INVESTMENT AND RISK SUMMARY

 

 

 

HIGHLAND HIGH INCOME FUND

 

 

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Senior Loans.   Senior loans are business loans that have a right to payment senior to most other debts of the borrower. The senior loans in which the High Income Fund may invest may not be rated by a rating organization, will not be registered with the SEC or any state securities commission and generally will not be listed or traded on any national securities exchange. Therefore, the amount of public information available about senior loans will be limited, and the performance of the High Income Fund’s investments in senior loans will be more dependent on the analytical abilities of the Adviser than would be the case for investments in more widely-rated, registered or exchange-listed or traded securities. In evaluating the creditworthiness of borrowers, the Adviser will consider, and may rely in part, on analyses performed by others. Moreover, certain senior loans will be subject to contractual restrictions on resale and, therefore, will be illiquid.

 

Second and Third Lien Loans.   Second and third lien loans are subject to the same risks associated with investment in senior loans and high-yield securities. However, second and third lien loans are second and third, respectively, in right of payment to senior loans and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the senior secured obligations of the borrower. Second and third lien loans are expected to have greater price volatility than senior loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in second and third lien loans, which would create greater credit risk exposure.

 

Other Secured Loans.   Secured loans other than senior loans and second lien loans are subject to the same risks associated with investment in senior loans, second lien loans and below investment grade securities. However, such loans may rank lower in right of payment than any outstanding senior loans and second lien loans of the borrower and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the higher ranking secured obligations of the borrower. Lower ranking secured loans are expected to have greater price volatility than senior loans and second lien loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in lower ranking secured loans, which would create greater credit risk exposure.

 

Unsecured Loans.   Unsecured loans are subject to the same risks associated with investment in senior loans, second lien loans, other secured loans and below investment grade securities. However, because unsecured loans have lower priority in right of payment to any higher ranking obligations of the borrower and are not backed by a security interest in any specific collateral, they are subject to additional risk that the cash flow of the borrower and available assets may be insufficient to meet scheduled payments after giving effect to any higher ranking obligations of the borrower. Unsecured loans are expected to have greater price volatility than senior loans, second lien loans and other secured loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in unsecured loans, which would create greater credit risk exposure.

 

Credit Default Swaps.   Credit default swaps involve greater risks than investing in the reference obligation directly. In addition to general market risks, credit default swaps are subject to illiquidity risk, counterparty risk and credit risk. A buyer will lose its investment and recover nothing should no event of default occur. If an event of default were to occur, the value of the reference obligation received by the seller, coupled with the periodic payments previously received, may be less than the full notional value it pays to the buyer, resulting in a loss of value to the seller. When the High Income Fund acts as a seller of a credit default swap, it is exposed to many of the same risks of leverage described below since if an event of default occurs the seller must pay the buyer the full notional value of the reference obligation.

 

Distressed and Defaulted Securities.   Investments in the securities of financially distressed companies involve substantial risks. These securities may involve a substantial risk of default or may be in default. The High Income Fund may incur additional expenses to the extent it is required to seek recovery upon a default in the payment of principal of or interest on its portfolio holdings. In any reorganization or liquidation proceeding relating to a portfolio company, the High Income Fund may lose its entire investment or may be required to accept cash or securities with a value less than the original investment. Among the risks inherent in investments in a troubled entity is the fact that it

 

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frequently may be difficult to obtain information as to the true condition of such issuer. Judgments about the credit quality of the issuer and the relative value of its securities may prove to be wrong.

 

Investment in Restricted Securities.   Restricted securities (i.e., securities acquired in private placement transactions) may offer higher yields than comparable publicly-traded securities. The High Income Fund, however, may not be able to sell these securities when the Adviser considers it desirable to do so or, to the extent they are sold privately, may have to sell them at less than the price of otherwise comparable securities.

 

Non-U.S. Securities.   Because the High Income Fund may own securities of non-U.S. issuers, it may be subject to risks not usually associated with owning securities of U.S. issuers. These risks can include fluctuations in foreign currencies, foreign currency exchange controls, political and economic instability, differences in financial reporting, differences in securities regulation, and trading and foreign taxation issues. The High Income Fund may also invest in issuers in developing or emerging market countries, which are subject to greater risks than securities of issuers in developed countries.

 

Investment in Zero Coupon Securities and Step-Up Bonds.   Zero coupon securities and step-up bonds are debt securities that do not entitle the holder to any periodic payment of interest prior to maturity or a specified date when the securities begin paying current interest. Because such securities do not entitle the holder to any periodic payments of interest prior to maturity, this prevents any reinvestment of interest payments at prevailing interest rates if prevailing interest rates rise. The High Income Fund accrues income on these investments for U.S. federal income tax purposes, which, because no cash is received by the Fund at the time of accrual, may require the Fund to dispose of other portfolio securities to satisfy the its distribution requirements and prevent its disqualification as a regulated investment company. Special tax considerations are associated with investing in these securities. See “Taxation.”

 

Convertible Securities.   Convertible securities generally offer lower interest or dividend yields than non-convertible debt securities of similar credit quality because of the potential for capital appreciation and are typically unrated or rated lower than such securities. In the event of a liquidation of the issuing company, holders of convertible securities would be paid before that company’s common shareholders. Consequently, an issuer’s convertible securities generally entail less risk than its common stock. Convertible securities, however, fall below debt obligations of the same issuer in order of preference or priority in the event of a liquidation.

 

Common Stock.   The High Income Fund may have exposure to common stocks, including through investments in convertible securities. Although common stocks historically have generated higher average returns than debt securities, common stocks also have experienced significantly more volatility in those returns. An adverse event, such as an unfavorable earnings report, may depress the value of a particular common stock held by the High Income Fund. Also, prices of common stocks are sensitive to general movements in the stock market, and a drop in the stock market may depress the prices of common stocks held by the High Income Fund or to which it has exposure.

 

Hedging.   The High Income Fund’s use of derivatives and other transactions, such as options, financial futures and options on financial futures, may involve risks not associated with other types of investments that the Fund intends to purchase. It is possible that a portfolio that utilizes hedging strategies may not perform as well as a portfolio that does not make use of such strategies. The High Income Fund’s use of derivatives or other transactions to reduce risk involves costs and will be subject to an Adviser’s ability to predict correctly changes in the relationships of such hedge instruments to the Fund’s portfolio holdings or other factors. No assurance can be given that such Adviser’s judgment in this respect will be correct. In addition, no assurance can be given that the High Income Fund will enter into hedging or other transactions at times or under circumstances in which it may be advisable to do so. Although the Adviser does not anticipate that derivatives or other such transactions will represent a significant component of the High Income Fund’s investment strategy or will be used for speculative purposes, the Fund has a policy to limit to 20% the portion of the Fund’s total assets that may be subject to such transactions or invested in such instruments.

 

Leverage.   Although it has no current intention to do so, the High Income Fund may employ leverage through borrowings (“borrowings” are sometimes referred to in this Prospectus as “leverage”), which can adversely affect the yield on the Fund’s shares. Capital raised through leverage will be subject to interest and other costs, and to the extent the

 

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High Income Fund is unable to invest the proceeds from the use of leverage in assets that pay interest at a rate that exceeds the rate paid in connection with the leverage, the yield on the Fund’s shares will decrease because the net investment income available for distribution to shareholders will be reduced. There can be no assurance that the High Income Fund’s income from the proceeds of leverage would exceed these costs. The effect of a general market decline in the value of assets such as those in which the High Income Fund invests or of a default on one or more loans or other interest-bearing instruments held by the Fund would be magnified in the Fund because of the leverage and may exaggerate the effect on the Fund’s NAV. The Adviser, however, would seek to use leverage for the purpose of making additional investments only if it believed, at the time of using leverage, that the total return on the assets purchased with such monies would exceed interest payments and other costs of the leverage. In addition, the Adviser would utilize leverage mechanisms whose interest rates float (or reset frequently) to reduce the risk that the costs of the use of leverage would exceed the total return on investments purchased with the proceeds of leverage. Additionally, the investment advisory fee paid to the Adviser will be higher when the High Income Fund borrows money, giving the Adviser incentive to use leverage.

 

Market Disruption.   Certain events may have a disruptive effect on the securities markets, such as terrorist attacks, war and other geopolitical events. The High Income Fund cannot predict the effects of similar events on the U.S. economy in the future. High-yield securities tend to be more volatile than investment grade securities, so these events and any actions resulting from them may have a greater impact on the prices and volatility of high-yield securities than on investment grade securities.

 

Risk/Return Bar Chart and Table

 

The High Income Fund is expected to commence investment operations on or about the date of this Prospectus; therefore, the High Income Fund currently has no investment performance information to report.   After the High Income Fund has had operations for at least one calendar year, its Prospectus will include a bar chart and a table that will provide an indication of the risks of investing in the Fund by showing changes in the Fund’s performance from year to year and by showing how the Fund’s average annual returns for the most recent one year, five years and ten years (or the life of the Fund, if shorter), compare to those of its benchmark, the Credit Suisse High Yield Index, a market-weighted index that includes publicly traded bonds rated below BBB by S&P and Baa by Moody’s. As with all mutual funds, the High Income Fund’s past performance (before and after taxes) will not predict how the Fund will perform in the future. Both the chart and the table will assume the reinvestment of dividends and distributions.

 

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FEES AND EXPENSES OF THE HIGH INCOME FUND

 

The following table describes the fees and expenses that an investor will pay if an investor buys and holds Class A and Class C Shares of the High Income Fund.

 

 

Expense Example.   This Example helps you compare the cost of investing in the High Income Fund to the cost of investing in other mutual funds. The Example assumes that (i) you invest $10,000 in the High Income Fund, (ii) your investment has a 5% return each year, (iii) operating expenses remain the same, and (iv) all income dividends and capital gains distributions are reinvested in additional shares. The Example should not be considered a representation of future expenses. Your actual costs may be higher or lower.

 

 

 

 

 

 

HIGHLAND HIGH INCOME FUND

 

INVESTMENT AND RISK SUMMARY

 

 

 

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may invest a greater percentage of its assets in a particular issuer or particular issuers than a diversified fund could. A non-diversified fund’s investment in fewer issuers may result in the fund’s shares being more sensitive to the economic results of those issuers.

 

 

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changes in the financial condition of the issuer, the Fund may find it more difficult to sell such securities when the Adviser believes it advisable to do so or may be able to sell such securities only at prices lower than if the securities were more widely held.

 

Non-Diversification.   Due to the nature of the Income Fund’s investment strategy and its non-diversified status, it is possible that a material amount of the Fund’s investments could be invested in the securities of only a few companies. Investing a significant portion of the Income Fund’s portfolio in any one or a few issuers would subject the Fund to a greater degree of risk with respect to the failure of any such issuer.

 

Senior Loans.   Senior loans are business loans that have a right to payment senior to most other debts of the borrower. The senior loans in which the Income Fund may invest may not be rated by a rating organization, will not be registered with the SEC or any state securities commission and generally will not be listed or traded on any national securities exchange. Therefore, the amount of public information available about senior loans will be limited, and the performance of the Income Fund’s investments in senior loans will be more dependent on the analytical abilities of the Adviser than would be the case for investments in more widely-rated, registered or exchange-listed or traded securities. In evaluating the creditworthiness of borrowers, the Adviser will consider, and may rely in part, on analyses performed by others. Moreover, certain senior loans will be subject to contractual restrictions on resale and, therefore, will be illiquid.

 

Second and Third Lien Loans.   Second and third lien loans are subject to the same risks associated with investment in senior loans and high-yield securities. However, second and third lien loans are second and third, respectively, in right of payment to senior loans and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the senior secured obligations of the borrower. Second and third lien loans are expected to have greater price volatility than senior loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in second and third lien loans, which would create greater credit risk exposure.

 

Other Secured Loans.   Secured loans other than senior loans and second lien loans are subject to the same risks associated with investment in senior loans, second lien loans and below investment grade securities. However, such loans may rank lower in right of payment than any outstanding senior loans and second lien loans of the borrower and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the higher ranking secured obligations of the borrower. Lower ranking secured loans are expected to have greater price volatility than senior loans and second lien loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in lower ranking secured loans, which would create greater credit risk exposure.

 

Unsecured Loans.   Unsecured loans are subject to the same risks associated with investment in senior loans, second lien loans, other secured loans and below investment grade securities. However, because unsecured loans have lower priority in right of payment to any higher ranking obligations of the borrower and are not backed by a security interest in any specific collateral, they are subject to additional risk that the cash flow of the borrower and available assets may be insufficient to meet scheduled payments after giving effect to any higher ranking obligations of the borrower. Unsecured loans are expected to have greater price volatility than senior loans, second lien loans and other secured loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in unsecured loans, which would create greater credit risk exposure.

 

Credit Default Swaps.   Credit default swaps involve greater risks than investing in the reference obligation directly. In addition to general market risks, credit default swaps are subject to illiquidity risk, counterparty risk and credit risk. A buyer will lose its investment and recover nothing should no event of default occur. If an event of default were to occur, the value of the reference obligation received by the seller, coupled with the periodic payments previously received, may be less than the full notional value it pays to the buyer, resulting in a loss of value to the seller. When the Income Fund acts as a seller of a credit default swap, it is exposed to many of the same risks of leverage described below since if an event of default occurs the seller must pay the buyer the full notional value of the reference obligation.

 

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Distressed and Defaulted Securities.   Investments in the securities of financially distressed companies involve substantial risks. These securities may involve a substantial risk of default or may be in default. The Income Fund may incur additional expenses to the extent it is required to seek recovery upon a default in the payment of principal of or interest on its portfolio holdings. In any reorganization or liquidation proceeding relating to a portfolio company, the Income Fund may lose its entire investment or may be required to accept cash or securities with a value less than the original investment. Among the risks inherent in investments in a troubled entity is the fact that it frequently may be difficult to obtain information as to the true condition of such issuer. Judgments about the credit quality of the issuer and the relative value of its securities may prove to be wrong.

 

Investment in Restricted Securities.   Restricted securities (i.e., securities acquired in private placement transactions) may offer higher yields than comparable publicly-traded securities. The Income Fund, however, may not be able to sell these securities when the Adviser considers it desirable to do so or, to the extent they are sold privately, may have to sell them at less than the price of otherwise comparable securities.

 

Non-U.S. Securities.   Because the Income Fund may own securities of non-U.S. issuers, it may be subject to risks not usually associated with owning securities of U.S. issuers. These risks can include fluctuations in foreign currencies, foreign currency exchange controls, political and economic instability, differences in financial reporting, differences in securities regulation, and trading and foreign taxation issues. The Income Fund may also invest in issuers in developing or emerging market countries, which are subject to greater risks than securities of issuers in developed countries.

 

Investment in Zero Coupon Securities and Step-Up Bonds.   Zero coupon securities and step-up bonds are debt securities that do not entitle the holder to any periodic payment of interest prior to maturity or a specified date when the securities begin paying current interest. Because such securities do not entitle the holder to any periodic payments of interest prior to maturity, this prevents any reinvestment of interest payments at prevailing interest rates if prevailing interest rates rise. The Income Fund accrues income on these investments for U.S. federal income tax purposes, which, because no cash is received by the Fund at the time of accrual, may require the Fund to dispose of other portfolio securities to satisfy the its distribution requirements and prevent its disqualification as a regulated investment company. Special tax considerations are associated with investing in these securities. See “Taxation.”

 

Convertible Securities.   Convertible securities generally offer lower interest or dividend yields than non-convertible debt securities of similar credit quality because of the potential for capital appreciation and are typically unrated or rated lower than such securities. In the event of a liquidation of the issuing company, holders of convertible securities would be paid before that company’s common shareholders. Consequently, an issuer’s convertible securities generally entail less risk than its common stock. Convertible securities, however, fall below debt obligations of the same issuer in order of preference or priority in the event of a liquidation.

 

Common Stock.   The Income Fund may have exposure to common stocks, including through investments in convertible securities. Although common stocks historically have generated higher average returns than debt securities, common stocks also have experienced significantly more volatility in those returns. An adverse event, such as an unfavorable earnings report, may depress the value of a particular common stock held by the Income Fund. Also, prices of common stocks are sensitive to general movements in the stock market, and a drop in the stock market may depress the prices of common stocks held by the Income Fund or to which it has exposure.

 

Hedging.   The Income Fund’s use of derivatives and other transactions, such as options, financial futures and options on financial futures, may involve risks not associated with other types of investments that the Fund intends to purchase. It is possible that a portfolio that utilizes hedging strategies may not perform as well as a portfolio that does not make use of such strategies. The Income Fund’s use of derivatives or other transactions to reduce risk involves costs and will be subject to an Adviser’s ability to predict correctly changes in the relationships of such hedge instruments to the Fund’s portfolio holdings or other factors. No assurance can be given that such Adviser’s judgment in this respect will be correct. In addition, no assurance can be given that the Income Fund will enter into hedging or other transactions at times or under circumstances in which it may be advisable to do so. Although the Adviser does not anticipate that derivatives or other such transactions will represent a significant component of the Income Fund’s

 

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investment strategy or will be used for speculative purposes, the Fund has a policy to limit to 20% the portion of the Fund’s total assets that may be subject to such transactions or invested in such instruments.

 

Leverage.   Although it has no current intention to do so, the Income Fund may employ leverage through borrowings (“borrowings” are sometimes referred to in this Prospectus as “leverage”), which can adversely affect the yield on the Fund’s shares. Capital raised through leverage will be subject to interest and other costs, and to the extent the Income Fund is unable to invest the proceeds from the use of leverage in assets that pay interest at a rate that exceeds the rate paid in connection with the leverage, the yield on the Fund’s shares will decrease because the net investment income available for distribution to shareholders will be reduced. There can be no assurance that the Income Fund’s income from the proceeds of leverage would exceed these costs. The effect of a general market decline in the value of assets such as those in which the Income Fund invests or of a default on one or more loans or other interest-bearing instruments held by the Fund would be magnified in the Fund because of the leverage and may exaggerate the effect on the Fund’s NAV. The Adviser, however, would seek to use leverage for the purpose of making additional investments only if it believed, at the time of using leverage, that the total return on the assets purchased with such monies would exceed interest payments and other costs of the leverage. In addition, the Adviser would utilize leverage mechanisms whose interest rates float (or reset frequently) to reduce the risk that the costs of the use of leverage would exceed the total return on investments purchased with the proceeds of leverage. Additionally, the investment advisory fee paid to the Adviser will be higher when the Income Fund borrows money, giving the Adviser incentive to use leverage.

 

Market Disruption.   Certain events may have a disruptive effect on the securities markets, such as terrorist attacks, war and other geopolitical events. The Income Fund cannot predict the effects on the U.S. economy of similar events in the future. High-yield securities tend to be more volatile than investment grade securities, so these events and any actions resulting from them may have a greater impact on the prices and volatility of high-yield securities than on investment grade securities.

 

Risk/Return Bar Chart and Table

 

The Income Fund is expected to commence investment operations on or about the date of this Prospectus; therefore, the Income Fund currently has no investment performance information to report. After the Income Fund has had operations for at least one calendar year, its Prospectus will include a bar chart and a table that will provide an indication of the risks of investing in the Fund by showing changes in the Fund’s performance from year to year and by showing how the Fund’s average annual returns for the most recent one year, five years and ten years (or the life of the Fund, if shorter), compare to those of its benchmark, the Lehman Brothers Aggregate Bond Index, a market-weighted index that measures the performance of the U.S. investment grade bond market. As with all mutual funds, the Income Fund’s past performance (before and after taxes) will not predict how the Fund will perform in the future. Both the chart and the table will assume the reinvestment of dividends and distributions.

 

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FEES AND EXPENSES OF THE INCOME FUND

 

The following table describes the fees and expenses that an investor will pay if an investor buys and holds Class A and Class C Shares of the Income Fund.

 

 

Expense Example.   This Example helps you compare the cost of investing in the Income Fund to the cost of investing in other mutual funds. The Example assumes that (i) you invest $10,000 in the Income Fund, (ii) your investment has a 5% return each year, (iii) operating expenses remain the same, and (iv) all income dividends and capital gains distributions are reinvested in additional shares. The Example should not be considered a representation of future expenses. Your actual costs may be higher or lower.

 

 

 

 

 

 

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INVESTMENT AND RISK INFORMATION

 

 

 

Portfolio Contents

 

High Yield Debt Securities.   The High Income Fund will, and the Income Fund may, invest in high-yield debt securities (also commonly referred to as “junk” securities), the generic name for debt securities rated between Ba/BB and C/D by Moody’s or S&P. High-yield debt securities are frequently issued by corporations in the growth stage of their development, but also may be issued by established companies. These bonds are regarded by the rating organizations, on balance, as predominantly speculative with respect to capacity to pay interest and repay principal in accordance with the terms of the obligation. Such securities also are generally considered to be subject to greater risk than securities with higher ratings with regard to a deterioration of general economic conditions. Securities that are rated Ba by Moody’s or BB by S&P have speculative characteristics with respect to the capacity to pay interest and repay principal. Securities that are rated B by Moody’s or S&P reflect the rating organizations’ view that such securities generally lack characteristics of a desirable investment and assurance of interest and principal payments over any long period of time may be small. Securities that are rated Caa by Moody’s or CCC by S&P or below are of poor standing. Those issues may be in default (such as those rated D by S&P) or present elements of danger with respect to principal or interest. Although the Funds do not currently intend to purchase securities that are in payment default, the Funds are not limited in their holdings of such securities and from time to time may invest in such securities, or securities held by the Funds may become subject to payment default subsequent to purchase. See the Appendix in the Statement of Additional Information (“SAI”) for a description of the rating categories of the rating organizations. High-yield securities held by the Funds may include securities received as a result of a corporate reorganization or issued as part of a corporate takeover. Securities issued to finance corporate restructurings may have special credit risks because of the highly-leveraged conditions of the issuers, and such securities usually are subordinate to securities subsequently issued by the issuer. In addition, such issuers may lose experienced management as a result of the restructurings. Finally, the market price of such securities may be more volatile to the extent that expected benefits from restructuring do not materialize.

 

Investment Grade Securities.   The Income Fund will, and the High Income Fund may, invest in a wide variety of bonds that are rated or determined by the Adviser to be of investment grade quality of varying maturities issued by U.S. corporations and other business entities. Bonds are fixed or variable rate debt obligations, including bills, notes, debentures, money market instruments and similar instruments and securities. Bonds generally are used by corporations and other issuers to borrow money from investors for a variety of business purposes. The issuer pays the investor a fixed or variable rate of interest and normally must repay the amount borrowed on or before maturity. Although more creditworthy and generally less risky than below investment grade securities, investment grade securities are still subject to market and credit risk. Investment grade securities are generally considered medium and high-quality securities. Some, however, may possess speculative characteristics, and may be more sensitive to economic changes and to changes in the financial condition of issuers.

 

Senior Loans.   Senior loans generally are made to corporations, partnerships and other business entities that operate in various industries and geographical regions. Senior loans typically hold the most senior position in a borrower’s capital structure, are typically secured with specific collateral and have a claim on the general assets of the borrower that is senior to that held by subordinated debtholders and stockholders of the borrower. Borrowers typically use proceeds from senior loans to finance leveraged buyouts, recapitalizations, mergers, acquisitions and stock repurchases and, to a lesser extent, to finance internal growth and for other corporate purposes. Senior loans typically have rates of interest which are redetermined either daily, monthly, quarterly or semi-annually by reference to a base lending rate, plus a premium. These base lending rates generally are LIBOR, the prime rate offered by one or more major U.S. banks (Prime Rate) or the certificate of deposit (CD) rate or other base lending rates used by commercial lenders. The Funds will invest primarily in senior loans that are below investment grade quality and are speculative investments that are subject to credit risk. The Funds will attempt to manage these risks through ongoing analysis and monitoring of borrowers.

 

Second and Third Lien Loans.   Second and third lien loans are loans made by public and private corporations and other nongovernmental entities and issuers for a variety of purposes. Second and third lien loans are second and third, respectively, in right of payment to one or more senior loans of the related borrower. Second and third lien loans typically are secured by a second or third priority security interest or lien to or on specified collateral securing the borrower’s obligation under the loan and typically have similar protections and rights as senior loans. Second lien loans are not (and by their terms cannot) become subordinate in right of payment to any obligation of the related borrower

other than senior loans of such borrower, and third lien loans are not (and by their terms cannot) become subordinate in right of payment to any obligation of the related borrower other than senior loans and second lien loans. Second and third lien loans, like senior loans, typically have adjustable floating rate interest payments. Because second and third lien loans are second to senior loans, they present a greater degree of investment risk but often pay interest at higher rates reflecting this additional risk. Such investments generally are of below investment grade quality. Other than their subordinated status, second and third lien loans have many characteristics and risks similar to senior loans discussed above.

 

Other Secured Loans.   Secured loans other than senior loans and second lien loans are made by public and private corporations and other non-governmental entities and issuers for a variety of purposes. Such secured loans may rank lower in right of payment to one or more senior loans and second lien loans of the borrower. Such secured loans typically are secured by a lower priority security interest or lien to or on specified collateral securing the borrower’s obligation under the loan, and typically have more subordinated protections and rights than senior loans and second lien loans. Secured loans may become subordinated in right of payment to more senior obligations of the borrower issued in the future. Such secured loans may have fixed or adjustable floating rate interest payments. Because such secured loans may rank lower as to right of payment than senior loans and second lien loans of the borrower, they may present a greater degree of investment risk than senior loans and second lien loans but often pay interest at higher rates reflecting this additional risk. Such investments generally are of below investment grade quality. Other than their more subordinated status, such investments have many characteristics and risks similar to senior loans and second lien loans discussed above. Because such loans, however, may rank lower in right of payment to senior loans and second lien loans of the borrower, they may be subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to repay the scheduled payments after giving effect to more senior secured obligations of the borrower. Such secured loans are also expected to have greater price volatility than senior loans and second lien loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in other secured loans, which would create greater credit risk exposure.

 

Unsecured Loans.   Unsecured loans are loans made by public and private corporations and other nongovernmental entities and issuers for a variety of purposes. Unsecured loans generally have lower priority in right of payment compared to holders of secured debt of the borrower. Unsecured loans are not secured by a security interest or lien to or on specified collateral securing the borrower’s obligation under the loan. Unsecured loans by their terms may be or may become subordinate in right of payment to other obligations of the borrower, including senior loans, second lien loans and other secured loans. Unsecured loans may have fixed or adjustable floating rate interest payments. Because unsecured loans are subordinate to the secured debt of the borrower, they present a greater degree of investment risk but often pay interest at higher rates reflecting this additional risk. Such investments generally are of below investment grade quality. Other than their subordinated and unsecured status, such investments have many characteristics and risks similar to senior loans, second lien loans and other secured loans discussed above.

 

Other Fixed Income Securities.   Securities acquired by the Funds may include preferred stock (including convertible preferred stock) and all types of debt obligations having varying terms with respect to security or credit support, subordination, purchase price, interest payments and maturity. Such obligations may include, for example, bonds, debentures, notes (including convertible debt securities), mortgage- or other asset-backed instruments, equipment lease certificates, equipment trust certificates, conditional sales contracts, commercial paper and obligations issued or guaranteed by the U.S. government or any of its political subdivisions, agencies or instrumentalities (including obligations, such as repurchase agreements, secured by such instruments). Most debt securities in which the Funds will invest will bear interest at fixed-rates, although each Fund reserves the right to invest in debt securities that have variable rates of interest. Each Fund also reserves the right to invest up to 10% of its total assets in debt securities that involve equity features, such as contingent interest or participations based on revenues, sales or profits ( i.e. , interest or other payments, often in addition to a fixed-rate of return, that are based on the borrower’s attainment of specified levels of revenues, sales or profits and thus enable the holder of the security to share in the potential success of the venture).

 

Credit Default Swaps.   To the extent consistent with Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”), each Fund may enter into credit default swap agreements. The “buyer” in a credit default contract is obligated to pay the “seller” a periodic stream of payments over the term of the contract provided that no event of default on an underlying reference obligation has occurred. If an event of default occurs, the seller must pay

the buyer the “par value” (full notional value) of the reference obligation in exchange for the reference obligation. A Fund may be either the buyer or seller in the transaction. If a Fund is a buyer and no event of default occurs, the Fund loses its investment and recovers nothing. However, if an event of default occurs, the buyer receives full notional value for a reference obligation that may have little or no value. As a seller, a Fund receives income throughout the term of the contract, which typically is between six months and three years, provided that there is no default event.

 

Zero Coupon Securities and Step-Up Bonds.   Each Fund may invest in zero coupon securities, including step-up bonds. Zero coupon securities pay no cash income but are purchased at a deep discount from their value at maturity, which discount varies depending on the time remaining until cash payments begin, prevailing interest rates, liquidity of the security and the perceived credit quality of the issuer. When held to maturity, their entire return, which consists of the amortized discount, comes from the difference between their purchase price and their maturity value. Step-up bonds are debt securities that typically do not pay interest for a specified period of time and then pay interest at a series of different rates. Special tax considerations are associated with investing in these securities. See “Taxation.”

 

Distressed and Defaulted Securities.   Each Fund is authorized to invest in the securities of financially distressed and bankrupt issuers, including debt obligations that are in covenant or payment default. Such investments generally trade significantly below par and are considered speculative. The repayment of defaulted obligations is subject to significant uncertainties. Defaulted obligations might be repaid only after lengthy workout or bankruptcy proceedings, during which the issuer might not make any interest or other payments. Typically such workout or bankruptcy proceedings result in only partial recovery of cash payments or an exchange of the defaulted obligation for other debt or equity securities of the issuer or its affiliates, which may in turn be illiquid or speculative. A Fund may not invest more than 20% of its total assets at the time of investment in defaulted securities.

 

Illiquid and Restricted Securities.   Each Fund may invest up to 15% of its total assets in illiquid securities. Each Fund may also invest up to 15% of its total assets in restricted securities, which are securities acquired in private placement transactions. Such securities generally may not be resold without registration under the Securities Act of 1933, as amended (the “Securities Act”), except in transactions exempt from the registration requirements of the Securities Act. A security that may be restricted as to resale under federal securities laws or otherwise will not be subject to this percentage limitation if the Adviser determines that the security is, at the time of acquisition, readily marketable. Illiquid and restricted securities may offer higher yields than comparable publicly-traded securities. However, a Fund may not be able to sell these securities when the Adviser considers it desirable to do so or, to the extent they are sold privately, may have to sell them at less than the price of otherwise comparable securities. Such securities may include, for example, those eligible for resale under Rule 144A under the Securities Act.

 

Temporary Defensive Investments.   If market conditions threaten to erode the value of a Fund’s assets, the Fund may adopt a temporary defensive investment strategy and invest without limitation in high-grade money market instruments, including commercial paper of domestic and non-U.S. corporations, certificates of deposit, bankers’ acceptances and other obligations of banks, repurchase agreements and short-term obligations issued or guaranteed by the U.S. government or its instrumentalities or agencies, and in investment grade debt securities. The yield on these securities will tend to be lower than the yield on other securities purchased by the Fund.

 

The achievement of each Fund’s investment objective(s) depends upon the Adviser’s analytical and portfolio management skills. In selecting securities for investment, the Adviser seeks to identify securities which entail reasonable credit risk considered in relation to each Fund’s investment policies. The Adviser uses an investment strategy of fundamental credit analysis and generally emphasizes issuers that it believes will remain financially sound and perform well in a range of market conditions. Portfolio securities are typically sold when the Adviser’s fundamental assessment of an issuer materially changes. There is no assurance that either Fund’s investment objective(s) will be attained in the future.

 

Portfolio Maturity and Turnover

 

A Fund’s holdings may include issues of various maturities. Ordinarily, the Funds will emphasize investments in medium and longer term instruments (i.e., those with maturities in excess of three years), but the weighted average maturity of portfolio holdings may be shortened or lengthened depending primarily on the Adviser’s outlook for interest rates. To the extent the weighted average maturity of a Fund’s portfolio securities is lengthened, the value of such holdings will be more susceptible to fluctuation in response to changes in interest rates, creditworthiness and general economic conditions. The weighted average of a Fund’s portfolio will fluctuate depending on market conditions and

investment opportunities. Each Fund, however, does not expect that the weighted average maturity of its portfolio will, under normal conditions, exceed ten years.

 

The Adviser actively makes portfolio adjustments that reflect each Fund’s investment strategy and may trade securities regardless of how long they have been held when it believes doing so will further the Fund’s investment objectives.

 

A Fund’s portfolio turnover rate may exceed 100% per year. A 100% annual turnover rate would occur, for example, if all the securities in the Fund’s portfolio were replaced once within a period of one year. Each Fund reserves full freedom with respect to portfolio turnover. In periods when there are rapid changes in economic conditions or security price levels or when investment strategy is changed significantly, portfolio turnover may be significantly higher than during times of economic and market price stability, when investment strategy remains relatively constant. A high rate of portfolio turnover (i.e., 100% or more) will result in increased transaction costs for the Fund in the form of increased dealer spreads and brokerage commissions. High portfolio turnover also could produce higher taxable distributions and lower the Fund’s after-tax performance.

 

the creditworthiness of the repurchase agreement counterparties with whom the Funds do business and will monitor their creditworthiness during the period of any repurchase agreement.

 

Options.   A Fund may write (sell) call options that are traded on national securities exchanges with respect to securities in its portfolio. A Fund may only write “covered” call options, that is, options on securities it holds in its portfolio or has an immediate right to acquire through conversion or exchange of securities held in its portfolio. A Fund may write call options on its portfolio securities in an attempt to realize a greater current return than would be realized on the securities alone. A Fund also may write call options as a partial hedge against a possible market decline. In view of their investment objectives, the Funds generally would write call options only in circumstances in which the Adviser does not anticipate significant appreciation of the underlying security in the near future or has otherwise determined to dispose of the security. As the writer of a call option, a Fund receives a premium for undertaking the obligation to sell the underlying security at a fixed price during the option period if the option is exercised. A Fund may also enter into “closing purchase transactions” in order to terminate its obligation as a writer of a call option prior to the expiration of the option.

 

Futures Contracts and Related Options.   The Funds currently do not intend to trade in futures contracts or related options on futures contracts. Each Fund, however, has reserved the right, subject to the approval of the Board of Trustees, to purchase and sell financial futures contracts and options on such futures contracts for the purpose of hedging its portfolio securities (or portfolio securities that it expects to acquire) against anticipated changes in prevailing interest rates. This technique could be employed if the Adviser anticipates that interest rates may rise, in which event a Fund could sell a futures contract to protect against the potential decline in the value of its portfolio securities. Conversely, if declining interest rates were anticipated, a Fund could purchase a futures contract to protect against a potential increase in the price of securities the Fund intends to purchase.

 

Interest Only Mortgage-Backed Securities.   A Fund is permitted to buy certain debt securities, known as “interest only” mortgage-backed securities, in which the issuer is only obligated to pay a fixed-rate of interest based on a stated principal amount, but does not make any principal payments. Each month the stated principal amount is adjusted to reflect both scheduled payments and prepayments of principal on the underlying mortgages. For example, a Fund may buy certain debt securities issued by Fannie Mae, a U.S. government agency, which carry additional risks not associated with other Fannie Mae issues. The holder purchases the security at a price that is lower than the holder’s expectations of payments of interest from the issuer.

 

Inverse Floaters.   A Fund is also permitted to buy certain debt securities, known as inverse interest rate floaters (“Inverse Floaters”). These securities do not carry a fixed-rate of interest, but instead pay interest based on a formula that varies inversely with the then current market interest rate (the “formula interest rate”), as reflected by a referenced interest rate on a specific date near the interest payment date (the “interest calculation date”). For example, if the referenced interest rate decreases on an interest calculation date from the referenced interest rate on the prior interest calculation date, then the formula interest rate will increase on that interest calculation date versus the prior interest calculation date. If the referenced rate of interest on the current interest calculation date is different from the amount such rate was on the interest calculation date prior to purchase, then the interest payments received by the holder may be more or less than the holder expected to receive based on the referenced rate in effect on the date of purchase.

 

investment, market and other risks. See “Principal Risks—Leverage” below. The High Income Fund generally invests a greater percentage of its assets in high-yield securities and therefore is generally subject to greater risks associated with such investments than the Income Fund. A Fund’s overall risk level will depend on the market sectors in which the Fund is invested and the current interest rate, credit quality and liquidity of securities of issuers in such sectors.

 

Credit.   Credit risk refers to an issuer’s ability to make timely payments of interest and principal. The High Income Fund invests primarily in, and the Income Fund may invest up to 60% of its total assets in, debt securities rated below investment grade (also referred to as “high-yield” or “junk” securities) and unrated debt securities of comparable quality, which involve greater risk than investment grade debt securities. High-yield securities generally offer a higher return potential than higher-rated debt securities, but also involve greater volatility of price and risk of loss of income and principal, including the possibility of default or bankruptcy of the issuers of the securities. As a result, investment in a Fund involves the risk that if an issuer of a high-yield security or an unrated security of comparable quality in which the Fund invests defaults, there may be a negative impact on the Fund’s income and asset coverage, and the Fund’s investment objective(s) may not be realized.

 

The values of high-yield securities tend to reflect individual corporate developments or adverse economic changes to a greater extent than higher-rated debt securities, which react primarily to fluctuations in the general level of interest rates. Periods of economic uncertainty and changes generally result in increased volatility in the market prices and yields of high-yield securities and thus in a Fund’s NAV. The rating organizations generally regard high-yield securities as predominantly speculative with respect to capacity to pay interest and repay principal and riskier than higher-rated debt securities. Changes by rating organizations in their ratings of any debt security and in the ability of an issuer to make payments of interest and principal may also affect the value of the a Fund’s investments. Changes in the value of portfolio securities will not necessarily affect cash income derived from such securities, but will affect a Fund’s NAV.

 

The Funds will rely on the Adviser’s judgment, analysis and experience in evaluating the creditworthiness of an issuer. In this evaluation, the Adviser will take into consideration, among other things, the issuer’s financial resources, its sensitivity to economic conditions and trends, its operating history, the quality of the issuer’s management and regulatory matters.

 

The credit ratings issued by rating organizations may not fully reflect the true risks of an investment. For example, credit ratings typically evaluate the safety of principal and interest payments of high-yield securities and not their market value risk. Also, credit rating organizations may fail to change on a timely basis a credit rating to reflect changes in economic or company conditions that affect a security’s market value. Although it considers ratings of nationally recognized statistical rating organizations such as Moody’s and S&P, the Adviser primarily relies on its own credit analysis, which includes a study of existing debt, capital structure, ability to service debt and to pay dividends, the issuer’s sensitivity to economic conditions, its operating history and the current trend of earnings.

 

Interest Rates.   Generally, when interest rates rise, the value of fixed-rate debt securities, including high-yield securities, tends to decrease, and such declines tend to be greater among fixed-rate debt securities with longer maturities. The Funds have no policy limiting the maturities of their investments. To the extent the Funds invest in fixed-rate debt securities with longer maturities, the Funds are subject to greater interest rate risk than funds investing solely in shorter-term fixed-rate debt securities. In addition, in a period of rising interest rates, the higher cost of any leveraged employed by a Fund and/or increasing defaults by issuers of high-yield securities would likely exacerbate any decline in the Fund’s NAV. If an issuer of a debt security containing a redemption or call provision exercises either provision in a declining interest rate market, the Fund would likely replace the security with a security having a lower interest rate, which could result in a decreased return for shareholders.

 

Liquidity.   At times a major portion of an issue of lower-rated debt securities may be held by relatively few institutional purchasers. Although the Funds generally consider such securities to be liquid because of the availability of an institutional market for such securities, under adverse market or economic conditions or in the event of adverse changes in the financial condition of the issuer, a Fund may find it more difficult to sell such securities when the Adviser believes it advisable to do so or may be able to sell such securities only at prices lower than if the securities were more widely held. In such circumstances, a Fund also may find it more difficult to determine the fair value of such securities for purposes of computing the Fund’s NAV. Each Fund, in most instances, utilizes an independent pricing service to determine the value of its securities. However, quotations from a pricing service (or other quotations) may not be a reliable indicator of the price the Fund could realize upon sale due to many factors, including, but not limited to, the number of active purchasers and sellers, variable economic and market conditions and changes in the

financial condition (or perceived financial condition) of the issuer at the time of sale. As a result, pricing of a Fund’s securities does not rely solely on a price determined by an independent pricing service; other relevant information is also monitored and other valuation methodologies may be used as appropriate.

 

Non-Diversification.   Due to the nature of each Fund’s investment strategy and their non-diversified status, it is possible that a material amount of a Fund’s investments could be invested in the securities of only a few companies. Investing a significant portion of a Fund’s portfolio in any one issuer would subject the Fund to a greater degree of risk with respect to the failure of any such issuer.

 

Senior Loans.   Senior loans in which a Fund may invest may not be rated by a rating organization, will not be registered with the SEC or any state securities commission and generally will not be listed or traded on any national securities exchange. Therefore, the amount of public information available about senior loans will be limited, and the performance of a Fund’s investments in senior loans will be more dependent on the analytical abilities of the Adviser than would be the case for investments in more widely-rated, registered or exchange-listed or traded securities. In evaluating the creditworthiness of borrowers, the Adviser will consider, and may rely in part, on analyses performed by others. Moreover, certain senior loans will be subject to contractual restrictions on resale and, therefore, will be illiquid.

 

Second and Third Lien Loans.   Second and third lien loans are subject to the same risks associated with investment in senior loans and high-yield securities. However, second and third lien loans are second and third, respectively, in right of payment to senior loans and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the senior secured obligations of the borrower. Second and third lien loans are expected to have greater price volatility than senior loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in second and third lien loans, which would create greater credit risk exposure.

 

Other Secured Loans.   Secured loans other than senior loans and second lien loans are subject to the same risks associated with investment in senior loans, second lien loans and below investment grade securities. However, such loans may rank lower in right of payment than any outstanding senior loans and second lien loans of the borrower and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the higher ranking secured obligations of the borrower. Lower ranking secured loans are expected to have greater price volatility than senior loans and second lien loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in lower ranking secured loans, which would create greater credit risk exposure.

 

Unsecured Loans.   Unsecured loans are subject to the same risks associated with investment in senior loans, second lien loans, other secured loans and below investment grade securities. However, because unsecured loans have lower priority in right of payment to any higher ranking obligations of the borrower and are not backed by a security interest in any specific collateral, they are subject to additional risk that the cash flow of the borrower and available assets may be insufficient to meet scheduled payments after giving effect to any higher ranking obligations of the borrower. Unsecured loans are expected to have greater price volatility than senior loans, second lien loans and other secured loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in unsecured loans, which would create greater credit risk exposure.

 

Credit Default Swaps.   Credit default swaps involve greater risks than investing in the reference obligation directly. In addition to general market risks, credit default swaps are subject to illiquidity risk, counterparty risk and credit risk. A buyer will lose its investment and recover nothing should no event of default occur. If an event of default were to occur, the value of the reference obligation received by the seller, coupled with the periodic payments previously received, may be less than the full notional value it pays to the buyer, resulting in a loss of value to the seller. When a Fund acts as a seller of a credit default swap, it is exposed to many of the same risks of leverage described below since if an event of default occurs the seller must pay the buyer the full notional value of the reference obligation.

 

Distressed and Defaulted Securities.   Investments in the securities of financially distressed companies involve substantial risks. These securities may involve a substantial risk of default or may be in default. A Fund may incur additional expenses to the extent it is required to seek recovery upon a default in the payment of principal of or interest on its portfolio holdings. High-yield, high-risk securities frequently are subordinated to the prior payment of senior indebtedness and are traded in markets that may be relatively less liquid than the market for higher-rated securities. In any reorganization or liquidation proceeding relating to a portfolio company, a Fund may lose its entire investment or may be required to accept cash or securities with a value less than the original investment. In addition, a

liquidation or bankruptcy proceeding either may be unsuccessful (for example, because of the failure to obtain requisite approvals), may be delayed (for example, until various liabilities, actual or contingent, have been satisfied) or may result in a distribution of cash or a new security the value of which will be less than a Fund’s purchase price of the security in respect of which such distribution was made.

 

Among the risks inherent in investments in troubled entities is that it frequently may be difficult to obtain information as to the true condition of such issuer. Judgments about the credit quality of the issuer and the relative value of its securities may prove to be wrong. Such investments also may be adversely affected by laws relating to, among other things, fraudulent transfers and other voidable transfers or payments, lender liability and the bankruptcy courts’ power to disallow, reduce, subordinate or disenfranchise particular claims. The market prices of such securities also are subject to abrupt and erratic market movements and above-average price volatility, and the spread between the bid and asked prices of such securities may be greater than those prevailing in other securities markets. It may take a number of years for the market price of such securities to reflect their intrinsic value, and the Adviser’s estimates of intrinsic value may be based on its views of market conditions, including interest rates, that may prove to be incorrect.

 

Investment in Restricted Securities.   Restricted securities (i.e., securities acquired in private placement transactions) may offer higher yields than comparable publicly-traded securities. The Funds, however, may not be able to sell these securities when the Adviser considers it desirable to do so or, to the extent they are sold privately, may have to sell them at less than the price of otherwise comparable securities. Restricted securities are subject to limitations on resale which can have an adverse effect on the price obtainable for such securities. Also, if in order to permit resale, the securities are registered under the Securities Act at a Fund’s expense, the Fund’s expenses would be increased.

 

Non-U.S. Securities.   Investing in non-U.S. securities involves certain risks not involved in domestic investments, including, but not limited to: (i) fluctuations in foreign exchange rates; (ii) future foreign economic, financial, political and social developments; (iii) different legal systems; (iv) the possible imposition of exchange controls or other foreign governmental laws or restrictions; (v) lower trading volume; (vi) much greater price volatility and illiquidity of certain foreign securities markets; (vii) different trading and settlement practices; (viii) less governmental supervision; (ix) changes in currency exchange rates; (x) high and volatile rates of inflation; (xi) fluctuating interest rates; (xii) less publicly available information; and (xiii) different accounting, auditing and financial recordkeeping standards and requirements. Certain countries in which the Funds may invest, especially emerging market countries, historically have experienced, and may continue to experience, high rates of inflation, high interest rates, exchange rate fluctuations, large amounts of external debt, balance of payments and trade difficulties and extreme poverty and unemployment. Many of these countries are also characterized by political uncertainty and instability. The cost of servicing external debt will generally be adversely affected by rising international interest rates because many external debt obligations bear interest at rates which are adjusted based upon international interest rates. In addition, with respect to certain foreign countries, there is a risk of: (i) the possibility of expropriation or nationalization of assets; (ii) confiscatory taxation; (iii) difficulty in obtaining or enforcing a court judgment; (iv) economic, political or social instability; and (v) diplomatic developments that could affect investments in those countries. Because the Funds will invest in securities denominated or quoted in currencies other than the U.S. dollar, changes in foreign currency exchange rates may affect the value of securities in the Funds and the unrealized appreciation or depreciation of investments. Currencies of certain countries may be volatile and therefore may affect the value of securities denominated in such currencies, which means that a Fund’s net asset value or current income could decline as a result of changes in the exchange rates between foreign currencies and the U.S. dollar. Certain investments in non-U.S. securities also may be subject to foreign withholding taxes. These risks often are heightened for investments in smaller, emerging capital markets. In addition, individual foreign economies may differ favorably or unfavorably from the U.S. economy in such respects as: (i) growth of gross domestic product; (ii) rates of inflation; (iii) capital reinvestment; (iv) resources; (v) self-sufficiency; and (vi) balance of payments position. As a result of these potential risks, the Adviser may determine that, notwithstanding otherwise favorable investment criteria, it may not be practicable or appropriate to invest in a particular country. The Funds may invest in countries in which foreign investors, including the Adviser, have had no or limited prior experience.

 

Emerging Markets.   Investing in securities of issuers based in underdeveloped emerging market countries entails all of the risks of investing in securities of non-U.S. issuers to a heightened degree. These heightened risks include: (i) greater risks of expropriation, confiscatory taxation, nationalization, and less social, political and economic stability; (ii) the smaller size of the markets for such securities and a lower volume of trading, resulting in lack of liquidity and in price volatility; and (iii) certain national policies that may restrict a Fund’s investment opportunities, including

restrictions on investing in issuers or industries deemed sensitive to relevant national interests. Emerging market countries generally include every nation in the world except the United States, Canada, Japan, Australia, New Zealand and most countries located in Western Europe.

 

Common Stock.   The Funds may have exposure to common stocks, including by investment in convertible securities. Although common stocks historically have generated higher average returns than debt securities, common stocks also have experienced significantly more volatility in those returns. An adverse event, such as an unfavorable earnings report, may depress the value of a particular common stock held by a Fund. Also, prices of common stocks are sensitive to general movements in the stock market, and a drop in the stock market may depress the prices of common stocks held by a Fund or to which it has exposure.

 

Small and Mid-Cap Securities.   The Funds may invest in companies with small or medium capitalizations. Securities issued by smaller and medium companies can be more volatile than, and perform differently from, larger company securities. There may be less trading in a smaller or medium company’s securities, which means that buy and sell transactions in those securities could have a larger impact on the security’s price than is the case with larger company securities. Smaller and medium companies may have fewer business lines; changes in any one line of business, therefore, may have a greater impact on a smaller or medium company’s security price than is the case for a larger company. In addition, smaller or medium company securities may not be well known to the investing public.

 

Investment in Zero Coupon Securities and Step-Up Bonds.   Zero coupon securities are debt obligations that do not entitle the holder to any periodic payment of interest prior to maturity or a specified date when the securities begin paying current interest. Because such securities do not entitle the holder to any periodic payments of interest prior to maturity, this prevents any reinvestment of interest payments at prevailing interest rates if prevailing interest rates rise. On the other hand, because there are no periodic interest payments to be reinvested prior to maturity, these securities eliminate the reinvestment risk and may lock in a favorable rate of return to maturity if interest rates drop. The Funds accrue income on these investments for U.S. federal income tax purposes, which, because no cash is received by the Funds at the time of accrual, may require the Funds to dispose of other portfolio securities to satisfy the their distribution requirements and prevent their disqualification as a regulated investment company. Special tax considerations are associated with investing in zero coupon securities and step-up bonds. See “Taxation.”

 

Convertible Securities.   Convertible securities generally offer lower interest or dividend yields than non-convertible debt securities of similar credit quality because of the potential for capital appreciation and are typically unrated or rated lower than such securities. The market values of convertible securities tend to decline as interest rates increase and, conversely, to increase as interest rates decline. A convertible security’s market value, however, also tends to reflect the market price of the common stock of the issuing company, particularly when that stock price is greater than the convertible security’s “conversion price.” As the market price of the underlying common stock declines below the conversion price, the price of the convertible security tends to be increasingly influenced more by the yield of the convertible security. In the event of a liquidation of the issuing company, holders of convertible securities would be paid before that company’s common shareholders. Consequently, an issuer’s convertible securities generally entail less risk than its common stock. Convertible securities, however, fall below debt obligations of the same issuer in order of preference or priority in the event of a liquidation.

 

Hedging.   A Fund’s use of derivatives and other transactions, such as options, financial futures and options on financial futures, may involve risks not associated with other types of investments that the Fund intends to purchase and it is possible that a portfolio that utilizes hedging strategies may not perform as well as a portfolio that does not make use of such strategies. A Fund’s use of derivatives or other transactions to reduce risk involves costs and will be subject to the Adviser’s ability to predict correctly changes in the relationships of such hedge instruments to the Fund’s portfolio holdings or other factors. No assurance can be given that the Adviser’s judgment in this respect will be correct. In addition, no assurance can be given that the Funds will enter into hedging or other transactions (including hedging exposure to non-U.S. currency exchange rate risk) at times or under circumstances in which it may be advisable to do so. Although the Adviser does not anticipate that derivatives or other such transactions will represent a significant component of each Fund’s investment strategy and will not be used for speculative purposes, each Fund has a policy to limit to 20% the portion of the Fund’s total assets that may be subject to such transactions or invested in such instruments.

 

A Fund’s positions in options and financial futures may be entered into and closed out only on a federally-licensed exchange that provides a market therefor, and there can be no assurance that a liquid market will exist for any

particular option or futures contract. Because financial futures and related options markets generally impose limits on daily price movement, it is possible that the Adviser would not be able to close out hedge positions promptly. The inability to close out options and futures positions could have an adverse impact on a Fund’s ability to hedge its securities effectively and might, in some cases, require a Fund to deposit substantial amounts of additional cash to meet applicable margin requirements. A Fund’s ability to hedge effectively through transactions in financial futures or options depends on the degree to which price movements, which include, in part, changes in interest rates, in the Fund’s holdings correlate with price movements of the hedging instruments. Inasmuch as a Fund’s options and futures will not duplicate such underlying securities, the correlation will probably not be perfect. Consequently, the prices, which include, in part, changes in interest rates, of the securities being hedged may not move in the same amount as the hedging instrument. It is possible that there may be a negative correlation between the hedging instrument and the hedged securities, which would prevent the Fund from achieving the anticipated benefits of hedging transactions or may cause the Fund to realize losses and thus be in a worse position than if such strategies had not been used. Pursuant to regulations and/or published positions of the SEC, a Fund may be required to segregate permissible liquid assets to cover its obligations relating to its transactions in futures and options. To maintain this required cover, a Fund may have to sell portfolio securities at disadvantageous prices or times because it may not be possible to liquidate a position at a reasonable price. In addition, the segregation of such assets will have the effect of limiting a Fund’s ability otherwise to invest those assets.

 

Market Disruption.   Certain events may have a disruptive effect on the securities markets, such as terrorist attacks, war and other geopolitical events. The Funds cannot predict the effects on the U.S. economy of similar events in the future. High-yield securities tend to be more volatile than investment grade securities, so these events and any actions resulting from them may have a greater impact on the prices and volatility of high-yield securities than on investment grade securities.

 

Prepayments.   If interest rates fall, the principal on debt held by the Funds may be paid earlier than expected. If this happens, the proceeds from a prepaid security may be reinvested by a Fund in securities bearing lower interest rates, resulting in a possible decline in the Fund’s income and distributions to shareholders. The Funds may invest in pools of mortgages and other assets issued or guaranteed by private issuers or U.S. government agencies and instrumentalities. Mortgage-related securities are especially sensitive to prepayment risk because borrowers often refinance their mortgages when interest rates drop.

 

Reinvestment.   The Funds reinvest the cash flows received from a security. The additional income from such reinvestment, sometimes called interest-on-interest, is reliant on the prevailing interest rate levels at the time of reinvestment. There is a risk that the interest rate at which interim cash flows can be reinvested will fall. Reinvestment risk is greater for longer holding periods and for securities with large, early cash flows such as high-coupon bonds. Reinvestment risk also applies generally to the reinvestment of the proceeds the Funds receive upon the maturity or sale of a portfolio security.

 

Key Adviser Personnel.   A Fund’s ability to identify and invest in attractive opportunities is dependent upon Highland, its investment adviser. If one or more key individuals leaves Highland, Highland may not be able to hire qualified replacements or may require an extended time to do so. This situation could prevent a Fund from achieving its investment objectives.

 

purchased with the proceeds of leverage. Additionally, the investment advisory fee paid to the Adviser will be higher when a Fund borrows money, giving the Adviser incentive to use leverage.

 

Securities Loans.   The risks in lending portfolio securities, as with other extensions of credit, consist of possible delays in recovery of the securities or possible loss of rights in the collateral should the borrower fail financially.

 

When-Issued and Delayed-Delivery Securities.   The Funds are dependent on the other party to complete successfully when-issued and delayed-delivery transactions. If such other party fails to complete its portion of the transaction, the Fund will have lost the opportunity to invest the amount segregated for such transaction.

 

Repurchase Agreements.   If the counterparty defaults, a Fund could realize a loss on the sale of the underlying security to the extent that the proceeds of the sale, including accrued interest, are less than the resale price provided in the agreement, including interest. In addition, if the counterparty should be involved in bankruptcy or insolvency proceedings, a Fund may incur delay and costs in selling the underlying collateral or may suffer a loss of principal and interest if the Fund is treated as an unsecured creditor and required to return the underlying collateral to the counterparty’s estate.

 

Options.   Although the writing of call options only on national securities exchanges increases the likelihood that a Fund will be able to make closing purchase transactions, there is no assurance that the Fund will be able to effect such transactions at any particular time or at any acceptable price. The writing of call options could result in increases in a Fund’s portfolio turnover rate, especially during periods when market prices of the underlying securities appreciate.

 

Futures Contracts and Related Options.   Futures contracts and related options may be traded on foreign exchanges. Such transactions may not be regulated as effectively as similar transactions in the United States, may not involve a clearing mechanism and related guarantees, and are subject to the risk of governmental actions affecting trading in, or the prices of, foreign securities. The value of such positions also could be adversely affected by: (i) other complex foreign political, legal and economic factors; (ii) lesser availability than in the U.S. of data on which to make trading decisions; (iii) delays in a Fund’s ability to act upon economic events occurring in the foreign markets during non-business hours in the United States; (iv) the imposition of different exercise and settlement terms and procedures and margin requirements than in the United States; and (v) lesser trading volume. Exchanges on which futures and related options are traded may impose limits on the positions that the Funds may take in certain circumstances.

 

Interest Only Mortgage-Backed Securities.   If payments of principal on the underlying mortgages are different than the holder’s expectation of principal paydowns, then the actual payments of interest by the issuer could be more or less than the holder’s expectation of interest payments. “Interest only” mortgage-backed securities present a heightened risk of total loss of investment.

 

Inverse Floaters.   As interest rates rise, Inverse Floaters produce less current income. A change in prevailing interest rates will often result in a greater change in the interest rate paid by an Inverse Floater. As a result, Inverse Floaters may have a greater degree of volatility than other types of interest-bearing securities of similar credit quality.

 

Portfolio Holdings

 

A description of the Funds’ policies and procedures with respect to the disclosure of the Funds’ portfolio securities is available (i) in the Funds’ SAI and (ii) on the Funds’ website at http://www.highlandfunds.com.

MANAGEMENT OF THE FUNDS

 

Fund’s portfolio. A discussion regarding the Board of Trustees’ approval of each Investment Advisory Agreement will be available in each Fund’s annual report for the fiscal year ending August 31, 2007.

 

Organized in March 1993, Highland is registered as an investment adviser under the Investment Advisers Act of 1940, as amended. As of December 31, 2006, Highland had approximately $33.1 billion in assets under management. Highland is controlled by James Dondero and Mark Okada, by virtue of their respective share ownership, and its general partner, Strand Advisors, Inc., of which Mr. Dondero is the sole stockholder.

 

Management Fees.   Highland receives from each Fund monthly advisory fees, computed and accrued daily, at an annual rate of 0.65% of the High Income Fund’s average daily managed assets and 0.50% of the Income Fund’s average daily managed assets. Highland is also each Fund’s administrator and receives a monthly administration fee from each Fund, computed and accrued daily, at an annual rate of 0.20% of each Fund’s average daily managed assets. “Average daily managed assets” shall mean the average daily value of a Fund’s total assets, less all accrued liabilities (other than the aggregate amount of any outstanding borrowings constituting financial leverage). Highland voluntarily has agreed to waive all of its advisory fee and 0.15% of its administration fee for each Fund, which waivers may be terminated at any time by Highland upon seven days’ written notice to shareholders of the Funds.

 

Portfolio Managers

 

Each Fund’s portfolio is managed by James D. Dondero and Chet Paipanandiker. The SAI provides additional information about the portfolio managers’ compensation, other accounts managed by the portfolio managers and the portfolio managers’ ownership of securities issued by the Funds.

 

James D. Dondero.   Mr. Dondero has managed the Funds since their inception. Mr. Dondero is a founder and President of Highland. Formerly, Mr. Dondero served as Chief Investment Officer of Protective Life’s GIC subsidiary and helped grow the business from concept to over $2 billion between 1989 and 1993. His portfolio management experience includes investments in mortgage-backed securities, investment grade corporate bonds, leveraged bank loans, emerging markets, derivatives, preferred stocks and common stocks. From 1985 to 1989, he managed approximately $1 billion in fixed income funds for American Express. Prior to American Express, he completed his financial training at Morgan Guaranty Trust Company. Mr. Dondero is a Beta Gamma Sigma graduate of the University of Virginia (1984) with degrees in Accounting and Finance. Mr. Dondero is a Certified Public Accountant, Chartered Financial Analyst and a Certified Management Accountant.

 

Chet Paipanandiker.   Mr. Paipanandiker has managed the Funds since their inception. Mr. Paipanandiker is a Portfolio Manager at Highland. Prior to joining Highland in 2002, Mr. Paipanandiker worked as an analyst at Enron analyzing and trading high-yield and distressed debt within the chemical sector. Mr. Paipanandiker originally joined Enron in 1999 and evaluated and modeled private investments for Enron’s Pulp and Paper group. He received a BBA in 1999 from the University of Texas at Austin where he graduated Magna Cum Laude, with concentrations in the Business Honors Program and Mechanical Engineering.

 

Distributor

 

Each Fund’s shares are offered for sale through PFPC Distributors, Inc. (the “Distributor”), 760 Moore Road, King of Prussia, Pennsylvania 19406. Shareholders and Financial Advisors (as defined under “How to Buy Shares”) should not send any transaction or account requests to this address.

HOW TO BUY SHARES

 

You can purchase shares of the Funds on any day that the New York Stock Exchange (“NYSE”) is open for business. You can purchase shares of the Funds from any financial advisor, broker-dealer or other financial intermediary that has entered into an agreement with the Distributor with respect to the sale of shares of the Funds (a “Financial Advisor”), or PFPC, Inc., the Funds’ transfer agent (the “Transfer Agent”). Your Financial Advisor can help you establish an appropriate investment portfolio, buy shares, and monitor your investments. The Funds have authorized Financial Advisors to receive purchase and redemption orders on their behalf. Financial Advisors are authorized to designate other intermediaries to receive purchase and redemption orders on the Funds’ behalf. The Funds will be deemed to have received a purchase or redemption order when a Financial Advisor or its authorized

designee receives the order in “good form.” “Good form” means that you placed your order with your Financial Advisor or its authorized designee or your payment (made in accordance with any of the methods set forth in the table below) has been received and your application is complete, including all necessary signatures. Customer orders will be priced at a Fund’s net asset value (“NAV”) next computed after they are received by a Financial Advisor or its authorized designee. Investors may be charged a fee by their Financial Advisor, payable to the Financial Advisor and not a Fund, if they effect a transaction in Fund shares through either a Financial Advisor or its authorized designee.

 

The USA Patriot Act may require a Fund, a Financial Advisor or its authorized designee to obtain certain personal information from you which will be used to verify your identity. If you do not provide the information, it may not be possible to open your account. If a Fund, a Financial Advisor or authorized designee is unable to verify your customer information, such Fund reserves the right to close your account or to take such other steps as it deems reasonable.

 

Outlined below are various methods for buying shares of the Funds:

 

 

 

 

 

 

 

Each Fund reserves the right to change the investment minimums. Each Fund also reserves the right to refuse a purchase order for any reason, including if it believes that doing so would be in the best interests of such Fund and its shareholders.

 

Choosing a Share Class

 

Each Fund offers two classes of shares in this Prospectus—Class A and Class C Shares. Each share class has its own sales charge and expense structure. Determining which share class is best for you depends on the dollar amount you are investing and the number of years for which you are willing to invest. Purchases of $1 million or more can be made only in Class A Shares. Based on your personal situation, your Financial Advisor can help you decide which class of shares makes the most sense for you. Your Financial Advisor is entitled to receive compensation for purchases made through him or her and may receive differing compensation for selling Class A and Class C Shares. The Funds also offer exclusively to certain institutional and other eligible investors an additional class of shares, Class Z Shares, which are made available through a separate prospectus.

 

Sales Charges

 

You may be subject to an initial sales charge when you purchase shares or a CDSC when you redeem your shares. These sales charges are described below. In certain circumstances, the sales charges may be waived, as described below and in the SAI.

 

Class A Shares

 

Your purchases of Class A Shares are made at the public offering price for these shares, that is, the NAV per share for Class A Shares plus a front-end sales charge that is based on the amount of your initial investment when you open your account. The front-end sales charge you pay on an additional investment is based on the total amount of your additional purchase and the current value of your account. Shares you purchase with reinvested dividends or other distributions are not subject to a sales charge. The amount of the sales charge, if any, differs depending on the amount you invest as shown in the table below.

 

 

 

 

Reduced Sales Charges for Larger Investments in Class A Shares

 

Right of Accumulation.   You may pay a lower sales charge when purchasing Class A Shares of a Fund through a Right of Accumulation, which privilege works as follows: if the combined value (determined at the current public offering price) of your accounts in all classes and shares of a Fund and other Participating Funds (as defined below) maintained by you, your spouse or your minor children, together with the value (also determined at the current public offering price) of your current purchase, reaches a sales charge discount level (according to the above chart), your current purchase will receive the lower sales charge, provided that you have notified the Distributor and your Financial Advisor in writing of the identity of such other accounts and your relationship to the other account holders and submitted information (such as account statements) sufficient to substantiate your eligibility for a reduced sales charge. Such reduced sales charge will be applied upon confirmation of such shareholders’ holdings by the Transfer Agent. The Funds may terminate or amend this Right of Accumulation at any time without notice. As used herein, “Participating Funds” refers to the registered investment companies and portfolios thereof advised by the Adviser and distributed by the Distributor as determined from time to time by the Board of Trustees of the Funds.

 

Letter of Intent.   You may also pay a lower sales charge when purchasing Class A Shares of a Fund and other Participating Funds by signing a Letter of Intent within 90 days of your purchase. By doing so, you would be able to pay the lower sales charge on all purchases by agreeing to invest a total of at least $100,000 within 13 months. If your Letter of Intent purchases are not completed within 13 months, you will be charged the applicable sales charge on the amount you had invested up to that date. Upon request, a Letter of Intent may reflect purchases within the previous 90 days. See “Programs for Reducing or Eliminating Sales Charges—Letter of Intent” in the SAI for additional information about this privilege.

 

Other Programs.   Certain other investors may purchase shares with reduced or no sales charges. See “Programs for Reducing or Eliminating Sales Charges” in the SAI for a description of these programs.

 

Class C Shares

 

Your purchases of Class C Shares are made at the NAV per share for Class C Shares. Although Class C Shares have no front-end sales charge, they carry a CDSC of 1.00% that is applied to shares sold within the first year after they are purchased. After holding Class C Shares for one year, you may sell them at any time without paying a CDSC.

 

Distribution and Service Fees

 

Each class of shares is authorized under a distribution plan (each a “Plan” and collectively the “Plans”) to use the assets attributable to such class to finance certain activities relating to the distribution of shares to investors. These activities include marketing and other activities to support the distribution of the Class A and Class C Shares and the services provided to you by your Financial Advisor. The Plans operate in a manner consistent with Rule 12b-1 under the 1940 Act, which regulates the manner in which an open-end investment company may directly or indirectly bear the expenses of distributing its shares.

 

Under the Plans, distribution and service fees paid by each Fund to the Distributor will be at an annual rate of 0.35% of average daily net assets attributable to Class A Shares and 1.00% of average daily net assets attributable to Class C Shares. The Distributor may pay all or a portion of these fees to Financial Advisors whose clients own shares of the Funds. Because the distribution and service fees are payable regardless of the Distributor’s expenses, the Distributor may realize a profit from the fees. The Plans authorize any other payments by the Funds to the Distributor and its affiliates to the extent that such payments might be construed to be indirect financing of the distribution of shares of the Funds. Because these fees are paid out of the Funds’ assets on an ongoing basis, these fees will increase the cost of your investment in a Fund. By purchasing a class of shares subject to higher distribution fees and service fees, you may pay more over time than on a class of shares with other types of sales charge arrangements. Long-term shareholders may pay more than the economic equivalent of the maximum front-end sales charges permitted by the rules of the National Association of Securities Dealers, Inc.

 

The Board of Trustees of the Funds believe that the Plans could be a significant factor in the growth and retention of assets in the Funds resulting in a more advantageous expense ratio and increased investment flexibility which could benefit each class of shareholders of each Fund. The Plans will continue in effect from year to year so long as continuance is specifically approved at least annually by a vote of the Trustees, including the Trustees who are not “interested persons” (as defined in the 1940 Act) of the Funds and who have no direct or indirect financial interest in the operation of the Plan or in any agreements related to the Plan (the “Independent Trustees”), cast in person at a meeting called for the purpose of voting on the Plans. The Plans may not be amended to increase the fees materially without approval by a vote of a majority of the outstanding voting securities of the relevant class of shares, and all material amendments of the Plans must be approved by the Trustees in the manner provided in the foregoing sentence. A Plan may be terminated with respect to a class at any time by a vote of a majority of the Independent Trustees or by a vote of a majority of the outstanding voting securities of the relevant class of shares. The continuance of the Plans will only be effective if the selection and nomination of the Independent Trustees is effected by such Independent Trustees.

 

In addition, Highland and/or the Distributor may, from time to time, at their own expense out of their own financial resources, make cash payments to broker-dealers as an incentive to sell shares of the Funds and/or to promote retention of their customers’ assets in the Funds. Such cash payments may be calculated on sales of shares of the Funds (“Sales-Based Payments”) or on the average daily net assets of the Funds attributable to that particular broker-dealer (“Asset-Based Payments”). Each of Highland and/or the Distributor may agree to make such cash payments to a broker-dealer in the form of either or both Sales-Based Payments and Asset-Based Payments. Highland and/or the Distributor may also make other cash payments to broker-dealers in addition to or in lieu of Sales-Based Payments and Asset-Based Payments, in the form of payment for travel expenses, including lodging, incurred in connection with trips taken by qualifying registered representatives of those broker-dealers and their families to places within or outside the United States; meeting fees; entertainment; transaction processing and transmission charges; advertising or other promotional expenses; allocable portions, based on shares of the Funds sold, of salaries and bonuses of registered representatives of an affiliated broker-dealer that is a Financial Advisor; or other expenses as determined in Highland’s or the Distributor’s discretion, as applicable. In certain cases these other payments could be significant to the broker-dealers. Any payments described above will not change the price paid by investors for the purchase of the shares of the Funds, the amount that the Funds will receive as proceeds from such sales, or the amounts payable under the Plans. Each of Highland and/or the Distributor determines the cash payments described above in its discretion in response to requests from broker-dealers, based on factors it deems relevant. Broker-dealers may not use sales of the Funds’ shares to qualify for any incentives to the extent that such incentives may be prohibited by law. Amounts paid by Highland and/or the Distributor to any broker-dealer in connection with the distribution of any shares of the Funds will count

towards the maximum imposed by the National Association of Securities Dealers, Inc. on underwriter compensation in connection with the public offering of securities.

 

Contingent Deferred Sales Charges (“CDSCs”)

 

As described above, certain investments in Class A and Class C Shares are subject to a CDSC. You will pay the CDSC only on shares you redeem within the prescribed amount of time after purchase. The CDSC is applied to the NAV at the time of purchase or redemption, whichever is lower. For purposes of calculating the CDSC, the start of the holding period is the day on which the purchase was made. Shares you purchase with reinvested dividends or capital gains are not subject to a CDSC. When shares are redeemed, the Funds will automatically redeem those shares not subject to a CDSC and then those you have held the longest. This policy helps reduce and possibly eliminate the potential impact of the CDSC. In certain circumstances, CDSCs may be waived, as described in the SAI.

 

Availability of Information

 

Clear and prominent information regarding sales charges of the Funds and the applicability and availability of discounts from sales charges is available free of charge through the Funds’ website at http://www.highlandfunds.com, which provides links to the Prospectus and Statement of Additional Information containing the relevant information.

 

You can redeem shares of a Fund on any day that the NYSE is open for business. Each Fund, however, may temporarily stop redeeming its shares when trading on the NYSE is restricted, when an emergency exists and the Fund cannot sell its shares or accurately determine the value of its assets, or if the SEC orders the Fund to suspend redemptions.

 

Each Fund redeems its shares based on the net asset value next determined after the Transfer Agent or Financial Advisor receives your redemption request in proper form. See “Net Asset Value” for a description of the calculation of net asset value.

 

The Funds are intended for long-term investors and not for those who wish to trade frequently in shares of the Funds. The Funds believe that excessive short-term trading of shares of the Funds, such as by traders seeking short-term profits from market momentum, time zone arbitrage and other timing strategies, creates risks for the Funds and their long-term shareholders, including interference with efficient portfolio management, increased administrative and brokerage costs and potential dilution in the value of shares.

 

In order to discourage frequent short-term trading in shares of the Funds, the Board of Trustees of the Funds has adopted policies and procedures that impose a 2.00% redemption fee or exchange fee (each a “short-term trading fee”) on Class A Shares and Class C Shares that are redeemed or exchanged within 60 days of the date of purchase. This fee is calculated based on the shares’ aggregate net asset value on the date of redemption or exchange and is deducted from the redemption or exchange proceeds. This fee is not a sales charge, is retained by the applicable Fund, and does not benefit the Funds’ Adviser, Distributor or any other third party. For purposes of computing this fee, shares will be redeemed or exchanged in reverse order of purchase (the latest shares acquired will be redeemed or exchanged first).

 

A short-term trading fee will not apply to redemptions or exchanges of shares where (i) the shares redeemed or exchanged were purchased through automatic reinvestment of dividends or other distributions, (ii) the redemption or exchange is initiated by a Fund, (iii) the shares redeemed or exchanged were purchased through programs that collect the short-term trading fee at the program level and remit them to a Fund or (iv) the shares redeemed or exchanged were purchased through programs (including programs utilizing omnibus accounts) that the Adviser determines have appropriate anti-short-term trading polices in place or as to which the Adviser has received assurances that look-through short-term trading fee procedures or effective anti-short-term trading policies and procedures will be in place. Recordkeepers for certain retirement plans who cannot implement short-term trading fees because of systems’ limitations and who have provided verification to that effect may be permitted to delay, temporarily, the implementation of such fees. The Funds seeks to apply these policies uniformly. Any shareholder purchasing shares of a Fund through a Financial Advisor should check with the Financial Advisor or the Fund to determine whether the shares will be subject to a short-term trading fee.

 

Each Fund reserves the right to refuse any purchase or exchange request from any person or group who, in the Fund’s view, is likely to engage in excessive trading or if such purchase or exchange is not in the best interests of the Fund and to limit, delay or impose other conditions on purchases or exchanges. Each Fund has adopted a policy of seeking to minimize short-term trading in its shares and monitors purchase, exchange and redemption activities to assist in minimizing short-term trading.

 

You may redeem shares of a Fund through your Financial Advisor or its authorized designee or directly from the Fund through the Transfer Agent. If you hold your shares in an individual retirement account (“IRA”), you should consult a tax advisor concerning the current tax rules applicable to IRAs. Outlined below are various methods for redeeming shares:

 

Automatic Cash Withdrawal Plan

 

You may automatically redeem shares on a monthly basis if you have at least $10,000 in your account and if your account is directly registered with the Transfer Agent. Call (877) 665-1287 or visit www.highlandfunds.com for more information about this plan.

 

Involuntary Redemption

 

A Fund may redeem all shares in your account (other than an IRA) if their aggregate value falls below $5,000 as a result of redemptions (but not as a result of a decline in net asset value). You will be notified in writing if the Fund initiates such action and allowed 30 days to increase the value of your account to at least $5,000.

 

Redemption Proceeds

 

A redemption request received by a Fund will be effected at the next determined NAV after the Fund receives the request. If you request redemption proceeds by check, the Fund will normally mail the check to you within seven days after receipt of your redemption request. If, however, you purchased your shares by check or ACH transaction and unless you have documentation satisfactory to the Fund that your transaction has cleared, the Fund may hold proceeds for shares purchased by check or ACH until the purchase amount has been deemed collected, which is eight business days for checks and five business days for ACH transactions. While the Fund will delay the processing of the payment until the check clears, your shares will be valued at the next determined NAV after receipt by the Transfer Agent or your Financial Advisor of your redemption request.

 

The Funds may pay your redemption proceeds wholly or partially in portfolio securities. Payments would be made in portfolio securities, which may include illiquid securities, only in the rare instance that the Board of Trustees of a Fund believes that it would be in the Fund’s best interests not to pay redemption proceeds in cash. If a Fund pays your redemption proceeds in portfolio securities, you will be exposed to market risk until you convert these portfolio securities into cash, and you will likely pay commissions upon any such conversion. If you receive illiquid securities, you could find it more difficult to sell such securities and may not be able to sell such securities at prices that reflect the Adviser’s or your assessment of their fair value or the amount paid for them by the Funds. Illiquidity may result from the absence of an established market for such securities as well as legal, contractual or other restrictions on their resale and other factors.

 

Shareholders of a Fund may exchange their shares on any day that the NYSE is open for business for shares of the same share class of any Participating Fund at the next determined NAV, plus any applicable exchange fee (see “Redemption of Shares”). Shares of a Fund may be exchanged for shares of any Participating Fund only if shares of that Participating Fund are available for sale. If you do not currently have an account in the Participating Fund into which you wish to exchange your shares, you will need to exchange enough shares to satisfy the Participating Fund’s current minimum investment account requirements. Current minimum investment account requirements, as well as other important information, are available in each Participating Fund’s current prospectus, which shareholders should obtain and read prior to seeking an exchange. A prospectus for each of the Participating Funds may be obtained by calling (877) 665-1287 or by visiting http://www.highlandfunds.com.

 

If you exchange shares of a Fund for shares of Highland Floating Rate Fund or Highland Floating Rate Advantage Fund (the “Floating Rate Funds”), please note that the Floating Rate Funds have restrictions on redemptions and exchanges. Shareholders of the Floating Rate Funds may only liquidate their shares by tendering their shares or effecting an exchange on a quarterly repurchase date. Please obtain and read a prospectus for the Floating Rate Funds before exchanging into the Floating Rate Funds.

 

If the Fund shares you are exchanging are subject to a CDSC, you will not be charged a CDSC upon the exchange. However, when you sell the shares acquired through the exchange (the “acquired shares”), they may be subject to a CDSC, depending upon when you originally purchased the Fund shares that you are exchanging. For purposes of determining the applicability of a CDSC, the length of time you own your acquired shares will be computed from the date of your original purchase of the Fund shares (and includes the period during which the acquired shares were held),

and the applicable CDSC will be the CDSC of the original Fund shares that you purchased. No CDSC is charged when you exchange your Fund shares into the RBB Money Market Fund (the “Money Market Fund”); however, notwithstanding any statement above to the contrary, the applicable CDSC will be imposed when shares are redeemed from the Money Market Fund and will be calculated without regard to the time such shares were held in the Money Market Fund. Your exchange privilege will be revoked if the exchange activity is considered excessive. In addition, the Funds may reject any exchange request for any reason, including if it does not think that it is in the best interests of the Funds and/or their shareholders to accept the exchange.

 

Unless you have a tax-deferred account, an exchange is a taxable event, and you may realize a gain or a loss for tax purposes. See “Taxation.” A Fund may terminate your exchange privilege if the Adviser determines that your exchange activity is likely to impact adversely its ability to manage the Fund or if the Fund otherwise determines that your exchange activity is contrary to its short-term trading policies and procedures. To exchange by telephone, please call (877) 665-1287. Please have your account and taxpayer identification number available when calling.

NET ASSET VALUE

 

The NAV per share of each Funds’ Class A Shares and Class C Shares is calculated as of the close of regular trading on the NYSE, normally 4:00 p.m., Eastern Time, on each day that the NYSE is open for business. The NYSE is open Monday through Friday, but currently is scheduled to be closed on New Year’s Day, Dr. Martin Luther King, Jr. Day, Presidents’ Day, Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day and on the preceding Friday or subsequent Monday when a holiday falls on a Saturday or Sunday, respectively. The NAV per share of a Fund is computed by dividing the value of the Fund’s net assets (i.e., the value of its securities and other assets less its liabilities, including expenses payable or accrued but excluding capital stock and surplus) attributable to the class of shares by the total number of shares of the class outstanding at the time the determination is made. The price of a particular class of a Fund’s shares for the purpose of purchase and redemption orders will be based upon the calculation of NAV per share of the Fund next made after the purchase or redemption order is received in good form.

 

Each Fund’s portfolio securities are valued in accordance with the Fund’s valuation policies approved by the Board of Trustees of the Funds. Portfolio securities for which market quotations are readily available are valued at their current market value, except that debt securities that are not credit impaired and have remaining maturities of 60 days or less will be valued at amortized cost, which approximates market value. All other portfolio securities are valued at fair value as determined in good faith pursuant to the Funds’ valuation policies. Pursuant to the Funds’ pricing procedures, securities for which market quotations are not readily available, and therefore are subject to being fair valued, may include securities that are subject to legal or contractual restrictions on resale, securities for which no or limited trading activity has occurred for a period of time, or securities that are otherwise deemed to be illiquid (i.e., securities that cannot be disposed of within seven days at approximately the price at which the security is currently priced by the Fund). Market quotations are also deemed not to be readily available when an event has occurred after the close of the principal foreign market on which a security trades, but before the time for determination of a Fund’s NAV, that has affected, or is likely to affect, more than minimally the NAV per share of the Fund.

 

When a market quotation is not readily available, a portfolio security is valued at its fair value, as determined in good faith under procedures established by the Board of Trustees of the Funds. In determining fair value, the Funds’ pricing procedures establish a process and methodology to be employed in attempting to ascertain, in good faith, fair value. Fair value is defined as the amount for which assets could be sold in an orderly disposition over a reasonable period of time, taking into account the nature of the asset. Fair value pricing, however, involves judgments that are inherently subjective and inexact, since fair valuation procedures are used only when it is not possible to be sure what value should be attributed to a particular asset or when an event will affect the market price of an asset and to what extent. As a result, there can be no assurance that fair value pricing will reflect actual market value, and it is possible that the fair value determined for a security will be materially different from the value that actually could be or is realized upon the sale of that asset. The Board of Trustees of the Funds will review the Adviser’s fair value determinations periodically. The value of a Fund’s portfolio assets may change on days the Fund is closed and on which you are not able to purchase or sell your shares.

 

The Funds intend to pay monthly dividends and any capital gain distributions on an annual basis. You may have dividends or capital gain distributions that are declared by a Fund automatically reinvested at NAV in additional shares of the Fund. You will make an election to receive dividends and distributions in cash or in Fund shares at the time you purchase your shares. You may change this election by notifying the appropriate Fund in writing at any time prior to the record date for a particular dividend or distribution. Dividends and other taxable distributions are taxable to you even if they are reinvested in additional shares of a Fund. There are no sales or other charges in connection with the reinvestment of dividends and capital gain distributions. Shares purchased through dividend reinvestment will receive a price based on the NAV per share on the reinvestment date, which is typically the date dividends are paid to shareholders. There is no fixed dividend rate, and there can be no assurance that the Funds will pay any dividends or realize any capital gains.

 

The following discussion is a brief summary of certain U.S. federal income tax considerations affecting the Funds and their U.S. shareholders. The discussion reflects applicable tax laws of the United States as of the date of this prospectus, which tax laws may be changed or subject to new interpretations by the courts or the Internal Revenue Service (the “IRS”) retroactively or prospectively. No attempt is made to present a detailed explanation of all U.S. federal, state, local and foreign tax law concerns affecting the Funds and their shareholders (including shareholders owning large positions in a Fund), and the discussion set forth herein does not constitute tax advice. For more information, please see “Additional Income Tax Considerations” in the SAI. Because each shareholder’s tax situation is unique, ask your tax professional about the tax consequences to you of an investment in the Funds.

 

Each Fund intends to elect to be treated and qualify annually as a regulated investment company under Subchapter M of the Code. Accordingly, the Funds generally will not be subject to U.S. federal income tax on income and gains that the Funds distribute to their shareholders. As a regulated investment company, each Fund must, among other things, (i) derive in each taxable year at least 90% of its gross income from (a) dividends, interest (including tax-exempt interest), payments with respect to certain securities loans, and gains from the sale or other disposition of stock, securities or foreign currencies, or other income (including but not limited to gain from options, futures and forward contracts) derived with respect to its business of investing in such stock, securities or currencies and (b) net income derived from interests in certain publicly traded partnerships that are treated as partnerships for U.S. federal income tax purposes and that derive less than 90% of their gross income from the items described in (a) above (each a “Qualified Publicly Traded Partnership”); and (ii) diversify its holdings so that, at the end of each quarter of each taxable year (a) at least 50% of the value of the Fund’s total assets is represented by cash and cash items, U.S. government securities, the securities of other regulated investment companies and other securities, with such other securities limited, in respect of any one issuer, to an amount not greater than 5% of the value of the Fund’s total assets and not more than 10% of the outstanding voting securities of such issuer and (b) not more than 25% of the value of the Fund’s total assets is invested in the securities of (I) any one issuer (other than U.S. government securities and the securities of other regulated investment companies), (II) any two or more issuers that the Fund controls and that are determined to be engaged in the same business or similar or related trades or businesses or (III) any one or more Qualified Publicly Traded Partnerships.

 

As a regulated investment company, each Fund generally will not be subject to U.S. federal income tax on income and gains that it distributes each taxable year to shareholders, if it distributes at least 90% of the sum of (i) its investment company taxable income (which includes, among other items, dividends, interest and the excess of any net short-term capital gains over net long-term capital losses and other taxable income, other than any net capital gain (as defined below), reduced by deductible expenses) determined without regard to the deduction for dividends and distributions paid and (ii) its net tax-exempt interest income (the excess of its gross tax-exempt interest income over certain disallowed deductions). Each Fund intends to distribute at least annually substantially all of such income. Each Fund will be subject to income tax at regular corporate rates on any taxable income or gains that it does not distribute to its shareholders.

 

Although the Funds do not presently expect to do so, each Fund is authorized to borrow funds and to sell assets in order to satisfy distribution requirements. Moreover, each Fund’s ability to dispose of assets to meet its distribution

requirements may be limited by (i) the illiquid nature of its portfolio and/or (ii) other requirements relating to its status as regulated investment company, including the diversification requirements. If either Fund disposes of assets in order to meet the distribution requirements or to avoid the federal excise tax, discussed below, such Fund may make such dispositions at times that, from an investment standpoint, are not advantageous.

 

Amounts not distributed on a timely basis in accordance with a calendar year distribution requirement are subject to a nondeductible 4% federal excise tax at the Fund level. To avoid the tax, each Fund must distribute during each calendar year an amount at least equal to the sum of (i) 98% of its ordinary income (not taking into account any capital gains or losses) for the calendar year, (ii) 98% of its capital gains in excess of its capital losses (adjusted for certain ordinary losses) for a one-year period generally ending on October 31 of the calendar year (unless an election is made to use the Fund’s fiscal year), and (iii) certain undistributed amounts from previous years on which the Fund paid no U.S. federal income tax. While each Fund intends to distribute any income and capital gains in the manner necessary to minimize imposition of the 4% federal excise tax, there can be no assurance that sufficient amounts of the Fund’s taxable income and capital gains will be distributed to avoid entirely the imposition of the tax. In that event, each Fund will be liable for the tax only on the amount by which it does not meet the foregoing distribution requirement.

 

If for any taxable year either Fund does not qualify as a regulated investment company, all of its taxable income (including its net capital gain) will be subject to tax at regular corporate rates without any deduction for distributions to shareholders.

 

Certain of the Funds’ investment practices are subject to special and complex U.S. federal income tax provisions that may, among other things: (i) disallow, suspend or otherwise limit the allowance of certain losses or deductions, (ii) convert lower taxed long-term capital gains or “qualified dividend income” into higher taxed short-term capital gains or ordinary income, (iii) convert ordinary loss or a deduction into capital loss (the deductibility of which is more limited), (iv) cause the Funds to recognize income or gain without a corresponding receipt of cash, (v) adversely affect the time as to when a purchase or sale of stock or securities is deemed to occur and (vi) adversely alter the characterization of certain complex financial transactions. These U.S. federal income tax provisions could therefore affect the amount, timing and character of distributions to stockholders. In particular, the Funds may recognize original issue discount ( i.e. , ordinary income prior to a corresponding receipt of cash) if the Funds acquire zero coupon securities, deferred interest securities or certain other securities, and the market discount rules may convert capital gains into ordinary income. Each Fund intends to monitor its transactions and may make certain tax elections, and may be required to borrow money or dispose of securities, to mitigate the effect of these provisions and prevent its disqualification as a regulated investment company.

 

Dividend, interest and other income received by either Fund from investments outside the United States may be subject to withholding and other taxes imposed by foreign countries. Tax treaties between the United States and other countries may reduce or eliminate such taxes. The Funds do not expect that they will be eligible to elect to treat any foreign taxes they pay as paid by their shareholders, who therefore will not be entitled to credits for such taxes on their own tax returns. Foreign taxes paid by either Fund will reduce the return from such Fund’s investments.

 

Distributions paid to you by a Fund from its net realized long-term capital gains, if any, that the Fund designates as capital gains dividends (“capital gain dividends”) are taxable as long-term capital gains, regardless of how long you have held your shares. All other dividends paid to you by a Fund (including dividends from short-term capital gains) from its current or accumulated earnings and profits (“ordinary income dividends”) are generally subject to tax as ordinary income. It is not generally expected that Fund distributions will qualify for favorable tax treatment as “qualified dividend income” for individual investors or as income eligible for the dividends received deduction for corporate investors.

 

Dividends and other taxable distributions are taxable to you even if they are reinvested in additional shares of a Fund. Dividends and other distributions paid by a Fund are generally treated as received by you at the time the dividend or distribution is made. If, however, a Fund pays you a dividend in January that was declared in the previous October, November or December and you were the shareholder 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 you on December 31 of the year in which the dividend was declared.

 

The price of shares purchased at any time may reflect the amount of a forthcoming distribution. If you purchase shares just prior to a distribution, you will receive a distribution that will be taxable to you even though it represents in part a return of your invested capital.

 

Generally, not later than 60 days after the close of its taxable year, your Fund will send you a written notice setting forth the amount and tax status of any distributions paid to you by the Fund. Ordinary income dividends and capital gain dividends may also be subject to state and local taxes.

 

If you sell or otherwise dispose of shares of your Fund (including exchanging them for shares of another fund), you will generally recognize a gain or loss in an amount equal to the difference between your tax basis in such shares of the Fund and the amount you receive upon disposition of such shares. If you hold your shares as capital assets, any such gain or loss will be long-term capital gain or loss if you have held such shares for more than one year at the time of sale.

 

If, for any calendar year, the total distributions exceed both current earnings and profits and accumulated earnings and profits, the excess will generally be treated as a tax-free return of capital up to the amount of a shareholder’s tax basis in the shares. The amount treated as a tax-free return of capital will reduce a shareholder’s tax basis in the shares, thereby increasing such shareholder’s potential gain or reducing his or her potential loss on the sale of the shares. Any amounts distributed to a shareholder in excess of his or her tax basis in the shares will be taxable to the shareholder as capital gain (assuming your shares are held as a capital asset).

 

Any loss upon the sale or exchange of shares of your Fund held for six months or less will be treated as long-term capital loss to the extent of any capital gain dividends received (including amounts credited as an undistributed capital gain dividend) by you. Any loss you realize on a sale or exchange of shares of your Fund will be disallowed if you acquire other shares of the same Fund (whether through the automatic reinvestment of dividends or otherwise) within a 61-day period beginning 30 days before and ending 30 days after your sale or exchange of the shares. In such case, the basis of the shares acquired will be adjusted to reflect the disallowed loss. Present law taxes both long-term and short-term capital gains of corporations at the rates applicable to ordinary income.

 

Your Fund may be required to withhold, for U.S. federal backup withholding tax purposes, a portion of the dividends, distributions and redemption proceeds payable to a shareholder who fails to provide the Fund (or its agent) with the shareholder’s correct taxpayer identification number (in the case of an individual, generally, such individual’s social security number) or to make the required certification, or who has been notified by the IRS that such shareholder is subject to backup withholding. Certain shareholders are exempt from backup withholding. Backup withholding is not an additional tax and any amount withheld may be refunded or credited against your U.S. federal income tax liability, if any, provided that you furnish the required information to the IRS.

 

The discussions set forth herein and in the SAI do not constitute tax advice, and investors are urged to consult their own tax advisors to determine the specific U.S. federal (including the application of the alternative minimum tax rules), state, local and foreign tax consequences to them of investing in the Funds.

 

In order to reduce duplicative mail and fees and expenses of the Funds, we will send a single copy of the Funds’ Prospectus and shareholder reports to your household even if more than one family member in your household owns shares of the Funds. Additional copies of the Prospectus and shareholder reports may be obtained by calling (877) 665-1287. If you do not want us to consolidate your Fund mailings and would prefer to receive separate mailings at any time in the future, please call us at the telephone number above and we will furnish separate mailings, in accordance with instructions, within 30 days of your request.

Privacy Policy

 

We recognize and respect your privacy expectations, whether you are a visitor to our website, a potential shareholder, a current shareholder or even a former shareholder.

 

Collection of Information.   We may collect nonpublic personal information about you from the following sources:

 

 

Disclosure of Information.   We may share the information we collect with our affiliates. We may also disclose this information as otherwise permitted by law. We do not sell your personal information to third parties for their independent use.

 

Confidentiality and Security of Information.   We restrict access to nonpublic personal information about you to our employees and agents who need to know such information to provide products or services to you. We maintain physical, electronic and procedural safeguards that comply with federal standards to guard your nonpublic personal information, although you should be aware that data protection cannot be guaranteed.

This Prospectus sets forth concisely the information that a prospective investor should know before investing in Class A Shares and Class C Shares of Highland High Income Fund (the “High Income Fund”) and Highland Income Fund (the “Income Fund”) (each, a “Fund,” and collectively, the “Funds”). Please read and retain this Prospectus for future reference. A Statement of Additional Information (“SAI”) regarding the Funds, dated March 1, 2007, has been filed with the SEC. This Prospectus incorporates by reference the entire SAI (together with any supplement to it).

 

Additional information about each Fund’s investments will be available in the Funds’ annual and semi-annual reports to shareholders.

 

You may obtain free copies of the SAI and the Funds’ annual and semi-annual reports, request other information about the Funds and make other inquiries by calling the Funds at (877) 665-1287. The SAI and the Funds’ annual and semi-annual reports are also available by visiting the Funds’ website (http://www.highlandfunds.com) or by writing to the Funds, c/o PFPC Inc., P.O. Box 9840, Providence, RI 02940.

 

Information about the Funds (including the SAI and the Funds’ annual and semi-annual reports) 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 (202) 551-8090. Information about the Funds is also available on the EDGAR Database on the SEC’s website at http://www.sec.gov. Copies of this information may be obtained, after paying a duplicating fee, by electronic request at the SEC’s e-mail address (publicinfo@sec.gov) or by writing the SEC’s Public Reference Section, Washington, D.C. 20549-0102.

 

Investment Co. Act
File Number: 811-21866

 

 

 

 

You should rely only on the information contained in, or incorporated by reference into, this Prospectus. The Funds have not authorized any other person to provide you with different information. If anyone provides you with different or inconsistent information, you should not rely on it. The Funds are not making an offer to sell these securities in any jurisdiction where the offer or sale is not permitted.

INVESTMENT AND RISK SUMMARY

 

 

 

HIGHLAND HIGH INCOME FUND

 

 

HIGHLAND HIGH INCOME FUND

 

Senior Loans.   Senior loans are business loans that have a right to payment senior to most other debts of the borrower. The senior loans in which the High Income Fund may invest may not be rated by a rating organization, will not be registered with the SEC or any state securities commission and generally will not be listed or traded on any national securities exchange. Therefore, the amount of public information available about senior loans will be limited, and the performance of the High Income Fund’s investments in senior loans will be more dependent on the analytical abilities of the Adviser than would be the case for investments in more widely-rated, registered or exchange-listed or traded securities. In evaluating the creditworthiness of borrowers, the Adviser will consider, and may rely in part, on analyses performed by others. Moreover, certain senior loans will be subject to contractual restrictions on resale and, therefore, will be illiquid.

 

Second and Third Lien Loans.   Second and third lien loans are subject to the same risks associated with investment in senior loans and high-yield securities. However, second and third lien loans are second and third, respectively, in right of payment to senior loans and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the senior secured obligations of the borrower. Second and third lien loans are expected to have greater price volatility than senior loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in second and third lien loans, which would create greater credit risk exposure.

 

Other Secured Loans.   Secured loans other than senior loans and second lien loans are subject to the same risks associated with investment in senior loans, second lien loans and below investment grade securities. However, such loans may rank lower in right of payment than any outstanding senior loans and second lien loans of the borrower and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the higher ranking secured obligations of the borrower. Lower ranking secured loans are expected to have greater price volatility than senior loans and second lien loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in lower ranking secured loans, which would create greater credit risk exposure.

 

Unsecured Loans.   Unsecured loans are subject to the same risks associated with investment in senior loans, second lien loans, other secured loans and below investment grade securities. However, because unsecured loans have lower priority in right of payment to any higher ranking obligations of the borrower and are not backed by a security interest in any specific collateral, they are subject to additional risk that the cash flow of the borrower and available assets may be insufficient to meet scheduled payments after giving effect to any higher ranking obligations of the borrower. Unsecured loans are expected to have greater price volatility than senior loans, second lien loans and other secured loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in unsecured loans, which would create greater credit risk exposure.

 

Credit Default Swaps.   Credit default swaps involve greater risks than investing in the reference obligation directly. In addition to general market risks, credit default swaps are subject to illiquidity risk, counterparty risk and credit risk. A buyer will lose its investment and recover nothing should no event of default occur. If an event of default were to occur, the value of the reference obligation received by the seller, coupled with the periodic payments previously received, may be less than the full notional value it pays to the buyer, resulting in a loss of value to the seller. When the High Income Fund acts as a seller of a credit default swap, it is exposed to many of the same risks of leverage described below since if an event of default occurs the seller must pay the buyer the full notional value of the reference obligation.

 

Distressed and Defaulted Securities.   Investments in the securities of financially distressed companies involve substantial risks. These securities may involve a substantial risk of default or may be in default. The High Income Fund may incur additional expenses to the extent it is required to seek recovery upon a default in the payment of principal of or interest on its portfolio holdings. In any reorganization or liquidation proceeding relating to a portfolio company, the High Income Fund may lose its entire investment or may be required to accept cash or securities with a value less than the original investment. Among the risks inherent in investments in a troubled entity is the fact that it

 

HIGHLAND HIGH INCOME FUND

frequently may be difficult to obtain information as to the true condition of such issuer. Judgments about the credit quality of the issuer and the relative value of its securities may prove to be wrong.

 

Investment in Restricted Securities.   Restricted securities (i.e., securities acquired in private placement transactions) may offer higher yields than comparable publicly-traded securities. The High Income Fund, however, may not be able to sell these securities when the Adviser considers it desirable to do so or, to the extent they are sold privately, may have to sell them at less than the price of otherwise comparable securities.

 

Non-U.S. Securities.   Because the High Income Fund may own securities of non-U.S. issuers, it may be subject to risks not usually associated with owning securities of U.S. issuers. These risks can include fluctuations in foreign currencies, foreign currency exchange controls, political and economic instability, differences in financial reporting, differences in securities regulation, and trading and foreign taxation issues. The High Income Fund may also invest in issuers in developing or emerging market countries, which are subject to greater risks than securities of issuers in developed countries.

 

Investment in Zero Coupon Securities and Step-Up Bonds.   Zero coupon securities and step-up bonds are debt securities that do not entitle the holder to any periodic payment of interest prior to maturity or a specified date when the securities begin paying current interest. Because such securities do not entitle the holder to any periodic payments of interest prior to maturity, this prevents any reinvestment of interest payments at prevailing interest rates if prevailing interest rates rise. The High Income Fund accrues income on these investments for U.S. federal income tax purposes, which, because no cash is received by the Fund at the time of accrual, may require the Fund to dispose of other portfolio securities to satisfy the its distribution requirements and prevent its disqualification as a regulated investment company. Special tax considerations are associated with investing in these securities. See “Taxation.”

 

Convertible Securities.   Convertible securities generally offer lower interest or dividend yields than non-convertible debt securities of similar credit quality because of the potential for capital appreciation and are typically unrated or rated lower than such securities. In the event of a liquidation of the issuing company, holders of convertible securities would be paid before that company’s common shareholders. Consequently, an issuer’s convertible securities generally entail less risk than its common stock. Convertible securities, however, fall below debt obligations of the same issuer in order of preference or priority in the event of a liquidation.

 

Common Stock.   The High Income Fund may have exposure to common stocks, including through investments in convertible securities. Although common stocks historically have generated higher average returns than debt securities, common stocks also have experienced significantly more volatility in those returns. An adverse event, such as an unfavorable earnings report, may depress the value of a particular common stock held by the High Income Fund. Also, prices of common stocks are sensitive to general movements in the stock market, and a drop in the stock market may depress the prices of common stocks held by the High Income Fund or to which it has exposure.

 

Hedging.   The High Income Fund’s use of derivatives and other transactions, such as options, financial futures and options on financial futures, may involve risks not associated with other types of investments that the Fund intends to purchase. It is possible that a portfolio that utilizes hedging strategies may not perform as well as a portfolio that does not make use of such strategies. The High Income Fund’s use of derivatives or other transactions to reduce risk involves costs and will be subject to an Adviser’s ability to predict correctly changes in the relationships of such hedge instruments to the Fund’s portfolio holdings or other factors. No assurance can be given that such Adviser’s judgment in this respect will be correct. In addition, no assurance can be given that the High Income Fund will enter into hedging or other transactions at times or under circumstances in which it may be advisable to do so. Although the Adviser does not anticipate that derivatives or other such transactions will represent a significant component of the High Income Fund’s investment strategy or will be used for speculative purposes, the Fund has a policy to limit to 20% the portion of the Fund’s total assets that may be subject to such transactions or invested in such instruments.

 

Leverage.   Although it has no current intention to do so, the High Income Fund may employ leverage through borrowings (“borrowings” are sometimes referred to in this Prospectus as “leverage”), which can adversely affect the yield on the Fund’s shares. Capital raised through leverage will be subject to interest and other costs, and to the extent the

 

HIGHLAND HIGH INCOME FUND

High Income Fund is unable to invest the proceeds from the use of leverage in assets that pay interest at a rate that exceeds the rate paid in connection with the leverage, the yield on the Fund’s shares will decrease because the net investment income available for distribution to shareholders will be reduced. There can be no assurance that the High Income Fund’s income from the proceeds of leverage would exceed these costs. The effect of a general market decline in the value of assets such as those in which the High Income Fund invests or of a default on one or more loans or other interest-bearing instruments held by the Fund would be magnified in the Fund because of the leverage and may exaggerate the effect on the Fund’s NAV. The Adviser, however, would seek to use leverage for the purpose of making additional investments only if it believed, at the time of using leverage, that the total return on the assets purchased with such monies would exceed interest payments and other costs of the leverage. In addition, the Adviser would utilize leverage mechanisms whose interest rates float (or reset frequently) to reduce the risk that the costs of the use of leverage would exceed the total return on investments purchased with the proceeds of leverage. Additionally, the investment advisory fee paid to the Adviser will be higher when the High Income Fund borrows money, giving the Adviser incentive to use leverage.

 

Market Disruption.   Certain events may have a disruptive effect on the securities markets, such as terrorist attacks, war and other geopolitical events. The High Income Fund cannot predict the effects of similar events on the U.S. economy in the future. High-yield securities tend to be more volatile than investment grade securities, so these events and any actions resulting from them may have a greater impact on the prices and volatility of high-yield securities than on investment grade securities.

 

Risk/Return Bar Chart and Table

 

The High Income Fund is expected to commence investment operations on or about the date of this Prospectus; therefore, the High Income Fund currently has no investment performance information to report.   After the High Income Fund has had operations for at least one calendar year, its Prospectus will include a bar chart and a table that will provide an indication of the risks of investing in the Fund by showing changes in the Fund’s performance from year to year and by showing how the Fund’s average annual returns for the most recent one year, five years and ten years (or the life of the Fund, if shorter), compare to those of its benchmark, the Credit Suisse High Yield Index, a market-weighted index that includes publicly traded bonds rated below BBB by S&P and Baa by Moody’s. As with all mutual funds, the High Income Fund’s past performance (before and after taxes) will not predict how the Fund will perform in the future. Both the chart and the table will assume the reinvestment of dividends and distributions.

 

HIGHLAND HIGH INCOME FUND

FEES AND EXPENSES OF THE HIGH INCOME FUND

 

The following table describes the fees and expenses that an investor will pay if an investor buys and holds Class Z Shares of the High Income Fund.

 

 

Expense Example.   This Example helps you compare the cost of investing in the High Income Fund to the cost of investing in other mutual funds. The Example assumes that (i) you invest $10,000 in the High Income Fund, (ii) your investment has a 5% return each year, (iii) operating expenses remain the same, and (iv) all income dividends and capital gains distributions are reinvested in additional shares. The Example should not be considered a representation of future expenses. Your actual costs may be higher or lower.

 

 

 

 

 

 

 

HIGHLAND INCOME FUND

INVESTMENT AND RISK SUMMARY

 

 

 

HIGHLAND INCOME FUND

may invest a greater percentage of its assets in a particular issuer or particular issuers than a diversified fund could. A non-diversified fund’s investment in fewer issuers may result in the fund’s shares being more sensitive to the economic results of those issuers.

 

 

HIGHLAND INCOME FUND

changes in the financial condition of the issuer, the Fund may find it more difficult to sell such securities when the Adviser believes it advisable to do so or may be able to sell such securities only at prices lower than if the securities were more widely held.

 

Non-Diversification.   Due to the nature of the Income Fund’s investment strategy and its non-diversified status, it is possible that a material amount of the Fund’s investments could be invested in the securities of only a few companies. Investing a significant portion of the Income Fund’s portfolio in any one or a few issuers would subject the Fund to a greater degree of risk with respect to the failure of any such issuer.

 

Senior Loans.   Senior loans are business loans that have a right to payment senior to most other debts of the borrower. The senior loans in which the Income Fund may invest may not be rated by a rating organization, will not be registered with the SEC or any state securities commission and generally will not be listed or traded on any national securities exchange. Therefore, the amount of public information available about senior loans will be limited, and the performance of the Income Fund’s investments in senior loans will be more dependent on the analytical abilities of the Adviser than would be the case for investments in more widely-rated, registered or exchange-listed or traded securities. In evaluating the creditworthiness of borrowers, the Adviser will consider, and may rely in part, on analyses performed by others. Moreover, certain senior loans will be subject to contractual restrictions on resale and, therefore, will be illiquid.

 

Second and Third Lien Loans.   Second and third lien loans are subject to the same risks associated with investment in senior loans and high-yield securities. However, second and third lien loans are second and third, respectively, in right of payment to senior loans and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the senior secured obligations of the borrower. Second and third lien loans are expected to have greater price volatility than senior loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in second and third lien loans, which would create greater credit risk exposure.

 

Other Secured Loans.   Secured loans other than senior loans and second lien loans are subject to the same risks associated with investment in senior loans, second lien loans and below investment grade securities. However, such loans may rank lower in right of payment than any outstanding senior loans and second lien loans of the borrower and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the higher ranking secured obligations of the borrower. Lower ranking secured loans are expected to have greater price volatility than senior loans and second lien loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in lower ranking secured loans, which would create greater credit risk exposure.

 

Unsecured Loans.   Unsecured loans are subject to the same risks associated with investment in senior loans, second lien loans, other secured loans and below investment grade securities. However, because unsecured loans have lower priority in right of payment to any higher ranking obligations of the borrower and are not backed by a security interest in any specific collateral, they are subject to additional risk that the cash flow of the borrower and available assets may be insufficient to meet scheduled payments after giving effect to any higher ranking obligations of the borrower. Unsecured loans are expected to have greater price volatility than senior loans, second lien loans and other secured loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in unsecured loans, which would create greater credit risk exposure.

 

Credit Default Swaps.   Credit default swaps involve greater risks than investing in the reference obligation directly. In addition to general market risks, credit default swaps are subject to illiquidity risk, counterparty risk and credit risk. A buyer will lose its investment and recover nothing should no event of default occur. If an event of default were to occur, the value of the reference obligation received by the seller, coupled with the periodic payments previously received, may be less than the full notional value it pays to the buyer, resulting in a loss of value to the seller. When the Income Fund acts as a seller of a credit default swap, it is exposed to many of the same risks of leverage described below since if an event of default occurs the seller must pay the buyer the full notional value of the reference obligation.

 

HIGHLAND INCOME FUND

 

Distressed and Defaulted Securities.   Investments in the securities of financially distressed companies involve substantial risks. These securities may involve a substantial risk of default or may be in default. The Income Fund may incur additional expenses to the extent it is required to seek recovery upon a default in the payment of principal of or interest on its portfolio holdings. In any reorganization or liquidation proceeding relating to a portfolio company, the Income Fund may lose its entire investment or may be required to accept cash or securities with a value less than the original investment. Among the risks inherent in investments in a troubled entity is the fact that it frequently may be difficult to obtain information as to the true condition of such issuer. Judgments about the credit quality of the issuer and the relative value of its securities may prove to be wrong.

 

Investment in Restricted Securities.   Restricted securities (i.e., securities acquired in private placement transactions) may offer higher yields than comparable publicly-traded securities. The Income Fund, however, may not be able to sell these securities when the Adviser considers it desirable to do so or, to the extent they are sold privately, may have to sell them at less than the price of otherwise comparable securities.

 

Non-U.S. Securities.   Because the Income Fund may own securities of non-U.S. issuers, it may be subject to risks not usually associated with owning securities of U.S. issuers. These risks can include fluctuations in foreign currencies, foreign currency exchange controls, political and economic instability, differences in financial reporting, differences in securities regulation, and trading and foreign taxation issues. The Income Fund may also invest in issuers in developing or emerging market countries, which are subject to greater risks than securities of issuers in developed countries.

 

Investment in Zero Coupon Securities and Step-Up Bonds.   Zero coupon securities and step-up bonds are debt securities that do not entitle the holder to any periodic payment of interest prior to maturity or a specified date when the securities begin paying current interest. Because such securities do not entitle the holder to any periodic payments of interest prior to maturity, this prevents any reinvestment of interest payments at prevailing interest rates if prevailing interest rates rise. The Income Fund accrues income on these investments for U.S. federal income tax purposes, which, because no cash is received by the Fund at the time of accrual, may require the Fund to dispose of other portfolio securities to satisfy the its distribution requirements and prevent its disqualification as a regulated investment company. Special tax considerations are associated with investing in these securities. See “Taxation.”

 

Convertible Securities.   Convertible securities generally offer lower interest or dividend yields than non-convertible debt securities of similar credit quality because of the potential for capital appreciation and are typically unrated or rated lower than such securities. In the event of a liquidation of the issuing company, holders of convertible securities would be paid before that company’s common shareholders. Consequently, an issuer’s convertible securities generally entail less risk than its common stock. Convertible securities, however, fall below debt obligations of the same issuer in order of preference or priority in the event of a liquidation.

 

Common Stock.   The Income Fund may have exposure to common stocks, including through investments in convertible securities. Although common stocks historically have generated higher average returns than debt securities, common stocks also have experienced significantly more volatility in those returns. An adverse event, such as an unfavorable earnings report, may depress the value of a particular common stock held by the Income Fund. Also, prices of common stocks are sensitive to general movements in the stock market, and a drop in the stock market may depress the prices of common stocks held by the Income Fund or to which it has exposure.

 

Hedging.   The Income Fund’s use of derivatives and other transactions, such as options, financial futures and options on financial futures, may involve risks not associated with other types of investments that the Fund intends to purchase. It is possible that a portfolio that utilizes hedging strategies may not perform as well as a portfolio that does not make use of such strategies. The Income Fund’s use of derivatives or other transactions to reduce risk involves costs and will be subject to an Adviser’s ability to predict correctly changes in the relationships of such hedge instruments to the Fund’s portfolio holdings or other factors. No assurance can be given that such Adviser’s judgment in this respect will be correct. In addition, no assurance can be given that the Income Fund will enter into hedging or other transactions at times or under circumstances in which it may be advisable to do so. Although the Adviser does not anticipate that derivatives or other such transactions will represent a significant component of the Income Fund’s

 

HIGHLAND INCOME FUND

investment strategy or will be used for speculative purposes, the Fund has a policy to limit to 20% the portion of the Fund’s total assets that may be subject to such transactions or invested in such instruments.

 

Leverage.   Although it has no current intention to do so, the Income Fund may employ leverage through borrowings (“borrowings” are sometimes referred to in this Prospectus as “leverage”), which can adversely affect the yield on the Fund’s shares. Capital raised through leverage will be subject to interest and other costs, and to the extent the Income Fund is unable to invest the proceeds from the use of leverage in assets that pay interest at a rate that exceeds the rate paid in connection with the leverage, the yield on the Fund’s shares will decrease because the net investment income available for distribution to shareholders will be reduced. There can be no assurance that the Income Fund’s income from the proceeds of leverage would exceed these costs. The effect of a general market decline in the value of assets such as those in which the Income Fund invests or of a default on one or more loans or other interest-bearing instruments held by the Fund would be magnified in the Fund because of the leverage and may exaggerate the effect on the Fund’s NAV. The Adviser, however, would seek to use leverage for the purpose of making additional investments only if it believed, at the time of using leverage, that the total return on the assets purchased with such monies would exceed interest payments and other costs of the leverage. In addition, the Adviser would utilize leverage mechanisms whose interest rates float (or reset frequently) to reduce the risk that the costs of the use of leverage would exceed the total return on investments purchased with the proceeds of leverage. Additionally, the investment advisory fee paid to the Adviser will be higher when the Income Fund borrows money, giving the Adviser incentive to use leverage.

 

Market Disruption.   Certain events may have a disruptive effect on the securities markets, such as terrorist attacks, war and other geopolitical events. The Income Fund cannot predict the effects on the U.S. economy of similar events in the future. High-yield securities tend to be more volatile than investment grade securities, so these events and any actions resulting from them may have a greater impact on the prices and volatility of high-yield securities than on investment grade securities.

 

Risk/Return Bar Chart and Table

 

The Income Fund is expected to commence investment operations on or about the date of this Prospectus; therefore, the Income Fund currently has no investment performance information to report. After the Income Fund has had operations for at least one calendar year, its Prospectus will include a bar chart and a table that will provide an indication of the risks of investing in the Fund by showing changes in the Fund’s performance from year to year and by showing how the Fund’s average annual returns for the most recent one year, five years and ten years (or the life of the Fund, if shorter), compare to those of its benchmark, the Lehman Brothers Aggregate Bond Index, a market-weighted index that measures the performance of the U.S. investment grade bond market. As with all mutual funds, the Income Fund’s past performance (before and after taxes) will not predict how the Fund will perform in the future. Both the chart and the table will assume the reinvestment of dividends and distributions.

 

HIGHLAND INCOME FUND

FEES AND EXPENSES OF THE INCOME FUND

 

The following table describes the fees and expenses that an investor will pay if an investor buys and holds Class Z Shares of the Income Fund.

 

 

Expense Example.   This Example helps you compare the cost of investing in the Income Fund to the cost of investing in other mutual funds. The Example assumes that (i) you invest $10,000 in the Income Fund, (ii) your investment has a 5% return each year, (iii) operating expenses remain the same, and (iv) all income dividends and capital gains distributions are reinvested in additional shares. The Example should not be considered a representation of future expenses. Your actual costs may be higher or lower.

 

 

 

 

 

 

 

INVESTMENT AND RISK INFORMATION

 

 

 

Portfolio Contents

 

High Yield Debt Securities.   The High Income Fund will, and the Income Fund may, invest in high-yield debt securities (also commonly referred to as “junk” securities), the generic name for debt securities rated between Ba/BB and C/D by Moody’s or S&P. High-yield debt securities are frequently issued by corporations in the growth stage of their development, but also may be issued by established companies. These bonds are regarded by the rating organizations, on balance, as predominantly speculative with respect to capacity to pay interest and repay principal in accordance with the terms of the obligation. Such securities also are generally considered to be subject to greater risk than securities with higher ratings with regard to a deterioration of general economic conditions. Securities that are rated Ba by Moody’s or BB by S&P have speculative characteristics with respect to the capacity to pay interest and repay principal. Securities that are rated B by Moody’s or S&P reflect the rating organizations’ view that such securities generally lack characteristics of a desirable investment and assurance of interest and principal payments over any long period of time may be small. Securities that are rated Caa by Moody’s or CCC by S&P or below are of poor standing. Those issues may be in default (such as those rated D by S&P) or present elements of danger with respect to principal or interest. Although the Funds do not currently intend to purchase securities that are in payment default, the Funds are not limited in their holdings of such securities and from time to time may invest in such securities, or securities held by the Funds may become subject to payment default subsequent to purchase. See the Appendix in the Statement of Additional Information (“SAI”) for a description of the rating categories of the rating organizations. High-yield securities held by the Funds may include securities received as a result of a corporate reorganization or issued as part of a corporate takeover. Securities issued to finance corporate restructurings may have special credit risks because of the highly-leveraged conditions of the issuers, and such securities usually are subordinate to securities subsequently issued by the issuer. In addition, such issuers may lose experienced management as a result of the restructurings. Finally, the market price of such securities may be more volatile to the extent that expected benefits from restructuring do not materialize.

 

Investment Grade Securities.   The Income Fund will, and the High Income Fund may, invest in a wide variety of bonds that are rated or determined by the Adviser to be of investment grade quality of varying maturities issued by U.S. corporations and other business entities. Bonds are fixed or variable rate debt obligations, including bills, notes, debentures, money market instruments and similar instruments and securities. Bonds generally are used by corporations and other issuers to borrow money from investors for a variety of business purposes. The issuer pays the investor a fixed or variable rate of interest and normally must repay the amount borrowed on or before maturity. Although more creditworthy and generally less risky than below investment grade securities, investment grade securities are still subject to market and credit risk. Investment grade securities are generally considered medium and high-quality securities. Some, however, may possess speculative characteristics, and may be more sensitive to economic changes and to changes in the financial condition of issuers.

 

Senior Loans.   Senior loans generally are made to corporations, partnerships and other business entities that operate in various industries and geographical regions. Senior loans typically hold the most senior position in a borrower’s capital structure, are typically secured with specific collateral and have a claim on the general assets of the borrower that is senior to that held by subordinated debtholders and stockholders of the borrower. Borrowers typically use proceeds from senior loans to finance leveraged buyouts, recapitalizations, mergers, acquisitions and stock repurchases and, to a lesser extent, to finance internal growth and for other corporate purposes. Senior loans typically have rates of interest which are redetermined either daily, monthly, quarterly or semi-annually by reference to a base lending rate, plus a premium. These base lending rates generally are LIBOR, the prime rate offered by one or more major U.S. banks (Prime Rate) or the certificate of deposit (CD) rate or other base lending rates used by commercial lenders. The Funds will invest primarily in senior loans that are below investment grade quality and are speculative investments that are subject to credit risk. The Funds will attempt to manage these risks through ongoing analysis and monitoring of borrowers.

 

Second and Third Lien Loans.   Second and third lien loans are loans made by public and private corporations and other nongovernmental entities and issuers for a variety of purposes. Second and third lien loans are second and third, respectively, in right of payment to one or more senior loans of the related borrower. Second and third lien loans typically are secured by a second or third priority security interest or lien to or on specified collateral securing the borrower’s obligation under the loan and typically have similar protections and rights as senior loans. Second lien loans are not (and by their terms cannot) become subordinate in right of payment to any obligation of the related borrower

other than senior loans of such borrower, and third lien loans are not (and by their terms cannot) become subordinate in right of payment to any obligation of the related borrower other than senior loans and second lien loans. Second and third lien loans, like senior loans, typically have adjustable floating rate interest payments. Because second and third lien loans are second to senior loans, they present a greater degree of investment risk but often pay interest at higher rates reflecting this additional risk. Such investments generally are of below investment grade quality. Other than their subordinated status, second and third lien loans have many characteristics and risks similar to senior loans discussed above.

 

Other Secured Loans.   Secured loans other than senior loans and second lien loans are made by public and private corporations and other non-governmental entities and issuers for a variety of purposes. Such secured loans may rank lower in right of payment to one or more senior loans and second lien loans of the borrower. Such secured loans typically are secured by a lower priority security interest or lien to or on specified collateral securing the borrower’s obligation under the loan, and typically have more subordinated protections and rights than senior loans and second lien loans. Secured loans may become subordinated in right of payment to more senior obligations of the borrower issued in the future. Such secured loans may have fixed or adjustable floating rate interest payments. Because such secured loans may rank lower as to right of payment than senior loans and second lien loans of the borrower, they may present a greater degree of investment risk than senior loans and second lien loans but often pay interest at higher rates reflecting this additional risk. Such investments generally are of below investment grade quality. Other than their more subordinated status, such investments have many characteristics and risks similar to senior loans and second lien loans discussed above. Because such loans, however, may rank lower in right of payment to senior loans and second lien loans of the borrower, they may be subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to repay the scheduled payments after giving effect to more senior secured obligations of the borrower. Such secured loans are also expected to have greater price volatility than senior loans and second lien loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in other secured loans, which would create greater credit risk exposure.

 

Unsecured Loans.   Unsecured loans are loans made by public and private corporations and other nongovernmental entities and issuers for a variety of purposes. Unsecured loans generally have lower priority in right of payment compared to holders of secured debt of the borrower. Unsecured loans are not secured by a security interest or lien to or on specified collateral securing the borrower’s obligation under the loan. Unsecured loans by their terms may be or may become subordinate in right of payment to other obligations of the borrower, including senior loans, second lien loans and other secured loans. Unsecured loans may have fixed or adjustable floating rate interest payments. Because unsecured loans are subordinate to the secured debt of the borrower, they present a greater degree of investment risk but often pay interest at higher rates reflecting this additional risk. Such investments generally are of below investment grade quality. Other than their subordinated and unsecured status, such investments have many characteristics and risks similar to senior loans, second lien loans and other secured loans discussed above.

 

Other Fixed Income Securities.   Securities acquired by the Funds may include preferred stock (including convertible preferred stock) and all types of debt obligations having varying terms with respect to security or credit support, subordination, purchase price, interest payments and maturity. Such obligations may include, for example, bonds, debentures, notes (including convertible debt securities), mortgage- or other asset-backed instruments, equipment lease certificates, equipment trust certificates, conditional sales contracts, commercial paper and obligations issued or guaranteed by the U.S. government or any of its political subdivisions, agencies or instrumentalities (including obligations, such as repurchase agreements, secured by such instruments). Most debt securities in which the Funds will invest will bear interest at fixed-rates, although each Fund reserves the right to invest in debt securities that have variable rates of interest. Each Fund also reserves the right to invest up to 10% of its total assets in debt securities that involve equity features, such as contingent interest or participations based on revenues, sales or profits ( i.e. , interest or other payments, often in addition to a fixed-rate of return, that are based on the borrower’s attainment of specified levels of revenues, sales or profits and thus enable the holder of the security to share in the potential success of the venture).

 

Credit Default Swaps.   To the extent consistent with Subchapter M of the Internal Revenue Code of 1986, as amended (the “Code”), each Fund may enter into credit default swap agreements. The “buyer” in a credit default contract is obligated to pay the “seller” a periodic stream of payments over the term of the contract provided that no event of default on an underlying reference obligation has occurred. If an event of default occurs, the seller must pay

the buyer the “par value” (full notional value) of the reference obligation in exchange for the reference obligation. A Fund may be either the buyer or seller in the transaction. If a Fund is a buyer and no event of default occurs, the Fund loses its investment and recovers nothing. However, if an event of default occurs, the buyer receives full notional value for a reference obligation that may have little or no value. As a seller, a Fund receives income throughout the term of the contract, which typically is between six months and three years, provided that there is no default event.

 

Zero Coupon Securities and Step-Up Bonds.   Each Fund may invest in zero coupon securities, including step-up bonds. Zero coupon securities pay no cash income but are purchased at a deep discount from their value at maturity, which discount varies depending on the time remaining until cash payments begin, prevailing interest rates, liquidity of the security and the perceived credit quality of the issuer. When held to maturity, their entire return, which consists of the amortized discount, comes from the difference between their purchase price and their maturity value. Step-up bonds are debt securities that typically do not pay interest for a specified period of time and then pay interest at a series of different rates. Special tax considerations are associated with investing in these securities. See “Taxation.”

 

Distressed and Defaulted Securities.   Each Fund is authorized to invest in the securities of financially distressed and bankrupt issuers, including debt obligations that are in covenant or payment default. Such investments generally trade significantly below par and are considered speculative. The repayment of defaulted obligations is subject to significant uncertainties. Defaulted obligations might be repaid only after lengthy workout or bankruptcy proceedings, during which the issuer might not make any interest or other payments. Typically such workout or bankruptcy proceedings result in only partial recovery of cash payments or an exchange of the defaulted obligation for other debt or equity securities of the issuer or its affiliates, which may in turn be illiquid or speculative. A Fund may not invest more than 20% of its total assets at the time of investment in defaulted securities.

 

Illiquid and Restricted Securities.   Each Fund may invest up to 15% of its total assets in illiquid securities. Each Fund may also invest up to 15% of its total assets in restricted securities, which are securities acquired in private placement transactions. Such securities generally may not be resold without registration under the Securities Act of 1933, as amended (the “Securities Act”), except in transactions exempt from the registration requirements of the Securities Act. A security that may be restricted as to resale under federal securities laws or otherwise will not be subject to this percentage limitation if the Adviser determines that the security is, at the time of acquisition, readily marketable. Illiquid and restricted securities may offer higher yields than comparable publicly-traded securities. However, a Fund may not be able to sell these securities when the Adviser considers it desirable to do so or, to the extent they are sold privately, may have to sell them at less than the price of otherwise comparable securities. Such securities may include, for example, those eligible for resale under Rule 144A under the Securities Act.

 

Temporary Defensive Investments.   If market conditions threaten to erode the value of a Fund’s assets, the Fund may adopt a temporary defensive investment strategy and invest without limitation in high-grade money market instruments, including commercial paper of domestic and non-U.S. corporations, certificates of deposit, bankers’ acceptances and other obligations of banks, repurchase agreements and short-term obligations issued or guaranteed by the U.S. government or its instrumentalities or agencies, and in investment grade debt securities. The yield on these securities will tend to be lower than the yield on other securities purchased by the Fund.

 

The achievement of each Fund’s investment objective(s) depends upon the Adviser’s analytical and portfolio management skills. In selecting securities for investment, the Adviser seeks to identify securities which entail reasonable credit risk considered in relation to each Fund’s investment policies. The Adviser uses an investment strategy of fundamental credit analysis and generally emphasizes issuers that it believes will remain financially sound and perform well in a range of market conditions. Portfolio securities are typically sold when the Adviser’s fundamental assessment of an issuer materially changes. There is no assurance that either Fund’s investment objective(s) will be attained in the future.

 

Portfolio Maturity and Turnover

 

A Fund’s holdings may include issues of various maturities. Ordinarily, the Funds will emphasize investments in medium and longer term instruments (i.e., those with maturities in excess of three years), but the weighted average maturity of portfolio holdings may be shortened or lengthened depending primarily on the Adviser’s outlook for interest rates. To the extent the weighted average maturity of a Fund’s portfolio securities is lengthened, the value of such holdings will be more susceptible to fluctuation in response to changes in interest rates, creditworthiness and general economic conditions. The weighted average of a Fund’s portfolio will fluctuate depending on market conditions and

investment opportunities. Each Fund, however, does not expect that the weighted average maturity of its portfolio will, under normal conditions, exceed ten years.

 

The Adviser actively makes portfolio adjustments that reflect each Fund’s investment strategy and may trade securities regardless of how long they have been held when it believes doing so will further the Fund’s investment objectives.

 

A Fund’s portfolio turnover rate may exceed 100% per year. A 100% annual turnover rate would occur, for example, if all the securities in the Fund’s portfolio were replaced once within a period of one year. Each Fund reserves full freedom with respect to portfolio turnover. In periods when there are rapid changes in economic conditions or security price levels or when investment strategy is changed significantly, portfolio turnover may be significantly higher than during times of economic and market price stability, when investment strategy remains relatively constant. A high rate of portfolio turnover (i.e., 100% or more) will result in increased transaction costs for the Fund in the form of increased dealer spreads and brokerage commissions. High portfolio turnover also could produce higher taxable distributions and lower the Fund’s after-tax performance.

 

the creditworthiness of the repurchase agreement counterparties with whom the Funds do business and will monitor their creditworthiness during the period of any repurchase agreement.

 

Options.   A Fund may write (sell) call options that are traded on national securities exchanges with respect to securities in its portfolio. A Fund may only write “covered” call options, that is, options on securities it holds in its portfolio or has an immediate right to acquire through conversion or exchange of securities held in its portfolio. A Fund may write call options on its portfolio securities in an attempt to realize a greater current return than would be realized on the securities alone. A Fund also may write call options as a partial hedge against a possible market decline. In view of their investment objectives, the Funds generally would write call options only in circumstances in which the Adviser does not anticipate significant appreciation of the underlying security in the near future or has otherwise determined to dispose of the security. As the writer of a call option, a Fund receives a premium for undertaking the obligation to sell the underlying security at a fixed price during the option period if the option is exercised. A Fund may also enter into “closing purchase transactions” in order to terminate its obligation as a writer of a call option prior to the expiration of the option.

 

Futures Contracts and Related Options.   The Funds currently do not intend to trade in futures contracts or related options on futures contracts. Each Fund, however, has reserved the right, subject to the approval of the Board of Trustees, to purchase and sell financial futures contracts and options on such futures contracts for the purpose of hedging its portfolio securities (or portfolio securities that it expects to acquire) against anticipated changes in prevailing interest rates. This technique could be employed if the Adviser anticipates that interest rates may rise, in which event a Fund could sell a futures contract to protect against the potential decline in the value of its portfolio securities. Conversely, if declining interest rates were anticipated, a Fund could purchase a futures contract to protect against a potential increase in the price of securities the Fund intends to purchase.

 

Interest Only Mortgage-Backed Securities.   A Fund is permitted to buy certain debt securities, known as “interest only” mortgage-backed securities, in which the issuer is only obligated to pay a fixed-rate of interest based on a stated principal amount, but does not make any principal payments. Each month the stated principal amount is adjusted to reflect both scheduled payments and prepayments of principal on the underlying mortgages. For example, a Fund may buy certain debt securities issued by Fannie Mae, a U.S. government agency, which carry additional risks not associated with other Fannie Mae issues. The holder purchases the security at a price that is lower than the holder’s expectations of payments of interest from the issuer.

 

Inverse Floaters.   A Fund is also permitted to buy certain debt securities, known as inverse interest rate floaters (“Inverse Floaters”). These securities do not carry a fixed-rate of interest, but instead pay interest based on a formula that varies inversely with the then current market interest rate (the “formula interest rate”), as reflected by a referenced interest rate on a specific date near the interest payment date (the “interest calculation date”). For example, if the referenced interest rate decreases on an interest calculation date from the referenced interest rate on the prior interest calculation date, then the formula interest rate will increase on that interest calculation date versus the prior interest calculation date. If the referenced rate of interest on the current interest calculation date is different from the amount such rate was on the interest calculation date prior to purchase, then the interest payments received by the holder may be more or less than the holder expected to receive based on the referenced rate in effect on the date of purchase.

 

investment, market and other risks. See “Principal Risks—Leverage” below. The High Income Fund generally invests a greater percentage of its assets in high-yield securities and therefore is generally subject to greater risks associated with such investments than the Income Fund. A Fund’s overall risk level will depend on the market sectors in which the Fund is invested and the current interest rate, credit quality and liquidity of securities of issuers in such sectors.

 

Credit.   Credit risk refers to an issuer’s ability to make timely payments of interest and principal. The High Income Fund invests primarily in, and the Income Fund may invest up to 60% of its total assets in, debt securities rated below investment grade (also referred to as “high-yield” or “junk” securities) and unrated debt securities of comparable quality, which involve greater risk than investment grade debt securities. High-yield securities generally offer a higher return potential than higher-rated debt securities, but also involve greater volatility of price and risk of loss of income and principal, including the possibility of default or bankruptcy of the issuers of the securities. As a result, investment in a Fund involves the risk that if an issuer of a high-yield security or an unrated security of comparable quality in which the Fund invests defaults, there may be a negative impact on the Fund’s income and asset coverage, and the Fund’s investment objective(s) may not be realized.

 

The values of high-yield securities tend to reflect individual corporate developments or adverse economic changes to a greater extent than higher-rated debt securities, which react primarily to fluctuations in the general level of interest rates. Periods of economic uncertainty and changes generally result in increased volatility in the market prices and yields of high-yield securities and thus in a Fund’s NAV. The rating organizations generally regard high-yield securities as predominantly speculative with respect to capacity to pay interest and repay principal and riskier than higher-rated debt securities. Changes by rating organizations in their ratings of any debt security and in the ability of an issuer to make payments of interest and principal may also affect the value of the a Fund’s investments. Changes in the value of portfolio securities will not necessarily affect cash income derived from such securities, but will affect a Fund’s NAV.

 

The Funds will rely on the Adviser’s judgment, analysis and experience in evaluating the creditworthiness of an issuer. In this evaluation, the Adviser will take into consideration, among other things, the issuer’s financial resources, its sensitivity to economic conditions and trends, its operating history, the quality of the issuer’s management and regulatory matters.

 

The credit ratings issued by rating organizations may not fully reflect the true risks of an investment. For example, credit ratings typically evaluate the safety of principal and interest payments of high-yield securities and not their market value risk. Also, credit rating organizations may fail to change on a timely basis a credit rating to reflect changes in economic or company conditions that affect a security’s market value. Although it considers ratings of nationally recognized statistical rating organizations such as Moody’s and S&P, the Adviser primarily relies on its own credit analysis, which includes a study of existing debt, capital structure, ability to service debt and to pay dividends, the issuer’s sensitivity to economic conditions, its operating history and the current trend of earnings.

 

Interest Rates.   Generally, when interest rates rise, the value of fixed-rate debt securities, including high-yield securities, tends to decrease, and such declines tend to be greater among fixed-rate debt securities with longer maturities. The Funds have no policy limiting the maturities of their investments. To the extent the Funds invest in fixed-rate debt securities with longer maturities, the Funds are subject to greater interest rate risk than funds investing solely in shorter-term fixed-rate debt securities. In addition, in a period of rising interest rates, the higher cost of any leveraged employed by a Fund and/or increasing defaults by issuers of high-yield securities would likely exacerbate any decline in the Fund’s NAV. If an issuer of a debt security containing a redemption or call provision exercises either provision in a declining interest rate market, the Fund would likely replace the security with a security having a lower interest rate, which could result in a decreased return for shareholders.

 

Liquidity.   At times a major portion of an issue of lower-rated debt securities may be held by relatively few institutional purchasers. Although the Funds generally consider such securities to be liquid because of the availability of an institutional market for such securities, under adverse market or economic conditions or in the event of adverse changes in the financial condition of the issuer, a Fund may find it more difficult to sell such securities when the Adviser believes it advisable to do so or may be able to sell such securities only at prices lower than if the securities were more widely held. In such circumstances, a Fund also may find it more difficult to determine the fair value of such securities for purposes of computing the Fund’s NAV. Each Fund, in most instances, utilizes an independent pricing service to determine the value of its securities. However, quotations from a pricing service (or other quotations) may not be a reliable indicator of the price the Fund could realize upon sale due to many factors, including, but not limited to, the number of active purchasers and sellers, variable economic and market conditions and changes in the

financial condition (or perceived financial condition) of the issuer at the time of sale. As a result, pricing of a Fund’s securities does not rely solely on a price determined by an independent pricing service; other relevant information is also monitored and other valuation methodologies may be used as appropriate.

 

Non-Diversification.   Due to the nature of each Fund’s investment strategy and their non-diversified status, it is possible that a material amount of a Fund’s investments could be invested in the securities of only a few companies. Investing a significant portion of a Fund’s portfolio in any one issuer would subject the Fund to a greater degree of risk with respect to the failure of any such issuer.

 

Senior Loans.   Senior loans in which a Fund may invest may not be rated by a rating organization, will not be registered with the SEC or any state securities commission and generally will not be listed or traded on any national securities exchange. Therefore, the amount of public information available about senior loans will be limited, and the performance of a Fund’s investments in senior loans will be more dependent on the analytical abilities of the Adviser than would be the case for investments in more widely-rated, registered or exchange-listed or traded securities. In evaluating the creditworthiness of borrowers, the Adviser will consider, and may rely in part, on analyses performed by others. Moreover, certain senior loans will be subject to contractual restrictions on resale and, therefore, will be illiquid.

 

Second and Third Lien Loans.   Second and third lien loans are subject to the same risks associated with investment in senior loans and high-yield securities. However, second and third lien loans are second and third, respectively, in right of payment to senior loans and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the senior secured obligations of the borrower. Second and third lien loans are expected to have greater price volatility than senior loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in second and third lien loans, which would create greater credit risk exposure.

 

Other Secured Loans.   Secured loans other than senior loans and second lien loans are subject to the same risks associated with investment in senior loans, second lien loans and below investment grade securities. However, such loans may rank lower in right of payment than any outstanding senior loans and second lien loans of the borrower and therefore are subject to additional risk that the cash flow of the borrower and any property securing the loan may be insufficient to meet scheduled payments after giving effect to the higher ranking secured obligations of the borrower. Lower ranking secured loans are expected to have greater price volatility than senior loans and second lien loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in lower ranking secured loans, which would create greater credit risk exposure.

 

Unsecured Loans.   Unsecured loans are subject to the same risks associated with investment in senior loans, second lien loans, other secured loans and below investment grade securities. However, because unsecured loans have lower priority in right of payment to any higher ranking obligations of the borrower and are not backed by a security interest in any specific collateral, they are subject to additional risk that the cash flow of the borrower and available assets may be insufficient to meet scheduled payments after giving effect to any higher ranking obligations of the borrower. Unsecured loans are expected to have greater price volatility than senior loans, second lien loans and other secured loans and may be less liquid. There is also a possibility that originators will not be able to sell participations in unsecured loans, which would create greater credit risk exposure.

 

Credit Default Swaps.   Credit default swaps involve greater risks than investing in the reference obligation directly. In addition to general market risks, credit default swaps are subject to illiquidity risk, counterparty risk and credit risk. A buyer will lose its investment and recover nothing should no event of default occur. If an event of default were to occur, the value of the reference obligation received by the seller, coupled with the periodic payments previously received, may be less than the full notional value it pays to the buyer, resulting in a loss of value to the seller. When a Fund acts as a seller of a credit default swap, it is exposed to many of the same risks of leverage described below since if an event of default occurs the seller must pay the buyer the full notional value of the reference obligation.

 

Distressed and Defaulted Securities.   Investments in the securities of financially distressed companies involve substantial risks. These securities may involve a substantial risk of default or may be in default. A Fund may incur additional expenses to the extent it is required to seek recovery upon a default in the payment of principal of or interest on its portfolio holdings. High-yield, high-risk securities frequently are subordinated to the prior payment of senior indebtedness and are traded in markets that may be relatively less liquid than the market for higher-rated securities. In any reorganization or liquidation proceeding relating to a portfolio company, a Fund may lose its entire investment or may be required to accept cash or securities with a value less than the original investment. In addition, a

liquidation or bankruptcy proceeding either may be unsuccessful (for example, because of the failure to obtain requisite approvals), may be delayed (for example, until various liabilities, actual or contingent, have been satisfied) or may result in a distribution of cash or a new security the value of which will be less than a Fund’s purchase price of the security in respect of which such distribution was made.

 

Among the risks inherent in investments in troubled entities is that it frequently may be difficult to obtain information as to the true condition of such issuer. Judgments about the credit quality of the issuer and the relative value of its securities may prove to be wrong. Such investments also may be adversely affected by laws relating to, among other things, fraudulent transfers and other voidable transfers or payments, lender liability and the bankruptcy courts’ power to disallow, reduce, subordinate or disenfranchise particular claims. The market prices of such securities also are subject to abrupt and erratic market movements and above-average price volatility, and the spread between the bid and asked prices of such securities may be greater than those prevailing in other securities markets. It may take a number of years for the market price of such securities to reflect their intrinsic value, and the Adviser’s estimates of intrinsic value may be based on its views of market conditions, including interest rates, that may prove to be incorrect.

 

Investment in Restricted Securities.   Restricted securities (i.e., securities acquired in private placement transactions) may offer higher yields than comparable publicly-traded securities. The Funds, however, may not be able to sell these securities when the Adviser considers it desirable to do so or, to the extent they are sold privately, may have to sell them at less than the price of otherwise comparable securities. Restricted securities are subject to limitations on resale which can have an adverse effect on the price obtainable for such securities. Also, if in order to permit resale, the securities are registered under the Securities Act at a Fund’s expense, the Fund’s expenses would be increased.

 

Non-U.S. Securities.   Investing in non-U.S. securities involves certain risks not involved in domestic investments, including, but not limited to: (i) fluctuations in foreign exchange rates; (ii) future foreign economic, financial, political and social developments; (iii) different legal systems; (iv) the possible imposition of exchange controls or other foreign governmental laws or restrictions; (v) lower trading volume; (vi) much greater price volatility and illiquidity of certain foreign securities markets; (vii) different trading and settlement practices; (viii) less governmental supervision; (ix) changes in currency exchange rates; (x) high and volatile rates of inflation; (xi) fluctuating interest rates; (xii) less publicly available information; and (xiii) different accounting, auditing and financial recordkeeping standards and requirements. Certain countries in which the Funds may invest, especially emerging market countries, historically have experienced, and may continue to experience, high rates of inflation, high interest rates, exchange rate fluctuations, large amounts of external debt, balance of payments and trade difficulties and extreme poverty and unemployment. Many of these countries are also characterized by political uncertainty and instability. The cost of servicing external debt will generally be adversely affected by rising international interest rates because many external debt obligations bear interest at rates which are adjusted based upon international interest rates. In addition, with respect to certain foreign countries, there is a risk of: (i) the possibility of expropriation or nationalization of assets; (ii) confiscatory taxation; (iii) difficulty in obtaining or enforcing a court judgment; (iv) economic, political or social instability; and (v) diplomatic developments that could affect investments in those countries. Because the Funds will invest in securities denominated or quoted in currencies other than the U.S. dollar, changes in foreign currency exchange rates may affect the value of securities in the Funds and the unrealized appreciation or depreciation of investments. Currencies of certain countries may be volatile and therefore may affect the value of securities denominated in such currencies, which means that a Fund’s net asset value or current income could decline as a result of changes in the exchange rates between foreign currencies and the U.S. dollar. Certain investments in non-U.S. securities also may be subject to foreign withholding taxes. These risks often are heightened for investments in smaller, emerging capital markets. In addition, individual foreign economies may differ favorably or unfavorably from the U.S. economy in such respects as: (i) growth of gross domestic product; (ii) rates of inflation; (iii) capital reinvestment; (iv) resources; (v) self-sufficiency; and (vi) balance of payments position. As a result of these potential risks, the Adviser may determine that, notwithstanding otherwise favorable investment criteria, it may not be practicable or appropriate to invest in a particular country. The Funds may invest in countries in which foreign investors, including the Adviser, have had no or limited prior experience.

 

Emerging Markets.   Investing in securities of issuers based in underdeveloped emerging market countries entails all of the risks of investing in securities of non-U.S. issuers to a heightened degree. These heightened risks include: (i) greater risks of expropriation, confiscatory taxation, nationalization, and less social, political and economic stability; (ii) the smaller size of the markets for such securities and a lower volume of trading, resulting in lack of liquidity and in price volatility; and (iii) certain national policies that may restrict a Fund’s investment opportunities, including

restrictions on investing in issuers or industries deemed sensitive to relevant national interests. Emerging market countries generally include every nation in the world except the United States, Canada, Japan, Australia, New Zealand and most countries located in Western Europe.

 

Common Stock.   The Funds may have exposure to common stocks, including by investment in convertible securities. Although common stocks historically have generated higher average returns than debt securities, common stocks also have experienced significantly more volatility in those returns. An adverse event, such as an unfavorable earnings report, may depress the value of a particular common stock held by a Fund. Also, prices of common stocks are sensitive to general movements in the stock market, and a drop in the stock market may depress the prices of common stocks held by a Fund or to which it has exposure.

 

Small and Mid-Cap Securities.   The Funds may invest in companies with small or medium capitalizations. Securities issued by smaller and medium companies can be more volatile than, and perform differently from, larger company securities. There may be less trading in a smaller or medium company’s securities, which means that buy and sell transactions in those securities could have a larger impact on the security’s price than is the case with larger company securities. Smaller and medium companies may have fewer business lines; changes in any one line of business, therefore, may have a greater impact on a smaller or medium company’s security price than is the case for a larger company. In addition, smaller or medium company securities may not be well known to the investing public.

 

Investment in Zero Coupon Securities and Step-Up Bonds.   Zero coupon securities are debt obligations that do not entitle the holder to any periodic payment of interest prior to maturity or a specified date when the securities begin paying current interest. Because such securities do not entitle the holder to any periodic payments of interest prior to maturity, this prevents any reinvestment of interest payments at prevailing interest rates if prevailing interest rates rise. On the other hand, because there are no periodic interest payments to be reinvested prior to maturity, these securities eliminate the reinvestment risk and may lock in a favorable rate of return to maturity if interest rates drop. The Funds accrue income on these investments for U.S. federal income tax purposes, which, because no cash is received by the Funds at the time of accrual, may require the Funds to dispose of other portfolio securities to satisfy the their distribution requirements and prevent their disqualification as a regulated investment company. Special tax considerations are associated with investing in zero coupon securities and step-up bonds. See “Taxation.”

 

Convertible Securities.   Convertible securities generally offer lower interest or dividend yields than non-convertible debt securities of similar credit quality because of the potential for capital appreciation and are typically unrated or rated lower than such securities. The market values of convertible securities tend to decline as interest rates increase and, conversely, to increase as interest rates decline. A convertible security’s market value, however, also tends to reflect the market price of the common stock of the issuing company, particularly when that stock price is greater than the convertible security’s “conversion price.” As the market price of the underlying common stock declines below the conversion price, the price of the convertible security tends to be increasingly influenced more by the yield of the convertible security. In the event of a liquidation of the issuing company, holders of convertible securities would be paid before that company’s common shareholders. Consequently, an issuer’s convertible securities generally entail less risk than its common stock. Convertible securities, however, fall below debt obligations of the same issuer in order of preference or priority in the event of a liquidation.

 

Hedging.   A Fund’s use of derivatives and other transactions, such as options, financial futures and options on financial futures, may involve risks not associated with other types of investments that the Fund intends to purchase and it is possible that a portfolio that utilizes hedging strategies may not perform as well as a portfolio that does not make use of such strategies. A Fund’s use of derivatives or other transactions to reduce risk involves costs and will be subject to the Adviser’s ability to predict correctly changes in the relationships of such hedge instruments to the Fund’s portfolio holdings or other factors. No assurance can be given that the Adviser’s judgment in this respect will be correct. In addition, no assurance can be given that the Funds will enter into hedging or other transactions (including hedging exposure to non-U.S. currency exchange rate risk) at times or under circumstances in which it may be advisable to do so. Although the Adviser does not anticipate that derivatives or other such transactions will represent a significant component of each Fund’s investment strategy and will not be used for speculative purposes, each Fund has a policy to limit to 20% the portion of the Fund’s total assets that may be subject to such transactions or invested in such instruments.

 

A Fund’s positions in options and financial futures may be entered into and closed out only on a federally-licensed exchange that provides a market therefor, and there can be no assurance that a liquid market will exist for any

particular option or futures contract. Because financial futures and related options markets generally impose limits on daily price movement, it is possible that the Adviser would not be able to close out hedge positions promptly. The inability to close out options and futures positions could have an adverse impact on a Fund’s ability to hedge its securities effectively and might, in some cases, require a Fund to deposit substantial amounts of additional cash to meet applicable margin requirements. A Fund’s ability to hedge effectively through transactions in financial futures or options depends on the degree to which price movements, which include, in part, changes in interest rates, in the Fund’s holdings correlate with price movements of the hedging instruments. Inasmuch as a Fund’s options and futures will not duplicate such underlying securities, the correlation will probably not be perfect. Consequently, the prices, which include, in part, changes in interest rates, of the securities being hedged may not move in the same amount as the hedging instrument. It is possible that there may be a negative correlation between the hedging instrument and the hedged securities, which would prevent the Fund from achieving the anticipated benefits of hedging transactions or may cause the Fund to realize losses and thus be in a worse position than if such strategies had not been used. Pursuant to regulations and/or published positions of the SEC, a Fund may be required to segregate permissible liquid assets to cover its obligations relating to its transactions in futures and options. To maintain this required cover, a Fund may have to sell portfolio securities at disadvantageous prices or times because it may not be possible to liquidate a position at a reasonable price. In addition, the segregation of such assets will have the effect of limiting a Fund’s ability otherwise to invest those assets.

 

Market Disruption.   Certain events may have a disruptive effect on the securities markets, such as terrorist attacks, war and other geopolitical events. The Funds cannot predict the effects on the U.S. economy of similar events in the future. High-yield securities tend to be more volatile than investment grade securities, so these events and any actions resulting from them may have a greater impact on the prices and volatility of high-yield securities than on investment grade securities.

 

Prepayments.   If interest rates fall, the principal on debt held by the Funds may be paid earlier than expected. If this happens, the proceeds from a prepaid security may be reinvested by a Fund in securities bearing lower interest rates, resulting in a possible decline in the Fund’s income and distributions to shareholders. The Funds may invest in pools of mortgages and other assets issued or guaranteed by private issuers or U.S. government agencies and instrumentalities. Mortgage-related securities are especially sensitive to prepayment risk because borrowers often refinance their mortgages when interest rates drop.

 

Reinvestment.   The Funds reinvest the cash flows received from a security. The additional income from such reinvestment, sometimes called interest-on-interest, is reliant on the prevailing interest rate levels at the time of reinvestment. There is a risk that the interest rate at which interim cash flows can be reinvested will fall. Reinvestment risk is greater for longer holding periods and for securities with large, early cash flows such as high-coupon bonds. Reinvestment risk also applies generally to the reinvestment of the proceeds the Funds receive upon the maturity or sale of a portfolio security.

 

Key Adviser Personnel.   A Fund’s ability to identify and invest in attractive opportunities is dependent upon Highland, its investment adviser. If one or more key individuals leaves Highland, Highland may not be able to hire qualified replacements or may require an extended time to do so. This situation could prevent a Fund from achieving its investment objectives.

 

purchased with the proceeds of leverage. Additionally, the investment advisory fee paid to the Adviser will be higher when a Fund borrows money, giving the Adviser incentive to use leverage.

 

Securities Loans.   The risks in lending portfolio securities, as with other extensions of credit, consist of possible delays in recovery of the securities or possible loss of rights in the collateral should the borrower fail financially.

 

When-Issued and Delayed-Delivery Securities.   The Funds are dependent on the other party to complete successfully when-issued and delayed-delivery transactions. If such other party fails to complete its portion of the transaction, the Fund will have lost the opportunity to invest the amount segregated for such transaction.

 

Repurchase Agreements.   If the counterparty defaults, a Fund could realize a loss on the sale of the underlying security to the extent that the proceeds of the sale, including accrued interest, are less than the resale price provided in the agreement, including interest. In addition, if the counterparty should be involved in bankruptcy or insolvency proceedings, a Fund may incur delay and costs in selling the underlying collateral or may suffer a loss of principal and interest if the Fund is treated as an unsecured creditor and required to return the underlying collateral to the counterparty’s estate.

 

Options.   Although the writing of call options only on national securities exchanges increases the likelihood that a Fund will be able to make closing purchase transactions, there is no assurance that the Fund will be able to effect such transactions at any particular time or at any acceptable price. The writing of call options could result in increases in a Fund’s portfolio turnover rate, especially during periods when market prices of the underlying securities appreciate.

 

Futures Contracts and Related Options.   Futures contracts and related options may be traded on foreign exchanges. Such transactions may not be regulated as effectively as similar transactions in the United States, may not involve a clearing mechanism and related guarantees, and are subject to the risk of governmental actions affecting trading in, or the prices of, foreign securities. The value of such positions also could be adversely affected by: (i) other complex foreign political, legal and economic factors; (ii) lesser availability than in the U.S. of data on which to make trading decisions; (iii) delays in a Fund’s ability to act upon economic events occurring in the foreign markets during non-business hours in the United States; (iv) the imposition of different exercise and settlement terms and procedures and margin requirements than in the United States; and (v) lesser trading volume. Exchanges on which futures and related options are traded may impose limits on the positions that the Funds may take in certain circumstances.

 

Interest Only Mortgage-Backed Securities.   If payments of principal on the underlying mortgages are different than the holder’s expectation of principal paydowns, then the actual payments of interest by the issuer could be more or less than the holder’s expectation of interest payments. “Interest only” mortgage-backed securities present a heightened risk of total loss of investment.

 

Inverse Floaters.   As interest rates rise, Inverse Floaters produce less current income. A change in prevailing interest rates will often result in a greater change in the interest rate paid by an Inverse Floater. As a result, Inverse Floaters may have a greater degree of volatility than other types of interest-bearing securities of similar credit quality.

 

Portfolio Holdings

 

A description of the Funds’ policies and procedures with respect to the disclosure of the Funds’ portfolio securities is available (i) in the Funds’ SAI and (ii) on the Funds’ website at http://www.highlandfunds.com.

MANAGEMENT OF THE FUNDS

 

 

Distributor

 

Each Fund’s shares are offered for sale through PFPC Distributors, Inc. (the “Distributor”), 760 Moore Road, King of Prussia, Pennsylvania 19406. Shareholders and Financial Advisors (as defined under “How to Buy Shares”) should not send any transaction or account requests to this address.

HOW TO BUY SHARES

 

You can purchase shares of the Funds on any day that the New York Stock Exchange (“NYSE”) is open for business. You can purchase shares of the Funds from any financial advisor, broker-dealer or other financial intermediary that has entered into an agreement with the Distributor with respect to the sale of shares of the Funds (a “Financial Advisor”), or PFPC, Inc., the Funds’ transfer agent (the “Transfer Agent”). Your Financial Advisor can help you establish an appropriate investment portfolio, buy shares, and monitor your investments. The Funds have authorized Financial Advisors to receive purchase and redemption orders on their behalf. Financial Advisors are authorized to designate other intermediaries to receive purchase and redemption orders on the Funds’ behalf. The Funds will be deemed to have received a purchase or redemption order when a Financial Advisor or its authorized designee receives the order in “good form.” “Good form” means that you placed your order with your Financial Advisor or its authorized designee or your payment (made in accordance with any of the methods set forth in the table below) has been received and your application is complete, including all necessary signatures. Customer orders will be priced at a Fund’s net asset value (“NAV”) next computed after they are received by a Financial Advisor or its authorized designee. Investors may be charged a fee by their Financial Advisor, payable to the Financial Advisor and not a Fund, if they effect a transaction in Fund shares through either a Financial Advisor or its authorized designee.

 

The USA Patriot Act may require a Fund, a Financial Advisor or its authorized designee to obtain certain personal information from you which will be used to verify your identity. If you do not provide the information, it may not be possible to open your account. If a Fund, a Financial Advisor or authorized designee is unable to verify your customer information, such Fund reserves the right to close your account or to take such other steps as it deems reasonable.

 

Outlined below are various methods for buying shares of the Funds:

 

 

 

 

 

 

 

Each Fund reserves the right to change the investment minimums. Each Fund also reserves the right to refuse a purchase order for any reason, including if it believes that doing so would be in the best interests of such Fund and its shareholders.

 

Multiple Class Funds

 

Each Fund offers one class of shares in this Prospectus — Class Z Shares, which are available to eligible investors at NAV without a sales charge or contingent deferred sales charge. Each Fund also offers two classes of shares to retail investors in a separate prospectus — Class A Shares and Class C Shares.

 

Eligible Investors

 

The Funds offer Class Z Shares exclusively to certain institutional and other eligible investors. Eligible investors are as follows:

 

 

 

 

 

 

Each Fund reserves the right to change the criteria for eligible investors. Each Fund also reserves the right to refuse a purchase order for any reason, including if it believes that doing so would be in the best interests of the Fund and its shareholders.

 

You can redeem shares of a Fund on any day that the NYSE is open for business. Each Fund, however, may temporarily stop redeeming its shares when trading on the NYSE is restricted, when an emergency exists and the Fund cannot sell its shares or accurately determine the value of its assets, or if the SEC orders the Fund to suspend redemptions.

 

Each Fund redeems its shares based on the net asset value next determined after the Transfer Agent or Financial Advisor receives your redemption request in proper form. See “Net Asset Value” for a description of the calculation of net asset value.

 

The Funds are intended for long-term investors and not for those who wish to trade frequently in shares of the Funds. The Funds believe that excessive short-term trading of shares of the Funds, such as by traders seeking short-term profits from market momentum, time zone arbitrage and other timing strategies, creates risks for the Funds and their long-term shareholders, including interference with efficient portfolio management, increased administrative and brokerage costs and potential dilution in the value of shares.

 

In order to discourage frequent short-term trading in shares of the Funds, the Board of Trustees of the Funds has adopted policies and procedures that impose a 2.00% redemption fee or exchange fee (each a “short-term trading fee”) on Class Z Shares that are redeemed or exchanged within 60 days of the date of purchase. This fee is calculated based on the shares’ aggregate net asset value on the date of redemption or exchange and is deducted from the redemption or exchange proceeds. This fee is not a sales charge, is retained by the applicable Fund, and does not benefit the Funds’ Adviser, Distributor or any other third party. For purposes of computing this fee, shares will be redeemed or exchanged in reverse order of purchase (the latest shares acquired will be redeemed or exchanged first).

 

A short-term trading fee will not apply to redemptions or exchanges of shares where (i) the shares redeemed or exchanged were purchased through automatic reinvestment of dividends or other distributions, (ii) the redemption or exchange is initiated by a Fund, (iii) the shares redeemed or exchanged were purchased through programs that collect the short-term trading fee at the program level and remit them to a Fund or (iv) the shares redeemed or exchanged were purchased through programs (including programs utilizing omnibus accounts) that the Adviser determines have

appropriate anti-short-term trading polices in place or as to which the Adviser has received assurances that look-through short-term trading fee procedures or effective anti-short-term trading policies and procedures will be in place. Recordkeepers for certain retirement plans who cannot implement short-term trading fees because of systems’ limitations and who have provided verification to that effect may be permitted to delay, temporarily, the implementation of such fees. The Funds seeks to apply these policies uniformly. Any shareholder purchasing shares of a Fund through a Financial Advisor should check with the Financial Advisor or the Fund to determine whether the shares will be subject to a short-term trading fee.

 

Each Fund reserves the right to refuse any purchase or exchange request from any person or group who, in the Fund’s view, is likely to engage in excessive trading or if such purchase or exchange is not in the best interests of the Fund and to limit, delay or impose other conditions on purchases or exchanges. Each Fund has adopted a policy of seeking to minimize short-term trading in its shares and monitors purchase, exchange and redemption activities to assist in minimizing short-term trading.

 

You may redeem shares of a Fund through your Financial Advisor or its authorized designee or directly from the Fund through the Transfer Agent. If you hold your shares in an individual retirement account (“IRA”), you should consult a tax advisor concerning the current tax rules applicable to IRAs. Outlined below are various methods for redeeming shares:

 

 

Automatic Cash Withdrawal Plan

 

You may automatically redeem shares on a monthly basis if you have at least $10,000 in your account and if your account is directly registered with the Transfer Agent. Call (877) 665-1287 or visit www.highlandfunds.com for more information about this plan.

 

Involuntary Redemption

 

A Fund may redeem all shares in your account (other than an IRA) if their aggregate value falls below $5,000 as a result of redemptions (but not as a result of a decline in net asset value). You will be notified in writing if the Fund initiates such action and allowed 30 days to increase the value of your account to at least $5,000.

 

Redemption Proceeds

 

A redemption request received by a Fund will be effected at the next determined NAV after the Fund receives the request. If you request redemption proceeds by check, the Fund will normally mail the check to you within seven days after receipt of your redemption request. If, however, you purchased your shares by check or ACH transaction and unless you have documentation satisfactory to the Fund that your transaction has cleared, the Fund may hold proceeds for shares purchased by check or ACH until the purchase amount has been deemed collected, which is eight business days for checks and five business days for ACH transactions. While the Fund will delay the processing of the payment until the check clears, your shares will be valued at the next determined NAV after receipt by the Transfer Agent or your Financial Advisor of your redemption request.

 

The Funds may pay your redemption proceeds wholly or partially in portfolio securities. Payments would be made in portfolio securities, which may include illiquid securities, only in the rare instance that the Board of Trustees of a Fund believes that it would be in the Fund’s best interests not to pay redemption proceeds in cash. If a Fund pays your redemption proceeds in portfolio securities, you will be exposed to market risk until you convert these portfolio securities into cash, and you will likely pay commissions upon any such conversion. If you receive illiquid securities, you could find it more difficult to sell such securities and may not be able to sell such securities at prices that reflect the Adviser’s or your assessment of their fair value or the amount paid for them by the Funds. Illiquidity may result from the absence of an established market for such securities as well as legal, contractual or other restrictions on their resale and other factors.

 

Shareholders of a Fund may exchange their shares on any day that the NYSE is open for business for shares of the same share class of any Participating Fund at the next determined NAV, plus any applicable exchange fee (see “Redemption of Shares”). Shares of a Fund may be exchanged for shares of any Participating Fund only if shares of that Participating Fund are available for sale. If you do not currently have an account in the Participating Fund into which you wish to exchange your shares, you will need to exchange enough shares to satisfy the Participating Fund’s current minimum investment account requirements. Current minimum investment account requirements, as well as other important information, are available in each Participating Fund’s current prospectus, which shareholders should obtain and read prior to seeking an exchange. A prospectus for each of the Participating Funds may be obtained by calling (877) 665-1287 or by visiting http://www.highlandfunds.com.

 

If you exchange shares of a Fund for shares of Highland Floating Rate Fund or Highland Floating Rate Advantage Fund (the “Floating Rate Funds”), please note that the Floating Rate Funds have restrictions on redemptions and exchanges. Shareholders of the Floating Rate Funds may only liquidate their shares by tendering their shares or

effecting an exchange on a quarterly repurchase date. Please obtain and read a prospectus for the Floating Rate Funds before exchanging into the Floating Rate Funds.

 

If the Fund shares you are exchanging are subject to a CDSC, you will not be charged a CDSC upon the exchange. However, when you sell the shares acquired through the exchange (the “acquired shares”), they may be subject to a CDSC, depending upon when you originally purchased the Fund shares that you are exchanging. For purposes of determining the applicability of a CDSC, the length of time you own your acquired shares will be computed from the date of your original purchase of the Fund shares (and includes the period during which the acquired shares were held), and the applicable CDSC will be the CDSC of the original Fund shares that you purchased. No CDSC is charged when you exchange your Fund shares into the RBB Money Market Fund (the “Money Market Fund”); however, notwithstanding any statement above to the contrary, the applicable CDSC will be imposed when shares are redeemed from the Money Market Fund and will be calculated without regard to the time such shares were held in the Money Market Fund. Your exchange privilege will be revoked if the exchange activity is considered excessive. In addition, the Funds may reject any exchange request for any reason, including if it does not think that it is in the best interests of the Funds and/or their shareholders to accept the exchange.

 

Unless you have a tax-deferred account, an exchange is a taxable event, and you may realize a gain or a loss for tax purposes. See “Taxation.” A Fund may terminate your exchange privilege if the Adviser determines that your exchange activity is likely to impact adversely its ability to manage the Fund or if the Fund otherwise determines that your exchange activity is contrary to its short-term trading policies and procedures. To exchange by telephone, please call (877) 665-1287. Please have your account and taxpayer identification number available when calling.

NET ASSET VALUE

 

The NAV per share of each Funds’ Class Z Shares is calculated as of the close of regular trading on the NYSE, normally 4:00 p.m., Eastern Time, on each day that the NYSE is open for business. The NYSE is open Monday through Friday, but currently is scheduled to be closed on New Year’s Day, Dr. Martin Luther King, Jr. Day, Presidents’ Day, Good Friday, Memorial Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day and on the preceding Friday or subsequent Monday when a holiday falls on a Saturday or Sunday, respectively. The NAV per share of a Fund is computed by dividing the value of the Fund’s net assets (i.e., the value of its securities and other assets less its liabilities, including expenses payable or accrued but excluding capital stock and surplus) attributable to the class of shares by the total number of shares of the class outstanding at the time the determination is made. The price of a particular class of a Fund’s shares for the purpose of purchase and redemption orders will be based upon the calculation of NAV per share of the Fund next made after the purchase or redemption order is received in good form.

 

Each Fund’s portfolio securities are valued in accordance with the Fund’s valuation policies approved by the Board of Trustees of the Funds. Portfolio securities for which market quotations are readily available are valued at their current market value, except that debt securities that are not credit impaired and have remaining maturities of 60 days or less will be valued at amortized cost, which approximates market value. All other portfolio securities are valued at fair value as determined in good faith pursuant to the Funds’ valuation policies. Pursuant to the Funds’ pricing procedures, securities for which market quotations are not readily available, and therefore are subject to being fair valued, may include securities that are subject to legal or contractual restrictions on resale, securities for which no or limited trading activity has occurred for a period of time, or securities that are otherwise deemed to be illiquid (i.e., securities that cannot be disposed of within seven days at approximately the price at which the security is currently priced by the Fund). Market quotations are also deemed not to be readily available when an event has occurred after the close of the principal foreign market on which a security trades, but before the time for determination of a Fund’s NAV, that has affected, or is likely to affect, more than minimally the NAV per share of the Fund.

 

When a market quotation is not readily available, a portfolio security is valued at its fair value, as determined in good faith under procedures established by the Board of Trustees of the Funds. In determining fair value, the Funds’ pricing procedures establish a process and methodology to be employed in attempting to ascertain, in good faith, fair value. Fair value is defined as the amount for which assets could be sold in an orderly disposition over a reasonable period of time, taking into account the nature of the asset. Fair value pricing, however, involves judgments that are inherently subjective and inexact, since fair valuation procedures are used only when it is not possible to be sure what value should be attributed to a particular asset or when an event will affect the market price of an asset and to what

extent. As a result, there can be no assurance that fair value pricing will reflect actual market value, and it is possible that the fair value determined for a security will be materially different from the value that actually could be or is realized upon the sale of that asset. The Board of Trustees of the Funds will review the Adviser’s fair value determinations periodically. The value of a Fund’s portfolio assets may change on days the Fund is closed and on which you are not able to purchase or sell your shares.

DIVIDENDS AND DISTRIBUTIONS

 

The Funds intend to pay monthly dividends and any capital gain distributions on an annual basis. You may have dividends or capital gain distributions that are declared by a Fund automatically reinvested at NAV in additional shares of the Fund. You will make an election to receive dividends and distributions in cash or in Fund shares at the time you purchase your shares. You may change this election by notifying the appropriate Fund in writing at any time prior to the record date for a particular dividend or distribution. Dividends and other taxable distributions are taxable to you even if they are reinvested in additional shares of a Fund. There are no sales or other charges in connection with the reinvestment of dividends and capital gain distributions. Shares purchased through dividend reinvestment will receive a price based on the NAV per share on the reinvestment date, which is typically the date dividends are paid to shareholders. There is no fixed dividend rate, and there can be no assurance that the Funds will pay any dividends or realize any capital gains.

 

The following discussion is a brief summary of certain U.S. federal income tax considerations affecting the Funds and their U.S. shareholders. The discussion reflects applicable tax laws of the United States as of the date of this prospectus, which tax laws may be changed or subject to new interpretations by the courts or the Internal Revenue Service (the “IRS”) retroactively or prospectively. No attempt is made to present a detailed explanation of all U.S. federal, state, local and foreign tax law concerns affecting the Funds and their shareholders (including shareholders owning large positions in a Fund), and the discussion set forth herein does not constitute tax advice. For more information, please see “Additional Income Tax Considerations” in the SAI. Because each shareholder’s tax situation is unique, ask your tax professional about the tax consequences to you of an investment in the Funds.

 

Each Fund intends to elect to be treated and qualify annually as a regulated investment company under Subchapter M of the Code. Accordingly, the Funds generally will not be subject to U.S. federal income tax on income and gains that the Funds distribute to their shareholders. As a regulated investment company, each Fund must, among other things, (i) derive in each taxable year at least 90% of its gross income from (a) dividends, interest (including tax-exempt interest), payments with respect to certain securities loans, and gains from the sale or other disposition of stock, securities or foreign currencies, or other income (including but not limited to gain from options, futures and forward contracts) derived with respect to its business of investing in such stock, securities or currencies and (b) net income derived from interests in certain publicly traded partnerships that are treated as partnerships for U.S. federal income tax purposes and that derive less than 90% of their gross income from the items described in (a) above (each a “Qualified Publicly Traded Partnership”); and (ii) diversify its holdings so that, at the end of each quarter of each taxable year (a) at least 50% of the value of the Fund’s total assets is represented by cash and cash items, U.S. government securities, the securities of other regulated investment companies and other securities, with such other securities limited, in respect of any one issuer, to an amount not greater than 5% of the value of the Fund’s total assets and not more than 10% of the outstanding voting securities of such issuer and (b) not more than 25% of the value of the Fund’s total assets is invested in the securities of (I) any one issuer (other than U.S. government securities and the securities of other regulated investment companies), (II) any two or more issuers that the Fund controls and that are determined to be engaged in the same business or similar or related trades or businesses or (III) any one or more Qualified Publicly Traded Partnerships.

 

As a regulated investment company, each Fund generally will not be subject to U.S. federal income tax on income and gains that it distributes each taxable year to shareholders, if it distributes at least 90% of the sum of (i) its investment company taxable income (which includes, among other items, dividends, interest and the excess of any net short-term capital gains over net long-term capital losses and other taxable income, other than any net capital gain (as defined below), reduced by deductible expenses) determined without regard to the deduction for dividends and

distributions paid and (ii) its net tax-exempt interest income (the excess of its gross tax-exempt interest income over certain disallowed deductions). Each Fund intends to distribute at least annually substantially all of such income. Each Fund will be subject to income tax at regular corporate rates on any taxable income or gains that it does not distribute to its shareholders.

 

Although the Funds do not presently expect to do so, each Fund is authorized to borrow funds and to sell assets in order to satisfy distribution requirements. Moreover, each Fund’s ability to dispose of assets to meet its distribution requirements may be limited by (i) the illiquid nature of its portfolio and/or (ii) other requirements relating to its status as regulated investment company, including the diversification requirements. If either Fund disposes of assets in order to meet the distribution requirements or to avoid the federal excise tax, discussed below, such Fund may make such dispositions at times that, from an investment standpoint, are not advantageous.

 

Amounts not distributed on a timely basis in accordance with a calendar year distribution requirement are subject to a nondeductible 4% federal excise tax at the Fund level. To avoid the tax, each Fund must distribute during each calendar year an amount at least equal to the sum of (i) 98% of its ordinary income (not taking into account any capital gains or losses) for the calendar year, (ii) 98% of its capital gains in excess of its capital losses (adjusted for certain ordinary losses) for a one-year period generally ending on October 31 of the calendar year (unless an election is made to use the Fund’s fiscal year), and (iii) certain undistributed amounts from previous years on which the Fund paid no U.S. federal income tax. While each Fund intends to distribute any income and capital gains in the manner necessary to minimize imposition of the 4% federal excise tax, there can be no assurance that sufficient amounts of the Fund’s taxable income and capital gains will be distributed to avoid entirely the imposition of the tax. In that event, each Fund will be liable for the tax only on the amount by which it does not meet the foregoing distribution requirement.

 

If for any taxable year either Fund does not qualify as a regulated investment company, all of its taxable income (including its net capital gain) will be subject to tax at regular corporate rates without any deduction for distributions to shareholders.

 

Certain of the Funds’ investment practices are subject to special and complex U.S. federal income tax provisions that may, among other things: (i) disallow, suspend or otherwise limit the allowance of certain losses or deductions, (ii) convert lower taxed long-term capital gains or “qualified dividend income” into higher taxed short-term capital gains or ordinary income, (iii) convert ordinary loss or a deduction into capital loss (the deductibility of which is more limited), (iv) cause the Funds to recognize income or gain without a corresponding receipt of cash, (v) adversely affect the time as to when a purchase or sale of stock or securities is deemed to occur and (vi) adversely alter the characterization of certain complex financial transactions. These U.S. federal income tax provisions could therefore affect the amount, timing and character of distributions to stockholders. In particular, the Funds may recognize original issue discount ( i.e. , ordinary income prior to a corresponding receipt of cash) if the Funds acquire zero coupon securities, deferred interest securities or certain other securities, and the market discount rules may convert capital gains into ordinary income. Each Fund intends to monitor its transactions and may make certain tax elections, and may be required to borrow money or dispose of securities, to mitigate the effect of these provisions and prevent its disqualification as a regulated investment company.

 

Dividend, interest and other income received by either Fund from investments outside the United States may be subject to withholding and other taxes imposed by foreign countries. Tax treaties between the United States and other countries may reduce or eliminate such taxes. The Funds do not expect that they will be eligible to elect to treat any foreign taxes they pay as paid by their shareholders, who therefore will not be entitled to credits for such taxes on their own tax returns. Foreign taxes paid by either Fund will reduce the return from such Fund’s investments.

 

Distributions paid to you by a Fund from its net realized long-term capital gains, if any, that the Fund designates as capital gains dividends (“capital gain dividends”) are taxable as long-term capital gains, regardless of how long you have held your shares. All other dividends paid to you by a Fund (including dividends from short-term capital gains) from its current or accumulated earnings and profits (“ordinary income dividends”) are generally subject to tax as ordinary income. It is not generally expected that Fund distributions will qualify for favorable tax treatment as “qualified dividend income” for individual investors or as income eligible for the dividends received deduction for corporate investors.

 

Dividends and other taxable distributions are taxable to you even if they are reinvested in additional shares of a Fund. Dividends and other distributions paid by a Fund are generally treated as received by you at the time the dividend or distribution is made. If, however, a Fund pays you a dividend in January that was declared in the previous October, November or December and you were the shareholder 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 you on December 31 of the year in which the dividend was declared.

 

The price of shares purchased at any time may reflect the amount of a forthcoming distribution. If you purchase shares just prior to a distribution, you will receive a distribution that will be taxable to you even though it represents in part a return of your invested capital.

 

Generally, not later than 60 days after the close of its taxable year, your Fund will send you a written notice setting forth the amount and tax status of any distributions paid to you by the Fund. Ordinary income dividends and capital gain dividends may also be subject to state and local taxes.

 

If you sell or otherwise dispose of shares of your Fund (including exchanging them for shares of another fund), you will generally recognize a gain or loss in an amount equal to the difference between your tax basis in such shares of the Fund and the amount you receive upon disposition of such shares. If you hold your shares as capital assets, any such gain or loss will be long-term capital gain or loss if you have held such shares for more than one year at the time of sale.

 

If, for any calendar year, the total distributions exceed both current earnings and profits and accumulated earnings and profits, the excess will generally be treated as a tax-free return of capital up to the amount of a shareholder’s tax basis in the shares. The amount treated as a tax-free return of capital will reduce a shareholder’s tax basis in the shares, thereby increasing such shareholder’s potential gain or reducing his or her potential loss on the sale of the shares. Any amounts distributed to a shareholder in excess of his or her tax basis in the shares will be taxable to the shareholder as capital gain (assuming your shares are held as a capital asset).

 

Any loss upon the sale or exchange of shares of your Fund held for six months or less will be treated as long-term capital loss to the extent of any capital gain dividends received (including amounts credited as an undistributed capital gain dividend) by you. Any loss you realize on a sale or exchange of shares of your Fund will be disallowed if you acquire other shares of the same Fund (whether through the automatic reinvestment of dividends or otherwise) within a 61-day period beginning 30 days before and ending 30 days after your sale or exchange of the shares. In such case, the basis of the shares acquired will be adjusted to reflect the disallowed loss. Present law taxes both long-term and short-term capital gains of corporations at the rates applicable to ordinary income.

 

Your Fund may be required to withhold, for U.S. federal backup withholding tax purposes, a portion of the dividends, distributions and redemption proceeds payable to a shareholder who fails to provide the Fund (or its agent) with the shareholder’s correct taxpayer identification number (in the case of an individual, generally, such individual’s social security number) or to make the required certification, or who has been notified by the IRS that such shareholder is subject to backup withholding. Certain shareholders are exempt from backup withholding. Backup withholding is not an additional tax and any amount withheld may be refunded or credited against your U.S. federal income tax liability, if any, provided that you furnish the required information to the IRS.

 

The discussions set forth herein and in the SAI do not constitute tax advice, and investors are urged to consult their own tax advisors to determine the specific U.S. federal (including the application of the alternative minimum tax rules), state, local and foreign tax consequences to them of investing in the Funds.

 

In order to reduce duplicative mail and fees and expenses of the Funds, we will send a single copy of the Funds’ Prospectus and shareholder reports to your household even if more than one family member in your household owns shares of the Funds. Additional copies of the Prospectus and shareholder reports may be obtained by calling (877) 665-1287. If you do not want us to consolidate your Fund mailings and would prefer to receive separate mailings at any time in the future, please call us at the telephone number above and we will furnish separate mailings, in accordance with instructions, within 30 days of your request.

Privacy Policy

 

We recognize and respect your privacy expectations, whether you are a visitor to our website, a potential shareholder, a current shareholder or even a former shareholder.

 

Collection of Information.   We may collect nonpublic personal information about you from the following sources:

 

 

Disclosure of Information.   We may share the information we collect with our affiliates. We may also disclose this information as otherwise permitted by law. We do not sell your personal information to third parties for their independent use.

 

Confidentiality and Security of Information.   We restrict access to nonpublic personal information about you to our employees and agents who need to know such information to provide products or services to you. We maintain physical, electronic and procedural safeguards that comply with federal standards to guard your nonpublic personal information, although you should be aware that data protection cannot be guaranteed.

 

This Prospectus sets forth concisely the information that a prospective investor should know before investing in Class Z Shares of Highland High Income Fund (the “High Income Fund”) and Highland Income Fund (the “Income Fund”) (each, a “Fund,” and collectively, the “Funds”). Please read and retain this Prospectus for future reference. A Statement of Additional Information (“SAI”) regarding the Funds, dated March 1, 2007, has been filed with the SEC. This Prospectus incorporates by reference the entire SAI (together with any supplement to it).

 

Additional information about each Fund’s investments will be available in the Funds’ annual and semi-annual reports to shareholders.

 

You may obtain free copies of the SAI and the Funds’ annual and semi-annual reports, request other information about the Funds and make other inquiries by calling the Funds at (877) 665-1287. The SAI and the Funds’ annual and semi-annual reports are also available by visiting the Funds’ website (http://www.highlandfunds.com) or by writing to the Funds, c/o PFPC Inc., P.O. Box 9840, Providence, RI 02940.

 

Information about the Funds (including the SAI and the Funds’ annual and semi-annual reports) 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 (202) 551-8090. Information about the Funds is also available on the EDGAR Database on the SEC’s website at http://www.sec.gov. Copies of this information may be obtained, after paying a duplicating fee, by electronic request at the SEC’s e-mail address (publicinfo@sec.gov) or by writing the SEC’s Public Reference Section, Washington, D.C. 20549-0102.

 

Investment Co. Act
File Number: 811-21866

 

 

 

 

You should rely only on the information contained in, or incorporated by reference into, this Prospectus. The Funds have not authorized any other person to provide you with different information. If anyone provides you with different or inconsistent information, you should not rely on it. The Funds are not making an offer to sell these securities in any jurisdiction where the offer or sale is not permitted.