As filed with the Securities and Exchange Commission on March 15, 2006
Securities Act File No. 2-57354
Investment Company Act File No. 811-02688
FORM N-1A
REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 /X/
Pre-Effective Amendment No. / /
Post Effective Amendment No. 32 /X/
and/or
REGISTRATION STATEMENT UNDER THE
INVESTMENT COMPANY ACT OF 1940 /X/
Amendment No. 30 /X/
(check appropriate box or boxes)
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Merrill Lynch Municipal Bond Fund, Inc.
(High Yield Portfolio)
(Exact Name of Registrant as Specified in Charter)
800 Scudders Mill Road, Plainsboro, New Jersey 08536
(Address of Principal Executive Office) (Zip Code)
Registrant's Telephone Number, including Area Code (609) 282-2800
Robert C. Doll, Jr.
Merrill Lynch Municipal Bond Fund, Inc.
800 Scudders Mill Road, Plainsboro, New Jersey
Mailing Address: P.O. Box 9011, Princeton, New Jersey 08543-9011
(Name and Address of Agent for Service)
Copies to:
Counsel for the Company: Andrew J. Donohue, Esq.
John A. MacKinnon, Esq. FUND ASSET MANAGEMENT, L.P.
SIDLEY AUSTIN LLP P.O. Box 9011
787 Seventh Avenue Princeton, New Jersey 08543-9011
New York, New York 10019-6018
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==========================
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It is proposed that this filing will become effective (check appropriate box)
| | immediately upon filing pursuant to paragraph (b) | | on (date) pursuant to paragraph (b) | | 60 days after filing pursuant to paragraph (a)(1) | | on (date) pursuant to paragraph (a)(1) |X| 75 days after filing pursuant to paragraph (a)(2) | | on (date) pursuant to paragraph (a)(2) of Rule 485.
If appropriate, check the following box:
| | This post-effective amendment designates a new effective date for a previously filed post-effective amendment.
Title of Securities Being Registered: Shares of Common Stock, Class A, Class B, Class C and Class I.
The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer is not permitted.
Subject to Completion Preliminary Prospectus dated March 15, 2006
Prospectus
[ ], 2006
Merrill Lynch Municipal Bond Fund, Inc.
High Yield Portfolio
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.
[The Portfolio's Distributor, FAM Distributors, Inc., and other selected securities dealers will solicit indications of interest from potential investors in the Portfolio during a period expected to end on or about [ ], 2006. After such time, the Portfolio will begin issuing shares to investors and commence operations.]
PAGE
KEY FACTS 1
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Merrill Lynch Municipal Bond Fund - High Yield Portfolio
At A Glance......................................................1
Risk/Return Bar Chart............................................2
Fees And Expenses................................................3
DETAILS ABOUT THE PORTFOLIO 5
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How The Portfolio Invests........................................5
Investment Risks.................................................6
Statement Of Additional Information.............................11
YOUR ACCOUNT 12
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Pricing Of Shares...............................................12
How To Buy, Sell, Transfer And Exchange Shares..................18
How Shares Are Priced...........................................23
Participation In Fee-Based Programs.............................24
Dividends And Taxes.............................................25
Electronic Delivery.............................................26
MANAGEMENT OF THE PORTFOLIO 26
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Fund Asset Management...........................................26
FOR MORE INFORMATION
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Shareholder Reports.....................................BACK COVER
Statement Of Additional Information.....................BACK COVER
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KEY FACTS MERRILL LYNCH MUNICIPAL BOND FUND -
HIGH YIELD PORTFOLIO AT A GLANCE
What is the Portfolio's investment objective?
In an effort to help The investment objective of the High Yield Portfolio
you better (the "Portfolio") of Merrill Lynch Municipal Bond Fund,
understand the many Inc. (the "Fund") is to provide shareholders with as
concepts involved in high a level of income exempt from Federal income taxes
making an investment as is consistent with the investment policies of the
decision, we have Portfolio.
defined the
highlighted terms in What are the Portfolio's main investment strategies?
this Prospectus in
the sidebar. Under normal circumstances, the Portfolio seeks to
achieve its objective by investing at least 80% of its
assets in municipal bonds. In choosing investments,
Municipal Bonds -- Portfolio management analyzes the credit quality of
debt obligations issuers and considers the yields available on municipal
issued by or on bonds with different maturities.
behalf of a
governmental entity The Portfolio may invest in municipal bonds rated in any
or other qualifying rating category or in unrated municipal bonds. The
issuer that pay Portfolio will usually invest in municipal bonds that
interest that is, in have a maturity of five years or longer. Portfolio
the opinion of bond management chooses municipal bonds that it believes
counsel to the offer a relatively high potential for total return
issuer, generally relative to their total risk. Although the Portfolio may
excludable from invest in municipal bonds in any rating category,
gross income for Portfolio management presently intends to invest at
Federal income tax least 65% of the Portfolio's net assets in medium- to
purposes (except low-quality bonds as rated by at least one independent
that the interest rating agency (BBB or lower by Standard & Poor's ("S&P")
may be includable in or Fitch Ratings ("Fitch") or Baa or lower by Moody's
taxable income for Investors Service, Inc. ("Moody's")), or if unrated,
purposes of the judged to be of comparable quality by the Portfolio's
Federal alternative investment adviser. Obligations rated below BBB or Baa
minimum tax). are commonly known as "junk bonds." It is possible that
the Portfolio could invest up to 100% of its assets in
junk bonds. The Portfolio may also invest up to [10%] of
its total assets in municipal bonds that are considered
distressed securities.
Distressed The Portfolio does not currently contemplate investing
Securities -- more than 25% of its total assets in municipal bonds
securities that are whose issuers are located in the same state.
the subject of
bankruptcy What are the main risks of investing in the Portfolio?
proceedings or
otherwise in default The Portfolio cannot guarantee that it will achieve its
as to the repayment investment objective.
of principal and/or
payment of interest As with any fund, the value of the Portfolio's
at the time of investments -- and therefore the value of the
acquisition by the Portfolio's shares -- may fluctuate. These changes may
Portfolio or are occur in response to interest rate changes or other
rated in the lowest developments that may affect the municipal bond market
rating categories by generally, or a particular issuer or obligation.
at least one Generally, when interest rates go up, the value of
independent rating municipal bonds goes down. Bonds with longer maturities
agency (CC or lower in which the Portfolio will usually invest are affected
by S&P or Fitch or more by changes in interest rates than bonds with
Ca or lower by shorter maturities. Also, Portfolio management may
Moody's), or if select securities that underperform the bond market, the
unrated, judged to relevant indices or the securities selected by other
be of comparable funds with similar investment objectives and investment
quality by the strategies. If the value of the Portfolio's investments
Portfolio's goes down, you may lose money.
investment adviser.
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Credit Risk -- the The Portfolio is also subject to credit risk and call
risk that the issuer and redemption risk.
of a bond or other
fixed-income
security will be The Portfolio may invest a substantial portion of its
unable to pay the assets in junk bonds. Investing in junk bonds is riskier
interest or than investing in higher quality municipal bonds --
principal when due. price fluctuations may be larger and more frequent, and
there is greater risk of losing both income and
Call and Redemption principal. Investing in municipal bonds that are
Risk -- the risk a distressed securities is speculative and involves
bond's issuer may significant risk in addition to the risks of investing
call a bond held by in junk bonds. The Portfolio will generally not receive
the Portfolio for interest payments on the distressed securities and may
redemption before it incur costs to protect its investment.
matures.
Who should invest?
The Portfolio may be an appropriate investment for you
if you:
o Are looking for an investment that provides
current income exempt from Federal income tax
o Want a professionally managed and diversified
portfolio without the administrative burdens of
direct investments in municipal bonds
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o Are looking for liquidity
o Can tolerate the risk of loss caused by changes in interest rates or adverse changes in the price of municipal bonds in general
o Are willing to accept the risk of greater loss of income and principal
RISK/RETURN BAR CHART
Because the Portfolio is new, it does not have performance information an investor would find useful in evaluating the risks of investing in the Portfolio.
Understanding
Expenses FEES AND EXPENSES
----------------------------------------------------
--------------------------------
Class Class Class Class
A B(b) C I
----------------------------------------------------
Fund investors pay Shareholder Fees
various fees and expenses, (fees paid
either directly directly from
or indirectly. Listed your investment)(a)
below are some of the ----------------------------------------------------
main types of expenses Maximum Sales 4.00%(c) None None None
that the Portfolio Charge (Load)
may charge: imposed on
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-------------------------- purchases (as a percentage of offering price) Expenses paid directly by ----------------------------------------------------
the shareholder: Maximum Deferred None(d) 4.00%(c) 1.00%(c) None
Sales Charge (Load)
(as a percentage of
original purchase
price or redemption
proceeds, whichever
is lower)
Shareholder Fees -- these ----------------------------------------------------
fees include sales Maximum Sales None None None None
charges that you may pay Charge (Load)
when you buy imposed on
or sell shares of the Dividend
Portfolio. Reinvestments
----------------------------------------------------
Redemption Fee None None None None
----------------------------------------------------
Expenses paid indirectly Exchange Fee None None None None
by the shareholder: ----------------------------------------------------
Annual Fund Operating Expenses (expenses that are
deducted from Portfolio assets):
Annual Fund ----------------------------------------------------
Operating Expenses Management Fee(e) % % % %
-- expenses that ----------------------------------------------------
cover the costs of Distribution 0.25% 0.75% 0.80% None
operating the and/or Service
Portfolio. (12b-1) Fees(f)
----------------------------------------------------
Other Expenses % % % %
Management Fee -- a (including
fee paid to the transfer agency
Investment Adviser fees)(g)
for managing the ----------------------------------------------------
Portfolio. Total Annual Fund % % % %
Operating Expenses
----------------------------------------------------
Distribution Fees --
fees used to support (a) In addition, certain selected securities dealers
the Portfolio's or other financial intermediaries may charge
marketing and clients a processing fee when a client buys or
distribution redeems shares. See "Your Account -- How to Buy,
efforts, such as Sell, Transfer and Exchange Shares."
compensating
financial advisers (b) Class B shares automatically convert to Class A
and other financial shares approximately ten years after you buy
intermediaries, them and will no longer be subject to
advertising and distribution fees.
promotion.
(c) Some investors may qualify for reductions in or
waivers of the sales charge (load). See "Your
Service (Account Account -- Pricing of Shares"
Maintenance) Fees --
fees used to (d) You may pay a deferred sales charge if you
compensate purchase $1 million or more and you redeem
securities dealers within one year.
and other financial
intermediaries for (e) The Investment Adviser may waive a portion of
account maintenance the Portfolio's management fee in connection
activities. with the Portfolio's investment in an affiliated
money market fund.
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(f) The Portfolio calls the "Service Fee" an "Account Maintenance Fee." Account Maintenance Fee is the term used elsewhere in this Prospectus and in all other Portfolio materials. If you hold Class B or Class C shares over time, it may cost you more in distribution and account maintenance (12b-1) fees than the maximum sales charge that you would have paid if you had bought one of the other classes.
(g) Financial Data Services, Inc., an affiliate of the Investment Adviser, provides transfer agency services to the Portfolio. The Portfolio pays a fee for these services. The Investment Adviser or its affiliates also provide certain accounting services to the Portfolio and the Portfolio reimburses the Investment Adviser or its affiliates for such services.
Examples:
These examples are intended to help you compare the cost of investing in the Portfolio with the cost of investing in other mutual funds.
These examples assume that you invest $10,000 in the Portfolio for the time periods indicated, that your investment has a 5% return each year, that you pay the sales charges, if any, that apply to the particular class and that the Portfolio'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 these examples. Although your actual costs may be higher or lower, based on these assumptions your costs would be:
1 Year 3 Years
----------------------------------------------
Class A $ $
----------------------------------------------
Class B $ $
----------------------------------------------
Class C $ $
----------------------------------------------
Class I $ $
----------------------------------------------
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1 Year 3 Years
----------------------------------------------
Class A $ $
----------------------------------------------
Class B $ $
----------------------------------------------
Class C $ $
----------------------------------------------
Class I $ $
----------------------------------------------
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Details About the HOW THE PORTFOLIO INVESTS
Portfolio
ABOUT THE INVESTMENT The investment objective of the Portfolio is to
ADVISER provide shareholders with as high a level of income
exempt from Federal income taxes as is consistent
with the investment policies of the Portfolio.
The Portfolio is
managed by Fund Asset Outlined below are the main strategies the
Management, L.P. Portfolio uses in seeking to achieve its investment
objectives:
ABOUT THE PORTFOLIO The Portfolio invests primarily in a diversified
MANAGER portfolio of municipal bonds. Under normal
circumstances, the Portfolio invests at least 80%
of its assets in municipal bonds. Municipal bonds
Theodore R. Jaeckel, may be obligations of a variety of issuers,
Jr., CFA, is a Vice including governmental entities or other qualifying
President and the issuers. Issuers may be states, territories and
portfolio manager of possessions of the United States and the District
the Portfolio. of Columbia and their political subdivisions,
agencies and instrumentalities. Municipal bonds
also include short-term tax-exempt obligations like
municipal notes and variable rate demand
obligations.
The Portfolio may invest in municipal bonds rated
in any rating category or in unrated municipal
bonds. The Portfolio will usually invest in
municipal bonds that have a maturity of five years
or longer. Portfolio management chooses municipal
bonds that it believes offer a relatively high
potential for total return relative to their total
risk. Although the Portfolio may invest in
municipal bonds in any rating category, Portfolio
management presently intends to invest at least 65%
of the Portfolio's net assets in medium- to
low-quality bonds as rated by at least one
independent rating agency (BBB or lower by S&P or
Fitch or Baa or lower by Moody's), or if unrated,
judged to be of comparable quality by the
Portfolio's investment adviser. Obligations rated
below BBB or Baa are commonly known as "junk
bonds." It is possible that the Portfolio could
invest up to 100% of its assets in junk bonds.
Portfolio management reserves the right to invest
less than 65% of the Portfolio's net assets in
municipal bonds rated BBB or Baa or lower if
Portfolio management determines that there is an
insufficient supply of such obligations available
for investment. The Portfolio may also invest up
to 10% of its total assets in municipal bonds that
are considered distressed securities.
The Portfolio does not currently contemplate
investing more than 25% of its total assets in
municipal bonds whose issuers are located in the
same state.
Portfolio management considers a variety of factors
when choosing investments, such as:
o Credit Quality of Issuers -- based
on bond ratings and other factors
including economic and financial
conditions.
o Yield Analysis -- takes into account
factors such as the different yields
available on different types of
obligations and the shape of the
yield curve (longer term obligations
typically have higher yields).
o 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, Portfolio management considers the
availability of features that protect
5
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against an early call of a bond by the issuer.
The Portfolio's investments may consist of private
activity bonds that may subject certain shareholders to
an alternative minimum tax.
Other Strategies. In addition to the main strategies
discussed above, the Portfolio may use certain other
investment strategies.
The Portfolio may invest up to 20% of its assets on a
temporary basis in taxable money market securities that
have a maturity of one year or less. The Portfolio may
make these investments for liquidity purposes or as a
temporary investment pending an investment in municipal
bonds. As a temporary measure for defensive purposes,
the Portfolio may invest without limitation in taxable
money market securities. These investments may prevent
the Portfolio from meeting its investment objective.
Investments in taxable money market securities as well
as some of the derivatives discussed below may cause
the Portfolio to have taxable investment income. The
Portfolio may also realize capital gains on the sale of
its municipal bonds (and other securities it holds).
These capital gains will be taxable regardless of
whether they are derived from a sale of municipal
bonds.
The Portfolio is permitted to engage in transactions in
certain derivatives, such as financial futures
contracts and options thereon, for hedging purposes.
The Portfolio may also invest in other derivatives,
such as indexed and inverse floating rate obligations
and swap agreements, including credit default swap
agreements, for hedging purposes or to enhance income.
Derivatives are financial instruments whose value is
derived from another security or an index such as the
Lehman Brothers Municipal Bond Index.
The Portfolio may invest uninvested cash balances in
affiliated money market funds.
INVESTMENT RISKS
-------------------------------------------------------
This section contains a summary discussion of the
general risks of investing in the Portfolio. As with
any fund, there can be no guarantee that the Portfolio
will meet its objective or that the Portfolio's
performance will be positive for any period of time.
Set forth below are the main risks of investing in the
Portfolio:
Market Risk and Selection Risk -- Market risk is the
risk that one or more markets in which the Portfolio
invests will go down in value, including the
possibility that the markets will go down sharply and
unpredictably. Selection risk is the risk that the
securities that Portfolio management selects will
underperform the markets, the relevant indices or the
securities selected by 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. Changes in an issuer's credit rating or the
market's perception of an issuer's creditworthiness may
also affect the value of the Portfolio's investment in
that issuer. The degree of credit risk depends on both
the financial condition of the issuer and the terms of
the obligation.
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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. The Portfolio may
lose money if short term or long term interest rates
rise sharply or otherwise change in a manner not
anticipated by Portfolio management.
Call and Redemption Risk -- A bond's issuer may call a
bond for redemption before it matures. If this happens
to a bond the Portfolio holds, the Portfolio may lose
income and may have to invest the proceeds in bonds
with lower yields.
General Obligation Bonds -- The faith, credit and
taxing power of the municipality that issues 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, or the
amount of revenues derived from another source.
Private Activity Bonds -- Municipalities and other
public authorities issue private activity 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 Portfolio 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 Notes -- Municipal notes are shorter term
municipal debt obligations. They may provide interim
financing in anticipation of, and are secured by, tax
collection, bond sales or revenue receipts. If there is
a shortfall in the anticipated proceeds, the notes may
not be fully repaid and the Portfolio may lose money.
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, if the issuer does not
fulfill its payment obligation it may be difficult to
sell the property and the proceeds of a sale may not
cover the Portfolio's loss.
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 Portfolio
may lose money.
Junk Bonds -- Although junk bonds generally pay higher
rates of interest than investment grade bonds, junk
bonds are high risk investments that may cause
7
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income and principal losses for the Portfolio. The
major risks in junk bond investments include:
o Junk bonds may be issued by less creditworthy
issuers. Issuers of junk bonds may have a
larger amount of outstanding debt relative to
their assets than issuers of investment grade
bonds. In the event of an issuer's bankruptcy,
claims of other creditors may have priority
over the claims of junk bond holders, leaving
few or no assets available to repay junk bond
holders.
o Prices of junk bonds are subject to extreme
price fluctuations. Adverse changes in an
issuer's industry and general economic
conditions may have a greater impact on the
prices of junk bonds than on other higher rated
fixed income securities.
o 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.
o Junk bonds frequently have redemption features
that permit an issuer to repurchase the
security from the Portfolio before it matures.
If the issuer redeems junk bonds, the Portfolio
may have to invest the proceeds in bonds with
lower yields and may lose income.
o 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 the Portfolio's
securities than is the case with securities
trading in a more liquid market.
o The Portfolio may incur expenses to the extent
necessary to seek recovery upon default or to
negotiate new terms with a defaulting issuer.
Distressed Securities -- The Portfolio may invest in
municipal bonds that are distressed securities.
Distressed securities are speculative and involve
substantial risks in addition to the risks of investing
in junk bonds. Generally, the Portfolio will invest in
distressed securities when Portfolio management
believes they offer significant potential for higher
returns or can be exchanged for other securities that
offer this potential. However, there can be no
assurance that the Portfolio will achieve these returns
or that the issuer will make an exchange offer or adopt
a plan of reorganization. The Portfolio will generally
not receive interest payments on the distressed
securities and may incur costs to protect its
investment. In addition, distressed securities involve
the substantial risk that principal will not be repaid.
Distressed securities and any securities received in an
exchange for such securities may be subject to
restrictions on resale.
The Portfolio may also be subject to certain other
risks associated with its investments and investment
strategies, including:
Borrowing Risk and Leverage Risk -- The Portfolio may
borrow for temporary or emergency purposes, including
to meet redemptions, for the payment of dividends, for
share repurchases or for the clearance of transactions.
Borrowing may
8
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exaggerate changes in the net asset value of the
Portfolio's shares and in the yield on the Portfolio's
holdings. Borrowing will cost the Portfolio interest
expense and other fees. The costs of borrowing may
reduce the Portfolio's return. Certain derivative
securities that the Portfolio may buy or other
techniques that the Portfolio may use may create
leverage, including, but not limited to, when issued
securities, forward commitments, futures contracts and
options.
Derivatives -- The Portfolio may use derivative
instruments to hedge its investments or to seek to
enhance returns. Derivatives allow the Portfolio 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)
in a derivative transaction will be unable to
honor its financial obligation to the Portfolio.
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 Portfolio may use derivatives for hedging purposes,
including anticipatory hedges. Hedging is a strategy in
which the Portfolio uses a derivative to offset the
risks associated with other Portfolio 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 Portfolio 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 Portfolio,
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 Portfolio's hedging strategy will
reduce risk or that hedging transactions will be either
available or cost effective. The Portfolio is not
required to use hedging and may choose not to do so.
Because the Portfolio may use derivatives to seek to
enhance returns, its investments will expose the
Portfolio to the risks outlined above to a greater
extent than if the Portfolio used derivatives solely
for hedging purposes. Use of derivatives to seek to
enhance returns may be considered speculative.
Indexed and Inverse Floating Rate Securities -- The
Portfolio may invest in securities whose potential
returns are directly related to changes in an
underlying index or interest rate, known as indexed
securities. The return on indexed securities will rise
when the underlying index or interest rate rises and
fall when the index or interest rate falls. The
Portfolio may also invest in securities whose return is
inversely related to changes in an interest rate
(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 Portfolio 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 Portfolio's investment. As a result, the
market value of such securities
9
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will generally be more volatile than that of fixed
rate, tax-exempt securities.
Swap Agreements -- Swap agreements involve the risk
that the party with whom the Portfolio has entered into
the swap will default on its obligation to pay the
Portfolio and the risk that the Portfolio will not be
able to meet its obligations to pay the other party to
the agreement.
When Issued Securities, Delayed Delivery Securities and
Forward Commitments -- The Portfolio may purchase or
sell securities that it is entitled to receive on a
when issued basis. The Portfolio may also purchase or
sell securities on a delayed delivery basis or through
a forward commitment. When issued and delayed delivery
securities and forward commitments involve the risk
that the security the Portfolio buys will lose value
prior to its delivery. There also is the risk that the
security will not be issued or that the other party to
the transaction will not meet its obligation. If this
occurs, the Portfolio loses both the investment
opportunity for the assets it set aside to pay for the
security and any gain in the security's price.
Taxability Risk -- The Portfolio intends to minimize
the payment of taxable income to shareholders by
investing in municipal securities in reliance at the
time of purchase on an opinion of bond counsel to the
issuer that the interest paid on those securities will
be excludable from gross income for Federal income tax
purposes. Such securities, however, may be determined
to pay, or have paid, taxable income subsequent to the
Portfolio's acquisition of the securities. In that
event, the Internal Revenue Service may demand that the
Portfolio pay Federal income taxes on the affected
interest income, and, if the Portfolio agrees to do so,
the Portfolio's yield could be adversely affected. If
the interest paid on any municipal security held by the
Portfolio is subsequently determined to be taxable, the
Portfolio will dispose of that security as soon as
reasonably practicable.
Illiquid Securities -- The Portfolio may invest up to
15% of its net assets in illiquid securities that it
cannot sell within seven days at approximately current
value. If the Portfolio 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.
Restricted Securities -- Restricted securities are
securities that cannot be offered for public resale
unless registered under the applicable securities laws
or that have a contractual restriction that prohibits
or limits their resale. They may include private
placement securities that have not been registered
under the applicable securities laws. Restricted
securities may not be listed on an exchange and may
have no active trading market.
Restricted securities may be illiquid. The Portfolio
may be unable to sell them on short notice or may be
able to sell them only at a price below current value.
Also, the Portfolio may get only limited information
about the issuer of a restricted security, so it may be
less able to predict a loss. In addition, if Portfolio
management receives material nonpublic information
about the issuer, the Portfolio may as a result be
unable to sell the securities.
|
If you would like further information about the Portfolio, including how it invests, please see the Statement of Additional Information.
For a discussion of the Portfolio's policies and procedures regarding the selective disclosure of its portfolio holdings, please see the Statement of Additional Information. The Portfolio makes the Portfolio's top ten holdings available on a monthly basis at www.mutualfunds.ml.com generally within 12 business days after the end of the month to which the information applies.
Your Account PRICING OF SHARES
The Portfolio offers four share classes, each with its
own sales charge and expense structure, allowing you to
invest in the way that best suits your needs ("Select
Pricing(SM) System"). Each share class represents the
same ownership interest in the portfolio investments of
the Portfolio. When you choose your class of shares,
you should consider the size of your investment and how
long you plan to hold your shares. Your financial
adviser or other financial intermediary can help you
determine which share class is best suited to your
personal financial goals.
For example, if you select Class I shares, you will not
pay any sales charge. However, only certain investors
may buy Class I shares. If you select Class A shares,
you generally pay a sales charge at the time of
purchase. If you buy Class A shares, you also pay an
ongoing account maintenance fee of 0.25% per year. You
may be eligible for a sales charge reduction or waiver.
Certain financial intermediaries that make Portfolio
shares available to their customers may charge fees in
addition to those described in this Prospectus for
providing certain services, including: marketing,
distribution or other services intended to assist in
the offer and sale of Portfolio shares; shareholder
servicing activities; and/or sub-transfer agency
services provided to individual shareholders or
beneficial owners where a financial intermediary
maintains omnibus accounts with the Portfolio's
transfer agent. The Investment Adviser, the Distributor
or their affiliates may pay all or a portion of those
fees out of their own resources. The amount of fees
paid to a financial intermediary in any given year will
vary and may be based on one or more factors, including
a fixed amount, a fixed percentage rate, the financial
intermediary's sales of Portfolio shares, assets in
Portfolio shares held by the intermediary's customers,
or other factors. In addition, consistent with
applicable regulations, the Distributor or its
affiliates may from time to time pay for or make
contributions to financial intermediaries or their
employees in connection with various activities
including: training and education seminars for
financial intermediary employees, clients and potential
clients; due diligence meetings regarding the
Portfolio; recreational activities; gifts; and/or other
non-cash items. See the Statement of Additional
Information for more information.
If you select Class B or Class C shares, you will
invest the full amount of your purchase price, but you
will be subject to an account maintenance fee of 0.25%
per year on an ongoing basis. In addition, if you
select Class B or Class C shares you will be subject to
a distribution fee of 0.50% per year for Class B shares
and 0.55% per year for Class C shares. Because these
fees are paid out of the Portfolio's assets on an
ongoing basis, over time these fees increase the cost
of your investment and may cost you more than paying
other types of sales charges. In addition, you may be
subject to a deferred sales charge when you sell Class
B or Class C shares of the Portfolio.
The Portfolio's shares are distributed by FAM
Distributors, Inc., an affiliate of the Investment
Adviser.
|
The table below summarizes key features of the Select Pricing(SM) System.
Class A Class B Class C Class I
---------------------------------------------------------------------------------------------------
Availability Generally Limited Generally Limited to certain
available availability available eligible investors
through through through including:
selected Merrill selected o Current Class I
securities Lynch. securities shareholders
dealers and Generally dealers and o Participants in
other available other certain programs
financial through other financial sponsored by the
intermediaries selected intermediaries. Investment Adviser
securities or affiliates of the
dealers and Investment Adviser
other or selected
financial securities dealers
intermediaries. or other financial
intermediaries
o Certain employees
and affiliates of
the Investment
Adviser or its
affiliates, or of
selected securities
dealers and other
financial
intermediaries
---------------------------------------------------------------------------------------------------
Initial Sales Yes. Payable at No. Entire No. Entire No. Entire
Charge? time of purchase. purchase price is purchase price is purchase price is
Lower sales invested in shares invested in shares invested in shares
charges available of the Portfolio. of the Portfolio. of the Portfolio.
for larger
investments.
---------------------------------------------------------------------------------------------------
Deferred Sales No. (May be Yes. Payable Yes. Payable No.
Charge? charged for if you redeem if you redeem
purchases over within six within one
$1 million years of year of
that are purchase. purchase.
redeemed
within one
year.)
---------------------------------------------------------------------------------------------------
Account 0.25% Annual 0.25% Annual 0.25% Annual No.
Maintenance and Account Account Account
Distribution Maintenance Maintenance Maintenance
Fees? Fee. No Fee. 0.50% Fee. 0.55%
Distribution Annual Annual
Fee. Distribution Distribution
Fee. Fee.
---------------------------------------------------------------------------------------------------
Conversion to N/A Yes, No. No.
Class A shares? automatically
after
approximately
ten years.
---------------------------------------------------------------------------------------------------
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Class I Shares
Class I shares are not subject to any sales charge. Only certain investors are eligible to buy Class I shares. Your financial adviser or other financial intermediary can help you determine whether you are eligible to buy Class I shares or participate in any of these programs.
Class A Shares -- Initial Sales Charge Option
If you select Class A shares, you will pay a sales charge at the time of purchase as shown in the
following tables.
Dealer
As a % Compensation
of As a % of as a % of
Offering Your Offering
Your Investment Price Investment* Price
----------------------------------------------------
4.00% 4.17% 3.75%
Less than $25,000
----------------------------------------------------
$25,000 but less
than $50,000 3.75% 3.90% 3.50%
----------------------------------------------------
$50,000 but less
than $100,000 3.25% 3.36% 3.00%
----------------------------------------------------
$100,000 but less
than $250,000 2.50% 2.56% 2.25%
----------------------------------------------------
$250,000 but less
than $1,000,000 1.50% 1.52% 1.25%
----------------------------------------------------
$1,000,000 and
over** 0.00% 0.00% 0.00%
----------------------------------------------------
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* Rounded to the nearest one-hundredth percent.
** If you invest $1,000,000 or more in Class A shares,
you may not pay an initial sales charge. In that
case, the Investment Adviser compensates the
selling dealer or other financial intermediary from
its own funds. However, if you redeem your shares
within one year after purchase, you may be charged
a deferred sales charge. This charge is 1.00%. Such
deferred sales charge may be waived in connection
with certain fee-based programs.
Right of The table above shows the reduced sales charges for
Accumulation -- which you may qualify when you purchase Class A shares
permits you to pay of the Portfolio. You may qualify for these reductions
the sales charge through a single purchase or under a right of
that would apply to accumulation or letter of intent. These reductions will
the original cost or apply to the value of all qualifying holdings in Class
value (whichever is A, Class B, Class C or Class I shares of the Portfolio
higher) of all or other Select Pricing(SM) System mutual funds advised
qualifying Class A, by the Investment Adviser or its affiliates ("Select
Class B, Class C and Pricing Funds") owned by you, your spouse and/or your
Class I shares taken children under the age of twenty-one. For this purpose,
together that you the value of your holdings means the offering price of
own in Select the newly purchased shares (including any applicable
Pricing Funds. sales charge) plus the higher of the current net asset
value or original cost (including any sales charges
Letter of Intent -- paid) of all shares you already hold taken together.
permits you to pay You may not combine with your other holdings shares
the sales charge held in pension, profit sharing or other employee
that would apply if benefit plans if those
you add up all
qualifying Class A,
Class B, Class C and
Class I shares of
Select Pricing Funds
that you agree to
buy within a
13-month period.
Certain restrictions
apply.
|
shares are held in the name of a nominee or custodian.
In order to receive a reduced sales charge, at the time you purchase shares of the Portfolio or any other Select Pricing Fund, you should inform your financial adviser or other financial intermediary of any other Class A, Class B, Class C and/or Class I shares of the Portfolio or any other Select Pricing Fund owned by you, your spouse and/or your children under the age of twenty-one. These may include shares held in accounts held at a selected securities dealer or another broker-dealer or other financial intermediary, including personal accounts, certain retirement accounts, employee benefit plan accounts, UGMA/UTMA accounts, Joint Tenancy accounts, Trust accounts and Transfer on Death accounts, as well as shares purchased by a trust of which you are a beneficiary. Your financial adviser or other financial intermediary may request documentation -- including account statements and records of the original cost of the shares owned by you, your spouse and/or your children under the age of twenty-one -- from you to show that you qualify for a reduced sales charge. You should retain these records because -- depending on where an account is held or the type of account -- the Portfolio, its Transfer Agent, and/or your financial adviser or other financial intermediary may not be able to maintain this information.
No initial sales charge applies to Class A shares that you buy through reinvestment of dividends.
A sales charge waiver on a purchase of Class A shares may also apply for:
o Trusts managed by banks, thrifts or trust companies, including those affiliated with the Investment Adviser or its affiliates that meet certain conditions
o Investment or central asset accounts sponsored by the Investment Adviser or its affiliates, or by selected securities dealers or other financial intermediaries that meet certain conditions
o Purchases using proceeds from the sale of certain affiliated closed-end funds that meet certain conditions
o Investors, including directors or trustees of the Investment Adviser or its affiliates or of mutual funds sponsored by the Investment Adviser or its affiliates, employees or customers of the Investment Adviser or its affiliates, and employees or customers of selected securities dealers that meet certain qualifications
o Fee-based programs of the Investment Adviser, its affiliates, or selected securities dealers and other financial intermediaries that have agreements with the Distributor or its affiliates and that meet certain conditions
More information about existing sales charge reductions and waivers is available free of charge in a clear and prominent format via hyperlink at
www.mutualfunds.ml.com and in the Statement of Additional Information, which is available on request.
If you are eligible to buy both Class A and Class I shares, you should buy Class I shares since Class A shares are subject to a front end sales charge and an annual 0.25% account maintenance fee, while Class I shares are not. The Distributor normally pays the annual 0.25% Class A account maintenance fee to dealers as a service fee on a monthly basis.
If you redeem Class A shares and within 30 days buy new shares of the same class, you will not pay a sales charge on the new purchase amount. The amount eligible for this "Reinstatement Privilege" may not exceed the amount of your redemption proceeds. To exercise the privilege, contact your financial adviser, selected securities dealer, other financial intermediary or the Portfolio's Transfer Agent at 1-800-637-3863.
Class B and Class C Shares -- Deferred Sales Charge Options
If you select Class B or Class C shares, you do not pay an initial sales charge at the time of purchase. However, if you redeem your Class B shares within six years after purchase, or your Class C shares within one year after purchase, you may be required to pay a deferred sales charge. You will also pay account maintenance fees for Class B and Class C shares of 0.25% and distribution fees each year under a distribution plan that the Fund has adopted under Rule 12b-1. You will pay distribution fees for your Class B and Class C shares in the amount of 0.50% or 0.55%, respectively, of your investment each year. Because these fees are paid out of the Portfolio's assets on an ongoing basis, over time these fees increase the cost of your investment and may cost you more than paying other types of sales charges. The Distributor uses the money that it receives from the deferred sales charges and the distribution fees to cover the costs of marketing, advertising and compensating the financial adviser, selected securities dealer or other financial intermediary who assists you in purchasing Portfolio shares.
The Distributor currently pays a sales concession of 4.00% of the purchase price of Class B shares to dealers from its own resources at the time of sale. The Distributor also normally pays the annual 0.25% Class B shares account maintenance fee to dealers as a service fee on a monthly basis. The Distributor normally retains the Class B shares distribution fee.
The Distributor currently pays dealers a sales concession of 1.00% of the purchase price of Class C shares from its own resources at the time of sale. The Distributor pays the annual 0.55% Class C shares distribution fee and the annual 0.25% Class C shares account maintenance fee as an ongoing concession and as a service fee, respectively, to dealers for Class C shares held for over a year and normally retains the Class C shares distribution fee and account maintenance fee during the first year after purchase. Under certain circumstances, the Distributor will pay the full Class C shares distribution fee and account maintenance fee to dealers beginning in the first year after purchase in lieu of paying the sales concession.
Class B Shares
If you redeem Class B shares within six years after purchase, you may be charged a deferred sales charge. The amount of the charge gradually decreases as you hold your shares over time, according to the following
schedule: Years Since Sales Charge* Purchase --------------------------------------------------- 0 - 1 4.00% --------------------------------------------------- 1 - 2 4.00% --------------------------------------------------- 2 - 3 3.00% --------------------------------------------------- 3 - 4 3.00% --------------------------------------------------- 4 - 5 2.00% --------------------------------------------------- 5 - 6 1.00% --------------------------------------------------- 6 and thereafter 0.00% --------------------------------------------------- |
* The percentage charge will apply to the lesser of the original cost of the shares being redeemed or the proceeds of your redemption. Shares acquired through reinvestment of dividends are not subject to a deferred sales charge. Not all Select Pricing Funds have identical deferred sales charge schedules. If you exchange your shares for shares of another fund, the higher charge will apply.
The deferred sales charge relating to Class B shares may be reduced or waived in certain circumstances, such as:
o Redemption in connection with participation in certain fee-based programs of the Investment Adviser, its affiliates, or selected securities dealers or other financial intermediaries that have agreements with the Distributor or its affiliates or in connection with involuntary termination of an account in which Portfolio shares are held
o Withdrawals resulting from shareholder death or disability as long as the waiver request is made within one year of death or disability or, if later, reasonably promptly following completion of probate
o Withdrawal through the systematic withdrawal plan offered by an affiliate of the Investment Adviser ("Systematic Withdrawal Plan") of up to 10% per year of your Class B account value at the time the plan is established
Your Class B shares convert automatically into Class A shares approximately ten years after purchase. Any Class B shares received through reinvestment of dividends paid on converting shares will also convert at that time. Class A shares are subject to lower annual expenses than Class B shares. The conversion of Class B shares to Class A shares is not a taxable event for Federal income tax purposes.
Different conversion schedules apply to Class B shares of different Select Pricing Funds. For example, Class B shares of a fixed-income fund typically convert approximately ten years after purchase compared to approximately eight years for equity funds. If you acquire your Class B shares in an exchange from another fund with a shorter conversion schedule, the Portfolio's longer conversion schedule will apply. If you exchange your Class B shares in the Portfolio for Class B shares of another fund with a longer conversion schedule, the other fund's longer conversion schedule will apply. The length of time that you hold both the original and exchanged Class B shares in both funds will count toward the conversion schedule. The conversion schedule may be modified in certain other cases as well.
Class C Shares
If you redeem Class C shares within one year after purchase, you may be charged a deferred sales charge of 1.00%. The charge will apply to the lesser of the original cost of the shares being redeemed or the proceeds of your redemption. You will not be charged a deferred sales charge when you redeem shares that you acquire through reinvestment of dividends. The deferred sales charge relating to Class C shares may be reduced or waived in connection with involuntary termination of an account in which Portfolio shares are held and withdrawals through the Systematic Withdrawal Plan.
Class C shares do not offer a conversion privilege.
The chart on the following pages summarizes how to buy, sell, transfer and exchange shares through your financial adviser, a selected securities dealer, broker, investment adviser, service provider or other financial intermediary. You may also buy, sell, transfer and exchange shares through the Transfer Agent. To learn more about buying, selling, transferring or exchanging shares through the Transfer Agent, call 1-800-637-3863. Because the selection of a mutual fund involves many considerations, your financial adviser or other financial intermediary may help you with this decision.
Because of the high costs of maintaining smaller shareholder accounts, the Portfolio may redeem the shares in your account (without charging any deferred sales charge) 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 Portfolio 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 Portfolio takes any action. This involuntary redemption does not apply to Uniform Gifts or Transfers to Minors Act accounts.
the share class in this Prospectus. Be sure to read this
appropriate for Prospectus carefully.
you
----------------------------------------------------------------
Next, determine The minimum initial investment for the
the amount of Portfolio is $1,000 for all accounts
your investment except:
o $250 for certain fee-based programs
(The minimums for initial investments may
be waived under certain circumstances.)
----------------------------------------------------------------
Have your financial The price of your shares is based on the
adviser, selected next calculation of net asset value after
securities dealer or your order is placed. Any purchase orders
other financial placed prior to the close of business on
intermediary submit the New York Stock Exchange (generally
your purchase order 4:00 p.m. Eastern time) will be priced at
the net asset value determined that day.
Certain financial intermediaries,
however, may require submission of orders
prior to that time.
Purchase orders placed after that time
will be priced at the net asset value
determined on the next business day. The
Portfolio may reject any order to buy
shares and may suspend the sale of shares
at any time. Selected securities dealers
or other financial intermediaries may
charge a processing fee to confirm a
purchase. Merrill Lynch, an affiliate of
the Investment Adviser generally charges
a processing fee of $5.35.
----------------------------------------------------------------
Or contact the To purchase shares directly, call the
Transfer Agent Transfer Agent at 1-800-637-3863 and
request a purchase application. Mail the
completed purchase application to the
Transfer Agent at the address on the
inside back cover of this Prospectus.
--------------------------------------------------------------------------------
Add to Your Purchase The minimum investment for additional
Investment additional purchases is generally $50 except that
shares certain programs, such as automatic
investment programs, may have higher
minimums.
(The minimums for additional purchases
may be waived under certain
circumstances.)
----------------------------------------------------------------
Acquire All dividends and capital gains
additional shares distributions are automatically
through reinvested without a sales charge.
the automatic
dividend
reinvestment
plan
----------------------------------------------------------------
Participate in You may invest a specific amount on a
the automatic periodic basis through certain investment
investment plan or central asset accounts sponsored by
the Investment Adviser's affiliates.
--------------------------------------------------------------------------------
|
If You Want to Your Choices Information Important for You to Know
--------------------------------------------------------------------------------
Transfer Transfer to a You may transfer your shares of the
Shares to participating Portfolio only to another securities
Another securities dealer that has entered into an agreement
Securities dealer or other with the Distributor. Certain shareholder
Dealer or financial services may not be available for the
Other intermediary transferred shares. You may only purchase
Financial additional shares of funds previously
Intermediary owned before the transfer. All future
trading of these assets must be
coordinated by the receiving firm.
----------------------------------------------------------------
Transfer to a You must either:
non-participating
securities o Transfer your shares to an account with
dealer or other the Transfer Agent; or
financial o Sell your shares, paying any applicable
intermediary deferred sales charge.
--------------------------------------------------------------------------------
Sell Your Have your The price of your shares is based on the
Shares financial next calculation of net asset value after
adviser, your order is placed. For your redemption
selected request to be priced at the net asset
securities value on the day of your request, you
dealer or other must submit your request to your dealer
financial or other financial intermediary prior to
intermediary that day's close of business on the New
submit your York Stock Exchange (generally 4:00 p.m.
sales order Eastern time). Certain financial
intermediaries, however, may require
submission of orders prior to that time.
Any redemption request placed after that
time will be priced at the net asset
value at the close of business on the
next business day.
Securities dealers or other financial
intermediaries, may charge a fee to
process a redemption of shares. Merrill
Lynch generally charges a fee of $5.35.
No processing fee is charged if you
redeem shares directly through the
Transfer Agent.
The Portfolio may reject an order to sell
shares under certain circumstances.
----------------------------------------------------------------
Sell through You may sell shares held at the Transfer
the Transfer Agent by writing to the Transfer Agent at
Agent 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 Transfer Agent will
normally mail redemption proceeds within
seven days following receipt of a
properly completed request. If you make a
redemption request before the Portfolio
has collected payment for the purchase of
shares, the Portfolio or the Transfer
Agent may delay mailing your proceeds.
This delay will usually not exceed ten
days.
You may also sell shares held at the
Transfer Agent by telephone request if
the amount being sold is less than
$50,000 and if certain other conditions
are met. Contact the Transfer Agent at
1-800-637-3863 for details.
--------------------------------------------------------------------------------
|
If You Want to Your Choices Information Important for You to Know
--------------------------------------------------------------------------------
Sell Shares Participate in You can choose to receive systematic
Systematically the Fund's payments from your Portfolio account
Systematic either by check or through direct deposit
Withdrawal Plan to your bank account on a monthly or
quarterly basis. If you hold your
Portfolio shares in a cash management
account offered by an affiliate of the
Investment Adviser you can arrange for
systematic redemptions of a fixed dollar
amount on a monthly, bi-monthly,
quarterly, semi-annual or annual basis,
subject to certain conditions. Under
either method you must have dividends and
other distributions automatically
reinvested. For Class B and Class C
shares your total annual withdrawals
cannot be more than 10% per year of the
value of your shares at the time your
plan is established. The deferred sales
charge is waived for systematic
redemptions.
Ask your financial adviser or other
financial intermediary for details.
-------------------------------------------------------------------------------
Exchange Your Select the fund You can exchange your Class A, Class B,
Shares into which you Class C and Class I shares of the
want to Portfolio for shares of many other Select
exchange. Be Pricing Funds. You must have held the
sure to read shares used in the exchange for at least
that fund's 15 calendar days before you can exchange
prospectus to another fund.
Class A, Class B, Class C and Class I
shares are generally exchangeable for
shares of the same class of another
Select Pricing Fund. If you own Class I
shares and wish to exchange into a fund
in which you have no Class I shares (and
are not eligible to buy Class I shares),
you will exchange into Class A shares.
Some of the Select Pricing Funds impose a
different initial or deferred sales
charge schedule. If you exchange Class A
shares for shares of a fund with a higher
initial sales charge than you originally
paid, you will be charged the difference
at the time of exchange. If you exchange
Class B shares for shares of a fund with
a different deferred sales charge
schedule, the higher schedule will apply.
The time you hold Class B or Class C
shares in both funds will count when
determining your holding period for
calculating a deferred sales charge at
redemption. If you exchange Class A or
Class I shares for money market fund
shares, you will receive Class A shares
of Summit Cash Reserves Fund. Class B or
Class C shares of the Portfolio will be
exchanged for Class B shares of Summit
Cash Reserves Fund.
To exercise the exchange privilege
contact your financial adviser or other
financial intermediary or call the
Transfer Agent at 1-800-637-3863.
Although there is currently no limit on
the number of exchanges that you can
make, the exchange privilege may be
modified or terminated at any time in the
future.
--------------------------------------------------------------------------------
|
Short Term Trading
The Portfolio reserves the right to reject any purchase order, including exchanges. Short-term or excessive trading (sometimes known as "market timing") into and out of the Portfolio, particularly in larger amounts, may harm performance by disrupting portfolio management strategies and by increasing expenses, including brokerage and administrative costs, and may also dilute the value of the holdings of other shareholders of the Portfolio. Short-term or excessive trading may cause the Portfolio to retain more cash than the portfolio manager would normally retain in order to meet unanticipated redemptions or may force the Portfolio to sell portfolio securities at disadvantageous times to raise the cash needed to meet those redemption or exchange requests. Accordingly, the Portfolio has adopted certain policies and procedures, which have been reviewed and approved by the Fund's Board of Directors, designed to deter such short-term or excessive trading. Shareholders may not exchange their shares of the Portfolio for shares of another mutual fund advised by the Investment Adviser or its affiliates unless they have held the shares to be used in the exchange for at least fifteen days. The Portfolio will reject purchase orders from investors who have previously purchased and sold shares of the Portfolio within a fifteen day period. In addition, the Portfolio will reject purchase orders, including exchanges that fall both within and outside the fifteen day holding period, from market timers or other investors if Portfolio management, in its discretion, has determined that such orders are short-term or excessive, and will be disruptive to the Portfolio. For these purposes, Portfolio management considers an investor's trading history in the Portfolio or other funds advised by the Investment Adviser or its affiliates, and accounts under common ownership or control. The Distributor has entered into agreements with respect to financial advisers and other financial intermediaries that maintain omnibus accounts with the Portfolio's Transfer Agent pursuant to which such financial advisers and other financial intermediaries undertake to cooperate with the Distributor in monitoring purchase, exchange and redemption orders by their customers in order to detect and prevent short-term or excessive trading in the Portfolio's shares through such accounts.
The Portfolio applies these policies to all shareholders. However, Portfolio management may not be able to determine that a specific order, particularly with respect to orders made through omnibus accounts or 401(k) plans, is short-term or excessive, and will be disruptive to the Portfolio and so makes no representation that all such orders can or will be rejected.
Anti-Money Laundering Requirements
The Portfolio is subject to the USA Patriot Act (the "Patriot Act"). The Patriot Act is intended to prevent the use of the U.S. financial system in furtherance of money laundering, terrorism or other illicit activities. Pursuant to requirements under the Patriot Act, the Portfolio may request information from shareholders to enable it to form a reasonable belief that it knows the true identity of its shareholders. This information will be used to verify the identity of investors or, in some cases, the status of financial advisers; it will be used only for compliance with the requirements of the Patriot Act. The Portfolio reserves the right to reject purchase orders from persons who have not submitted information sufficient to allow the Portfolio to verify their identity. The Portfolio also reserves the right to redeem any amounts in the Portfolio from persons whose identity it is unable to verify on a timely basis.
It is the Portfolio's policy to cooperate fully with appropriate regulators in any investigations conducted with respect to potential money laundering, terrorism or other illicit activities.
Net Asset Value -- When you buy shares, you pay the net asset value, plus
the market value of any applicable sales charge. This is the offering
the Portfolio's total price. Shares are also redeemed at their net asset
assets after value, minus any applicable deferred sales charge. The
deducting Portfolio calculates the net asset value of each class
liabilities, divided of its shares (generally by using market quotations)
by the number of each day the New York Stock Exchange (the "Exchange")
shares outstanding. 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 share price is the
next one calculated after your purchase or redemption
order is placed.
The Portfolio generally values its portfolio securities
using market prices provided by an independent pricing
service approved by the Fund's Board of Directors. If
market quotations are not readily available or, in the
Investment Adviser's judgment, they do not accurately
reflect fair value for a security, that security will
be valued by another method that the Board of Directors
believes more accurately reflects the fair value. The
Board has adopted valuation procedures for the
Portfolio and has delegated the day-to-day
responsibility for fair value determinations to the
Investment Adviser's Valuation Committee. Fair value
determinations may be made by the Portfolio's
independent pricing service using a matrix pricing
system or by the Valuation Committee after
consideration of the material factors that may affect
the value of a particular security. Fair value
determinations by the Investment Adviser that
materially affect the Portfolio's net asset value are
subject to review, approval or ratification, as
appropriate, by the Board of Directors. The Portfolio's
use of fair value pricing is designed to ensure that
the Portfolio's net asset value reflects the value of
its underlying portfolio securities as accurately as
possible. There can be no assurance, however, that a
fair value used by the Portfolio on any given day will
more accurately reflect the market value of a security
or securities than the market price of such security or
securities on that day.
The Portfolio may accept orders from certain authorized
financial intermediaries or their designees. The
Portfolio will be deemed to receive an order when
accepted by the intermediary or designee and the order
will receive the net asset value next computed by the
Portfolio after such acceptance. If the payment for a
purchase order is not made by a designated later time,
the order will be canceled and the financial
intermediary could be held liable for any losses.
Generally, Class I shares will have the highest net
asset value because that class has the lowest expenses,
and Class A shares will have a higher net asset value
than Class B or Class C shares. Class B shares of the
Portfolio will have a higher net asset value than Class
C shares because Class B shares have lower distribution
expenses than Class C shares. Also, dividends paid on
Class A and Class I shares will generally be higher
than dividends paid on Class B and Class C shares
because Class A and Class I shares have lower expenses.
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You generally cannot transfer shares held through a fee-based program into another account. Instead, you will have to redeem your shares held through the program and purchase shares of another class, which may be subject to distribution and account maintenance fees. This may be a taxable event and you will pay any applicable sales charges.
Shareholders that participate in a fee-based program generally have two options at termination. The program can be terminated and the shares liquidated or the program can be terminated and the shares held in an account. In general, when a shareholder chooses to continue to hold the shares, whatever share class was held in the program can be held after termination. Shares that have been held for less than specified periods within the program may be subject to a fee upon redemption. Shareholders that held Class A or Class I shares in the program are eligible to purchase additional shares of the respective share class of the Portfolio, but may be subject to upfront sales charges with respect to Class A shares. Additional purchases of Class I shares are eligible only if you have an existing position at the time of purchase or are otherwise eligible to purchase Class I shares.
Details about these features and the relevant charges are included in the client agreement for each fee-based program and are available from your financial adviser, selected securities dealer or other financial intermediary.
DIVIDENDS AND TAXES
Dividends -- The Portfolio will distribute net investment income, if
exempt-interest, any, monthly and net realized capital gains, if any, at
ordinary income and least annually. The Portfolio may also pay a special
capital gains paid to distribution at the end of the calendar year to comply
shareholders. with Federal tax requirements. Dividends may be
Dividends may be reinvested automatically in shares of the Portfolio at
reinvested in net asset value without a sales charge or may be taken
additional Portfolio in cash. If you would like to receive dividends in
shares as they are cash, contact your financial adviser, selected
paid. securities dealer, other financial intermediary or the
Transfer Agent. The Portfolio intends to make
"BUYING A DIVIDEND" distributions most of which will be excludable from
gross income for Federal income tax purposes.
You may want to avoid
buying shares shortly The Portfolio intends to make distributions most of
before the Portfolio which will be excludable from gross income for Federal
pays a dividend income tax purposes.
although the impact
on you will be The Portfolio will only purchase a municipal security
significantly less if it is accompanied by an opinion of counsel to the
than if you were issuer, which is delivered on the date of issuance of
invested in a fund the security, that the interest paid on such security
paying fully taxable is excludable from gross income for Federal income tax
dividends. The purposes. To the extent that the dividends distributed
reason? If you buy by the Portfolio are from bond interest income that is
shares when the excludable from gross income for Federal income tax
Portfolio has purposes, they are exempt from Federal income tax.
realized but not yet
distributed taxable There is a possibility that events occurring after the
ordinary income or date of issuance of a security, or after the
capital gains, you Portfolio's acquisition of a security, may result in a
will pay the full determination that the interest on that security is, in
price for the shares fact, includable in gross income for Federal income tax
and then receive a purposes retroactively to its date of issue. Such a
portion of the price determination may cause a portion of prior
back in the form of a distributions received by shareholders to be taxable to
taxable dividend. those shareholders in the year of receipt.
Before investing you
may want to consult Distributions derived from taxable interest income or
your tax adviser. capital gains on portfolio securities, if any, will be
subject to Federal income taxes and will generally be
subject to state and local income taxes. If you redeem
or exchange Portfolio shares, you generally will be
treated as having sold your shares and any gain on the
transaction may be subject to tax. Certain investors
may be subject to a Federal alternative minimum tax on
dividends attributable to the Portfolio's investment in
private activity bonds.
Generally, within 60 days after the end of the
Portfolio's taxable year, the Portfolio will tell you
the amount of exempt-interest dividends and capital
gain dividends you received that year. Capital gain
dividends are taxable as long term capital gains to
you, regardless of how long you have held your shares.
The tax treatment of dividends from the Portfolio is
the same whether you choose to receive them in cash or
to have them reinvested in shares of the Portfolio.
By law, your dividends and redemption proceeds 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.
This section summarizes some of the consequences under
current Federal tax law of an investment in the
Portfolio. It is not a substitute for personal tax
advice. Consult your personal tax adviser about the
potential tax consequences of an investment in the
Portfolio under all applicable tax laws.
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The Portfolio offers electronic delivery of communications to its shareholders. In order to receive this service, you must register your account and provide us with e-mail information. To sign up for this service, simply access the web site at 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 any other changes to the service.
Management of FUND ASSET MANAGEMENT
the Portfolio --------------------------------------------------------
Fund Asset Management, L.P., the Portfolio's Investment
Adviser, manages the Portfolio's investments and its
business operations under the overall supervision of
the Fund's Board of Directors. The Investment Adviser
has the responsibility for making all investment
decisions for the Portfolio.
As compensation for its services to the Portfolio, the
Investment Adviser receives at the end of each month a
fee from the Portfolio at the annual rate of [ ]% of
the Portfolio's average daily net assets.
Theodore R. Jaeckel, Jr., CFA, is the Portfolio's
portfolio manager and is primarily responsible for the
day-to-day management of the Portfolio's portfolio and
the selection of its investments. Mr. Jaeckel is a Vice
President of the Fund. Mr. Jaeckel has been a Director
(Municipal Tax-Exempt Fund Management) of Merrill Lynch
Investment Managers, L.P., an affiliate of the
Investment Adviser, since 1997. He has been a portfolio
manager therewith since 1991. For more information
about the portfolio manager's compensation, other
accounts he manages and his ownership of Portfolio
shares, please see the Statement of Additional
Information.
Fund Asset Management, L.P. was organized as an
investment adviser in 1977 and offers investment
advisory services to more than 50 registered investment
companies. Fund Asset Management, L.P. and its
affiliates had approximately $560 billion in investment
company and other portfolio assets under management as
of January 2006.
On February 15, 2006, BlackRock, Inc. ("BlackRock") and
Merrill Lynch & Co., Inc. ("Merrill Lynch") announced
that they have reached an agreement to merge Merrill
Lynch's investment management business, Merrill Lynch
Investment Managers, L.P. and certain affiliates
(including Fund Asset Management, L.P. and Merrill
Lynch International Limited), and BlackRock to create a
new independent company that will be one of the world's
largest asset management firms with nearly $1 trillion
in assets under management.
26
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Merrill Lynch will hold a 49.8% stake and will have a
45% voting interest in the combined company. The new
company will operate under the BlackRock name and be
governed by a board of directors with a majority of
independent members. The combined company will offer a
full range of equity, fixed income, cash management and
alternative investment products with strong
representation in both retail and institutional
channels, in the U.S. and in non-U.S. markets. It will
have over 4,500 employees in 18 countries and a major
presence in most key markets, including the United
States, the United Kingdom, Asia, Australia, the Middle
East and Europe. The transaction has been approved by
the boards of directors of both Merrill Lynch and
BlackRock and is expected to close in the third quarter
of 2006.
As a result of the above transaction, the combined
company is expected to become the investment adviser to
the Portfolio contingent upon the approval of the
Fund's Board of Directors and the Portfolio's
shareholders.
Conflicts of Interest
The investment activities of the Investment Adviser and
its affiliates in the management of, or their interest
in, their own accounts and other accounts they manage,
may present conflicts of interest that could
disadvantage the Portfolio and its shareholders. The
Investment Adviser provides investment management
services to other funds and discretionary managed
accounts that follow an investment program similar to
that of the Portfolio. Merrill Lynch (including, for
these purposes, the Investment Adviser, Merrill Lynch &
Co., Inc. and their affiliates, directors, partners,
trustees, managing members, officers and employees), is
a diversified global financial services firm involved
with a broad spectrum of financial services and asset
management activities, that may, for example, engage in
the ordinary course of business in activities in which
its interests or the interests of its clients may
conflict with those of the Portfolio. Merrill Lynch's
trading activities are carried out without reference to
positions held directly or indirectly by any Portfolio
and may result in Merrill Lynch having positions that
are adverse to those of the Portfolio. Merrill Lynch is
not under any obligation to share any investment
opportunity, idea or strategy with the Portfolio. As a
result, Merrill Lynch may compete with the Portfolio
for appropriate investment opportunities. In addition,
the Portfolio may invest in securities of companies
with which Merrill Lynch has or is trying to develop
investment banking relationships. The Portfolio also
may invest in securities of companies for which Merrill
Lynch provides or may some day provide research
coverage. The Portfolio may also make brokerage and
other payments to Merrill Lynch in connection with the
Portfolio's portfolio investment transactions.
The activities of the Investment Adviser or its
affiliates may give rise to other conflicts of interest
that could disadvantage the Portfolio and its
shareholders. The Investment Adviser has adopted
policies and procedures designed to address these
potential conflicts of interest. See the Statement of
Additional Information for further information.
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POTENTIAL
INVESTORS
[1] Open an account (two options). [2]
FINANCIAL ADVISER TRANSFER AGENT
OR SECURITIES DEALER
Financial Data Services,
(Advises shareholders on Inc.
their Portfolio
investments) ADMINISTRATIVE OFFICES
4800 Deer Lake Drive East
Jacksonville, Florida
32246-6484
MAILING ADDRESS
P.O. Box 45289
Jacksonville, Florida
32232-5289
Performs recordkeeping
and reporting services.
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DISTRIBUTOR
FAM Distributors, Inc.
P.O. Box 9081
Princeton, New Jersey 08543-9081
Arranges for the sale of
the Portfolio shares.
COUNSEL THE PORTFOLIO CUSTODIAN
Sidley Austin LLP The Board of Directors of Bank of New York
787 Seventh Avenue the Fund oversees the 100 Church Street
New York, New York Portfolio. New York, New York 10007
10019-6018
Provides legal advice to Holds the Portfolio's
the Portfolio. assets for safekeeping.
INDEPENDENT REGISTERED ACCOUNTING SERVICES INVESTMENT ADVISER
PUBLIC ACCOUNTING FIRM PROVIDER
Fund Asset Management, L.P.
Deloitte & Touche LLP State Street Bank and
750 College Road East Trust Company ADMINISTRATIVE OFFICES
Princeton, New Jersey 08540 500 College Road East 800 Scudders Mill Road
Princeton, New Jersey Plainsboro, New Jersey
08540 08536
Audits the financial Provides certain MAILING ADDRESS
statements of the Fund and accounting services to P.O. Box 9011
the Portfolio. the Portfolio. Princeton, New Jersey
08543-9011
TELEPHONE NUMBER
1-800-637-3863
Manages the Portfolio's
day-to-day activities.
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For More Information
Shareholder Reports
Additional information about the Portfolio's investments will be available in the Fund's Annual and Semi-Annual Reports. In the Fund's Annual Report you will find a discussion of the market conditions and investment strategies that significantly affected the Portfolio's performance during its last fiscal year. After the Portfolio has commenced operations, you may obtain these reports at no cost at www.mutualfunds.ml.com or by calling 1-800-637-3863.
The Portfolio will send you one copy of each shareholder report and certain other mailings, regardless of the number of Portfolio accounts you have. To receive separate shareholder reports for each account, call your financial adviser or other financial intermediary or write to the Transfer Agent at its mailing address. Include your name, address, tax identification number and brokerage or mutual fund account number. If you have any questions, please call your financial adviser or other financial intermediary or call the Transfer Agent at 1-800-637-3863.
Statement of Additional Information
The Statement of Additional Information contains further information about the Portfolio. The portions of the Statement of Additional Information relating to the Portfolio 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 Portfolio are not incorporated by reference, are not part of this Prospectus, and should not be relied on by investors in the Portfolio. You may obtain a free copy at www.mutualfunds.ml.com or by writing to the Portfolio at Financial Data Services, Inc., P.O. Box 45289, Jacksonville, Florida 32231-5289 or by calling 1-800-637-3863.
Information about the Portfolio (including the Statement of Additional
Information) can be reviewed and copied at the Securities and Exchange
Commission's ("SEC") Public Reference Room in Washington, D.C. Call
1-202-551-8090 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 #811-02688
Code #10051-[ ]
(C)Fund Asset Management, L.P.
Prospectus
[ ], 2006
Merrill Lynch Municipal Bond Fund, Inc.
High Yield Portfolio
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.
[LOGO] Merrill Lynch Investment Managers
www.mlim.ml.com
Mercury Advisors
A Division of Merrill Lynch Investment Managers
www.mercury.ml.com
The information in this statement of additional information is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This statement of additional information is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.
Subject to Completion
Preliminary Statement of Additional Information dated March 15, 2006
STATEMENT OF ADDITIONAL INFORMATION
MERRILL LYNCH MUNICIPAL BOND FUND, INC.
HIGH YIELD PORTFOLIO
P.O. Box 9011, Princeton, New Jersey 08543-9011 o Phone No. (609) 282-2800
This Statement of Additional Information of High Yield Portfolio (the
"Portfolio") of Merrill Lynch Municipal Bond Fund, Inc. is not a prospectus
and should be read in conjunction with the Prospectus of the Portfolio, dated
[ ], 2006, which has been filed with the Securities and Exchange Commission
(the "Commission") and can be obtained, without charge, by calling
1-800-637-3863 or by writing to the Portfolio at the above address. The
Portfolio'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 Portfolio have been incorporated by reference into the
Portfolio's Prospectus. The portions of Part II of this Statement of
Additional Information that do not relate to the Portfolio do not form a part
of the Portfolio's Statement of Additional Information, have not been
incorporated by reference into the Portfolio's Prospectus and should not be
relied upon by investors in the Portfolio.
FUND ASSET MANAGEMENT, L.P. -- INVESTMENT ADVISER
FAM DISTRIBUTORS, INC. -- DISTRIBUTOR
The date of this Statement of Additional Information is [ ], 2006
Table Of Contents
Part I
Investment Objectives and Policies................................ I-1
Investment Restrictions........................................... I-2
Information on Officers and Directors............................. I-4
Management and Advisory Arrangements.............................. I-8
Information on Sales Charges and Distribution Related Expenses.... I-10
Computation of Offering Price..................................... I-11
Portfolio Transactions and Brokerage.............................. I-11
Additional Information............................................ I-11
Financial Statements.............................................. I-14
Part II
Investment Risks and Considerations............................... II-1
Management and other Service Arrangements......................... II-36
Purchase of Shares................................................ II-43
Redemption of Shares.............................................. II-53
Shareholder Services.............................................. II-54
Pricing of Shares................................................. II-59
Portfolio Transactions and Brokerage Commissions.................. II-61
Dividends and Taxes............................................... II-64
Performance Data.................................................. II-68
Proxy Voting Policies and Procedures.............................. II-70
General Information............................................... II-73
Appendix A........................................................ A-1
Appendix B........................................................ B-1
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PART I: INFORMATION ABOUT HIGH YIELD PORTFOLIO OF
MERRILL LYNCH MUNICIPAL BOND FUND, INC.
Part I of this Statement of Additional Information sets forth information about High Yield Portfolio (the "Portfolio") of Merrill Lynch Municipal Bond Fund, Inc. (the "Fund"). This Part I includes information about the Fund's Board of Directors, the advisory services provided to and the management fees paid by the Portfolio and information about other fees paid by and services provided to the Portfolio. This Part I should be read in conjunction with the Portfolio's Prospectus and those portions of Part II of this Statement of Additional Information that pertain to the Portfolio.
I. Investment Objectives and Policies
The investment objective of the Portfolio is to provide shareholders with as high a level of income exempt from Federal income taxes as is consistent with the investment policies of the Portfolio. The Portfolio seeks to achieve its objective by investing in a diversified portfolio of debt obligations issued by or on behalf of states, territories and possessions of the United States and their political subdivisions, agencies and instrumentalities, the interest on which, in the opinion of bond counsel to the issuer, is generally excludable from gross income for Federal income tax purposes, except that the interest may be includable in taxable income for purposes of the Federal alternative minimum tax (such obligations are herein referred to as "Municipal Bonds"). Municipal Bonds include general obligation bonds, revenue or special obligation bonds, private activity bonds, variable rate demand notes, and short-term tax-exempt municipal obligations such as tax anticipation notes. Under normal circumstances, the Portfolio invests at least 80% of its net assets in Municipal Bonds. For this purpose, net assets include any borrowings for investment purposes. This is a fundamental policy of the Portfolio and may not be changed without a vote of the majority of the outstanding shares of the Portfolio as defined in the Investment Company Act of 1940, as amended (the "Investment Company Act"). The Fund is classified as diversified under the Investment Company Act. The Portfolio currently contemplates that it will not invest more than 25% of its total assets (taken at market value) in Municipal Bonds whose issuers are located in the same state. There can be no assurance that the investment objective of the Portfolio can be attained.
While the Portfolio does not intend to realize significant taxable investment income, the Portfolio has the authority to invest as much as 20% of its assets on a temporary basis in taxable money market securities with remaining maturities not in excess of one year from the date of purchase ("Temporary Investments") for liquidity purposes or as a temporary investment of cash pending investment of such cash in Municipal Bonds. In addition, the Portfolio reserves the right to temporarily invest a greater portion of its assets in Temporary Investments for defensive purposes, when, in the judgment of Fund Asset Management, L.P. (the "Investment Adviser" or "FAM"), market conditions warrant such action. Temporary Investments consist of U.S. Government securities, U.S. Government Agency securities, domestic bank certificates of deposit and bankers' acceptances, short-term corporate debt securities such as commercial paper and repurchase agreements. From time to time, the Portfolio may realize capital gains that will constitute taxable income.
The Portfolio may invest in certain tax-exempt securities that are classified as "private activity bonds," which may subject certain investors to an alternative minimum tax.
Certain instruments in which the Portfolio may invest may be characterized as derivative instruments. The Portfolio is authorized to engage in transactions in financial futures contracts and options thereon only for hedging purposes. The Portfolio is also authorized to invest in indexed and inverse floating rate obligations and swap agreements, including credit default swap agreements, both for hedging purposes and to seek to enhance income.
Investment Policies of the Portfolio
The Portfolio pursues its investment objective through the investment policies described below. These policies can be expected to affect the yield on the Portfolio and the degree of market, financial and interest rate risk to which the Portfolio is subject. Generally, Municipal Bonds with longer maturities tend to produce higher yields and are subject to greater market fluctuations as a result of changes in interest rates ("interest rate risk") than are Municipal Bonds with shorter maturities. In addition, lower rated Municipal Bonds generally will provide a higher yield than higher rated Municipal Bonds of similar maturity but are also generally subject to greater market risk and to a greater
degree of risk with respect to the ability of the issuer to meet its principal and interest obligations ("credit risk"). The Portfolio's net asset value may fall when interest rates rise and rise when interest rates fall. Because of its emphasis on investments in Municipal Bonds, the Portfolio should be considered as a means of diversifying an investment portfolio and not in itself a balanced investment plan.
The Portfolio may invest in Municipal Bonds rated in any rating category or in unrated Municipal Bonds. The Portfolio will usually invest in Municipal Bonds that have a maturity of five years or longer. Portfolio management chooses Municipal Bonds that it believes offer a relatively high potential for total return relative to their total risk. Although the Portfolio may invest in Municipal Bonds in any rating category, Portfolio management presently intends to invest at least 65% of the Portfolio's net assets in medium- to low-quality bonds as rated by at least one independent rating agency (BBB or lower by Standard & Poor's ("S&P") or Fitch Ratings ("Fitch") or Baa or lower by Moody's Investors Service, Inc. ("Moody's")), or if unrated, judged to be of comparable quality by the Portfolio's investment adviser. Obligations rated below BBB or Baa are commonly known as "junk bonds." It is possible that the Portfolio could invest up to 100% of its assets in junk bonds. The Portfolio may also invest up to [10%] of its total assets in Municipal Bonds that are the subject of bankruptcy proceedings or otherwise in default as to the repayment of principal and/or payment of interest at the time of acquisition by the Portfolio or are rated in the lowest rating categories by at least one rating agency (CC or lower by S&P or Fitch or Ca or lower by Moody's), or if unrated, judged to be of comparable quality by the Portfolio's investment adviser.
Because investment in medium to lower rated Municipal Bonds entails relatively greater risks of loss of income or principal than an investment in higher rated securities, an investment in the Portfolio may not be appropriate for all investors. Investors should consider these risks before investing.
II. Investment Restrictions
The Fund, on behalf of the Portfolio, has adopted restrictions and policies relating to the investment of the Portfolio's assets and its activities. Certain of the restrictions are fundamental policies of the Portfolio and may not be changed without the approval of the holders of a majority of the Portfolio's outstanding voting securities (which for this purpose and under the Investment Company Act, means the lesser of (i) 67% of the shares represented at a meeting at which more than 50% of the outstanding shares are represented or (ii) more than 50% of the outstanding shares). The Fund, on behalf of the Portfolio, has also adopted certain non-fundamental investment restrictions, which may be changed by the Board of Directors without shareholder approval.
Set forth below are the Portfolio's fundamental and non-fundamental investment restrictions. Unless otherwise provided, all references below to the assets of the Portfolio are in terms of current market value.
Under the Portfolio's fundamental investment restrictions, the Portfolio may not:
1. Make any investment inconsistent with the Fund's classification as a diversified company under the Investment Company Act.
2. Invest more than 25% of its assets, taken at market value, in the securities of issuers in any particular industry (excluding the U.S. Government and its agencies and instrumentalities).
3. Make investments for the purpose of exercising control or management.
4. Purchase or sell real estate, except that, to the extent permitted by applicable law, the Portfolio may invest in securities directly or indirectly secured by real estate or interests therein or issued by companies which invest in real estate or interests therein.
5. Make loans to other persons, except (i) that the acquisition of bonds, debentures or other corporate debt securities and investments in government obligations, commercial paper, pass-through instruments, certificates of deposit, bankers' acceptances, repurchase agreements or any similar instruments shall not be deemed to be the making of a loan, (ii) that the Portfolio may lend its portfolio securities, provided that the lending of portfolio securities may be made only in accordance with applicable law and the guidelines set forth in the Portfolio's Prospectus and Statement
of Additional Information, as they may be amended from time to time and (iii) as may otherwise be permitted by an exemptive order issued to the Fund by the SEC.
6. Issue senior securities to the extent such issuance would violate applicable law.
7. Borrow money, except that (i) the Portfolio may borrow in amounts up to 33 1/3% of its total assets (including the amount borrowed), (ii) the Portfolio may, to the extent permitted by applicable law, borrow up to an additional 5% of its total assets for temporary purposes, (iii) the Portfolio may obtain such short term credit as may be necessary for the clearance of purchases and sales of portfolio securities and (iv) the Portfolio may purchase securities on margin to the extent permitted by applicable law. The Portfolio may not pledge its assets other than to secure such borrowings or, to the extent permitted by the Portfolio's investment policies as set forth in its Prospectus and Statement of Additional Information, as they may be amended from time to time, in connection with hedging transactions, short sales, when-issued and forward commitment transactions and similar investment strategies.
8. Underwrite securities of other issuers except insofar as the Portfolio technically may be deemed an underwriter under the Securities Act of 1933, as amended (the "Securities Act"), in selling portfolio securities.
9. Purchase or sell commodities or contracts on commodities, except to the extent that the Portfolio may do so in accordance with applicable law and the Portfolio's Prospectus and Statement of Additional Information, as they may be amended from time to time, and without registering as a commodity pool operator under the Commodity Exchange Act.
Under the Portfolio's non-fundamental investment restrictions, the Portfolio may not:
a. Purchase securities of other investment companies, except to the extent such purchases are permitted by applicable law. As a matter of policy, however, the Portfolio will not purchase shares of any registered open-end investment company or registered unit investment trust, in reliance on Section 12(d)(1)(F) or (G) (the "fund of funds" provisions) of the Investment Company Act, at any time its shares are owned by another investment company that is part of the same group of investment companies as the Portfolio.
b. Make short sales of securities or maintain a short position, except to the extent permitted by applicable law. The Portfolio currently does not intend to engage in short sales, except short sales "against the box."
c. Invest in securities that cannot be readily resold or that cannot otherwise be marketed, redeemed or put to the issuer or a third party, if at the time of acquisition more than 15% of its net assets would be invested in such securities. This restriction shall not apply to securities that mature within seven days or securities that the Board of Directors of the Fund has otherwise determined to be liquid pursuant to applicable law. Securities purchased in accordance with Rule 144A under the Securities Act (a "Rule 144A Security") and determined to be liquid by the Fund's Board of Directors are not subject to the limitations set forth in this investment restriction.
d. Notwithstanding fundamental investment restriction (7) above, borrow money or pledge its assets, except that the Portfolio (a) may borrow as a temporary measure for extraordinary or emergency purposes or to meet redemptions in amounts not exceeding 33 (1)/3% (taken at market value) of its total assets and pledge its assets to secure such borrowings, (b) may obtain such short-term credit as may be necessary for the clearance of purchases and sales of portfolio securities and (c) may purchase securities on margin to the extent permitted by applicable law. The deposit or payment by the Portfolio of initial or variation margin in connection with financial futures contracts or options transactions is not considered to be the purchase of a security on margin. The purchase of securities while borrowings are outstanding will have the effect of leveraging the Portfolio. The Portfolio will not purchase securities while borrowings exceed 5% of its total assets.
Except with respect to restriction (7), if a percentage restriction on the investment or use of assets set forth above is adhered to at the time a transaction is effected, later changes in percentages resulting from changing values will not be considered a violation.
For purposes of investment restriction (2) above, the Portfolio uses the
classifications and subclassifications of Morgan Stanley Capital International
as a guide to identify industries. Also for purposes of investment restriction
(2), tax-exempt securities issued by states, municipalities and their
political subdivisions are not considered to be part of any industry.
III. Information on Officers and Directors
The Board of Directors of the Fund consists of seven individuals, six of whom are not "interested persons" of the Fund as defined in the Investment Company Act (the "non-interested Directors"). The Directors are responsible for the overall supervision of the operations of the Fund and perform the various duties imposed on the directors of investment companies by the Investment Company Act.
Each non-interested Director is a member of the Fund's Audit Committee (the "Audit Committee"). The principal responsibilities of the Audit Committee are the appointment, compensation and oversight of the Fund's independent accountants, including the resolution of disagreements regarding financial reporting between Fund management and such independent accountants. The Audit 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 Fund; (ii) discuss with the independent accountants certain matters relating to the Fund'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 with the independent accountants any relationships or services disclosed in the statement that may impact the objectivity and independence of the Fund'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 Fund's accounting and financial reporting policies and practices and internal controls and Fund management's responses thereto. The Board of the Fund has adopted a written charter for the Audit Committee. The Audit Committee has retained independent legal counsel to assist it in connection with these duties. The Audit Committee met four times during the fiscal year ended June 30, 2005.
Cynthia A. Montgomery and Edward D. Zinbarg are the members of the Fund's Nominating Committee. The principal responsibilities of the Nominating Committee are to identify individuals qualified to serve as non-interested Directors of the Fund and to recommend its nominees for consideration by the full Board. While the Nominating Committee is solely responsible for the selection and nomination of the Fund's non-interested Directors, the Nominating Committee may consider nominations for the office of Director made by Portfolio shareholders as it deems appropriate. Portfolio shareholders who wish to recommend a nominee should send nominations to the Secretary of the Fund that include biographical information and set forth the qualifications of the proposed nominee. The Nominating Committee did not meet during the fiscal year ended June 30, 2005.
Biographical Information
Certain biographical and other information relating to the non-interested
Directors of the Fund 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 funds and portfolios overseen in the complex of
funds advised by the Investment Adviser, Merrill Lynch Investment Managers,
L.P. ("MLIM") or their affiliates ("MLIM/FAM-advised funds"), and other public
directorships.
Number of
MLIM/FAM-
Advised
Term of Funds
Name, Address* Position(s) Office** and and
and Age Held with Length of Principal Occupation(s) Portfolio Public
of Director the Fund Time Served During Past Five Years Overseen Directorships
---------------- ----------- -------------- ---------------------------------------- ---------- ----------------
Ronald W. Forbes Director Director since Professor Emeritus of Finance, School of 49 None
(65)*** 1977 Business, State University of New York at registered
Albany since 2000 and Professor thereof investment
from 1989 to 2000; International companies
Consultant, Urban Institute, Washington, consisting
D.C. from 1995 to 1999. of
I-4
|
Number of
MLIM/FAM-
Advised
Term of Funds
Name, Address* Position(s) Office** and and
and Age Held with Length of Principal Occupation(s) Portfolio Public
of Director the Fund Time Served During Past Five Years Overseen Directorships
---------------- ----------- -------------- ---------------------------------------- ---------- ----------------
50 portfolios
Cynthia A. Director Director since Professor, Harvard Business School since 49 Newell
Montgomery (53)**** 1994 1989; Associate Professor, J.L. Kellogg registered Rubbermaid Inc.
Graduate School of Management, investment (manufacturing)
Northwestern University from 1985 to companies
1989; Associate Professor, Graduate consisting
School of Business Administration, of 50
University of Michigan from 1979 to 1985; portfolios
Director, Harvard Business School of
Publishing since 2005.
Jean Margo Reid (60) Director Director since Self-employed consultant since 2001; 49 None
2004 Counsel of Alliance Capital Management registered
(investment adviser) in 2000; General investment
Counsel, Director and Secretary of companies
Sanford C. Bernstein & Co., Inc. consisting
(investment adviser/broker-dealer) from of 50
1997 to 2000; Secretary, Sanford C. portfolios
Bernstein Fund, Inc. from 1994 to 2000;
Director and Secretary of SCB, Inc. since
1998; Director and Secretary of SCB
Partners, Inc. since 2000; and Director
of Covenant House from 2001 to 2004.
Roscoe S. Suddarth Director Director since President, Middle East Institute, from 49 None
(70) 2000 1995 to 2001; Foreign Service Officer, registered
United States Foreign Service, from 1961 investment
to 1995; Career Minister from 1989 to companies
1995; Deputy Inspector General, U.S. consisting
Department of State, from 1991 to 1994; of 50
U.S. Ambassador to the Hashemite Kingdom portfolios
of Jordan from 1987 to 1990.
Richard R. West (67) Director Director since Professor of Finance from 1984 to 1995, 49 Bowne & Co., Inc.
1981 Dean from 1984 to 1993 and since 1995 registered (financial
Dean Emeritus of New York University's investment printers);
Leonard N. Stern School of Business companies Vornado Realty
Administration. consisting Trust (real
of 50 estate company);
portfolios Alexander's, Inc.
(real estate
company)
Edward D. Zinbarg Director Director since Self-employed financial consultant since 49 None
(71) 2000 1994; Executive Vice President of the registered
Prudential Insurance Company of America investment
from 1988 to 1994; Former Director of companies
Prudential Reinsurance Company and former consisting
Trustee of the Prudential Foundation. of 50
portfolios
|
** Each Director serves until his or her successor is elected and qualified, or until December 31 of the year in which he or she turns 72, or until his or her death or resignation, or removal as provided in the Fund's by-laws or charter or by statute.
*** Chairman of the Board of Directors and the Audit Committee.
**** Chairman of the Nominating Committee.
Certain biographical and other information relating to the Director who is an officer and an "interested person" of the Fund as defined in the Investment Company Act (the "interested Director") and to the other officers of the Fund 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 funds and portfolios overseen in MLIM/FAM-advised funds and public directorships held.
Number of
Term of MLIM/FAM-
Position(s) Office** and Advised Funds
Name, Address* and Held with Length of Principal Occupation(s) and Portfolio Public
Age the Fund Time Served During Past Five Years Overseen Directorships
------------------- ------------- ------------- --------------------------------------- ------------- -------------
Robert C. Doll, Jr. President and President and President of the MLIM/FAM-advised funds 131 registered None
(51) Director Director**** since 2005; President of MLIM and FAM investment
*** since 2005 since 2001; Co-Head (Americas Region) companies
thereof from 2000 to 2001 and Senior consisting of
Vice President from 1999 to
I-5
|
Number of
Term of MLIM/FAM-
Position(s) Office** and Advised Funds
Name, Address* and Held with Length of Principal Occupation(s) and Portfolio Public
Age the Fund Time Served During Past Five Years Overseen Directorships
------------------- ------------- ------------- --------------------------------------- ------------- -------------
2001, President and Director of Princeton 177 portfolios
Services, Inc. ("Princeton Services")
since 2001; President of Princeton
Administrators, L.P. ("Princeton
Administrators") since 2001; Chief
Investment Officer of OppenheimerFunds,
Inc. in 1999 and Executive Vice
President thereof from 1991 to 1999.
Kenneth A. Jacob (54) Senior Vice Senior Vice Managing Director of MLIM since 2000; 39 registered None
President President since Director (Tax-Exempt Fund Management) of investment
2002 MLIM from 1997 to 2000. companies
consisting of
52 portfolios
John Loffredo (41) Senior Vice Senior Vice Managing Director of MLIM since 2000; 40 registered None
President President since Director (Tax Exempt Fund Management) of investment
2002 MLIM from 1997 to 2000. companies
consisting of
53 portfolios
Theodore R. Jaeckel, Vice President Vice President Managing Director of MLIM since 2005; 8 registered None
Jr. (46) and Portfolio since 2006 Director (Municipal Tax-Exempt Fund investment
Manager of the Management) of MLIM from 1997 to 2004. companies
Portfolio consisting of
8 portfolios
Donald C. Burke (45) Vice President Vice President First Vice President of MLIM and FAM 139 None
and Treasurer since 1993 and since 1997 and Treasurer thereof since registered
Treasurer since 1999; Senior Vice President and investment
1999 Treasurer of Princeton Services since companies
1999 and Director since 2004; Vice
consisting of President of FAM
Distributors, Inc. 185 portfolios
("FAMD") since 1999; Vice President of
MLIM and FAM from 1990 to 1997;
Director of Taxation of MLIM from 1990
to 2001; Vice President, Treasurer and
Secretary of the IQ Funds since 2004.
Jeffrey Hiller (54) Chief Compliance Chief Compliance Chief Compliance Officer of the 140 None
Officer Officer since 2004 MLIM/FAM-advised funds and First Vice registered
President and Chief Compliance Officer investment
of MLIM (Americas Region) since 2004; companies
Chief Compliance Officer of the IQ Funds consisting of
since 2004; Global Director of 186 portfolios
Compliance at Morgan Stanley Investment
Management from 2002 to 2004; Managing
Director and Global Director of
Compliance at Citigroup Asset Management
from 2000 to 2002; Chief Compliance
Officer at Soros Fund Management in
2000; Chief Compliance Officer at
Prudential Financial from 1995 to 2000;
Senior Counsel in the Commission's
Division of Enforcement in Washington,
D.C. from 1990 to 1995.
Alice A. Pellegrino Secretary Secretary since Director (Legal Advisory) of MLIM since 132 None
(45) 2004 2002; Vice President of MLIM from 1999 registered
to 2002; Attorney associated with MLIM investment
since 1997; Secretary of MLIM, FAM, FAMD companies
and Princeton Services since 2004. consisting of
178 portfolios
----------------------
|
* The address of each officer is P.O. Box 9011, Princeton, New Jersey 08543-9011.
** Each officer is elected by and serves at the pleasure of the Board of Directors of the Fund.
*** Mr. Doll is an "interested person," as defined in the Investment Company Act, of the Fund based on his positions with MLIM, FAM, Princeton Services and Princeton Administrators.
**** As a Director, Mr. Doll 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 Fund's by-laws or charter or by statute.
Share Ownership
Information relating to each Director's share ownership in the Fund and in all registered funds in the MLIM/FAM-advised funds that are overseen by the respective Director ("Supervised Funds") as of December 31, 2005 is set forth in the chart below.
Aggregate Dollar Aggregate Dollar
Range Range of Equity
of Equity Securities Securities in
Name in the Fund Supervised Funds
------------------- --------------------- --------------------
Interested Director:
Robert C. Doll, Jr. [$10,001-$50,000] Over $100,000
Non-Interested Directors:
Ronald W. Forbes [$1-$10,000] Over $100,000
Cynthia A. Montgomery [None] Over $100,000
Roscoe S. Suddarth [None] Over $100,000
Jean Margo Reid [Over $100,000] Over $100,000
Richard R. West [None] Over $100,000
Edward D. Zinbarg [Over $100,000] Over $100,000
|
Directors of the Fund may purchase Class I shares of the Portfolio.
As of [ ], 2006 the Directors and officers of the Fund as a group owned an aggregate of less than 1% of the outstanding shares of the Fund. As of December 31, 2005, none of the non-interested Directors of the Fund or their immediate family members owned beneficially or of record any securities in Merrill Lynch & Co., Inc. ("ML & Co.").
Compensation of Directors
The Fund pays each non-interested Director a combined fee, for service on the Board and Audit Committee, of $9,000 per year plus $250 per in-person Board meeting attended and $250 per in-person Audit Committee meeting attended. The Chairman of the Audit Committee receives an additional fee of $2,083 per year. The Fund reimburses each non-interested Director for his or her out-of-pocket expenses relating to attendance at Board, Audit Committee and any Nominating Committee meetings.
The following table shows the compensation earned by the non-interested Directors with respect to the Fund for the fiscal year ended June 30, 2005 and the aggregate compensation paid to them by all MLIM/FAM-advised funds for the calendar year ended December 31, 2005.
Aggregate
Pension or Compensation
Retirement from Fund
Benefits and Other
Accrued as MLIM/FAM-
Compensation Part of Advised
Name from Fund Fund Expense Funds*
------------ ------------ ------------ -----------
Ronald W. Forbes** $10,214 None $304,567
Cynthia A. Montgomery $ 9,000 None $254,567
Jean Margo Reid+ $ 7,333 None $254,567
Kevin A. Ryan++ $ 4,500 None $0
Roscoe S. Suddarth $ 9,000 None $254,567
Richard R. West $ 9,000 None $254,567
Edward D. Zinbarg $ 9,000 None $254,567
----------------
|
* For the number of MLIM/FAM-advised funds from which each Director receives compensation, see the table beginning on page I-8.
** Chairman of the Board and Audit Committee
+ Ms. Reid became a Director effective August 19, 2004.
++ Mr. Ryan retired as a Director of the Fund and a director/trustee of certain other MLIM/FAM-advised funds effective January 1, 2005
IV. Management and Advisory Arrangements
The Fund, on behalf of the Portfolio, has entered into an investment advisory agreement with FAM (the "Investment Advisory Agreement"), pursuant to which FAM acts as the investment adviser for the Portfolio and provides the Fund and the Portfolio with management services.
As compensation for its services to the Portfolio, the Investment Adviser receives at the end of each month a fee from the Portfolio at the annual rate of [ ]% of the Portfolio's average daily net assets.
Consideration of the Investment Advisory Agreement
Activities and Composition of the Board of Directors. All but one member of the Fund's Board of Directors is a non-interested Director whose only affiliation with the Investment Adviser or other Merrill Lynch affiliates is as a director of the Fund and certain other funds advised by the Investment Adviser or its affiliates. The Chairman of the Board is also a non-interested Director. New director nominees are chosen as nominees by a Nominating Committee of non-interested Directors. All non-interested Directors also are members of the Board's Audit Committee and the non-interested Directors meet in executive session at each in person Board meeting. The Board and the Audit Committee meet in person for at least two days each quarter and conduct other in person and telephone meetings throughout the year, some of which are formal board meetings, and some of which are informational meetings. The independent counsel to the non-interested Directors attends all in-person Board and Audit Committee meetings and other meetings at the non-interested Directors' request.
Investment Advisory Agreement -- Matters Considered by the Board
[To be provided by subsequent amendment.]
Transfer Agency Services
As of the date of this Statement of Additional Information, the Portfolio has not made any payments to Financial Data Services, Inc. for transfer agency services.
Accounting Services
As of the date of this Statement of Additional Information, the Portfolio has not made any payments to State Street Bank and Trust Company or to the Investment Adviser for accounting services.
Information Regarding the Portfolio Manager
Theodore R. Jaeckel, Jr., CFA, is the Portfolio's portfolio manager and is primarily responsible for the day-to-day operations of the Portfolio.
Other Funds and Accounts Managed
The following table sets forth information about funds and accounts other than
the Portfolio for which the Portfolio's portfolio manager is primarily
responsible for the day-to-day portfolio management as of [December 31, 2005]
[MLIM confirm].
----------------------------------------------------------------------------------------------------------------------
Number of Other Accounts Managed Number of Accounts and Assets for Which
and Assets by Account Type Advisory Fee is Performance-Based
------------------------------------------ ---------------------------------------------
Other
Registered Pooled Registered Other Pooled
Name of Investment Investment Other Investment Investment Other
Portfolio Manager Companies Vehicles accounts Companies Vehicles accounts
----------------------------------------------------------------------------------------------------------------------
Theodore R. Jaeckel, Jr.
[MLIM provide]
----------------------------------------------------------------------------------------------------------------------
|
Portfolio Manager Compensation Overview
The portfolio manager compensation program of Merrill Lynch Investment Managers, L.P. and its affiliates (collectively, herein "MLIM") is critical to MLIM's ability to attract and retain the most talented asset management professionals. This program ensures that compensation is aligned with maximizing investment returns and it provides a competitive pay opportunity for competitive performance.
Compensation Program
The elements of total compensation for MLIM portfolio managers are: fixed base salary, annual performance-based cash and stock compensation (cash and stock bonus) and other benefits. MLIM has balanced these components of pay to provide portfolio managers with a powerful incentive to achieve consistently superior investment performance. By design, portfolio manager compensation levels fluctuate -- both up and down -- with the relative investment performance of the portfolios that they manage.
Base Salary
Under the MLIM approach, like that of many asset management firms, base salaries represent a relatively small portion of a portfolio manager's total compensation. This approach serves to enhance the motivational value of the performance-based (and therefore variable) compensation elements of the compensation program.
Performance-Based Compensation
MLIM believes that the best interests of investors are served by recruiting and retaining exceptional asset management talent and managing their compensation within a consistent and disciplined framework that emphasizes pay for performance in the context of an intensely competitive market for talent. To that end, the portfolio manager incentive compensation is based on a formulaic compensation program.
MLIM's formulaic portfolio manager compensation program includes: pre-tax investment performance relative to the appropriate competitors or benchmarks over 1-, 3- and 5-year performance periods and a measure of operational efficiency. If a portfolio manager's tenure is less than 5 years, performance periods will reflect time in position. Portfolio managers are compensated based on products they manage. A smaller discretionary element of portfolio manager compensation may include consideration of: financial results, expense control, profit margins, strategic planning and implementation, quality of client service, market share, corporate reputation, capital allocation, compliance and risk control, leadership, workforce diversity, supervision, technology and innovation. MLIM also considers the extent to which individuals exemplify and foster Merrill Lynch's principles of Client Focus, Respect for the Individual, Teamwork, Responsible Citizenship and Integrity. All factors are considered collectively by MLIM management.
Cash Bonus
Performance-based compensation is distributed to portfolio managers in a combination of cash and stock. Typically, the cash bonus, when combined with base salary, represents more than 60% of total compensation for portfolio managers.
Stock Bonus
A portion of the dollar value of the total annual performance-based bonus is paid in restricted shares of stock of Merrill Lynch & Co., Inc. (the "Company"). Paying a portion of annual bonuses in stock puts compensation earned by a portfolio manager for a given year "at risk" based on the Company's ability to sustain and improve its performance over future periods. The ultimate value of stock bonuses is dependent on future Company stock price performance. As such, the stock bonus aligns each portfolio manager's financial interests with those of the Company's shareholders and encourages a balance between short-term goals and long-term strategic objectives. Management strongly believes that providing a significant portion of competitive performance-based compensation in stock is in the best interests of investors and shareholders. This approach ensures that portfolio managers
participate as shareholders in both the "downside risk" and "upside opportunity" of the Company's performance. Portfolio managers therefore have a direct incentive to protect the Company's reputation for integrity.
Other Compensation Programs
Portfolio managers who meet relative investment performance and financial management objectives during a performance year are eligible to participate in a deferred cash program. Awards under this program are in the form of deferred cash that may be benchmarked to a menu of MLIM mutual funds (including their own fund) during a five-year vesting period. The deferred cash program aligns the interests of participating portfolio managers with the investment results of MLIM products and promotes continuity of successful portfolio management teams.
Other Benefits
Portfolio managers are also eligible to participate in broad-based plans offered generally to Merrill Lynch employees, including broad-based retirement, 401(k), health, and other employee benefit plans.
Potential Material Conflicts of Interest
Real, potential or apparent conflicts of interest may arise when a portfolio manager has day-to-day portfolio management responsibilities with respect to more than one fund or account, including the following:
Certain investments may be appropriate for the Portfolio and also for other clients advised by MLIM and its affiliates, including other client accounts managed by the Portfolio's portfolio manager. Investment decisions for the Portfolio and other clients are made with a view to achieving their respective investment objectives and after consideration of such factors as their current holdings, availability of cash for investment and the size of their investments generally. Frequently, a particular security may be bought or sold for only one client or in different amounts and at different times for more than one but less than all clients. Likewise, because clients of MLIM and its affiliates may have differing investment strategies, a particular security may be bought for one or more clients when one or more other clients are selling the security. The investment results for the Portfolio may differ from the results achieved by other clients of MLIM and its affiliates and results among clients may differ. In addition, purchases or sales of the same security may be made for two or more clients on the same day. In such event, such transactions will be allocated among the clients in a manner believed by MLIM to be equitable to each. MLIM will not determine allocations based on whether it receives a performance based fee from the client. In some cases, the allocation procedure could have an adverse effect on the price or amount of the securities purchased or sold by the Portfolio. Purchase and sale orders for the Portfolio may be combined with those of other clients of MLIM and its affiliates in the interest of achieving the most favorable net results to the Portfolio.
To the extent that the Portfolio's portfolio manager has responsibilities for managing accounts in addition to the Portfolio, the portfolio manager will need to divide his time and attention among relevant accounts.
In some cases, a real, potential or apparent conflict may also arise where (i) MLIM may have an incentive, such as a performance based fee, in managing one account and not with respect to other accounts it manages or (ii) where the Portfolio's portfolio manager owns an interest in one fund or account he manages and not another.
Portfolio Ownership
As of the date of this Statement of Additional Information the Portfolio has not yet commenced operations, therefore the portfolio manager does not own shares of the Portfolio at this time.
V. Information on Sales Charges and Distribution Related Expenses
As of the date of this Statement of Additional Information, the Portfolio has not made any payments pursuant to the Fund's Distribution Plans.
VI. Computation of Offering Price
An illustration of the computation of the offering price for Class A, Class B, Class C and Class I shares of the Portfolio based on a hypothetical investment of $10,000 in each class of shares is set forth below.
Class A Class B Class C Class I
-------- -------- -------- --------
Net Assets $10,000 $10,000 $10,000 $10,000
Number of Shares Outstanding 1,000 1,000 1,000 1,000
Net Asset Value Per share
(net assets divided by
number of shares
outstanding) $ 10.00 $ 10.00 $ 10.00 $ 10.00
Sales charge (for Class A
shares:
4.00% of offering price;
4.17% of net asset value per
share)* $ 0.55 $ 0.55 $ 0.55 $ 0.55
-------- -------- -------- --------
Offering Price $ 10.55 $ 10.55 $ 10.55 $ 10.55
======== ======== ======== ========
---------------------
|
* Rounded to the nearest one-hundredth percent; assumes maximum sales charge is applicable. ** Class B and Class C shares are not subject to an initial sales charge but may be subject to a CDSC on redemption of shares. See "Your Account - Pricing of Shares -- Class B and Class C Shares - Deferred Sales Charge Options" in the Prospectus and "Purchase of Shares -- Deferred Sales Charge Alternatives -- Class B and Class C Shares" in
Part II of this Statement of Additional Information.
VII. Portfolio Transactions and Brokerage
See "Portfolio Transactions and Brokerage" in Part II of this Statement of Additional Information for more information.
As of the date of this Statement of Additional Information, the Portfolio has not paid any brokerage commissions.
VIII. Additional Information
Description of Shares
The Fund is a diversified, open-end management investment company organized under the laws of the State of Maryland that commenced operations on October 21, 1977. Prior to September 21, 1979, the Fund consisted solely of the Insured Portfolio. Currently, the Fund is comprised of four separate Portfolios: Insured Portfolio, National Portfolio, Short-Term Portfolio and High Yield Portfolio.
The authorized capital stock of the Fund consists of 4,250,000,000 shares of Common Stock, divided into four series, each of which is divided into four classes, designated Class A, Class B, Class C and Class I Common Stock, having a par value of $0.10 per share. The authorized shares of each series are as follows: Insured Portfolio Series Common Stock (500,000,000 Class A shares, 375,000,000 Class B shares, 375,000,000 Class C shares, 500,000,000 Class I shares), National Portfolio Series Common Stock (375,000,000 Class A shares, 375,000,000 Class B shares, 375,000,000 Class C shares, 375,000,000 Class I shares), Short-Term Portfolio Series Common Stock (150,000,000 Class A shares, 150,000,000 Class B shares, 150,000,000 Class C shares, 150,000,000 Class I shares), and High Yield Portfolio Series Common Stock (100,000,000 Class A shares, 100,000,000 Class B shares, 100,000,000 Class C shares, 100,000,000 Class I shares). Each Class A, Class B, Class C and Class I share of common stock of each of the Portfolios represents an interest in the same assets of such Portfolio and are identical in all respects to the shares of the other classes except that the Class A, Class B and Class C shares bear certain expenses related to the account maintenance associated with such shares, and Class B and Class C shares bear certain expenses related to the distribution of such shares. Each Class of shares of the Portfolio has exclusive voting rights with respect to matters relating to account maintenance services and distribution expenditures relative to that Portfolio, as applicable (except that Class B shareholders have certain voting rights with respect to the Class A Distribution Plan). Only shares of each respective Portfolio are entitled to vote on matters concerning only that Portfolio.
Principal Shareholders
As of the date of this Statement of Additional Information, the Investment Adviser owned 100% of the outstanding common stock of the Portfolio. The Investment Adviser may be deemed to control the Portfolio until such time as it owns less than 25% of the outstanding shares of the Portfolio.
IX. Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBIC ACCOUNTING FIRM
To the Board of Directors and Stockholder of High Yield Portfolio of Merrill Lynch Municipal Bond Fund, Inc.:
We have audited the accompanying statement of assets and liabilities of High Yield Portfolio of Merrill Lynch Municipal Bond Fund, Inc. (the "Company") as of [ ], 2006. This statement of assets and liabilities is the responsibility of the Company's management. Our responsibility is to express an opinion on this statement of assets and liabilities based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the statement of assets and liabilities is free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the statement of assets and liabilities, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the statement of assets and liabilities. We believe that our audit of the statement of assets and liabilities provides a reasonable basis for our opinion.
In our opinion, the statement of assets and liabilities referred to above presents fairly, in all material respects, the financial position of the Company at [ ], 2006 in conformity with accounting principles generally accepted in the United States.
[ ]
[ ], 2006
HIGH YIELD PORTFOLIO OF
MERRILL LYNCH MUNICIPAL BOND FUND, INC.
STATEMENT OF ASSETS AND LIABILITIES
[ ], 2006
ASSETS:
Cash (Note 1) $[ ]
Deferred offering costs (Note 3)
-----------
Total assets $[ ]
-----------
LIABILITIES:
Liabilities and accrued expenses $[ ]
-----------
NET ASSETS: $[ ]
-----------
NET ASSETS CONSIST OF:
Class A Shares of Common Stock
Class B Shares of Common Stock
Class C Shares of Common Stock
Class I Shares of Common Stock
Paid-in Capital in excess of par
-----------
NET ASSET VALUE: $[ ]
-----------
---------------
|
Notes to Statement of Assets and Liabilities.
(1) Merrill Lynch Municipal Bond Fund, Inc. (the "Fund") is a diversified,
open-end management investment company organized under the laws of the
State of Maryland that commenced operations on October 21, 1977. Prior to
September 21, 1979, the Fund consisted solely of the Insured Portfolio.
Currently, the Fund is comprised of four separate Portfolios: Insured
Portfolio, National Portfolio, Short-Term Portfolio and High Yield
Portfolio. To date, the High Yield Portfolio has not had any transactions
other than those relating to organizational matters and the sale of
[1,000] shares of common stock to Fund Asset Management, L.P. (the
"Investment Adviser").
(2) The Fund, on behalf of the High Yield Portfolio, has entered into an
investment advisory agreement with FAM. Upon the commencement of
operations of the High Yield Portfolio, the Investment Adviser will
receive a fee from the High Yield Portfolio at the annual rate of [ ]% of
the average daily net assets of the High Yield Portfolio. The Fund, on
behalf of the High Yield Portfolio, has also entered into a distribution
agreement with FAM Distributors, Inc. (the "Distributor") and a transfer
agency agreement with Financial Data Services, Inc. (the "Transfer
Agent"). Certain officers and/or Directors of the Fund are officers
and/or directors or trustees of the Investment Adviser, the Distributor
and the Transfer Agent.
(3) Deferred offering costs consist of registration fees, legal fees and
printing fees related to preparing the registration statement, and will
be amortized over a 12-month period beginning with the commencement of
operations of the High Yield Portfolio. The Investment Adviser, on behalf
of the High Yield Portfolio, will incur organizational costs estimated at
$[ ].
(4) The High Yield Portfolio's statement of assets and liabilities is
prepared in conformity with accounting principles generally accepted in
the United States of America, which may require the use of management
accruals and estimates.
(5) The Fund qualifies and intends to continue to qualify as a "regulated
investment company" and as such (and by complying with the applicable
provisions of the Internal Revenue Code of 1986, as amended) will not be
subject to Federal income tax on taxable income (including realized
capital gains) that is distributed to stockholders.
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 Merrill Lynch California Municipal Series Trust ("California Insured"); Merrill Lynch Inflation Protected Fund ("Inflation Protected"); Merrill Lynch Low Duration Fund of Merrill Lynch Investment Managers Funds, Inc. ("Low Duration"); High Yield Portfolio, Insured Portfolio, National Portfolio and Short Term 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 Real Investment Fund ("Real Investment"); Merrill Lynch U.S. Government Fund ("U.S. Government"); Merrill Lynch U.S. High Yield Fund, Inc. ("U.S. High Yield"); and Merrill Lynch World Income Fund, Inc. ("World Income").
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 and Pennsylvania Municipal Bond are collectively referred to herein as the "Municipal Funds."
Each Fund is organized as a Maryland corporation, a Massachusetts business trust or a Delaware statutory 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, Declaration of Trust or Agreement and Declaration of Trust, together with all amendments thereto, 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 and strategies as the corresponding Feeder Fund. All investments are generally 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 Bond Municipal Municipal
Fund -- Fund -- Fund -- Bond -- Municipal Bond -- Municipal
Core High Intermediate High Bond -- Short Bond --
Bond Income Term California Inflation Low Yield Insured Term National
Portfolio Portfolio Portfolio Insured Protected Duration Portfolio Portfolio Portfolio Portfolio
-----------------------------------------------------------------------------------------------------------------------------------
144 A Securities X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Asset Backed Securities X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Borrowing and Leverage X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Convertible Securities X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Corporate Loans X X
-----------------------------------------------------------------------------------------------------------------------------------
Debt Securities X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Derivatives X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Hedging X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Indexed and Inverse X X X X X X X X X X
Floating Rate
-----------------------------------------------------------------------------------------------------------------------------------
Swap Agreements X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Interest Rate Swaps, X X X X X
Caps and Floors
-----------------------------------------------------------------------------------------------------------------------------------
Credit Default Swap X X X X X X X X X X
Agreements
-----------------------------------------------------------------------------------------------------------------------------------
Credit Linked Securities X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Total Return Swap X X X X X X X X X X
Agreements
-----------------------------------------------------------------------------------------------------------------------------------
Hybrid Instruments
-----------------------------------------------------------------------------------------------------------------------------------
Options on Securities X X X X X X X X X X
and Securities Indices
-----------------------------------------------------------------------------------------------------------------------------------
Types of Options X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Call Options X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Put Options X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Options on Government X X X X X X X X X X
National Mortgage
Association ("GNMA")
Certificates
-----------------------------------------------------------------------------------------------------------------------------------
Futures X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Foreign Exchange X X X X
Transactions
-----------------------------------------------------------------------------------------------------------------------------------
Forward Foreign X X X X
Exchange Transactions
-----------------------------------------------------------------------------------------------------------------------------------
Currency Futures X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Currency Options X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Limitations on X X X X
Currency Hedging
-----------------------------------------------------------------------------------------------------------------------------------
Risk Factors in X X X X
Hedging Foreign
Currency Risks
-----------------------------------------------------------------------------------------------------------------------------------
Risk Factors in X X X X X X X X X X
Derivatives
-----------------------------------------------------------------------------------------------------------------------------------
Credit Risk X 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 X
-----------------------------------------------------------------------------------------------------------------------------------
Liquidity Risk X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Additional Risk Factors X X X X X X X X X X
of OTC Transactions;
Limitations on the use
of OTC Derivatives
-----------------------------------------------------------------------------------------------------------------------------------
Distressed Securities X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Dollar Rolls X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Foreign Investment Risks X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Foreign Market Risk X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Foreign Economy Risk X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Currency Risk and X X X X X
Exchange Risk
-----------------------------------------------------------------------------------------------------------------------------------
Governmental Supervision X X X X X
and Regulation /
Accounting Standards
-----------------------------------------------------------------------------------------------------------------------------------
Certain Risks of Holding X X X X X
Fund Assets Outside the
United States
-----------------------------------------------------------------------------------------------------------------------------------
Settlement Risk X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
New New Short
Municipal Florida Jersey York Pennsylvania Term U.S.
Intermediate Municipal Municipal Municipal Municipal Real U.S. U.S. High World
Term Bond Bond Bond Bond Investment Government Government Yield Income
-----------------------------------------------------------------------------------------------------------------------------------
144 A Securities
-----------------------------------------------------------------------------------------------------------------------------------
Asset Backed Securities X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Borrowing and Leverage X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Convertible Securities X X X
-----------------------------------------------------------------------------------------------------------------------------------
Corporate Loans X
-----------------------------------------------------------------------------------------------------------------------------------
Debt Securities X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Derivatives X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Hedging X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Indexed and Inverse X X X X X X X X X X
Floating Rate
-----------------------------------------------------------------------------------------------------------------------------------
Swap Agreements X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Interest Rate Swaps, X X X X X
Caps and Floors
-----------------------------------------------------------------------------------------------------------------------------------
Credit Default Swap X X X X X X X X X X
Agreements
-----------------------------------------------------------------------------------------------------------------------------------
Credit Linked Securities X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Total Return Swap X X X X X X X X X X
Agreements
-----------------------------------------------------------------------------------------------------------------------------------
Hybrid Instruments X
-----------------------------------------------------------------------------------------------------------------------------------
Options on Securities X X X X X X X X X X
and Securities Indices
-----------------------------------------------------------------------------------------------------------------------------------
Types of Options X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Call Options X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Put Options X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Options on Government X X X X X X X X X X
National Mortgage
Association ("GNMA")
Certificates
-----------------------------------------------------------------------------------------------------------------------------------
Futures X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Foreign Exchange X X X
Transactions
-----------------------------------------------------------------------------------------------------------------------------------
Forward Foreign X X X
Exchange Transactions
-----------------------------------------------------------------------------------------------------------------------------------
Currency Futures X X X
-----------------------------------------------------------------------------------------------------------------------------------
Currency Options X X X
-----------------------------------------------------------------------------------------------------------------------------------
Limitations on X X X
Currency Hedging
-----------------------------------------------------------------------------------------------------------------------------------
Risk Factors in X X X
Hedging Foreign
Currency Risks
-----------------------------------------------------------------------------------------------------------------------------------
Risk Factors in X X X X X X X X X X
Derivatives
-----------------------------------------------------------------------------------------------------------------------------------
Credit Risk X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Currency Risk X X X
-----------------------------------------------------------------------------------------------------------------------------------
Leverage Risk X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Liquidity Risk X X X X X X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Additional Risk Factors X X X X X X X X X X
of OTC Transactions;
Limitations on the use
of OTC Derivatives
-----------------------------------------------------------------------------------------------------------------------------------
X X
Distressed Securities
-----------------------------------------------------------------------------------------------------------------------------------
Dollar Rolls X X X X X
-----------------------------------------------------------------------------------------------------------------------------------
Foreign Investment Risks X X X
-----------------------------------------------------------------------------------------------------------------------------------
Foreign Market Risk X X X
-----------------------------------------------------------------------------------------------------------------------------------
Foreign Economy Risk X X X
-----------------------------------------------------------------------------------------------------------------------------------
Currency Risk and X X X
Exchange Risk
-----------------------------------------------------------------------------------------------------------------------------------
Governmental Supervision X X X
and Regulation /
Accounting Standards
-----------------------------------------------------------------------------------------------------------------------------------
Certain Risks of Holding X X X
Fund Assets Outside the
United States
-----------------------------------------------------------------------------------------------------------------------------------
Settlement Risk X X X
-----------------------------------------------------------------------------------------------------------------------------------
|
II-2
Bond Bond Bond Municipal Municipal
Fund -- Fund -- Fund -- Bond -- Municipal Bond -- Municipal
Core High Intermediate High Bond -- Short Bond --
Bond Income Term California Inflation Low Yield Insured Term National
Portfolio Portfolio Portfolio Insured Protected Duration Portfolio Portfolio Portfolio Portfolio
-----------------------------------------------------------------------------------------------------------------------------------
Illiquid or Restricted X X X X X X X X X X
Securities
--------------------------------------------------------------------------------------------------------------------------------
Inflation-indexed Bonds X X X X
--------------------------------------------------------------------------------------------------------------------------------
Investment in Emerging X X X X X
Markets
--------------------------------------------------------------------------------------------------------------------------------
Restriction on Certain
Investments
--------------------------------------------------------------------------------------------------------------------------------
Investment in Other X X X X X X X X X X
Investment Companies
--------------------------------------------------------------------------------------------------------------------------------
Junk Bonds X X X X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Mortgage-Related Securities X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Mortgage Backed
Securities X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Mortgage Pass-Through X X X X X
Securities
--------------------------------------------------------------------------------------------------------------------------------
Collateralized Mortgage X X X X X
Obligations ("CMOs")
--------------------------------------------------------------------------------------------------------------------------------
Adjustable Rate Mortgage X X X X X
Securities
--------------------------------------------------------------------------------------------------------------------------------
CMO Residuals X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Stripped Mortgage Backed X X X X X
Securities
--------------------------------------------------------------------------------------------------------------------------------
Tiered Index Bonds X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Municipal Investments X X X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Risk Factors and Special
Considerations Relating X X X X X X X
to Municipal Bonds
--------------------------------------------------------------------------------------------------------------------------------
Description of Municipal X X X X X X X
Bonds
--------------------------------------------------------------------------------------------------------------------------------
General Obligation Bonds X X X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Revenue Bonds X X X X X X X
--------------------------------------------------------------------------------------------------------------------------------
PABs X X X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Moral Obligation Bonds X X X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Municipal Notes X X X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Municipal Commercial X X X X X X X
Paper
--------------------------------------------------------------------------------------------------------------------------------
Municipal Lease X X X X X X X
Obligations
--------------------------------------------------------------------------------------------------------------------------------
Yields X X X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Variable Rate Demand
Obligations ("VRDOs") and X X X X X X X
Participating VRDOs
--------------------------------------------------------------------------------------------------------------------------------
Transactions in Financial X X X X X X X
Futures Contracts
--------------------------------------------------------------------------------------------------------------------------------
Call Rights X X X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Municipal Interest Rate X X X X X X X
Swap Transactions
--------------------------------------------------------------------------------------------------------------------------------
Real Estate Investment X X X X X
Trusts ("REITs")
--------------------------------------------------------------------------------------------------------------------------------
Repurchase Agreements and X X X X X X X X X X
Purchase and Sale Contracts
--------------------------------------------------------------------------------------------------------------------------------
Reverse Repurchase
Agreements X X X X X X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Securities Lending X X X X X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Short Sales X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Sovereign Debt X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Standby Commitment X X X X X
Agreements
--------------------------------------------------------------------------------------------------------------------------------
Stripped Securities X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Supranational Entities X X X X X
--------------------------------------------------------------------------------------------------------------------------------
Warrants X X X X X
--------------------------------------------------------------------------------------------------------------------------------
When Issued Securities,
Delayed Delivery Securities X X X X X X X X X X
and Forward Commitments
--------------------------------------------------------------------------------------------------------------------------------
Zero Coupon Securities X X X X X
--------------------------------------------------------------------------------------------------------------------------------
New New Short
Municipal Florida Jersey York Pennsylvania Term U.S.
Intermediate Municipal Municipal Municipal Municipal Real U.S. U.S. High World
Term Bond Bond Bond Bond Investment Government Government Yield Income
-----------------------------------------------------------------------------------------------------------------------------------
Illiquid or Restricted X X X X X X X X X X
Securities
----------------------------------------------------------------------------------------------------------------------------------
Inflation-indexed Bonds X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Investment in Emerging X X
Markets
----------------------------------------------------------------------------------------------------------------------------------
Restriction on Certain X
Investments
----------------------------------------------------------------------------------------------------------------------------------
Investment in Other X X X X X X X X X X
Investment Companies
----------------------------------------------------------------------------------------------------------------------------------
Junk Bonds X X X X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Mortgage-Related Securities X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Mortgage Backed
Securities X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Mortgage Pass-Through X X X X X
Securities
----------------------------------------------------------------------------------------------------------------------------------
Collateralized Mortgage X X X X X
Obligations ("CMOs")
----------------------------------------------------------------------------------------------------------------------------------
Adjustable Rate Mortgage X X X X X
Securities
----------------------------------------------------------------------------------------------------------------------------------
CMO Residuals X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Stripped Mortgage Backed X X X X X
Securities
----------------------------------------------------------------------------------------------------------------------------------
Tiered Index Bonds X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Municipal Investments X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Risk Factors and Special
Considerations Relating X X X X X
to Municipal Bonds
----------------------------------------------------------------------------------------------------------------------------------
Description of Municipal X X X X X
Bonds
----------------------------------------------------------------------------------------------------------------------------------
General Obligation Bonds X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Revenue Bonds X X X X X
----------------------------------------------------------------------------------------------------------------------------------
PABs X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Moral Obligation Bonds X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Municipal Notes X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Municipal Commercial X X X X X
Paper
----------------------------------------------------------------------------------------------------------------------------------
Municipal Lease X X X X X
Obligations
----------------------------------------------------------------------------------------------------------------------------------
Yields X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Variable Rate Demand
Obligations ("VRDOs") and X X X X X
Participating VRDOs
----------------------------------------------------------------------------------------------------------------------------------
Transactions in Financial X X X X X
Futures Contracts
----------------------------------------------------------------------------------------------------------------------------------
Call Rights X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Municipal Interest Rate X X X X X
Swap Transactions
----------------------------------------------------------------------------------------------------------------------------------
Real Estate Investment X X X X X
Trusts ("REITs")
----------------------------------------------------------------------------------------------------------------------------------
Repurchase Agreements and X X X X X X X X X X
Purchase and Sale Contracts
----------------------------------------------------------------------------------------------------------------------------------
Reverse Repurchase
Agreements X X X X X X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Securities Lending X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Short Sales X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Sovereign Debt X X X
----------------------------------------------------------------------------------------------------------------------------------
Standby Commitment X X X X X
Agreements
----------------------------------------------------------------------------------------------------------------------------------
Stripped Securities X X X X X
----------------------------------------------------------------------------------------------------------------------------------
Supranational Entities X X X
----------------------------------------------------------------------------------------------------------------------------------
Warrants X X X
----------------------------------------------------------------------------------------------------------------------------------
When Issued Securities,
Delayed Delivery Securities X X X X X X X X X X
and Forward Commitments
----------------------------------------------------------------------------------------------------------------------------------
Zero Coupon Securities X X X X X
----------------------------------------------------------------------------------------------------------------------------------
|
II-3
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.
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.
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
II-4
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.
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.
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.
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
II-5
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.
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.
A Fund may also invest in synthetic convertible securities. 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 or another party 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 that has 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 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 to certain market fluctuations differently from 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 be expected to 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.
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
II-6
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 develops 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, 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.
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. Changes in an issuer's credit rating or the market's perception of an issuer's creditworthiness may also affect the value of a Fund's investment in that issuer. Credit 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.
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 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
II-7
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.
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 that 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
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accrued daily (offset against any amounts owing to the Fund) and any accrued but unpaid net amounts owed to a swap counterparty 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.
Interest Rate Swaps, Caps and Floors. A Fund may enter into interest rate swaps, which are over-the-counter 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.
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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 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 and Similar Instruments. Each Fund may enter into credit default swap agreements and similar agreements, and may also buy credit linked securities. The credit default swap agreement or similar instrument 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 up front 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 up front 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 up front 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.
Credit Linked Securities. Among the income producing securities in which a Fund may invest are credit linked securities, which are issued by a limited purpose trust or other vehicle that, in turn, invests in a derivative instrument or basket of derivative instruments, such as credit default swaps, interest rate swaps and other securities, in order to provide exposure to certain fixed income markets. For instance, a Fund may invest in credit linked securities as a cash management tool in order to gain exposure to a certain market and/or to remain fully invested when more traditional income producing securities are not available.
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Like an investment in a bond, investments in these credit linked securities represent the right to receive periodic income payments (in the form of distributions) and payment of principal at the end of the term of the security. However, these payments are conditioned on the issuer's receipt of payments from, and the issuer's potential obligations to, the counterparties to the derivative instruments and other securities in which the issuer invests. For instance, the issuer may sell one or more credit default swaps, under which the issuer would receive a stream of payments over the term of the swap agreements provided that no event of default has occurred with respect to the referenced debt obligation upon which the swap is based. If a default occurs, the stream of payments may stop and the issuer would be obligated to pay to the counterparty the par (or other agreed upon value) of the referenced debt obligation. This, in turn, would reduce the amount of income and principal that a Fund would receive. A Fund's investments in these instruments are indirectly subject to the risks associated with derivative instruments, including, among others, credit risk, default or similar event risk, counterparty risk, interest rate risk, leverage risk and management risk. It is also expected that the securities will be exempt from registration under the Securities Act of 1933. Accordingly, there may be no established trading market for the securities and they may constitute illiquid investments.
Total Return Swap Agreements. Total return swap agreements are contracts in which one party agrees to make periodic payments based on the change in market value of the underlying assets, which may include a specified security, basket of securities or securities indices during the specified period, in return for periodic payments based on a fixed or variable interest rate or the total return from other underlying assets. Total return swap agreements may be used to obtain exposure to a security or market without owning or taking physical custody of such security or market. Total return swap agreements may effectively add leverage to the Fund's portfolio because, in addition to its total net assets, the Fund would be subject to investment exposure on the notional amount of the swap.
Total return swap agreements entail the risk that a party will default on its payment obligations to the Fund thereunder. Swap agreements also bear the risk that the Fund will not be able to meet its obligation to the counterparty. Generally, the Fund will enter into total return swaps 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). The net amount of the excess, if any, of the Fund's obligations over its entitlements with respect to each total return swap will be accrued on a daily basis, and an amount of cash or liquid instruments having an aggregate net asset value at least equal to the accrued excess will be segregated by the Fund. If the total return swap transaction is entered into on other than a net basis, the full amount of the Fund's obligations will be accrued on a daily basis, and the full amount of the Fund's obligations will be segregated by the Fund in an amount equal to or greater than the market value of the liabilities under the total return swap agreement or the amount it would have cost the Fund initially to make an equivalent direct investment, plus or minus any amount the Fund is obligated to pay or is to receive under the total return swap agreement.
Hybrid Instruments. Certain Funds seek to gain exposure to the commodities markets primarily through investments in hybrid instruments. Hybrid instruments are either equity or debt derivative securities with one or more commodity-dependent components that have payment features similar to a commodity futures contract, a commodity option contract, or a combination of both. Therefore, these instruments are "commodity-linked." They are considered "hybrid" instruments because they have both commodity-like and security-like characteristics. Hybrid instruments are derivative instruments because at least part of their value is derived from the value of an underlying commodity, futures contract, index or other readily measurable economic variable.
Qualifying Hybrid Instruments. Certain Funds may invest in hybrid
instruments that qualify for exclusion from regulation under the Commodity
Exchange Act and the regulations adopted thereunder. A hybrid instrument that
qualifies for this exclusion from regulation must be "predominantly a
security." A hybrid instrument is considered to be predominantly a security if
(a) the issuer of the hybrid instrument receives payment in full of the
purchase price of the hybrid instrument, substantially contemporaneously with
delivery of the hybrid instrument; (b) the purchaser or holder of the hybrid
instrument is not required to make any payment to the issuer in addition to
the purchase price paid under subparagraph (a), whether as margin, settlement
payment, or otherwise, during the life of the hybrid instrument or at
maturity; (c) the issuer of the hybrid instrument is not subject by the terms
of the instrument to mark-to-market margining requirements; and (d) the hybrid
instrument is not marketed as a contract of sale of a commodity for future
delivery (or option on such a contract) subject to applicable provisions of
the Commodity Exchange Act. Hybrid instruments may be principal protected,
partially protected, or offer no principal protection. A principal protected
hybrid instrument means that the issuer will pay, at a minimum, the par value
of
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the note at maturity. Therefore, if the commodity value to which the hybrid instrument is linked declines over the life of the note, the Fund will receive at maturity the face or stated value of the note. With a principal protected hybrid instrument, the Fund will receive at maturity the greater of the par value of the note or the increase in its value based on the underlying commodity or index. This protection is, in effect, an option whose value is subject to the volatility and price level of the underlying commodity. The Manager's decision whether to use principal protection depends in part on the cost of the protection. In addition, the protection feature depends upon the ability of the issuer to meet its obligation to buy back the security, and, therefore, depends on the creditworthiness of the issuer. With full principal protection, the Fund will receive at maturity of the hybrid instrument either the stated par value of the hybrid instrument, or potentially, an amount greater than the stated par value if the underlying commodity, index, futures contract or economic variable to which the hybrid instrument is linked has increased in value. Partially protected hybrid instruments may suffer some loss of principal if the underlying commodity, index, futures contract or economic variable to which the hybrid instrument is linked declines in value during the term of the hybrid instrument. However, partially protected hybrid instruments have a specified limit as to the amount of principal that they may lose.
Hybrid Instruments Without Principal Protection. Certain Funds may invest in hybrid instruments that offer no principal protection. At maturity, there is a risk that the underlying commodity price, futures contract, index or other economic variable may have declined sufficiently in value such that some or all of the face value of the hybrid instrument might not be returned. Some of the hybrid instruments that a Fund may invest in may have no principal protection and the hybrid instrument could lose all of its value. The Manager, at its discretion, may invest in a partially protected principal structured note or a note without principal protection. In deciding to purchase a note without principal protection, the Manager may consider, among other things, the expected performance of the underlying commodity futures contract, index or other economic variable over the term of the note, the cost of the note, and any other economic factors that the Manager believes are relevant.
Limitations on Leverage. Some of the hybrid instruments in which a Fund may invest may involve leverage. To avoid being subject to undue leverage risk, a Fund will seek to limit the amount of economic leverage it has under one hybrid instrument in which it invests and the leverage of the Fund's overall portfolio. A Fund will not invest in a hybrid instrument if, at the time of purchase: (i) that instrument's "leverage ratio" exceeds 300% of the price increase in the underlying commodity, futures contract, index or other economic variable or (ii) the Fund's "portfolio leverage ratio" exceeds 150%, measured at the time of purchase. "Leverage ratio" is the expected increase in the value of a hybrid instrument, assuming a one percent price increase in the underlying commodity, futures contract, index or other economic factor. In other words, for a hybrid instrument with a leverage factor of 150%, a 1% gain in the underlying economic variable would be expected to result in a 1.5% gain in value for the hybrid instrument. Conversely, a hybrid instrument with a leverage factor of 150% would suffer a 1.5% loss if the underlying economic variable lost 1% of its value. "Portfolio leverage ratio" is defined as the average (mean) leverage ratio of all instruments in a Fund's portfolio, weighted by the market values of such instruments or, in the case of futures contracts, their notional values. To the extent that the policy on a Fund's use of leverage stated above conflicts with the Investment Company Act or the rules and regulations thereunder, the Fund will comply with the applicable provisions of the Investment Company Act. A Fund may at times or from time to time decide not to use leverage in its investments or use less leverage than may otherwise be allowable.
Counterparty Risk. A significant risk of hybrid instruments is counterparty risk. Unlike exchange-traded futures and options, which are standard contracts, hybrid instruments are customized securities, tailor-made by a specific issuer. With a listed futures or options contract, an investor's counterparty is the exchange clearinghouse. Exchange clearinghouses are capitalized by the exchange members and typically have high investment grade ratings (e.g., ratings of AAA or AA by Standard & Poor's). Therefore, the risk is small that an exchange clearinghouse might be unable to meet its obligations at maturity. However, with a hybrid instrument, a Fund will take on the counterparty credit risk of the issuer. That is, at maturity of the hybrid instrument, there is a risk that the issuer may be unable to perform its obligations under the structured note.
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.
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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.
Call Options. Each Fund may purchase call options on any of the types of securities or instruments in which it may invest. A purchased call option gives a Fund the right to buy, and obligates the seller to sell, the underlying security at the exercise price at any time during the option period. A Fund also may purchase and sell call options on indices. Index options are similar to options on securities except that, rather than taking or making delivery of securities underlying the option at a specified price upon exercise, an index option gives the holder the right to receive cash upon exercise of the option if the level of the index upon which the option is based is greater than the exercise price of the option.
Each Fund also is authorized to write (i.e., sell) covered call options on the securities or instruments in which it may invest and to enter into closing purchase transactions with respect to certain of such options. A covered call option is an option in which a Fund, in return for a premium, gives another party a right to buy specified securities owned by the Fund at a specified future date and price set at the time of the contract. The principal reason for writing call options is the attempt to realize, through the receipt of premiums, a greater return than would be realized on the securities alone. By writing covered call options, a Fund gives up the opportunity, while the option is in effect, to profit from any price increase in the underlying security above the option exercise price. In addition, a Fund's ability to sell the underlying security will be limited while the option is in effect unless the Fund enters into a closing purchase transaction. A closing purchase transaction cancels out a Fund's position as the writer of an option by means of an offsetting purchase of an identical option prior to the expiration of the option it has written. Covered call options also serve as a partial hedge to the extent of the premium received against the price of the underlying security declining.
Each Fund also is authorized to write (i.e., sell) uncovered call options on securities or instruments in which it may invest but that are not currently held by the Fund. The principal reason for writing uncovered call options is to realize income without committing capital to the ownership of the underlying securities or instruments. When writing uncovered call options, a Fund must deposit and maintain sufficient margin with the broker dealer through which it made the uncovered call option as collateral to ensure that the securities can be purchased for delivery if and when the option is exercised. In addition, in connection with each such transaction a Fund will segregate unencumbered liquid securities or cash with a value at least equal to the Fund's exposure (the difference between the unpaid amounts owed by the Fund on such transaction minus any collateral deposited with the broker dealer), on a marked-to-market basis (as calculated pursuant to requirements of the Commission). Such segregation will ensure that the Fund has assets available to satisfy its obligations with respect to the transaction and will avoid any potential leveraging of the Fund's portfolio. Such segregation will not limit the Fund's exposure to loss. During periods of declining securities prices or when prices are stable, writing uncovered calls can be a profitable strategy to increase a Fund's income with minimal capital risk. Uncovered calls are riskier than covered calls because there is no underlying security held by a Fund that can act as a partial hedge. Uncovered calls have speculative characteristics and the potential for loss is unlimited. When an uncovered call is exercised, a Fund must purchase the underlying security to meet its call obligation. There is also a risk, especially with less liquid preferred and debt securities, that the securities may not be available for purchase. If the purchase price exceeds the exercise price, a Fund will lose the difference.
Put Options. Each Fund is authorized to purchase put options to seek to hedge against a decline in the value of its securities or to enhance its return. By buying a put option, a Fund acquires a right to sell such underlying securities or instruments at the exercise price, thus limiting the Fund's risk of loss through a decline in the market value of the securities or instruments until the put option expires. The amount of any appreciation in the value of the underlying securities or instruments will be partially offset by the amount of the premium paid for the put option and any related transaction costs. Prior to its expiration, a put option may be sold in a closing sale transaction and profit or loss from the sale will depend on whether the amount received is more or less than the premium paid for the put option plus the related transaction costs. A closing sale transaction cancels out a Fund's position as the purchaser of
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an option by means of an offsetting sale of an identical option prior to the expiration of the option it has purchased. A Fund also may purchase uncovered put options.
Each Fund also has authority to write (i.e., sell) put options on the types of securities or instruments that may be held by the Fund, provided that such put options are covered, meaning that such options are secured by segregated, liquid instruments. A Fund will receive a premium for writing a put option, which increases the Fund's return. A Fund will not sell puts if, as a result, more than 50% of the Fund's assets would be required to cover its potential obligations under its hedging and other investment transactions.
Each Fund is also authorized to write (i.e., sell) uncovered put options on securities or instruments in which it may invest but that the Fund does not currently have a corresponding short position or has not deposited cash equal to the exercise value of the put option with the broker dealer through which it made the uncovered put option as collateral. The principal reason for writing uncovered put options is to receive premium income and to acquire such securities or instruments at a net cost below the current market value. A Fund has the obligation to buy the securities or instruments at an agreed upon price if the securities or instruments decrease below the exercise price. If the securities or instruments price increases during the option period, the option will expire worthless and a Fund will retain the premium and will not have to purchase the securities or instruments at the exercise price. In connection with such transaction, a Fund will segregate unencumbered liquid securities or cash with a value at least equal to the Fund's exposure, on a marked-to-market basis (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 and will avoid any potential leveraging of the Fund's portfolio. Such segregation will not limit the Fund's exposure to loss.
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.
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
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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.
Each Fund's Manager has claimed an exclusion from the definition of the term "commodity pool operator" under the Commodity Exchange Act ("CEA") pursuant to Rule 4.5 under the CEA. The Manager is not, therefore, subject to registration or regulation as a "commodity pool operator" under the CEA and each Fund is operated so as not to be 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, the Fund may also sell a call option that, 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
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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 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, or the risk that the reference entity in a credit default swap or similar derivative will not be able to honor its financial obligations.
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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 that 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 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.
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.
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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 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.
Dollar Rolls. A Fund may enter into dollar rolls, in which the Fund will sell or buy securities for delivery in the current month and simultaneously contract to repurchase or resell 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.
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, 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
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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.
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 thereby reducing the amount available for distribution to shareholders.
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.
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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.
Inflation-Indexed Bonds. Inflation-indexed bonds are fixed income securities or other instruments whose principal value is periodically adjusted according to the rate of inflation. Two structures are common. The U.S. Treasury and some other issuers use a structure that accrues inflation into the principal value of the bond. Most other issuers pay out the Consumer Price Index ("CPI") accruals as part of a semi-annual coupon.
Inflation-indexed securities issued by the U.S. Treasury have maturities of five, ten or thirty years, although it is possible that securities with other maturities will be issued in the future. The U.S. Treasury securities pay interest on a semi-annual basis, equal to a fixed percentage of the inflation-adjusted principal amount. For example, if the Fund purchased an inflation-indexed bond with a par value of $1,000 and a 3% real rate of return coupon (payable 1.5% semi-annually), and inflation over the first six months was 1%, the mid-year value of the bond would be $1,010 and the first semi-annual interest payment would be $15.15 ($1,010 times 1.5%). If inflation during the second half of the year resulted in the whole year's inflation equaling 3%, the end of year value of the bond would be $1,030 and the second semi-annual interest payment would be $15.45 ($1,030 times 1.5%).
If the periodic adjustment rate measuring inflation falls, the principal value of inflation-indexed bonds will be adjusted downward, and, consequently, the interest payable on these securities (calculated with respect to a smaller principal amount) will be reduced. Repayment of the original bond principal on maturity (as adjusted for inflation) is guaranteed in the case of U.S. Treasury inflation-indexed bonds, even during a period of deflation. However, the current market value of the bonds is not guaranteed and will fluctuate. The Fund may also invest in other inflation related bonds that may or may not provide a similar guarantee. If a guarantee of principal is not provided, the adjusted principal value of the bond repaid at maturity may be less than the original principal. In addition, if the Fund purchases inflation-indexed bonds offered by foreign issuers, the rate of inflation measured by the foreign inflation index may not be correlated to the rate of inflation in the United States.
The value of inflation-indexed bonds is expected to change in response to changes in real interest rates. Real interest rates, in turn, are tied to the relationship between nominal interest rates and the rate of inflation. Therefore, if inflation were to rise at a faster rate than nominal interest rates, real interest rates might decline, leading to an increase in value of inflation-indexed bonds. In contrast, if nominal interest rates increased at a faster rate than inflation, real interest rates might rise, leading to a decrease in value of inflation-indexed bonds. There can be no assurance, however, that the value of inflation-indexed bonds will be directly correlated to changes in interest rates.
While these securities are expected to be protected from long-term inflationary trends, short-term increases in inflation may lead to a decline in value. If interest rates rise due to reasons other than inflation (for example, due to changes in currency exchange rates), investors in these securities may not be protected to the extent that the increase is not reflected in the bond's inflation measure.
In general, the measure used to determine the periodic adjustment of U.S. inflation-indexed bonds is the CPI for Urban Consumers ("CPI-U"), which is calculated monthly by the U.S. Bureau of Labor Statistics. The CPI-U is a measurement of changes in the cost of living, made up of components such as housing, food, transportation and energy. Inflation-indexed bonds issued by a foreign government are generally adjusted to reflect a comparable
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inflation index calculate by the applicable government. There can be no assurance that the CPI-U or any foreign inflation index will accurately measure the real rate of inflation in the prices of goods and services. Moreover, there can be no assurance that the rate of inflation in a foreign country will be correlated to the rate of inflation in the United States.
An increase in the principal amount of an inflation-indexed bond will be considered taxable ordinary income, even though investors do not receive their principal until maturity.
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.
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
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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.
Investment in Other Investment Companies. Each Fund may invest in other investment companies, including exchange traded funds. 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. As with other investments, investments in other investment companies are subject to market and selection risk. In addition, 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.
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:
o 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.
o 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.
o 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.
o 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.
o 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.
o 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.
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o A Fund may incur expenses to the extent necessary to seek recovery upon default or to negotiate new terms with a defaulting issuer.
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"), or by government sponsored enterprises, such as 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.
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
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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
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principal on each payment date to more than one class. PAC bonds generally require payments of a specified amount of principal on each 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 multi-class 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 of the principal. While a
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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 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.
Municipal Investments
The Municipal Funds and certain other 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 excludable from gross income for Federal income tax purposes ("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 excludable from gross income for applicable state and local income tax purposes and/or allow the value of their shares to be exempt from applicable state and local personal property 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 excludable from gross income for Federal and applicable state and local income tax purposes and/or applicable state and local personal property 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 excludable from gross income for Federal income tax purposes will be considered "Municipal Bonds" for purposes of a Municipal Fund's investment objective and policies. Non-Municipal Tax-Exempt Securities that pay interest excludable from gross income for Federal and applicable state and local income tax purposes and/or allow the value of a Fund's shares to be exempt from applicable state and local personal property 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
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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.
A Municipal Fund's ability to distribute dividends exempt from Federal income tax will depend on the exclusion from gross income of the interest income that it receives on the Municipal Bonds in which it invests. The Municipal Funds will only purchase Municipal Bonds if they are accompanied by an opinion of counsel to the issuer, which is delivered on the date of issuance of that security, that interest on such securities is excludable from gross income for Federal income tax purposes (the "tax exemption opinion").
Events occurring after the date of issuance of the Municipal Bonds, however, may cause the interest on such securities to be includable in gross income for Federal income tax purposes. For example, the Internal Revenue Code establishes certain requirements, such as restrictions as to the investment of the proceeds of the issue, limitations as to the use of proceeds of such issue and the property financed by such proceeds, and the payment of certain excess earnings to the Federal government, that must be met after the issuance of the Municipal Bonds for interest on such securities to remain excludable from gross income for Federal income tax purposes. The issuers and the conduit borrowers of the Municipal Bonds generally covenant to comply with such requirements and the tax exemption opinion generally assumes continuing compliance with such requirements. Failure to comply with these continuing requirements, however, may cause the interest on such Municipal Bonds to be includable in gross income for Federal income tax purposes retroactive to their date of issue.
In addition, the Internal Revenue Service has an ongoing enforcement program that involves the audit of tax exempt bonds to determine whether an issue of bonds satisfies all of the requirements that must be met for interest on such bonds to be excludable from gross income for Federal income tax purposes. From time to time, some of the Municipal Bonds held by a Fund may be the subject of such an audit by the IRS, and the IRS may determine that the interest on such securities is includable in gross income for Federal income tax purposes either because the IRS has taken a legal position adverse to the conclusion reached by the counsel to the issuer in the tax exemption opinion or as a result of an action taken or not taken after the date of issue of such obligation.
If interest paid on a Municipal Security in which a Municipal Fund invests is determined to be taxable subsequent to its acquisition of such security, the IRS may demand that such Fund pay taxes on the affected interest income and if the Fund agrees to do so, its yield could be adversely affected. If the interest paid on any Municipal Security held by a Municipal Fund is determined to be taxable, such Fund will dispose of the security as soon as practicable.
A determination that interest on a security held by a Municipal Fund is includable in gross income for Federal or state income tax purposes retroactively to its date of issue may, likewise, cause a portion of prior distributions received by shareholders to be taxable to those shareholders in the year of receipt.
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 private activity bonds ("PABs") (or "industrial development bonds" under pre-1986 law).
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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.
PABs. 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. 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 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 that 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
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Fitch Ratings ("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 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).
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Transactions in Financial Futures Contracts.
The Municipal Funds and certain other 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.
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
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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.
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 of failing to maintain their exemptions from registration under the Investment Company Act. REITs are also subject to changes in the Code, including changes affecting their tax status.
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 certain REITs involves risks similar to those associated with investing in small capitalization companies. These 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 these 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.
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
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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 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.
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
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lend portfolio securities to Merrill Lynch, Pierce, Fenner & Smith Incorporated or its affiliates and to retain an affiliate of the Fund as lending agent.
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. 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.
A Fund may also make short sales "against the box" without being subject to the limitations imposed on other short sale transactions. 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.
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.
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
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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.
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 or "IO" security) and the other to receive the principal payments (the principal only or "PO" 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.
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.
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.
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.
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.
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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.
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.
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 that is generally based on a multiple of the premium
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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. For purposes of this restriction, the Municipal Funds generally will regard each state and each of its political subdivisions, agencies or instrumentalities and each multi-state agency of which the state is a member as a separate issuer. Each public authority that issues securities on behalf of a private entity generally will also be regarded as a separate issuer, except that if the security is backed only by the assets and revenues of a non-government entity, then the entity with the ultimate responsibility for the payment of interest and principal may be regarded as the sole 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.
MANAGEMENT AND OTHER SERVICE ARRANGEMENTS
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 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 or a portion of its assets in shares of a Master Portfolio. Feeder Funds that invest all of their assets in a Master Portfolio do not invest directly in portfolio securities and do not require management services. For such funds, all portfolio management occurs at the Master Portfolio level.
Management Fee. Each Fund has entered into a management agreement with the Manager, 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 specific fee rates for your Fund and the 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 (each a "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 any fees paid by the Manager to the Sub-Adviser pursuant to the Sub-Advisory Agreement for the Fund's last three
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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, 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. Merrill Lynch Investment Managers, LLC is a limited liability company of which MLIM is the sole member and controlling person.
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.
Other Service Arrangements
Administrative Services and Administrative Fee. Certain Funds have entered into an administration agreement (the "Administration Agreement") with an administrator identified in the Fund's prospectus and Part I of the Fund's Statement of Additional Information (each, an "Administrator"). For information regarding any administrative fees paid by your Fund to the Administrator for the periods indicated, see Part I, Section IV "Management and Advisory Arrangements" of that Fund's Statement of Additional Information.
Each Administration Agreement obligates the Administrator to provide certain administrative services to the 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 Fund. Each Administrator is also obligated to pay, or cause its affiliates to pay, the fees of those officers and Directors of the Fund who are affiliated persons of the Administrator or any of its affiliates.
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 Directors 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
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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 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 Funds Advisor (Merrill Lynch MFASM)
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. 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 Registered Public Accounting Firm. The Audit committee of each Fund, which is comprised of all of the Fund's non-interested Directors, has selected an independent registered public accounting firm for that Fund that audits the Fund's financial statements. Please see your Fund's Prospectus for information on your Fund's independent registered public accounting firm.
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 certain 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.
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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.
Selective Disclosure of Portfolio Holdings
Pursuant to policies and procedures adopted by the Fund and the Manager, the Fund and the Manager may, under certain circumstances as set forth below, make selective disclosure with respect to the Fund's portfolio holdings. The Fund's Board of Directors approved the adoption by the Fund of the policies and procedures set forth below, and has delegated to the Manager the responsibility for ongoing monitoring and supervision to ensure compliance with these policies and procedures. The Board provides ongoing oversight of the Fund's and Manager's compliance with the policies and procedures. As part of this oversight function, the Directors receive from the Fund's Chief Compliance Officer at least quarterly and more often, as necessary, reports on compliance with these polices and procedure, including reports on any violations of these policies and procedures that may occur. In addition, the Directors receive an annual assessment of the adequacy and effect of the policies and procedures with respect to the Fund, and any changes thereto, and an annual review of the operation of the policies and procedures.
Examples of the information that may be disclosed pursuant to the Fund's policies and procedures would include (but is not limited to) specific portfolio holdings - including the number of shares held, weightings of particular holdings, specific sector and industry weightings, trading details, and the Fund manager's discussion of Fund performance and reasoning for significant changes in portfolio composition. This information may be both material non-public information ("Confidential Information") and proprietary information of the firm. The Fund may disclose such information to individual investors, institutional investors, financial advisers and other financial intermediaries that sell the Fund's shares, affiliates of the Fund, third party service providers to the Fund, lenders to the Fund, and independent rating agencies and ranking organizations. The Fund, the Manager and it affiliates receive no compensation or other consideration with respect to such disclosures.
Subject to the exceptions set forth below, Confidential Information relating to the Fund may not be disclosed to persons not employed by the Manager or its affiliates unless such information has been publicly disclosed via a filing with the Commission (e.g., fund annual report), through a press release or placement on a publicly-available internet web site, including our web site at www.mutualfunds.ml.com. If the Confidential Information has not been publicly disclosed, an employee of the Manager who wishes to distribute Confidential Information relating to the Fund must first do the following: (i) require the person or company receiving the Confidential Information to sign, before the Manager will provide disclosure of any such information, a confidentiality agreement approved by an attorney in the Manager's Legal department in which he/she (a) agrees to use the Confidential Information solely in connection with a legitimate business use (i.e., due diligence, etc.) and (b) agrees not to trade on the basis of the information so provided; (ii) obtain the authorization of the an attorney in the Manager's Legal department prior to disclosure; and (iii) only distribute Confidential Information that is at least thirty (30) calendar days old unless a shorter period has specifically been approved by an attorney in the Manager's Legal department. Prior to providing any authorization for such disclosure of Confidential Information, an attorney in the Manager's Legal Department must review the proposed arrangement and make a determination that it is in the best interests of the Fund's shareholders. In connection with day-to-day portfolio management, the Fund may disclose Confidential Information to executing brokers-dealers that is less than thirty days old in order to facilitate the purchase and sale of portfolio holdings. The Fund has adopted policies and procedures, including a Code of Ethics, Code of Conduct, and various policies regarding securities trading and trade allocations, to address potential conflicts of interest that may arise in connection with disclosure of Confidential Information. These procedures are designed, among other things, to prohibit personal trading based on Confidential Information, to ensure that portfolio transactions are conducted in the best interests of each Fund and its shareholders and to prevent portfolio management from using Confidential Information for the benefit of one fund or account at the expense of another. In addition, as noted, an attorney in the Manager's Legal Department must determine that disclosure of Confidential Information is for a legitimate business purpose and is in the best interests of the Fund's shareholders, and that any conflicts of interest created by release of the Confidential Information have been addressed by the Manager's existing policies and procedures. For more
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information with respect to potential conflicts of interest, see the section entitled "Management and Other Services Arrangements - Potential Conflicts of Interest" in this Statement of Additional Information.
Confidential Information - whether or not publicly disclosed - may be disclosed to Fund Directors, the independent Directors' counsel, outside Fund counsel, the Fund's accounting services provider and the Fund's independent registered public accounting firm without meeting the conditions outlined above. Confidential Information may, with the prior approval of the Fund's Chief Compliance Officer or the Manager's General Counsel, also be disclosed to any auditor of the parties to a service agreement involving the Fund, or as required by judicial or administrative process or otherwise by applicable law or regulation. If Confidential Information is disclosed to such persons, each such person will be subject to restrictions on trading in the subject securities under either the Fund's and Manager's Code of Ethics or an applicable confidentiality agreement, or under applicable laws or regulations or court order.
The Manager has entered into ongoing arrangements to provide selective disclosure of Fund portfolio holdings to the following persons or entities:
Fund's Board of Directors
Fund's Transfer Agent
Fund's Independent Registered Public Accounting Firm
Fund's accounting services provider - State Street Bank and Trust Company
Fund Custodian
Independent Rating Agencies - Morningstar, Inc. and Lipper Inc.
Information aggregators - Wall Street on Demand and Thomson Financial
Sponsors of 401(k) plans that include MLIM/FAM-advised funds - E.I. Dupont de
Nemours and Company, Inc.
Consultants for pension plans that invest in MLIM/FAM-advised funds - Rocaton
Investment Advisors, LLC; Mercer
Investment Consulting; Watson Wyatt Investment Consulting; Towers Perrin HR
Services
Other than with respect to the Board of Directors, each of the persons or entities set forth above is subject to an agreement to keep the information disclosed confidential and to use it only for legitimate business purposes. The Board of Directors has a fiduciary duty as directors to act in the best interests of the Fund and its shareholders. Selective disclosure is made to the Fund's Board of Directors and independent registered public accounting firm at least quarterly and otherwise as frequently as necessary to enable such persons or entities to provide services to the Fund. Selective disclosure is made to the Fund's Transfer Agent, accounting services provider, and Custodian as frequently as necessary to enable such persons or entities to provide services to the Fund, typically on a daily basis. Disclosure is made to Lipper Inc. and Wall Street on Demand on a monthly basis and to Morningstar and Thomson Financial on a quarterly basis, and to each such firm upon specific request with the approval of the Manager's Legal department. Disclosure is made to 401(k) plan sponsors on a yearly basis and pension plan consultants on a quarterly basis.
The Fund and the Manager monitor, to the extent possible, the use of Confidential Information by the individuals or firms to which it has been disclosed. To do so, in addition to the requirements of any applicable confidentiality agreement and/or the terms and conditions of the Fund's and Manager's Code of Ethics and Code of Conduct - all of which require persons or entities in possession of Confidential Information to keep such information confidential and not to trade on such information for their own benefit - the Manager's compliance personnel under the supervision of the Fund's Chief Compliance Officer, monitor the Manager's securities trading desks to determine whether individuals or firms who have received Confidential Information have made any trades on the basis of that information. In addition, the Manager maintains an internal restricted list to prevent trading by the personnel of the Manager or its affiliates in securities - including securities held by the Fund - about which the Manager has Confidential Information. There can be no assurance, however, that the Fund's policies and procedures with respect to the selective disclosure of Fund portfolio holdings will prevent the misuse of such information by individuals or firms that receive such information.
Potential Conflicts of Interest
Activities of the Manager, Merrill Lynch & Co., Inc., Merrill Lynch, Pierce, Fenner & Smith Incorporated and their Affiliates (collectively, "Merrill Lynch") and Other Accounts Managed by Merrill Lynch. Merrill Lynch is a worldwide, full service investment banking, broker-dealer, asset management and financial services organization.
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As a result, Merrill Lynch (including, for these purposes, its Directors, partners, trustees, managing members, officers and employees), including the entities and personnel who may be involved in the investment activities and business operations of the Fund, is engaged in businesses and has interests other than that of managing the Fund. These are considerations of which investors in the Fund should be aware, and which may cause conflicts of interest that could disadvantage the Fund. These activities and interests include potential multiple advisory, transactional, financial and other interests in securities and other instruments, and companies that may be purchased or sold by the Fund.
Merrill Lynch and its affiliates, including, without limitation, the Manager and its advisory affiliates, have proprietary interests in, and may manage or advise with respect to, accounts or funds (including separate accounts and other funds and collective investment vehicles) that have investment objectives similar to those of the Fund and/or that engage in transactions in the same types of securities, currencies and instruments as the Fund. Merrill Lynch and its affiliates are also major participants in the global currency, equities, swap and fixed-income markets, in each case both on a proprietary basis and for the accounts of customers. As such, Merrill Lynch and its affiliates are actively engaged in transactions in the same securities, currencies, and instruments in which the Fund invests. Such activities could affect the prices and availability of the securities, currencies, and instruments in which the Fund invests, which could have an adverse impact on the Fund's performance. Such transactions, particularly in respect of most proprietary accounts or customer accounts, will be executed independently of the Fund's transactions and thus at prices or rates that may be more or less favorable than those obtained by the Fund. When the Manager and its advisory affiliates seek to purchase or sell the same assets for their managed accounts, including the Fund, the assets actually purchased or sold may be allocated among the accounts on a basis determined in their good faith discretion to be equitable. In some cases, this system may adversely affect the size or the price of the assets purchased or sold for the Fund.
The results of the Fund's investment activities may differ significantly from the results achieved by the Manager and its affiliates for their proprietary accounts or other accounts (including investment companies or collective investment vehicles) managed or advised by them. It is possible that Merrill Lynch and its affiliates and such other accounts will achieve investment results that are substantially more or less favorable than the results achieved by the Fund. Moreover, it is possible that the Fund will sustain losses during periods in which Merrill Lynch and its affiliates achieve significant profits on their trading for proprietary or other accounts. The opposite result is also possible.
The investment activities of Merrill Lynch and its affiliates for their proprietary accounts and accounts under their management may also limit the investment opportunities for the Fund in certain emerging and other markets in which limitations are imposed upon the amount of investment, in the aggregate or in individual issuers, by affiliated foreign investors.
From time to time, the Fund's activities may also be restricted because of regulatory restrictions applicable to Merrill Lynch and its affiliates, and/or their internal policies designed to comply with such restrictions. As a result, there may be periods, for example, when the Manager, and/or its affiliates, will not initiate or recommend certain types of transactions in certain securities or instruments with respect to which the Manager and/or its affiliates are performing services or when position limits have been reached.
In connection with its management of the Fund, the Manager may have access to certain fundamental analysis and proprietary technical models developed by Merrill Lynch. The Manager will not be under any obligation, however, to effect transactions on behalf of the Fund in accordance with such analysis and models. In addition, neither Merrill Lynch nor any of its affiliates will have any obligation to make available any information regarding their proprietary activities or strategies, or the activities or strategies used for other accounts managed by them, for the benefit of the management of the Fund and it is not anticipated that the Manager will have access to such information for the purpose of managing the Fund. The proprietary activities or portfolio strategies of Merrill Lynch and its affiliates or the activities or strategies used for accounts managed by them or other customer accounts could conflict with the transactions and strategies employed by the Manager in managing the Fund.
In addition, certain principals and certain employees of the Manager are also principals or employees of Merrill Lynch or its affiliated entities. As a result, the performance by these principals and employees of their obligations to such other entities may be a consideration of which investors in the Fund should be aware.
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The Manager may enter into transactions and invest in securities, instruments and currencies on behalf of the Fund in which customers of Merrill Lynch (or, to the extent permitted by the Commission, Merrill Lynch) serve as the counterparty, principal or issuer. In such cases, such party's interests in the transaction will be adverse to the interests of the Fund, and such party may have no incentive to assure that the Fund obtains the best possible prices or terms in connection with the transactions. In addition, the purchase, holding and sale of such investments by the Fund may enhance the profitability of Merrill Lynch. Merrill Lynch and its affiliates may also create, write or issue derivative instruments for customers of Merrill Lynch or its affiliates, the underlying securities, currencies or instruments of which may be those in which the Fund invests or which may be based on the performance of the Fund. The Fund may, subject to applicable law, purchase investments that are the subject of an underwriting or other distribution by Merrill Lynch or its affiliates and may also enter into transactions with other clients of Merrill Lynch or its affiliates where such other clients have interests adverse to those of the Fund. At times, these activities may cause departments of Merrill Lynch or its affiliates to give advice to clients that may cause these clients to take actions adverse to the interests of the Fund. To the extent affiliated transactions are permitted, the Fund will deal with Merrill Lynch and its affiliates on an arms-length basis.
The Fund will be required to establish business relationships with its counterparties based on the Fund's own credit standing. Neither Merrill Lynch nor its affiliates will have any obligation to allow their credit to be used in connection with the Fund's establishment of its business relationships, nor is it expected that the Fund's counterparties will rely on the credit of Merrill Lynch or any of its affiliates in evaluating the Fund's creditworthiness.
It is also possible that, from time to time, Merrill Lynch or any of its affiliates may, although they are not required to, purchase and hold shares of the Fund in order to increase the assets of the Fund. Increasing the Fund's assets may enhance investment flexibility and diversification and may contribute to economies of scale that tend to reduce the Fund's expense ratio. Merrill Lynch reserves the right to redeem at any time some or all of the shares of the Fund acquired for its own account. A large redemption of shares of the Fund by Merrill Lynch could significantly reduce the asset size of the Fund, which might have an adverse effect on the Fund's investment flexibility, portfolio diversification and expense ratio. Merrill Lynch will consider the effect of redemptions on the Fund and other shareholders in deciding whether to redeem its shares.
It is possible that the Fund may invest in securities of companies with which Merrill Lynch has or is trying to develop investment banking relationships as well as securities of entities in which Merrill Lynch makes a market. The Fund also may invest in securities of companies that Merrill Lynch provides or may someday provide research coverage. Such investments could cause conflicts between the interests of the Fund and the interests of other Merrill Lynch clients. In making investment decisions for the Fund, the Manager is not permitted to obtain or use material non-public information acquired by any division, department or affiliate of Merrill Lynch in the course of these activities. In addition, from time to time, Merrill Lynch's activities may limit the Fund's flexibility in purchases and sales of securities. When Merrill Lynch is engaged in an underwriting or other distribution of securities of an entity, the Manager may be prohibited from purchasing or recommending the purchase of certain securities of that entity for the Fund.
The Manager, its affiliates and their Directors, officers and employees, may buy and sell securities or other investments for their own accounts, and may have conflicts of interest with respect to investments made on behalf of the Fund. As a result of differing trading and investment strategies or constraints, positions may be taken by Directors, officers and employees and affiliates of the Manager that are the same, different from or made at different times than positions taken for the Fund. To lessen the possibility that the Fund will be adversely affected by this personal trading, the Fund and the Manager each has adopted a Code of Ethics in compliance with Section 17(j) of the Investment Company Act that restricts securities trading in the personal accounts of investment professionals and others who normally come into possession of information regarding the Fund's portfolio transactions. The Code of Ethics can be reviewed and copied at the SEC's Public Reference Room in Washington, D.C. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-202-942-8090. The Code of Ethics is also available on the EDGAR Database on the SEC's Internet site at http://www.sec.gov, and copies may be obtained, after paying a duplicating fee, by e-mail at publicinfo@sec.gov or by writing the SEC's Public Reference Section, Washington, DC 20549-0102.
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The Manager and its affiliates will not purchase securities or other property from, or sell securities or other property to, the Fund, except that the Fund may in accordance with rules adopted under the Investment Company Act engage in transactions with accounts that are affiliated with the Fund as a result of common officers, Directors, or investment advisers. These transactions would be effected in circumstances in which the Manager determined that it would be appropriate for the Fund to purchase and another client to sell, or the Fund to sell and another client to purchase, the same security or instrument on the same day.
Present and future activities of Merrill Lynch, including the Manager, in addition to those described in this section, may give rise to additional conflicts of interest.
PURCHASE OF SHARES
Each Fund offers multiple classes of shares under the Merrill Lynch Select Pricing(SM) System("Select Pricing 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."
The Select Pricing System is used by more than 50 registered investment companies advised by the Managers. Funds that use the Select Pricing System are referred to herein as "Select Pricing Funds."
The applicable offering price for purchase orders is based on the net asset value of the Fund next determined after receipt of the purchase order by a dealer or other financial intermediary ("Selling Dealer") that has been authorized by the Distributor by contract to accept such orders. As to purchase orders received by Selling Dealers prior to the close of business on the New York Stock Exchange ("NYSE") (generally, the NYSE closes at 4:00 p.m. Eastern time), on the day the order is placed, which includes orders received after the close of business on the previous day, the applicable offering price is based on the net asset value determined as of the close of business on the NYSE on that day. If the purchase orders are not received by the Selling Dealer before the close of business on the NYSE, such orders are deemed received on the next business day.
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 nor other financial intermediaries are permitted to withhold placing orders to benefit themselves by a price change.
The term "purchase," as used in the Prospectus and this Statement of Additional Information refers to (i) a single purchase by an individual, (ii) concurrent purchases 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.
Class I Shares
Class I shares may be purchased at net asset value without a sales charge. Only certain investors are eligible to purchase Class I shares. Investors who are eligible to purchase Class I shares should purchase Class I shares because they are not subject to any sales charge and have lower ongoing expenses than Class A, Class B, Class C or Class R shares.
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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. A Fund realizes economies of scale and reduction of sales-related expenses by virtue of the familiarity of these persons with the Fund. Employees, Directors, and Board members of other funds wishing to purchase shares of a Fund must satisfy the Fund's suitability standards.
Initial Sales Charge Alternatives -- Class A Shares
Investors who prefer an initial sales charge alternative may elect to purchase Class A 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 who do not qualify for reduced initial sales charges and who expect to maintain their investment for an extended period of time also may elect to purchase Class A shares, because over time the accumulated ongoing account maintenance and distribution fees on Class B, Class C or Class R shares may exceed the Class A initial sales charge and 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 that 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.
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 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, certain other trusts managed by banks, thrifts or trust companies, 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 and to employees or customers of selected securities dealers that meet certain qualifications. Class I shares of Bond Fund are also available at net asset value to institutional investors that purchase more than $50 million of that Fund's shares. 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."
See Part I, Section V "Information on Sales Charges and Distribution Related Expenses -- Class A Sales Charge Information" of each Fund's Statement of Additional Information for information about amounts paid to the Distributor in connection with Class A 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
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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 in 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.
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 shares of a Fund or any other Select Pricing Funds made within a 13 month period pursuant to a Letter of Intent. 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 shares. If you bought Class A 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 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 shares equal to at least 5% 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% 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 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, purchases 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 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.
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Class A 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.
Purchase Privileges of Certain Persons. Class A shares are available at net asset value to investors that, for regulatory reasons, are required to transfer investment positions from a non-U.S. registered investment company advised by MLIM, FAM or their affiliates to a U.S. registered MLIM/FAM-advised 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 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 and other financial intermediaries 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 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.
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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 schedule that applies to the Class B CDSC for all Funds except Bond Fund - Intermediate Term Portfolio, Municipal Bond - Limited Maturity Portfolio, and Municipal Intermediate Term:
CDSC as a Percentage
Years Since Purchase Of Dollar Amount
Payment Made 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 schedule that applies to the Class B1 CDSC for Short Term U.S. Government and the Class B CDSC for Bond Fund - Intermediate Term Portfolio, Municipal Bond - Limited Maturity Portfolio, and Municipal Intermediate Term:
CDSC as a Percentage
Years Since Purchase Of Dollar Amount
Payment Made Subject to Charge +
------------ -------------------
0-1 1.0%
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 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-
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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 of up to 10% per year of your Class B account value at the time the plan is established, or on redemptions made in connection with the payment of account custodial fees.. 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, in the past, issued stock certificates and you hold such 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.
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
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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 or on redemptions made in connection with the payment of account custodial fees. 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% per year and an ongoing account maintenance fee of 0.25% per year. Distribution fees are used to support the Fund's marketing and distribution efforts, such as compensating 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.
Redemption Fee
Certain Funds charge a 2.00% redemption fee on the proceeds (calculated at market value) of a redemption (either by sale or exchange) of Fund shares made within 30 days of purchase. The redemption fee is paid to the Fund and is intended to offset the trading costs, market impact and other costs associated with short-term trading into and out of the Fund. The redemption fee is imposed to the extent that the number of Fund shares redeemed within 30 days exceeds the number of Fund shares that have been held for more than 30 days. For redemptions of Fund shares acquired by exchange, your holding period for the shares exchanged will not be tacked on to the holding period for the Fund shares acquired in determining whether to apply the redemption fee. The redemption fee will not apply in the following circumstances:
o Redemptions resulting from death or disability
o Redemptions through a Systematic Withdrawal Plan
o Redemptions of shares purchased through an Automatic Investment Plan
o Redemptions of shares acquired through dividend reinvestment
o Redemptions of shares held in certain omnibus accounts, including
retirement plans qualified under Sections 401(a) or 401(k) of the Internal
Revenue Code of 1986, as amended, or plans administered as college savings
plans under Section 529 of the Internal Revenue Code
o Redemptions of shares held through advisory fee-based programs that the
Distributor determines are not designed to facilitate short-term trading
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
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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 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 a 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 advisers 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
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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 adviser 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.
Other Compensation to Selling Dealers.
The Manager, the Distributor and their affiliates, at their expense, currently provide additional compensation to certain financial intermediaries that make Fund shares available to their customers. With respect to affiliates of the Manager or the Distributor, including Merrill Lynch, Pierce, Fenner & Smith Incorporated, such compensation may be in the form of payments or intercompany transfers.
The amount of payments made to a financial intermediary in any given year will vary based on the amount of the previous year's fund sales by a financial intermediary and/or the amount of assets attributable to a financial intermediary. These payments help defray the costs incurred by financial intermediaries for, among other things, providing marketing and other services intended to assist in the offer and sale of Fund shares, for shareholder servicing activities, and/or for sub-transfer agency services provided to individual shareholders where a financial intermediary maintains omnibus accounts with the Fund's Transfer Agent.
As of the date of this Statement of Additional Information, the financial intermediaries that the Distributor anticipates will receive additional payments include:
ADP Broker Dealer Inc.
AIG Valic Retirement Services
American Express /Ameriprise Financial
American Skandia Advisory Services
Amvescap Services, Inc. Retirement Services
AST
AXA Advisors
Bear Stearns
Bisys
BMO Nesbitt Burns Co.
Boston Financial Data Services, Inc. (BFDS)
Brown Brothers Harriman Co.
Ceridian Retirement Plan Services
Charles Schwab & Co., Inc.
Chicago Mercantile Exchange
Citigroup Global Markets
Citistreet, LLC
CNS Distributors, Inc.
Columbia Funds Distributor, Inc.
Edgwood Services / Federated Trust
Fascorp/GWFS Equities Inc
Federated Edgewood Services, Inc.
Fidelity Brokerage Services, LLC/National Financial
Fidelity Investment Retirement Services
Fidelity Investments Institutional Operations Company, Inc.
First Trust - Datalynx
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First Trust - Trustlynx
Fiserv Securities, Inc.
Great West/Benefits Corp
Hand Benefits & Trust Company
Hartford Life Insurance Company
Hewitt Services, LLC
HSBC Bank USA (Fedders) Services
ICMA-RC Services LLC
Invesmart
Janney Montgomery Scott
JP Morgan Retirement Services
LPL
M&I Trust
Manulife Financial Group
Manulife/John Hancock
Matrix
Mercer (Putnam)
Merrill Lynch, Pierce, Fenner & Smith Incorporated
Metlife Securities
MFS Investment Services
MidAtlantic Capital Corporation
MSCS Financial Services, LLC
National Investor Services Corp.
Nationwide Financial Services, Inc.
Pershing, LLC
PFPC/WySTAR
PNC
Prudential Investment Management Services
Prudential Securities, Inc.
Putnam Fiduciary Trust Company
RBC Dain Rauscher, Inc.
Salomon Smith Barney, Inc.
SEI
Sungard
T. Rowe Price Retirement Plans Services Inc.
TC Advisors
Trust Company of America
UBS
US Asset Management, LLC
US Bancorp/US Bank National Association
US Bank
US Clearing
USAA
Vining Sparks
Wachovia Bank NA
Wachovia Securities
Wells Fargo NA Institutional Investments
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) 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
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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 circumstances, 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 or redemption fee 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 such shares 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 you hold share certificates issued by your Fund, 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,
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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.
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 normally will accept orders to repurchase shares from Selling Dealers for their customers. Shares will be priced at the net asset value of the Fund next determined after receipt of the repurchase order by a Selling Dealer that has been authorized by the Distributor by contract to accept such orders. As to repurchase orders received by Selling Dealers prior to the close of business on the NYSE (generally, the NYSE closes at 4:00 p.m. Eastern time), on the day the order is placed, which includes orders received after the close of business on the previous day, the repurchase price is the net asset value determined as of the close of business on the NYSE on that day. If the orders for repurchase are not received by the Selling Dealer before the close of business on the NYSE, such orders are deemed received on the next business day.
These repurchase arrangements are for your convenience and do not involve a charge by the Fund (other than any applicable CDSC or redemption fee). 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 Shares
If you redeemed Class A or Class I shares of a Fund, you may reinstate your account by buying Class A shares 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 financial adviser or other financial intermediary 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
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number on the cover page, or from the Distributor, your financial adviser, 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 make additions to it at any time by mailing a check directly to the Transfer Agent. You may also maintain an account through a selected securities dealer or other financial intermediary. If you transfer shares out of 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 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 one selected securities dealer 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 the original selected securities dealer 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 money market fund advised by FAM 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.
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 I shares outstanding ("outstanding Class I shares") for Class I shares of a second Select Pricing Fund, or for Class A shares of Summit ("new Class I shares") are effected on the basis of relative net asset value per Class I share. Exchanges of Class A shares outstanding ("outstanding Class A shares") for Class A shares of a second Select Pricing Fund, or for Class A shares of Summit ("new Class A shares") are effected on the basis of relative net asset value per Class A share plus an amount equal to the difference, if any, between the sales charge previously paid on the exchanged Class A shares and the sales charge payable at the time of the exchange on the new Class A shares. With respect to outstanding Class A shares received in a previous exchange, the "sales charge
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previously paid" will include the aggregate of the sales charges paid with respect to such Class A shares in the initial purchase and any subsequent exchange. Class A 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 shares on which the dividend was paid. Based on this formula, Class A shares of a Fund generally may be exchanged into the Class A shares of a second fund with a reduced sales charge or without a sales charge. If you held the outstanding Class A or Class I shares used in the exchange for 30 days or less, you may also be charged a redemption fee at the time of the exchange.
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 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. If you held the outstanding Class B or Class C shares used in the exchange for 30 days or less, you may also be charged a redemption fee at the time of the exchange.
Exchanges for Shares of a Money Market Fund. You may exchange Class A and Class I shares of a Fund 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 financial advisor or other financial intermediary for further information.
Prior to October 12, 1998, exchanges from certain Select Pricing Funds into a money market fund were directed to certain money market funds advised by the Manager 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.
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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 the Manager, an affiliate of the Manager, or selected securities dealers or other financial intermediaries that have an agreement with the Distributor. See "Fee-Based Programs" below.
Exercise of the Exchange Privilege. To exercise the exchange privilege, you should contact your financial adviser, who will advise each Fund of the exchange. If you do not hold 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 1-800-637-3863
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.
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 the Manager or its affiliates of a selected securities dealer or other financial intermediaries that has an agreement with the Distributor, 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. Shareholders that participate in a fee based program generally have two options at termination. The program can be terminated and the shares liquidated or the program can be terminated and the shares held in an account. In general, when shares are held whatever share class was held in the program can be held after termination. Shares that have been held for less than specified periods within the program may be subject to a fee upon redemption. Shareholders that held Class A or Class I shares in the program are eligible to purchase additional shares of the respective share class of the fund, but purchase of Class A shares may be subject to upfront sales charges. Additional purchases of Class I shares are eligible only if you have an existing position at the time of purchase or are otherwise eligible for Class I shares.
Retirement and Education Savings Plans
Individual retirement accounts and other retirement and education savings plans are available from your financial intermediary. Under these plans, investments may be made in a Fund (other than a Municipal Fund) and certain of the other mutual funds sponsored by MLIM or its affiliates 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 your financial intermediary.
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
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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 cash management account you may arrange to have periodic investments made in a Fund. Contact your financial intermediary for more information.
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 (1-800-637-3863). For other accounts, you should contact your financial adviser, 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 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 that have 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 financial advisor or other financial intermediary.
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
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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 cash management account or retirement account you may elect to have shares redeemed on a periodic basis as determined by the program. 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. A systematic redemption program may not be available if Fund shares are being purchased within the account pursuant to the automatic investment program. For more information shareholders should contact their financial adviser or other financial intermediary.
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.
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Securities that are held by a Fund that are traded on stock exchanges or the NASDAQ National Market are valued at the last sale price or official close price on the exchange, 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 equity 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 Directors of the Fund. Long positions 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 Directors of the Fund. Short positions 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.
Options written are valued at 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 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. Swap agreements are valued daily based upon quotations from market makers. Financial futures contracts and options thereon, which are traded on exchanges, are valued at their last sale price as of the close of such exchanges. Obligations with remaining maturities of 60 days or less are valued at amortized cost unless the Manager believes that this method no longer produces fair valuations.
Repurchase agreements are valued at cost plus accrued interest. Each Fund employs pricing services to provide certain 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 Board of 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 Fund's Board of Directors. Such valuations and procedures will be reviewed periodically by the Board of Directors of the Fund.
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 (for example, a company announcement, market volatility or a natural disaster) occur during such periods that are expected to materially affect the value of such securities, those securities may be valued at their fair value as determined in good faith by a Fund's Board of Directors or by the Manager using a pricing service and/or procedures approved by a Fund's 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, which 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.
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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.
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 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 generally invests 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 pay with 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.
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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).
The Manager does not consider sales of shares of the mutual funds it advises as a factor in the selection of brokers or dealers to execute portfolio transactions for a Fund; however, whether or not a particular broker or dealer sells shares of the mutual funds advised by the Manager neither qualifies nor disqualifies such broker or dealer to execute transactions for those mutual funds.
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 a 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 have 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
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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 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.
Portfolio Turnover
While a Fund generally does not expect to engage in trading for short term gains, it will effect portfolio transactions without regard to holding period if, in Fund management's judgment, such transactions are advisable in light of a change in circumstances of a particular company or within a particular industry or in general market, economic or financial conditions. The portfolio turnover rate is calculated by dividing the lesser of a Fund's annual sales or purchases of portfolio securities (exclusive of purchases or sales of U.S. government securities and all other securities whose maturities at the time of acquisition were one year or less) by the monthly average value of the securities in the portfolio during the year. A high rate of portfolio turnover results in certain tax consequences, such
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as increased capital gain dividends and/or ordinary income dividends and in correspondingly greater transaction costs in the form of dealer spreads and brokerage commissions, which are borne directly by a Fund.
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.
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 (as determined under U.S. Federal income tax principles) to its shareholders would be taxable as ordinary dividend income eligible for the maximum 15% tax rate for non-corporate shareholders and the dividends-received deduction for corporate shareholders. However, a Municipal Fund's distributions derived from income on tax-exempt obligations, as defined herein, would no longer qualify for treatment as exempt interest.
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.
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General Treatment of Fund Shareholders
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. Certain dividend income and long term capital gain are eligible for taxation at a reduced rate applicable to non-corporate shareholders for taxable years ending in or prior to 2008. Under these new rules, a certain portion of ordinary income dividends constituting "qualified dividend income" when paid by a RIC to non-corporate shareholders may be taxable to such shareholders at long term capital gain rates. However, to the extent a Fund's distributions are derived from income on debt securities, certain types of preferred stock treated as debt for federal income tax purposes and short-term capital gain, such distributions will not constitute "qualified dividend income." Thus, ordinary income dividends paid by the Funds generally will not be eligible for taxation at the reduced rates.
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 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
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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"). Backup withholding may also be required on distributions paid by a Municipal Fund, unless such Fund reasonably estimates that at least 95% of its distributions during the taxable year are comprised of exempt-interest dividends. 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. Backup withholding is not an additional tax. Any amount withheld generally may be allowed as a refund or a credit against a shareholder's Federal income tax liability provided that the required information is timely forwarded to the Internal Revenue Service.
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. Further, to the extent that a Fund engages in securities lending with respect to a security paying income subject to foreign taxes, it may not be able to pass through to its shareholders the ability to take a foreign tax credit. 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 non-corporate 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.
Certain transactions entered into by the Funds are subject to special tax rules of the Code that may, among other things, (a) affect the character of gains and losses realized, (b) 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 RICs under the Code.
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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. However, 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 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.
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 after the close of the 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
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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. 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.
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 shares and the CDSC that would be applicable to a complete
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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 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 applicable marginal individual Federal 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 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 applicable marginal individual Federal 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.
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.
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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 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 Inc. ("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.
PROXY VOTING POLICIES AND PROCEDURES
Each Fund's Board of Directors has delegated to the Manager authority to vote all proxies relating to the Fund's portfolio securities. The Manager has adopted policies and procedures ("Proxy Voting Procedures") with respect to the voting of proxies related to the portfolio securities held in the account of one or more of its clients, including a Fund. Pursuant to these Proxy Voting Procedures, the Manager's primary objective when voting proxies is to make proxy voting decisions solely in the best interests of each Fund and its shareholders, and to act in a manner that the Manager believes is most likely to enhance the economic value of the securities held by the Fund. The Proxy Voting Procedures are designed to ensure that that the Manager considers the interests of its clients, including the Funds, and not the interests of the Manager, when voting proxies and that real (or perceived) material conflicts that may arise between the Manager's interest and those of the Manager's clients are properly addressed and resolved.
In order to implement the Proxy Voting Procedures, the Manager has formed a Proxy Voting Committee (the "Committee"). The Committee is comprised of the Manager's Chief Investment Officer (the "CIO"), one or more other senior investment professionals appointed by the CIO, portfolio managers and investment analysts appointed by the CIO and any other personnel the CIO deems appropriate. The Committee will also include two non-voting representatives from the Manager's legal department appointed by the Manager's General Counsel. The Committee's membership shall be limited to full-time employees of the Manager. No person with any investment banking, trading, retail brokerage or research responsibilities for the Manager's affiliates may serve as a member of the Committee or participate in its decision making (except to the extent such person is asked by the Committee to present information to the Committee, on the same basis as other interested knowledgeable parties not affiliated with the Manager might be asked to do so). The Committee determines how to vote the proxies of all clients, including a
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Fund, that have delegated proxy voting authority to the Manager and seeks to ensure that all votes are consistent with the best interests of those clients and are free from unwarranted and inappropriate influences. The Committee establishes general proxy voting policies for the Manager and is responsible for determining how those policies are applied to specific proxy votes, in light of each issuer's unique structure, management, strategic options and, in certain circumstances, probable economic and other anticipated consequences of alternate actions. In so doing, the Committee may determine to vote a particular proxy in a manner contrary to its generally stated policies. In addition, the Committee will be responsible for ensuring that all reporting and recordkeeping requirements related to proxy voting are fulfilled.
The Committee may determine that the subject matter of a recurring proxy issue is not suitable for general voting policies and requires a case-by-case determination. In such cases, the Committee may elect not to adopt a specific voting policy applicable to that issue. The Manager believes that certain proxy voting issues require investment analysis - such as approval of mergers and other significant corporate transactions - akin to investment decisions, and are, therefore, not suitable for general guidelines. The Committee may elect to adopt a common position for the Manager on certain proxy votes that are akin to investment decisions, or determine to permit the portfolio manager to make individual decisions on how best to maximize economic value for a Fund (similar to normal buy/sell investment decisions made by such portfolio managers). While it is expected that the Manager will generally seek to vote proxies over which the Manager exercises voting authority in a uniform manner for all the Manager's clients, the Committee, in conjunction with a Fund's portfolio manager, may determine that the Fund's specific circumstances require that its proxies be voted differently.
To assist the Manager in voting proxies, the Committee has retained Institutional Shareholder Services ("ISS"). ISS is an independent adviser that specializes in providing a variety of fiduciary-level proxy-related services to institutional investment managers, plan sponsors, custodians, consultants, and other institutional investors. The services provided to the Manager by ISS include in-depth research, voting recommendations (although the Manager is not obligated to follow such recommendations), vote execution, and recordkeeping. ISS will also assist the Fund in fulfilling its reporting and recordkeeping obligations under the Investment Company Act.
The Manager's Proxy Voting Procedures also address special circumstances that can arise in connection with proxy voting. For instance, under the Proxy Voting Procedures, the Manager generally will not seek to vote proxies related to portfolio securities that are on loan, although it may do so under certain circumstances. In addition, the Manager will vote proxies related to securities of foreign issuers only on a best efforts basis and may elect not to vote at all in certain countries where the Committee determines that the costs associated with voting generally outweigh the benefits. The Committee may at any time override these general policies if it determines that such action is in the best interests of a Fund.
From time to time, the Manager may be required to vote proxies in respect of an issuer where an affiliate of the Manager (each, an "Affiliate"), or a money management or other client of the Manager, including investment companies for which the Manager provides investment advisory, administrative and/or other services (each, a "Client") is involved. The Proxy Voting Procedures and the Manager's adherence to those procedures are designed to address such conflicts of interest. The Committee intends to strictly adhere to the Proxy Voting Procedures in all proxy matters, including matters involving Affiliates and Clients. If, however, an issue representing a non-routine matter that is material to an Affiliate or a widely known Client is involved such that the Committee does not reasonably believe it is able to follow its guidelines (or if the particular proxy matter is not addressed by the guidelines) and vote impartially, the Committee may, in its discretion for the purposes of ensuring that an independent determination is reached, retain an independent fiduciary to advise the Committee on how to vote or to cast votes on behalf of the Manager's clients.
In the event that the Committee determines not to retain an independent fiduciary, or it does not follow the advice of such an independent fiduciary, the Committee may pass the voting power to a subcommittee, appointed by the CIO (with advice from the Secretary of the Committee), consisting solely of Committee members selected by the CIO. The CIO shall appoint to the subcommittee, where appropriate, only persons whose job responsibilities do not include contact with the Client and whose job evaluations would not be affected by the Manager's relationship with the Client (or failure to retain such relationship). The subcommittee shall determine whether and how to vote all proxies on behalf of the Manager's clients or, if the proxy matter is, in their judgment, akin to an investment decision, to defer to the applicable portfolio managers, provided that, if the subcommittee determines to alter the
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Manager's normal voting guidelines or, on matters where the Manager's policy is case-by-case, does not follow the voting recommendation of any proxy voting service or other independent fiduciary that may be retained to provide research or advice to the Manager on that matter, no proxies relating to the Client may be voted unless the Secretary, or in the Secretary's absence, the Assistant Secretary of the Committee concurs that the subcommittee's determination is consistent with the Manager's fiduciary duties.
In addition to the general principles outlined above, the Manager has adopted voting guidelines with respect to certain recurring proxy issues that are not expected to involve unusual circumstances. These policies are guidelines only, and the Manager may elect to vote differently from the recommendation set forth in a voting guideline if the Committee determines that it is in a Fund's best interest to do so. In addition, the guidelines may be reviewed at any time upon the request of a Committee member and may be amended or deleted upon the vote of a majority of Committee members present at a Committee meeting at which there is a quorum.
The Manager has adopted specific voting guidelines with respect to the following proxy issues:
o Proposals related to the composition of the Board of Directors of issuers other than investment companies. As a general matter, the Committee believes that a company's Board of Directors (rather than shareholders) is most likely to have access to important, nonpublic information regarding a company's business and prospects, and is therefore best-positioned to set corporate policy and oversee management. The Committee, therefore, believes that the foundation of good corporate governance is the election of qualified, independent corporate directors who are likely to diligently represent the interests of shareholders and oversee management of the corporation in a manner that will seek to maximize shareholder value over time. In individual cases, the Committee may look at a nominee's number of other directorships, history of representing shareholder interests as a director of other companies or other factors, to the extent the Committee deems relevant.
o Proposals related to the selection of an issuer's independent auditors. As a general matter, the Committee believes that corporate auditors have a responsibility to represent the interests of shareholders and provide an independent view on the propriety of financial reporting decisions of corporate management. While the Committee will generally defer to a corporation's choice of auditor, in individual cases, the Committee may look at an auditors' history of representing shareholder interests as auditor of other companies, to the extent the Committee deems relevant.
o Proposals related to management compensation and employee benefits. As a general matter, the Committee favors disclosure of an issuer's compensation and benefit policies and opposes excessive compensation, but believes that compensation matters are normally best determined by an issuer's board of directors, rather than shareholders. Proposals to "micro-manage" an issuer's compensation practices or to set arbitrary restrictions on compensation or benefits will, therefore, generally not be supported.
o Proposals related to requests, principally from management, for approval of amendments that would alter an issuer's capital structure. As a general matter, the Committee will support requests that enhance the rights of common shareholders and oppose requests that appear to be unreasonably dilutive.
o Proposals related to requests for approval of amendments to an issuer's charter or by-laws. As a general matter, the Committee opposes poison pill provisions.
o Routine proposals related to requests regarding the formalities of corporate meetings.
o Proposals related to proxy issues associated solely with holdings of investment company shares. As with other types of companies, the Committee believes that a fund's Board of Directors (rather than its shareholders) is best positioned to set fund policy and oversee management. However, the Committee opposes granting Boards of Directors authority over certain matters, such as changes to a fund's investment objective, which the Investment Company Act envisions will be approved directly by shareholders.
o Proposals related to limiting corporate conduct in some manner that relates to the shareholder's environmental or social concerns. The Committee generally believes that annual shareholder meetings are inappropriate
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forums for discussion of larger social issues, and opposes shareholder resolutions "micromanaging" corporate conduct or requesting release of information that would not help a shareholder evaluate an investment in the corporation as an economic matter. While the Committee is generally supportive of proposals to require corporate disclosure of matters that seem relevant and material to the economic interests of shareholders, the Committee is generally not supportive of proposals to require disclosure of corporate matters for other purposes.
Information about how a Fund voted proxies relating to securities held in the Fund's portfolio during the most recent 12-month period ended June 30 is available without charge (1) at www.mutualfunds.ml.com and (2) on the Commission's web site at http://www.sec.gov.
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 that bears distribution and/or 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 such 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.
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.
Certain Funds are organized as Delaware statutory trusts.
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.
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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.
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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.
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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.
Description of Moody's U.S. Short-Term Ratings
MIG 1/VMIG 1 This designation denotes superior credit quality.
Excellent protection is afforded by established cash flows,
highly reliable liquidity support, or demonstrated
broad-based access to the market for refinancing.
MIG 2/VMIG 2 This designation denotes strong credit quality.
Margins of protection are ample, although not as large as in
the preceding group.
MIG 3/VMIG 3 This designation denotes acceptable credit quality.
Liquidity and cash-flow protection may be narrow, and market
access 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.
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Description of Moody's Commercial Paper Ratings / Demand Obligation 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:
P-1 Issuers (or supporting institutions) rated Prime-1 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.
P-2 Issuers (or supporting institutions) rated Prime-2 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.
P-3 Issuers (or supporting institutions) rated Prime-3 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 (or supporting institutions) rated Not Prime do not fall
within any of the Prime rating categories.
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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.
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
B as having significant speculative B characteristics. "BB"
CCC indicates the least degree of speculation and "C" the highest
CC degree of speculation. While such debt will likely have some
C quality and protective characteristics, these may be outweighed
by large uncertainties or major risk exposures to adverse
conditions.
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.
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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
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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 that 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
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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
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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.
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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.
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
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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 that, 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.
DD Such bonds are extremely speculative and should be valued on
DDD the basis of their ultimate recovery value in liquidation
or reorganization of the obligor. "DDD" represents the highest
potential for recovery on these bonds, and "D" represents the
lowest potential for recovery.
Plus (+) 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.
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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
characteristics 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.
PART C. OTHER INFORMATION
Item 23. Financial Statements and Exhibits.
Exhibit Number Description ------ ----------- |
1(a)--Articles of Incorporation, dated September 30, 1976.(a)
(b)--Articles of Amendment, dated October 4, 1976.(a)
(c)--Articles of Amendment changing the name of the Registrant, dated April
22, 1977.(a)
(d)--Articles of Amendment increasing the number of shares of authorized
capital stock, dated September 21, 1979.(a)
(e)--Articles of Amendment increasing the number of shares of authorized
capital stock, dated June 11, 1984.(a)
(f)--Articles of Amendment increasing the number of shares of authorized
capital stock, dated January 28, 1987.(a)
(g)--Articles of Amendment increasing the number of shares of authorized
capital stock, dated March 2, 1987.(a)
(h)--Articles of Amendment reclassifying shares of common stock, dated
September 30, 1988.(a)
(i)--Articles Supplementary to the Articles of Incorporation increasing the
number of shares of authorized capital stock, dated May 21, 1990.(a)
(j)--Articles Supplementary to the Articles of Incorporation reclassifying
shares of common stock, dated June 21, 1991.(a)
(k)--Articles Supplementary to the Articles of Incorporation increasing the
number of shares of authorized capital stock, dated October 18,
1994.(a)
(l)--Articles of Amendment, dated October 21, 1994.(a)
(m)--Articles of Amendment to Articles Supplementary renaming issued and
outstanding shares of capital stock, dated October 4, 2001.(b)
(n)--Articles of Amendment designating Class A Common Stock into Class I
Common Stock and Class D Common Stock into Class A Common Stock,
dated March 21, 2003.(c)
(o)--Articles Supplementary to Articles of Incorporation increasing the
authorized capital stock and reclassifying shares of authorized
common stock, dated March 10, 2006.
2 --Amended and Restated By-Laws, dated April 14, 2003.(a)
3 --Inapplicable.
4(a)--Form of Investment Advisory Agreement between Registrant and Fund
Asset Management, L.P. ("FAM").(a)
(b)--Supplement to Investment Advisory Agreement between Registrant and
FAM, dated January 3, 1994.(a)
(c)--Form of Investment Advisory Agreement between Registrant, on behalf of
High Yield Portfolio, and FAM.*
5 --Form of Unified Distribution Agreement between Registrant and FAM
Distributors, Inc. (the "Distributor").(d)
6 --Inapplicable.
7 --Form of Custodian Agreement between Registrant and The Bank of New
York, dated October 26, 2001.(e)
8(a)--Form of Unified Transfer Agency, Dividend Disbursing Agency and
Shareholder Servicing Agency Agreement between the Registrant and
Financial Data Services, Inc.(f)
(b)(1)--Amended and Restated Credit Agreement between the Registrant and a
syndicate of banks.(g)
(b)(2)--Form of Second Amended and Restated Credit Agreement among the
Registrant, a syndicate of banks and certain other parties.(h)
(b)(3)--Form of Third Amended and Restated Credit Agreement among the
Registrant, a syndicate of banks and certain other parties.(i)
(b)(4)--Form of Fourth Amended and Restated Credit Agreement among the
Registrant, a syndicate of banks and certain other parties.(j)
(b)(5)--Form of Fifth Amended and Restated Credit Agreement among the
Registrant, a syndicate of banks and certain other parties.(k)
(b)(6)--Form of Sixth Amended and Restated Credit Agreement among the
Registrant, a syndicate of banks and certain other parties. (l)
(c)--Form of Administrative Services Agreement between the Registrant and
State Street Bank and Trust Company.(m)
9(a)--Opinion and Consent of Rogers & Wells LLP.(n)
(b)--Opinion of Sidley Austin LLP.*
10 --Consent of ____________, independent registered public accounting firm
for the Registrant.*
11 --Inapplicable.
12(a)--Letter from Fund Asset Management, Inc. with respect to the purchase
of 10,257 shares of Registrant's Common Stock.(o)
(b)--Letter from Fund Asset Management, L.P. with respect to the purchase
of shares of Registrant's Class C and Class D Common Stock of the
Insured Portfolio.(p)
(c)--Letter from Fund Asset Management, L.P. with respect to the purchase
of shares of Registrant's Class C and Class D Common Stock of the
National Portfolio.(p)
(d)--Letter from Fund Asset Management, L.P. with respect to the purchase
of shares of Registrant's Class C and Class D Common Stock of the
Short-Term Portfolio.(p)
13(a)--Form of Amended and Restated Class A Distribution Plan of
Registrant.(q)
(b)--Form of Amended and Restated Class B Distribution Plan.(r)
(c)--Form of Amended and Restated Class C Distribution Plan.(r)
14 --Merrill Lynch Select Pricing System Plan pursuant to Rule 18f-3.(q)
15 --Code of Ethics.(s)
16 --Power of Attorney.(t)
* To be filed by subsequent amendment.
(a) Filed on October 4, 2004 as an Exhibit to Post-Effective Amendment No. 30
to the Registrant's Registration Statement on Form N-1A (File No.
2-57354) (the "Registration Statement").
(b) Filed on October 14, 2003 as Exhibit 1(e) to Post-Effective Amendment No.
29 to the Registration Statement.
(c) Filed on October 14, 2003 as Exhibit 1(f) to Post-Effective Amendment No.
29 to the Registration Statement.
(d) Incorporated by reference to Exhibit 5 to Post-Effective Amendment No. 27
to the Registration Statement on Form N-1A of Merrill Lynch Bond Fund,
Inc. (File No. 2-62329), filed on December 15, 2000.
(e) Incorporated by reference to Exhibit 7 to Post-Effective Amendment No. 13
to the Registration Statement on Form N-1A of The Asset Program, Inc.
(File No. 33-53887), filed on March 21, 2002.
(f) Incorporated by reference to Exhibit 8(a)(1) to Post-Effective Amendment
No. 35 to the Registration Statement on Form N-1A of Merrill Lynch Bond
Fund, Inc. (File No. 2-62329), filed on January 14, 2005.
(g) Incorporated by reference to Exhibit (b) to the Issuer Tender Offer
Statement on Schedule TO of Merrill Lynch Senior Floating Rate Fund, Inc.
(File No. 333-15973), filed on December 14, 2000.
(h) Incorporated by reference to Exhibit (b)(2) to the Issuer Tender Offer
Statement on Schedule TO of Merrill Lynch Senior Floating Rate Fund, Inc.
(File No. 333-39837), filed on December 14, 2001.
(i) Incorporated by reference to Exhibit (b)(3) to the Issuer Tender Offer
Statement on Schedule TO of Merrill Lynch Senior Floating Rate Fund, Inc.
(File No. 333-39837), filed on December 13, 2002.
(j) Incorporated by reference to Exhibit 8(c)(4) to Post-Effective Amendment
No. 8 to the Registration Statement on Form N-1A of Merrill Lynch Global
Growth Fund, Inc. (File No. 333-32899), filed on December 4, 2003.
(k) Incorporated by reference to Exhibit 8(c)(5) to Post-Effective Amendment
No. 35 to the Registration Statement on Form N-1A of Merrill Lynch Bond
Fund, Inc. (File No. 2-62329), filed on January 14, 2005.
(l) Incorporated by reference to Exhibit 8(b)(6) to Post-Effective Amendment
No. 24 to the Registration Statement on Form N-1A of Merrill Lynch U.S.
Government Fund (File No. 2-92366), filed on December 21, 2005.
(m) Incorporated by reference to Exhibit 8(d) to Post-Effective Amendment No.
1 to the Registration Statement on Form N-1A of Merrill Lynch Focus
Twenty Fund, Inc. (File No. 333-89775), filed on March 20, 2001.
(n) Filed on October 29, 1999 as Exhibit 9 to Post-Effective Amendment No. 25
to the Registrant's Registration Statement.
(o) Filed on August 10, 1979 as Exhibit 13 to Post-Effective Amendment No. 3
to the Registrant's Registration Statement.
(p) Filed on October 31, 1995 as Exhibit 13 to Post-Effective Amendment No.
20 to the Registrant's Registration Statement.
(q) Incorporated by reference to Exhibit 13(a) and 14 to Post-Effective
Amendment No. 36 to the Registration Statement on Form N-1A of Merrill
Lynch Pacific Fund, Inc. (File No. 2-56978), filed on April 17, 2003.
(r) Incorporated by reference to Exhibit 13 to Post-Effective Amendment No.
10 to the Registration Statement on Form N-1A of Merrill Lynch Emerging
Markets Debt Fund, Inc. (File No. 33-64398), filed on June 21, 2000.
(s) Incorporated by reference to Exhibit 15 to Pre-Effective Amendment No. 1
to the Registration Statement on Form N-1A of Merrill Lynch Inflation
Protected Fund (File No. 333-110936), filed on January 22, 2004.
(t) Incorporated by reference to Exhibit 16 to Post-Effective Amendment No.
24 to the Registration Statement on Form N-1A of Merrill Lynch Municipal
Intermediate Term Fund (File No. 33-8058), filed on February 24, 2006.
Item 24. Persons Controlled by or under Common Control with the Registrant.
The Fund does not control and is not under common control with any person.
Item 25. Indemnification.
Reference is made to Article VI of the Registrant's Articles of Incorporation, Article VI of the Registrant's By-Laws, Section 2-418 of the Maryland General Corporation Law and Section 9 of the Distribution Agreement.
Insofar as the conditional advancing of indemnification moneys for actions
based on the Investment Company Act of 1940, as amended (the "Investment
Company Act"), may be concerned, Article VI of the Registrant's By-Laws
provides that such payments will be made only on the following conditions: (i)
advances may be made only on receipt of a written affirmation of such person's
good faith belief that the standard of conduct necessary for indemnification
has been met and a written undertaking to repay any such advance if it is
ultimately determined that the standard of conduct has not been met; and (ii)
(a) such promise must be secured by a security for the undertaking in form and
amount acceptable to the Registrant, (b) the Registrant is insured against
losses arising by receipt of the advance, or (c) a majority of a quorum of the
Registrant's disinterested non-party Directors, or an independent legal
counsel in a written opinion, shall determine, based upon a review of readily
available facts, that at the time the advance is proposed to be made, there is
reason to believe that the person seeking indemnification will ultimately be
found to be entitled to indemnification.
In Section 9 of the Distribution Agreement relating to the securities being offered hereby, the Registrant agrees to indemnify the Distributor and each person, if any, who controls the Distributor within the meaning of the Securities Act of 1933, as amended (the "Securities Act"), against certain types of civil liabilities arising in connection with the Registration Statement or Prospectus and Statement of Additional Information.
Insofar as indemnification for liabilities arising under the Securities Act may be permitted to Directors, officers and controlling persons of the Registrant and the principal underwriter pursuant to the foregoing provisions or otherwise, the Registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the Registrant of expenses incurred or paid by a Director, officer, or controlling person of the Registrant and the principal underwriter in connection with the successful defense of any action, suit or proceeding) is asserted by such Director, officer or controlling person or the principal underwriter in connection with the shares being registered, the Registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Securities Act and will be governed by the final adjudication of such issue.
Item 26. Business and Other Connections of Investment Adviser.
Fund Asset Management, L.P. (the "Investment Adviser" or "FAM") acts as the investment adviser for a number of affiliated open-end and closed-end registered investment companies.
Merrill Lynch Investment Managers, L.P. ("MLIM"), an affiliate of the Investment Adviser, acts as the investment adviser for a number of affiliated open-end and closed-end registered investment companies and also acts as sub-adviser to certain other portfolios.
The address of each of these registered investment companies is P.O. Box 9011, Princeton, New Jersey 08543-9011, except that the address of Merrill Lynch Funds for Institutions Series is One Financial Center, 23rd Floor, Boston, Massachusetts 02111-2646. The address of the Investment Adviser, MLIM, Princeton Services, Inc. ("Princeton Services") and Princeton Administrators, L.P. ("Princeton Administrators") is also P.O. Box 9011, Princeton, New Jersey 08543-9011. The address of FAM Distributors, Inc. ("FAMD") is P.O. Box 9081, Princeton, New Jersey 08543-9081. The address of Merrill Lynch, Pierce, Fenner & Smith Incorporated ("Merrill Lynch") and Merrill Lynch & Co., Inc. ("ML & Co.") is World Financial Center, North Tower, 250 Vesey Street, New York,
New York 10080. The address of the Fund's transfer agent, Financial Data Services, Inc. ("FDS"), is 4800 Deer Lake Drive East, Jacksonville, Florida 32246-6484.
Set forth below is a list of each executive officer and partner of the Investment Adviser indicating each business, profession, vocation or employment of a substantial nature in which each such person or entity has been engaged for at least the last two fiscal years for his, her or its own account or in the capacity of director, officer, partner or trustee. Additionally, Mr. Burke is Vice President and Treasurer of all or substantially all of the investment companies for which the Investment Adviser, MLIM or their affiliates act as investment adviser, and Mr. Doll is President and/or a Board Member of all or substantially all of such companies.
Position with
Investment Other Substantial Business,
Name Adviser Profession, Vocation or Employment
------------------ --------------- ------------------------------------
ML & Co. Limited Partner Financial Services Holding Company;
Limited Partner of MLIM.
Princeton Services General Partner General Partner of MLIM.
Robert C. Doll, Jr. President President of MLIM; Co-Head (Americas
Region) of MLIM from 2000 to 2001,
and Senior Vice President thereof
from 1999 to 2001; Director of
Princeton Services.
Donald C. Burke First Vice First Vice President and Treasurer
President of MLIM; Senior Vice President,
and Treasurer Director and Treasurer of Princeton
Services; Vice President of FAMD.
Andrew J. Donohue Senior Vice Senior Vice President and General
President Counsel of MLIM; Senior Vice
and General President, General Counsel and
Counsel Director of Princeton Services;
Director and General Counsel of
FAMD.
Alice A. Pellegrino Secretary Secretary of MLIM, Princeton
Services and FAMD.
|
Item 27. Principal Underwriters.
(a) FAMD acts as the principal underwriter for each of the following open-end registered investment companies, including the Registrant: FDP Series, Inc., Financial Institutions Series Trust, Managed Account Series, Mercury Basic Value Fund, Inc., Mercury Funds II, Merrill Lynch Balanced Capital Fund, Inc., Merrill Lynch Basic Value Fund, Inc., Merrill Lynch Bond Fund, Inc., Merrill Lynch California Municipal Series Trust, Merrill Lynch Developing Capital Markets Fund, Inc., Merrill Lynch Disciplined Equity Fund, Inc., Merrill Lynch Equity Dividend Fund, Merrill Lynch EuroFund, Merrill Lynch Focus Twenty Fund, Inc., Merrill Lynch Focus Value Fund, Inc., Merrill Lynch Fundamental Growth Fund, Inc., Merrill Lynch Funds for Institutions Series, Merrill Lynch Global Allocation Fund, Inc., Merrill Lynch Global Equity Opportunities Fund, Merrill Lynch Global Financial Services Fund, Inc., Merrill Lynch Global Growth Fund, Inc., Merrill Lynch Global SmallCap Fund, Inc., Merrill Lynch Global Technology Fund, Inc., Merrill Lynch Global Value Fund, Inc., Merrill Lynch Healthcare Fund, Inc., Merrill Lynch Index Funds, Inc., Merrill Lynch International Fund of Mercury Funds, Inc., Merrill Lynch Latin America Fund, Inc., Merrill Lynch Large Cap Series Funds, Inc., Merrill Lynch Multi-State Municipal Series Trust, Merrill Lynch Municipal Bond Fund, Inc., Merrill Lynch Municipal Series Trust, Merrill Lynch Natural Resources Trust, Merrill Lynch Pacific Fund, Inc., Merrill Lynch Principal Protected Trust, Merrill Lynch Ready Assets Trust, Merrill Lynch Retirement Series Trust, FAM Series Fund, Inc., Merrill Lynch Short Term U.S. Government Fund, Inc., Merrill Lynch Value Opportunities Fund, Inc., Merrill Lynch U.S. Government Fund, Merrill Lynch U.S. High Yield Fund, Inc., Merrill Lynch U.S. Treasury Money Fund, Merrill Lynch U.S.A. Government Reserves, Merrill Lynch Utilities and Telecommunications Fund, Inc., FAM Variable Series Funds, Inc., Merrill Lynch World Income Fund, Inc. and The Asset Program, Inc. FAMD also acts as the principal underwriter for the following closed-end registered investment companies: Merrill Lynch Senior Floating Rate Fund, Inc. and Merrill Lynch Senior Floating Rate Fund II, Inc.
(b) Set forth below is information concerning each director and officer of FAMD. The principal business address of each such person is P.O. Box 9081, Princeton, New Jersey 08543-9081.
Position(s) and
Position(s) and Office(s)
Name Office(s) with FAMD with the Registrant
-------------- ---------------------- ---------------------
Frank Porcelli President and Director None
Andrew J. Donohue Director None
Michael G. Clark Director None
Thomas J. Verage Director None
Donald C. Burke Vice President Vice President and
Treasurer
Stephen W. Mandella Treasurer None
Daniel Dart Director None
Alice A. Pellegrino Secretary Secretary
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(c) Not applicable.
Item 28. Location Of Accounts And Records.
All accounts, books and other documents required to be maintained by
Section 31(a) of the Investment Company Act, and the rules thereunder will be
maintained at the offices of the Registrant, 800 Scudders Mill Road,
Plainsboro, New Jersey 08536, and its transfer agent, Financial Data Services,
Inc., 4800 Deer Lake Drive East, Jacksonville, Florida 32246-6484.
Item 29. Management Services.
Other than as set forth under the caption "Management of the Portfolio" in the Prospectus constituting Part A of the Registration Statement and under
Part I "Management and Advisory Arrangements" and Part II "Management and
Other Service Arrangements" in the Statement of Additional Information constituting Part B of the Registration Statement, Registrant is not a party to any management-related services contract.
Item 30. Undertakings.
Not applicable.
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933 and the Investment Company Act of 1940, the Registrant has duly caused this Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the Township of Plainsboro and State of New Jersey, on the 15th day of March, 2006.
MERRILL LYNCH MUNICIPAL BOND FUND, INC.
(REGISTRANT)
By: /s/ DONALD C. BURKE
---------------------------------
(Donald C. Burke
Vice President and Treasurer)
|
Pursuant to the requirements of the Securities Act, this Amendment to the Registrant's Registration Statement has been signed below by the following persons in the capacities and on the date indicated.
Signature Title Date
ROBERT C. DOLL, JR.* President (Principal
------------------------------- Executive Officer)
Robert C. Doll, Jr. and Director
Vice President and Treasurer
DONALD C. BURKE* (Principal
------------------------------- Financial and Accounting
Donald C. Burke Officer)
RONALD W. FORBES* Director
-------------------------------
Ronald W. Forbes
CYNTHIA A. MONTGOMERY* Director
-------------------------------
Cynthia A. Montgomery
JEAN MARGO REID* Director
-------------------------------
Jean Margo Reid
ROSCOE S. SUDDARTH* Director
-------------------------------
Roscoe S. Suddarth
RICHARD R. WEST* Director
-------------------------------
Richard R. West
EDWARD D. ZINBARG* Director
-------------------------------
Edward D. Zinbarg
*By: Donald C. Burke March 15, 2006
-------------------------------
Donald C. Burke, Attorney-in-Fact
|
EXHIBIT INDEX
Exhibit
Number Description
-------- -------------------------------------------------------------------
1(o) - Articles Supplementary to Articles of Incorporation increasing the
authorized capital stock and reclassifying shares of authorized
common stock, dated March 10, 2006.
|
Exhibit 1(o)
MERRILL LYNCH MUNICIPAL BOND FUND, INC.
ARTICLES SUPPLEMENTARY TO ARTICLES OF INCORPORATION
INCREASING THE AUTHORIZED CAPITAL STOCK OF THE CORPORATION
AND RECLASSIFYING SHARES OF AUTHORIZED CAPITAL STOCK
MERRILL LYNCH MUNICIPAL BOND FUND, INC., a Maryland corporation, having its principal office in the city of Baltimore, Maryland (the "Corporation"), does hereby certify to the State Department of Assessments and Taxation of Maryland (the "Department") that:
FIRST: The Corporation is registered as an open-end investment company under the Investment Company Act of 1940, as amended, with the authority to issue Three Billion Eight Hundred Fifty Million (3,850,000,000) shares of capital stock. The capital stock of the Corporation is divided into three series, each of which consists of four classes of common stock as follows:
Series and Classes Number of Authorized Shares
------------------ ---------------------------
Insured Portfolio Series Common Stock
Class A Common Stock 500,000,000
Class B Common Stock 375,000,000
Class C Common Stock 375,000,000
Class I Common Stock 500,000,000
National Portfolio Series Common Stock
Class A Common Stock 375,000,000
Class B Common Stock 375,000,000
Class C Common Stock 375,000,000
Class I Common Stock 375,000,000
Short-Term Portfolio Series Common Stock
Class A Common Stock 150,000,000
Class B Common Stock 150,000,000
Class C Common Stock 150,000,000
Class I Common Stock 150,000,000
|
Total: 3,850,000,000
All shares of all classes and series of the Corporation's capital stock have a par value of Ten Cents ($0.10) per share. The aggregate par value of all shares of all classes and series of the Corporation's capital stock is Three Hundred Eighty-Five Million Dollars ($385,000,000).
SECOND: The Board of Directors of the Corporation, acting in accordance with Section 2-105(c) of the General Corporation Law of the State of Maryland, hereby increases the number of authorized shares of capital stock of the Corporation's common stock by Four Hundred Million (400,000,000) shares.
THIRD: After this increase in the number of authorized shares of capital stock of the Corporation's common stock, the Corporation will have the authority to issue Four Billion Two Hundred Fifty Million (4,250,000,000) shares of capital stock as follows:
Series and Classes Number of Authorized Shares
------------------ ---------------------------
Insured Portfolio Series Common Stock
Class A Common Stock 500,000,000
Class B Common Stock 375,000,000
Class C Common Stock 375,000,000
Class I Common Stock 500,000,000
National Portfolio Series Common Stock
Class A Common Stock 375,000,000
Class B Common Stock 375,000,000
Class C Common Stock 375,000,000
Class I Common Stock 375,000,000
Short-Term Portfolio Series Common Stock
Class A Common Stock 150,000,000
Class B Common Stock 150,000,000
Class C Common Stock 150,000,000
Class I Common Stock 150,000,000
|
Total: 3,850,000,000
The remainder of the Corporation's capital stock, Four Hundred Million (400,000,000) shares of common stock, is not designated as to any class or series.
After this increase in the number of authorized shares of capital stock of the Corporation, all shares of all classes and series of the Corporation's capital stock, including the shares of common stock which are not designated as to any class or series, will have a par value of Ten Cents ($0.10) per share and the aggregate par value of the shares of all classes and series of the Corporation's capital stock will be Four Hundred Twenty-Five Million Dollars ($425,000,000).
FOURTH: Pursuant to authority expressly vested in the Board of Directors of the Corporation by its charter, the Board of Directors hereby reclassifies Four Hundred Million (400,000,000) authorized and unissued shares of the Corporation's common stock which are not designated as to any class or series as a new series of common stock designated High Yield Portfolio, which series shall consist of four classes of common stock, as follows:
Series and Classes Number of Authorized Shares
------------------ ---------------------------
High Yield Portfolio Series Common Stock
Class A Common Stock 100,000,000
Class B Common Stock 100,000,000
Class C Common Stock 100,000,000
Class I Common Stock 100,000,000
|
FIFTH: The designations, preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends, qualifications or terms or conditions of redemption of High Yield Portfolio Class A common stock are as follows:
High Yield Portfolio Class A common stock of the Corporation shall represent the same interest in the Corporation and have identical designations, preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends, qualifications or terms or conditions of redemption as the Class A common stock in the other series of the Corporation's common stock as of the date of these Articles Supplementary, except as otherwise set forth in the Corporation's charter and except that:
(i) Expenses related to the account maintenance of the High Yield Portfolio Class A common stock shall be borne solely by such class and such class shall have exclusive voting rights with respect to matters relating to the expenses being borne solely by such class;
(ii) Such account maintenance expenses borne solely by High Yield Portfolio Class A common stock shall be appropriately reflected (in the manner determined by the Board of Directors) in the net asset value, dividends, distribution and liquidation rights of the shares of such class.
SIXTH: The designations, preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends, qualifications or terms or conditions of redemption of High Yield Portfolio Class B common stock are as follows:
High Yield Portfolio Class B common stock of the Corporation shall represent the same interest in the Corporation and have identical designations, preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends, qualifications or terms or conditions of redemption as the Class B common stock in the other series of the Corporation's common stock as of the date of these Articles Supplementary, except as otherwise set forth in the Corporation's charter and except that:
(i) Expenses related to the account maintenance and distribution of the High Yield Portfolio Class B common stock shall be borne solely by such class and such class shall have exclusive voting rights with respect to matters relating to the expenses being borne solely by such class;
(ii) Such account maintenance and distribution expenses borne solely by High Yield Portfolio Class B common stock shall be appropriately reflected (in the manner determined by the Board of Directors) in the net asset value, dividends, distribution and liquidation rights of the shares of such class.
SEVENTH: The designations, preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends, qualifications or terms or conditions of redemption of High Yield Portfolio Class C common stock are as follows:
High Yield Portfolio Class C common stock of the Corporation shall represent the same interest in the Corporation and have identical designations, preferences, conversion
or other rights, voting powers, restrictions, limitations as to dividends, qualifications or terms or conditions of redemption as the Class C common stock in the other series of the Corporation's common stock as of the date of these Articles Supplementary, except as otherwise set forth in the Corporation's charter and except that:
(i) Expenses related to the account maintenance and distribution of the High Yield Portfolio Class C common stock shall be borne solely by such class and such class shall have exclusive voting rights with respect to matters relating to the expenses being borne solely by such class;
(ii) Such account maintenance and distribution expenses borne solely by High Yield Portfolio Class C common stock shall be appropriately reflected (in the manner determined by the Board of Directors) in the net asset value, dividends, distribution and liquidation rights of the shares of such class.
EIGHTH: The designations, preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends, qualifications or terms or conditions of redemption of High Yield Portfolio Class I common stock are as follows:
High Yield Portfolio Class I common stock of the Corporation shall represent the same interest in the Corporation and have identical designations, preferences, conversion or other rights, voting powers, restrictions, limitations as to dividends, qualifications or terms or conditions of redemption as the Class I common stock in the other series of the Corporation's common stock as of the date of these Articles Supplementary, except as otherwise set forth in the Corporation's charter.
IN WITNESS WHEREOF, the Corporation has caused these Articles Supplementary to be signed in its name and on its behalf by its Vice President and Treasurer and attested by its Secretary on the 10th day of March, 2006.
MERRILL LYNCH MUNICIPAL BOND FUND, INC.
By: /s/ Donald C. Burke
-----------------------
Donald C. Burke,
Vice President and Treasurer
Attest:
/s/ Alice A. Pellegrino
------------------------------
Alice A. Pellegrino, Secretary
|
THE UNDERSIGNED, VICE PRESIDENT AND TREASURER OF MERRILL LYNCH MUNICIPAL BOND FUND, INC., who executed on behalf of said Corporation the foregoing Articles Supplementary, of which this certificate is made a part, hereby acknowledges, in the name and on behalf of said Corporation, the foregoing Articles Supplementary to be the corporate act of said Corporation and further certifies that, to the best of his knowledge, information and belief, the matters and facts set forth therein with respect to the authorization and approval thereof are true in all material respects, and that this statement is made under the penalties for perjury.
/s/ Donald C. Burke
----------------------------
Donald C. Burke,
Vice President and Treasurer
Dated: March 10, 2006
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