IO class)
receives most of the interest and the remainder of the principal. In the most
extreme case, the IO class receives all of the interest, while the PO class
receives all the principal. While a Fund may purchase securities of a PO class,
a Fund is more likely to purchase the securities of an IO class. The yield to
maturity of an IO class is extremely sensitive to the rate
II-13
of principal payments (including prepayments) on the related underlying assets,
and a rapid rate of principal payments in excess of that considered in pricing
the securities will have a material adverse effect on an IO security's yield to
maturity. If the underlying mortgage assets experience greater than anticipated
payments of principal, a Fund may fail to recoup fully its initial investment in
IOs. In addition, there are certain types of IOs that represent the interest
portion of a particular class as opposed to the interest portion of the entire
pool. The sensitivity of this type of IO to interest rate fluctuations may be
increased because of the characteristics of the principal portion to which they
relate. As a result of the above factors, a Fund generally will purchase IOs
only as a component of so called "synthetic" securities. This means that
purchases of IOs will be matched with certain purchases of other securities,
such as POs, inverse floating rate CMOs or fixed rate securities; as interest
rates fall, presenting a greater risk of unanticipated prepayments of principal,
the negative effect on a Fund because of its holdings of IOs should be
diminished somewhat because of the increased yield on the inverse floating rate
CMOs or the increased appreciation on the POs or fixed rate securities. IOs and
POs are considered by the staff of the Commission to be illiquid securities and,
consequently, a Fund will not invest in IOs or POs in an amount which, taken
together with the Fund's other investments in illiquid securities, exceeds 15%
of the Fund's net assets.
Tiered Index Bonds. Tiered index bonds are relatively new forms of
mortgage-related securities. The interest rate on a tiered index bond is tied to
a specified index or market rate. So long as this index or market rate is below
a predetermined "strike" rate, the interest rate on the tiered index bond
remains fixed. If, however, the specified index or market rate rises above the
"strike" rate, the interest rate of the tiered index bond will decrease. Thus,
under these circumstances, the interest rate on a tiered index bond, like an
inverse floater, will move in the opposite direction of prevailing interest
rates, with the result that the price of the tiered index bond may be
considerably more volatile than that of a fixed-rate bond.
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 a
Fund. 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 Fund for its asset-backed securities, the yield the Fund
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 Fund 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 Fund purchases asset-backed
securities at a premium, prepayments may result in a loss to the extent of the
premium paid. If a Fund 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 longer 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
the Fund.
Foreign Investment Risks
Foreign Market Risk. Funds that may invest in foreign securities offer the
potential for more diversification than a Fund that invests only in the United
States because securities traded on foreign markets have often (though not
always) performed differently than securities in the United States. However,
such investments involve special risks not present in U.S. investments that can
increase the chances that a Fund will lose money. In particular, a Fund is
subject to the risk that, because there are generally fewer investors on foreign
exchanges and a smaller number of shares traded each day, it may be difficult
for the Fund to buy and sell securities on those exchanges. In addition, prices
of foreign securities may fluctuate more than prices of securities traded in the
United States.
Foreign Economy Risk. The economies of certain foreign markets often do not
compare favorably with that of the United States with respect to such issues as
growth of gross national product, reinvestment of capital, resources, and
balance of payments position. Certain such economies may rely heavily on
particular industries or foreign capital and are more vulnerable to diplomatic
developments, the imposition of economic sanctions against a particular country
or countries, changes in international trading patterns, trade barriers, and
other protectionist or retaliatory measures. Investments in foreign markets may
also be adversely affected by governmental actions such as the imposition of
capital controls,
II-14
nationalization of companies or industries, expropriation of assets, or the
imposition of punitive taxes. In addition, the governments of certain countries
may prohibit or impose substantial restrictions on foreign investing in their
capital markets or in certain industries. Any of these actions could severely
affect security prices, impair a Fund's ability to purchase or sell foreign
securities or transfer the Fund's assets or income back into the United States,
or otherwise adversely affect a Fund's operations. Other foreign market risks
include foreign exchange controls, difficulties in pricing securities, defaults
on foreign government securities, difficulties in enforcing favorable legal
judgments in foreign courts, and political and social instability. Legal
remedies available to investors in certain foreign countries may be less
extensive than those available to investors in the United States or other
foreign countries.
Currency Risk and Exchange Risk. Securities in which a Fund invests may be
denominated or quoted in currencies other than the U.S. dollar. Changes in
foreign currency exchange rates will affect the value of a Fund's portfolio.
Generally, when the U.S. dollar rises in value against a foreign currency, a
security denominated in that currency loses value because the currency is worth
fewer U.S. dollars. Conversely, when the U.S. dollar decreases in value against
a foreign currency, a security denominated in that currency gains value because
the currency is worth more U.S. dollars. This risk, generally known as "currency
risk," means that a stronger U.S. dollar will reduce returns for U.S. investors
while a weak U.S. dollar will increase those returns.
Governmental Supervision and Regulation/Accounting Standards. Many foreign
governments supervise and regulate stock exchanges, brokers and the sale of
securities less than does the United States. Some countries may not have laws to
protect investors comparable to the U.S. securities laws. For example, some
foreign countries may have no laws or rules against insider trading. Insider
trading occurs when a person buys or sells a company's securities based on
nonpublic information about that company. Accounting standards in other
countries are not necessarily the same as in the United States. If the
accounting standards in another country do not require as much detail as U.S.
accounting standards, it may be harder for Fund management to completely and
accurately determine a company's financial condition. Also, brokerage
commissions and other costs of buying or selling securities often are higher in
foreign countries than they are in the United States. This reduces the amount a
Fund can earn on its investments.
Certain Risks of Holding Fund Assets Outside the United States. A Fund generally
holds its foreign securities and cash in foreign banks and securities
depositories. Some foreign banks and securities depositories may be recently
organized or new to the foreign custody business. In addition, there may be
limited or no regulatory oversight over their operations. Also, the laws of
certain countries may put limits on a Fund's ability to recover its assets if a
foreign bank or depository or issuer of a security or any of their agents goes
bankrupt. In addition, it is often more expensive for a Fund to buy, sell and
hold securities in certain foreign markets than in the United States. The
increased expense of investing in foreign markets reduces the amount a Fund can
earn on its investments and typically results in a higher operating expense
ratio for the Fund as compared to investment companies that invest only in the
United States.
Settlement Risk. Settlement and clearance procedures in certain foreign markets
differ significantly from those in the United States. Foreign settlement
procedures and trade regulations also may involve certain risks (such as delays
in payment for or delivery of securities) not typically generated by the
settlement of U.S. investments. Communications between the United States and
emerging market countries may be unreliable, increasing the risk of delayed
settlements or losses of security certificates. Settlements in certain foreign
countries at times have not kept pace with the number of securities
transactions; these problems may make it difficult for a Fund to carry out
transactions. If a Fund cannot settle or is delayed in settling a purchase of
securities, it may miss attractive investment opportunities and certain of its
assets may be uninvested with no return earned thereon for some period. If a
Fund cannot settle or is delayed in settling a sale of securities, it may lose
money if the value of the security then declines or, if it has contracted to
sell the security to another party, the Fund could be liable to that party for
any losses incurred.
Dividends or interest on, or proceeds from the sale of, foreign securities may
be subject to foreign withholding taxes.
Investment in Emerging Markets. Certain Funds may invest in the securities of
issuers domiciled in various countries with emerging capital markets.
Specifically, a country with an emerging capital market is any country that the
World Bank, the International Finance Corporation, the United Nations or its
authorities has determined to have a low or middle income economy. Countries
with emerging markets can be found in regions such as Asia, Latin America,
Eastern Europe and Africa.
II-15
Investments in the securities of issuers domiciled in countries with emerging
capital markets involve certain additional risks not involved in investments in
securities of issuers in more developed capital markets, such as (i) low or
non-existent trading volume, resulting in a lack of liquidity and increased
volatility in prices for such securities, as compared to securities of
comparable issuers in more developed capital markets, (ii) uncertain national
policies and social, political and economic instability, increasing the
potential for expropriation of assets, confiscatory taxation, high rates of
inflation or unfavorable diplomatic developments, (iii) possible fluctuations in
exchange rates, differing legal systems and the existence or possible imposition
of exchange controls, custodial restrictions or other foreign or U.S.
governmental laws or restrictions applicable to such investments, (iv) national
policies that may limit a Fund's investment opportunities such as restrictions
on investment in issuers or industries deemed sensitive to national interests,
and (v) the lack or relatively early development of legal structures governing
private and foreign investments and private property. In addition to withholding
taxes on investment income, some countries with emerging markets may impose
differential capital gains taxes on foreign investors.
Such capital markets are emerging in a dynamic political and economic
environment brought about by events over recent years that have reshaped
political boundaries and traditional ideologies. In such a dynamic environment,
there can be no assurance that these capital markets will continue to present
viable investment opportunities for a Fund. In the past, governments of such
nations have expropriated substantial amounts of private property, and most
claims of the property owners have never been fully settled. There is no
assurance that such expropriations will not reoccur. In such an event, it is
possible that a Fund could lose the entire value of its investments in the
affected markets.
Also, there may be less publicly available information about issuers in emerging
markets than would be available about issuers in more developed capital markets,
and such issuers may not be subject to accounting, auditing and financial
reporting standards and requirements comparable to those to which U.S. companies
are subject. In certain countries with emerging capital markets, reporting
standards vary widely. As a result, traditional investment measurements used in
the United States, such as price/earnings ratios, may not be applicable.
Emerging market securities may be substantially less liquid and more volatile
than those of mature markets, and companies may be held by a limited number of
persons. This may adversely affect the timing and pricing of the Fund's
acquisition or disposal of securities.
Practices in relation to settlement of securities transactions in emerging
markets involve higher risks than those in developed markets, in part because a
Fund will need to use brokers and counterparties that are less well capitalized,
and custody and registration of assets in some countries may be unreliable. The
possibility of fraud, negligence, undue influence being exerted by the issuer or
refusal to recognize ownership exists in some emerging markets, and, along with
other factors, could result in ownership registration being completely lost. A
Fund would absorb any loss resulting from such registration problems and may
have no successful claim for compensation.
Restrictions on Certain Investments. A number of publicly traded closed-end
investment companies have been organized to facilitate indirect foreign
investment in developing countries, and certain of such countries, such as
Thailand, South Korea, Chile and Brazil have specifically authorized such funds.
There also are investment opportunities in certain of such countries in pooled
vehicles that resemble open-end investment companies. In accordance with the
Investment Company Act, a Fund may invest up to 10% of its total assets in
securities of other investment companies, not more than 5% of which may be
invested in any one such company. In addition, under the Investment Company Act,
a Fund may not own more than 3% of the total outstanding voting stock of any
investment company. These restrictions on investments in securities of
investment companies may limit opportunities for a Fund to invest indirectly in
certain developing countries. Shares of certain investment companies may at
times be acquired only at market prices representing premiums to their net asset
values. If a Fund acquires shares of other investment companies, shareholders
would bear both their proportionate share of expenses of the Fund (including
management and advisory fees) and, indirectly, the expenses of such other
investment companies.
Depositary Receipts. A Fund may invest in the securities of foreign issuers in
the form of Depositary Receipts or other securities convertible into securities
of foreign issuers. Depositary Receipts may not necessarily be denominated in
the same currency as the underlying securities into which they may be converted.
American Depositary Receipts ("ADRs") are receipts typically issued by an
American bank or trust company that evidence ownership of underlying securities
issued by a foreign corporation. European Depositary Receipts ("EDRs") are
receipts issued in Europe that evidence a similar ownership arrangement. Global
Depositary Receipts ("GDRs") are receipts issued throughout the world that
evidence a similar arrangement. Generally, ADRs, in registered form, are
designed for use in the U.S. securities markets, and EDRs, in bearer form, are
designed for use in European securities markets. GDRs are tradable both in the
United States and in Europe and are designed for use throughout the world. A
Fund may invest in unsponsored Depositary Receipts. The
II-16
issuers of unsponsored Depositary Receipts are not obligated to disclose
material information in the United States, and, therefore, there may be less
information available regarding such issuers and there may not be a correlation
between such information and the market value of the Depositary Receipts.
Supranational Entities. A Fund may invest in debt securities of supranational
entities as defined above. Examples include the International Bank for
Reconstruction and Development (the World Bank), the European Steel and Coal
Community, the Asian Development Bank and the Inter-American Development Bank.
The government members, or "stockholders," usually make initial capital
contributions to the supranational entity and in many cases are committed to
make additional capital contributions if the supranational entity is unable to
repay its borrowings.
Sovereign Debt. Investment in sovereign debt can involve a high degree of risk.
The governmental entity that controls the repayment of sovereign debt may not be
able or willing to repay the principal and/or interest when due in accordance
with the terms of such debt. A governmental entity's willingness or ability to
repay principal and interest due in a timely manner may be affected by, among
other factors, its cash flow situation, the extent of its foreign reserves, the
availability of sufficient foreign exchange on the date a payment is due, the
relative size of the debt service burden to the economy as a whole, the
government entity's policy towards the International Monetary Fund and the
political constraints to which a government entity may be subject. Governmental
entities may also be dependent on expected disbursements from foreign
governments, multilateral agencies and others abroad to reduce principal and
interest arrearages on their debt. The commitment on the part of these
governments, agencies and others to make such disbursements may be conditioned
on the implementation of economic reforms and/or economic performance and the
timely service of such debtor's obligations. Failure to implement such reforms,
achieve such levels of economic performance or repay principal or interest when
due may result in the cancellation of such third parties' commitments to lend
funds to the governmental entity, which may further impair such debtor's ability
or willingness to timely service its debts. Consequently, governmental entities
may default on their sovereign debt.
Holders of sovereign debt may be requested to participate in the rescheduling of
such debt and to extend further loans to government entities. In the event of a
default by a governmental entity, there may be few or no effective legal
remedies for collecting on such debt.
Short Sales. Certain Funds may make short sales of securities, either as a hedge
against potential declines in value of a portfolio security or to realize
appreciation when a security that the Fund does not own declines in value. When
a Fund makes a short sale, it borrows the security sold short and delivers it to
the broker-dealer through which it made the short sale, as collateral for its
obligation to deliver the security upon conclusion of the sale. A Fund may have
to pay a fee to borrow particular securities and is often obligated to turn over
any payments received on such borrowed securities to the lender of the
securities.
A Fund secures its obligation to replace the borrowed security by depositing
collateral with the broker-dealer, usually in cash, U.S. Government securities
or other liquid securities similar to those borrowed. With respect to the
uncovered short positions, a Fund is required to deposit similar collateral with
its custodian, if necessary, to the extent that the value of both collateral
deposits in the aggregate is at all times equal to at least 100% of the current
market value of the security sold short. Depending on arrangements made with the
broker-dealer from which the Fund borrowed the security, regarding payment over
of any payments received by the Fund on such security, a Fund may not receive
any payments (including interest) on its collateral deposited with such
broker-dealer.
Because making short sales in securities that it does not own exposes a Fund to
the risks associated with those securities, such short sales involve speculative
exposure risk. As a result, if a Fund makes short sales in securities that
increase in value, it will likely underperform similar mutual funds that do not
make short sales in securities they do not own. A Fund will incur a loss as a
result of a short sale if the price of the security increases between the date
of the short sale and the date on which the Fund replaces the borrowed security.
A Fund will realize a gain if the security declines in price between those
dates. There can be no assurance that a Fund will be able to close out a short
sale position at any particular time or at an acceptable price. Although a
Fund's gain is limited to the price at which it sold the security short, its
potential loss is limited only by the maximum attainable price of the security,
less the price at which the security was sold and may, theoretically, be
unlimited.
II-17
A Fund may also make short sales "against the box" without being subject to such
limitations. In this type of short sale, at the time of the sale, the Fund owns
or has the immediate and unconditional right to acquire the identical security
at no additional cost.
Derivatives
Each Fund may use instruments referred to as derivative securities
("Derivatives"). Derivatives are financial instruments the value of which is
derived from another security, a commodity (such as gold or oil), a currency or
an index (a measure of value or rates, such as the S&P 500 Index or the prime
lending rate). Derivatives allow a Fund to increase or decrease the level of
risk to which the Fund is exposed more quickly and efficiently than transactions
in other types of instruments. Each Fund may use Derivatives for hedging
purposes. Certain Funds may also use derivatives for speculative purposes (that
is, to seek to enhance returns). The use of a Derivative is speculative if the
Fund is primarily seeking to achieve gains, rather than offset the risk of other
positions. When the Fund invests in a Derivative for speculative purposes, the
Fund will be fully exposed to the risks of loss of that Derivative, which may
sometimes be greater than the Derivative's cost. No Fund may use any Derivative
to gain exposure to an asset or class of assets that it would be prohibited by
its investment restrictions from purchasing directly.
Hedging. Hedging is a strategy in which a Derivative is used to offset the risks
associated with other Fund holdings. Losses on the other investment may be
substantially reduced by gains on a Derivative that reacts in an opposite manner
to market movements. While hedging can reduce losses, it can also reduce or
eliminate gains or cause losses if the market moves in a different manner than
anticipated by the Fund or if the cost of the Derivative outweighs the benefit
of the hedge. Hedging also involves the risk that changes in the value of the
Derivative will not match those of the holdings being hedged as expected by a
Fund, in which case any losses on the holdings being hedged may not be reduced
or may be increased. The inability to close options and futures positions also
could have an adverse impact on a Fund's ability to hedge effectively its
portfolio. There is also a risk of loss by the Fund of margin deposits or
collateral in the event of bankruptcy of a broker with whom the Fund has an open
position in an option, a futures contract or a related option. There can be no
assurance that a Fund's hedging strategies will be effective. No Fund is
required to engage in hedging transactions and each Fund may choose not to do
so.
A Fund may use Derivative instruments and trading strategies including the
following:
Indexed and Inverse Floating Rate Securities. A Fund may invest in securities
that yield a potential return based on a particular index of value or interest
rates. For example, a Fund may invest in securities that pay interest based on
an index of interest rates. The principal amount payable upon maturity of
certain securities also may be based on the value of the index. To the extent a
Fund invests in these types of securities, the Fund's return on such securities
will be subject to risk with respect to the value of the particular index.
Interest and principal payable on the securities may also be based on relative
changes among particular indices. Also, a Fund may invest in so-called "inverse
floating obligations" or "residual interest bonds" on which the interest rates
vary inversely with a floating rate (which may be reset periodically by a dutch
auction, a remarketing agent, or by reference to a short-term tax-exempt
interest rate index). A Fund may purchase synthetically-created inverse floating
rate bonds evidenced by custodial or trust receipts. Generally, income on
inverse floating rate bonds will decrease when interest rates increase, and will
increase when interest rates decrease. Such securities have the effect of
providing a degree of investment leverage, since they may increase or decrease
in value in response to changes, as an illustration, in market interest rates at
a rate which is a multiple (typically two) of the rate at which fixed-rate
securities increase or decrease in response to such changes. As a result, the
market values of such securities will generally be more volatile than the market
values of fixed-rate securities. To seek to limit the volatility of these
securities, a Fund may purchase inverse floating obligations with shorter-term
maturities or which contain limitations on the extent to which the interest rate
may vary. Certain investments in such obligations may be illiquid. A Fund may
not invest in such illiquid obligations if such investments, together with other
illiquid investments, would exceed 15% of the Fund's net assets. The Manager
believes that indexed and inverse floating obligations represent flexible
portfolio management instruments for a Fund that allow the Fund to seek
potential investment rewards, hedge other portfolio positions or vary the degree
of investment leverage relatively efficiently under different market conditions.
A Fund may invest in indexed and inverse securities for hedging purposes only or
to increase returns. When used for hedging purposes, indexed and inverse
securities involve correlation risk. (Furthermore, where such a security
includes a contingent liability, in the event of such an adverse movement, a
Fund may be required to pay substantial additional margin to maintain the
position.)
II-18
Swap Agreements. A Fund 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 a Fund than if the Fund 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. A Fund'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 "). A
Fund's obligations under a swap agreement will be accrued daily (offset against
any amounts owing to the Fund) 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 Fund's
portfolio.
Whether a Fund's use of swap agreements will be successful in furthering its
investment objective will depend on the Manager'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, a Fund 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 Fund's ability to terminate existing swap agreements or to
realize amounts to be received under such agreements.
See "Credit Default Swap Agreements," "Interest Rate Swaps, Caps and Floors" and
"Municipal Interest Rate Swap Agreements" below for further information on
particular types of swap agreements that may be used by certain Funds.
Options on Securities and Securities Indices. A Fund may invest in options on
individual securities, baskets of securities or particular measurements of
value or rate (an "index"), such as an index of the price of treasury securities
or an index representative of short term interest rates.
Purchasing Put Options. A Fund may purchase put options on securities held in
its portfolio or on securities or interest rate indices that are correlated with
securities held in its portfolio. When a Fund purchases a put option, in
consideration for an upfront payment (the "option premium"), the Fund acquires a
right to sell to another party specified securities owned by the Fund at a
specified price (the "exercise price") on or before a specified date (the
"expiration date"), in the case of an option on securities, or to receive from
another party a payment based on the amount a specified securities index
declines below a specified level on or before the expiration date, in the case
of an option on a securities index. The purchase of a put option limits a Fund's
risk of loss in the event of a decline in the market value of the portfolio
holdings underlying the put option prior to the option's expiration date. If the
market value of the portfolio holdings associated with the put option increases
rather than decreases, however, the Fund will lose the option premium and will
consequently realize a lower return on the portfolio holdings than would have
been realized without the purchase of the put. Purchasing a put option may
involve correlation risk, and may also involve liquidity and credit risk.
Purchasing Call Options. A Fund may also purchase call options on securities it
intends to purchase or securities or interest rate indices, which are correlated
with the types of securities it intends to purchase. When a Fund purchases a
call option, in consideration for the option premium the Fund acquires a right
to purchase from another party specified securities at the exercise price on or
before the expiration date, in the case of an option on securities, or to
receive from another party a payment based on the amount a specified securities
index increases beyond a specified level on or before the expiration date, in
the case of an option on a securities index. The purchase of a call option may
protect a Fund from having to pay more for a security as a consequence of
increases in the market value for the security during a period when the Fund is
contemplating its purchase, in the case of an option on a security, or
attempting to identify specific securities in which to invest in a market the
Fund believes to be attractive, in the case of an option on an index (an
"anticipatory hedge"). In the event a Fund determines not to purchase a security
underlying a call option, however, the Fund may lose the entire option premium.
Purchasing a call option involves correlation risk, and may also involve
liquidity and credit risk.
II-19
A Fund is also authorized to purchase put or call options in connection with
closing out put or call options it has previously sold. The profit or loss
realized by a Fund from such a closing transaction will depend on whether the
amount received is more or less than the premium paid for the option plus the
related transaction costs.
Options on Government National Mortgage Association ("GNMA") Certificates. The
following information relates to unique characteristics of options on GNMA
Certificates. Since the remaining principal balance of GNMA Certificates
declines each month as a result of mortgage payments, a Fund, as a writer of a
GNMA call holding GNMA Certificates as "cover" to satisfy its delivery
obligation in the event of exercise, may find that the GNMA Certificates it
holds no longer have a sufficient remaining principal balance for this purpose.
Should this occur, a Fund will purchase additional GNMA Certificates from the
same pool (if obtainable) or other GNMA Certificates in the cash market in order
to maintain its "cover."
A GNMA Certificate held by a Fund to cover an option position in any but the
nearest expiration month may cease to represent cover for the option in the
event of a decline in the GNMA coupon rate at which new pools are originated
under the FHA/VA loan ceiling in effect at any given time. If this should occur,
a Fund will no longer be covered, and the Fund will either enter into a closing
purchase transaction or replace such Certificate with a certificate which
represents cover. When a Fund closes its position or replaces such Certificate,
it may realize an unanticipated loss and incur transaction costs.
Writing Call Options. A Fund may write (i.e., sell) call options on securities
held in its portfolio or securities indices the performance of which correlates
with securities held in its portfolio. When a Fund writes a call option, in
return for an option premium the Fund gives another party the right to buy
specified securities owned by the Fund at the exercise price on or before the
expiration date, in the case of an option on securities, or agrees to pay to
another party an amount based on any gain in a specified securities index beyond
a specified level on or before the expiration date, in the case of an option on
a securities index. A Fund may write call options to earn income, through the
receipt of option premiums. In the event the party to which a Fund has written
an option fails to exercise its rights under the option because the value of the
underlying securities is less than the exercise price, the Fund will partially
offset any decline in the value of the underlying securities through the receipt
of the option premium. By writing a call option, however, a Fund limits its
ability to sell the underlying securities, and gives up the opportunity to
profit from any increase in the value of the underlying securities beyond the
exercise price, while the option remains outstanding. Writing a call option may
involve correlation risk.
Writing Put Options. A Fund may also write put options on securities or
securities indices. When a Fund writes a put option, in return for an option
premium the Fund gives another party the right to sell to the Fund a specified
security at the exercise price on or before the expiration date, in the case of
an option on a security, or agrees to pay to another party an amount based on
any decline in a specified securities index below a specified level on or before
the expiration date, in the case of an option on a securities index. A Fund may
write put options to earn income, through the receipt of option premiums. In the
event the party to which a Fund has written an option fails to exercise its
rights under the option because the value of the underlying securities is
greater than the exercise price, the Fund will profit by the amount of the
option premium. By writing a put option, however, a Fund will be obligated to
purchase the underlying security at a price that may be higher than the market
value of the security at the time of exercise as long as the put option is
outstanding, in the case of an option on a security, or make a cash payment
reflecting any decline in the index, in the case of an option on an index.
Accordingly, when a Fund writes a put option it is exposed to a risk of loss in
the event the value of the underlying securities falls below the exercise price,
which loss potentially may substantially exceed the amount of option premium
received by the Fund for writing the put option. A Fund will write a put option
on a security or a securities index only if the Fund would be willing to
purchase the security at the exercise price for investment purposes (in the case
of an option on a security) or is writing the put in connection with trading
strategies involving combinations of options - for example, the sale and
purchase of options with identical expiration dates on the same security or
index but different exercise prices (a technique called a "spread"). Writing a
put option may involve substantial leverage risk.
A Fund is also authorized to sell call or put options in connection with closing
out call or put options it has previously purchased.
Other than with respect to closing transactions, a Fund will only write call or
put options that are "covered." A call or put option will be considered covered
if a Fund has segregated assets with respect to such option in the manner
described in "Risk Factors in Derivatives" below. A call option will also be
considered covered if a Fund owns the securities it would be required to deliver
upon exercise of the option (or, in the case of an option on a securities index,
securities which
II-20
substantially correlate with the performance of such index) or owns a call
option, warrant or convertible instrument which is immediately exercisable for,
or convertible into, such security.
Types of Options. A Fund may engage in transactions in options on securities or
securities indices on exchanges and in the over-the-counter ("OTC") markets. In
general, exchange-traded options have standardized exercise prices and
expiration dates and require the parties to post margin against their
obligations, and the performance of the parties' obligations in connection with
such options is guaranteed by the exchange or a related clearing corporation.
OTC options have more flexible terms negotiated between the buyer and the
seller, but generally do not require the parties to post margin and are subject
to greater credit risk. OTC options also involve greater liquidity risk. See
"Additional Risk Factors of OTC Transactions; Limitations on the Use of OTC
Derivatives" below.
Futures. A Fund may engage in transactions in futures and options thereon.
Futures are standardized, exchange-traded contracts which obligate a purchaser
to take delivery, and a seller to make delivery, of a specific amount of an
asset at a specified future date at a specified price. No price is paid upon
entering into a futures contract. Rather, upon purchasing or selling a futures
contract a Fund 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 Fund 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. Futures involve substantial leverage
risk.
The sale of a futures contract limits a Fund's risk of loss through a decline in
the market value of portfolio holdings correlated with the futures contract
prior to the futures contract's expiration date. In the event the market value
of the portfolio holdings correlated with the futures contract increases rather
than decreases, however, a Fund will realize a loss on the futures position and
a lower return on the portfolio holdings than would have been realized without
the purchase of the futures contract.
The purchase of a futures contract may protect a Fund from having to pay more
for securities as a consequence of increases in the market value for such
securities during a period when the Fund was attempting to identify specific
securities in which to invest in a market the Fund believes to be attractive. In
the event that such securities decline in value or a Fund determines not to
complete an anticipatory hedge transaction relating to a futures contract,
however, the Fund may realize a loss relating to the futures position.
A Fund is also authorized to purchase or sell call and put options on futures
contracts including financial futures and stock indices in connection with its
hedging activities. Generally, these strategies would be used under the same
market and market sector conditions (i.e., conditions relating to specific types
of investments) in which the Fund entered into futures transactions. A Fund may
purchase put options or write call options on futures contracts and stock
indices rather than selling the underlying futures contract in anticipation of a
decrease in the market value of its securities. Similarly, a Fund can purchase
call options, or write put options on futures contracts and stock indices, as a
substitute for the purchase of such futures to hedge against the increased cost
resulting from an increase in the market value of securities which the Fund
intends to purchase
A Fund will limit transactions in futures and options on futures to financial
futures contracts (i.e., contracts for which the underlying asset is a currency
or securities or interest rate index) purchased or sold for hedging purposes
(including anticipatory hedges). A Fund will further limit transactions in
futures and options on futures to the extent necessary to prevent the Fund from
being deemed a "commodity pool" under regulations of the Commodity Futures
Trading Commission.
Foreign Exchange Transactions. A Fund may engage in spot and forward foreign
exchange transactions and currency swaps, purchase and sell options on
currencies and purchase and sell currency futures and related options thereon
(collectively, "Currency Instruments") for purposes of hedging against the
decline in the value of currencies in which its portfolio holdings are
denominated against the U.S. dollar or to seek to enhance returns. Such
transactions could be effected with respect to hedges on non-U.S. dollar
denominated securities owned by a Fund, sold by a Fund but not yet delivered, or
committed or anticipated to be purchased by a Fund. As an illustration, a Fund
may use such techniques to hedge the stated value in U.S. dollars of an
investment in a yen-denominated security. In such circumstances, for example,
the Fund may purchase a foreign currency put option enabling it to sell a
specified amount of yen for dollars at a specified price by a future date. To
the extent the hedge is successful, a loss in the value of the yen relative to
the dollar will tend to be offset by an increase in the value of the put option.
To offset, in whole or in part, the cost of acquiring such a put option,
II-21
the Fund may also sell a call option which, if exercised, requires it to sell a
specified amount of yen for dollars at a specified price by a future date (a
technique called a "straddle"). By selling such a call option in this
illustration, the Fund gives up the opportunity to profit without limit from
increases in the relative value of the yen to the dollar. "Straddles" of the
type that may be used by a Fund are considered to constitute hedging
transactions and are consistent with the policies described above. No Fund will
attempt to hedge all of its foreign portfolio positions.
Forward Foreign Exchange Transactions. Forward foreign exchange transactions are
OTC contracts to purchase or sell a specified amount of a specified currency or
multinational currency unit at a price and future date set at the time of the
contract. Spot foreign exchange transactions are similar but require current,
rather than future, settlement. A Fund will enter into foreign exchange
transactions for purposes of hedging either a specific transaction or a
portfolio position, or to seek to enhance returns. A Fund may enter into a
foreign exchange transaction for purposes of hedging a specific transaction by,
for example, purchasing a currency needed to settle a security transaction or
selling a currency in which the Fund has received or anticipates receiving a
dividend or distribution. A Fund may enter into a foreign exchange transaction
for purposes of hedging a portfolio position by selling forward a currency in
which a portfolio position of the Fund is denominated or by purchasing a
currency in which the Fund anticipates acquiring a portfolio position in the
near future. A Fund may also hedge portfolio positions through currency swaps,
which are transactions in which one currency is simultaneously bought for a
second currency on a spot basis and sold for the second currency on a forward
basis. Forward foreign exchange transactions involve substantial currency risk,
and also involve credit and liquidity risk.
Currency Futures. A Fund may also seek to enhance returns or hedge against the
decline in the value of a currency against the U.S. dollar through use of
currency futures or options thereon. Currency futures are similar to forward
foreign exchange transactions except that futures are standardized,
exchange-traded contracts. See "Futures" above. Currency futures involve
substantial currency risk, and also involve leverage risk.
Currency Options. A Fund may also seek to enhance returns or hedge against the
decline in the value of a currency against the U.S. dollar through the use of
currency options. Currency options are similar to options on securities, but in
consideration for an option premium the writer of a currency option is obligated
to sell (in the case of a call option) or purchase (in the case of a put option)
a specified amount of a specified currency on or before the expiration date for
a specified amount of another currency. A Fund may engage in transactions in
options on currencies either on exchanges or OTC markets. See "Types of Options"
above and "Additional Risk Factors of OTC Transactions; Limitations on the Use
of OTC Derivatives" below. Currency options involve substantial currency risk,
and may also involve credit, leverage or liquidity risk.
Limitations on Currency Hedging. Most Funds will not speculate in Currency
Instruments, although World Income may use such instruments to seek to enhance
returns. Accordingly, a Fund will not hedge a currency in excess of the
aggregate market value of the securities which it owns (including receivables
for unsettled securities sales), or has committed to or anticipates purchasing,
which are denominated in such currency. A Fund may, however, hedge a currency by
entering into a transaction in a Currency Instrument denominated in a currency
other than the currency being hedged (a "cross-hedge"). A Fund will only enter
into a cross-hedge if the Manager believes that (i) there is a demonstrable high
correlation between the currency in which the cross-hedge is denominated and the
currency being hedged, and (ii) executing a cross-hedge through the currency in
which the cross-hedge is denominated will be significantly more cost-effective
or provide substantially greater liquidity than executing a similar hedging
transaction by means of the currency being hedged.
Risk Factors in Hedging Foreign Currency Risks. Hedging transactions involving
Currency Instruments involve substantial risks, including correlation risk.
While a Fund's use of Currency Instruments to effect hedging strategies is
intended to reduce the volatility of the net asset value of the Fund's shares,
the net asset value of the Fund's shares will fluctuate. Moreover, although
Currency Instruments will be used with the intention of hedging against adverse
currency movements, transactions in Currency Instruments involve the risk that
anticipated currency movements will not be accurately predicted and that the
Fund's hedging strategies will be ineffective. To the extent that a Fund hedges
against anticipated currency movements that do not occur, the Fund may realize
losses and decrease its total return as the result of its hedging transactions.
Furthermore, a Fund will only engage in hedging activities from time to time and
may not be engaging in hedging activities when movements in currency exchange
rates occur.
In connection with its trading in forward foreign currency contracts, a Fund
will contract with a foreign or domestic bank, or foreign or domestic securities
dealer, to make or take future delivery of a specified amount of a particular
currency. There are no limitations on daily price moves in such forward
contracts, and banks and dealers are not required to continue
II-22
to make markets in such contracts. There have been periods during which certain
banks or dealers have refused to quote prices for such forward contracts or have
quoted prices with an unusually wide spread between the price at which the bank
or dealer is prepared to buy and that at which it is prepared to sell.
Governmental imposition of credit controls might limit any such forward contract
trading. With respect to its trading of forward contracts, if any, a Fund will
be subject to the risk of bank or dealer failure and the inability of, or
refusal by, a bank or dealer to perform with respect to such contracts. Any such
default would deprive the Fund of any profit potential or force the Fund to
cover its commitments for resale, if any, at the then market price and could
result in a loss to the Fund.
It may not be possible for a Fund to hedge against currency exchange rate
movements, even if correctly anticipated, in the event that (i) the currency
exchange rate movement is so generally anticipated that the Fund is not able to
enter into a hedging transaction at an effective price, or (ii) the currency
exchange rate movement relates to a market with respect to which Currency
Instruments are not available and it is not possible to engage in effective
foreign currency hedging. The cost to a Fund of engaging in foreign currency
transactions varies with such factors as the currencies involved, the length of
the contract period and the market conditions then prevailing. Since
transactions in foreign currency exchange usually are conducted on a principal
basis, no fees or commissions are involved.
Risk Factors in Derivatives
Derivatives are volatile and involve significant risks, including:
Credit Risk -- the risk that the counterparty on a Derivative transaction will
be unable to honor its financial obligation to a Fund.
Currency Risk -- the risk that changes in the exchange rate between two
currencies will adversely affect the value (in U.S. dollar terms) of an
investment.
Leverage Risk -- the risk associated with certain types of investments or
trading strategies (such as borrowing money to increase the amount of
investments) that relatively small market movements may result in large changes
in the value of an investment. Certain investments or trading strategies that
involve leverage can result in losses that greatly exceed the amount originally
invested.
Liquidity Risk -- the risk that certain securities may be difficult or
impossible to sell at the time that the seller would like or at the price that
the seller believes the security is currently worth.
Use of Derivatives for hedging purposes involves correlation risk. If the value
of the Derivative moves more or less than the value of the hedged instruments, a
Fund will experience a gain or loss which will not be completely offset by
movements in the value of the hedged instruments.
A Fund intends to enter into transactions involving Derivatives only if there
appears to be a liquid secondary market for such instruments or, in the case of
illiquid instruments traded in OTC transactions, such instruments satisfy the
criteria set forth below under "Additional Risk Factors of OTC Transactions;
Limitations on the Use of OTC Derivatives." However, there can be no assurance
that, at any specific time, either a liquid secondary market will exist for a
Derivative or the Fund will otherwise be able to sell such instrument at an
acceptable price. It may therefore not be possible to close a position in a
Derivative without incurring substantial losses, if at all.
Certain transactions in Derivatives (such as futures transactions or sales of
put options) involve substantial leverage risk and may expose a Fund to
potential losses, which exceed the amount originally invested by the Fund. When
a Fund engages in such a transaction, the Fund will deposit in a segregated
account at its custodian liquid securities with a value at least equal to the
Fund's exposure, on a mark-to-market basis, to the transaction (as calculated
pursuant to requirements of the Commission). Such segregation will ensure that a
Fund has assets available to satisfy its obligations with respect to the
transaction, but will not limit the Fund's exposure to loss.
Additional Risk Factors of OTC Transactions; Limitations on the Use of OTC
Derivatives
Certain Derivatives traded in OTC markets, including indexed securities, swaps
and OTC options, involve substantial liquidity risk. The absence of liquidity
may make it difficult or impossible for a Fund to sell such instruments promptly
at
II-23
an acceptable price. The absence of liquidity may also make it more difficult
for a Fund to ascertain a market value for such instruments. A Fund will,
therefore, acquire illiquid OTC instruments (i) if the agreement pursuant to
which the instrument is purchased contains a formula price at which the
instrument may be terminated or sold, or (ii) for which the Manager anticipates
the Fund can receive on each business day at least two independent bids or
offers, unless a quotation from only one dealer is available, in which case that
dealer's quotation may be used.
Because Derivatives traded in OTC markets are not guaranteed by an exchange or
clearing corporation and generally do not require payment of margin, to the
extent that a Fund has unrealized gains in such instruments or has deposited
collateral with its counterparty the Fund is at risk that its counterparty will
become bankrupt or otherwise fail to honor its obligations. A Fund will attempt
to minimize the risk that a counterparty will become bankrupt or otherwise fail
to honor its obligations by engaging in transactions in Derivatives traded in
OTC markets only with financial institutions that have investment grade credit
ratings or that have provided the Fund with a third-party guaranty or other
credit enhancement.
Interest Rate Swaps, Caps and Floors. A Fund may enter into interest rate swaps,
which are OTC contracts in which each party agrees to make a periodic payment
based on an index or the value of an asset in return for a periodic payment from
the other party based on a different index or asset.
In order to hedge the value of a Fund's portfolio against interest rate
fluctuations or to enhance a Fund's income, a Fund may enter into various
transactions, such as interest rate swaps and the purchase or sale of interest
rate caps and floors. A Fund expects to enter into these transactions primarily
to preserve a return or spread on a particular investment or portion of its
portfolio or to protect against any increase in the price of securities the Fund
anticipates purchasing at a later date. A Fund generally will use these
transactions primarily as a hedge and not as a speculative investment. However,
a Fund may also invest in interest rate swaps to enhance income or to increase
the Fund's yield during periods of steep interest rate yield curves (i.e., wide
differences between short term and long term interest rates).
A Fund usually will enter into interest rate swap transactions on a net basis,
i.e., the two payment streams are netted out, with the Fund receiving or paying,
as the case may be, only the net amount of the two payments. Inasmuch as these
transactions are entered into for good faith hedging purposes, the Manager
believes that such obligations do not constitute senior securities and,
accordingly, will not treat them as being subject to its borrowing restrictions.
The net amount of the excess, if any, of a Fund's obligations over its
entitlements with respect to each interest rate swap will be accrued on a daily
basis, and an amount of cash or liquid securities having an aggregate net asset
value at least equal to the accrued excess will be maintained in a segregated
account by the Fund's custodian. If the interest rate swap transaction is
entered into on other than a net basis, the full amount of a Fund's obligations
will be accrued on a daily basis, and the full amount of the Fund's obligations
will be maintained in a segregated account by the Fund's custodian.
In an interest rate swap, a Fund exchanges with another party their respective
commitments to pay or receive interest, e.g., an exchange of fixed rate payments
for floating rate payments. For example, if a Fund holds a mortgage backed
security with an interest rate that is reset only once each year, it may swap
the right to receive interest at this fixed rate for the right to receive
interest at a rate that is reset every week. This would enable a Fund to offset
a decline in the value of the mortgage backed security due to rising interest
rates but would also limit its ability to benefit from falling interest rates.
Conversely, if a Fund holds a mortgage backed security with an interest rate
that is reset every week and it would like to lock in what it believes to be a
high interest rate for one year, it may swap the right to receive interest at
this variable weekly rate for the right to receive interest at a rate that is
fixed for one year. Such a swap would protect the Fund from a reduction in yield
due to falling interest rates and may permit the Fund to enhance its income
through the positive differential between one week and one year interest rates,
but would preclude it from taking full advantage of rising interest rates.
A Fund also may engage in interest rate transactions in the form of purchasing
or selling interest rate caps or floors. The purchase of an interest rate cap
entitles the purchaser, to the extent that a specified index exceeds a
predetermined interest rate, to receive payments of interest on a notional
principal amount from the party selling such interest rate cap. The purchase of
an interest rate floor entitles the purchaser, to the extent that a specified
index falls below a predetermined interest rate, to receive payments of interest
on a notional principal amount from the party selling such interest rate floor.
Typically the parties with which a Fund will enter into interest rate
transactions will be broker-dealers and other financial institutions. A Fund
will enter into interest rate swap, cap or floor transactions only with
counterparties that are rated investment grade quality by at least one
nationally recognized statistical rating organization at the time of entering
into such
II-24
transaction or whose creditworthiness is believed by the Manager to be
equivalent to such rating. If there is a default by the other party to such a
transaction, a Fund will have contractual remedies pursuant to the agreements
related to the transaction. The swap market has grown substantially in recent
years with a large number of banks and investment banking firms acting both as
principals and as agents utilizing standardized swap documentation. As a result,
the swap market has become relatively liquid in comparison with other similar
instruments traded in the interbank market. Caps and floors, however, are less
liquid than swaps. Certain Federal income tax requirements may limit a Fund's
ability to engage in certain interest rate transactions. Gains from transactions
in interest rate swaps distributed to shareholders will be taxable as ordinary
income or, in certain circumstances, as long term capital gains to shareholders.
Credit Default Swap Agreements. Certain Funds may enter into credit default swap
agreements. The credit default swap agreement may have as reference obligations
one or more securities that are not currently held by a Fund. The protection
"buyer" in a credit default contract may be obligated to pay the protection
"seller" an upfront or a periodic stream of payments over the term of the
contract provided generally that no credit event on a reference obligation has
occurred. If a credit event occurs, the seller generally must pay the buyer the
"par value" (full notional value) of the swap in exchange for an equal face
amount of deliverable obligations of the reference entity described in the swap,
or the seller may be required to deliver the related net cash amount, if the
swap is cash settled. A Fund may be either the buyer or seller in the
transaction. If a Fund is a buyer and no credit event occurs, the Fund recovers
nothing if the swap is held through its termination date. However, if a credit
event occurs, the buyer may elect to receive the full notional value of the swap
in exchange for an equal face amount of deliverable obligations of the reference
entity that may have little or no value. As a seller, a Fund generally receives
an upfront payment or a fixed rate of income throughout the term of the swap,
which typically is between six months and three years, provided that there is no
credit event. If a credit event occurs, generally the seller must pay the buyer
the full notional value of the swap in exchange for an equal face amount of
deliverable obligations of the reference entity that may have little or no
value.
Credit default swaps involve greater risks than if a Fund had invested in the
reference obligation directly, since, in addition to general market risks,
credit default swaps are subject to illiquidity risk, counterparty risk and
credit risks. A Fund will enter into credit default swap agreements only with
counterparties who are rated investment grade quality by at least one nationally
recognized statistical rating organization at the time of entering into such
transaction or whose creditworthiness is believed by the Manager to be
equivalent to such rating. A buyer also will lose its investment and recover
nothing should no credit event occur and the swap is held to its termination
date. If a credit event were to occur, the value of any deliverable obligation
received by the seller, coupled with the upfront or periodic payments previously
received, may be less than the full notional value it pays to the buyer,
resulting in a loss of value to a Fund. When a Fund acts as a seller of a credit
default swap, it is exposed to many of the same risks of leverage since, if a
credit event occurs, the seller may be required to pay the buyer the full
notional value of the contract net of any amounts owed by the buyer related to
its delivery of deliverable obligations.
Stripped Securities. Stripped securities are created when the issuer separates
the interest and principal components of an instrument and sells them as
separate securities. In general, one security is entitled to receive the
interest payments on the underlying assets (the interest only) and the other to
receive the principal payments (the principal only security). Some stripped
securities may receive a combination of interest and principal payments. The
yields to maturity on IOs and POs are sensitive to the expected or anticipated
rate of principal payments (including prepayments) on the related underlying
assets, and principal payments may have a material effect on yield to maturity.
If the underlying assets experience greater than anticipated prepayments of
principal, a Fund may not fully recoup its initial investment in IOs.
Conversely, if the underlying assets experience less than anticipated
prepayments of principal, the yield on POs could be adversely affected. Stripped
securities may be highly sensitive to changes in interest rates and rates of
prepayment.
Real Estate Investment Trusts ("REITs"). Investing in REITs involves certain
unique risks in addition to those risks associated with investing in the real
estate industry in general. Equity REITs may be affected by changes in the value
of the underlying property owned by the REITs, while mortgage REITs may be
affected by the quality of any credit extended. REITs are dependent upon
management skills, may not be diversified geographically or by property type,
and are subject to heavy cash flow dependency, default by borrowers and
self-liquidation. REITs must also meet certain requirements under the Code to
avoid entity level tax and be eligible to pass-through certain tax attributes of
their income to shareholders. REITs are consequently subject to the risk of
failing to meet these requirements for favorable tax treatment and failing to
maintain their exemptions from registration under the Investment Company Act.
REITs are also subject to changes in the Code, including changes involving their
tax status.
II-25
REITs (especially mortgage REITs) are also subject to interest rate risks. When
interest rates decline, the value of a REIT's investment in fixed rate
obligations can be expected to rise. Conversely, when interest rates rise, the
value of a REIT's investment in fixed rate obligations can be expected to
decline. In contrast, as interest rates on adjustable rate mortgage loans are
reset periodically, yields on a REIT's investments in such loans will gradually
align themselves to reflect changes in market interest rates, causing the value
of such investments to fluctuate less dramatically in response to interest rate
fluctuations than would investments in fixed rate obligations.
Investing in REITs involves risks similar to those associated with investing in
small capitalization companies. REITs may have limited financial resources, may
trade less frequently and in limited volume and may be subject to more abrupt or
erratic price movements than larger company securities. Historically, small
capitalization stocks, such as REITs, have been more volatile in price than the
larger capitalization stocks included in the S&P 500 Index. The management of a
REIT may be subject to conflicts of interest with respect to the operation of
the business of the REIT and may be involved in real estate activities
competitive with the REIT. REITs may own properties through joint ventures or in
other circumstances in which the REIT may not have control over its investments.
REITs may incur significant amounts of leverage.
Zero Coupon Securities. Certain Funds may invest in zero coupon securities. Zero
coupon securities are securities that are sold at a discount to par value and on
which interest payments are not made during the life of the security. The
discount approximates the total amount of interest the security will accrue and
compound over the period until maturity on the particular interest payment date
at a rate of interest reflecting the market rate of the security at the time of
issuance. Upon maturity, the holder is entitled to receive the par value of the
security. While interest payments are not made on such securities, holders of
such securities are deemed to have received income ("phantom income") annually,
notwithstanding that cash may not be received currently. The effect of owning
instruments that do not make current interest payments is that a fixed yield is
earned not only on the original investment but also, in effect, on all discount
accretion during the life of the obligations. This implicit reinvestment of
earnings at the same rate eliminates the risk of being unable to invest
distributions at a rate as high as the implicit yield on the zero coupon bond,
but at the same time eliminates the holder's ability to reinvest at higher rates
in the future. For this reason, some of these securities may be subject to
substantially greater price fluctuations during periods of changing market
interest rates than are comparable securities that pay interest currently, which
fluctuation increases the longer the period to maturity. These investments
benefit the issuer by mitigating its need for cash to meet debt service, but
also require a higher rate of return to attract investors who are willing to
defer receipt of cash. A Fund accrues income with respect to these securities
for Federal income tax and accounting purposes prior to the receipt of cash
payments. Zero coupon securities may be subject to greater fluctuation in value
and lesser liquidity in the event of adverse market conditions than comparable
rated securities paying cash interest at regular intervals.
In addition to the above-described risks, there are certain other risks related
to investing in zero coupon securities. During a period of severe market
conditions, the market for such securities may become even less liquid. In
addition, as these securities do not pay cash interest, a Fund's investment
exposure to these securities and their risks, including credit risk, will
increase during the time these securities are held in the Fund's portfolio.
Further, to maintain its qualification for pass-through treatment under the
Federal tax laws, a Fund is required to distribute income to its shareholders
and, consequently, may have to dispose of its portfolio securities under
disadvantageous circumstances to generate the cash, or may have to leverage
itself by borrowing the cash to satisfy these distributions, as they relate to
the distribution of phantom income. The required distributions will result in an
increase in a Fund's exposure to such securities.
Municipal Investments
The Municipal Funds may invest in obligations issued by or on behalf of states,
territories and possessions of the United States and the District of Columbia
and their political subdivisions, agencies and instrumentalities, the payments
from which, in the opinion of bond counsel to the issuer, are exempt from
Federal income taxes ("Municipal Bonds"). California Insured, Florida Municipal
Bond, New Jersey Municipal Bond, New York Municipal Bond and Pennsylvania
Municipal Bond also invest in Municipal Bonds that pay interest exempt from
and/or allow the value of a Fund's shares to be exempt from applicable state and
local taxes ("State Municipal Bonds"). The Municipal Funds may also invest in
securities not issued by or on behalf of a state or territory or by an agency or
instrumentality thereof, if the Manager believes such securities to pay interest
exempt from Federal income taxation and/or applicable state and local taxes
("Non-Municipal Tax-Exempt Securities "). Non-Municipal Tax-Exempt Securities
could include trust certificates or other instruments evidencing interest in one
or more long term municipal securities. Non-Municipal Tax-Exempt Securities also
may include securities issued by other investment companies that invest in
municipal bonds, to the extent such investments are permitted by applicable law.
Non-Municipal Tax-Exempt Securities that pay interest exempt from Federal income
tax will be
II-26
considered "Municipal Bonds" for purposes of a Municipal Fund's investment
objective and policies. Non-Municipal Tax-Exempt Securities that pay interest
exempt from Federal income tax and applicable state and local taxes will be
considered "State Municipal Bonds" for purposes of the investment objective and
policies of each of California Insured, Florida Municipal Bond, New Jersey
Municipal Bond, New York Municipal Bond and Pennsylvania Municipal Bond.
Risk Factors and Special Considerations Relating to Municipal Bonds. The risks
and special considerations involved in investment in Municipal Bonds vary with
the types of instruments being acquired. Investments in Non-Municipal Tax-Exempt
Securities may present similar risks, depending on the particular product.
Certain instruments in which the Fund may invest may be characterized as
derivative instruments.
The value of Municipal Bonds generally may be affected by uncertainties in the
municipal markets as a result of legislation or litigation, including
legislation or litigation that changes the taxation of Municipal Bonds or the
rights of Municipal Bond holders in the event of a bankruptcy. Municipal
bankruptcies are rare and certain provisions of the U.S. Bankruptcy Code
governing such bankruptcies are unclear. Further, the application of state law
to Municipal Bond issuers could produce varying results among the states or
among Municipal Bond issuers within a state. These uncertainties could have a
significant impact on the prices of the Municipal Bonds in which a Fund invests.
Description of Municipal Bonds
Municipal Bonds include debt obligations issued to obtain funds for various
public purposes, including the construction of a wide range of public
facilities, refunding of outstanding obligations and obtaining funds for general
operating expenses and loans to other public institutions and facilities. In
addition, certain types of bonds are issued by or on behalf of public
authorities to finance various privately owned or operated facilities, including
certain facilities for the local furnishing of electric energy or gas, sewage
facilities, solid waste disposal facilities and other specialized facilities.
Such obligations are included within the term Municipal Bonds if the interest
paid thereon is excluded from gross income for Federal income tax purposes and
any applicable state and local taxes. Other types of industrial development
bonds or private activity bonds, the proceeds of which are used for the
construction, equipment or improvement of privately operated industrial or
commercial facilities, may constitute Municipal Bonds, although the current
Federal tax laws place substantial limitations on the size of such issues. The
interest on Municipal Bonds may bear a fixed rate or be payable at a variable or
floating rate. The two principal classifications of Municipal Bonds are "general
obligation" and "revenue" bonds, which latter category includes industrial
development bonds ("IDBs") and, for bonds issued after August 15, 1986, private
activity bonds ("PABs").
General Obligation Bonds. General obligation bonds are secured by the issuer's
pledge of its faith, credit and taxing power for the payment of principal and
interest. The taxing power of any governmental entity may be limited, however,
by provisions of its state constitution or laws, and an entity's
creditworthiness will depend on many factors, including potential erosion of its
tax base due to population declines, natural disasters, declines in the state's
industrial base or inability to attract new industries, economic limits on the
ability to tax without eroding the tax base, state legislative proposals or
voter initiatives to limit ad valorem real property taxes and the extent to
which the entity relies on Federal or state aid, access to capital markets or
other factors beyond the state's or entity's control. Accordingly, the capacity
of the issuer of a general obligation bond as to the timely payment of interest
and the repayment of principal when due is affected by the issuer's maintenance
of its tax base.
Revenue Bonds. Revenue bonds are payable only from the revenues derived from a
particular facility or class of facilities or, in some cases, from the proceeds
of a special excise tax or other specific revenue source such as payments from
the user of the facility being financed; accordingly the timely payment of
interest and the repayment of principal in accordance with the terms of the
revenue or special obligation bond is a function of the economic viability of
such facility or such revenue source.
IDBs and PABs. IDBs and PABs are, in most cases, tax-exempt securities issued by
states, municipalities or public authorities to provide funds, usually through a
loan or lease arrangement, to a private entity for the purpose of financing
construction or improvement of a facility to be used by the entity. Such bonds
are secured primarily by revenues derived from loan repayments or lease payments
due from the entity, which may or may not be guaranteed by a parent company or
otherwise secured. IDBs and PABs generally are not secured by a pledge of the
taxing power of the issuer of such bonds. Therefore, an investor should be aware
that repayment of such bonds generally depends on the revenues of a private
entity and be aware of the risks that such an investment may entail. Continued
ability of an entity to generate sufficient revenues
II-27
for the payment of principal and interest on such bonds will be affected by many
factors including the size of the entity, capital structure, demand for its
products or services, competition, general economic conditions, government
regulation and the entity's dependence on revenues for the operation of the
particular facility being financed.
Moral Obligation Bonds. "Moral obligation" bonds are normally issued by special
purpose public authorities. If an issuer of moral obligation bonds is unable to
meet its obligations, the repayment of such bonds becomes a moral commitment but
not a legal obligation of the state or municipality in question.
Municipal Notes. Municipal notes are shorter term municipal debt obligations.
They may provide interim financing in anticipation of tax collection, bond sales
or revenue receipts. If there is a shortfall in the anticipated proceeds, the
note may not be fully repaid and a Fund may lose money.
Municipal Commercial Paper. Municipal commercial paper is generally unsecured
and issued to meet short-term financing needs. The lack of security presents
some risk of loss to a Fund.
Municipal Lease Obligations. Also included within the general category of
Municipal Bonds are certificates of participation ("COPs") issued by government
authorities or entities to finance the acquisition or construction of equipment,
land and/or facilities. The COPs represent participations in a lease, an
installment purchase contract or a conditional sales contract (hereinafter
collectively called "lease obligations") relating to such equipment, land or
facilities. Although lease obligations do not constitute general obligations of
the issuer for which the issuer's unlimited taxing power is pledged, a lease
obligation is frequently backed by the issuer's covenant to budget for,
appropriate and make the payments due under the lease obligation. However,
certain lease obligations contain "non-appropriation" clauses which provide that
the issuer has no obligation to make lease or installment purchase payments in
future years unless money is appropriated for such purpose on a yearly basis.
Although "non-appropriation" lease obligations are secured by the leased
property, disposition of the property in the event of foreclosure might prove
difficult. These securities represent a type of financing that has not yet
developed the depth of marketability associated with more conventional
securities. Certain investments in lease obligations may be illiquid. A Fund may
not invest in illiquid lease obligations if such investments, together with all
other illiquid investments, would exceed 15% of the Fund's net assets. A Fund
may, however, invest without regard to such limitation in lease obligations that
the Manager, pursuant to guidelines that have been adopted by the Directors and
subject to the supervision of the Directors, determines to be liquid. The
Manager will deem lease obligations to be liquid if they are publicly offered
and have received an investment grade rating of Baa or better by Moody's, or BBB
or better by S&P or Fitch. Unrated lease obligations, or those rated below
investment grade, will be considered liquid if the obligations come to the
market through an underwritten public offering and at least two dealers are
willing to give competitive bids. In reference to the latter, the Manager must,
among other things, also review the creditworthiness of the entity obligated to
make payment under the lease obligation and make certain specified
determinations based on such factors as the existence of a rating or credit
enhancement such as insurance, the frequency of trades or quotes for the
obligation and the willingness of dealers to make a market in the obligation.
Yields. Yields on Municipal Bonds are dependent on a variety of factors,
including the general condition of the money market and of the municipal bond
market, the size of a particular offering, the financial condition of the
issuer, the maturity of the obligation and the rating of the issue. The ability
of a Fund to achieve its investment objective is also dependent on the
continuing ability of the issuers of the securities in which the Fund invests to
meet their obligations for the payment of interest and principal when due. There
are variations in the risks involved in holding Municipal Bonds, both within a
particular classification and between classifications, depending on numerous
factors. Furthermore, the rights of owners of Municipal Bonds and the
obligations of the issuer of such Municipal Bonds may be subject to applicable
bankruptcy, insolvency and similar laws and court decisions affecting the rights
of creditors generally and to general equitable principles, which may limit the
enforcement of certain remedies.
Variable Rate Demand Obligations ("VRDOs") and Participating VRDOs. VRDOs are
tax-exempt obligations that contain a floating or variable interest rate
adjustment formula and a right of demand on the part of the holder thereof to
receive payment of the unpaid principal balance plus accrued interest upon a
short notice period not to exceed seven days. There is, however, the possibility
that because of default or insolvency the demand feature of VRDOs and
Participating VRDOs may not be honored. The interest rates are adjustable at
intervals (ranging from daily to up to one year) to some prevailing market rate
for similar investments, such adjustment formula being calculated to maintain
the market rate of the VRDOs at approximately the par value of the VRDOs on the
adjustment date. The adjustments typically are based upon the Public Securities
Association Index or some other appropriate interest rate adjustment index. A
Fund may invest in all
II-28
types of tax-exempt instruments currently outstanding or to be issued in the
future which satisfy the short-term maturity and quality standards of the Fund.
Participating VRDOs provide a Fund with a specified undivided interest (up to
100%) of the underlying obligation and the right to demand payment of the unpaid
principal balance plus accrued interest on the Participating VRDOs from the
financial institution upon a specified number of days notice, not to exceed
seven days. In addition, the Participating VRDO is backed by an irrevocable
letter of credit or guaranty of the financial institution. A Fund would have an
undivided interest in the underlying obligation and thus participate on the same
basis as the financial institution in such obligation except that the financial
institution typically retains fees out of the interest paid on the obligation
for servicing the obligation, providing the letter of credit and issuing the
repurchase commitment. The Funds have been advised by counsel that they should
be entitled to treat the income received on Participating VRDOs as interest from
tax-exempt obligations. It is not contemplated that any Fund will invest more
than a limited amount of its total assets in Participating VRDOs.
VRDOs that contain a right of demand to receive payment of the unpaid principal
balance plus accrued interest on a notice period exceeding seven days may be
deemed to be illiquid securities. A VRDO with a demand notice period exceeding
seven days will therefore be subject to a Fund's restriction on illiquid
investments unless, in the judgment of the Directors such VRDO is liquid. The
Directors may adopt guidelines and delegate to the Manager the daily function of
determining and monitoring liquidity of such VRDOs. The Directors, however, will
retain sufficient oversight and will be ultimately responsible for such
determinations.
The VRDOs and Participating VRDOs in which a Fund may invest will be in the
following rating categories at the time of purchase: MIG-1/ VMIG-1 through
MIG-3/VMIG-3 for notes and VRDOs and Prime-1 through Prime-3 for commercial
paper (as determined by Moody's), SP-1 through SP-2 for notes and A-1 through
A-3 for VRDOs and commercial paper (as determined by S&P), or F-1 through F-3
for notes, VRDOs and commercial paper (as determined by Fitch Ratings
("Fitch")).
Transactions in Financial Futures Contracts.
The Municipal Funds deal in financial futures contracts based on a long-term
municipal bond index developed by the Chicago Board of Trade ("CBT") and The
Bond Buyer (the "Municipal Bond Index"). The Municipal Bond Index is comprised
of 40 tax-exempt municipal revenue and general obligation bonds. Each bond
included in the Municipal Bond Index must be rated A or higher by Moody's or S&P
and must have a remaining maturity of 19 years or more. Twice a month new issues
satisfying the eligibility requirements are added to, and an equal number of old
issues are deleted from, the Municipal Bond Index. The value of the Municipal
Bond Index is computed daily according to a formula based on the price of each
bond in the Municipal Bond Index, as evaluated by six dealer-to-dealer brokers.
The Municipal Bond Index futures contract is traded only on the CBT. Like other
contract markets, the CBT assures performance under futures contracts through a
clearing corporation, a nonprofit organization managed by the exchange
membership which is also responsible for handling daily accounting of deposits
or withdrawals of margin
The particular municipal bonds comprising the index underlying the Municipal
Bond Index financial futures contract may vary from the bonds held by a
Municipal Fund. As a result, a Municipal Fund's ability to hedge effectively all
or a portion of the value of its Municipal Bonds through the use of such
financial futures contracts will depend in part on the degree to which price
movements in the index underlying the financial futures contract correlate with
the price movements of the Municipal Bonds held by the Fund. The correlation may
be affected by disparities in the average maturity, ratings, geographical mix or
structure of a Municipal Fund's investments as compared to those comprising the
Municipal Bond Index and general economic or political factors. In addition, the
correlation between movements in the value of the Municipal Bond Index may be
subject to change over time as additions to and deletions from the Municipal
Bond Index alter its structure. The correlation between futures contracts on
U.S. Government securities and the Municipal Bonds held by a Municipal Fund may
be adversely affected by similar factors and the risk of imperfect correlation
between movements in the prices of such futures contracts and the prices of
Municipal Bonds held by a Municipal Fund may be greater. Municipal Bond Index
futures contracts were approved for trading in 1986. Trading in such futures
contracts may tend to be less liquid than trading in other futures contracts.
The trading of futures contracts also is subject to certain market risks, such
as inadequate trading activity, which could at times make it difficult or
impossible to liquidate existing positions.
II-29
Call Rights.
A Fund may purchase a Municipal Bond issuer's right to call all or a portion of
such Municipal Bond for mandatory tender for purchase (a "Call Right"). A holder
of a Call Right may exercise such right to require a mandatory tender for the
purchase of related Municipal Bonds, subject to certain conditions. A Call Right
that is not exercised prior to maturity of the related Municipal Bond will
expire without value. The economic effect of holding both the Call Right and the
related Municipal Bond is identical to holding a Municipal Bond as a
non-callable security. Certain investments in such obligations may be illiquid.
A Fund may not invest in such illiquid obligations if such investments, together
with other illiquid investments, would exceed 15% of a Fund's net assets.
Municipal Interest Rate Swap Transactions.
In order to hedge the value of a Fund against interest rate fluctuations or to
enhance a Fund's income, a Fund may enter into interest rate swap transactions
such as Municipal Market Data AAA Cash Curve swaps ("MMD Swaps") or Bond Market
Association Municipal Swap Index swaps ("BMA Swaps"). To the extent that a Fund
enters into these transactions, the Fund expects to do so primarily to preserve
a return or spread on a particular investment or portion of its portfolio or to
protect against any increase in the price of securities the Fund anticipates
purchasing at a later date. A Fund intends to use these transactions primarily
as a hedge rather than as a speculative investment. However, a Fund also may
invest in MMD Swaps and BMA Swaps to enhance income or gain or to increase the
Fund's yield, for example, during periods of steep interest rate yield curves
(i.e., wide differences between short term and long term interest rates).
A Fund may purchase and sell BMA Swaps in the BMA swap market. In a BMA Swap, a
Fund exchanges with another party their respective commitments to pay or receive
interest (e.g., an exchange of fixed rate payments for floating rate payments
linked to the Bond Market Association Municipal Swap Index). Because the
underlying index is a tax-exempt index, BMA Swaps may reduce cross-market risks
incurred by a Fund and increase a Fund's ability to hedge effectively. BMA Swaps
are typically quoted for the entire yield curve, beginning with a seven day
floating rate index out to 30 years. The duration of a BMA Swap is approximately
equal to the duration of a fixed-rate Municipal Bond with the same attributes as
the swap (e.g., coupon, maturity, call feature).
A Fund may also purchase and sell MMD Swaps, also known as MMD rate locks. An
MMD Swap permits a Fund to lock in a specified municipal interest rate for a
portion of its portfolio to preserve a return on a particular investment or a
portion of its portfolio as a duration management technique or to protect
against any increase in the price of securities to be purchased at a later date.
By using an MMD Swap, a Fund can create a synthetic long or short position,
allowing the Fund to select the most attractive part of the yield curve. An MMD
Swap is a contract between a Fund and an MMD Swap provider pursuant to which the
parties agree to make payments to each other on a notional amount, contingent
upon whether the Municipal Market Data AAA General Obligation Scale is above or
below a specified level on the expiration date of the contract. For example, if
a Fund buys an MMD Swap and the Municipal Market Data AAA General Obligation
Scale is below the specified level on the expiration date, the counterparty to
the contract will make a payment to the Fund equal to the specified level minus
the actual level, multiplied by the notional amount of the contract. If the
Municipal Market Data AAA General Obligation Scale is above the specified level
on the expiration date, a Fund will make a payment to the counterparty equal to
the actual level minus the specified level, multiplied by the notional amount of
the contract.
In connection with investments in BMA and MMD Swaps, there is a risk that
municipal yields will move in the opposite direction than anticipated by a Fund,
which would cause the Fund to make payments to its counterparty in the
transaction that could adversely affect the Fund's performance. A Fund has no
obligation to enter into BMA or MMD Swaps and may not do so. The net amount of
the excess, if any, of a Fund's obligations over its entitlements with respect
to each interest rate swap will be accrued on a daily basis and an amount of
cash or liquid securities having an aggregate net asset value at least equal to
the accrued excess will be maintained in a segregated account by the Fund's
custodian.
Suitability (All Funds)
The economic benefit of an investment in any Fund depends upon many factors
beyond the control of the Fund, the Manager and its affiliates. Each Fund should
be considered a vehicle for diversification and not as a balanced investment
program. The suitability for any particular investor of a purchase of shares in
a Fund will depend upon, among other things, such investor's investment
objectives and such investor's ability to accept the risks associated with
investing in securities, including the risk of loss of principal.
II-30
Investment Restrictions (All Funds)
See Part I, Section II "Investment Restrictions" of each Fund's Statement of
Additional Information for the specific fundamental and non-fundamental
investment restrictions adopted by each Fund. In addition to those investment
restrictions, each Fund is also subject to the restrictions discussed below.
The staff of the Commission has taken the position that purchased OTC options
and the assets used as cover for written OTC options are illiquid securities.
Therefore, each Fund has adopted an investment policy pursuant to which it will
not purchase or sell OTC options (including OTC options on futures contracts)
if, as a result of any such transaction, the sum of the market value of OTC
options currently outstanding that are held by the Fund, the market value of the
underlying securities covered by OTC call options currently outstanding that
were sold by the Fund and margin deposits on the Fund's existing OTC options on
financial futures contracts, together with all other assets of the Fund that are
illiquid or are not otherwise readily marketable, exceeds 15% of the net assets
of the Fund, taken at market value. However, if an OTC option is sold by a Fund
to a primary U.S. Government securities dealer recognized by the Federal Reserve
Bank of New York and if the Fund has the unconditional contractual right to
repurchase such OTC option from the dealer at a predetermined price, then the
Fund will treat as illiquid such amount of the underlying securities as is equal
to the repurchase price less the amount by which the option is "in-the-money"
(i.e., current market value of the underlying securities minus the option's
strike price). The repurchase price with the primary dealers is typically a
formula price which is generally based on a multiple of the premium received for
the option, plus the amount by which the option is "in-the-money." This policy
as to OTC options is not a fundamental policy of any Fund and may be amended by
the Board of Directors of the Fund without the approval of the Fund's
shareholders. However, no Fund will change or modify this policy prior to the
change or modification by the Commission staff of its position.
Each Fund's investments will be limited in order to allow the Fund to qualify as
a "regulated investment company" for purposes of the Code. See "Dividends and
Taxes -- Taxes." To qualify, among other requirements, each Fund will limit its
investments so that, at the close of each quarter of the taxable year, (i) not
more than 25% of the market value of the Fund's total assets will be invested in
the securities of a single issuer, and (ii) with respect to 50% of the market
value of its total assets, not more than 5% of the market value of its total
assets will be invested in the securities of a single issuer and the Fund will
not own more than 10% of the outstanding voting securities of a single issuer.
Foreign government securities (unlike U.S. government securities) are not exempt
from the diversification requirements of the Code and the securities of each
foreign government issuer are considered to be obligations of a single issuer.
These tax-related limitations may be changed by the Directors of a Fund to the
extent necessary to comply with changes to the Federal tax requirements. A Fund
that is "diversified" under the Investment Company Act must satisfy the
foregoing 5% and 10% requirements with respect to 75% of its total assets.
Directors and Officers
See Part I, Section III "Information on Officers and Directors," "--
Biographical Information," "-- Share Ownership" and "-- Compensation of
Directors" of each Fund's Statement of Additional Information for biographical
and certain other information relating to the Directors and officers of your
Fund, including Directors' compensation.
MANAGEMENT AND OTHER SERVICE ARRANGEMENTS
Management Services. The Manager provides each Fund with investment advisory and
management services. Subject to the supervision of the Directors, the Manager is
responsible for the actual management of a Fund's portfolio and reviews the
Fund's holdings in light of its own research analysis and that from other
relevant sources. The responsibility for making decisions to buy, sell or hold a
particular security rests with the Manager. The Manager performs certain of the
other administrative services and provides all the office space, facilities,
equipment and necessary personnel for management of each Fund.
Each Feeder Fund invests all of its assets in shares of a Master Portfolio.
Accordingly, Feeder Funds do not invest directly in portfolio securities and do
not require management services. All portfolio management occurs at the Master
Portfolio level.
II-31
Management Fee. Each Fund has entered into a management agreement with the
Manager (the "Management Agreement"), pursuant to which the Manager receives for
its services to the Fund monthly compensation at an annual rate based on the
average daily net assets of the Fund. For information regarding fees paid by
your Fund to the Manager for the Fund's last three fiscal years or other
applicable periods, see Part I, Section IV "Management and Advisory
Arrangements" of each Fund's Statement of Additional Information.
Sub-Advisory Fee. The Manager of certain Funds has entered into a sub-advisory
agreement (the "Sub-Advisory Agreement") with the sub-adviser identified in each
such Fund's prospectus (the "Sub-Adviser") pursuant to which the Sub-adviser
provides sub-advisory services to the Manager with respect to the Fund. For
information relating to the fees paid by the Manager to the Sub-Adviser pursuant
to the Sub-Advisory Agreement for the Fund's last three fiscal years or other
applicable periods, see Part I, Section IV "Management and Advisory
Arrangements" of each Fund's Statement of Additional Information.
Payment of Fund Expenses. Each Management Agreement obligates the Manager to
provide management services and to pay all compensation of and furnish office
space for officers and employees of a 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 interested persons of the Fund. Each
Fund pays all other expenses incurred in the operation of that Fund, including
among other things: taxes; expenses for legal and auditing services; costs of
preparing, printing and mailing proxies, stock certificates, shareholder
reports, prospectuses and statements of additional information, except to the
extent paid by FAM Distributors, Inc. (the "Distributor"); charges of the
custodian and sub-custodian, and the transfer agent; expenses of redemption of
shares; Commission fees; expenses of registering the shares under Federal, state
or foreign laws; fees and expenses of Directors who are not interested persons
of a Fund as defined in the Investment Company Act (the "non-interested
Directors"); accounting and pricing costs (including the daily calculations of
net asset value); insurance; interest; brokerage costs; litigation and other
extraordinary or non-recurring expenses; and other expenses properly payable by
the Fund. Certain accounting services are provided to each Fund by State Street
Bank and Trust Company ("State Street") pursuant to an agreement between State
Street and each Fund. Each Fund pays a fee for these services. In addition, the
Manager provides certain accounting services to each Fund and the Fund pays the
Manager a fee for such services. The Distributor pays certain promotional
expenses of the Funds incurred in connection with the offering of shares of the
Funds. Certain expenses are financed by each Fund pursuant to distribution plans
in compliance with Rule 12b-1 under the Investment Company Act. See "Purchase of
Shares -- Distribution Plans."
Organization of the Manager. Fund Asset Management, L.P. and Merrill Lynch
Investment Managers, L.P. each is a limited partnership. The partners of FAM and
MLIM are Merrill Lynch & Co., Inc. ("ML & Co."), a financial services holding
company and the parent of Merrill Lynch, Pierce Fenner & Smith Incorporated
("Merrill Lynch"), and Princeton Services, Inc. ("Princeton Services"). ML & Co.
and Princeton Services are "controlling persons" of FAM and MLIM (as defined
under the Investment Company Act) because of their ownership of FAM's and MLIM's
voting securities or their power to exercise a controlling influence over FAM's
and MLIM's management or policies. Merrill Lynch Investment Managers
International Limited ("MLIMIL") is an affiliate of FAM and MLIM. The ultimate
parent of MLIMIL is ML & Co. ML & Co. is a controlling person of MLIMIL (as
defined under the Investment Company Act) because of its ownership of MLIMIL's
voting securities or its power to exercise a controlling influence over MLIMIL's
management or policies.
The following entities may be considered "controlling persons" of Merrill Lynch
Asset Management U.K. Limited ("MLAM U.K."): Merrill Lynch Europe PLC (MLAM
U.K.'s parent), a subsidiary of Merrill Lynch International Holdings, Inc., a
subsidiary of Merrill Lynch International, Inc., a subsidiary of ML & Co.
Administrative Services and Administrative Fee. Each Feeder Fund has entered
into an administration agreement (the "Administration Agreement") with an
administrator identified in the Feeder Fund's prospectus and Part I of each
Feeder Fund's Statement of Additional Information (each, an "Administrator").
For information regarding administrative fees paid by your Fund to the
Administrator for the periods indicated, see Part I, Section IV "Management and
Advisory Arrangements" of each Feeder Fund's Statement of Additional
Information.
Each Administration Agreement obligates the Administrator to provide certain
administrative services to the Feeder Fund and to pay, or cause its affiliates
to pay, for maintaining its staff and personnel and to provide office space,
facilities and necessary personnel for the Feeder Fund. Each Administrator is
also obligated to pay, or cause its affiliates to pay, the fees of those
officers and Directors of the Feeder Fund who are affiliated persons of the
Administrator or any of its affiliates.
II-32
Duration and Termination. Unless earlier terminated as described below, each
Management Agreement and, if applicable, each Sub-Advisory Agreement and
Administration Agreement will remain in effect from year to year if approved
annually (a) by the Board or by a vote of a majority of the outstanding voting
securities 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. Each Agreement is not assignable 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 each Fund's (other than Municipal Investment
Accumulation's) Transfer Agent pursuant to a Transfer Agency, Dividend
Disbursing Agency and Shareholder Servicing Agency Agreement (each, a "Transfer
Agency Agreement"). Pursuant to each Transfer Agency Agreement, the Transfer
Agent is responsible for the issuance, transfer and redemption of shares and the
opening and maintenance of shareholder accounts. Each Fund currently pays
between $16.00 and $20.00 for each Class A or Class I shareholder account,
between $19.00 and $23.00 for each Class B or Class C shareholder account,
depending on the level of service required, and, where applicable, $16.00 for
each Class R shareholder account. Each Fund reimburses the Transfer Agent's
reasonable out-of-pocket expenses and pays a fee of 0.10% of account assets for
certain accounts that participate in the Merrill Lynch Mutual Fund Advisor
(Merrill Lynch MFA/SM/) Program (the "MFA Program"). For purposes of each
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. The Bank of New York acts as transfer agent to Municipal Investment
Accumulation's for a fee. See Part I, Section IV "Management and Advisory
Arrangements -- Transfer Agency Fees" of each Fund's Statement of Additional
Information for information on the transfer agency fees paid by your Fund for
the periods indicated.
Independent Auditor. The Directors of each Fund have selected an independent
auditor for that Fund that audits the Fund's financial statements. Please see
your Fund's Prospectus for information on your Fund's independent auditor.
Custodian Services. The name and address of the custodian (the "Custodian") of
each Fund are identified on the back cover page of the Fund's Prospectus. The
Custodian is responsible for safeguarding and controlling the Fund's cash and
securities, handling the receipt and delivery of securities and collecting
interest and dividends on the Fund's investments. 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.
For certain Feeder Funds, the Custodian also acts as the custodian of the Master
Portfolio's assets.
Accounting Services. Each Fund has entered into an agreement with State Street,
pursuant to which State Street provides certain accounting services to the Fund.
Each Fund pays a fee for these services. State Street provides similar
accounting services to the Master Trusts. For Funds operating prior to January
1, 2001, the Manager or the Administrator (in the case of Feeder Funds) provided
accounting services to each Fund and was reimbursed by each Fund at its cost in
connection with such services. The Manager or the Administrator continues to
provide certain accounting services to each Fund and each Fund reimburses the
Manager or the Administrator for these services.
See Part I, Section IV "Management and Advisory Arrangements -- Accounting
Services" of each Fund's Statement of Additional Information for information on
the amounts paid by your Fund and Master Trust, if applicable, to State Street
and the Manager or, if applicable, the Administrator for the periods indicated.
Distribution Expenses. Each Select Pricing Fund (as defined below) has entered
into a distribution agreement with FAM Distributors, Inc. in connection with the
continuous offering of each class 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 Select
Pricing Funds. 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 these documents 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 Management Agreement described above.
II-33
Code of Ethics
The Board of each Fund has approved a Code of Ethics pursuant to Rule 17j-1
under the Investment Company Act, which covers the Fund, the Manager, the
Sub-Adviser, if any, and the Distributor. The Code of Ethics establishes
procedures for personal investing and restricts certain transactions. Employees
subject to the Code of Ethics may invest in securities for their personal
investment accounts, including securities that may be purchased or held by the
Fund.
PURCHASE OF SHARES
Each Fund (other than Municipal Investment Accumulation) offers multiple classes
of shares under the Merrill Lynch Select Pricing/SM/ System: Class A and Class I
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 alternatives. In addition, certain Funds offer Class R shares to certain
retirement plans. Please see your Fund's prospectus to determine whether it
offers Class R shares. Each class has different exchange privileges. See
"Shareholder Services -- Exchange Privilege."
Municipal Investment Accumulation offers a single class of shares, which is sold
without a sales charge or a distribution fee and is available only to certain
investors. Municipal Investment Accumulation shares do not have an exchange
privilege.
The Merrill Lynch Select Pricing/SM/ System is used by more than 50 registered
investment companies advised by the Managers. Funds that use the Merrill Lynch
Select Pricing/SM/ System are referred to herein as "Select Pricing Funds."
The offering price of 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) 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. Purchase orders that are not received
by the Distributor prior to this time will be deemed received on the next
business day. Dealers or other financial intermediaries have the responsibility
of submitting purchase orders to the Distributor not later than 30 minutes after
the close of business on the NYSE in order to purchase shares at that day's
offering price.
The Fund or the Distributor may suspend the continuous offering of the Fund's
shares of any class at any time in response to conditions in the securities
markets or otherwise and may resume offering of shares from time to time. Any
order may be rejected by the Fund or the Distributor. Neither the Distributor,
the securities dealers or other financial intermediaries are permitted to
withhold placing orders to benefit themselves by a price change.
Initial Sales Charge Alternatives -- Class A and Class I Shares
Investors who prefer an initial sales charge alternative may elect to purchase
Class A shares or, if an eligible investor, Class I shares. Investors choosing
the initial sales charge alternative who are eligible to purchase Class I shares
should purchase Class I shares rather than Class A shares because there is an
account maintenance fee imposed on Class A shares. Investors qualifying for
significantly reduced initial sales charges may find the initial sales charge
alternative particularly attractive because similar sales charge reductions are
not available with respect to the deferred sales charges imposed in connection
with purchases of Class B or Class C shares. Investors not qualifying for
reduced initial sales charges who expect to maintain their investment for an
extended period of time also may elect to purchase Class A or Class I shares,
because over time the accumulated ongoing account maintenance and distribution
fees on Class B, Class C or Class R shares may exceed the initial sales charges
and, in the case of Class A shares, the account maintenance fee. Although some
investors who previously purchased Class I shares may no longer be eligible to
purchase Class I shares of other Select Pricing Funds, those previously
purchased Class I shares, together with Class A, Class B and Class C share
holdings, will count toward a right of accumulation which may qualify the
investor for a reduced initial sales charge on new initial sales charge
purchases. In addition, the ongoing Class B, Class C and Class R shares account
maintenance and distribution fees will cause Class B, Class C and Class R shares
to have higher expense ratios, pay lower dividends and have lower total returns
than the initial sales charge shares. The ongoing Class A account maintenance
fees will cause Class A shares to have a higher expense ratio, pay lower
dividends and have a lower total return than Class I shares.
The term "purchase," as used in the Prospectus and this Statement of Additional
Information in connection with an investment in Class A and Class I shares of a
Fund, refers to (i) a single purchase by an individual, (ii) concurrent
purchases
II-34
by an individual, his or her spouse and their children under the age of 21 years
purchasing shares for his, her or their own account, and (iii) single purchases
by a trustee or other fiduciary purchasing shares for a single trust estate or
single fiduciary account although more than one beneficiary may be involved. The
term "purchase" also includes purchases by any "company," as that term is
defined in the Investment Company Act, but does not include (i) purchases by any
company that has not been in existence for at least six months, (ii) a company
that has no purpose other than the purchase of shares of a Fund or shares of
other registered investment companies at a discount, or (iii) any group of
individuals whose sole organizational nexus is that its participants are credit
cardholders of a company, policyholders of an insurance company, customers of
either a bank or broker-dealer or clients of an investment adviser.
Eligible Class I Investors. Class I shares are offered to a limited group of
investors. Investors who currently own Class I shares in a shareholder account,
including participants in the Merrill Lynch Blueprint/SM/ Program, are entitled
to purchase additional Class I shares of a Fund in that account. Certain
employer-sponsored retirement or savings plans, including eligible 401(k) plans,
may purchase Class I shares at net asset value provided such plans meet the
required minimum number of eligible employees or required amount of assets
advised by the Manager or any of its affiliates. Class I shares are available at
net asset value to corporate warranty insurance reserve fund programs and U.S.
branches of foreign banking institutions provided that the program or bank has
$3 million or more initially invested in Select Pricing Funds. Also eligible to
purchase Class I 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 and certain purchases
made in connection with certain fee-based programs. In addition, Class I shares
are offered at net asset value to ML & Co. and its subsidiaries and their
directors and employees and to members of the Boards of investment companies
advised by MLIM, FAM or their affiliates. Certain persons who acquired shares of
certain closed-end funds advised by MLIM or FAM 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 a Fund also may purchase Class I shares of the Fund if
certain conditions are met. In addition, Class I shares of certain Select
Pricing Funds are offered at net asset value to shareholders of certain
continuously offered closed-end funds advised by MLIM or FAM who wish to
reinvest the net proceeds from the sale of a certain of their shares of common
stock pursuant to a tender offer conducted by such funds. See "Purchase of
Shares --Closed-End Fund Reinvestment Options."
Other Class I Waivers. Class I shares are also offered at net asset value to
collective investment trusts for which Merrill Lynch Trust Company serves as
trustee and certain purchases made in connection with certain fee-based
programs.
See Part I, Section V "Information on Sales Charges and Distribution Related
Expenses -- Class A and Class I Sales Charge Information" of each Fund's
Statement of Additional Information for information about amounts paid to the
Distributor in connection with Class A and I shares for the periods indicated.
The Distributor may reallow discounts to selected securities dealers and other
financial intermediaries and retain the balance over such discounts. At times
the Distributor may reallow the entire sales charge to such dealers. Since
securities dealers and other financial intermediaries selling Class A and Class
I shares of a Fund will receive a concession equal to most of the sales charge,
they may be deemed to be underwriters under the Securities Act.
Reduced Initial Sales Charges
Certain investors may be eligible for a reduction or waiver of a sales load due
to the nature of the investors and/or the reduced sales efforts necessary to
obtain their investments.
Reinvested Dividends. No sales charges are imposed upon shares issued as a
result of the automatic reinvestment of dividends.
Rights of Accumulation. Eligible investors may purchase shares of a Fund subject
to an 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 qualifying classes of shares of a Fund and
of any other Select Pricing Funds. The purchaser or the purchaser's securities
dealer or other financial intermediary must provide the Distributor at the time
of purchase with sufficient information to confirm qualification. 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.
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Letter of Intent. Reduced sales charges are applicable to purchases aggregating
$25,000 or more ($100,000 or more for Bond Fund - Intermediate Term Portfolio
and Municipal Bond - Limited Maturity Portfolio), of Class A or Class I shares
of a Fund or any other Select Pricing Funds made within a 13-month period. The
Letter of Intent is available only to investors whose accounts are established
and maintained at the Transfer Agent. The Letter of Intent is not available to
employee benefit plans for which affiliates of the Manager provide plan
participant record-keeping services. The Letter of Intent is not a binding
obligation to purchase any amount of Class A or Class I shares. If you bought
Class A or Class I shares prior to signing a Letter of Intent, those shares may
be included under a subsequent Letter of Intent executed within 90 days of the
purchase if you inform the Distributor in writing of your intent within the
90-day period. The value (at cost or maximum offering price, whichever is
higher) of Class A and Class I shares of a Select Pricing Fund presently held on
the date of the first purchase under the Letter of Intent may be included as a
credit toward the completion of such Letter, but the reduced sales charge will
be applied only to new purchases. If the total amount of shares does not equal
the amount stated in the Letter of Intent, you will be notified and must pay,
within 20 days of the expiration of such Letter, the difference between the
reduced sales charge and the applicable sales charge. Class A or Class I shares
equal to at least 5.0% of the intended amount will be held in escrow during the
13-month period (while remaining registered in the name of the purchaser) for
this purpose. The first purchase under the Letter of Intent must be at least
5.0% of the dollar amount of such Letter. You may be entitled to further reduced
sales charges under a right of accumulation for purchases made during the term
of a Letter. You will not, however, be entitled to further reduced sales charges
on any purchases made before the execution of the Letter.
The value of any shares you redeem prior to termination or completion of the
Letter of Intent will be deducted from the total purchases made under such
Letter. An exchange from the Summit Cash Reserves Fund ("Summit"), a series of
Financial Institutions Series Trust, into a Fund that imposes a sales charge
will count toward completing a Letter of Intent from the Fund.
Merrill Lynch Blueprint/SM/ Program. Class A shares of certain Funds are offered
to participants in the Merrill Lynch Blueprint/SM/ Program ("Blueprint"). In
addition, participants in Blueprint who own Class I shares of a Fund may
purchase additional Class I shares of the Fund through Blueprint. Blueprint is
directed to small investors, group IRAs and participants in certain affinity
groups such as credit unions, trade associations and benefit plans. Investors
purchasing Class A or Class I shares of a Fund through Blueprint will acquire
the shares at net asset value plus a sales charge calculated in accordance with
the Blueprint sales charge schedule. Under this schedule, purchase of up to $300
are subject to a sales charge of 4.25%; purchases of $300.01 up to $5,000 are
subject to a sales charge of 3.25% plus $3; and purchases of $5,000.01 or more
are subject to the standard sales charge rates disclosed in the Prospectus. In
addition, Class A or Class I shares of each Fund are offered at net asset value
plus a sales charge of .50% of 1% for corporate or group IRA programs purchasing
shares through Blueprint.
Class A and Class I shares are offered at net asset value to participants in
Blueprint 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 has entered into a Merrill Lynch Directed IRA
Rollover Program Service Agreement.
Shareholder services, including the exchange privilege, available to Class A,
Class B and Class I investors through Blueprint may differ from those available
to other Class A, Class B or Class I investors. Orders for purchases and
redemptions of Class A, Class B or Class I shares of a 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. There are no minimum initial or subsequent purchase
requirements for participants who are part of an automatic investment plan.
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.
TMA/SM/ Managed Trusts. Class I shares are offered at net asset value to TMA/SM/
Managed Trusts to which Merrill Lynch Trust Company provides discretionary
trustee services.
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Purchase Privileges of Certain Persons. Directors of each Fund, members of the
Boards of other funds advised by the Manager or an affiliate, ML & Co. and its
subsidiaries and their directors and employees and any trust, pension,
profit-sharing or other benefit plan for such persons, may purchase Class I
shares at net asset value. A 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 a Fund
must satisfy the Fund's suitability standards.
Class A shares of each Fund are offered at net asset value, without a sales
charge, to an investor that 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 A shares of a Fund with proceeds from a redemption of shares
of a mutual fund that was sponsored by the Financial Advisor's previous firm and
was subject to a sales charge either at the time of purchase or on a deferred
basis; and second, the investor must establish that the redemption had been made
within 60 days prior to the investment in a Fund and the proceeds from the
redemption had been maintained in the interim in cash or a money market fund.
Class A shares of each Fund are also offered at net asset value, without a sales
charge, to an investor that has a business relationship with a Merrill Lynch
Financial Advisor and that 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 A shares of a Fund with
proceeds from a redemption of shares of such other mutual fund and the shares of
such other fund were subject to a sales charge either at the time of purchase or
on a deferred basis; and, second, such purchase of Class A shares must be made
within 90 days after such notice.
Class A shares of each Fund are offered at net asset value, without a sales
charge, to an investor that has a business relationship with a Merrill Lynch
Financial Advisor and that 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 it will purchase Class A
shares of a Fund with proceeds from the redemption of shares of such other
mutual fund and that such shares have been outstanding for a period of no less
than six months; and, second, such purchase of Class A shares must be made
within 60 days after the redemption and the proceeds from the redemption must be
maintained in the interim in cash or a money market fund.
Acquisition of Certain Investment Companies. Class A 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 I shares of a Fund through certain
financial advisors, 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 a Fund.
The deferred sales charge alternatives may be particularly appealing to
investors who do not qualify for the reduction in initial sales charges. Both
Class B and Class C shares are subject to ongoing account maintenance fees and
distribution fees; however, these fees potentially may be offset to the extent
any return is realized on the additional funds initially invested in Class B or
Class C shares. In addition, Class B shares will be converted into Class A
shares of the Fund after a conversion period of approximately ten years, and
thereafter investors will be subject to lower ongoing fees.
Merrill Lynch compensates its Financial Advisors for selling Class B and Class C
shares at the time of purchase from its own funds. Proceeds from the contingent
deferred sales charge ("CDSC") and the distribution fee are paid to the
Distributor and are used by the Distributor to defray the expenses of securities
dealers or other financial intermediaries (including Merrill Lynch) related to
providing distribution-related services to each Fund in connection with the sale
of the Class B and Class C shares. The combination of the CDSC and the ongoing
distribution fee facilitates the ability of each
II-37
Fund to sell the Class B and Class C shares without a sales charge being
deducted at the time of purchase. See "Distribution Plans" below. 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" below.
Contingent Deferred Sales Charges -- Class B Shares. If you redeem Class B
shares within six years of purchase (three years for Bond Fund - Intermediate
Term Portfolio, Municipal Bond - Limited Maturity Portfolio, and Municipal
Intermediate Term) you may be charged a CDSC at the rates indicated in the
Prospectus and below. The CDSC will be calculated in a manner that results in
the lowest applicable rate being charged. 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 order of
redemption will be first of shares held for over six years or three years, as
applicable, in the case of Class B shares, next of shares acquired pursuant to
reinvestment of dividends, and finally of shares in the order of those held
longest. The same order of redemption will apply if you transfer shares from
your account to another account.
The following table sets forth the Class B CDSC for all Funds except Bond Fund -
Intermediate Term Portfolio, Municipal Bond - Limited Maturity Portfolio, and
Municipal Intermediate Term:
Year Since Purchase CDSC as a Percentage
Payment Made of Dollar Amount
Subject to Charge+
0-1 4.0%
1-2 4.0%
2-3 3.0%
3-4 3.0%
4-5 2.0%
5-6 1.0%
6 and thereafter None
+ For Class B shares purchased before December 1, 2002, the four-year
CDSC schedule in effect at that time will apply.
To provide an example, assume an investor purchased 100 shares 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 or her
first redemption of 50 shares (proceeds of $600), 10 shares will not be subject
to a CDSC because they were issued through dividend reinvestment. With respect
to the remaining 40 shares, the charge 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 at a rate of
3.0% (the applicable rate in the third year after purchase).
The following table sets forth the Class B CDSC for Bond Fund - Intermediate
Term Portfolio, Municipal Bond - Limited Maturity Portfolio, and Municipal
Intermediate Term:
Year Since Purchase CDSC as a Percentage
Payment Made of Dollar Amount
Subject to Charge+
0-1 1.00%
1-2 0.50%
2-3 0.25%
3 and thereafter None
+ For Class B shares purchased before December 1, 2002, the one-year
CDSC schedule in effect at that time will apply.
The Class B CDSC may be waived on redemptions of shares 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
II-38
Code) of a 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 or, if later,
reasonably promptly following completion of probate. The Class B CDSC also may
be waived on redemptions of shares by certain eligible 401(a) and 401(k) plans.
The CDSC may also be waived for any Class B shares that are purchased by
eligible 401(k) or eligible 401(a) plans that 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 may be waived 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 by
a Merrill Lynch rollover IRA that was funded by a rollover from a terminated
401(k) plan managed by MLIM Private Investors and held in such account at the
time of redemption. The Class B CDSC may also be waived or its terms may be
modified in connection with certain fee-based programs. The Class B CDSC may
also be waived in connection with involuntary termination of an account in which
Fund shares are held or for withdrawals through the Merrill Lynch Systematic
Withdrawal Plan. See "Shareholder Services --Fee-Based Programs "and
"--Systematic Withdrawal Plans."
Class B shareholders of a Fund exercising the exchange privilege described under
"Shareholder Services --Exchange Privilege" will continue to be subject to that
Fund's CDSC schedule if such schedule is higher than the CDSC schedule relating
to the Class B shares acquired as a result of the exchange.
Class B shares of certain Funds are offered through Blueprint only to members of
certain affinity groups with a waiver of the CDSC upon redemption.
Employer-Sponsored Retirement or Savings Plans and Certain Other Arrangements.
Certain employer-sponsored retirement or savings plans and certain other
arrangements may purchase Class B shares with a waiver of the CDSC upon
redemption, 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. Such
Class B shares will convert into Class A shares approximately ten years after
the plan purchases the first share of any Select Pricing 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 1-800-237-7777.
Conversion of Class B Shares to Class A Shares. Approximately ten years after
purchase (the "Conversion Period"), Class B shares of each Fund will convert
automatically into Class A shares of that Fund. The conversion will occur at
least once each month (on the "Conversion Date") on the basis of the relative
net asset value 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 A shares will not be deemed a purchase or sale of the shares for
Federal income tax purposes.
Shares acquired through reinvestment of dividends on Class B shares will also
convert automatically to Class A shares. The Conversion Date for dividend
reinvestment shares will be calculated taking into account the length of time
the shares underlying the dividend reinvestment shares were outstanding. If, at
the Conversion Date, the conversion will result in less than $50 worth of Class
B shares being left in an account, all of the Class B shares of the Fund held in
the account will be converted into Class A shares of the Fund.
In general, Class B shares of equity Select Pricing Funds will convert
approximately eight years after initial purchase and Class B shares of taxable
and tax-exempt fixed income Select Pricing Funds will convert approximately ten
years after initial purchase. If you exchange 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 on to the holding period for the shares acquired. The Conversion Period
also may be modified for investors that participate in certain fee-based
programs. See "Shareholder Services--Fee-Based Programs."
If you own shares of a Fund that issues stock certificates, you must deliver any
certificates for Class B shares of the Fund to be converted to the Transfer
Agent at least one week prior to the Conversion Date applicable to those
shares. If the Transfer Agent does not receive the certificates at least one
week prior to the Conversion Date, your Class B shares will convert to Class A
shares on the next scheduled Conversion Date after the certificates are
delivered.
II-39
Contingent Deferred Sales Charges - Class C Shares
Class C shares that are redeemed within one year of purchase may be subject to a
1.00% CDSC charged as a percentage of the dollar amount subject thereto. 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. 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. It will be assumed that the
redemption is first of shares held for over one year or shares acquired pursuant
to reinvestment of dividends and then of shares held longest during the one-year
period. 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. The Class C CDSC
may be waived in connection with involuntary termination of an account in which
Fund shares are held, for withdrawals through the Merrill Lynch Systematic
Withdrawal Plan, and in connection with the redemption of Class C shares by
certain retirement plans. See "Shareholder Services - Systematic Withdrawal
Plans."
See Part I Section V "Information on Sales Charges and Distribution Related
Expenses - Class B and Class C Sales Charge Information" of each Fund's
Statement of Additional Information for information about amounts paid to the
Distributor in connection with Class B and C shares for the periods indicated.
Class R Shares
Certain of the Funds offer Class R shares as described in each such Fund's
prospectus. Class R shares are available only to certain retirement plans. Class
R shares are not subject to an initial sales charge or a contingent deferred
sales charge but are subject to an ongoing distribution fee of 0.25% and an
ongoing account maintenance fee of 0.25%. Distribution fees are used to support
the Fund's marketing and distribution efforts, such as compensating Merrill
Lynch Financial Advisors and other financial intermediaries, advertising and
promotion. Account maintenance fees are used to compensate securities dealers
and other financial intermediaries for account maintenance activities. If Class
R shares are held over time, these fees may exceed the maximum sales charge that
an investor would have paid as a shareholder of one of the other share classes.
Closed-End Fund Reinvestment Options
Class I shares of each Fund are offered at net asset value to shareholders of
certain closed-end funds advised by a Manager who purchased their 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 such
shares in Class I shares, if the conditions set forth below are satisfied.
Alternatively, shareholders of closed-end funds who purchased shares on or after
October 21, 1994 and wish to reinvest the net proceeds from a sale of those
shares may purchase Class I shares (if eligible to buy Class I shares) or Class
A shares of each Fund at net asset value if the following conditions are met.
First, the sale of closed-end fund shares must be made through Merrill Lynch,
and the net proceeds must be immediately reinvested in Class A or Class I
shares. Second, the closed-end fund shares must either have been acquired in
that fund's initial public offering or represent dividends paid on shares of
common stock acquired in such offering. Third, the closed-end fund shares must
have been continuously maintained in a Merrill Lynch securities account. Fourth,
there must be a minimum purchase of $250 to be eligible for the reinvestment
option.
Subject to the conditions set forth below, shares of each Fund are offered at
net asset value to shareholders of certain continuously offered closed-end funds
advised by a Manager (an "Eligible Fund") who wish to reinvest the net proceeds
from a sale of such shares. Upon exercise of this reinvestment option,
shareholders of Merrill Lynch Senior Floating Rate Fund, Inc. will receive Class
I shares of a Fund and shareholders of Merrill Lynch Senior Floating Rate Fund
II, Inc. will receive Class C shares of a Fund.
In order to exercise this reinvestment option, a shareholder of an Eligible Fund
must sell his or her shares back to the Eligible Fund in connection with a
tender offer conducted by the Eligible Fund and reinvest the proceeds
immediately in the designated class of shares of a Fund. This option is
available only with respect to shares as to which no Early Withdrawal Charge (as
defined in the Eligible Fund's prospectus) is applicable. Purchase orders from
Eligible Fund shareholders who wish to exercise this reinvestment option will be
accepted only on the day that the related tender offer terminates and will be
effected at the net asset value of the designated class of shares of a Fund on
such day. The Class C
II-40
CDSC may be waived upon redemption of Class C shares purchased by an investor
pursuant to this closed-end fund reinvestment option. This waiver is subject to
the requirement that the investor has held the tendered shares for a minimum of
one year and to such other conditions as are set forth in the prospectus for the
related closed-end fund.
Distribution Plans
The distribution plan for each of the Class A, Class B, Class C and Class R
shares (each, a "Distribution Plan") provides that the Fund pays the Distributor
an account maintenance fee, accrued daily and paid monthly, at an annual rate
based on the average daily net assets of the Fund attributable to shares of the
relevant class. This fee compensates the Distributor, Merrill Lynch, a selected
securities dealer or other financial intermediary (pursuant to a sub-agreement)
for account maintenance activities with respect to Class A, Class B, Class C and
Class R shares.
The Distribution Plan for each of the Class B, Class C and Class R shares also
provides that the Fund pays the Distributor a distribution fee, accrued daily
and paid monthly, at an annual rate based on the average daily net assets of the
Fund attributable to the shares of the relevant class. This fee compensates the
Distributor, Merrill Lynch, a selected securities dealer or other financial
intermediary (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, Class C and Class R shares of the Fund.
Each Distribution Plan is subject to the provisions of Rule 12b-1 under the
Investment Company Act. In their consideration of a Distribution Plan, the
Directors must consider all factors they deem relevant, including information as
to the benefits of the Distribution Plan to a Fund and the related class of
shareholders. In approving each Distribution Plan in accordance with Rule 12b-1,
the non-interested Directors of each Fund concluded that there is reasonable
likelihood that the Distribution Plan will benefit the Fund and its related
class of shareholders.
Each Distribution Plan provides that, so long as the Distribution Plan remains
in effect, the non-interested Directors then in office will select and nominate
other non-interested Directors. Each Distribution Plan can be terminated at any
time, without penalty, by the vote of a majority of the non-interested Directors
or by the vote of the holders of a majority of the outstanding related class of
voting securities of a Fund. A Distribution Plan cannot be amended to increase
materially the amount to be spent by the Fund without the approval of the
related class of shareholders. All material amendments are required to be
approved by the vote of Directors, including a majority of the non-interested
Directors who have no direct or indirect financial interest in the Distribution
Plan, cast in person at a meeting called for that purpose. Rule 12b-1 further
requires that each 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 the Distribution Plan or such report, the first two years in an easily
accessible place.
Among other things, each Distribution Plan provides that the Directors will
review quarterly reports of the account maintenance and/or distribution fees
paid to the Distributor. Payments under the Distribution Plans are based on a
percentage of average daily net assets attributable to the shares regardless of
the amount of expenses incurred. As a result, distribution-related revenues from
the Distribution Plans may be more or less than distribution-related expenses of
the related class. Information with respect to the distribution-related revenues
and expenses is presented to the Directors for their consideration quarterly.
Distribution-related revenues consist of the account maintenance fees, the
distribution fees and the CDSCs. Distribution-related expenses consist of
financial advisor compensation, branch office and regional operation center
selling and transaction processing expenses, advertising, sales promotion and
marketing expenses and interest expense. The distribution-related revenues paid
with respect to one 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.
See Part I, Section V "Information on Sales Charges and Distribution Related
Expenses" of each Select Pricing Fund's Statement of Additional Information for
information relating to the fees paid by your Fund to the Distributor under each
Distribution Plan during its most recent fiscal year.
Limitations on the Payment of Deferred Sales Charges
The maximum sales charge rule in the Conduct Rules of the NASD imposes a
limitation on certain asset-based sales charges such as the distribution fee
borne by Class R shares, and the distribution fee and the CDSC borne by the
Class B and Class C shares. This limitation does not apply to the account
maintenance fee. The maximum sales charge rule is applied separately to each
class and limits the aggregate of distribution fee payments and CDSCs payable
by a Fund to (1)
II-41
6.25% of eligible gross sales of Class B, Class C and Class R shares, computed
separately (excluding shares issued pursuant to dividend reinvestments and
exchanges), plus (2) interest on the unpaid balance for the respective class,
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
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 the Class B shares is 6.75% of eligible gross sales. The
Distributor retains the right to stop waiving the interest charges at any time.
To the extent payments would exceed the voluntary maximum, no Fund will 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, each
Fund will continue to make payments of the account maintenance fee. In certain
circumstances the amount payable pursuant to the voluntary maximum may exceed
the amount payable under the NASD formula. In such circumstance payment in
excess of the amount payable under the NASD formula will not be made.
See Part I, Section V "Information on Sales Charges and Distribution Related
Expenses - Limitation on the Payment of Deferred Sales Charges" of each Select
Pricing Fund's Statement of Additional Information for comparative information
as of your Fund's most recent fiscal year end with respect to the Class B, Class
C and, if applicable, Class R shares of your Fund.
Redemption of Shares
Each Fund is required to redeem for cash all shares of the Fund 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. The value of shares of each Fund at the time of redemption may be
more or less than your cost at the time of purchase, depending in part on the
market value of the securities held by the Fund at such time. Except for any
CDSC that may be applicable, there will be no redemption charge if your
redemption request is sent directly to the Transfer Agent. If you are
liquidating your holdings you will receive all dividends reinvested through the
date of redemption
The right to redeem shares may be suspended for more than seven days only (i)
for any period during which trading on the NYSE is restricted as determined by
the Securities and Exchange Commission (the "Commission") or during which the
NYSE is closed (other than customary weekend and holiday closings), (ii) 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 the Fund is not reasonably practicable, and (iii) for such other
periods as the Commission may by order permit for the protection of shareholders
of the Fund.
Each Fund has entered into a joint committed line of credit with other
investment companies advised by the Manager 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 shareholders in extraordinary or emergency
circumstances.
Redemption
If you hold shares with the Transfer Agent you may redeem without charge by
writing to the Fund's Transfer Agent, Financial Data Services, Inc., P.O. Box
45289, Jacksonville, Florida 32232-5289. Redemption requests delivered other
than by mail should be sent to Financial Data Services, Inc., 4800 Deer Lake
Drive East, Jacksonville, Florida 32246-6484. If your Fund has issued share
certificates, the letter must be accompanied by certificates for the shares.
Redemption requests should not be sent to the Fund. A redemption request
requires the signature(s) of all persons in whose name(s) the shares are
registered, signed exactly as such name(s) appear(s) on the Transfer Agent's
register. The signature(s) on the redemption request may require a guarantee by
an "eligible guarantor institution" as defined in Rule 17Ad-15 under the
Securities Exchange Act of 1934 (the "Exchange Act"), whose existence and
validity may be verified by the Transfer Agent through the use of 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) the request contains the signature(s) of all persons in whose name(s) shares
are recorded on the Transfer Agent's register; (ii) the check is mailed to the
stencil address of record on the Transfer Agent's register and (iii) the stencil
address has not changed within 30 days. Certain rules may apply regarding
certain types of accounts, including but not limited to UGMA/UTMA accounts,
Joint Tenancies With Rights of Survivorship, contra broker 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.
II-42
You may also redeem shares held with the Transfer Agent by calling
1-800-MER-FUND. You must be the shareholder of record and the request must 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 if: (i) the accountholder is
deceased, (ii) the proceeds are to be sent to someone other than the shareholder
of record, (iii) funds are to be wired to the client's bank account, (iv) a
systematic withdrawal plan is in effect, (v) the request is by an individual
other than the accountholder of record, (vi) the account is held by joint
tenants who are divorced, (vii) the address on the account has changed within
the last 30 days or share certificates have been issued on the account, or
(viii) to protect against fraud, 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 Funds or the Transfer Agent may
temporarily suspend telephone transactions at any time.
If you redeem shares directly with the Transfer Agent, payments will generally
be mailed within seven days of receipt of the proper notice of redemption. A
Fund may delay the mailing of a redemption check until good payment (that is,
cash, Federal funds or certified check drawn on a U.S. bank) has been collected
for the purchase of Fund shares, which will usually not exceed 10 days. If your
account is held directly with the Transfer Agent and contains a fractional share
balance following a redemption, the fractional share balance will be
automatically redeemed by the Fund.
Repurchase
A Fund will repurchase its shares through a selected securities dealer or other
financial intermediary. Each Fund normally will accept orders to repurchase
shares by wire or telephone from dealers for their customers. Shares will be
priced at the net asset value calculated on the day the request is received,
provided that your request for repurchase is submitted to your selected
securities dealer or other financial intermediary prior to the regular close of
business on the NYSE and the request is received by the Fund from your selected
securities dealer or other financial intermediary not later than 30 minutes
after the close of business on the NYSE on the same day.
These repurchase arrangements are for your convenience and do not involve a
charge by the Fund (other than any applicable CDSC). Securities firms that do
not have selected dealer agreements with the Distributor, however, may impose a
transaction charge for transmitting the notice of repurchase to the Fund. Each
Fund reserves the right to reject any order for repurchase. A shareholder whose
order for repurchase is rejected by a Fund, however, may redeem shares as set
out above.
Reinstatement Privilege -- Class A and Class I Shares
If you redeemed Class A or Class I shares of a Fund, you may reinstate your
account by buying Class A or Class I shares, as the case may be, of the Fund at
net asset value without a sales charge up to the dollar amount you redeemed. You
may exercise the reinstatement privilege by sending a notice of exercise along
with a check for the amount to be reinstated to the Transfer Agent or by
contacting your Merrill Lynch Financial Advisor within 30 days after the date
the redemption request 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.
SHAREHOLDER SERVICES
Each Fund offers one or more of the shareholder services described below that
are designed to facilitate investment in its shares. You can obtain more
information about these services from each Fund, by calling the telephone number
on the cover page, or from the Distributor, Merrill Lynch, your selected
securities dealer or other financial intermediary. Certain of these services are
available only to U.S. investors.
Investment Account
If your account is maintained at the Transfer Agent (an "Investment Account")
you will receive statements, at least quarterly, from the Transfer Agent. These
statements will serve as confirmations for automatic investment purchases and
the reinvestment of dividends. The statements also will show any other activity
in your Investment Account since the last statement. You also will receive
separate confirmations for each purchase or sale transaction other than
automatic investment purchases and the reinvestment of dividends. If your
Investment Account is held at the Transfer Agent you may
II-43
make additions to it at any time by mailing a check directly to the Transfer
Agent. You may also maintain an account through Merrill Lynch, a selected
securities dealer or other financial intermediary. If you transfer shares out of
a Merrill Lynch brokerage account or an account maintained with a selected
securities dealer or other financial intermediary, an Investment Account in your
name may be opened automatically at the Transfer Agent.
You may transfer Fund shares from Merrill Lynch, a selected securities dealer or
other financial intermediary to another securities dealer or other financial
intermediary that has entered into an agreement with the Distributor. Certain
shareholder services may not be available for the transferred shares. After the
transfer, you may purchase additional shares of Funds owned before the transfer.
All future trading of these assets must be coordinated by the new firm. If you
wish to transfer your shares to a securities dealer or other financial
intermediary that has not entered into an agreement with the Distributor, you
must either (i) redeem your shares, paying any applicable CDSC or (ii) continue
to maintain an Investment Account at the Transfer Agent for those shares. You
also may request that the new securities dealer or other financial intermediary
maintain the shares in an account at the Transfer Agent registered in the name
of the securities dealer or other financial intermediary for your benefit
whether the securities dealer or other financial intermediary has entered into a
selected dealer agreement or not.
If you are considering transferring a tax-deferred retirement account such as an
individual retirement account, from Merrill Lynch to another securities dealer
or other financial intermediary, you should be aware that if the new firm will
not take delivery of shares of the Fund, you 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 you must continue to maintain a retirement account
at Merrill Lynch for those shares.
Exchange Privilege
U.S. shareholders of Class A, Class B, Class C and Class I shares of each Select
Pricing Fund have an exchange privilege with certain other Select Pricing Funds
and Summit, which is a Merrill Lynch-sponsored money market fund specifically
designated for exchange by shareholders of Select Pricing Funds. In order to
qualify for the exchange privilege, the shares you wish to exchange are required
to have a net asset value of at least $100 and must have been held by you for at
least 15 days. Before effecting an exchange, you should obtain a currently
effective prospectus of the fund into which you wish to make the exchange.
Exercise of the exchange privilege is treated as a sale of the exchanged shares
and a purchase of the acquired shares for Federal income tax purposes. Municipal
Investment Accumulation does not offer an exchange privilege.
Exchanges of Class A and Class I Shares. You may exchange Class A or Class I
shares of a Fund for Class I shares of a second Select Pricing Fund if you hold
any Class I shares of the second fund in your account at the time of the
exchange or are eligible to purchase Class I shares of the second fund;
otherwise, you will receive Class A shares of the second fund. Class A shares
are exchangeable with shares of the same class of other Select Pricing Funds.
Exchanges of Class A or Class I shares outstanding ("outstanding Class A or
Class I shares") for Class A or Class I shares of a second Select Pricing Fund,
or for Class A shares of Summit ("new Class A or Class I shares") are effected
on the basis of relative net asset value per Class A or Class I share,
respectively, plus an amount equal to the difference, if any, between the sales
charge previously paid on the exchanged Class A or Class I shares and the sales
charge payable at the time of the exchange on the new Class A or Class I shares.
With respect to outstanding Class A or Class I shares received in a previous
exchange, the "sales charge previously paid" will include the aggregate of the
sales charges paid with respect to such Class A or Class I shares in the initial
purchase and any subsequent exchange. Class A or Class I shares issued pursuant
to dividend reinvestment are not subject to a sales charge. For purposes of the
exchange privilege, however, these shares will be deemed to have been sold with
a sales charge equal to the sales charge previously paid on the Class A or Class
I shares on which the dividend was paid. Based on this formula, Class A and
Class I shares of a Fund generally may be exchanged into the Class A or Class I
shares, respectively, of a second fund with a reduced sales charge or without a
sales charge.
Exchanges of Class B and Class C Shares. Certain Select Pricing Funds with Class
B or Class C shares outstanding ("outstanding Class B or Class C shares ") offer
to exchange their Class B or Class C shares for Class B or Class C shares,
respectively, of certain other Select Pricing Funds or for Class B shares of
Summit ("new Class B or Class C shares ") 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 the redemption of the outstanding shares. Certain Select
Pricing Funds impose different CDSC schedules. If you
II-44
exchange your Class B shares for shares of a fund with a different CDSC
schedule, the higher schedule will apply. For purposes of computing the CDSC
that may be payable on a disposition of the new Class B or Class C shares, the
holding period for the exchanged Class B or Class C shares is "tacked" to the
holding period of the new Class B or Class C shares. The length of the CDSC
period of certain equity funds advised by MLIM, FAM or their affiliates ("equity
funds") was extended from four years to six years on June 1, 2001. A shareholder
who purchased a Fund's Class B shares on or after June 1, 2001, and who wishes
to exchange those shares for Class B shares of an equity fund will be subject to
the equity fund's six-year CDSC schedule. For example, if you exchange Class B
shares of a Fund purchased on or after June 1, 2001 for those of an equity fund
after having held the Fund's Class B shares for two and a half years, the 3.0%
CDSC that generally would apply to a redemption would not apply to the exchange.
Four years later if you decide to redeem the Class B shares of the equity 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 the Fund Class B shares to
the four-year holding period for the equity fund Class B shares, you will be
deemed to have held the equity fund shares for more than six years. If you
purchased Class B shares prior to June 1, 2001 and wish to exchange those shares
for Class B shares of an equity fund, you will continue to be subject to the
four-year CDSC schedule in effect prior to June 1, 2001 and will have your
holding period "tacked" to the holding period for the new Class B shares. If you
purchased a Fund's Class B shares prior to December 1, 2002 and wish to exchange
those shares for Class B shares of another fixed income fund, you will continue
to be subject to the four-year CDSC schedule (one year for Bond Fund -
Intermediate Term Portfolio, Municipal Bond - Limited Maturity Portfolio and
Municipal Intermediate Term) in effect for fixed income funds prior to December
1, 2002 and your holding period "tacked" to the holding period for the new Class
B shares.
Exchanges for Shares of a Money Market Fund. You may exchange Class A and Class
I shares for Class A shares of Summit and Class B and Class C shares of a Fund
for Class B shares of Summit. You may exchange Class A shares of Summit back
into Class A or Class I shares of a Fund. You may exchange Class B shares of
Summit back into Class B or Class C shares of a Fund and, in the event of such
an exchange, the period of time that you held Class B shares of Summit 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. Please see your Merrill Lynch Financial Advisor for further information.
Prior to October 12, 1998, exchanges from certain Select Pricing Funds into a
money market fund were directed to certain Merrill Lynch-sponsored money market
funds other than Summit ("Other Money Funds"). If you exchanged Select Pricing
Fund shares for Other Money Funds and subsequently wish to exchange Other Money
Fund shares for shares of a Select Pricing Fund ("Acquired Fund"), you will be
subject to the CDSC schedule applicable to the Acquired Fund shares, if any. The
holding period for Other Money Fund shares will not count toward satisfaction of
the holding period requirement for reduction of the CDSC imposed on Acquired
Fund shares, if any, and, with respect to Class B shares, toward satisfaction of
the Conversion Period. However, the time you held the fund shares originally
exchanged for Other Money Fund shares will count towards the holding period of
the Class B or C shares of the Acquired Fund for purposes of reducing the CDSC
or satisfying the Conversion Period.
Exchanges by Participants in Certain Programs. The exchange privilege is
modified with respect to certain participants in mutual fund advisory programs
and other fee-based programs sponsored by Merrill Lynch. See "Fee-Based
Programs" below.
Exercise of the Exchange Privilege. To exercise the exchange privilege, you
should contact your Merrill Lynch Financial Advisor, who will advise each Fund
of the exchange. If you own shares of a Fund that has not issued share
certificates, you may exercise the exchange privilege by wire through your
securities dealer or other financial intermediary. Each Fund reserves the right
to require a properly completed exchange application.
You may also request exchanges by calling the Transfer Agent at 1-800-MER-FUND
if your account is held with the Transfer Agent for amounts up to $50,000. 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 if: (i) the accountholder is
deceased, (ii) the request is by an individual other than the accountholder of
record, (iii) the account is held by joint tenants who are divorced or the
address on the account has changed within the last 30 days, or (iv) 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. Each
Fund or the Transfer Agent may temporarily suspend telephone transactions at any
time.
II-45
This exchange privilege may be modified or terminated in accordance with the
rules of the Commission. Each Fund reserves the right to limit the number of
times an investor may exercise the exchange privilege. Certain Funds may suspend
the continuous offering of their shares to the general public at any time and
may resume such offering from time to time. The exchange privilege is available
only to U.S. shareholders in states where the exchange legally may be made. The
exchange privilege may be applicable to other new mutual funds whose shares may
be distributed by the Distributor.
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
I shares at net asset value. Under specified circumstances, participants in
certain Programs may exchange their shares in the Program for Class I 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 or the automatic exchange of shares to another class at
net asset value. In addition, upon termination of participation in a Program,
shares that have been held for less than specified periods within the Program
may be subject to a fee based on 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 the Program's client agreement and from the Transfer Agent at
1-800-MER-FUND.
Retirement and Education Savings Plans
Individual retirement accounts and other retirement and education savings plans
are available from Merrill Lynch. Under these plans, investments may be made in
a Fund (other than a Municipal Fund) and certain of the other mutual funds
sponsored by Merrill Lynch as well as in other securities. There may be fees
associated with investing through these plans. Information with respect to these
plans is available on request from Merrill Lynch.
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 IRAs
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 to the plan and should consult
their attorneys or tax advisers with respect to the establishment and
maintenance of any such plan.
Automatic Investment Plans
You may make additions to an Investment Account through a service known as the
Automatic Investment Plan. Under the Automatic Investment Plan, a Fund is
authorized, on a regular basis, to provide systematic additions to your
Investment Account through charges of $50 or more to your regular bank account
by either pre-authorized checks or automated clearing house debits. If you buy
shares of a Fund through Blueprint, no minimum charge to your bank account is
required. Alternatively, if you maintain a CMA(R) Account you may arrange to
have periodic investments made in a Fund in amounts of $100 ($1 or more for
retirement accounts) or more through the CMA(R) Automated Investment Program.
Automatic Dividend Reinvestment Plan
Unless you provide specific instructions as to the method of payment, dividends
will be automatically reinvested, without sales charge, in additional full and
fractional shares of the same Fund. You may, at any time, elect to have
dividends paid in cash, rather than reinvested in shares of a Fund (provided
that, if a payment on an account maintained at the Transfer Agent would amount
to $10.00 or less, the payment will automatically be reinvested in additional
shares). If your account is maintained with the Transfer Agent, you may contact
the Transfer Agent in writing or by telephone (1-800-MER-FUND). For other
accounts, you should contact your Merrill Lynch Financial Advisor, selected
securities dealer or other financial intermediary. Your instructions will be
effected ten days after the receipt by the Transfer Agent of such notice. A
II-46
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
dividend checks. Cash payments can also be deposited directly in the
shareholder's bank account.
Systematic Withdrawal Plans
You may elect to receive systematic withdrawals from your Investment Account by
check or through automatic payment by direct deposit to your bank account on
either a monthly or quarterly basis as provided below. Quarterly withdrawals are
available if you have acquired shares of a Fund having a value, based on cost or
the current offering price, of $5,000 or more, and monthly withdrawals are
available if your shares have a value of $10,000 or more.
At the time of each withdrawal payment, sufficient shares are redeemed from your
account to provide the withdrawal payment specified by you. You may specify the
dollar amount and class of shares to be redeemed. Redemptions will be made at
net asset value as determined as of the close of business on the NYSE 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 such date, the
shares will be redeemed at the net asset value determined as of the close of
business on the NYSE on the following business day. The check for the withdrawal
payment will be mailed or the direct deposit will be made, on the next business
day following redemption. When you make systematic withdrawals, dividends and
distributions on all shares in the Investment Account are reinvested
automatically in Fund shares. Your systematic withdrawal plan may be terminated
at any time, without charge or penalty, by you, a Fund, the Transfer Agent or
the Distributor.
The maximum number of Class B or Class C shares that can be redeemed from an
Investment Account annually will 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. Any CDSC that 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
normally redeemed. See "Purchase of Shares -- Deferred Sales Charge Alternatives
- -- Class B and Class C Shares." Where the systematic withdrawal plan is applied
to Class B shares, upon conversion of the last Class B shares in an account to
Class A shares, you must make a new election to join the systematic withdrawal
program with respect to the Class A shares. If you wish to change the amount
being withdrawn in a systematic withdrawal plan, you should contact your Merrill
Lynch Financial Advisor.
Withdrawal payments should not be considered as dividends. Withdrawals generally
are treated as sales of shares and may result in taxable gain or loss. If
periodic withdrawals continuously exceed reinvested dividends, the shareholder's
original investment may be reduced correspondingly. Purchases of additional
shares concurrent with withdrawals are ordinarily disadvantageous to the
shareholder because of sales charges and tax liabilities. A Fund will not
knowingly accept purchase orders for shares of a Fund from investors who
maintain a systematic withdrawal plan with respect to that Fund 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 in which the shareholder has elected to make systematic withdrawals.
Alternatively, if your shares are held within a CMA(R) or Retirement Account you
may elect to have shares redeemed on a monthly, bimonthly, quarterly, semiannual
or annual basis through the CMA(R) Systematic Redemption Program or the
redemption program of the Retirement Account. The minimum fixed dollar amount
that is redeemable is $50. The proceeds of systematic redemptions will be posted
to your account three business days after the date the shares are redeemed. All
redemptions are made at net asset value. You may elect to have your 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, you 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, third 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) Systematic
Redemption Program is not available if Fund shares are being purchased within
the account pursuant to the Automated Investment Program. For more information
on the CMA(R) Systematic Redemption Program, eligible shareholders should
contact their Merrill Lynch Financial Advisor.
II-47
PRICING OF SHARES
Determination of Net Asset Value
The net asset value of each class of shares of each Fund 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 foreign 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 trading on New Year's Day, Martin Luther
King, Jr. Day, Presidents' Day, Good Friday, Memorial Day, Independence Day,
Labor Day, Thanksgiving Day and Christmas Day.
Net asset value per share is computed by dividing the value of the securities
held by a Fund plus any cash or other assets (including interest and dividends
accrued but not yet received) minus all liabilities (including accrued expenses)
by the total number of shares outstanding at such time (on a class by class
basis), rounded to the nearest cent. Expenses, including the fees payable to the
Manager and Distributor, are accrued daily.
The principal asset of each Feeder Fund will normally be its interest in an
underlying Master Portfolio. The value of that interest is based on the net
assets of the Master Portfolio, which are comprised of the value of the
securities held by the Master Portfolio plus any cash or other assets (including
interest and dividends accrued but not yet received) minus all liabilities
(including accrued expenses of the Master Portfolio). Expenses of a Master
Portfolio, including the investment advisory fees, are accrued daily. The net
asset value of a Feeder Fund is equal to the value of the Feeder Fund's
proportionate interest in the net assets of the Master Portfolio plus any cash
or other assets, minus all liabilities (including accrued expenses) of the
Feeder Fund. To determine a Feeder Fund's net asset value per share, the Feeder
Fund's net asset value is divided by the total number of shares outstanding of
the Feeder Fund at such time (on a class by class basis), rounded to the nearest
cent. Expenses, including fees payable to the Administrator and Distributor, are
accrued daily.
The per share net asset value of Class A, Class B, Class C and Class R shares
generally will be lower than the per share net asset value of Class I shares,
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, the daily expense accruals of the account maintenance fees applicable
with respect to Class A shares and the daily expense accruals of the account
maintenance and distribution fees applicable to Class R shares. Moreover, the
per share net asset value of the Class B, Class C and Class R shares generally
will be lower than the per share net asset value of Class A shares reflecting
the daily expense accruals of the distribution fees and higher transfer agency
fees applicable with respect to Class B and Class C shares and the daily expense
accruals of the distribution fees applicable to Class R shares of a Fund. In
addition, the per share net asset value of Class B and Class C shares generally
will be lower than the per share net asset value of Class R shares due to the
daily expense accruals of the distribution fees and higher transfer agency fees
applicable to Class B and Class C shares. It is expected, however, that the per
share net asset value of all classes of a Fund 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 among
the classes.
Securities that are held by a Fund that are traded on stock exchanges or NASDAQ
National are valued at the last sale price or official close price on the
exchange on which such securities are traded, as of the close of business on the
day the securities are being valued or, lacking any sales, at the last available
bid price for long positions, and at the last available ask price for short
positions. In cases where securities are traded on more than one exchange, the
securities are valued on the exchange designated as the primary market by or
under the authority of the Board of each Fund. Long positions in securities
traded in the OTC market, NASDAQ Small Cap or Bulletin Board are valued at the
last available bid price or yield equivalent obtained from one or more dealers
or pricing services approved by the Board of a Fund. Short positions in
securities traded in the OTC market are valued at the last available ask price.
Portfolio securities that are traded both in the OTC market and on a stock
exchange are valued according to the broadest and most representative market.
When a Fund writes an option, the amount of the premium received is recorded on
the books of the Fund as an asset and an equivalent liability. The amount of the
liability is subsequently valued to reflect the current market value of the
option written, based on the last sale price in the case of exchange-traded
options or, in the case of options traded in the OTC market, the last ask price.
Options purchased by a Fund are valued at their last sale price in the case of
exchange-traded options or, in the case of options traded in the OTC market, the
last bid price. The value of swaps, including interest rate swaps, caps and
floors, will be determined by obtaining dealer quotations. Other investments,
including futures contracts and related options, are stated at market value.
Obligations with remaining maturities of 60 days or less are valued at amortized
cost unless the
II-48
Manager believes that this method no longer produces fair valuations. Repurchase
agreements will be valued at cost plus accrued interest. Each Fund employs
certain pricing services to provide securities prices for the Fund. Securities
and assets for which market quotations are not readily available are valued at
fair value as determined in good faith by or under the direction of the
Directors of a Fund, including valuations furnished by the pricing services
retained by the Fund, which may use a matrix system for valuations. The
procedures of a pricing service and its valuations are reviewed by the officers
of a Fund under the general supervision of the Directors. Such valuations and
procedures will be reviewed periodically by the Directors.
The Municipal Bonds and other portfolio securities in which the Municipal Funds
invest are traded primarily in over-the-counter ("OTC") municipal bond and money
markets and are valued at the last available bid price for long positions and at
the last available ask price for short positions in the OTC market or on the
basis of yield equivalents as obtained from one or more dealers or pricing
services approved by the Directors. One bond is the "yield equivalent" of
another bond when, taking into account market price, maturity, coupon rate,
credit rating and ultimate return of principal, both bonds will theoretically
produce an equivalent return to the bondholder. Financial futures contracts and
options thereon, which are traded on exchanges, are valued at their settlement
prices as of the close of such exchanges. Short-term investments with a
remaining maturity of 60 days or less are valued on an amortized cost basis,
which approximates market value, unless the Manager believes that this method no
longer produces fair valuations. Repurchase agreements will be valued at cost
plus accrued interest. 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 Directors, including valuations furnished by a
pricing service retained by the Municipal Funds, which may use a matrix system
for valuations. The procedures of the pricing service and its valuations are
reviewed by the officers of the Funds under the general supervision of the
Directors.
Generally, trading in foreign securities, as well as U.S. Government securities
and money market instruments, is substantially completed each day at various
times prior to the close of business on the NYSE. The values of such securities
used in computing the net asset value of a Fund's shares are determined as of
such times. Foreign currency exchange rates also are generally determined prior
to the close of business on the NYSE. Occasionally, events affecting the values
of such securities and such exchange rates may occur between the times at which
they are determined and the close of business on the NYSE that may not be
reflected in the computation of a Fund's net asset value. If events (e.g., a
company announcement, market volatility or a natural disaster) occur during such
periods that are expected to materially affect the value of such securities,
those securities may be valued at their fair value as determined in good faith
by the Board of Directors or by the Manager using a pricing service and/or
procedures approved by the Board of Directors.
For Funds organized in a master-feeder structure, each investor in a Master
Portfolio may add to or reduce its investment in the Master Portfolio on each
day the NYSE is open for trading. The value of each investor's (including a
Feeder Fund's) interest in a Master Portfolio will be determined after the close
of business on the NYSE by multiplying the net asset value of the Master
Portfolio by the percentage, effective for that day, that represents that
investor's share of the aggregate interests in the Master Portfolio. Any
additions or withdrawals to be effected on that day will then be effected. The
investor's percentage of the aggregate beneficial interests in a Master
Portfolio will then be recomputed as the percentage equal to the fraction (i)
the numerator of which is the value of such investor's investment in the Master
Portfolio as of the time of determination on such day plus or minus, as the case
may be, the amount of any additions to or withdrawals from the investor's
investment in the Master Portfolio effected on such day, and (ii) the
denominator of which is the aggregate net asset value of the Master Portfolio as
of such time on such day plus or minus, as the case may be, the amount of the
net additions to or withdrawals from the aggregate investments in the Master
Portfolio by all investors in the Master Portfolio. The percentage so determined
will then be applied to determine the value of the investor's interest in a
Master Portfolio after the close of business of the NYSE or the next
determination of net asset value of the Master Portfolio.
Computation of Offering Price Per Share
See Part I, Section VI "Computation of Offering Price" of each Fund's Statement
of Additional Information for an illustration of the computation of the offering
price for Class A, Class B, Class C, Class I and, if applicable, Class R shares
of your Select Pricing Fund or for shares of Municipal Investment Accumulation.
PORTFOLIO TRANSACTIONS AND BROKERAGE
Subject to policies established by the Board of each Fund, the Manager is
primarily responsible for the execution of a Fund's portfolio transactions and
the allocation of brokerage. The Manager does not execute transactions through
any
II-49
particular broker or dealer, but 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,
operational facilities of the firm and the firm's risk and skill in positioning
blocks of securities. While the Manager generally seeks reasonable trade
execution costs, a Fund does not necessarily pay the lowest spread or commission
available. Subject to applicable legal requirements, the Manager may select a
broker based partly upon brokerage or research services provided to the Manager
and its clients, including a Fund. In return for such services the Manager may
cause a Fund to pay a higher commission than other brokers would charge if the
Manager determines in good faith that the commission is reasonable in relation
to the services provided.
In the case of Feeder Funds, because each Feeder Fund will invest exclusively in
beneficial interests in a Master Portfolio, it is expected that all transactions
in portfolio securities will be entered into by the Master Portfolio.
Section 28(e) of the Exchange Act ("Section 28(e)") permits a manager, under
certain circumstances, to cause an account to pay a broker a commission for
effecting a transaction that exceeds the amount another broker or dealer would
have charged for effecting the same transaction in recognition of the value of
brokerage and research services provided by that broker or dealer. This includes
commissions paid on riskless principal transactions under certain conditions.
Brokerage and research services include (1) furnishing advice as to the value of
securities, the advisability of investing in, purchasing or selling securities,
and the availability of securities or purchasers or sellers of securities; (2)
furnishing analyses and reports concerning issuers, industries, securities,
economic factors and trends, portfolio strategy, and the performance of
accounts; and (3) effecting securities transactions and performing functions
incidental to securities transactions (such as clearance, settlement, and
custody). The Manager believes that access to independent investment research is
beneficial to its investment decision-making processes and, therefore, to a
Fund.
To the extent research services may be a factor in selecting brokers, such
services may be in written form or through direct contact with individuals and
may include information as to particular companies and securities as well as
market, economic, or institutional areas and information that assists in the
valuation of investments. Examples of research-oriented services for which the
Manager might use Fund commissions include research reports and other
information on the economy, industries, groups of securities, individual
companies, statistical information, political developments, technical market
action, pricing and appraisal services, credit analysis, risk measurement
analysis, performance and other analysis. Except as noted immediately below,
research services furnished by brokers may be used in servicing some or all
client accounts and not all services may be used in connection with the account
that paid commissions to the broker providing such services. In some cases,
research information received from brokers by mutual fund management personnel
or personnel principally responsible for the Manager's individually managed
portfolios is not necessarily shared by and between such personnel. Any
investment advisory or other fees paid by a Fund to the Manager are not reduced
as a result of the Manager's receipt of research services.
In some cases the Manager may receive a service from a broker that has both a
"research" and a "non-research" use. When this occurs the Manager makes a good
faith allocation, under all the circumstances, between the research and
non-research uses of the service. The percentage of the service that is used for
research purposes may be paid for with client commissions, while the Manager
will use its own funds to pay for the percentage of the service that is used for
non-research purposes. In making this good faith allocation, the Manager faces a
potential conflict of interest, but the Manager believes that its allocation
procedures are reasonably designed to ensure that it appropriately allocates the
anticipated use of such services to their research and non-research uses.
From time to time, a Fund may purchase new issues of securities in a fixed price
offering. In these situations, the broker may be a member of the selling group
that will, in addition to selling securities, provide the Manager with research
services. The NASD has adopted rules expressly permitting these types of
arrangements under certain circumstances. Generally, the broker will provide
research "credits" in these situations at a rate that is higher than that which
is available for typical secondary market transactions. These arrangements may
not fall within the safe harbor of Section 28(e).
In addition, consistent with the Conduct Rules of the NASD and policies
established by the Board of a Fund and subject to best execution, the Manager
may consider sales of shares of the Fund as a factor in the selection of brokers
and 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.
II-50
Each Fund anticipates that any brokerage transactions involving foreign
securities generally will be conducted primarily on the principal stock
exchanges of the applicable country. Foreign equity securities may be held by a
Fund in the form of Depositary Receipts, or other securities convertible into
foreign equity securities. Depositary Receipts may be listed on stock exchanges,
or traded in over-the-counter markets in the United States or Europe, as the
case may be. American Depositary Receipts, like other securities traded in the
United States, will be subject to negotiated commission rates. Because the
shares of each Fund are redeemable on a daily basis in U.S. dollars, each Fund
intends to manage its portfolio so as to give reasonable assurance that it will
be able to obtain U.S. dollars to the extent necessary to meet anticipated
redemptions. Under present conditions, it is not believed that these
considerations will have significant effect on its portfolio strategies.
See Part I Section VII "Portfolio and Brokerage Transactions" of each Fund's
Statement of Additional Information for information about the brokerage
commissions paid by your Fund, including commissions paid to Merrill Lynch, if
any, for the periods indicated.
Each Fund invests primarily in securities traded in the OTC market and intends
to deal directly with the dealers who make a market in the particular
securities, except in those circumstances in which better prices and execution
are available elsewhere. Under the Investment Company Act, persons affiliated
with a Fund and persons who are affiliated with such affiliated persons are
prohibited from dealing with the Fund as principal in the purchase and sale of
securities unless a permissive order allowing such transactions is obtained from
the Commission. Since transactions in the OTC market usually involve
transactions with the dealers acting as principal for their own accounts, the
Funds will not deal with affiliated persons, including Merrill Lynch and its
affiliates, in connection with such transactions. However, an affiliated person
of a Fund may serve as its broker in OTC transactions conducted on an agency
basis provided that, among other things, the fee or commission received by such
affiliated broker is reasonable and fair compared to the fee or commission
received by non-affiliated brokers in connection with comparable transactions.
In addition, a Fund may not purchase securities during the existence of any
underwriting syndicate for such securities 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 the Fund that either comply with
rules adopted by the Commission or with interpretations of the Commission staff.
The Municipal Funds recently received an exemptive order under which they may
purchase investment grade Municipal Bonds through group orders from an
underwriting syndicate of which Merrill Lynch is a member subject to conditions
set forth in such order (the "Group Order Exemptive Order"). A group order is an
order for securities held in an underwriting syndicate for the account of all
members of the syndicate, and in proportion to their respective participation in
the syndicate. Under another exemptive order, the Municipal Funds may effect
principal transactions with Merrill Lynch in high quality, short-term,
tax-exempt securities subject to conditions set forth in such order. Please see
Part I, Section VII "Portfolio Transactions and Brokerage" of each Fund's
Statement of Additional Information for information regarding transactions
executed by your Fund pursuant to these exemptive orders.
The Funds may not purchase securities, including Municipal Bonds, 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 Directors that either comply with rules
adopted by the Commission or with interpretations of the Commission staff or
pursuant to the Group Order Exemptive Order. Rule 10f-3 under the Investment
Company Act and the Group Order Exemptive Order set forth conditions under which
a Fund may purchase Municipal Bonds from an underwriting syndicate of which
Merrill Lynch is a member. The rule and the Group Order Exemptive Order set
forth requirements relating to, among other things, the terms of an issue of
Municipal Bonds purchased by a Fund, the amount of Municipal Bonds that may be
purchased in any one issue and the assets of the Fund that may be invested in a
particular issue.
Each Fund has received an exemptive order from the Commission permitting it to
lend portfolio securities to Merrill Lynch or its affiliates. Pursuant to that
order, each Fund also has retained or may retain an affiliated entity of the
Manager as the securities lending agent (the "lending agent") for a fee,
including a fee based on a share of the returns on investment of cash
collateral. At present, the Municipal Funds do not intend to engage in
securities lending transactions. Please see Part I, Section VII "Portfolio
Transactions and Brokerage" of each Fund's Statement of Additional Information
for information on the securities lending fees paid to the lending agent by your
Fund. In connection with securities lending activities, the lending agent may,
on behalf of a Fund, invest cash collateral received by the Fund for such loans,
among other things, in a private investment company managed by the lending agent
or in registered money market funds advised by the Manager or its affiliates, or
in a private investment company managed by the lending agent. If a Fund acquires
shares in either the
II-51
private investment company or an affiliated money market fund, shareholders
would bear both their proportionate share of the Fund's expenses, and
indirectly, the expense of such other entities. However, in accordance with the
exemptive order, the manager to the private investment company will not charge
any advisory fees with respect to shares purchased by a Fund. Such shares also
will not be subject to a sales load, redemption fee, distribution fee or service
fee, or in the case of the shares of an affiliated money market fund, the
payment of any such sales load, redemption fee, distribution fee or service fee
will be offset by the Manager's waiver of a portion of its advisory fee.
Section 11(a) of the Exchange Act generally prohibits members of the U.S.
national securities exchanges from executing exchange transactions for their
affiliates and institutional accounts that they manage unless the member (i) has
obtained prior express authorization from the account to effect such
transactions, (ii) at least annually furnishes the account with a statement
setting forth the aggregate compensation received by the member in effecting
such transactions, and (iii) complies with any rules the Commission has
prescribed with respect to the requirements of clauses (i) and (ii). To the
extent Section 11(a) would apply to Merrill Lynch acting as a broker for a Fund
in any of its portfolio transactions executed on any securities exchange of
which it is a member, appropriate consents have been obtained from each Fund and
annual statements as to aggregate compensation will be provided to each Fund.
The Board of each Fund has considered the possibility of seeking to recapture
for the benefit of the Fund brokerage commissions and other expenses of possible
portfolio transactions by conducting portfolio transactions through affiliated
entities. For example, brokerage commissions received by affiliated brokers
could be offset against the advisory fee paid by each Fund to a Manager. After
considering all factors deemed relevant, the Board of each Fund made a
determination not to seek such recapture. The Board of each Fund will reconsider
this matter from time to time.
Because of different objectives or other factors, a particular security may be
bought for one or more funds or clients advised by the Manager or its affiliates
(collectively, "clients") when one or more clients of the Manager or its
affiliates are selling the same security. If purchases or sales of securities
arise for consideration at or about the same time that would involve a Fund or
other clients or funds for which the Manager or an affiliate act as investment
manager, 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 Manager or its
affiliates 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.
DIVIDENDS AND TAXES
Dividends
Each Fund intends to distribute substantially all of its net investment income,
if any. Dividends from such net investment income are paid as set forth in each
Fund's prospectus. Each Fund will also distribute all net realized capital
gains, if any, to its shareholders at least annually. From time to time, a Fund
may declare a special distribution 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, a Fund has net income from certain foreign currency transactions,
such income will be distributed at least annually.
For information concerning the manner in which dividends may be reinvested
automatically in shares of each Fund, see "Shareholder Services -- Automatic
Dividend Reinvestment Plan." Shareholders may also 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 A, Class B, Class C and Class R shares will be
lower than the per share dividends on Class I shares as a result of the account
maintenance, distribution and higher transfer agency fees applicable to Class B
and Class C shares, the account maintenance fees applicable to Class A shares,
and the account maintenance and distribution fees applicable to Class R shares.
Similarly, the per share dividends on Class B, Class C and Class R shares will
be lower than the per share dividends on Class A shares as a result of the
distribution fees and higher transfer agency fees applicable to Class B and
Class C shares and the distribution fees applicable to Class R shares, and the
per share dividends on Class B and Class C shares will be lower than the per
share dividends on Class R shares as a result of the distribution fees and
higher transfer agency fees applicable to Class B and Class C shares.
II-52
Taxes
Each Fund intends to qualify, or continue to qualify, for the special tax
treatment afforded to regulated investment companies ("RICs") under the Code. As
long as a Fund 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 that it distributes to Class A, Class B, Class C and
Class I shareholders (together, the "shareholders"). Each Fund intends to
distribute substantially all of such income and gains.
If, in any taxable year, a Fund fails to qualify as a RIC under the Code, such
Fund would be taxed in the same manner as an ordinary corporation and all
distributions from earnings and profits to its shareholders would be taxable as
ordinary income.
For Funds that are series of a series fund, each series is treated as a separate
corporation for Federal income tax purposes. Each series, therefore, is
considered to be a separate entity in determining its treatment under the rules
for RICS described in each Fund's Prospectus and Statement of Additional
Information. Losses in one series of a Fund do not offset gains in another
series of such Fund, and the requirements (other than certain organizational
requirements) for qualifying for status as a RIC are determined separately at
the level of each individual series.
The Code requires a RIC to pay a nondeductible 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
the previous years. While each 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 a Fund's taxable income and
capital gains will be distributed to achieve this objective. In such event, a
Fund will be liable for the tax only on the amount by which it does not meet the
foregoing distribution requirements. Because the required distributions are
based on the taxable income of a RIC, the excise tax generally will not apply to
the tax-exempt income of the Municipal Funds.
Dividends paid by a Fund from its ordinary income or from an excess of net short
term capital gains over net long term capital losses (together referred to 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 (including gains or losses from certain transactions in
futures and options) ("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 will be treated as long term capital loss to the extent of
any capital gain dividends received by the shareholder. Distributions in excess
of a Fund's earnings and profits will first reduce the adjusted tax basis of a
shareholder's shares and, after such adjusted tax basis is reduced to zero, will
constitute capital gains to such shareholder (assuming the shares are held as a
capital asset). Long term capital gains (i.e. gains, from a sale or exchange of
capital assets held for more than one year) are generally taxed at preferential
rates to non-corporate taxpayers. Generally not later than 60 days after the
close of its taxable year, each Fund will provide its shareholders with a
written notice designating the amount of any capital gain dividends or exempt
interest dividends, as applicable, as well as certain other types of income as
noted below.
Ordinary income and capital gain dividends are taxable to shareholders even if
they are reinvested in additional shares of a Fund. Distributions by a Fund,
whether from ordinary income or capital gains, generally will not be eligible
for the dividends received deduction. If a Fund pays a dividend in January that
was declared in the previous October, November or December to shareholders of
record on a specified date in one of such months, then such dividend will be
treated for tax purposes as being paid by the Fund and received by its
shareholders on December 31 of the year in which the dividend was declared.
No gain or loss will be recognized by Class B shareholders on the conversion of
their Class B shares into Class A shares. A shareholder's basis in the Class A
shares acquired upon conversion will be the same as the shareholder's basis in
the converted Class B shares, and the holding period of the acquired Class A
shares will include the holding period for the converted Class B shares.
If a shareholder exercises an exchange privilege within 90 days of acquiring the
shares of a Fund, then the loss that the shareholder recognizes on the exchange
will be reduced (or the gain increased) to the extent any sales charge paid on
the
II-53
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 sales charge will be treated as an amount paid for the new shares.
A loss realized on a sale or exchange of shares of a Fund will be disallowed if
such 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 on which the shares are disposed of. In such case,
the basis of the shares acquired will be adjusted to reflect the disallowed
loss.
A Fund may invest in zero coupon U.S. Treasury bonds and other debt securities
that are issued at a discount or provide for deferred interest. Even though a
Fund receives no actual interest payments on these securities, it will be deemed
to receive income equal, generally, to a portion of the excess of the face value
of the securities over their issue price ("original issue discount") each year
that the securities are held. Since the original issue discount income earned by
a Fund in a taxable year may not be represented by cash income, it may have to
dispose of securities, which it might otherwise have continued to hold, or
borrow to generate cash in order to satisfy its distribution requirements. In
addition, a Fund's investment in foreign currencies or foreign currency
denominated or referenced debt securities, certain asset-backed securities and
contingent payment and inflation-indexed debt instruments also may increase or
accelerate the Fund's recognition of income, including the recognition of
taxable income in excess of cash generated by such investments.
Ordinary income dividends paid to shareholders who are non-resident aliens or
foreign entities will be subject to a 30% U.S. withholding tax under existing
provisions of the Code applicable to foreign individuals and entities unless a
reduced rate of withholding 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.
Under certain provisions of the Code, some shareholders may be subject to a
withholding tax on ordinary income dividends, capital gain dividends and
redemption payments ("backup withholding"). Generally, shareholders subject to
backup withholding will be those for whom no certified taxpayer identification
number is 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 penalty of perjury that such number is correct and that such investor is
not otherwise subject to backup withholding.
Dividends and interest received by a Fund may give rise to withholding and other
taxes imposed by foreign countries. Tax conventions between certain foreign
countries and the U.S. may reduce or eliminate such taxes.
Shareholders of certain Funds that invest more than 50% of the value of their
assets at the close of a taxable year in foreign securities may be able to claim
U.S. foreign tax credits with respect to such foreign taxes paid by such Funds,
subject to certain requirements and limitations contained in the Code. For
example, certain retirement accounts and tax-exempt organizations cannot claim
foreign tax credits on investments in foreign securities held in a Fund. In
addition, a foreign tax credit may be claimed with respect to withholding tax on
a dividend only if the shareholder meets certain holding period requirements. A
Fund also must meet these holding period requirements, and if a Fund fails to do
so, it will not be able to "pass through" to shareholders the ability to claim a
credit or a deduction for the related foreign taxes paid by the Fund. If a Fund
satisfies the applicable requirements, such Fund will be eligible to file an
election with the Internal Revenue Service pursuant to which shareholders of the
Fund will be required to include their proportionate shares of such foreign
taxes in their U.S. income tax returns as gross income, treat such proportionate
shares as taxes paid by them, and deduct such proportionate shares in computing
their taxable incomes or, alternatively, use them as foreign tax credits against
their U.S. Federal income taxes. No deductions for foreign taxes, however, may
be claimed by noncorporate shareholders who do not itemize deductions. A
shareholder that is a nonresident alien individual or a foreign corporation may
be subject to U.S. withholding tax on the income resulting from a Fund's
election described in this paragraph but may not be able to claim a credit or
deduction against such U.S. Federal withholding tax for the foreign taxes
treated as having been paid by such shareholder. A Fund will report annually to
its shareholders the amount per share of such foreign taxes and other
information needed to claim the foreign tax credit. For this purpose, a Fund
will allocate foreign source income among the Class A, Class B, Class C, Class I
and Class R shareholders according to a method (which it believes is consistent
with the rule permitting the issuance and sale of multiple classes of stock)
that is based on the gross income allocable to Class A, Class B, Class C, Class
I and Class R shareholders during the taxable year, or such other method as the
Internal Revenue Service may prescribe.
The transactions of certain Funds are subject to special tax rules of the Code
that may, among other things, (a) affect the character of gains and losses
realized (with capital gains generally subject to tax at lower rates than
ordinary income), (b)
II-54
disallow, suspend or otherwise limit the allowance of certain losses or
deductions, and (c) accelerate the recognition of income without a corresponding
receipt of cash (with which to make the necessary distributions to satisfy
distribution requirements applicable to RICs). Operation of these rules could,
therefore, affect the character, amount and timing of distributions to
shareholders. Special tax rules also may require a Fund to mark to market
certain types of positions in its portfolio (i.e., treat them as sold on the
last day of the taxable year), and may result in the recognition of income
without a corresponding receipt of cash. Funds engaging in transactions affected
by these provisions intend to monitor their transactions, make appropriate tax
elections and make appropriate entries in their books and records to lessen the
effect of these tax rules and avoid any possible disqualification for the
special treatment afforded RIC's under the Code.
If a Fund purchases shares of an investment company (or similar investment
entity) organized under foreign law, the Fund will generally be treated as
owning shares in a passive foreign investment company ("PFIC") for U.S. Federal
income tax purposes. A Fund may be subject to U.S. Federal income tax, and an
interest charge (at the rate applicable to tax underpayments) on tax liability
treated as having been deferred with respect to certain distributions from such
a company and on gain from the disposition of the shares of such a company
(collectively referred to as "excess distributions"), even if such excess
distributions are paid by the Fund as a dividend to its shareholders. A Fund may
be eligible to make an election with respect to certain PFICs in which it owns
shares that will allow it to avoid the taxes on excess distributions. However,
such election may cause a Fund to recognize income in a particular year in
excess of the distributions received from such PFICs. Alternatively, a Fund
could elect to "mark to market" at the end of each taxable year all shares that
it holds in PFICs. If it made this election, a Fund would recognize as ordinary
income any increase in the value of such shares as of the close of the taxable
year over their adjusted basis and as ordinary loss any decrease in such value
but only to the extent of previously recognized "mark-to-market" gains. By
making the mark-to-market election, a Fund could avoid imposition of the
interest charge with respect to excess distributions from PFICs, but in any
particular year might be required to recognize income in excess of the
distributions it received from PFICs.
Municipal Funds
Each Municipal Fund intends to qualify to pay "exempt-interest dividends" as
defined in Section 852(b)(5) of the Code. Under such section if, at the close of
each quarter of a Fund's taxable year, at least 50% of the value of the Fund's
total assets consists of obligations exempt from Federal income tax ("tax-exempt
obligations") under Section 103(a) of the Code (relating generally to
obligations of a state or local governmental unit), the Fund shall be qualified
to pay exempt-interest dividends to its Class A, Class B, Class C and Class I
shareholders (together the "shareholders"). Exempt-interest dividends are
dividends or any part thereof paid by a Fund that are attributable to interest
on tax-exempt obligations and designated by the Fund as exempt-interest
dividends in a written notice mailed to the Fund's shareholders within 60 days
after the close of the Fund's taxable year. A Fund will allocate interest from
tax-exempt obligations (as well as ordinary income, capital gains and tax
preference items discussed below) among the Class A, Class B, Class C and Class
I shareholders according to a method (which it believes is consistent with the
Commission rule permitting the issuance and sale of multiple classes of shares)
that is based upon the gross income that is allocable to the Class A, Class B,
Class C and Class I shareholders during the taxable year, or such other method
as the Internal Revenue Service may prescribe.
Exempt-interest dividends will be excludable from a shareholder's gross income
for Federal income tax purposes. Exempt-interest dividends are included,
however, in determining the portion, if any, of a person's social security and
railroad retirement benefits subject to Federal income taxes. Interest on
indebtedness incurred or continued to purchase or carry shares of a RIC paying
exempt-interest dividends, such as the Fund, will not be deductible by the
investor for Federal income tax purposes to the extent attributable to
exempt-interest dividends. Shareholders are advised to consult their tax
advisers with respect to whether exempt-interest dividends retain the exclusion
under Code Section 103(a) if a shareholder would be treated as a "substantial
user" or "related person" under Code Section 147(a) with respect to property
financed with the proceeds of an issue of "IDBs" or "PABs," if any, held by a
Fund.
All or a portion of a Fund's gains from the sale or redemption of tax-exempt
obligations purchased at a market discount will be treated as ordinary income
rather than capital gain. This rule may increase the amount of ordinary income
dividends received by shareholders. Distributions in excess of a 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). Any loss upon
the sale or exchange of Fund shares held for six months or less will be
disallowed to the extent of any exempt-interest dividends received by the
shareholder. In addition, any such loss that is not disallowed under the rule
stated above will be treated as long-term capital loss to the extent of any
capital gain dividends received by the shareholder.
II-55
The Code subjects interest received on certain otherwise tax-exempt securities
to a Federal alternative minimum tax. The alternative minimum tax applies to
interest received on certain "PABs" issued after August 7, 1986. PABs are bonds
which, although tax-exempt, are used for purposes other than those generally
performed by governmental units and which benefit non-governmental entities
(e.g., bonds used for industrial development or housing purposes). Income
received on such bonds is classified as an item of "tax preference," which could
subject certain investors in such bonds, including shareholders of a Fund, to a
Federal alternative minimum tax. A Fund will purchase such "PABs" and will
report to shareholders within 60 days after calendar year-end the portion of the
Fund's dividends declared during the year which constitute an item of tax
preference for alternative minimum tax purposes. The Code further provides that
corporations are subject to a Federal alternative minimum tax based, in part, on
certain differences between taxable income as adjusted for other tax preferences
and the corporation's "adjusted current earnings," which more closely reflect a
corporation's economic income. Because an exempt-interest dividend paid by a
Fund will be included in adjusted current earnings, a corporate shareholder may
be required to pay alternative minimum tax on exempt-interest dividends paid by
the Fund.
Each Municipal Fund may engage in interest rate swaps. The Federal income tax
rules governing the taxation of interest rate swaps are not entirely clear and
may require a Fund to treat payments received under such arrangements as
ordinary income and to amortize payments made under certain circumstances.
Additionally, because the treatment of swaps under the RIC qualification rules
is not clear, each Fund will monitor its activity in this regard in order to
maintain its qualification as a RIC. Because payments received by a Fund in
connection with swap transactions will be taxable rather than tax-exempt, they
may result in increased taxable distributions to shareholders.
Please see Part I of your Fund's Statement of Additional Information for certain
state tax information relevant to an investment in California Insured, Florida
Municipal Bond, New Jersey Municipal Bond, New York Municipal Bond and
Pennsylvania Municipal Bond, as well as information on economic conditions
within each applicable state.
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 Code sections and the
Treasury regulations promulgated thereunder. The Code and the Treasury
regulations are subject to change by legislative, judicial or administrative
action either prospectively or retroactively.
Ordinary income and capital gain dividends may also be subject to state and
local taxes.
Certain states exempt from state income taxation dividends paid by RICs that are
derived from interest on U.S. Government obligations. State law varies as to
whether dividend income attributable to U.S. Government obligations is exempt
from state income tax.
Shareholders of each Fund are urged to consult their tax advisers regarding
specific questions as to Federal, foreign, state or local taxes with respect to
their Fund. Foreign investors should consider applicable foreign taxes in their
evaluation of an investment in a Fund.
In the case of a Feeder Fund, such Fund is entitled to look to the underlying
assets of the Master Portfolio in which it has invested for purposes of
satisfying various qualification requirements of the Code applicable to RICs.
Each Master Portfolio is classified as a partnership for tax purposes. If
applicable tax provisions were to change, then the Board of a Feeder Fund will
determine, in its discretion, the appropriate course of action for the Feeder
Fund. One possible course of action would be to withdraw the Feeder Fund's
investments from the Master Portfolio and to retain an investment manager to
manage the Feeder Fund's assets in accordance with the investment policies
applicable to the Feeder Fund.
PERFORMANCE DATA
From time to time a Fund may include its average annual total return and other
total return data, and if applicable, yield and tax-equivalent yield in
advertisements or information furnished to present or prospective shareholders.
Total return, yield and tax-equivalent yield each is based on a Fund's
historical performance and is not intended to indicate future performance.
Average annual total return, yield and tax-equivalent yield each is determined
separately for Class A, Class B, Class C, Class I and Class R shares in
accordance with a formula specified by the Commission.
II-56
Quotations of average annual total return, before tax, 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 before taxes is computed assuming all dividends 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 I
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 but does not take into account taxes payable on dividends or on
redemption.
Quotations of average annual total return, after taxes, on dividends for the
specified periods are computed by finding the average annual compounded rates of
return that would equate the initial amount invested to the ending value of such
investment at the end of each period assuming payment of taxes on dividends
received during such period. Average annual total return after taxes on
dividends is computed assuming all dividends, less the taxes due on such
dividends, 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 I 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. The taxes due on dividends are calculated by
applying to each dividend the highest marginal Federal individual income tax
rates in effect on the reinvestment date for that dividend. The rates used
correspond to the tax character of each dividend. The taxable amount and tax
character of each dividend are specified by each Fund on the dividend
declaration date, but may be adjusted to reflect subsequent recharacterizations
of distributions. The applicable tax rates may vary over the measurement period.
The effects of state and local taxes are not reflected. Applicable tax credits,
such as foreign credits, are taken into account according to Federal law. The
ending value is determined assuming complete redemption at the end of the
applicable periods with no tax consequences associated with such redemption.
Quotations of average annual total return, after taxes, on both dividends and
redemption for the specified periods are computed by finding the average annual
compounded rates of return that would equate the initial amount invested to the
ending value of such investment at the end of each period assuming payment of
taxes on dividends received during such period as well as on complete
redemption. Average annual total return after taxes on distributions and
redemption is computed assuming all dividends, less the taxes due on such
dividends, 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 I 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 assuming, for all classes of shares, complete
redemption and payment of taxes due on such redemption. The ending value is
determined assuming complete redemption at the end of the applicable periods,
subtracting capital gains taxes resulting from the redemption and adding the
presumed tax benefit from capital losses resulting from redemption. The taxes
due on dividends and on the deemed redemption are calculated by applying the
highest individual marginal Federal individual income tax rates in effect on the
reinvestment and/or the redemption date. The rates used correspond to the tax
character of each component of each dividend and/or the redemption payment.
The applicable tax rates may vary over the measurement period. The effects of
state and local taxes are not reflected.
A 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) as required by the periods of the quotations,
actual annual, annualized or aggregate data, rather than average annual data,
may be quoted and (2) the maximum applicable sales charges 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 charges, 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.
Yield quotations will be computed based on a 30-day period by dividing (a) the
net income based on the yield 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. Tax equivalent yield quotations will be computed
by dividing (a) the part of a Fund's yield that is tax-exempt by (b) one minus a
stated tax rate and (c) adding the result to that part, if any, of the Fund's
yield that is not tax-exempt.
II-57
See Part I Section VIII "Fund Performance" of each Fund's Statement of
Additional Information for performance information for the Class A, Class B,
Class C, Class I and, if applicable, Class R shares of your Fund for the periods
indicated.
A Fund's total return will vary depending on market conditions, the securities
comprising a Fund's portfolio, a Fund'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 Fund will fluctuate and an investor's shares, when
redeemed, may be worth more or less than their original cost.
In order to reflect the reduced sales charges in the case of Class A or Class I
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" and
"Redemption of Shares," respectively, the total return data quoted by a Fund in
advertisements directed to such investors may take into account the reduced, and
not the maximum, sales charge or may take into account the CDSC waiver and
therefore may reflect greater total return since, due to the reduced sales
charges or the waiver of sales charges, a lower amount of expenses is deducted.
On occasion, a Fund may compare its performance to, among other things, the
Fund's benchmark index indicated in the Prospectus, the Value Line Composite
Index, the Dow Jones Industrial Average, or to other published indices, or to
performance data published by Lipper Analytical Services, Inc. Morningstar
Publications ("Morningstar"), Money Magazine, U.S. News & World Report,
BusinessWeek, Forbes Magazine, Fortune Magazine or other industry publications.
When comparing its performance to a market index, a Fund may refer to various
statistical measures derived from the historic performance of a Fund and the
index, such as standard deviation and beta. As with other performance data,
performance comparisons should not be considered indicative of a Fund's relative
performance for any future period. In addition, from time to time a Fund may
include the Fund's Morningstar risk-adjusted performance ratings assigned by
Morningstar in advertising or supplemental sales literature. From time to time a
Fund may quote in advertisements or other materials other applicable measures of
Fund performance and may also make reference to awards that may be given to the
Manager.
A Fund may provide information designed to help investors understand how the
Fund is seeking to achieve its investment objectives. This may include
information about past, current or possible economic, market, political or other
conditions, descriptive information or general principles of investing such as
asset allocation, diversification and risk tolerance, discussion of a Fund's
portfolio composition, investment philosophy, strategy or investment techniques,
comparisons of the Fund's performance or portfolio composition to that of other
funds or types of investments, indices relevant to the comparison being made, or
to a hypothetical or model portfolio. A Fund may also quote various measures of
volatility and benchmark correlation in advertising and other materials, and may
compare these measures to those of other funds or types of investments.
GENERAL INFORMATION
Description of Shares
Shareholders of a Fund are entitled to one vote for each full share held and
fractional votes for fractional shares held in the election of Directors and
generally on other matters submitted to the vote of shareholders of the Fund.
Shareholders of a class bearing distribution and account maintenance expenses
have exclusive voting rights with respect to matters relating to such
distribution and account maintenance expenditures (except that Class B
shareholders may vote upon any material changes to expenses charged under the
Class A Distribution Plan). Voting rights are not cumulative, so that the
holders of more than 50% of the shares voting in the election of Directors can,
if they choose to do so, elect all the Directors of a Fund, in which event the
holders of the remaining shares would be unable to elect any person as a
Director.
No Fund intends to hold an annual meeting of shareholders in any year in which
the Investment Company Act does not require shareholders to act upon any of the
following matters: (i) election of Directors; (ii) approval of a management
agreement; (iii) approval of a distribution agreement; and (iv) ratification of
selection of independent accountants. Shares issued are fully paid and
non-assessable and have no preemptive rights. Redemption and conversion rights
are discussed elsewhere herein and in each Fund's Prospectus. Each share of
Class A, Class B, Class C, Class I and Class R Common Stock is entitled to
participate equally in dividends and distributions declared by a Fund and in the
net assets of the Fund upon liquidation or dissolution after satisfaction of
outstanding liabilities.
II-58
For Funds organized as Maryland corporations, the by-laws of the Fund require
that a special meeting of shareholders be held upon the written request of a
minimum percentage of the outstanding shares of the Fund entitled to vote at
such meeting, if they comply with applicable Maryland law.
Certain of the Funds are organized as "Massachusetts business trusts." Under
Massachusetts law, shareholders of such a trust may, under certain
circumstances, be held personally liable as partners for its obligations.
However, the Declaration of Trust establishing a trust, a copy of which for each
applicable Fund, together with all amendments thereto (the "Declaration of Trust
"), is on file in the office of the Secretary of the Commonwealth of
Massachusetts, contains an express disclaimer of shareholder liability for acts
or obligations of the trust and provides for indemnification and reimbursement
of expenses out of the trust property for any shareholder held personally liable
for the obligations of the trust. The Declaration of Trust also provides that a
trust may maintain appropriate insurance (for example, fidelity bonding and
errors and omissions insurance) for the protection of the trust, its
shareholders, Trustees, officers, employees and agents covering possible tort
and other liabilities. Thus, the risk of a shareholder incurring financial loss
on account of shareholder liability is limited to circumstances in which both
inadequate insurance existed and the trust itself was unable to meet its
obligations.
See Part I, Section IX "Additional Information - Description of Shares" of each
Fund's Statement of Additional Information for additional capital stock
information for your Fund.
Additional Information
Under a separate agreement, ML & Co. has granted each 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 a Fund at any time or to grant the use of such name to any
other company, and each Fund has granted ML & Co. under certain conditions, the
use of any other name it might assume in the future, with respect to any
corporation organized by ML & Co.
See Part I, Section IX "Additional Information - Principal Holders" of each
Fund's Statement of Additional Information for information on the holders of 5%
or more of any class of shares of your Fund.
II-59
APPENDIX A
Description OF BOND RATINGS
Description of Moody's Investors Service, Inc.'s ("Moody's") Bond Ratings
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 as 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 the 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 which 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.
Note: Moody's applies numerical modifiers 1, 2, and 3 in each generic rating
classification from Aa through Caa. The modifier 1 indicates that the obligation
ranks in the higher end of its generic rating category; the modifier 2 indicates
a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of
that generic rating category.
A-1
Description of Moody's U.S. Short-Term Ratings
MIG
1/VMIG This designation denotes superior credit quality. Excellent protection is
afforded by established cash flows, highly 1 reliable liquidity support, or
demonstrated broad-based access to the market for refinancing.
MIG
2/VMIG This designation denotes strong credit quality. Margins of protection are
ample, although not as large as in the preceding group.
MIG
3/VMIG This designation denotes acceptable credit quality. Liquidity and
cash-flow protection may be narrow, and market access 3 for refinancing is
likely to be less well-established.
SG This designation denotes speculative-grade credit quality. Debt
instruments in this category may lack sufficient margins of protection.
Description of Moody's Commercial Paper Ratings
Moody's Commercial Paper ratings are opinions of the ability of issuers to
repay punctually promissory obligations not having an original maturity in
excess of nine months. Moody's employs the following three designations, all
judged to be investment grade, to indicate the relative repayment capacity of
rated issuers:
Issuers rated Prime-1 (or supporting institutions) have a superior ability
for repayment of short term promissory obligations. Prime-1 repayment ability
will often be evidenced by many of the following characteristics: leading market
positions in well established industries; high rates of return on funds
employed; conservative capitalization structures with moderate reliance on debt
and ample asset protection; broad margins in earning coverage of fixed financial
charges and high internal cash generation; and well established access to a
range of financial markets and assured sources of alternate liquidity.
Issuers rated Prime-2 (or supporting institutions) have a strong ability for
repayment of short term promissory obligations. This will normally be evidenced
by many of the characteristics cited above but to a lesser degree. Earnings
trends and coverage ratios, while sound, may be more subject to variation.
Capitalization characteristics, while still appropriate, may be more affected by
external conditions. Ample alternate liquidity is maintained.
Issuers rated Prime-3 (or supporting institutions) have an acceptable ability
for repayment of short term promissory obligations. The effects of industry
characteristics and market composition may be more pronounced. Variability in
earnings and profitability may result in changes to the level of debt protection
measurements and may require relatively high financial leverage. Adequate
alternate liquidity is maintained.
Issuers rated Not Prime do not fall within any of the Prime rating
categories.
Description of Standard & Poor's, a Division of The McGraw-Hill Companies, Inc.
("Standard & Poor's"), Debt Ratings
A Standard & Poor's issue credit rating is a current opinion of the
creditworthiness of an obligor with respect to a specific financial obligation,
a specific class of financial obligations or a specific program. It takes into
consideration the creditworthiness of guarantors, insurers, or other forms of
credit enhancement on the obligation.
The issue credit rating is not a recommendation to purchase, sell or hold a
financial obligation, inasmuch as it does not comment as to market price or
suitability for a particular investor.
The issue credit ratings are based on current information furnished by the
obligors or obtained by Standard & Poor's from other sources Standard & Poor's
considers reliable. Standard & Poor's does not perform an audit in connection
with any rating and may, on occasion, rely on unaudited financial information.
The ratings may be changed, suspended, or withdrawn as a result of changes in,
or unavailability of, such information, or based on other circumstances.
A-2
The issue credit ratings are based, in varying degrees, on the following
considerations:
I. Likelihood of payment--capacity and willingness of the obligor as to the
timely payment of interest and repayment of principal in accordance with the
terms of the obligation;
II. Nature of and provisions of the obligation;
III. Protection afforded to, and relative position of, the obligation in the
event of bankruptcy, reorganization or other arrangement under the laws of
bankruptcy and other laws affecting creditors' rights.
Long Term Issue Credit Ratings
AAA An obligation rated "AAA" has the highest rating assigned by Standard &
Poor's. Capacity to meet its financial commitment on the obligation is
extremely strong.
AA An obligation rated "AA" differs from the highest rated issues only in small
degree. The Obligor's capacity to meet its financial commitment on the
obligation is very strong.
A An obligation rated "A" is somewhat more susceptible to the adverse effects
of changes in circumstances and economic conditions than debt in
higher-rated categories. However, the obligor's capacity to meet its
financial commitment on the obligation is still strong.
BBB An obligation rated "BBB" exhibits adequate protection parameters. However,
adverse economic conditions or changing circumstances are more likely to
lead to a weakened capacity of the obligor to meet its financial commitment
on the obligation.
BB An obligation rated "BB," "B," "CCC," "CC" and "C" are regarded as having
significant speculative characteristics. "BB" B indicates the least degree of
speculation and "C" the highest degree of speculation. While such debt will
likely have some CCC quality and protective characteristics, these may be
outweighed by large uncertainties or major risk exposures to adverse CC
conditions.
C
D An obligation rated "D" is in payment default. The "D" rating category is
used when payments on an obligation are not made on the date due even if the
applicable grace period has not expired, unless Standard & Poor's believes
that such payments will be made during such grace period. The "D" rating
also will be used upon the filing of a bankruptcy petition or the taking of
similar action if payments on an obligation are jeopardized.
c The `c' subscript is used to provide additional information to investors
that the bank may terminate its obligation to purchase tendered bonds if the
long term credit rating of the issuer is below an investment-grade level
and/or the issuer's bonds are deemed taxable.
p The letter `p' indicates that the rating is provisional. A provisional
rating assumes the successful completion of the project financed by the debt
being rated and indicates that payment of debt service requirements is
largely or entirely dependent upon the successful, timely completion of the
project. This rating, however, while addressing credit quality subsequent to
the completion of the project, makes no comment on the likelihood of or the
risk of default upon failure of such completion. The investor should
exercise his own judgment with respect to such likelihood and risk.
* Continuance of the ratings is contingent upon Standard & Poor's receipt of
an executed copy of the escrow agreement or closing documentation confirming
investments and cash flows.
r This symbol is attached to the ratings of instruments with significant
noncredit risks. It highlights risks to principal or volatility of expected
returns which are not addressed in the credit rating.
A-3
N.R. This indicates that no rating has been requested, that there is
insufficient information on which to base a rating, or that Standard &
Poor's does not rate a particular obligation as a matter of policy.
Plus (+) or Minus (-): The ratings from "AA" to "CCC" may be modified by the
addition of a plus or minus sign to show relative standing within the major
rating categories.
Description of Standard & Poor's Commercial Paper Ratings
A Standard & Poor's commercial paper rating is a current assessment of the
likelihood of timely payment of debt having an original maturity of no more than
365 days. Ratings are graded into several categories, ranging from "A-1" for the
highest-quality obligations to "D" for the lowest. These categories are as
follows:
A-1 A short-term obligation rated "A-1" is rated in the highest category by
Standard & Poor's. The obligor's capacity to meet its financial commitment
on the obligation is strong. Within this category, certain obligations are
designated with a plus sign (+). This indicates that the obligor's capacity
to meet its financial commitment on these obligations is extremely strong.
A-2 A short-term obligation rated "A-2" is somewhat more susceptible to the
adverse effects of changes in circumstances and economic conditions than
obligations in higher rating categories. However, the obligor's capacity to
meet its financial commitment on the obligation is satisfactory.
A-3 A short-term obligation rated "A-3" exhibits adequate protection parameters.
However, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity of the obligor to meet its financial
commitment on the obligation.
B A short-term obligation rated "B" is regarded as having significant
speculative characteristics. The obligor currently has the capacity to meet
its financial commitment on the obligation; however, it faces major ongoing
uncertainties which could lead to the obligor's inadequate capacity to meet
its financial commitment on the obligation.
C A short-term obligation rated "C" is currently vulnerable to nonpayment and is
dependent upon favorable business, financial and economic conditions for the
obligor to meet its financial commitment on the obligation.
D A short-term obligation rated "D" is in payment default. The "D" rating
category is used when interest payments or principal payments are not made
on the date due even if the applicable grace period has not expired, unless
Standard & Poor's believes that such payments will be made during such grace
period. The "D" rating will also be used upon the filing of a bankruptcy
petition or the taking of a similar action if payments on an obligation are
jeopardized.
c The "c" subscript is used to provide additional information to investors
that the bank may terminate its obligation to purchase tendered bonds if the
long term credit rating of the issuer is below an investment-grade level
and/or the issuer's bonds are deemed taxable.
p The letter "p" indicates that the rating is provisional. A provisional
rating assumes the successful completion of the project financed by the debt
being rated and indicates that payment of debt service requirements is
largely or entirely dependent upon the successful, timely completion of the
project. This rating, however, while addressing credit quality subsequent to
completion of the project, makes no comment on the likelihood of or the risk
of default upon failure of such completion. The investor should exercise his
own judgment with respect to such likelihood and risk.
* Continuance of the ratings is contingent upon Standard & Poor's receipt of
an executed copy of the escrow agreement or closing
r The "r" highlights derivative, hybrid, and certain other obligations that
Standard & Poor's believes may experience high volatility or high
variability in expected returns as a result of noncredit risks. Examples
A-4
of such obligations are securities with principal or interest return
indexed to equities, commodities, or currencies; certain swaps and
options, and interest-only and principal-only mortgage securities. The
absence of an "r" symbol should not be taken as an indication that an
obligation will exhibit no volatility or variability in total return.
A commercial paper rating is not a recommendation to purchase or sell a
security. The ratings are based on current information furnished to Standard &
Poor's by the issuer or obtained by Standard & Poor's from other sources it
considers reliable. The ratings may be changed, suspended, or withdrawn as a
result of changes in, or unavailability of, such information.
A Standard & Poor's note rating reflects the liquidity factors and market
access risks unique to notes. Notes due in three years or less will likely
receive a note rating. Notes maturing beyond three years will most likely
receive a long term debt rating. The following criteria will be used in making
that assessment.
--Amortization schedule--the larger the final maturity relative to other
maturities, the more likely it will be treated as a note.
--Source of payment--the more dependent the issue is on the market for its
refinancing, the more likely it will be treated as a note.
Note rating symbols are as follows:
SP-1 Strong capacity to pay principal and interest. An issue determined to
possess a very strong capacity to pay debt service is given a plus (+)
designation.
SP-2 Satisfactory capacity to pay principal and interest with some vulnerability
to adverse financial and economic changes over the term of the notes.
SP-3 Speculative capacity to pay principal and interest.
Description of Fitch Ratings' ("Fitch") Investment Grade Bond Ratings
Fitch investment grade bond ratings provide a guide to investors in
determining the credit risk associated with a particular security. The rating
represents Fitch's assessment of the issuer's ability to meet the obligations of
a specific debt issue or class of debt in a timely manner.
The rating takes into consideration special features of the issue, its
relationship to other obligations of the issuer, the current and prospective
financial condition and operating performance of the issuer and any guarantor,
as well as the economic and political environment that might affect the issuer's
future financial strength and credit quality.
Fitch ratings do not reflect any credit enhancement that may be provided by
insurance policies or financial guarantees unless otherwise indicated.
Bonds carrying the same rating are of similar but not necessarily identical
credit quality since the rating categories do not fully reflect small
differences in the degrees of credit risk.
Fitch ratings are not recommendations to buy, sell, or hold any security.
Ratings do not comment on the adequacy of market price, the suitability of any
security for a particular investor, or the tax-exempt nature or taxability of
payments made in respect of any security.
Fitch ratings are based on information obtained from issuers, other obligors,
underwriters, their experts, and other sources Fitch believes to be reliable.
Fitch does not audit or verify the truth or accuracy of such information.
Ratings may be changed, suspended, or withdrawn as a result of changes in, or
the unavailability of, information or for other reasons.
A-5
AAA Bonds 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 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 "F-1+."
A Bonds 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 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 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.
Plus (+) or Minus (-): 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.
Description of Fitch's Speculative Grade Bond Ratings
Fitch speculative grade bond ratings provide a guide to investors in
determining the credit risk associated with a particular security. The ratings
("BB" to "C") represent Fitch's assessment of the likelihood of timely payment
of principal and interest in accordance with the terms of obligation for bond
issues not in default. For defaulted bonds, the rating ("DDD" to "D") is an
assessment of the ultimate recovery value through reorganization or liquidation.
The rating takes into consideration special features of the issue, its
relationship to other obligations of the issuer, the current and prospective
financial condition and operating performance of the issuer and any guarantor,
as well as the economic and political environment that might affect the issuer's
future financial strength.
Bonds that have the rating are of similar but not necessarily identical
credit quality since rating categories cannot fully reflect the differences in
degrees of credit risk.
BB Bonds 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 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 have certain identifiable characteristics which, if not remedied, may
lead to default. The ability to meet obligations requires an advantageous
business and economic environment.
CC Bonds are minimally protected. Default in payment of interest and/or
principal seems probable over time.
C Bonds are in imminent default in payment of interest or principal.
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D Bonds are in default on interest and/or principal payments. Such bonds are
extremely speculative and should be valued on DD the basis of their ultimate
recovery value in liquidation or reorganization of the obligor. "DDD" represents
the highest DDD potential for recovery on these bonds, and "D" represents the
lowest potential for recovery.
Plus (+) or Minus (-): 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 "DDD," "DD," or "D" categories.
Description of Fitch's Short term Ratings
Fitch's short term ratings apply to debt obligations that are payable on
demand or have original maturities of up to three years, including commercial
paper, certificates of deposit, medium-term notes, and investment notes.
The short term rating places greater emphasis than a long term rating on the
existence of liquidity necessary to meet the issuer's obligations in a timely
manner.
Fitch short term ratings are as follows:
F-1+ Exceptionally Strong Credit Quality. Issues assigned this rating are
regarded as having the strongest degree of assurance for timely
payment.
F-1 Very Strong Credit Quality. Issues assigned this rating reflect an
assurance of timely payment only slightly less in degree than issues
rated "F-1+."
F-2 Good Credit Quality. Issues assigned this rating have a satisfactory
degree of assurance for timely payment, but the margin of safety is
not as great as for issues assigned "F-1+" and "F-1" ratings.
F-3 Fair Credit Quality. Issues assigned this rating have
characteristics suggesting that the degree of assurance for timely
payment is adequate; however, near-term adverse changes could cause
these securities to be rated below investment grade.
F-S Weak Credit Quality. Issues assigned this rating have character-
istics suggesting a minimal degree of assurance for timely payment
and are vulnerable to near-term adverse changes in financial and
economic conditions.
D Default. Issues assigned this rating are in actual or imminent
payment default.
LOC The symbol "LOC" indicates that the rating is based on a letter of credit
issued by a commercial bank.
NR Indicates that Fitch does not rate the specific issue.
Conditional A conditional rating is premised on the successful completion of a
project or the occurrence of a specific event.
Suspended A rating is suspended when Fitch deems the amount of information
available from the issuer to be inadequate for rating purposes.
Withdrawn A rating will be withdrawn when an issue matures or is called or
refinanced and, at Fitch's discretion, when an issuer fails to
furnish proper and timely information.
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FitchAlert Ratings are placed on FitchAlert to notify investors of an occurrence
that is likely to result in a rating change and the likely direction
of such change. These are designated as "Positive," indicating a
potential upgrade, "Negative," for potential downgrade, or
"Evolving," where ratings may be raised or lowered. FitchAlert is
relatively short term, and should be resolved within 12 months.
Ratings Outlook: An outlook is used to describe the most likely direction of
any rating change over the intermediate term. It is described as "Positive" or
"Negative." The absence of a designation indicates a stable outlook.
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