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Salomon Brothers
Variable Series Funds Inc
7 WORLD TRADE CENTER NEW YORK, NEW YORK 10048
888-777-0102
SALOMON BROTHERS VARIABLE SERIES FUNDS INC ('VARIABLE SERIES FUNDS'), AN
OPEN-END MANAGEMENT COMPANY, CONSISTS OF SALOMON BROTHERS VARIABLE INVESTORS
FUND (THE 'INVESTORS FUND'), SALOMON BROTHERS VARIABLE CAPITAL FUND (THE
'CAPITAL FUND'), SALOMON BROTHERS VARIABLE TOTAL RETURN FUND (THE 'TOTAL RETURN
FUND'), SALOMON BROTHERS VARIABLE HIGH YIELD BOND FUND (THE 'HIGH YIELD BOND
FUND'), SALOMON BROTHERS VARIABLE STRATEGIC BOND FUND (THE 'STRATEGIC BOND
FUND'), SALOMON BROTHERS VARIABLE U.S. GOVERNMENT INCOME FUND (THE 'U.S.
GOVERNMENT INCOME FUND') AND SALOMON BROTHERS VARIABLE ASIA GROWTH FUND (THE
'ASIA GROWTH FUND') (EACH A 'FUND' AND COLLECTIVELY, THE 'FUNDS'). VARIABLE
SERIES FUNDS IS OFFERED EXCLUSIVELY AS A FUNDING VEHICLE FOR VARIABLE ANNUITY
('VA') CONTRACTS AND VARIABLE LIFE INSURANCE ('VLI') POLICIES OFFERED THROUGH
SEPARATE ACCOUNTS OF VARIOUS LIFE INSURANCE COMPANIES ('PARTICIPATING INSURANCE
COMPANIES') AND FOR QUALIFIED PENSION AND RETIREMENT PLANS. EACH INVESTOR SHOULD
REFER TO THE PROSPECTUS FOR HIS OR HER CONTRACT OR POLICY OR HIS OR HER PLAN
DOCUMENTS FOR INFORMATION AS TO WHICH PORTFOLIOS OF VARIABLE SERIES FUNDS ARE
AVAILABLE FOR INVESTMENT THROUGH THE CONTRACT, POLICY OR PLAN. EACH OF THE FUNDS
HAS A SPECIFIC INVESTMENT OBJECTIVE.
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THERE CAN BE NO ASSURANCE THAT ANY FUND WILL ACHIEVE ITS INVESTMENT OBJECTIVE(S)
AND EACH OF THE FUNDS MAY EMPLOY CERTAIN INVESTMENT PRACTICES WHICH INVOLVE
SPECIAL RISK CONSIDERATIONS. CERTAIN FUNDS MAY INVEST IN CERTAIN SECURITIES,
COMMONLY REFERRED TO AS JUNK BONDS, WHICH PRESENT A HIGH DEGREE OF RISK. SUCH
LOWER-QUALITY SECURITIES INVOLVE COMPARATIVELY GREATER RISKS, INCLUDING PRICE
VOLATILITY AND THE RISK OF DEFAULT IN THE TIMELY PAYMENT OF INTEREST AND
PRINCIPAL, THAN HIGHER-QUALITY SECURITIES. THE HIGH YIELD BOND FUND AND THE
STRATEGIC BOND FUND ARE NOT LIMITED IN THE PERCENTAGE OF THEIR ASSETS WHICH MAY
BE INVESTED IN SUCH SECURITIES. EACH OF THE INVESTORS FUND, THE CAPITAL FUND,
THE TOTAL RETURN FUND AND THE ASIA GROWTH FUND MAY INVEST UP TO 5%, 10%, 20%,
AND 10% RESPECTIVELY, OF ITS TOTAL ASSETS IN NON-CONVERTIBLE SECURITIES OF THIS
TYPE AND MAY INVEST WITHOUT LIMIT IN CONVERTIBLE SECURITIES OF THIS TYPE. SEE
'ADDITIONAL INVESTMENT ACTIVITIES AND RISK FACTORS.'
This Prospectus sets forth concisely the information a prospective investor
should know before investing in any of the Funds and should be read and retained
for future reference. A Statement of Additional Information dated January 2,
1998, containing additional information about each Fund (the 'Statement of
Additional Information') has been filed with the Securities and Exchange
Commission (the 'SEC') and is incorporated herein by reference. It is available
without charge and can be obtained by writing to the Funds at the address, or by
calling the toll-free telephone number, listed above.
THE SEC MAINTAINS A WEB SITE AT HTTP://WWW.SEC.GOV THAT CONTAINS THE STATEMENT
OF ADDITIONAL INFORMATION, MATERIAL INCORPORATED BY REFERENCE AND OTHER
INFORMATION REGARDING THE VARIABLE SERIES FUNDS.
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THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A
CRIMINAL OFFENSE.
SALOMON BROTHERS ASSET MANAGEMENT INC -- INVESTMENT MANAGER
SALOMON BROTHERS INC -- DISTRIBUTOR
JANUARY 2, 1998
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Table of Contents
Summary 3
Expense Information 6
Investment Objectives and Policies 8
Additional Investment Activities and Risk
Factors 27
Investment Limitations 44
Management 47
Determination of Net Asset Value 51
Participating Insurance Companies and Plans 52
Purchase of Shares 52
Redemption of Shares 53
Performance Information 54
Dividends and Distributions 55
Taxation 56
Account Services 57
Capital Stock 57
Appendix A A-1
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Summary
THE FUNDS
Each of the Funds, is an investment portfolio of the Variable Series Funds, an
open-end investment company incorporated in Maryland on October 1, 1997. Shares
of the Fund are sold only to: (i) separate accounts of Participating Insurance
Companies to fund the benefits for VA contracts and VLI policies; and (ii)
Qualified Pension and Retirement Plans ('Plans). Accordingly, all references to
'shareholders' in this Prospectus refer to such Participating Insurance
Companies and Plans and not to individual contract or policy holders or plan
participants. See 'Participating Insurance Companies and Plans.'
Each of the Funds, except the Capital Fund and the Asia Growth Fund, is
classified as a diversified Fund under the Investment Company Act of 1940, as
amended (the '1940 Act').
THE FUNDS' OBJECTIVES AND POLICIES
INVESTORS FUND. The Investors Fund's primary objective is long-term growth of
capital. Current income is a secondary objective. The Fund seeks to achieve its
objectives primarily through investments in common stocks of well-known
companies.
CAPITAL FUND. The objective of the Capital Fund is to seek capital appreciation
through investments primarily in common stock, or securities convertible into
common stocks, which are believed to have above-average price appreciation
potential and which may also involve above-average risk. Current income is an
incidental consideration.
TOTAL RETURN FUND. The Total Return Fund seeks to obtain above-average income
(compared to a portfolio entirely invested in equity securities). As a
secondary objective, the Fund seeks to take advantage of opportunities for
growth of capital and income. The Fund seeks to achieve its objectives
primarily through investments in a broad variety of securities, including
equity securities, fixed-income securities and short-term obligations.
HIGH YIELD BOND FUND. The objective of the High Yield Bond Fund is to maximize
current income. As a secondary objective, the Fund seeks capital appreciation.
The Fund seeks to achieve its objectives by investing primarily in a
diversified portfolio of high yield fixed-income securities rated in medium or
lower rating categories or determined by Salomon Brothers Asset Management Inc
('SBAM') to be of comparable quality.
STRATEGIC BOND FUND. The primary objective of the Strategic Bond Fund is to
seek a high level of current income. As a secondary objective, the Fund will
seek capital appreciation. The Fund seeks to achieve its objectives by
investing in a globally diverse portfolio of fixed-income investments and by
giving SBAM broad discretion to deploy the Fund's assets among certain segments
of the fixed-income market that the investment manager believes will best
contribute to achievement of the Fund's investment objectives. In pursuing its
investment objectives, the Strategic Bond Fund reserves the right to invest
predominantly in securities rated in medium or lower rating categories or as
determined by the investment manager to be of comparable quality. Although the
investment manager has the ability to invest up to 100% of the Strategic Bond
Fund's assets in lower-rated securities, the investment manager does not
anticipate investing in excess of 75% of the assets in such securities.
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SALOMON BROTHERS VARIABLE SERIES
U.S. GOVERNMENT INCOME FUND. The objective of the U.S. Government Income Fund
is to seek a high level of current income. The Fund seeks to achieve its
objective by investing in securities issued or guaranteed by the U.S.
government, its agencies or instrumentalities. From time to time, a significant
portion of the Fund's assets may be invested in mortgage-backed securities.
ASIA GROWTH FUND. The Asia Growth Fund's objective is long-term capital
appreciation. The Fund seeks to achieve its objective by investing at least 65%
of its total assets in equity and equity-related securities of Asian Companies
(as defined under 'Investment Objectives and Policies').
There can be no assurance that any Fund will achieve its investment
objective(s). See 'Investment Objectives and Policies.'
INVESTMENT MANAGER
SBAM is the Funds' investment manager. SBAM also serves as investment manager
to other investment companies and numerous individuals and institutions. See
'Management.'
With respect to the Strategic Bond Fund, SBAM has entered into a subadvisory
consulting agreement with its affiliate, Salomon Brothers Asset Management
Limited ('SBAM Limited') pursuant to which SBAM Limited provides certain
advisory services to SBAM relating to currency transactions and investments in
non-dollar denominated debt securities for the benefit of the Fund. Subject to
the supervision of SBAM, Salomon Brothers Asia Pacific Limited ('SBAM AP')
serves as sub-adviser to the Asia Growth Fund. SBAM Limited and SBAM AP are
compensated by SBAM at no additional cost to the Funds. For a discussion of
these arrangements, see 'Management.'
RISK FACTORS
Prospective investors should consider certain risks associated with an
investment in each Fund. Certain Funds may use various investment practices
that involve special considerations, including investing in high yield and/or
illiquid securities, foreign securities (including emerging markets
securities), warrants, municipal obligations, zero coupon securities, loan
participations and assignments, entering into repurchase and reverse repurchase
agreements, entering into securities transactions on a firm commitment or when
issued basis, lending portfolio securities and high portfolio turnover rates.
Certain Funds may engage in derivatives which involve special risks. See
'Investment Objectives and Policies' and 'Additional Investment Activities and
Risk Factors.'
PURCHASE OF SHARES
Shares of each Fund may be purchased at their next determined net asset value by
Participating Insurance Companies and Plans. Individuals may not place orders
directly with the Funds. See 'Purchase of Shares.'
REDEMPTION OF SHARES
Each Fund redeems shares at the applicable next determined net asset value. The
value of shares at the time of redemption may be more or less than the
shareholder's cost. See 'Redemption of Shares.'
DIVIDENDS AND DISTRIBUTIONS
Substantially all of the net investment income of each Fund will be declared as
an annual dividend, and shareholders will receive such dividends annually. Each
Fund will pay net realized long-term capital gains annually. See 'Dividends and
Distributions.' Dividends and
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distributions are reinvested in additional shares of the same Fund unless a
shareholder requests otherwise. See 'Dividends and Distributions' and
'Taxation.'
The information in this Summary is qualified in its entirety by the more
detailed information appearing elsewhere in this Prospectus and in the
Statement of Additional Information.
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Expense Information
ANNUAL FUND OPERATING EXPENSES
Information in the table below is given as a percentage of average daily net
assets.
<TABLE>
<CAPTION>
FUND
- ----------------------------------------------------------------------------------------------------------
<S> <C>
Investors
Management Fees........................................................................... 0.70
Other Expenses (after reimbursement)*,'D'................................................. 0.30
----
Total Fund Operating expenses (after reimbursement)*...................................... 1.00%
Capital
Management Fees........................................................................... 0.85
Other Expenses) (after reimbursement)*,'D'................................................ 0.15
----
Total Fund Operating expenses (after reimbursement)*...................................... 1.00%
Total Return
Management Fees........................................................................... 0.80
Other Expenses (after reimbursement)*,'D'................................................. 0.20
----
Total Fund Operating expenses (after reimbursement)*...................................... 1.00%
High Yield Bond
Management Fees........................................................................... 0.75
Other Expenses (after reimbursement)*,'D'................................................. 0.25
----
Total Fund Operating expenses (after reimbursement)*...................................... 1.00%
Strategic Bond
Management Fees........................................................................... 0.75
Other Expenses (after reimbursement)*,'D'................................................. 0.25
----
Total Fund Operating expenses (after reimbursement)*...................................... 1.00%
U.S. Government Income
Management Fees........................................................................... 0.60
Other Expenses (after reimbursement)*,'D'................................................. 0.40
----
Total Fund Operating expenses (after reimbursement)*...................................... 1.00%
Asia Growth
Management Fees........................................................................... 1.00
Other Expenses (after reimbursement)*,'D'................................................. 0.50
----
Total Fund Operating expenses (after reimbursement)*...................................... 1.50%
</TABLE>
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* Reflects the voluntary agreement by SBAM to impose an expense cap for the
fiscal year ending December 31, 1998 on the total operating expenses of each
Fund (exclusive of taxes, interest and extraordinary expenses such as
litigation and indemnification expenses) at the amounts shown in the table
through the reimbursement of expenses. Absent such agreement, the ratio of
other expenses and total operating expenses to the average daily net assets
would be 1.91% and 2.61% for the Investors Fund; and 1.91% and 2.76% for the
Capital Fund; 1.91% and 2.71% for the Total Return Fund; 1.91% and 2.66% for
the High Yield Bond Fund; 1.91% and 2.66% for the Strategic Bond Fund; 1.91%
and 2.51% for the U.S. Government Income Fund; 2.10% and 3.10% for the Asia
Growth Fund, respectively.
'D' As of the date of this Prospectus, the Fund had not commenced investment
operations. The amounts set forth for 'Other Expenses' are therefore based
on estimates for the current fiscal year and will include fees for
shareholder services, administrative fees, custodial fees, legal and
accounting fees, printing costs and registration fees.
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Example:
The following table demonstrates the projected dollar amount of total cumulative
expenses that would be incurred over various periods with respect to a
hypothetical investment in each Fund. The example assumes payment by each Fund
of operating expenses at the levels set forth in the table above and are also
based upon the following assumptions:
An investor would pay the following expenses on a $1,000 investment, assuming
(1) 5% annual return and (2) redemption at the end of each time period:
<TABLE>
<CAPTION>
FUND 1 YEAR 3 YEARS
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<S> <C> <C>
Investors....................................................................... $ 10 $32
Capital......................................................................... $ 10 $32
Total Return.................................................................... $ 10 $32
High Yield Bond................................................................. $ 10 $32
Strategic Bond.................................................................. $ 10 $32
U.S. Government Income.......................................................... $ 10 $32
Asia Growth..................................................................... $ 15 $47
</TABLE>
THE EXAMPLE SHOULD NOT BE CONSIDERED A REPRESENTATION OF PAST OR FUTURE
EXPENSES. ACTUAL EXPENSES FOR ANY OF THE FUNDS MAY BE HIGHER OR LOWER THAN THE
AMOUNTS SHOWN IN THE FEE TABLES. Moreover, while the example assumes a 5% annual
return, each Fund's performance will vary and may result in a return greater or
less than 5%.
The information in the foregoing summary is qualified in its entirety by the
more detailed information appearing elsewhere in this Prospectus and in the
Statement of Additional Information.
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Investment Objectives
and Policies
The investment objective(s) of each Fund are deemed to be fundamental policies
and may not be changed without the affirmative vote of the holders of a
majority of its outstanding shares, as defined in the 1940 Act. There can be no
assurance that any Fund will achieve its investment objective(s).
INVESTORS FUND
The primary investment objective of the Investors Fund is to seek long-term
growth of capital. Current income is a secondary objective. The Fund seeks to
achieve its objectives primarily through investments in common stocks of well-
known companies.
The Investor Fund's policy is to retain flexibility in the management of its
portfolio, without restrictions as to the proportion of assets which may be
invested in any class of securities. It is anticipated that the Fund's
portfolio will generally consist of common and preferred stocks. The Fund may
purchase securities of companies located in foreign countries which SBAM deems
consistent with the investment objectives and policies of the Fund, but not if
upon such purchase more than 20% of the Fund's net assets would be so invested.
For a discussion of the risks associated with investment in foreign securities,
see 'Additional Investment Activities and Risk Factors -- Foreign Securities.'
Under normal conditions, the selection of common stock or securities convertible
into common stock, such as convertible preferred stock or convertible
debentures, with growth possibilities will be favored. Income-producing
securities are a secondary consideration in portfolio selection. To meet
operating expenses and to meet anticipated redemption requests, the Investors
Fund generally holds a portion of its assets in short-term fixed-income
securities (governmental obligations or investment grade debt securities) or
cash or cash equivalents. As described below, short-term investments may
include repurchase agreements with banks or broker/dealers. When management
deems it appropriate, consistent with the Investors Fund's secondary objective
of current income, or during temporary defensive periods due to economic or
market conditions, the Fund may invest without limitation in fixed-income
securities or hold assets in cash or cash equivalents. The types and
characteristics of investment grade corporate debt securities and investment
grade foreign debt securities which may be purchased by the Fund are set forth
below in the discussion of investment objectives and policies for the Strategic
Bond Fund. Investments in such investment grade fixed-income securities may
also be made for the purpose of capital appreciation, as in the case of
purchases of bonds traded at a substantial discount, or when interest rates are
expected to decline. Investment grade debt securities are debt securities rated
BBB or better by S&P or Baa or better by Moody's, or if rated by other rating
agencies or if unrated, securities deemed by SBAM to be of comparable quality.
See Appendix A to this Prospectus for a description of these ratings. Certain
risks associated with investment in debt securities carrying the fourth highest
quality rating ('Baa' by Moody's or 'BBB' by S&P) are described below in the
investment objectives and policies for the Strategic Bond Fund.
The Investors Fund from time to time may invest up to 5% of its net assets in
non-convertible debt securities rated below
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investment grade by Standard & Poor's Ratings Group ('S&P') and Moody's
Investors Service ('Moody's') with no minimum rating required or comparable
unrated securities. There is no limit on the amount of Investors Fund's assets
that can be invested in convertible securities rated below investment grade.
For additional information on these high yield debt securities, which involve a
high degree of risk, see the description above of investment objectives and
polices for the High Yield Bond Fund and 'Additional Investment Activities and
Risk Factors -- High Yield Securities.'
The Investors Fund maintains a carefully selected portfolio of securities
diversified among industries and companies. The Fund may invest up to 25% of
its net assets in any one industry. The Fund generally purchases marketable
securities, primarily those traded on the New York Stock Exchange ('NYSE') or
other national securities exchanges, but also issues traded in the
over-the-counter market. The Fund will not invest more than 15% of the value of
its total assets in illiquid securities, such as 'restricted securities' which
are illiquid, and securities that are not readily marketable. As more fully
described in the Statement of Additional Information, the Fund may purchase
certain restricted securities ('Rule 144A Securities') for which there is a
secondary market of qualified institutional buyers as contemplated by Rule 44A
under the Securities Act of 1933 (the '1933 Act'). The Fund's holdings of Rule
144A securities which are liquid securities will not be subject to the 15%
limitation on investments in illiquid securities. For further discussion of
illiquid securities and their associated risks, see 'Additional Investment
Activities and Risk Factors -- Restricted Securities and Securities with
Limited Trading Markets.'
From time to time, the Investors Fund may lend portfolio securities to brokers
or dealers or other financial institutions. Such loans will not exceed 33 1/3%
of the Fund's total assets, taken at value. For a discussion of the risks
associated with lending portfolio securities, see 'Additional Investment
Activities and Risk Factors -- Loans of Portfolio Securities.'
For a description of repurchase agreements and their associated risks, see
'Additional Investment Activities and Risk Factors -- Repurchase Agreements.'
As a hedge against either a decline in the value of securities included in the
Investors Fund's portfolio or against an increase in the price of securities
which it plans to purchase or in order to preserve or maintain a return or
spread on a particular investment or portion of its portfolio or to achieve a
particular return on cash balances, or in order to increase income or gain, the
Investors Fund may use all of the various investment strategies referred to
under 'Additional Investment Activities and Risk Factors -- Derivatives.' The
Fund's ability to pursue certain of these strategies may be limited by
applicable regulations of the SEC, the Commodity Futures Trading Commission
('CFTC') and the federal income tax requirements applicable to regulated
investment companies. See 'Additional Investment Activities and Risk Factors --
Derivatives' and the Statement of Additional Information for a description of
these strategies and of certain risks associated therewith.
The foregoing investment policies and activities, other than the Investors
Fund's investment objectives are not fundamental policies and may be changed by
vote of the Board of Directors without the approval of shareholders.
CAPITAL FUND
The investment objective of the Capital Fund is to seek capital appreciation
through investments in securities which are believed to have above-average price
appreciation potential. Such investments may also involve above-average risk.
There
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can be no assurance that the Fund's objective will be achieved. Although the
Fund may receive current income from dividends, interest and other sources,
income is an incidental consideration to seeking capital appreciation. The Fund
is non-diversified within the meaning of the 1940 Act. See 'Additional
Investment Activities and Risk Factors -- Non-Diversification.'
In seeking capital appreciation, the Capital Fund may purchase securities of
seasoned issuers, relatively smaller and newer companies as well as in new
issues and may be subject to wide fluctuations in market value. Portfolio
securities may have limited marketability or may be widely and publicly traded.
The Fund will not concentrate its investments in any particular industry.
The Capital Fund anticipates that its investments generally will be in
securities of companies which it considers to reflect the following
characteristics:
(1) share prices which appear to undervalue the company's assets or which
appear not to take into account adequately factors such as prospective reversal
of an unfavorable industry trend, lack of investor recognition or disappointing
earnings believed to be temporary;
(2) special situations such as existing or possible changes in management or
management policies, corporate structure or control, capitalization, regulatory
environment, or other circumstances which could be expected to favor earnings or
market price of such company's shares; or
(3) growth potential due to technological advances, new methods in marketing or
production, new or unique products or services, changes in demand for products
or services or other significant new developments.
The Capital Fund intends to invest primarily in common stocks, or securities
convertible into or exchangeable for common stocks, such as convertible
preferred stocks or convertible debentures. To meet operating expenses and to
meet anticipated redemption requests, the Fund generally holds a portion of its
assets in short-term fixed income securities (government obligations or
investment grade debt securities) or cash or cash equivalents. As described
below, short-term investments may include repurchase agreements with banks or
brokers-dealers. When management deems it appropriate, for temporary defensive
purposes, the Fund may invest without limitation in investment grade
fixed-income securities or hold assets in cash or cash equivalents. Investment
grade debt securities are debt securities rated BBB or better by S&P or Baa or
better by Moody's, or if rated by other rating agencies or if unrated,
securities deemed by SBAM to be of comparable quality. See 'Appendix A:
Description of Ratings.' Investments in such investment grade fixed-income
securities may also be made for the purpose of capital appreciation, as in the
case of purchases of bonds traded at a substantial discount or when SBAM
believes interest rates may decline. Certain risks associated with investment
in debt securities carrying the fourth highest quality rating ('Baa' by Moody's
or 'BBB' by S&P) are described below in the investment objectives and policies
for the Strategic Bond Fund.
The Capital Fund from time to time may invest up to 10% of its net assets in
non-convertible debt securities rated below investment grade by S&P and Moody's
with no minimum rating required or comparable unrated securities. There is no
limit on the amount of the Fund's assets that can be invested in convertible
securities rated below investment grade. For additional information on these
high yield debt securities, which may involve a high degree of risk, see the
description below of the investment objectives and policies for the High Yield
Bond Fund and 'Additional Investment Activities and Risk Factors -- High Yield
Securities.' The
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SALOMON BROTHERS VARIABLE SERIES
Fund may invest up to 20% of the value of the Fund's assets in securities of
foreign issuers. See 'Additional Investment Activities and Risk
Factors -- Foreign Securities.'
The Capital Fund may purchase securities for which there is a limited trading
market or which are subject to restrictions on resale to the public. The Fund
will not invest more than 15% of the value of its total assets in illiquid
securities, such as 'restricted securities' which are illiquid, and securities
that are not readily marketable. For further discussion of illiquid securities
and their associated risks, see 'Additional Investment Activities and Risk
Factors -- Restricted Securities and Securities With Limited Trading Markets.'
As more fully described in the Statement of Additional Information, the Fund
may purchase Rule 144A securities. The Fund's holding of Rule 144A securities
which are liquid securities will not be subject to the 15% limitation on
investments in illiquid securities.
As indicated below under 'Investment Limitations,' the Fund may from time to
time lend portfolio securities to brokers or dealers or other financial
institutions. Such loans will not exceed 33 1/3% of the Fund's total assets
taken at value. For a discussion of the risks associated with lending portfolio
securities, see 'Additional Investment Activities and Risk Factors -- Loans of
Portfolio Securities.'
The Fund enters into repurchase agreements with respect to securities in which
it may otherwise invest. For a description of repurchase agreements and their
associated risks, see 'Additional Investment Activities and Risk Factors --
Repurchase Agreements.' In addition, in order to meet redemptions or to take
advantage of promising investment opportunities without disturbing an
established portfolio, the Fund may borrow up to an aggregate of 15% of the
value of its total assets taken at the time of borrowing. In addition, the Fund
may borrow for temporary or emergency purposes an aggregate amount which may
not exceed 5% of the value of its total assets at the time of borrowing. The
Fund shall borrow only from banks. Borrowings may be unsecured, or may be
secured by not more than 15% of the value of the Fund's total assets. As a
matter of operating policy, however, the Fund will not secure borrowings by
more than 10% of the value of the Fund's total assets. For a discussion of the
risks associated with borrowings, see 'Additional Investment Activities and
Risk Factors -- Borrowing.'
As a hedge against either a decline in the value of the securities included in
the Capital Fund's portfolio, or against an increase in the price of the
securities which it plans to purchase, or in order to preserve or maintain a
return or spread on a particular investment or portion of its portfolio or to
achieve a particular return on cash balances, or in order to increase income or
gain, the Capital Fund may use all of the investment strategies referred to
under 'Additional Investment Activities and Risk Factors -- Derivatives.' The
Fund's ability to pursue certain of these strategies may be limited by
applicable regulations of the SEC, the CFTC and the federal income tax
requirements applicable to regulated investment companies. See 'Additional
Investment Activities and Risk Factors -- Derivatives' for a description of
these strategies and of certain risks associated therewith.
The foregoing investment policies and activities other than the Capital Fund's
investment objective are not fundamental policies and may be changed by vote of
the Board of Directors without the approval of shareholders.
TOTAL RETURN FUND
The primary investment objective of the Total Return Fund is to obtain above
average income (compared to a portfolio entirely invested in equity
securities). The Fund's secondary objective is to take advantage of
opportunities for growth of
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SALOMON BROTHERS VARIABLE SERIES
capital and income. The policy of the Total Return Fund is to invest in a broad
variety of securities, including equity securities, fixed-income securities and
short-term obligations. The Fund may vary the percentage of assets invested in
any one type of security in accordance with the investment manager's view of
existing and anticipated economic and market conditions, fiscal and monetary
policy and underlying security values. Under normal market conditions, it is
anticipated that at least 40% of the Fund's total assets will be invested in
equity securities.
Equity securities include common and preferred stock (including convertible
preferred stock), bonds, notes and debentures convertible into common or
preferred stock, stock purchase warrants and rights, equity interests in trusts,
partnerships, joint ventures or similar enterprises and American, Global or
other types of Depositary Receipts. Most of the equity securities purchased by
the Fund are expected to be traded on a stock exchange or in an over-the-counter
market.
SBAM will have discretion to invest in the full range of maturities of
fixed-income securities. Generally, most of the Fund's long-term debt
investments will consist of 'investment grade' securities; that is, securities
rated Baa or better by Moody's or BBB or better by S&P or determined by SBAM to
be of comparable quality to securities so rated. See Appendix A to this
Prospectus for a description of these ratings. Certain risks associated with
investment in debt securities carrying the fourth highest quality rating ('Baa'
by Moody's or 'BBB' by S&P) are described below in the investment objectives and
policies for the Strategic Bond Fund.
Up to 20% of the Fund's net assets may be invested in nonconvertible fixed
income securities that are rated Ba or lower by Moody's or BB or lower by S&P or
determined by SBAM to be of comparable quality. These securities are commonly
known as 'junk bonds.' There is no limit on the amount of the Total Return
Fund's assets that can be invested in convertible securities rated below
investment grade. For additional information on these lower rated, high yield
debt securities, which involve a high degree of risk, see the discussion below
under the investment objectives and policies for the High Yield Bond Fund and
'Additional Investment Activities and Risk Factors -- High Yield Securities.'
In addition to corporate debt securities, the Total Return Fund may invest in
U.S. Government securities and mortgage-backed securities, the types and
characteristics of which are set forth below in the discussion of the investment
objective and policies for the U.S. Government Income Fund. The Fund may also
purchase privately issued mortgage securities which are not guaranteed by the
U.S. government or its agencies or instrumentalities. For a description of
these securities and the risks associated therewith see 'Additional Investment
Activities and Risk Factors.' The Total Return Fund may invest in corporate
asset-backed securities, the characteristics and risks of which are described
below under the investment objective and policies of the Strategic Bond Fund.
Other fixed income securities in which the Total Return Fund may invest include
zero coupon bonds, deferred interest bonds and bonds on which the interest is
payable in kind ('PIK bonds'). For additional information on zero coupon bonds
and PIK bonds, see 'Additional Investment Activities and Risk Factors -- Zero
Coupon Securities, PIK Bonds and Deferred Payment Securities.' Deferred
interest bonds are debt obligations which are issued or purchased at a
significant discount from face value and provide for a period of delay before
the regular payment of interest begins. The characteristics and related risks
of these bonds are similar to those of zero coupon bonds.
The Total Return Fund may invest up to 20% (and generally expects to invest
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SALOMON BROTHERS VARIABLE SERIES
between 10% and 20%) of its total assets in foreign securities (including
American Depositary Receipts). For a discussion of the risks associated with
investment in foreign securities, see 'Additional Investment Activities and
Risk Factors -- Foreign Securities.'
The Total Return Fund may invest a portion of its assets in Loan Participations
and Assignments. For a discussion of Loan Participations and Assignments and
their associated risks, see 'Additional Investment Activities and Risk
Factors -- Loan Participation and Assignments.'
The Total Return Fund may enter into repurchase agreements and reverse
repurchase agreements, may purchase securities on a firm commitment basis,
including when-issued securities, and may lend portfolio securities. For a
description of these investment practices, see 'Additional Investment
Activities and Risk Factors.' The Fund will not invest more than 10% of its
assets in repurchase agreements maturing in more than seven days.
The Total Return Fund may purchase securities for which there is a limited
trading market or which are subject to restrictions on resale to the public. The
Fund will not invest more than 15% of the value of its total assets in illiquid
securities, such as 'restricted securities' which are illiquid, and securities
that are not readily marketable. As more fully described in the Statement of
Additional Information, the Fund may purchase Rule 144A securities for which
there is a secondary market of qualified institutional buyers as contemplated
by Rule 144A under the 1933 Act. The Fund's holdings of Rule 144A securities
which are liquid securities will not be subject to the 15% limitation on
investments in illiquid securities. For further discussion of illiquid
securities and their associated risks, see 'Additional Investment Activities
and Risk Factors -- Restricted Securities and Securities with Limited Trading
Market.'
The Total Return Fund is currently authorized to use all of the various
investment strategies referred to under 'Additional Investment Activities and
Risk Factors -- Derivatives.' With the exception of currency transactions,
however, it is not presently anticipated that any of these strategies will be
used to a significant degree by the Fund. The Fund's ability to pursue certain
of these strategies may be limited by applicable regulations of the SEC, the
CFTC and the federal income tax requirements applicable to regulated investment
companies. See 'Additional Investment Activities and Risk
Factors -- Derivatives' and the Statement of Additional Information for a
description of these strategies and of certain risks associated therewith.
The foregoing investment policies and activities, other than the Total Return
Fund's investment objectives, are not fundamental policies and may be changed
by vote of the Board of Directors without the approval of shareholders.
HIGH YIELD BOND FUND
The High Yield Bond Fund's investment objective is to maximize current income.
As a secondary objective, the High Yield Bond Fund will seek capital
appreciation. The Fund seeks to achieve its objective by investing primarily in
a diversified portfolio of high yield fixed-income securities rated in medium
or lower rating categories or determined by SBAM to be of comparable quality.
The High Yield Bond Fund intends to invest, under normal market conditions, at
least 65% of its assets in securities rated 'Baa' or lower by Moody's or 'BBB'
or lower by S&P, or in securities determined by SBAM to be of comparable
quality. The Fund may invest up to 35% of its total assets in foreign
fixed-income securities as more fully described below. Medium and low-rated and
comparable unrated securities offer yields that fluctuate over time, but
generally are
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SALOMON BROTHERS VARIABLE SERIES
superior to the yields offered by higher rated securities. However, such
securities also involve significantly greater risks, including price volatility
and risk of default in the payment of interest and principal, than higher rated
securities. Certain of the debt securities purchased by the Fund may be rated
as low as 'C' by Moody's or 'D' by S&P or may be comparable to securities so
rated. The lower-rated bonds in which the Fund may invest are commonly referred
to as 'junk bonds.'
An investment in the High Yield Bond Fund should not be considered as a
complete investment program. For further discussion of high yield securities
and the special risks associated therewith, see 'Additional Investment
Activities and Risk Factors -- High Yield Securities.'
In light of the risks associated with high yield debt securities, SBAM will take
various factors into consideration in evaluating the creditworthiness of an
issuer. For corporate debt securities, these will typically include the
issuer's financial resources, its sensitivity to economic conditions and
trends, the operating history of the issuer, and the experience and track
record of the issuer's management. For sovereign debt instruments, these will
typically include the economic and political conditions within the issuer's
country, the issuer's overall and external debt levels and debt service ratios,
the issuer's access to capital markets and other sources of funding, and the
issuer's debt service payment history. SBAM will also review the ratings, if
any, assigned to the security by any recognized rating agencies, although the
investment manager's judgment as to the quality of a debt security may differ
from that suggested by the rating published by a rating service. The High Yield
Bond Fund's ability to achieve its investment objectives may be more dependent
on SBAM's credit analysis than would be the case if it invested in higher
quality debt securities. A description of the ratings used by Moody's and S&P
is set forth in Appendix A to this Prospectus.
The investment manager will have discretion to select the range of maturities
of the fixed-income securities in which the High Yield Bond Fund may invest. The
investment manager anticipates that under current market conditions, the Fund
will have an average portfolio maturity of 10 to 15 years. However, the average
portfolio maturity may vary substantially from time to time depending on
economic and market conditions.
The High Yield Bond Fund may invest up to 35% of its total assets in foreign
fixed-income securities all or a portion of which may be non-U.S. dollar
denominated and which include: (a) debt obligations issued or guaranteed by
foreign national, provincial, state, municipal or other governments with taxing
authority or by their agencies or instrumentalities, including Brady Bonds; (b)
debt obligations of supranational entities; (c) debt obligations of the U.S.
government issued in non-dollar securities; (d) debt obligations and other
fixed-income securities of foreign corporate issuers (both dollar and
non-dollar denominated); and (e) U.S. corporate issuers (both Eurodollar and
non-dollar denominated). There is no minimum rating criteria for the Fund's
investments in such securities. A description of Brady Bonds is set forth in
the discussion of investment objectives and policies of the Strategic Bond
Fund. The risks associated with these investments are described under the
captions 'Additional Investment Activities and Risk Factors -- Foreign
Securities' and ' -- High Yield Debt Securities.' Moreover, substantial
investments in foreign securities may have adverse tax implications as described
under 'Taxation.'
The High Yield Bond Fund may also invest in zero coupon securities and
pay-in-kind bonds, which involve special risk considerations. See 'Additional
Investment Activities and Risk Factors --
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SALOMON BROTHERS VARIABLE SERIES
Zero Coupon Securities, Pay-in-Kind Bonds and Deferred Payment Securities.'
The High Yield Bond Fund may invest in fixed and floating rate loans ('Loans')
arranged through private negotiations between a corporate borrower or a foreign
sovereign entity and one or more financial institutions ('Lenders'). The Fund
may invest in such Loans in the form of participations in Loans
('Participations') and assignments of all or a portion of Loans from third
parties ('Assignments'). See 'Additional Investment Activities and Risk
Factors -- Loan Participations and Assignments.'
The High Yield Bond Fund may invest up to 20% of its assets in common stock,
convertible securities, warrants, preferred stock or other equity securities
when consistent with the Fund's objectives. The Fund will generally hold such
equity investments as a result of purchases of unit offerings of fixed-income
securities which include such securities or in connection with an actual or
proposed conversion or exchange of fixed-income securities, but may also
purchase equity securities not associated with fixed-income securities when, in
the opinion of the investment manager, such purchase is appropriate.
There may be times when, in SBAM's judgment, conditions in the securities
markets would make pursuing the Fund's basic investment strategy inconsistent
with the best interests of the Fund's shareholders. At such times, the Fund may
employ alternative strategies, including investment of a substantial portion of
its assets in securities rated higher than 'Baa' by Moody's or 'BBB' by S&P, or
of comparable quality. In addition, in order to maintain liquidity, the Fund
may invest up to 35% of its assets in high-quality short-term money market
instruments. Such instruments may include obligations of the U.S. government or
its agencies or instrumentalities; commercial paper of issuers rated, at the
time of purchase, A-2 or better by S&P or P-2 or better by Moody's or which, in
SBAM's determination, are of comparable quality; certificates of deposit,
banker's acceptances or time deposits of U.S. banks with total assets of at
least $1 billion (including obligations of foreign branches of such banks) and
of the 75 largest foreign commercial banks in terms of total assets (including
domestic branches of such banks), and repurchase agreements with respect to
such obligations.
If at some future date, in SBAM's opinion, adverse conditions prevail in the
securities markets which makes the High Yield Bond Fund's investment strategy
inconsistent with the best interests of the Fund's shareholders, the Fund may
invest its assets without limit in high-quality short-term money market
instruments.
The High Yield Bond Fund may enter into repurchase agreements and reverse
repurchase agreements, may purchase securities on a firm commitment basis,
including when-issued securities and may lend portfolio securities. For a
description of these investment practices and the risks associated therewith,
see 'Additional Investment Activities and Risk Factors.'
The High Yield Bond Fund may purchase securities for which there is a limited
trading market or which are subject to restrictions on resale to the public. The
Fund will not invest more than 15% of the value of its total assets in illiquid
securities, such as 'restricted securities' which are illiquid, and securities
that are not readily marketable. As more fully described in the Statement of
Additional Information, the Fund may purchase certain Rule 144A securities for
which there is a secondary market of qualified institutional buyers as
contemplated by Rule 144A under the 1933 Act. The Fund's holdings of Rule 144A
securities which are liquid securities will not be subject to the 15%
limitation on investments in illiquid securities. For further discussion of
illiquid securities and their associated risks, see 'Additional Investment
Activities and Risk Factors --
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SALOMON BROTHERS VARIABLE SERIES
Restricted Securities and Securities with Limited Trading Markets.'
The High Yield Bond Fund is currently authorized to use all of the various
investment strategies referred to under 'Additional Investment Activities and
Risk Factors -- Derivatives.' It is not presently anticipated that any of these
strategies will be used to a significant degree by the Fund. The Fund's ability
to pursue certain of these strategies may be limited by applicable regulations
of the SEC, the CFTC and the federal income tax requirements applicable to
regulated investment companies. See 'Additional Investment Activities and Risk
Factors -- Derivatives' and the Statement of Additional Information for a
description of these strategies and of certain risks associated therewith.
The foregoing investment policies and activities, other than the High Yield Bond
Fund's investment objectives, are not fundamental policies and may be changed
by vote of the Fund's Board of Directors without the approval of shareholders.
STRATEGIC BOND FUND
The primary investment objective of the Strategic Bond Fund is to seek a high
level of current income. As a secondary objective, the Fund seeks capital
appreciation. The Strategic Bond Fund seeks to achieve its objectives by
investing in a globally diverse portfolio of fixed-income investments and by
giving SBAM broad discretion to deploy the Strategic Bond Fund's assets among
certain segments of the fixed-income market that SBAM believes will best
contribute to the achievement of the Fund's objectives. At any point in time,
SBAM will deploy the Fund's assets based on its analysis of current economic and
market conditions and the relative risks and opportunities present in the
following market segments: U.S. government obligations, investment grade
domestic corporate debt, high yield domestic corporate debt securities,
mortgage-backed securities and investment grade and high yield foreign
corporate and sovereign debt securities. SBAM has entered into a subadvisory
consulting agreement with its London based affiliate, SBAM Limited, pursuant to
which SBAM Limited will provide certain advisory services to SBAM relating to
currency transactions and investments in non-dollar-
denominated debt securities for the benefit of the Fund.
SBAM will determine the amount of assets to be allocated to each type of
security in which it invests based on its assessment of the maximum level of
income and capital appreciation that can be achieved from a portfolio which is
invested in these securities. In making this determination, SBAM will rely in
part on quantitative analytical techniques that measure relative risks and
opportunities of each type of security based on current and historical
economic, market, political and technical data for each type of security, as
well as on its own assessment of economic and market conditions both on a
global and local (country) basis. In performing quantitative analysis, SBAM
will employ prepayment analysis and option adjusted spread technology to
evaluate mortgage securities, mean variance optimization models to evaluate
foreign debt securities, and total rate of return analysis to measure relative
risks and opportunities in other fixed-income markets. Economic factors
considered will include current and projected levels of growth and inflation,
balance of payment status and monetary policy. The allocation of assets to
foreign debt securities will further be influenced by current and expected
currency relationships and political and sovereign factors. SBAM will
continuously review this allocation of assets and make such adjustments as it
deems appropriate. The Fund does not plan to establish a minimum or a maximum
percentage of the assets which it will invest in any particular type of
fixed-income security.
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SALOMON BROTHERS VARIABLE SERIES
In addition, SBAM will have discretion to select the range of maturities of the
various fixed-income securities in which the Strategic Bond Fund invests. SBAM
anticipates that under current market conditions, the Fund's portfolio
securities will have a weighted average life of 6 to 10 years. However, the
weighted average life of the portfolio securities may vary substantially from
time to time depending on economic and market conditions.
The investment grade corporate debt securities and the investment grade foreign
debt securities to be purchased by the Fund are domestic and foreign debt
securities rated within the four highest bond ratings of either Moody's or S&P,
or, if unrated, deemed by SBAM to be of equivalent quality. While debt
securities carrying the fourth highest quality rating ('Baa' by Moody's or
'BBB' by S&P) are considered investment grade and are viewed to have adequate
capacity for payment of principal and interest, investments in such securities
involve a higher degree of risk than that associated with investments in debt
securities in the higher rating categories and such debt securities lack
outstanding investment characteristics and in fact have speculative
characteristics as well. For example, changes in economic conditions or other
circumstances are more likely to lead to a weakened capacity to make principal
and interest payments than is the case with higher grade debt securities.
The types and characteristics of the U.S. government obligations and mortgage
backed securities to be purchased by the Strategic Bond Fund are set forth below
in the discussion of the investment objective and policies for the U.S.
Government Income Fund. In addition, the Fund may purchase privately issued
mortgage securities which are not guaranteed by the U.S. government or its
agencies or instrumentalities and may purchase stripped mortgage securities,
including interest-only and principal-only securities. The Strategic Bond Fund
does not currently intend to invest more than 10% of its total assets in
interest-only and principal-only securities. Additional information with
respect to securities to be purchased by the Fund is set forth below in the
section entitled 'Additional Investment Activities and Risk Factors' and in the
section entitled 'Additional Information on Portfolio Instruments and
Investment Policies' in the Statement of Additional Information.
The Strategic Bond Fund may invest in debt obligations issued or guaranteed by a
foreign sovereign government or one of its agencies or political subdivisions
and debt obligations issued or guaranteed by supranational organizations.
Supranational entities include international organizations designated or
supported by governmental entities to promote economic reconstruction or
development and international banking institutions and related government
agencies. Examples include the World Bank, the European Coal and Steel
Community, the Asian Development Bank and the Inter-American Development Bank.
Such supranational issued instruments may be denominated in multi-national
currency units. The Strategic Bond Fund will not invest more than 10% of its
total assets in issuers located in any one country (other than issuers located
in the United States).
In pursuing the Strategic Bond Fund's investment objectives, the Fund reserves
the right to invest predominantly in medium or lower-rated securities, commonly
known as 'junk bonds.' Investments of this type involve significantly greater
risks, including price volatility and risk of default in the payment of
interest and principal, than higher-quality securities. Although the investment
manager does not anticipate investing in excess of 75% of the Strategic Bond
Fund's assets in domestic and developing country debt securities that are rated
below investment grade, the Strategic Bond Fund may invest a greater percentage
in such securities when, in
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SALOMON BROTHERS VARIABLE SERIES
SBAM's determination, the yield available from such securities outweighs their
additional risks. SBAM anticipates that under current market conditions, a
significant portion of the Fund's assets will be invested in such securities.
By investing a portion of the Strategic Bond Fund's assets in securities rated
below investment grade as well as through investments in mortgage securities
and foreign debt securities, the investment manager expects to provide
investors with a higher yield than a high-quality domestic corporate bond fund.
Certain of the debt securities in which the Strategic Bond Fund may invest may
be rated as low as 'C' by Moody's or 'D' by S&P or may be considered comparable
to securities having such ratings. See 'Additional Investment Activities and
Risk Factors -- High Yield Securities.'
In light of the risks associated with high yield corporate and sovereign debt
securities, SBAM will take various factors into consideration in evaluating the
creditworthiness of an issuer. For corporate debt securities, these will
typically include the issuer's financial resources, its sensitivity to economic
conditions and trends, the operating history of the issuer, and the experience
and track record of the issuer's management. For sovereign debt instruments,
these will typically include the economic and political conditions within the
issuer's country, the issuer's overall and external debt levels and debt
service ratios, the issuer's access to capital markets and other sources of
funding, and the issuer's debt service payment history. SBAM will also review
the ratings, if any, assigned to the security by any recognized rating
agencies, although the investment manager's judgment as to the quality of a
debt security may differ from that suggested by the rating published by a
rating service. The Strategic Bond Fund's ability to achieve its investment
objectives may be more dependent on SBAM's credit analysis than would be the
case if it invested in higher quality debt securities. A description of the
ratings used by Moody's and S&P is set forth in Appendix A to this Prospectus.
The high yield sovereign debt securities in which the Strategic Bond Fund may
invest are U.S. dollar-denominated and non-dollar-denominated debt securities,
including Brady Bonds, that are issued or guaranteed by governments or
governmental entities of developing and emerging market countries. SBAM expects
that these countries will consist primarily of those which have issued or have
announced plans to issue Brady Bonds, but the Fund is not limited to investing
in the debt of such countries. Brady Bonds are debt securities issued under the
framework of the Brady Plan, an initiative announced by former U.S. Treasury
Secretary Nicholas F. Brady in 1989 as a mechanism for debtor nations to
restructure their outstanding external indebtedness. For a description of Brady
Bonds, see 'Additional Investment Activities and Risk Factors -- High Yield
Securities' in this Prospectus and 'Additional Information on Portfolio
Instruments and Investment Policies -- Brady Bonds' in the Statement of
Additional Information. SBAM anticipates that the Fund's investments in
sovereign debt will be concentrated in Latin American countries, including
Central and South American and Caribbean countries. SBAM also expects to take
advantage of additional opportunities for investment in the debt of North
African countries, such as Nigeria and Morocco, Eastern European countries,
such as Poland and Hungary, and Southeast Asian countries, such as the
Philippines. Sovereign governments may include national, provincial, state,
municipal or other foreign governments with taxing authority. Governmental
entities may include the agencies and instrumentalities of such governments, as
well as state-owned enterprises. For a more detailed discussion of high yield
sovereign debt securities, see
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SALOMON BROTHERS VARIABLE SERIES
'Additional Investment Activities and Risk Factors -- High Yield Securities.'
The Strategic Bond Fund will be subject to special risks as a result of its
ability to invest up to 100% of its assets in foreign securities (including
emerging market securities). Such securities may be non-U.S. dollar denominated
and there is no limit on the percentage of the Fund's assets that can be
invested in non-dollar denominated securities. SBAM anticipates that under
current market conditions, a significant portion of the Fund's assets will be
invested in foreign securities. These risks are described under the captions
'Additional Investment Activities and Risk Factors -- Foreign Securities.'
Moreover, substantial investments in foreign securities may have adverse tax
implications as described under 'Taxation.' The ability to spread its
investments among the fixed-income markets in a number of different countries
may, however, reduce the overall level of market risk to the extent it may
reduce the Strategic Bond Fund's exposure to a single market.
The Strategic Bond Fund may invest in zero coupon securities, pay-in-kind bonds,
Loan Participations and Assignments. See 'Additional Investment Activities and
Risk Factors-Zero Coupon Securities, Pay-in-Kind Bonds and Deferred Payment
Securities' and ' -- Loan Participations and Assignments.'
The Strategic Bond Fund may invest up to 20% of its assets in common stock,
convertible securities, warrants, preferred stock or other equity securities
when consistent with the Fund's objectives. The Fund will generally hold such
equity investments as a result of purchases of unit offerings of fixed-income
securities which include such securities or in connection with an actual or
proposed conversion or exchange of fixed-income securities, but may also
purchase equity securities not associated with fixed-income securities when, in
SBAM's opinion such purchase is appropriate.
The Strategic Bond Fund currently intends to invest substantially all of its
assets in fixed-income securities. In order to maintain liquidity, the
Strategic Bond Fund may invest up to 25% of its assets in high-quality
short-term money market instruments. Such instruments may include obligations
of the U.S. government or its agencies or instrumentalities; commercial paper
of issuers rated, at the time of purchase, A-2 or better by S&P or P-2 or
better by Moody's or which, in SBAM's determination, are of comparable quality;
certificates of deposit, banker's acceptances or time deposits of U.S. banks
with total assets of at least $1 billion (including obligations of foreign
branches of such banks) and of the 75 largest foreign commercial banks in terms
of total assets (including domestic branches of such banks), and repurchase
agreements with respect to such obligations.
The Strategic Bond Fund may enter into repurchase agreements and reverse
repurchase agreements, may purchase securities on a firm commitment basis,
including when-issued securities and may lend portfolio securities. The Fund
may also enter into mortgage 'dollar rolls.' For a description of these
investment practices and the risks associated therewith, see 'Additional
Investment Activities and Risk Factors.'
The Strategic Bond Fund may purchase securities for which there is a limited
trading market or which are subject to restrictions on resale to the public.
The Fund will not invest more than 15% of the value of its total assets in
illiquid securities, such as 'restricted securities' which are illiquid, and
securities that are not readily marketable. As more fully described in the
Statement of Additional Information, the Fund may purchase Rule 144A securities
for which there is a secondary market of qualified institutional buyers as
contemplated by Rule 144A under the 1933 Act. The Fund's holdings of Rule 144A
securities which are liquid securities will not be subject to the 15%
limitation on investments in illiquid securities. For further discussion
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SALOMON BROTHERS VARIABLE SERIES
of illiquid securities and their associated risks, see 'Additional Investment
Activities and Risk Factors -- Restricted Securities and Securities with
Limited Trading Markets.'
The Strategic Bond Fund is currently authorized to use all of the various
investment strategies referred to under 'Additional Investment Activities and
Risk Factors -- Derivatives.' With the exception of currency transactions,
however, it is not presently anticipated that any of these strategies will be
used to a significant degree by the Fund. The Fund's ability to pursue certain
of these strategies may be limited by applicable regulations of the SEC, the
CFTC and the federal income tax requirements applicable to regulated investment
companies. See 'Additional Investment Activities and Risk
Factors -- Derivatives' and the Statement of Additional Information for a
description of these strategies and of certain risks associated therewith.
The foregoing investment policies and activities, other than the Strategic Bond
Fund's investment objectives, are not fundamental policies and may be changed by
vote of the Fund's Board of Directors without the approval of shareholders.
U.S. GOVERNMENT INCOME FUND
The investment objective of the U.S. Government Income Fund is to obtain a high
level of current income. The Fund seeks to attain its objective by investing
under normal circumstances 100% of its assets in debt obligations and mortgage-
backed securities issued or guaranteed by the U.S. government, its agencies or
instrumentalities. The securities in which the U.S. Government Income Fund may
invest are:
(1) U.S. Treasury obligations;
(2) obligations issued or guaranteed by agencies or instrumentalities of the
U.S. government which are backed by their own credit and may not be backed by
the full faith and credit of the U.S. government;
(3) mortgage-backed securities guaranteed by the Government National Mortgage
Association ('GNMA'), popularly known as 'Ginnie Maes,' that are supported by
the full faith and credit of the U.S. government. Such securities entitle the
holder to receive all interest and principal payments due whether or not
payments are actually made on the underlying mortgages;
(4) mortgage-backed securities guaranteed by agencies or instrumentalities of
the U.S. government which are supported by their own credit but not the full
faith and credit of the U.S. government, such as the Federal Home Loan Mortgage
Corporation ('FHLMC') and the Federal National Mortgage Association ('FNMA'),
commonly known as 'Fannie Maes;' and
(5) collateralized mortgage obligations issued by private issuers for which the
underlying mortgage-backed securities serving as collateral are backed: (i) by
the credit alone of the U.S. government agency or instrumentality which issues
or guarantees the mortgage-backed securities; or (ii) by the full faith and
credit of the U.S. government.
Any guarantee of the securities in which the U.S. Government Income Fund invests
runs only to principal and interest payments on the securities and not to the
market value of such securities or the principal and interest payments on the
underlying mortgages. In addition, the guarantee only runs to the portfolio
securities held by the U.S. Government Income Fund and not to the purchase of
shares of the Fund.
The U.S. Government Income Fund currently expects that it will maintain an
average portfolio effective duration of two to five years. Duration is an
approximate measure of the sensitivity of the value of a fixed income security
to changes in interest rates. In general, the percentage change in a fixed
income security's value
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SALOMON BROTHERS VARIABLE SERIES
in response to changes in interest rates is a function of that security's
duration multiplied by the percentage point change in interest rates. The Fund
may, however, invest in securities of any maturity or effective duration and
accordingly, the composition and weighted average maturity of the Fund's
portfolio will vary from time to time, based upon SBAM's determination of how
best to achieve the Fund's investment objective. With respect to
mortgage-backed securities in which the Fund invests, average maturity and
duration are determined by using mathematical models that incorporate
prepayment assumptions and other factors that involve estimates of future
economic parameters. These estimates may vary from actual results, particularly
during periods of extreme market volatility. In addition, the average maturity
and duration of mortgage-backed derivative securities may not accurately
reflect the price volatility of such securities under certain market conditions.
From time to time, a significant portion of the Fund's assets may be invested in
mortgage-backed securities. The mortgage-backed securities in which the U.S.
Government Income Fund invests represent participating interests in pools of
fixed rate and adjustable rate residential mortgage loans issued or guaranteed
by agencies or instrumentalities of the U.S. government. Mortgage-backed
securities are issued by lenders such as mortgage bankers, commercial banks,
and savings and loan associations. Mortgage-backed securities generally provide
monthly payments which are, in effect, a 'pass-through' of the monthly interest
and principal payments (including any prepayments) made by the individual
borrowers on the pooled mortgage loans. Principal prepayments result from the
sale of the underlying property or the refinancing or foreclosure of underlying
mortgages.
The yield of the mortgage securities is based on the prepayment rates
experienced over the life of the security. Prepayments tend to increase during
periods of falling interest rates, while during periods of rising interest rates
prepayments will most likely decline. Reinvestment by the U.S. Government
Income Fund of scheduled principal payments and unscheduled prepayments may
occur at higher or lower rates than the original investment, thus affecting the
yield of the Fund. Monthly interest payments received by the Fund have a
compounding effect which will increase the yield to shareholders as compared to
debt obligations that pay interest semiannually. For further discussion of
mortgage-backed securities and collateralized mortgage obligations and their
associated risks, see 'Additional Investment Activities and Risk Factors --
Mortgage-Backed Securities' and 'Additional Information on Portfolio
Instruments and Investment Policies -- Mortgage-Backed Securities' in the
Statement of Additional Information.
While the U.S. Government Income Fund seeks a high level of current income, it
cannot invest in instruments such as lower grade corporate obligations which
offer higher yields but are subject to greater credit risks. Shares of the Fund
are neither insured nor guaranteed by the U.S. government, its agencies or
instrumentalities. Neither the issuance by nor the guarantee of a U.S.
government agency for a security constitutes assurance that the security will
not significantly fluctuate in value or that the U.S. Government Income Fund
will receive the originally anticipated yield on the security.
The U.S. Government Income Fund may enter into repurchase agreements and
reverse repurchase agreements, may purchase securities on a firm commitment
basis, including when-issued securities and may lend portfolio securities. The
Fund may also enter into mortgage 'dollar rolls.' For a description of these
investment practices and the risks associated
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therewith, see 'Additional Investment Activities and Risk Factors.'
The U.S. Government Income Fund may purchase securities for which there is a
limited trading market or which are subject to restrictions on resale to the
public. The Fund will not invest more than 15% of the value of its total assets
in illiquid securities, such as 'restricted securities' which are illiquid, and
securities that are not readily marketable. For further discussion of illiquid
securities and their associated risks, see 'Additional Investment Activities
and Risk Factors -- Restricted Securities and Securities with Limited Trading
Markets.'
The U.S. Government Income Fund is not currently authorized to use any of the
various investment strategies referred to under 'Additional Investment
Activities and Risk Factors -- Derivatives.' However, such strategies may be
used in the future by the Fund. The Fund's ability to pursue certain of these
strategies may be limited by applicable regulations of the SEC, the CFTC and
the federal income tax requirements applicable to regulated investment
companies. See 'Additional Investment Activities and Risk
Factors -- Derivatives' and the Statement of Additional Information for a
description of these strategies and of certain risks associated therewith.
The foregoing investment policies and activities, other than the U.S. Government
Income Fund's investment objective, are not fundamental policies and may be
changed by vote of the Fund's Board of Directors without the approval of
shareholders.
ASIA GROWTH FUND
The Asia Growth Fund's objective is to achieve long-term capital appreciation.
The Fund seeks to achieve its objective by investing at least 65% of its total
assets in equity and equity-related securities of Asian Companies. Asian
Companies include companies that: (i) are organized under the laws of
Bangladesh, China, Hong Kong, India, Indonesia, Korea, Malaysia, Pakistan, the
Philippines, Singapore, Sri Lanka, Taiwan, Thailand or any other country in the
Asian region (other than Japan, Australia and New Zealand) that currently or in
the future permits foreign investment (collectively, 'Asian Countries'); or
(ii) regardless of where organized and as determined by SBAM AP, (a) derive at
least 50% of their revenues from goods produced or sold, investments made, or
services performed in or with one or more of the Asian Countries, (b) maintain
at least 50% of their assets in one or more of the Asian Countries, or (c) have
securities which are traded principally on a stock exchange in an Asian
Country. The Fund is non-diversified within the meaning of the 1940 Act. See
'Additional Investment Activities and Risk Factors -- Non-
Diversification.'
Equity securities in which the Asia Growth Fund may invest include common and
preferred stocks (including convertible preferred stock), bonds, notes and
debentures convertible into common and preferred stock, stock purchase warrants
and rights, equity-linked debt securities, equity interests in trusts,
partnerships, joint ventures or similar enterprises, and American, Global or
other types of Depositary Receipts. Equity-linked debt securities are debt
instruments whose prices are indexed to the prices of equity securities or
securities indices. In other words, the value at maturity or coupon rate of
these equity-linked debt instruments is determined by reference to a specific
instrument or statistic. The performance of equity-linked debt instruments
depends to a great extent on the performance of the security or index to which
they are indexed, and may also be influenced by interest rate changes in the
United States and abroad. At the same time, these instruments are subject to the
credit risks associated with the issuer of
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the security, and their values may decline substantially if the issuer's
creditworthiness deteriorates. Indexed instruments may be more volatile than
the underlying instruments.
There are no prescribed limits on geographic asset distributions among Asian
Countries and from time to time, SBAM AP expects to invest a significant portion
of the Asia Growth Fund's assets in Hong Kong, Malaysia, Singapore and Thailand.
Investments in each of these countries may from time to time exceed 25% of the
Fund's total assets. In addition, more than 25% of the Fund's total assets may
be denominated or quoted in the currencies of any one or more of such
countries. In this connection, SBAM AP anticipates that up to 40% of the Fund's
total assets may be invested in Hong Kong. Under an agreement signed in 1984,
Britain passed Hong Kong's sovereignty to China effective July 1, 1997. The
political, social and financial ramifications of China's assumption of
sovereignty over Hong Kong, and the impact on the financial markets in Hong
Kong, Asia or elsewhere, are uncertain.
Although SBAM AP expects that most of the equity securities purchased by the
Fund will be traded on a stock exchange or in an over-the-counter market, most
of the Asian securities markets have substantially less volume than U.S. or
other established markets and some of the stock exchanges in the Asian
Countries are in the early stages of their development. Concentration of the
Fund's assets in one or a few of the Asian countries and Asian currencies will
subject the Fund, to a greater extent than if the Fund's assets were less
geographically concentrated, to the risks of adverse changes in the securities
and foreign exchange markets of such countries and social, political or
economic events which may occur in those countries. For a more detailed
discussion of the special risks which the Fund is subject to by virtue of its
investment in foreign securities, see 'Additional Investment Activities and
Risk Factors -- Foreign Securities.' An investment in the Asia Growth Fund
should not be considered as a complete investment program.
In pursuing the Asia Growth Fund's investment objective, SBAM AP will combine a
traditional fundamental approach towards evaluating industry sectors and
individual securities of Asian Companies with a risk management driven approach
seeking to keep the Fund's volatility of return in line with or lower than that
currently experienced in the Asian markets.
SBAM AP expects to focus on certain industry groups across Asian Countries in
an attempt to identify and capture the relative value of such groups on a
pan-regional basis. SBAM AP will research individual companies in an effort to
identify the investment opportunities within these industry groups which will
provide long-term capital appreciation. In addition, SBAM AP intends to meet the
management of individual companies on a periodic basis. As part of the Asia
Growth Fund's risk management objective, SBAM AP will also concentrate on
macroeconomic issues and other variables influencing the direction of monetary
policies followed by Asian Central Banks.
The investment process to be implemented by SBAM AP will consist of the three
following principal (and potentially overlapping) types of approaches.
PAN REGIONAL INDUSTRY GROUP DECISIONS. SBAM AP will seek to identify the
pan-regional industrial sectors which are likely to exhibit attractive returns
over the long-term. In selecting such industrial sectors, SBAM AP will focus on
industry cycles and competitiveness as well as the industrial characteristics
of the Asian economies. In addition, SBAM AP will review government
regulations, industrial policies, access to technology and industrial research
reports provided by industrial companies or associations and
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securities dealers in Asian Countries. SBAM AP will focus on those industries
which represent meaningful weightings in the total market capitalization of the
Asian Countries including, but not limited to, telecommunications, consumer
durables and nondurables, food and beverage, electronics, hotels, power
engineering and generation, basic industries, public utilities, property and
financial sectors. SBAM AP believes that an investment process that places
emphasis on industry groups is appropriate given the current state of economic
and financial integration being achieved by the Asian Countries and the
relatively significant concentration of market capitalization in Asian Countries
toward certain industrial sectors.
FUNDAMENTAL ANALYSIS. In order to identify the most attractive investment
opportunities within industry groups, SBAM AP will employ extensive research to
select investments in Asian Countries that offer long-term growth potential for
investors. While the Asia Growth Fund generally seeks to invest in securities of
larger companies within the particular Asian market, it may also invest in the
securities of medium and smaller companies that, in the opinion of SBAM AP,
have potential for growth. In particular, SBAM AP will employ the following
three-step process to evaluate particular investment opportunities for the Fund.
SCREENING PROCESS. SBAM AP will implement a systematic screening process in an
effort to identify individual securities it believes likely to exhibit
attractive returns over the long term. SBAM AP will screen companies according
to factors such as the perceived quality of their management and business,
overall sustainable competitiveness, historical earnings, dividend records over
at least a full business cycle, liquidity, trading volumes and historical and
expected volatility.
FINANCIAL ANALYSIS PROCESS. The financial analysis of selected companies will
focus on evaluating the fundamental value of the enterprise. SBAM AP will use a
value-driven process which will emphasize quantitative analysis based on return
on equity ('ROE') and its components, such as operating margins, financial
leverage, asset turnover and interest and tax burdens. In addition, the
company's cash flow generating capabilities and return on assets will be
considered. SBAM AP believes that ROE and cash flow dynamics are appropriate
variables when analyzing companies which operate in high growth markets, such
as Asia, as the ability of such companies to capture this growth by using the
right allocation of resources and asset financing is of utmost importance.
VALUATION PROCESS AND VOLATILITY ANALYSIS. The valuation process will focus on
Price Earnings Ratio ('PER') calculations and comparisons with historical
relative PER bands and local market conditions. SBAM AP will use measures such
as PER/growth, and will evaluate whether the security enjoys accelerating
earnings growth momentum due to management changes or the introduction of new
products and/or services. In addition, where appropriate, SBAM AP will conduct
specific dividend discount model and discount cash flow analyses for specific
securities with predictable cash flows or dividend streams. Through the use of
this analysis, SBAM AP will attempt to identify companies with strong potential
for appreciation relative to their downside exposure. Lastly, SBAM AP will
conduct a volatility analysis on selected securities in an effort to forecast
the expected risk of such securities and compare the results of such risk
analysis with these securities' expected returns. Investments may be made in
companies that do not have extensive operating experience provided that SBAM AP
believes such companies nevertheless have significant growth potential.
RISK MANAGEMENT AND MACROECONOMIC/TOP-DOWN ANALYSIS. SBAM AP will also consider
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macroeconomic variables, such as liquidity and capital flows, foreign equity and
industrial investments and the direction of monetary policies in the Asian
Countries in an effort to capture individual market movements as well as attain
an optimal asset allocation mix and to identify the appropriate risk management
parameters for the Asia Growth Fund. The macroeconomic data SBAM AP will
monitor and analyze includes, but is not limited to, gross domestic product
growth, balance of payments and current account balances, budget deficits or
surpluses, inflation and interest rates. SBAM AP intends to meet with central
bankers, regional economists and strategists on a regular basis to assess the
present and future direction of monetary policies and their likely impact on
the markets of the Asian Countries.
As part of the Fund's risk management approach and in an attempt to better
assess and control the Fund's overall risk level on an ongoing basis, SBAM AP
will employ a quantitative analysis at each stage of the investment process
which will consist of analyzing and forecasting volatilities of the Asian
markets and securities. SBAM AP will use a number of volatility-control
strategies, including derivative instruments (as discussed below), in an effort
to attain an optimal asset allocation mix, for hedging purposes in an attempt
to control the Fund's overall risk level and to obtain exposure to markets in
the Asian Countries which have restrictions on foreign investment.
The Asia Growth Fund from time to time may invest up to 10% of its total assets
in non-convertible debt securities, which may include securities rated below
investment grade by S&P and Moody's with no minimum rating required or
comparable unrated securities, commonly known as 'junk bonds.' There is no
limit on the amount of the Fund's assets that can be invested in convertible
securities rated below investment grade. For additional information on these
high yield debt securities, which may involve a high degree of risk, see
'Additional Investment Activities and Risk Factors -- High Yield Securities.'
In order to maintain liquidity, the Asia Growth Fund may hold and/or invest up
to 35% of its total assets in debt securities denominated in U.S. dollars or in
another freely convertible currency including: (1) short-term (less than 12
months to maturity) and medium-term (not greater than five years to maturity)
obligations issued or guaranteed by (a) the U.S. government or the government
of an Asian Country, their agencies or instrumentalities or (b) international
organizations designated or supported by multiple foreign governmental entities
to promote economic reconstruction or development ('supranational entities');
(2) finance company obligations, corporate commercial paper and other short-term
commercial obligations, in each case rated, or issued by companies with similar
securities outstanding that are rated, 'Prime-1' or 'A' or better by Moody's or
'A-1' or 'A' or better by S&P or, if unrated, of comparable quality as
determined by SBAM AP; (3) obligations (including certificates of deposit, time
deposits, demand deposits and bankers' acceptances) of banks; and (4) repurchase
agreements (as described below under 'Additional Investment Activities and Risk
Factors -- Repurchase Agreements') with respect to securities in which the Fund
may invest. If at some future date, in the opinion of SBAM AP, adverse
conditions prevail in the securities markets which makes the Asia Growth Fund's
investment strategy inconsistent with the best interests of the Fund's
shareholders, the Fund may invest its assets without limit in such instruments.
The Asia Growth Fund may enter into repurchase agreements and reverse
repurchase agreements, may purchase securities on a firm commitment basis,
including when-issued securities and may lend portfolio securities. The Fund may
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SALOMON BROTHERS VARIABLE SERIES
also invest in investment funds. For a description of these investment practices
and the risks associated therewith, see 'Additional Investment Activities and
Risk Factors.'
The Asia Growth Fund may purchase securities for which there is a limited
trading market or which are subject to restrictions on resale to the public. The
Fund will not invest more than 15% of the value of its total assets in illiquid
securities, such as 'restricted securities' which are illiquid, and securities
that are not readily marketable. For further discussion of illiquid securities
and their associated risks, see 'Additional Investment Activities and Risk
Factors -- Restricted Securities and Securities With Limited Trading Markets.'
As more fully described in the Statement of Additional Information, the Fund
may purchase Rule 144A securities. The Fund's holdings of Rule 144A securities
which are liquid securities will not be subject to the 15% limitation on
investments in illiquid securities.
The Asia Growth Fund is currently authorized and intends to use the various
investment strategies referred to under 'Additional Investment Activities and
Risk Factors -- Derivatives.' The Fund's ability to pursue certain of these
strategies may be limited by applicable regulations of the SEC, the CFTC and
the federal income tax requirements applicable to regulated investment
companies. See 'Additional Investment Activities and Risk Factors --
Derivatives' and the Statement of Additional Information for a description of
these strategies and of certain risks associated therewith.
The foregoing investment policies and activities, other than the Asia Growth
Fund's investment objective, are not fundamental policies and may be changed by
vote of the Fund's Board of Directors without the approval of shareholders.
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Additional Investment Activities
and Risk Factors
BANK OBLIGATIONS. Banks are subject to extensive governmental regulations which
may limit both the amounts and types of loans and other financial commitments
which may be made and interest rates and fees which may be charged. The
profitability of this industry is largely dependent upon the availability and
cost of capital funds for the purpose of financing lending operations under
prevailing money market conditions. Also, general economic conditions play an
important part in the operations of this industry and exposure to credit losses
arising from possible financial difficulties of borrowers might affect a bank's
ability to meet its obligations.
Investors should also be aware that securities issued or guaranteed by foreign
banks, foreign branches of U.S. banks, and foreign government and private
issuers may involve investment risks in addition to those relating to domestic
obligations. See ' -- Foreign Securities' below. None of the Funds will
purchase bank obligations which SBAM believes, at the time of purchase, will be
subject to exchange controls or foreign withholding taxes; however, there can
be no assurance that such laws may not become applicable to certain of the
Funds' investments. In the event unforeseen exchange controls or foreign
withholding taxes are imposed with respect to a Fund's investments, the effect
may be to reduce the income received by the Fund on such investments.
FLOATING AND VARIABLE RATE INSTRUMENTS. The Strategic Bond Fund may invest in
floating and variable rate obligations. Floating or variable rate obligations
bear interest at rates that are not fixed, but vary with changes in specified
market rates or indices, such as the prime rate, and at specified intervals.
Certain of the floating or variable rate obligations that may be purchased by a
Fund may carry a demand feature that would permit the holder to tender them
back to the issuer at par value prior to maturity. Such obligations include
variable rate master demand notes, which are unsecured instruments issued
pursuant to an agreement between the issuer and the holder that permit the
indebtedness thereunder to vary and provide for periodic adjustments in the
interest rate. A Fund will limit its purchases of floating and variable rate
obligations to those of the same quality as it otherwise is allowed to
purchase. SBAM will monitor on an ongoing basis the ability of an issuer of a
demand instrument to pay principal and interest on demand. For a further
discussion of floating and variable rate obligations, see 'Additional
Information on Portfolio Instruments and Investment Policies -- Floating and
Variable Rate Instruments' in the Statement of Additional Information.
REPURCHASE AGREEMENTS. Each Fund may enter into repurchase agreements for cash
management purposes. A repurchase agreement is a transaction in which the
seller of a security commits itself at the time of the sale to repurchase that
security from the buyer at a mutually agreed upon time and price.
Each Fund will enter into repurchase agreements only with dealers, domestic
banks or recognized financial institutions which, in the opinion of SBAM based
on guidelines established by the Board of Directors, are deemed creditworthy.
SBAM will monitor the value of the securities underlying the repurchase
agreement at the time the transaction is entered into and at all times during
the term of the repurchase agreement to ensure that the value of the securities
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SALOMON BROTHERS VARIABLE SERIES
always equals or exceeds the repurchase price. Each Fund requires that
additional securities be deposited if the value of the securities purchased
decreases below their resale price and does not bear the risk of a decline in
the value of the underlying security unless the seller defaults under the
repurchase obligation. In the event of default by the seller under the
repurchase agreement, a Fund could experience losses and experience delays in
connection with the disposition of the underlying security. To the extent that,
in the meantime, the value of the securities that a Fund has purchased has
decreased, the Fund could experience a loss. Repurchase agreements with
maturities of more than seven days will be treated as illiquid securities by a
Fund.
REVERSE REPURCHASE AGREEMENTS. The Total Return Fund, High Yield Bond Fund,
Strategic Bond Fund and Asia Growth Fund may enter into 'reverse' repurchase
agreements to avoid selling securities during unfavorable market conditions to
meet redemptions. Pursuant to a reverse repurchase agreement, a Fund will sell
portfolio securities and agree to repurchase them from the buyer at a
particular date and price. Whenever a Fund enters into a reverse repurchase
agreement, it will establish a segregated account of liquid assets in an amount
at least equal to the repurchase price marked to market daily (including accrued
interest), and will subsequently monitor the account to ensure that such
equivalent value is maintained, in accordance with procedures established by
the Board of Directors. A Fund pays interest on amounts obtained pursuant to
reverse repurchase agreements. Reverse repurchase agreements are considered to
be borrowings by a Fund.
LOANS OF PORTFOLIO SECURITIES. Each Fund may lend portfolio securities to
generate income. In the event of the bankruptcy of the other party to a
securities loan, a Fund could experience delays in recovering the securities it
lent. To the extent that, in the meantime, the value of the securities a Fund
lent has increased, the Fund could experience a loss. The value of securities
loaned will be marked to market daily. Any securities that a Fund may receive
as collateral will not become a part of its portfolio at the time of the loan.
In the event of a default by the borrower, the Fund will, if permitted by law,
dispose of such collateral except that the Fund may retain any such part
thereof that is a security in which the Fund is permitted to invest. The Fund
may invest the cash collateral and earn additional income or receive an agreed-
upon fee from a borrower that has delivered cash equivalent collateral. Cash
collateral received by a Fund may be invested in securities in which the Fund is
permitted to invest. Portfolio securities purchased with cash collateral are
subject to possible depreciation. Voting rights may pass with the lending of
portfolio securities. Loans of securities by a Fund will be subject to
termination at the Fund's or the borrower's option. A Fund may pay
administrative and custodial fees in connection with a securities loan and may
pay a negotiated portion of the interest or fee earned with respect to the
collateral to the borrower or a placing broker.
FIRM COMMITMENTS AND WHEN-ISSUED SECURITIES. Each Fund may purchase securities
on a firm commitment basis, including when-issued securities. Securities
purchased on a firm commitment basis are purchased for delivery beyond the
normal settlement date at a stated price and yield. No income accrues to the
purchaser of a security on a firm commitment basis prior to delivery. Such
securities are recorded as an asset and are subject to changes in value based
upon changes in the general level of interest rates. Purchasing a security on a
firm commitment basis can involve a risk that the market price at the time of
delivery may be lower than the agreed upon purchase price, in which case
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there could be an unrealized loss at the time of delivery. A Fund will only make
commitments to purchase securities on a firm commitment basis with the intention
of actually acquiring the securities, but may sell them before the settlement
date if it is deemed advisable. A Fund will establish a segregated account in
which it will maintain liquid assets in an amount at least equal in value to
the Fund's commitments to purchase securities on a firm commitment basis. If
the value of these assets declines, the Fund will place additional liquid
assets in the account on a daily basis so that the value of the assets in the
account is equal to the amount of such commitments.
ZERO COUPON SECURITIES, PIK BONDS AND DEFERRED PAYMENT SECURITIES. The Total
Return Fund, High Yield Bond Fund and Strategic Bond Fund may invest in zero
coupon securities, PIK bonds and deferred payment securities.
Zero coupon securities are debt securities that pay no cash income but are sold
at substantial discounts from their value at maturity. When a zero coupon
security is held to maturity, its entire return, which consists of the
amortization of discount, comes from the difference between its purchase price
and its maturity value. This difference is known at the time of purchase, so
that investors holding zero coupon securities until maturity know at the time
of their investment what the expected return on their investment will be.
Certain zero coupon securities also are sold at substantial discounts from their
maturity value and provide for the commencement of regular interest payments at
a deferred date. Zero coupon securities may have conversion features. A Fund
also may purchase PIK bonds. PIK bonds pay all or a portion of their interest
in the form of debt or equity securities. Deferred payment securities are
securities that remain zero coupon securities until a predetermined date, at
which time the stated coupon rate becomes effective and interest becomes
payable at regular intervals.
Zero coupon securities, PIK bonds and deferred payment securities tend to be
subject to greater price fluctuations in response to changes in interest rates
than are ordinary interest-paying debt securities with similar maturities. The
value of zero coupon securities appreciates more during periods of declining
interest rates and depreciates more during periods of rising interest rates
than ordinary interest-paying debt securities with similar maturities. Zero
coupon securities, PIK bonds and deferred payment securities may be issued by a
wide variety of corporate and governmental issuers. Although these instruments
are generally not traded on a national securities exchange, they are widely
traded by brokers and dealers and, to such extent, will not be considered
illiquid for the purposes of a Fund's limitation on investments in illiquid
securities.
Current federal income tax law requires the holder of a zero coupon security,
certain PIK bonds, deferred payment securities and certain other securities
acquired at a discount (such as Brady Bonds) to accrue income with respect to
these securities prior to the receipt of cash payments. Accordingly, to avoid
liability for federal income and excise taxes, a Fund may be required to
distribute income accrued with respect to these securities and may have to
dispose of portfolio securities under disadvantageous circumstances in order to
generate cash to satisfy these distribution requirements.
LOAN PARTICIPATIONS AND ASSIGNMENTS. The Total Return Fund, High Yield Bond
Fund and Strategic Bond Fund may invest in Loan Participations and Assignments.
The Funds consider these investments to be investments in debt securities for
purposes of this Prospectus. Loan Participations typically will result in a
Fund having a contractual relationship only with the Lender, not with the
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borrower. A Fund will have the right to receive payments of principal, interest
and any fees to which it is entitled only from the Lender selling the
Participation and only upon receipt by the Lender of the payments from the
borrower. In connection with purchasing Loan Participations, a Fund generally
will have no right to enforce compliance by the borrower with the terms of the
Loan agreement relating to the Loan, nor any rights of set-off against the
borrower, and the Fund may not benefit directly from any collateral supporting
the Loan in which it has purchased the Participation. As a result, a Fund will
assume the credit risk of both the borrower and the Lender that is selling the
Participation. In the event of the insolvency of the Lender selling a
Participation, a Fund may be treated as a general creditor of the Lender and
may not benefit from any set-off between the Lender and the borrower. A Fund
will acquire Loan Participations only if the Lender interpositioned between the
Fund and the borrower is determined by SBAM to be creditworthy. When a Fund
purchases Assignments from Lenders, the Fund will acquire direct rights against
the borrower on the Loan, except that under certain circumstances such rights
may be more limited than those held by the assigning Lender.
A Fund may have difficulty disposing of Assignments and Loan Participations.
Because the market for such instruments is not highly liquid, the Funds
anticipate that such instruments could be sold only to a limited number of
institutional investors. The lack of a highly liquid secondary market may have
an adverse impact on the value of such instruments and will have an adverse
impact on a Fund's ability to dispose of particular Assignments or Loan
Participations in response to a specific economic event, such as deterioration
in the creditworthiness of the borrower.
The Board of Directors has adopted policies and procedures for the purpose of
determining whether Assignments and Loan Participations are liquid or illiquid.
Pursuant to those policies and procedures, the Board of Directors has delegated
to SBAM the determination as to whether a particular Loan Participation or
Assignment is liquid or illiquid, requiring that consideration be given to,
among other things, the frequency of quotes, the number of dealers willing to
sell and the number of potential purchasers, the nature of the Loan
Participation or Assignment and the time needed to dispose of it and the
contractual provisions of the relevant documentation. To the extent that liquid
Assignments and Loan Participation that a Fund holds become illiquid, due to the
lack of sufficient buyers or market or other conditions, the percentage of a
Fund's assets invested in illiquid assets would increase. SBAM, under the
supervision of the Board of Directors, monitors Fund investments in Assignments
and Loan Participations and will consider appropriate measures to enable a Fund
to maintain sufficient liquidity for operating purposes and to meet redemption
requests.
In valuing a Loan Participation or Assignment held by a Fund for which a
secondary trading market exists, the Fund will rely upon prices or quotations
provided by banks, dealers or pricing services. To the extent a secondary
trading market does not exist, a Fund's Loan Participations and Assignments
will be valued in accordance with procedures adopted by the Board of Directors,
taking into consideration, among other factors: (i) the creditworthiness of the
borrower under the Loan and the Lender; (ii) the current interest rate; period
until next rate reset and maturity of the Loan; (iii) recent prices in the
market for similar Loans; and (iv) recent prices in the market for instruments
of similar quality, rate, period until next interest rate reset and maturity.
See 'Net Asset Value.'
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RESTRICTED SECURITIES AND SECURITIES WITH LIMITED TRADING MARKETS. Each Fund
may purchase securities for which there is a limited trading market or which
are subject to restrictions on resale to the public. If a Fund were to assume
substantial positions in securities with limited trading markets, the
activities of the Fund could have an adverse effect upon the liquidity and
marketability of such securities and the Fund might not be able to dispose of
its holdings in those securities at then current market prices. Circumstances
could also exist (to satisfy redemptions, for example) when portfolio
securities might have to be sold by a Fund at times which otherwise might be
considered to be disadvantageous so that the Fund might receive lower proceeds
from such sales than it had expected to realize. Investments in securities
which are 'restricted' may involve added expenses to a Fund should the Fund be
required to bear registration costs with respect to such securities and could
involve delays in disposing of such securities which might have an adverse
effect upon the price and timing of sales of such securities and the liquidity
of the Fund with respect to redemptions. Restricted securities and securities
for which there is a limited trading market may be significantly more difficult
to value due to the unavailability of reliable market quotations for such
securities, and investment in such securities may have an adverse impact on net
asset value. As more fully described in the Statement of Additional Information,
certain Funds may purchase Rule 144A securities for which there may be a
secondary market of qualified institutional buyers as contemplated by recently
adopted Rule 144A under the 1933 Act. A Fund's holdings of Rule 144A securities
which are liquid securities will not be subject to the Fund's applicable
limitation on investments in illiquid securities. Rule 144A is a recent
development and there is no assurance that a liquid market in Rule 144A
securities will develop or be maintained. To the extent that the number of
qualified institutional buyers is reduced, a previously liquid Rule 144A
security may be determined to be illiquid, thus increasing the percentage of
illiquid assets in a Fund's portfolio. SBAM, under the supervision of the Board
of Directors, is responsible for monitoring the liquidity of Rule 144A
securities and the selection of such securities. The Board of Directors
periodically reviews purchases and sales of such securities.
WARRANTS. Each of the Funds, except for the U.S. Government Income Fund, may
invest in warrants, which are securities permitting, but not obligating, their
holder to subscribe for other securities. Warrants do not carry the right to
dividends or voting rights with respect to their underlying securities, and
they do not represent any rights in assets of the issuer. An investment in
warrants may be considered speculative. In addition, the value of a warrant
does not necessarily change with the value of the underlying securities and a
warrant ceases to have value if it is not exercised prior to its expiration
date.
FOREIGN SECURITIES. Investors should recognize that investing in the securities
of foreign issuers involves special considerations which are not typically
associated with investing in the securities of U.S. issuers. Investments in
securities of foreign issuers may involve risks arising from differences
between U.S. and foreign securities markets, including less volume, much
greater price volatility in and illiquidity of certain foreign securities
markets, different trading and settlement practices and less governmental
supervision and regulation, from changes in currency exchange rates, from high
and volatile rates of inflation, from economic, social and political conditions
and, as with domestic multinational corporations, from fluctuating interest
rates.
Investment in certain emerging market securities is restricted or controlled to
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varying degrees which may at times limit or preclude investment in certain
emerging market securities and increase the costs and expenses of a Fund.
Certain emerging market countries require governmental approval prior to
investments by foreign persons, limit the amount of investment by foreign
persons in a particular issuer, limit the investment by foreign persons only to
a specific class of securities of an issuer that may have less advantageous
rights than other classes, restrict investment opportunities in issuers in
industries deemed important to national interests and/or impose additional
taxes on foreign investors.
Certain emerging market countries may require governmental approval for the
repatriation of investment income, capital or the proceeds of sales of
securities by foreign investors which could adversely affect a Fund. In
addition, if a deterioration occurs in the country's balance of payments, it
could impose temporary restrictions on foreign capital remittances. Investing
in local markets in emerging market countries may require a Fund to adopt
special procedures, seek local government approvals or take other actions, each
of which may involve additional costs to the Fund.
Other investment risks include the possible imposition of foreign withholding
taxes on certain amounts of a Fund's income, the possible seizure or
nationalization of foreign assets and the possible establishment of exchange
controls, expropriation, confiscatory taxation, other foreign governmental laws
or restrictions which might affect adversely payments due on securities held by
a Fund, the lack of extensive operating experience of eligible foreign
subcustodians and legal limitations on the ability of a Fund to recover assets
held in custody by a foreign subcustodian in the event of the subcustodian's
bankruptcy. Moreover, brokerage commissions and other transactions costs on
foreign securities exchanges are generally higher than in the United States.
In addition, there may be less publicly-available information about a foreign
issuer than about a U.S. issuer, and foreign issuers may not be subject to the
same accounting, auditing and financial record-keeping standards and
requirements as U.S. issuers. In particular, the assets and profits appearing
on the financial statements of an emerging market country issuer may not
reflect its financial position or results of operations in the way they would
be reflected and the financial statements been prepared in accordance with U.S.
generally accepted accounting principles. In addition, for an issuer that keeps
accounting records in local currency, inflation accounting rules may require,
for both tax and accounting purposes, that certain assets and liabilities be
restated on the issuer's balance sheet in order to express items in terms of
currency of constant purchasing power. Inflation accounting may indirectly
generate losses or profits. Consequently, financial data may be materially
affected by restatements for inflation and may not accurately reflect the real
condition of those issuers and securities markets. See ' -- High Yield
Securities.'
Finally, in the event of a default in any such foreign obligations, it may be
more difficult for a Fund to obtain or enforce a judgment against the issuers
of such obligations. For a further discussion of certain risks involved in
investing in foreign securities, particularly of emerging market issuers, see
'Additional Information on Portfolio Instruments and Investment
Policies -- Foreign Securities' in the Statement of Additional Information.
FIXED-INCOME SECURITIES. Changes in market yields will affect a Fund's net asset
value as prices of fixed-income securities generally increase when interest
rates decline and decrease when interest rates rise. Prices of longer term
securities
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generally increase or decrease more sharply than those of shorter term
securities in response to interest rate changes, particularly if such securities
were purchased at a discount. Because the, U.S. Government Income Fund, the
High Yield Bond Fund and the Strategic Bond Fund will invest primarily in fixed-
income securities and the Total Return Fund may from time to time invest in a
substantial amount of fixed-income securities, the net asset value of these
Fund's shares can be expected to change as general levels of interest rates
fluctuate. It should be noted that the market values of securities rated below
investment grade and comparable unrated securities tend to react less to
fluctuations in interest rate levels than do those of higher-rated securities.
Except to the extent that values are affected independently by other factors
such as developments relating to a specific issuer, when interest rates
decline, the value of a fixed-income portfolio can generally be expected to
rise. Conversely, when interest rates rise, the value of a fixed-income
portfolio can generally be expected to decline.
In addition, many fixed-income securities contain call or buy-back features that
permit their issuers to call or repurchase the securities from their holders.
Such securities may present risks based on payment expectations. Although a Fund
would typically receive a premium if an issuer were to redeem a security, if an
issuer exercises such a 'call option' and redeems the security during a time of
declining interest rates, a Fund may realize a capital loss on its investment if
the security was purchased at a premium and a Fund may have to replace the
called security with a lower yielding security, resulting in a decreased rate
of return to the Fund.
MORTGAGE-BACKED SECURITIES. The yield characteristics of the mortgage-backed
securities in which the Total Return Fund, the Strategic Bond Fund and the U.S.
Government Income Fund may invest differ from those of traditional debt
securities. Among the major differences are that interest and principal
payments are made more frequently on mortgage-backed securities, usually
monthly, and that principal may be prepaid at any time because the underlying
mortgage loans generally may be prepaid at any time. As a result, if these
securities are purchased at a premium, faster than expected prepayments will
reduce yield to maturity, while slower than expected prepayments will increase
yield to maturity. Conversely, if these securities are purchased at a discount,
faster than expected prepayments will increase yield to maturity, while slower
than expected prepayments will reduce yield to maturity. Accelerated
prepayments on securities purchased at a premium also impose a risk of loss of
principal because the premium may not have been fully amortized at the time the
principal is prepaid in full. Because of the reinvestment of prepayments of
principal at current rates, mortgage-backed securities may be less effective
than Treasury bonds of similar maturity at maintaining yields during periods of
declining interest rates. When interest rates rise, the value and liquidity of
mortgage-backed securities may decline sharply and generally will decline more
than would be the case with other fixed-income securities; however, when
interest rates decline, the value of mortgage-backed securities may not
increase as much as other fixed-income securities due to the prepayment
feature. Certain market conditions may result in greater than expected
volatility in the prices of mortgage-backed securities. For example, in periods
of supply and demand imbalances in the market for such securities and/or in
periods of sharp interest rate movements, the prices of mortgage-backed
securities may fluctuate to a greater extent than would be expected from
interest rate movements alone. For a description of multiple class mortgage
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pass-through securities, see ' -- Collateralized Mortgage Obligations and
Multiclass Pass-Through Securities' below.
ADJUSTABLE RATE MORTGAGE SECURITIES. Unlike fixed rate mortgage securities,
adjustable rate mortgage securities are collateralized by or represent
interests in mortgage loans with variable rates of interest. These variable
rates of interest reset periodically to align themselves with market rates. A
Fund will not benefit from increases in interest rates to the extent that
interest rates rise to the point where they cause the current coupon of the
underlying adjustable rate mortgages to exceed any maximum allowable annual or
lifetime reset limits (or 'cap rates') for a particular mortgage. In this
event, the value of the mortgage securities in a Fund would likely decrease.
Also, a Fund's net asset value could vary to the extent that current yields on
adjustable rate mortgage securities are different than market yields during
interim periods between coupon reset dates or if the timing of changes to the
index upon which the rate for the underlying mortgages is based lags behind
changes in market rates. During periods of declining interest rates, income to
a Fund derived from adjustable rate mortgages which remain in a mortgage pool
will decrease in contrast to the income on fixed rate mortgages, which will
remain constant. Adjustable rate mortgages also have less potential for
appreciation in value as interest rates decline than do fixed rate investments.
PRIVATELY-ISSUED MORTGAGE SECURITIES. The Total Return Fund and the Strategic
Bond Fund may also purchase mortgage-backed securities issued by private issuers
which may entail greater risk than mortgage-backed securities that are
guaranteed by the U.S. government, its agencies or instrumentalities. Privately-
issued mortgage securities are issued by private originators of, or investors
in, mortgage loans, including mortgage bankers, commercial banks, investment
banks, savings and loan associations and special purpose subsidiaries of the
foregoing. Since privately-issued mortgage certificates are not guaranteed by
an entity having the credit status of GNMA or FHLMC, such securities generally
are structured with one or more types of credit enhancement. Such credit support
falls into two categories: (i) liquidity protection; and (ii) protection against
losses resulting from ultimate default by an obligor on the underlying assets.
Liquidity protection refers to the provision of advances, generally by the
entity administering the pool of assets, to ensure that the pass-through of
payments due on the underlying pool occurs in a timely fashion. Protection
against losses resulting from ultimate default enhances the likelihood of
ultimate payment of the obligations on at least a portion of the assets in the
pool. Such protection may be provided through guarantees, insurance policies or
letters of credit obtained by the issuer or sponsor from third parties, through
various means of structuring the transaction or through a combination of such
approaches.
The ratings of mortgage securities for which third-party credit enhancement
provides liquidity protection or protection against losses from default are
generally dependent upon the continued creditworthiness of the provider of the
credit enhancement. The ratings of such securities could be subject to
reduction in the event of deterioration in the creditworthiness of the credit
enhancement provider even in cases where the delinquency and loss experience on
the underlying pool of assets is better than expected. There can be no
assurance that the private issuers or credit enhancers of mortgage-backed
securities can meet their obligations under the relevant policies or other
forms of credit enhancement.
Examples of credit support arising out of the structure of the transaction
include 'senior-subordinated securities' (multiple class securities with one or
more classes
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subordinate to other classes as to the payment of principal thereof and interest
thereon, with the result that defaults on the underlying assets are borne first
by the holders of the subordinated class), creation of 'reserve funds' (where
cash or investments sometimes funded from a portion of the payments on the
underlying assets are held in reserve against future losses) and
'over-collateralization' (where the scheduled payments on, or the principal
amount of, the underlying assets exceed those required to make payment of the
securities and pay any servicing or other fees). The degree of credit support
provided for each issue is generally based on historical information with
respect to the level of credit risk associated with the underlying assets.
Delinquency or loss in excess of that which is anticipated could adversely
affect the return on an investment in such security.
COLLATERALIZED MORTGAGE OBLIGATIONS AND MULTICLASS PASS-THROUGH SECURITIES. The
Strategic Bond Fund and the U.S. Government Income Fund may invest in
collateralized mortgage obligations ('CMOs'). CMOs are debt obligations
collateralized by mortgage loans or mortgage pass-through securities.
Typically, CMOs are collateralized by GNMA, Fannie Mae or Freddie Mac
Certificates, but also may be collateralized by whole loans or private
pass-throughs (such collateral collectively hereinafter referred to as
'Mortgage Assets'). Multiclass pass-through securities are interests in a trust
composed of Mortgage Assets. Unless the context indicates otherwise, all
references herein to CMOs include multiclass pass-through securities. Payments
of principal and of interest on the Mortgage Assets, and any reinvestment
income thereon, provide the funds to pay debt service on the CMOs or make
scheduled distributions on the multiclass pass-through securities. CMOs may be
issued by agencies or instrumentalities of the U.S. government, or by private
originators of, or investors in, mortgage loans, including savings and loan
associations, mortgage banks, commercial banks, investment banks and special
purpose subsidiaries of the foregoing. CMOs acquired by the U.S. Government
Income Fund will be limited to those issued or guaranteed by agencies or
instrumentalities of the U.S. government and, if available in the future, the
U.S. government.
In a CMO, a series of bonds or certificates is issued in multiple classes. Each
class of CMOs, often referred to as a 'tranche,' is issued at a specified fixed
or floating coupon rate and has a stated maturity or final distribution date.
Principal prepayments on the Mortgage Assets may cause the CMOs to be retired
substantially earlier than their stated maturities or final distribution dates.
Interest is paid or accrues on all classes of the CMOs on a monthly, quarterly
or semi-annual basis. The principal of and interest on the Mortgage Assets may
be allocated among the several classes of a series of a CMO in innumerable
ways. In one structure, payments of principal, including any principal
prepayments, on the Mortgage Assets are applied to the classes of a CMO in the
order of their respective stated maturities or final distribution dates, so
that no payment of principal will be made on any class of CMOs until all other
classes having an earlier stated maturity or final distribution date have been
paid in full. The Strategic Bond and U.S. Government Income Funds have no
present intention to invest in CMO residuals. The market for CMOs may be less
liquid than the market for other securities. As market conditions change, and
particularly during periods of rapid or unanticipated changes in market interest
rates, the attractiveness of the CMO classes and the ability of the structure to
provide the anticipated investment characteristics may be significantly
reduced. Such changes can result in volatility in the market value, and in some
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instances reduced liquidity, of the CMO class.
The Strategic Bond Fund and the U.S. Government Income Fund may also invest in,
among others, parallel pay CMOs and Planned Amortization Class CMOs ('PAC
Bonds'). Parallel pay CMOs are structured to provide payments of principal on
each payment date to more than one class. These simultaneous payments are taken
into account in calculating the stated maturity date or final distribution date
of each class, which, as with other CMO structures, must be retired by its
stated maturity date or a final distribution date but may be retired earlier.
PAC Bonds are a type of CMO tranche or series designed to provide relatively
predictable payments of principal provided that, among other things, the actual
prepayment experience on the underlying mortgage loans falls within a
predefined range. If the actual prepayment experience on the underlying
mortgage loans is at a rate faster or slower than the predefined range or if
deviations from other assumptions occur, principal payments on the PAC Bond may
be earlier or later than predicted. The magnitude of the predefined range
varies from one PAC Bond to another; a narrower range increases the risk that
prepayments on the PAC Bond will be greater or smaller than predicted. Because
of these features, PAC Bonds generally are less subject to the risks of
prepayment than are other types of mortgage-backed securities.
STRIPPED MORTGAGE SECURITIES. The Strategic Bond Fund may purchase stripped
mortgage securities which are derivative multiclass mortgage securities.
Stripped mortgage securities may be issued by agencies or instrumentalities of
the U.S. government, or by private originators of, or investors in, mortgage
loans, including savings and loan associations, mortgage banks, commercial
banks, investment banks and special purpose subsidiaries of the foregoing.
Stripped mortgage securities have greater volatility than other types of
mortgage securities. Although stripped mortgage securities are purchased and
sold by institutional investors through several investment banking firms acting
as brokers or dealers, the market for such securities has not yet been fully
developed. Accordingly, stripped mortgage securities are generally illiquid.
Stripped mortgage securities are structured with two or more classes of
securities that receive different proportions of the interest and principal
distributions on a pool of mortgage assets. A common type of stripped mortgage
security will have at least one class receiving only a small portion of the
interest and a larger portion of the principal from the mortgage assets, while
the other class will receive primarily interest and only a small portion of the
principal. In the most extreme case, one class will receive all of the interest
('IO' or interest-only), while the other class will receive all of the
principal ('PO' or principal-only class). The yield to maturity on IOs, POs and
other mortgage-backed securities that are purchased at a substantial premium or
discount generally are extremely sensitive not only to changes in prevailing
interest rates but also to the rate of principal payments (including
prepayments) on the related underlying mortgage assets, and a rapid rate of
principal payments may have a material adverse effect on such securities' yield
to maturity. If the underlying mortgage assets experience greater than
anticipated prepayments of principal, a Fund may fail to fully recoup its
initial investment in these securities even if the securities have received the
highest rating by a nationally recognized statistical rating organizations.
In addition to the stripped mortgage securities described above, the Strategic
Bond Fund may invest in similar securities such as Super POs and Levered IOs
which are more volatile than POs, IOs and IOettes. Risks associated with
instruments such as Super POs are similar in nature to those risks related to
investments in POs. Risks connected with Levered IOs and
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IOettes are similar in nature to those associated with IOs. The Strategic Bond
Fund may also invest in other similar instruments developed in the future that
are deemed consistent with its investment objective, policies and restrictions.
POs may generate taxable income from the current accrual of original issue
discount, without a corresponding distribution of cash to the Fund. See
'Taxation' in this Prospectus and 'Additional Information Concerning Taxes' in
the Statement of Additional Information.
MORTGAGE ROLLS. The Strategic Bond Fund and the U.S. Government Income Fund may
enter into mortgage 'dollar rolls' in which a Fund sells mortgage-backed
securities for delivery in the current month and simultaneously contracts to
repurchase substantially similar (same type, coupon and maturity) securities on
a specified future date. During the roll period, a Fund foregoes principal and
interest paid on the mortgage-backed securities. A Fund is compensated by the
difference between the current sales price and the lower forward price for the
future purchase (often referred to as the 'drop') as well as by the interest
earned on the cash proceeds of the initial sale. A Fund may only enter into
covered rolls. A 'covered roll' is a specific type of dollar roll for which
there is an offsetting cash position which matures on or before the forward
settlement date of the dollar roll transaction. At the time a Fund enters into
a mortgage 'dollar roll,' it will establish a segregated account with its
custodian bank in which it will maintain liquid assets equal in value to its
obligations in respect of dollar rolls, and accordingly, such dollar rolls will
not be considered borrowings. Mortgage dollar rolls involve the risk that the
market value of the securities the Fund is obligated to repurchase under the
agreement may decline below the repurchase price. In the event the buyer of
securities under a mortgage dollar roll files for bankruptcy or becomes
insolvent, the Fund's use of proceeds of the dollar roll may be restricted
pending a determination by the other party, or its trustee or receiver, whether
to enforce the Fund's obligation to repurchase the securities.
HIGH YIELD SECURITIES. The High Yield Bond Fund and the Strategic Bond Fund may
invest without limitation in domestic and foreign 'high yield' securities,
commonly known as 'junk bonds.' The Investors Fund, the Capital Fund and the
Total Return Fund may invest without limitation in convertible securities of
this type and up to 5%, 10% and 20%, respectively, of their net assets in non-
convertible securities of this type. The Asia Growth Fund may invest without
limitation in convertible non-U.S. high yield securities and up to 10% of its
total assets in non-convertible non-U.S. high yield securities.
Under rating agency guidelines, medium-and lower-rated securities and comparable
unrated securities will likely have some quality and protective characteristics
that are outweighed by large uncertainties or major risk exposures to adverse
conditions. Medium and lower rated securities are considered to have extremely
poor prospects of ever attaining any real investment standing, to have a current
identifiable vulnerability to default or are in default, to be unlikely to have
the capacity to pay interest and repay principal when due in the event of
adverse business, financial or economic conditions, and/or to be in default or
not current in the payment of interest or principal. Such securities are
considered speculative with respect to the issuer's capacity to pay interest
and repay principal in accordance with the terms of the obligations.
Accordingly, it is possible that these types of factors could, in certain
instances, reduce the value of securities held by a Fund with a commensurate
effect on the value of the Fund's shares.
Changes by recognized rating services in their ratings of any fixed-income
security and in the ability of an issuer to make payments of interest and
principal may also affect the value of these investments.
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A description of the ratings used by Moody's and S&P is set forth in Appendix A
to this Prospectus. The ratings of Moody's and S&P generally represent the
opinions of those organizations as to the quality of the securities that they
rate. Such ratings, however, are relative and subjective, are not absolute
standards of quality, are subject to change and do not evaluate the market risk
or liquidity of the securities. Ratings of a non-U.S. debt instrument, to the
extent that those ratings are undertaken, are related to evaluations of the
country in which the issuer of the instrument is located. Ratings generally
take into account the currency in which a non-U.S. debt instrument is
denominated. Instruments issued by a foreign government in other than the local
currency, for example, typically have a lower rating than local currency
instruments due to the existence of an additional risk that the government will
be unable to obtain the required foreign currency to service its foreign
currency-denominated debt. In general, the ratings of debt securities or
obligations issued by a non-U.S. public or private entity will not be higher
than the rating of the currency or the foreign currency debt of the central
government of the country in which the issuer is located, regardless of the
intrinsic creditworthiness of the issuer.
The secondary markets for high yield securities are not as liquid as the
secondary markets for higher rated securities. The secondary markets for high
yield securities are concentrated in relatively few market makers and
participants in the market are mostly institutional investors, including
insurance companies, banks, other financial institutions and mutual funds. In
addition, the trading volume for high yield securities is generally lower than
that for higher-rated securities and the secondary markets could contract under
adverse market or economic conditions independent of any specific adverse
changes in the condition of a particular issuer. These factors may have an
adverse effect on the ability of a Fund holding such securities to dispose of
particular portfolio investments, may adversely affect the Fund's net asset
value per share and may limit the ability of such a Fund to obtain accurate
market quotations for purposes of valuing securities and calculating net asset
value. If a Fund is not able to obtain precise or accurate market quotations
for a particular security, it will become more difficult to value such Fund's
portfolio securities, and a greater degree of judgment may be necessary in
making such valuations. Less liquid secondary markets may also affect the
ability of a Fund to sell securities at their fair value. If the secondary
markets for high yield securities contract due to adverse economic conditions
or for other reasons, certain liquid securities in a Fund's portfolio may
become illiquid and the proportion of the Fund's assets invested in illiquid
securities may significantly increase.
Prices for high yield securities may be affected by legislative and regulatory
developments. These laws could adversely affect a Fund's net asset value and
investment practices, the secondary market for high yield securities, the
financial condition of issuers of these securities and the value of outstanding
high yield securities. For example, federal legislation requiring the
divestiture by federally insured savings and loan associations of their
investments in high yield bonds and limiting the deductibility of interest by
certain corporate issuers of high yield bonds adversely affected the market in
recent years.
HIGH YIELD CORPORATE SECURITIES. While the market values of securities rated
below investment grade and comparable unrated securities tend to react less to
fluctuations in interest rate levels than do those of higher-rated securities,
the market values of certain of these securities also tend to be more sensitive
to individual corporate developments and changes in economic conditions than
higher-rated securities. In addition, such securities present a higher degree
of credit risk. Issuers of these securities are often highly leveraged and may
not have more traditional methods of
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financing available to them, so that their ability to service their debt
obligations during an economic downturn or during sustained periods of rising
interest rates may be impaired. The risk of loss due to default by such issuers
is significantly greater than with investment grade securities because such
securities generally are unsecured and frequently are subordinated to the prior
payment of senior indebtedness. A Fund also may incur additional expenses to
the extent that it is required to seek recovery upon a default in the payment
of principal or interest on its portfolio holdings.
The development of a market for high yield non-U.S. corporate securities has
been a relatively recent phenomenon. On the other hand, the market for high
yield U.S. corporate debt securities is more established than that for high
yield non-U.S. corporate debt securities, but has undergone significant changes
in the past and may undergo significant changes in the future.
High yield non-U.S. and U.S. corporate securities in which the applicable Funds
may invest include bonds, debentures, notes, commercial paper and preferred
stock and will generally be unsecured. Most of the debt securities will bear
interest at fixed rates. However, a Fund may also invest in corporate debt
securities with variable rates of interest or which 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).
HIGH YIELD FOREIGN SOVEREIGN DEBT SECURITIES. Investing in fixed and floating
rate high yield foreign sovereign debt securities will expose Funds investing in
such securities to the direct or indirect consequences of political, social or
economic changes in the countries that issue the securities. See ' -- Foreign
Securities' above. The ability and willingness of sovereign obligors in
developing and emerging market countries or the governmental authorities that
control repayment of their external debt to pay principal and interest on such
debt when due may depend on general economic and political conditions within
the relevant country. Countries such as those in which a Fund may invest have
historically experienced, and may continue to experience, high rates of
inflation, high interest rates, exchange rate trade difficulties and extreme
poverty and unemployment. Many of these countries are also characterized by
political uncertainty or instability. Additional factors which may influence
the ability or willingness to service debt include, but are not limited to, a
country's cash flow situation, the availability of sufficient foreign exchange
on the date a payment is due, the relative size of its debt service burden to
the economy as a whole, and its government's policy towards the International
Monetary Fund, the World Bank and other international agencies.
The ability of a foreign sovereign obligor to make timely payments on its
external debt obligations will also be strongly influenced by the obligor's
balance of payments, including export performance, its access to international
credits and investments, fluctuations in interest rates and the extent of its
foreign reserves. A country whose exports are concentrated in a few commodities
or whose economy depends on certain strategic imports could be vulnerable to
fluctuations in international prices of these commodities or imports. To the
extent that a country receives payment for its exports in currencies other than
U.S. dollars, its ability to make debt payments denominated in U.S. dollars
could be adversely affected. If a foreign sovereign obligor cannot generate
sufficient earnings from foreign trade to service its external debt, it may
need to depend on continuing loans and aid from foreign governments, commercial
banks and multilateral organizations, and inflows of foreign investment. The
commitment on the part
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of these foreign governments, multilateral organizations and others to make such
disbursements may be conditioned on the government's implementation of economic
reforms and/ or economic performance and the timely service of its obligations.
Failure to implement such reforms, achieve such levels of economic performance
or repay principal or interest when due may result in the cancellation of such
third parties' commitments to lend funds, which may further impair the
obligor's ability or willingness to timely service its debts. The cost of
servicing external debt will also 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.
The ability to service external debt will also depend on the level of the
relevant government's international currency reserves and its access to foreign
exchange. Currency devaluations may affect the ability of a sovereign obligor to
obtain sufficient foreign exchange to service its external debt.
As a result of the foregoing, a governmental obligor may default on its
obligations. If such an event occurs, a Fund may have limited legal recourse
against the issuer and/or guarantor. Remedies must, in some cases, be pursued
in the courts of the defaulting party itself, and the ability of the holder of
foreign sovereign debt securities to obtain recourse may be subject to the
political climate in the relevant country. In addition, no assurance can be
given that the holders of commercial bank debt will not contest payments to the
holders of other foreign sovereign debt obligations in the event of default
under their commercial bank loan agreements.
Certain debt obligations, customarily referred to as 'Brady Bonds,' are created
through the exchange of existing commercial bank loans to foreign entities for
new obligations in connection with debt restructuring under a plan introduced
by former U.S. Secretary of the Treasury, Nicholas F. Brady (the 'Brady Plan').
Brady Bonds have been issued only recently, and, accordingly, do not have a
long payment history. They may be collateralized or uncollateralized and issued
in various currencies (although most are dollar-denominated) and they are
actively traded in the over-the-counter secondary market. Dollar-denominated,
collateralized Brady Bonds, which may be fixed rate par bonds or floating rate
discount bonds, are generally collateralized in full as to principal due at
maturity by U.S. Treasury zero coupon obligations which have the same maturity
as the Brady Bonds. Certain interest payments on these Brady Bonds may be
collateralized by cash or securities in an amount that, in the case of fixed
rate bonds, is typically equal to between 12 and 18 months of rolling interest
payments or, in the case of floating rate bonds, initially is typically equal
to between 12 and 18 months rolling interest payments based on the applicable
interest rate at that time and is adjusted at regular intervals thereafter with
the balance of interest accruals in each case being uncollateralized. The
applicable Funds may purchase Brady Bonds with no or limited collateralization,
and will be relying for payment of interest and (except in the case of
principal collateralized Brady Bonds) principal primarily on the willingness
and ability of the foreign government to make payment in accordance with the
terms of the Brady Bonds. In the event of a default with respect to
collateralized Brady Bonds as a result of which the payment obligations of the
issuer are accelerated, the U.S. Treasury zero coupon obligations held as
collateral for the payment of principal will not be distributed to investors,
nor will such obligations be sold and the proceeds distributed. The collateral
will be held by the collateral agent to the scheduled maturity of the defaulted
Brady Bonds, which will continue to be outstanding, at which time the face
amount of the collateral will equal the principal payments which would have
then been due on the Brady Bonds in the normal course. Based upon current
market conditions, a Fund would not intend to purchase Brady Bonds
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which, at the time of investment, are in default as to payments. However, in
light of the residual risk of the Brady Bonds and, among other factors, the
history of default with respect to commercial bank loans by public and private
entities of countries issuing Brady Bonds, investments in Brady Bonds are to be
viewed as speculative. A substantial portion of the Brady Bonds and other
sovereign debt securities in which the High Yield Bond and Strategic Bond Funds
invest are likely to be acquired at a discount, which involves certain
considerations discussed below under 'Taxation.'
Sovereign obligors in developing and emerging market countries are among the
world's largest debtors to commercial banks, other governments, international
financial organizations and other financial institutions. These obligors have
in the past experienced substantial difficulties in servicing their external
debt obligations, which led to defaults on certain obligations and the
restructuring of certain indebtedness. Restructuring arrangements have
included, among other things, reducing and rescheduling interest and principal
payments by negotiating new or amended credit agreements or converting
outstanding principal and unpaid interest to Brady Bonds, and obtaining new
credit to finance interest payments. Holders of certain foreign sovereign debt
securities may be requested to participate in the restructuring of such
obligations and to extend further loans to their issuers. There can be no
assurance that the Brady Bonds and other foreign sovereign debt securities in
which certain of the Funds may invest will not be subject to similar
restructuring arrangements or to requests for new credit which may adversely
affect a Fund's holdings. Furthermore, certain participants in the secondary
market for such debt may be directly involved in negotiating the terms of these
arrangements and may therefore have access to information not available to
other market participants.
INVESTMENT FUNDS. A Fund may invest in unaffiliated investment funds which
invest principally in securities in which that Fund is authorized to invest.
Under the 1940 Act, the Fund may invest a maximum of 10% of its total assets in
the securities of other investment companies. In addition, under the 1940 Act,
not more than 5% of the Fund's total assets may be invested in the securities
of any one investment company and a Fund may not purchase more than 3% of the
outstanding voting stock of such investment company. To the extent a Fund
invests in other investment funds, the Fund's shareholders will incur certain
duplicative fees and expenses, including investment advisory fees. A Fund's
investment in certain investment funds will result in special U.S. Federal
income tax consequences described below under 'Taxation.'
BORROWING. Each of the Funds may borrow in certain limited circumstances. See
'Investment Limitations.' Borrowing creates an opportunity for increased
return, but, at the same time, creates special risks. For example, borrowing may
exaggerate changes in the net asset value of a Fund's shares and in the return
on the Fund's portfolio. Although the principal of any borrowing will be fixed,
a Fund's assets may change in value during the time the borrowing is
outstanding. A Fund may be required to liquidate portfolio securities at a time
when it would be disadvantageous to do so in order to make payments with
respect to any borrowing, which could affect the investment manager's strategy
and the ability of the Fund to comply with certain provisions of the Internal
Revenue Code of 1986, as amended (the 'Code') in order to provide 'pass-though'
tax treatment to shareholders. Furthermore, if a Fund were to engage in
borrowing, an increase in interest rates could reduce the value of the Fund's
shares by increasing the Fund's interest expense.
NON-DIVERSIFICATION. The Capital Fund and the Asia Growth Fund are classified as
'non-diversified' funds under the 1940 Act, which means that each Fund is not
limited by the 1940 Act in the proportion
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SALOMON BROTHERS VARIABLE SERIES
of its assets that may be invested in the obligations of a single issuer. Each
Fund, however, intends to comply with the diversification requirements imposed
by the Code in order to continue to qualify as a regulated investment company.
To the extent the Funds invest a greater proportion of their assets in the
securities of a smaller number of issuers, each Fund may be more susceptible to
any single economic, political or regulatory occurrence than a more widely
diversified fund and may be subject to greater risk of loss with respect to its
portfolio securities.
DERIVATIVES. Each of the Funds, except the U.S. Government Income Fund, may use
various investment strategies described below to hedge market risks (such as
broad or specific market movements, interest rates and currency exchange
rates), to manage the effective maturity or duration of debt instruments held
by a Fund, or to seek to increase a Fund's income or gain. Although these
strategies are regularly used by some investment companies and other
institutional investors, it is not presently anticipated that any of these
strategies will be used to a significant degree by any Fund unless otherwise
specifically indicated in the description of the particular Fund contained in
this Prospectus. Over time, however, techniques and instruments may change as
new instruments and strategies are developed or regulatory changes occur.
Subject to the constraints described above, a Fund may (if and to the extent so
authorized) purchase and sell interest rate, currency or stock or bond index
futures contracts and enter into currency forward contracts and currency swaps;
purchase and sell (or write) exchange listed and over-the-counter put and call
options on securities, currencies, futures contracts, indices and other
financial instruments, and a Fund may enter into interest rate transactions,
equity swaps and related transactions, invest in indexed debt securities and
other similar transactions which may be developed to the extent the investment
manager determines that they are consistent with the applicable Fund's
investment objective and policies and applicable regulatory requirements
(collectively, these transactions are referred to in this Prospectus as
'Derivatives'). A Fund's interest rate transactions may take the form of swaps,
caps, floors and collars, and a Fund's currency transactions may take the form
of currency forward contracts, currency futures contracts, currency swaps and
options on currencies.
Derivatives may be used to attempt to protect against possible changes in the
market value of securities held or to be purchased for a Fund's portfolio
resulting from securities markets or currency exchange rate fluctuations, to
protect a Fund's unrealized gains in the value of its securities, to facilitate
the sale of those securities for investment purposes, to manage the effective
maturity or duration of a Fund's portfolio or to establish a position in the
derivatives markets as a temporary substitute for purchasing or selling
particular securities or to seek to enhance a Fund's income or gain. A Fund may
use any or all types of Derivatives which it is authorized to use at any time;
no particular strategy will dictate the use of one type of transaction rather
than another, as use of any authorized Derivative will be a function of numerous
variables, including market conditions. The ability of a Fund to utilize
Derivatives successfully will depend on numerous factors including the
investment manager's ability to predict pertinent market movements, which
cannot be assured. These skills are different from those needed to select a
Fund's portfolio securities. None of the Funds is a 'commodity pool' (i.e., a
pooled investment vehicle which trades in commodity futures contracts and
options thereon and the operator of which is registered with the CFTC), and
Derivatives involving futures contracts and options on futures contracts will be
purchased, sold or entered into only for bona fide hedging purposes, provided
that
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a Fund may enter into such transactions for purposes other than bona fide
hedging if, immediately thereafter, the sum of the amount of its initial margin
and premiums on open contracts and options would not exceed 5% of the
liquidation value of the Fund's portfolio, after taking into account unrealized
profits and losses on existing contracts provided, further, that, in the case
of an option that is in-the-money, the in-the-money amount may be excluded in
calculating the 5% limitation. The use of certain Derivatives in certain
circumstances will require that a Fund segregate liquid assets to the extent a
Fund's obligations are not otherwise 'covered' through ownership of the
underlying security, financial instrument or currency.
Derivatives involve special risks, including possible default by the other
party to the transaction, illiquidity and, to the extent the investment
manager's view as to certain market movements is incorrect, the risk that the
use of Derivatives could result in significantly greater losses than if it had
not been used. Losses resulting from the use of Derivatives will reduce a
Fund's net asset value, and possibly income. Use of put and call options could
result in losses to a Fund, force the purchase or sale of portfolio securities
at inopportune times or for prices higher or lower than current market values,
or cause a Fund to hold a security it might otherwise sell. The use of currency
transactions could result in a Fund's incurring losses as a result of the
imposition of exchange controls, suspension of settlements, or the inability to
deliver or receive a specified currency in addition to exchange rate
fluctuations. The use of options and futures transactions entails certain
special risks. In particular, the variable degree of correlation between price
movements of futures contracts and price movements in the related portfolio
position of a Fund could create the possibility that losses on the Derivative
will be greater than gains in the value of the Fund's position. In addition,
futures and options markets could be illiquid in some circumstances and certain
over-the-counter options could have no markets. A Fund might not be able to
close out certain positions without incurring substantial losses. To the extent
a Fund utilizes futures and options transactions for hedging, such transactions
should tend to minimize the risk of loss due to a decline in the value of the
hedged position and, at the same time, limit any potential gain to the Fund
that might result from an increase in value of the position. Finally, the daily
variation margin requirements for futures contracts create a greater ongoing
potential financial risk than would purchases of options, in which case the
exposure is limited to the cost of the initial premium and transaction costs
and the losses may be significantly greater than if Derivatives had not been
used. Additional information regarding the risks and special considerations
associated with Derivatives appears in the Statement of Additional Information.
The degree of a Fund's use of Derivatives may be limited by certain provisions
of the Code. See 'Taxation.'
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Investment Limitations
The following investment restrictions and those described in the Statement of
Additional Information are fundamental policies applicable to the individual
Funds which may be changed only when permitted by law and approved by the
holders of a majority of each Fund's outstanding voting securities, as defined
in the 1940 Act. Except for the investment restrictions set forth below and in
the Statement of Additional Information and each Fund's investment
objective(s), the other policies and percentage limitations referred to in this
Prospectus and in the Statement of Additional Information are not fundamental
policies of the Funds and may be changed by the applicable Fund's Board of
Directors without shareholder approval.
If a percentage restriction on investment or use of assets set forth in this
Prospectus or in the Statement of Additional Information is adhered to at the
time a transaction is effected, later changes in percentages resulting from
changing values will not be considered a violation.
INVESTORS FUND, TOTAL RETURN FUND, HIGH YIELD BOND FUND, STRATEGIC BOND FUND
AND U.S. GOVERNMENT INCOME FUND.
The Investors Fund, Total Return Fund, High Yield Bond Fund, Strategic Bond
Fund and U.S. Government Income Fund may not:
(1) purchase securities of any issuer if the purchase would cause more than 5%
of the value of each Fund's total assets to be invested in the securities of
any one issuer (excluding securities issued or guaranteed by the U.S.
government, its agencies or instrumentalities and bank obligations) or cause
more than 10% of the voting securities of the issuer to be held by a Fund,
except that up to 25% of the value of each Fund's total assets may be invested
without regard to this restriction and provided that each Fund may invest all
or substantially all of its assets in another registered investment company
having substantially the same investment objective(s) and policies and
substantially the same investment restrictions as those with respect to such
Fund;
(2) borrow money (including entering into reverse repurchase agreements),
except for temporary or emergency purposes and then not in excess of 10% of the
value of the total assets of the applicable Fund at the time the borrowing is
made, except that for the purpose of this restriction, short-term credits
necessary for settlement of securities transactions are not considered
borrowings (a Fund will not purchase additional securities at any time its
borrowings exceed 5% of total assets, provided, however, that a Fund may
increase its interest in another registered investment company having
substantially the same investment objective(s) and policies and substantially
the same investment restrictions as those with respect to such Fund while such
borrowings are outstanding); or
(3) invest more than 25% of the total assets of each Fund in the securities of
issuers having their principal activities in any particular industry, except for
obligations issued or guaranteed by the U.S. government, its agencies or
instrumentalities or by any state, territory or any possession of the United
States or any of their authorities, agencies, instrumentalities or political
subdivisions, or with respect to repurchase agreements collateralized by any of
such obligations (for purposes of this restriction, supranational issuers will
be considered to comprise an industry as will each foreign government that
issues securities purchased by a Fund), provided, however, that each Fund may
invest all or
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SALOMON BROTHERS VARIABLE SERIES
substantially all of its assets in another registered investment
company having substantially the same investment objective(s) and policies and
substantially the same investment restrictions as those with respect to such
Fund.
For purposes of investment limitations (1) and (3) above, both the borrower
under a Loan and the Lender selling a Participation will be considered an
'issuer.' See 'Additional Investment Activities and Risk Factors -- Loan
Participations and Assignments.'
CAPITAL FUND. The Capital Fund may not:
(1) borrow money, except as described under 'Investment Objective and Policies
and except that for the purpose of this restriction, short-term credits
necessary for settlement of securities transactions are not considered
borrowings.
(2) invest more than 25% of the total assets of the Fund in the securities of
issuers having their principal activities in any particular industry, except for
obligations issued or guaranteed by the U.S. government, its agencies or
instrumentalities or by any state, territory or any possession of the United
States or any of their authorities, agencies, instrumentalities or political
subdivisions, or with respect to repurchase agreements collateralized by any of
such obligations (for purposes of this restriction, supranational issuers will
be considered to comprise an industry as will each foreign government that
issues securities purchased by the Fund), provided, however, that each Fund may
invest all or substantially all of its assets in another registered investment
company having substantially the same investment objective(s) and policies and
substantially the same investment restrictions as the Fund.
Each Fund may, in the future, seek to achieve its investment objective(s) by
investing all of its assets in a no-load, open-end management investment
company for which SBAM serves as investment manager and which has substantially
the same investment objective(s) and policies and substantially the same
investment restrictions as those applicable to such Fund. In such event, the
Fund's applicable investment advisory agreement would be terminated since the
investment management would be performed by or on behalf of such other
registered investment company.
ASIA GROWTH FUND. The Asia Growth Fund may not:
(1) borrow money (including entering into reverse repurchase agreements),
except for temporary or emergency purposes and then not in excess of 5% of the
value of the total assets of the applicable Fund at the time the borrowing is
made, except that for the purpose of this restriction, short-term credits
necessary for settlement of securities transactions are not considered
borrowings (the Fund will not purchase additional securities at any time its
borrowings exceed 5% of total assets, provided, however, that the Fund may
increase its interest in another registered investment company having
substantially the same investment objective(s) and policies and substantially
the same investment restrictions as those with respect to the Fund while such
borrowings are outstanding); or
(2) invest more than 25% of the total assets of each Fund in the securities of
issuers having their principal activities in any particular industry, except for
obligations issued or guaranteed by the U.S. government, its agencies or
instrumentalities or by any state, territory or any possession of the United
States or any of their authorities, agencies, instrumentalities or political
subdivisions, or with respect to repurchase agreements collateralized by any of
such obligations (for purposes of this restriction, supranational issuers will
be considered to comprise an industry as will each foreign
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SALOMON BROTHERS VARIABLE SERIES
government that
issues securities purchased by a Fund, provided, however, that the Fund may
invest all or substantially all of its assets in another registered investment
company having substantially the same investment objective(s) and policies and
substantially the same investment restrictions as the Fund).
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Management
The business and affairs of each Fund are managed under the direction of the
Board of Directors. The Board of Directors approves all significant agreements
between a Fund and the persons or companies that furnish services to the Fund,
including agreements with its distributor, investment manager, administrator,
custodian and transfer agent. The day-to-day operations of the Funds are
delegated to SBAM, the Fund's investment manager and administrator.
The Statement of Additional Information contains general background information
regarding each director and executive officer of each Fund.
INVESTMENT MANAGER
Each Fund retains SBAM, a wholly owned subsidiary of Salomon Brothers Holding
Company Inc, which is in turn wholly owned by Salomon Smith Barney Holdings,
Inc., which is in turn wholly owned by Travelers Group Inc. ('Travelers'), as
its investment manager under an investment management contract. SBAM was
incorporated in 1987 and together with SBAM affiliates in London, Frankfurt,
Tokyo and Hong Kong, provides a broad range of fixed-income and equity
investment advisory services to various individuals and institutional clients
located throughout the world, and serves as investment adviser to various
investment companies. As of December 31, 1997, SBAM and such affiliates managed
approximately $26 billion of assets. In providing advisory services, SBAM has
access to hundreds of affiliated economists and mortgage, bond, sovereign and
equity analysts. Michael S. Hyland serves as President of SBAM. SBAM's business
offices are located at 7 World Trade Center, New York, New York 10048.
In connection with SBAM's service as investment manager to the Strategic Bond
Fund, SBAM Limited, whose business address is Victoria Plaza, 111 Buckingham
Palace Road, London SW1W OSB, England, provides certain advisory services to
SBAM relating to currency transactions and investments in non-dollar-denominated
debt securities for the benefit of the Strategic Bond Fund. SBAM Limited is
compensated by SBAM at no additional expense to the Fund. Like SBAM, SBAM
Limited is a wholly-owned subsidiary of Salomon Brothers Holding Company Inc.
SBAM Limited is a member of the Investment Management Regulatory Organization
Limited in the United Kingdom and is registered as an investment adviser in the
United States pursuant to the Investment Advisers Act of 1940, as amended.
Pursuant to a subadvisory agreement, SBAM has retained SBAM AP, whose business
address is Three Exchange Square, Hong Kong, to act as sub-adviser to the Asia
Growth Fund, subject to the supervision of SBAM. SBAM AP is compensated by SBAM
at no additional cost to the Fund. Like SBAM, SBAM AP is a wholly-owned
subsidiary of Salomon Brothers Holding Company Inc. SBAM AP, which was organized
in 1995, is a member of the Hong Kong Securities and Futures Commission and is
registered as an investment adviser in the United States pursuant to the
Investment Advisers Act of 1940, as amended.
Allan R. White III is a Managing Director of Salomon Brothers Inc ('Salomon
Brothers') and SBAM and is primarily responsible for the day-to-day management
of the Investors Fund. Since 1989 he has been a Vice President of SBAM. Prior to
1989 he was a Vice President at The First Boston Corporation. Mr. White is also
Executive Vice President and portfolio
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SALOMON BROTHERS VARIABLE SERIES
manager for the Salomon Brothers Investors Fund Inc, as well as The Salomon
Brothers Fund Inc. Mr. White is assisted in the management of the Investors Fund
by Pamela P. Milunovich. Ms. Milunovich has been a Director of SBAM since
January 1997, and a portfolio manager since joining SBAM in June 1992. Prior to
June 1992, Ms. Milunovich was an associate at James Capel Wardley Inc.
Ross S. Margolies is primarily responsible for the day-to-day management of the
Capital Fund. Mr. Margolies is a managing director with SBAM who manages other
investments in equities, options, convertible bonds and high yield bonds. He is
also the portfolio manager for Salomon Brothers Capital Fund Inc. Prior to
joining SBAM in 1992, Mr. Margolies was a Senior Vice President and analyst in
the High Yield Research Department at Lehman Brothers.
Richard E. Dahlberg is primarily responsible for the day-to-day management of
the Total Return Fund. Mr. Dahlberg is also the portfolio manager for the
Salomon Brothers Total Return Fund, a portfolio of the Series Funds. Prior to
joining SBAM in July 1995, Mr. Dahlberg was employed by Massachusetts Financial
Services Company since 1968. Mr. Dahlberg had been primarily responsible for the
day-to-day management of the MFS Total Return Fund for ten years prior to
joining SBAM.
Peter J. Wilby is primarily responsible for the day-to-day management of the
High Yield Bond Fund and the high yield and sovereign bond portions of the
Strategic Bond Fund. Mr. Wilby, who joined SBAM in 1989, is a Managing Director
of Salomon Brothers and SBAM and a Senior Portfolio Manager of SBAM, responsible
for SBAM's investment company and institutional portfolios which invest in high
yield non-U.S. and U.S. corporate debt securities and high yield foreign
sovereign debt securities. Mr. Wilby is portfolio manager for Salomon Brothers
High Yield Bond Fund and the Salomon Brothers Strategic Bond Fund portfolios of
Salomon Brothers Series Funds Inc ('Series Funds'), Salomon Brothers
Institutional High Yield Bond Fund and Salomon Brothers Institutional Emerging
Markets Debt Fund, each a portfolio of Salomon Brothers Institutional Series
Funds Inc ('Institutional Series Funds'), Global Partners Income Fund Inc., The
Emerging Markets Income Fund Inc, The Emerging Markets Income Fund II Inc, The
Emerging Markets Floating Rate Fund Inc, Salomon Brothers Worldwide Income Fund
Inc, Salomon Brothers High Income Fund Inc, and the foreign sovereign debt
component of Salomon Brothers 2008 Worldwide Dollar Government Term Trust Inc.
Steven Guterman is primarily responsible for the day-to-day management of the
U.S. Government Income Fund and the investment grade and asset allocation
portions of the Strategic Bond Fund. Mr. Guterman is assisted by Roger Lavan in
the management of the two foregoing Funds. Mr. Guterman who joined SBAM in 1990
is a Managing Director of Salomon Brothers and SBAM and is currently a Senior
Portfolio Manager, responsible for SBAM's investment company and institutional
portfolios which invest primarily in investment grade securities. Mr. Guterman
also serves as portfolio manager for the Salomon Brothers U.S. Government Income
Fund and the Salomon Brothers Strategic Bond Fund portfolios of the Series
Funds, as well as an offshore mortgage funds. In addition, Mr. Guterman serves
as portfolio manager for a number of SBAM's institutional clients. Mr. Guterman
joined Salomon Brothers in 1983. He initially worked in the mortgage research
group where he became a Research Director and later traded derivative
mortgage-backed securities for Salomon Brothers. Mr. Lavan joined SBAM in 1990
and is a Portfolio Manager and Quantitative Fixed Income Analyst. He is
responsible for working with senior portfolio managers to monitor and analyze
market relationships and identify and implement relative value transactions in
SBAM's investment company and
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SALOMON BROTHERS VARIABLE SERIES
institutional portfolios which invest in mortgage-backed securities and U.S.
Government securities. Prior to joining SBAM, Mr. Lavan spent four years
analyzing portfolios for Salomon Brothers' Fixed Income Sales Group and Product
Support Divisions. David J. Scott is primarily responsible for a portion of the
Strategic Bond Fund relating to currency transactions and investments in
non-dollar denominated debt securities. Prior to joining SBAM Limited in April,
1994, Mr. Scott worked for four years at JP Morgan Investment Management where
he was responsible for global and non-dollar portfolios. Before joining JP
Morgan Investment Management, Mr. Scott worked for three years at Mercury Asset
Management where he was responsible for captive insurance portfolios and
products.
Giampaolo G. Guarnieri is primarily responsible for the day-to-day management of
the Asia Growth Fund. Mr. Guarnieri has served as a Director of SBAM AP since
July 1996 and has been employed as a Senior Portfolio Manager since joining SBAM
AP in April 1995. Prior to joining SBAM AP, Mr. Guarnieri spent five years as a
Senior Portfolio Investment Manager at Credit Agricole Asset Management (South
East Asia) Limited in Hong Kong, a wholly-owned subsidiary of the Credit
Agricole Group as a senior portfolio manager since 1992 and as head of direct
investment activities prior to that. Mr. Guarnieri is the portfolio manager for
Salomon Brothers Asia Growth Fund, a portfolio of the Series Funds, and Salomon
Brothers Institutional Asia Growth Fund, a portfolio of Institutional Series
Funds.
Subject to policy established by the Board of Directors, which has overall
responsibility for the business and affairs of each Fund, SBAM manages the
investment and reinvestment of each Fund's assets pursuant to the applicable
management contract. SBAM also furnishes office space, personnel and certain
facilities required for the performance by SBAM of certain additional services
provided by it to each Fund under the applicable management contract, including
SEC compliance, supervision of Fund operations and certain administrative and
clerical services, and pays the compensation of the Funds' officers, employees
and directors affiliated with SBAM. Except for the expenses paid by SBAM that
are described herein, each Fund bears all costs of its operations.
As compensation for its services, the Investors Fund pays SBAM a monthly fee at
an annual rate of .70% of the Fund's average daily net assets; the Capital Fund
pays SBAM a monthly fee at an annual rate of .85% of average daily net assets;
the Total Return Fund pays SBAM a monthly fee at an annual rate of .80% of the
Fund's average daily net assets; the High Yield Bond Fund pays SBAM a monthly
fee at an annual rate of .75% of the Fund's average daily net assets; the
Strategic Bond Fund pays SBAM a monthly fee at an annual rate of .75% of the
Fund's average daily net assets; the U.S. Government Income Fund pays SBAM a
monthly fee at an annual rate of .60% of the Fund's average daily net assets;
and the Asia Growth Fund pays SBAM a monthly fee at an annual rate of 1.00% of
the Fund's average daily net assets. With respect to all Funds except the Asia
Growth Fund, for the 1998 fiscal year, SBAM has voluntarily agreed to impose an
expense cap on total Fund operating expenses (exclusive of taxes, interest and
extraordinary expenses such as litigation and indemnification expenses) at
1.00%. With respect to the Asia Growth Fund, for the 1998 fiscal year, SBAM has
voluntarily agreed to impose an expense cap on total Fund operating expenses
(exclusive of taxes, interest and extraordinary expenses such as litigation and
indemnification expenses) at 1.50%.
With respect to the Strategic Bond Fund and in connection with the subadvisory
consulting agreement between SBAM and SBAM Limited, SBAM pays SBAM Limited, as
full compensation for all services provided under the subadvisory consulting
agreement, a portion of its
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investment management fee. The amount payable to SBAM Limited is equal to the
fee payable under SBAM's management agreement multiplied by the portion of the
assets of the Strategic Bond Fund that SBAM Limited has been delegated to manage
divided by the current value of the net assets of the Strategic Bond Fund.
With respect to the Asia Growth Fund, SBAM pays SBAM AP as full compensation for
its services provided under the subadvisory agreement, a portion of its
investment management fee.
SBAM may waive all or part of its fee from time to time in order to increase
each Fund's net investment income available for distribution to shareholders.
The Funds will not be required to reimburse SBAM for any advisory fees waived.
In addition, Participating Insurance Companies that purchase the Funds' shares
may perform certain administrative services relating to the Funds and SBAM may
pay those companies for such services.
The services of SBAM, SBAM Limited and SBAM AP are not deemed to be exclusive,
and nothing in the relevant agreements will prevent either of them or their
affiliates from providing similar services to other investment companies and
other clients (whether or not their investment objectives and policies are
similar to those of any of the Funds) or from engaging in other activities.
Consistent with the Rules of Fair Practice of the National Association of
Securities Dealers (the 'NASD'), and subject to seeking the most favorable price
and execution available, the investment manager may consider sales of shares of
the Funds as a factor in the selection of brokers to execute portfolio
transactions for the Funds. The Funds may use Salomon Brothers Inc, other
broker-dealer subsidiaries of Travelers and their affiliates to execute
portfolio transactions when the investment manager believes that the broker's
charge for the transaction does not exceed the usual and customary levels
charged by other brokers in connection with comparable transactions involving
similar securities. See the Statement of Additional Information for a more
complete description of the Funds' policies with respect to portfolio
transactions.
DISTRIBUTOR
Salomon Brothers, located at 7 World Trade Center, New York, New York 10048,
serves as each Fund's distributor. Salomon Brothers, a wholly-owned subsidiary
of Salomon Brothers Holding Company Inc, is also one of the largest securities
dealers in the world and a registered broker-dealer. Salomon Brothers, along
with other broker-dealer subsidiaries of Travelers, makes markets in securities
and provides a broad range of underwriting, research, and financial advisory
services to governments, international corporations, and institutional
investors. Salomon Brothers and other affiliated broker-dealers from time to
time may receive fees from the Funds in connection with the execution of
portfolio transactions on behalf of the Funds.
ADMINISTRATOR
Each Fund employs SBAM (in such capacity, the 'Admininstrator') under
administration agreements to provide certain administrative services to the
Funds. The Administrator is not involved in the Funds' investment decisions.
The services provided by the Administrator under the applicable administration
agreement include certain accounting, clerical and bookkeeping services, Blue
Sky reports, corporate secretarial services and assistance in the preparation
and filing of tax returns and reports to shareholders and the SEC. For its
services as administrator, each Fund pays the Administrator a fee, calculated
daily and payable monthly, at an annual rate of .05% of the applicable Fund's
aggregate average daily net assets. The Administrator has delegated its
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responsibilities under the administrative agreement to one of its affiliates.
EXPENSES
Each Fund's expenses include taxes, interest, fees and salaries of the directors
and officers who are not directors, officers or employees of the Fund's service
contractors, SEC fees, state securities qualification fees, costs of preparing
and printing prospectuses for regulatory purposes and for distribution to
existing shareholders, advisory and administration fees, charges of the
custodian, transfer agent and dividend disbursing agent, certain insurance
premiums, outside auditing and legal expenses, costs of shareholder reports and
shareholder meetings and any extraordinary expenses. Each Fund also pays for
brokerage fees and commissions (if any) in connection with the purchase and sale
of portfolio securities.
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Determination
of Net Asset Value
For the purpose of pricing purchase and redemption orders, the net asset value
per share of each Fund is calculated separately and is determined once daily as
of the close of regularly scheduled trading on the NYSE. With respect to each
Fund, such calculation is determined on each day that the NYSE is open for
trading, i.e., Monday through Friday, except for New Year's Day, Martin Luther
King, Jr. Day, President's Day, Good Friday, Memorial Day, Independence Day,
Labor Day, Thanksgiving Day and Christmas Day, and the preceding Friday or
subsequent Monday when one of those holidays falls on a Saturday or Sunday,
respectively. Net asset value per share of each Fund is calculated by dividing
the value of the Fund's securities and other assets, less the liabilities, by
the number of shares outstanding. In calculating net asset value, all portfolio
securities will be valued at market value when there is a reliable market
quotation available for the securities and otherwise pursuant to procedures
adopted by each Fund's Board of Directors. Securities that are primarily traded
on foreign exchanges generally are valued at the preceding closing values of
such securities on their respective exchanges, except that when an occurrence
subsequent to the time a value was so established is likely to have changed such
value, then the fair value of those securities may be determined by
consideration of other factors by or under the direction of the Board of
Directors. Securities may be valued by independent pricing services which use
prices provided by market-makers or estimates of market values obtained from
yield data relating to instruments or securities with similar characteristics.
In valuing a Fund's assets, any assets or liabilities initially expressed in
terms of a foreign currency are converted to U.S. dollar equivalents at the then
current exchange rate. Corporate actions by issuers of foreign securities held
by the Fund, such as payment of dividends or distributions, are reflected in the
net asset value on the ex-dividend date therefor, except that such actions will
be so reflected on the date the Fund is actually advised of the corporate action
if subsequent to the ex-dividend date. Further information regarding the Funds'
valuation policies is contained in the Statement of Additional Information.
PAGE 51
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Participating Insurance Companies
and Plans
Variable Series Funds is a funding vehicle for VA contracts and VLI policies to
be offered by separate accounts of Participating Insurance Companies and for
Plans. The VA contracts and the VLI policies are described in the separate
prospectuses issued by the Participating Insurance Companies for which the Fund
assumes no responsibility, and the Plans are described in the relevant Plan
documents for which the Fund assumes no responsibility. Variable Series Funds
currently does not foresee any disadvantages to the holders of VA contracts and
VLI policies or Plan Participants arising from the fact that the interests of
the holders of such policies and such Plan Participants may differ in the future
due to differences in tax treatment of variable products and Plans or other tax
considerations.
Nevertheless, the Variable Series Funds' Board of Directors intends to monitor
events in order to identify any material conflicts which may arise and to
determine what action, if any, should be taken in response thereto. Resolution
of an irreconcilable conflict might result in the withdrawal of a substantial
amount of a Fund's assets which could adversely affect the Fund's net asset
value per share.
Individual VA contract holders and VLI policy holders and Plan Participants are
not the 'shareholders' of the Funds. Rather, the separate accounts of
Participating Insurance Companies and the Plans are the shareholders. However,
the Participating Insurance Companies have informed the Fund that they will pass
through voting rights to their VA contract and VLI policy holders. Plans will
vote shares as required by applicable law and governing plan documents.
- --------------------------------------------------------------------------------
Purchase of Shares
Shares of the Funds are sold at net asset value to the separate accounts of
Participating Insurance Companies and to Plans. Individuals may not place orders
directly with the Funds. See the prospectus of the separate account of the
Participating Insurance Company or the relevant Plan documents for more
information on the purchase of Fund shares and with respect to the availability
for investment in each Fund. There are no sales commissions or redemption
charges; however, other charges may apply to the variable annuity contracts or
life insurance policies or Plans. The Funds do not issue share certificates.
Purchase orders will be effected at the net asset value of a Fund determined on
the business day received if the orders are received by such Fund through First
Data Investor Services Group, Inc. ('Investor Services Group' or the 'Transfer
Agent') in proper form and in accordance with the
PAGE 52
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SALOMON BROTHERS VARIABLE SERIES
applicable requirements prior to the close of regular trading on the New York
Stock Exchange on any day that such Fund calculates its net asset value and the
Federal Funds (monies of member banks within the Federal Reserve System which
are held on deposit at a Federal Reserve Bank) in the net amount of such orders
are received by such Fund on such business day in accordance with applicable
requirements. Otherwise, the orders will be priced as of the time the net asset
value is next determined. It is each Plan and Participating Insurance Company's
responsibility to properly transmit purchase orders and Federal Funds in
accordance with applicable requirements. VA contract or VLI policy holders and
Plan Participants should refer to the prospectus for their contracts or policies
or Plan documents in this regard.
Each Fund reserves the right to reject any purchase order in whole or in part.
- --------------------------------------------------------------------------------
Redemption of Shares
Fund shares may be redeemed at any time by the separate accounts of the
Participating Insurance Companies and the Plans. Individuals may not place
redemption orders directly with the Funds. Redemption requests will be effected
at the net asset value of each Fund next determined after receipt of redemption
instructions by such Fund in proper form and in accordance with applicable
requirements. It is the responsibility of the Participating Insurance Company to
properly transmit redemption requests in accordance with applicable
requirements. VA contract holders and VLI policy holders and Plan Participants
should consult their Participating Insurance Company or Plan in this regard. The
value of the shares redeemed may be more or less than their original cost,
depending on each Fund's then-current net asset value. No charges are imposed by
the Funds when shares are redeemed.
Payment of redemption proceeds may be made in securities, subject to regulation
by some state securities commissions. Payment of the redemption price will be
made within seven days after receipt of the redemption instructions in good
order (or such shorter time period as may be required), but each Fund may
suspend the right of redemption during any period when: (i) trading on the NYSE
is restricted or the NYSE is closed, other than customary weekend and holiday
closings; (ii) the SEC has by order permitted such suspension; or (iii) an
emergency exists, as defined by rules of the SEC, making disposal of portfolio
securities or determination of the value of the net assets of each Fund not
reasonably practicable.
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Performance Information
From time to time, a Fund may advertise its 'yield,' 'tax-equivalent yield,'
'effective yield' and/or standardized and nonstandardized 'average annual total
return' over various periods of time. Total return and yield quotations are
computed separately for each class of shares of a Fund. Total return figures
show the average annual percentage change in value of an investment in a Fund
from the beginning date of the measuring period to the end of the measuring
period. These figures reflect changes in the price of the shares and assume that
any income dividends and/or capital gains distributions made by a Fund during
the period were reinvested in shares of the same Fund.
Standardized total return is calculated in accordance with the SEC's formula.
Nonstandardized total return differs from the standardized total return only in
that it may relate to a nonstandard period or is presented in the aggregate
rather than as an annual average.
Total return figures will be given for the most current one-, five- and ten-year
periods, or the life of a Fund to the extent it has not been in existence for
any such periods, and may be given for other periods as well, such as on a
year-by-year basis. When considering average total return figures for periods
longer than one year, it is important to note that the total return for any one
year in the period might have been greater or less than the average for the
entire period. 'Aggregate total return' figures may be used for various periods,
representing the cumulative change in value of an investment in Fund shares for
the specific period (again reflecting changes in share prices and assuming
reinvestment of dividends and distributions). Aggregate total return may be
shown by means of schedules, charts or graphs and may indicate subtotals of the
various components of total return (i.e., change in the value of initial
investment, income dividends and capital gains distributions).
Furthermore, in reports or other communications to shareholders or in
advertising materials, performance of Fund shares may be compared with that of
other mutual funds or classes of shares of other mutual funds, as listed in the
rankings prepared by Lipper Analytical Services, Inc. or similar independent
services that monitor the performance of mutual funds, financial indices such as
the S&P 500 Index or other industry or financial publications, including, but
not limited to, Bank Rate Monitor, Barron's, Business Week, CDA Investment
Technologies, Inc., Changing Times, Forbes, Fortune, ICB Donaghue's Money Fund
Report, Institutional Investor, Investors Daily, Money, Morningstar Mutual Fund
Values, The New York Times, USA Today and The Wall Street Journal. Performance
figures are based on historical earnings and are not intended to indicate future
performance. See 'Performance Data' in the Statement of Additional Information.
PAGE 54
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Dividends and Distributions
Each Fund will declare dividends from net investment income annually and will
pay such dividends annually. Net investment income is a Fund's investment
company taxable income, as that term is defined in the Code, determined without
regard to the deduction for dividends paid and excluding any net realized
capital gains. For the purpose of calculating dividends, net investment income
shall consist of interest earned, which includes, where applicable, any discount
accreted or premium amortized to the date of maturity, minus estimated expenses.
Shares of a Fund are entitled to dividends declared beginning on the day after
the purchase order is received in good order.
Dividends are determined in the same manner and are paid in the same amount for
each Fund share.
Net realized short-term capital gains of each Fund, if any, will be distributed
whenever the Directors determine that such distributions would be in the best
interest of shareholders, but in any event at least once a year. Each Fund
distributes annually any net realized long-term capital gains from the sale of
securities (after deducting any net realized losses that may be carried forward
from prior years).
If, for any full fiscal year, a Fund's total distributions exceed net investment
income and net realized capital gains, the excess distributions generally will
be treated as a tax-free return of capital (up to the amount of the
shareholder's tax basis in his or her shares). The amount treated as a tax-free
return of capital will reduce a shareholder's adjusted basis in his or her
shares. Pursuant to the requirements of the 1940 Act and other applicable laws,
a notice will accompany any distribution paid from sources other than net
investment income. In the event a Fund distributes amounts in excess of its net
investment income and net realized capital gains, such distributions may have
the effect of decreasing the Fund's total assets, which may increase the Fund's
expense ratio.
Dividend and/or capital gains distributions will be reinvested automatically in
additional shares of the same class of a Fund at the applicable net asset value
per share and such shares will be automatically credited to a shareholder's
account, unless a shareholder elects to receive either dividends or capital
gains distributions in cash.
PAGE 55
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Taxation
FEDERAL INCOME TAX MATTERS. Each Fund intends to qualify and elect to be treated
as a regulated investment company under Subchapter M of the Code. If it so
qualifies, a Fund will not be subject to U.S. federal income taxes on its net
investment income (i.e., its investment company taxable income, as that term is
defined in the Code, determined without regard to the deduction for dividends
paid) and net capital gain (i.e., the excess of a Fund's net realized long-term
capital gain over its net realized short-term capital loss), if any, that it
distributes to its shareholders in each taxable year, provided that it
distributes to its shareholders at least 90% of its net investment income for
such taxable year. If in any year a Fund fails to qualify as a regulated
investment company, such Fund would incur regular corporate federal income tax
on its taxable income for that year and be subject to certain additional
distribution requirements upon requalification.
Each Fund will be subject to federal corporate income tax (currently at a
maximum rate of 35%) on any undistributed income and to alternative minimum tax
(currently at a maximum rate of 28%) on alternative minimum taxable income.
Each Fund is subject to a nondeductible 4% excise tax calculated as a percentage
of certain undistributed amounts of ordinary income and capital gain net income.
To the extent possible, each Fund intends to make sufficient distributions to
avoid the application of both the corporate income and excise taxes.
HONG KONG TAX MATTERS. The Asia Growth Fund would be subject to Hong Kong
profits tax, which is currently charged at the rate of 16.5% for corporations
and 15% for individuals, if, by virtue of the fact that SBAM AP is located in
Hong Kong, (a) the Fund or its agents were deemed to carry on a trade,
profession or business in Hong Kong and (b) profits from that trade, profession
or business were to arise in or be derived from Hong Kong. Hong Kong profits tax
will not be payable in respect of profits from the sale of shares and other
securities transacted outside Hong Kong, interest arising or derived from
outside Hong Kong and profits in the nature of capital gains. The sale of
securities will not be treated as the sale of capital assets if the profit or
loss from such sale is regarded as attributable to a trade or business carried
on in Hong Kong. The Asia Growth Fund does not currently believe that it will be
subject to Hong Kong profits tax.
Dividends which the Fund pays to its shareholders are not taxable in Hong Kong
(whether through withholding or otherwise) under current legislation and
practice. No Hong Kong stamp duty will be payable in respect of transactions in
shares of the Asia Growth Fund provided that the register of shareholders is
maintained outside of Hong Kong.
DIVIDENDS. Notice as to the tax status of dividends and distributions will be
mailed to shareholders annually. Dividends paid from net investment income
generally are taxable as ordinary income whether received in cash or reinvested
in additional shares. Distributions from net capital gain which are designated
as 'capital gain dividends' generally are taxable as long-term capital gain
whether received in cash or reinvested in additional shares. Since the Funds'
shareholders are the separate accounts of Participating Insurance Companies and
the Plans, no discussion is included herein as to the federal income tax
consequences to VA contract holders, VLI policy holders and Plan Participants.
For information concerning the federal income tax consequences to such holders,
PAGE 56
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SALOMON BROTHERS VARIABLE SERIES
see the prospectus for such contract or policy or the applicable Plan documents.
DIVERSIFICATION. Section 817(h) of the Code requires that the investments of a
segregated asset account of an insurance company be 'adequately diversified' as
provided therein or in accordance with U.S. Treasury Regulations in order for
the account to serve as the basis for VA contracts and VLI policies. Section
817(h) and the U.S. Treasury Regulations issued thereunder provide the manner in
which a segregated asset account will treat investments in a regulated
investment company for purposes of the diversification requirements. If a Fund
satisfies certain conditions, a segregated asset account owning shares of such
Fund will be treated as owning the account's proportionate share of each of the
assets of the Fund. Each Fund intends to satisfy these conditions so that the
shares of the Fund owned by a segregated asset account of a Participating
Insurance Company will be treated as adequately diversified.
Participating Insurance Companies and Plans should consult their tax advisers
regarding specific questions as to Federal, state or local taxes.
- ----------------------------------------------------------------------------
Account Services
Shareholders of each Fund are kept informed through semi-annual reports showing
current investments and other financial data for such Fund. Annual reports for
all Funds include audited financial statements.
- -----------------------------------------------------------------------
Capital Stock
The Variable Series Funds was incorporated in Maryland on October 1, 1997. The
authorized capital stock of the Series Funds consists of 10,000,000,000 shares
having a par value of $.001 per share. Pursuant to the Series Funds' Articles of
Incorporation and Articles Supplementary, the Directors have authorized the
issuance of seven series of shares, each representing shares in one of seven
separate Funds; namely, the Investors Fund, Capital Fund, Total Return Fund,
High Yield Bond Fund, Strategic Bond Fund, U.S. Government Income Fund and the
Asia Growth Fund. The assets of each Fund are segregated and separately managed.
The Variable Series Funds' Board of Directors may, in the
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SALOMON BROTHERS VARIABLE SERIES
future, authorize the issuance of additional classes of capital stock
representing shares of additional investment portfolios. As of the date of this
Prospectus, SBAM owns all the shares of each Fund and consequently is deemed to
be a 'control person,' as defined in the 1940 Act, of each Fund.
Although each Fund is offering only its own shares, it is possible that a Fund
could become liable for a misstatement in this Prospectus about another Fund.
The Directors of the Variable Series Funds have considered this factor in
approving the use of a combined Prospectus.
All shares of each Fund have equal voting rights and will be voted in the
aggregate, and not by series, except where voting by series is required by law
or where the matter involved affects only one series. Pursuant to current
interpretations of the 1940 Act, the Fund anticipates that each Participating
Insurance Company will solicit voting instructions from VA contract and VLI
policy owners with respect to any matters that are presented to a vote of
shareholders, and will vote shares in proportion to the voting instructions
received. Plans will vote shares as required by applicable law and governing
Plan documents. All shares of each Fund will, when issued, be fully paid and
nonassessable. Under the corporate law of Maryland, the state of incorporation
of the Variable Series Funds and the By-Laws of each of the Variable Series
Funds, the Variable Series Fund is not required and does not currently intend to
hold annual meetings of shareholders for the election of directors except as
required under the 1940 Act. A more complete statement of the voting rights of
shareholders is contained in the Statement of Additional Information.
PAGE 58
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Appendix A:
Description of Ratings
A DESCRIPTION OF THE RATING POLICIES OF MOODY'S, S&P AND FITCH WITH RESPECT TO
BONDS AND COMMERCIAL PAPER APPEARS BELOW.
MOODY'S CORPORATE BOND RATINGS
AAA -- Bonds which are rated 'Aaa' are judged to be of the best quality and
carry the smallest degree of investment risk. Interest payments are protected
by a large or by an exceptionally stable margin, and principal is secure. While
the various protective elements are likely to change, such changes as can be
visualized are most unlikely to impair the fundamentally strong position of
such issues.
AA -- Bonds which are rated 'Aa' are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally known
as high grade bonds. They are rated lower than the best bonds because margins
of protection may not be as large as in Aaa securities or fluctuation of
protective elements may be of greater amplitude or there may be other elements
present which make the long-term risks appear somewhat larger than in Aaa
securities.
A -- Bonds which are rated 'A' possess many favorable investment qualities and
are to be considered as upper medium grade obligations. Factors giving security
to principal and interest are considered adequate but elements may be present
which suggest a susceptibility to impairment sometime in the future.
BAA -- Bonds which are rated 'Baa' are considered as medium grade obligations,
i.e., they are neither highly protected nor poorly secured. Interest payments
and principal security appear adequate for the present but certain protective
elements may be lacking or may be characteristically unreliable over any great
length of time. Such bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
BA -- Bonds which are rated 'Ba' are judged to have speculative elements; their
future cannot be considered as well assured. Often the protection of interest
and principal payments may be very moderate and thereby not well safeguarded
during both good and bad times over the future. Uncertainty of position
characterizes bonds in this class.
B -- Bonds which are rated 'B' generally lack characteristics of a desirable
investment. Assurance of interest and principal payments or of maintenance and
other terms of the contract over any long period of time may be small.
CAA -- Bonds which are rated 'Caa' are of poor standing. Such issues may be in
default or there may be present elements of danger with respect to principal or
interest.
CA -- Bonds which are rated 'Ca' represent obligations which are speculative to
a high degree. Such issues are often in default or have other marked
shortcomings.
C -- Bonds which are rated 'C' are the lowest rated class of bonds and issues
so rated can be regarded as having extremely poor prospects of ever attaining
any real investment standing.
Moody's applies numerical modifiers '1', '2' and '3' to certain of its rating
classifications. The modifier '1' indicates that the security ranks in the
higher end of
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SALOMON BROTHERS VARIABLE SERIES
its generic rating category; the modifier '2' indicates a mid-range ranking;
and the modifier '3' indicates that the issue ranks in the lower end of its
generic rating category.
S&P's CORPORATE BOND RATINGS
AAA -- This is the highest rating assigned by S&P to a debt obligation and
indicates an extremely strong capacity to repay principal and pay interest.
AA -- Bonds rated 'AA' also qualify as high quality debt obligations. Capacity
to pay principal and interest is very strong, and differs from 'AAA' issues
only in small degree.
A -- Bonds rated 'A' have a strong capacity to repay principal and pay interest,
although they are somewhat more susceptible to the adverse effects of changes in
circumstances and economic conditions than debt in higher-rated categories.
BBB -- Bonds rated 'BBB' are regarded as having an adequate capacity to repay
principal and pay interest. Whereas they normally exhibit adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to repay principal and pay interest for
bonds in this category than for higher-rated categories.
BB-B-CCC-CC-C -- Bonds rated 'BB', 'B', 'CCC', 'CC' and 'C' are regarded, on
balance, as predominantly speculative with respect to the issuer's capacity to
pay interest and repay principal in accordance with the terms of the
obligations. BB indicates the lowest degree of speculation and C the highest
degree of speculation. While such bonds will likely have some quality and
protective characteristics, these are outweighed by large uncertainties or
major risk exposures to adverse conditions.
CI -- Bonds rated 'CI' are income bonds on which no interest is being paid.
D -- Bonds rated 'D' are in default. The 'D' category is used when interest
payments or principal payments are not made on the date due even if the
applicable grace period has not expired unless S&P believes that such payments
will be made during such grace period. The 'D' rating is also used upon the
filing of a bankruptcy petition if debt service payments are jeopardized.
The ratings set forth above may be modified by the addition of a plus or minus
to show relative standing within the major rating categories.
MOODY'S COMMERCIAL PAPER RATINGS
PRIME-1 -- Issuers (or related supporting institutions) rated 'Prime-1' have a
superior ability for repayment of senior short-term debt obligations. 'Prime-1'
repayment ability will often be evidenced by many of the following
characteristics: leading market positions in well-established industries, high
rates of return on funds employed, conservative capitalization structures with
moderate reliance on debt and ample asset protection, broad margins in earnings
coverage of fixed financial charges and high internal cash generation, and
well-established access to a range of financial markets and assured sources of
alternate liquidity.
PRIME-2 -- Issuers (or related supporting institutions) rated 'Prime-2' have a
strong ability for repayment of senior short-term debt obligations. This will
normally be evidenced by many of the characteristics cited above but to a
lesser degree. Earnings trends and coverage ratios, while sound, will be more
subject to variation. Capitalization
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SALOMON BROTHERS VARIABLE SERIES
characteristics, while still appropriate, may be more affected by external
conditions. Ample alternative liquidity is maintained.
PRIME-3 -- Issuers (or related supporting institutions) rated 'Prime-3' have an
acceptable ability for repayment of senior short-term obligations. The effect
of industry characteristics and market compositions may be more pronounced.
Variability in earnings and profitability may result in changes in the level of
debt protection measurements and the requirement for relatively high financial
leverage. Adequate alternate liquidity is maintained.
NOT PRIME -- Issuers rated 'Not Prime' do not fall within any of the Prime
rating categories.
S&P's COMMERCIAL PAPER RATINGS
A -- S&P commercial paper rating is a current assessment of the likelihood of
timely payment of debt having an original maturity of no more than 365 days.
Ratings are graded into several categories, ranging from 'A-1' for the highest
quality obligations to 'D' for the lowest. The four categories are as follows:
A-1 -- This highest category indicates that the degree of safety regarding
timely payment is strong. Those issues determined to possess extremely strong
safety characteristics are denoted with a plus (+) sign designation.
A-2 -- Capacity for timely payment on issues with this designation is
satisfactory. However, the relative degree of safety is not as high as for
issues designated 'A-1'.
A-3 -- Issues carrying this designation have adequate capacity for timely
payment. They are, however, somewhat more vulnerable to the adverse effects of
changes in circumstances than obligations carrying the higher designations.
B -- Issues rated 'B' are regarded as having only speculative capacity for
timely payment.
C -- This rating is assigned to short-term debt obligations with a doubtful
capacity for payment.
D -- Debt rated 'D' is in payment default. The 'D' rating category is used when
interest payments or principal payments are not made on the date due, even if
the applicable grace period has not expired, unless S&P believes that such
payments will be made during such grace period.
Like higher-rated bonds, bonds rated in the Baa or BBB categories are
considered to have adequate capacity to pay principal and interest. However,
such bonds may have speculative characteristics, and changes in economic
conditions or other circumstances are more likely to lead to a weakened
capacity to make principal and interest payments than is the case with higher
grade bonds.
After purchase by a Fund, a security may cease to be rated or its rating may be
reduced below the minimum required for purchase by such Fund. Neither event will
require a sale of such security by a Fund. However, a Fund's investment manager
will consider such event in its determination of whether such Fund should
continue to hold the security. To the extent the ratings given by Moody's, or
S&P may change as a result of changes in such organizations or their rating
systems, a Fund will attempt to use comparable ratings as standards for
investments in accordance with the investment policies contained in this
Prospectus and in the Statement of Additional Information.
PAGE A-3
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DISTRIBUTOR
Salomon Brothers Inc
7 World Trade Center
New York, New York 10048
INVESTMENT MANAGER
Salomon Brothers Asset
Management Inc
7 World Trade Center
New York, New York 10048
CUSTODIANS
PNC Bank, N.A.
Airport Business Center
International Court 2
200 Stevens Drive
Lester, Pennsylvania 19113
The Chase Manhattan Bank
4 Chase Metrotech Center
Brooklyn, NY 11245
TRANSFER AGENT AND
DIVIDEND DISBURSING AGENT
First Data Investors Services Group, Inc.
P.O. Box 5127
Westborough, Massachusetts 01581-5127
INDEPENDENT ACCOUNTANTS
Price Waterhouse LLP
1177 Avenue of the Americas
New York, New York 10036
LEGAL COUNSEL
Simpson Thacher & Bartlett
425 Lexington Avenue
New York, New York 10017
NO DEALER, SALESMAN OR OTHER PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION
OR TO MAKE ANY REPRESENTATIONS, OTHER THAN THOSE CONTAINED IN THIS PROSPECTUS,
IN CONNECTION WITH THE OFFER CONTAINED IN THIS PROSPECTUS, AND, IF GIVEN OR
MADE, SUCH OTHER INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS
HAVING BEEN AUTHORIZED BY A FUND, THE DISTRIBUTOR OR THE INVESTMENT MANAGER.
THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFERING IN ANY STATE IN WHICH SUCH
OFFERING MAY NOT LAWFULLY BE MADE.
-----------------------------------------------
SALOMON BROTHERS ASSET MANAGEMENT
-----------------------------------------------
<PAGE>
<PAGE>
SALOMON BROTHERS VARIABLE SERIES FUNDS INC
7 WORLD TRADE CENTER
NEW YORK, NEW YORK 10048
888-777-1012
STATEMENT OF ADDITIONAL INFORMATION
Salomon Brothers Variable Series Funds Inc consists of Salomon Brothers
Variable Investors Fund (the 'Investors Fund'), Salomon Brothers Variable
Capital Fund (the 'Capital Fund), Salomon Brothers Variable Total Return Fund
(the 'Total Return Fund'), Salomon Brothers Variable High Yield Bond Fund (the
'High Yield Bond Fund'), Salomon Brothers Variable Strategic Bond Fund (the
'Strategic Bond Fund'), Salomon Brothers U.S. Government Income Fund (the 'U.S.
Government Income Fund'), and Salomon Brothers Variable Asia Growth Fund (the
'Asia Growth Fund') (each, a 'Fund' and collectively, the 'Funds'). Each of the
Funds is an investment portfolio of the Salomon Brothers Variable Series Funds
Inc (the 'Variable Series Funds'), an open-end investment company incorporated
in Maryland on October 1, 1997. The Asia Growth Fund and Capital Fund are
non-diversified portfolios and the other Funds which are part of the Variable
Series Funds are diversified portfolios.
This Statement of Additional Information (the 'SAI') is not a prospectus
and is only authorized for distribution only when preceded or accompanied by the
Variable Series Funds' current Prospectus, dated January 2, 1998. This SAI
supplements and should be read in conjunction with the Prospectus, a copy of
which may be obtained without charge by writing the Funds at the address, or by
calling the toll-free telephone number, listed above.
January 2, 1998
<PAGE>
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TABLE OF CONTENTS
<TABLE>
<S> <C>
Additional Information on Portfolio Instruments and Investment Policies......................... 3
Investment Limitations.......................................................................... 26
Management...................................................................................... 27
Investment Manager.............................................................................. 29
Portfolio Transactions.......................................................................... 32
Net Asset Value................................................................................. 32
Additional Purchase Information................................................................. 33
Additional Redemption Information............................................................... 33
Additional Information Concerning Taxes......................................................... 34
Performance Data................................................................................ 35
Capital Stock................................................................................... 36
Custodian and Transfer Agent.................................................................... 37
Independent Accountants......................................................................... 37
Counsel......................................................................................... 37
Financial Statements............................................................................ 38
</TABLE>
2
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ADDITIONAL INFORMATION ON PORTFOLIO INSTRUMENTS
AND INVESTMENT POLICIES
The Prospectus indicates the extent to which each Fund may purchase the
instruments or engage in the investment activities described below. The
discussion below supplements the information set forth in the Prospectus under
'Investment Objectives and Policies,' and 'Additional Investment Activities and
Risk Factors.' References herein to the investment manager means Salomon
Brothers Asset Management Inc ('SBAM'), except with respect to the Asia Growth
Fund, in which case it means Salomon Brothers Asset Management Asia Pacific
Limited ('SBAM AP').
FOREIGN SECURITIES
As discussed in the Prospectus, investing in the securities of foreign
issuers generally, and particularly in emerging market issuers, involves special
considerations which are not typically associated with investing in securities
of U.S. issuers. The following discussion supplements the discussion contained
in the Prospectus under 'Additional Investment Activities and Risk
Factors -- Foreign Securities' and ' -- High Yield Securities.' See also
' -- Brady Bonds' below.
Certain of the risks associated with international investments and
investing in smaller capital markets are heightened for investments in emerging
market countries. For example, some of the currencies of emerging market
countries have experienced devaluations relative to the U.S. dollar, and major
adjustments have been made periodically in certain of such currencies. Certain
of such countries face serious exchange constraints. In addition, governments of
many emerging market countries have exercised and continue to exercise
substantial influence over many aspects of the private sector. In certain cases,
the government owns or controls many companies. Accordingly, government actions
in the future could have a significant effect on economic conditions in
developing countries which could affect private sector companies and
consequently, the value of certain securities held in a Fund's portfolio.
Certain markets are in only the earliest stages of development. There is
also a high concentration of market capitalization and trading volume in a small
number of issuers representing a limited number of industries, as well as a high
concentration of investors and financial intermediaries. Many of such markets
also may be affected by developments with respect to more established markets in
the region. Brokers in emerging market countries typically are fewer in number
and less capitalized than brokers in the United States. These factors, combined
with the U.S. regulatory requirements for open-end investment companies and the
restrictions on foreign investment, result in potentially fewer investment
opportunities for a Fund and may have an adverse impact on the investment
performance of a Fund.
There generally is less governmental supervision and regulation of
exchanges, brokers and issuers in foreign countries than there is in the United
States. For example, there may be no comparable provisions under certain foreign
laws to insider trading and similar investor protection securities laws that
apply with respect to securities transactions consummated in the United States.
Further, brokerage commissions and other transaction costs on foreign securities
exchanges generally are higher than in the United States.
With respect to investments in certain emerging market countries, different
legal standards may have an adverse impact on a Fund. For example, while the
potential liability of a shareholder in a U.S. corporation with respect to acts
of the corporation is generally limited to the amount of the shareholder's
investment, the notion of limited liability is less clear in certain emerging
market countries. Similarly, the rights of investors in emerging market
companies may be more limited than those of shareholders of U.S. corporations.
In some countries, banks or other financial institutions may constitute a
substantial number of the leading companies or companies with the most actively
traded securities. The Investment Company Act of 1940, as amended (the '1940
Act'), limits a Fund's ability to invest in any equity security of an issuer
which, in its most recent fiscal year, derived more than 15% of its revenues
from 'securities related activities,' as defined by the rules
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thereunder. These provisions may also restrict a Fund's investments in certain
foreign banks and other financial institutions.
The manner in which foreign investors may invest in companies in certain
emerging market countries, as well as limitations on such investments, also may
have an adverse impact on the operations of a Fund. For example, the Fund may be
required in some countries to invest initially through a local broker or other
entity and then have the shares purchased re-registered in the name of the Fund.
Re-registration may in some instances not occur on a timely basis, resulting in
a delay during which the Fund may be denied certain of its rights as an
investor.
Foreign markets have different clearance and settlement procedures, and in
certain markets there have been times when settlements have failed to keep pace
with the volume of securities transactions, making it difficult to conduct such
transactions. Further, satisfactory custodial services for investment securities
may not be available in some countries having smaller, emerging capital markets,
which may result in a Fund incurring additional costs and delays in transporting
and custodying such securities outside such countries. Delays in settlement or
other problems could result in periods when assets of a Fund are uninvested and
no return is earned thereon. The inability of a Fund to make intended security
purchases due to settlement problems or the risk of intermediary counterparty
failures could cause a Fund to forego attractive investment opportunities. The
inability to dispose of a portfolio security due to settlement problems could
result either in losses to a Fund due to subsequent declines in the value of
such portfolio security or, if the Fund has entered into a contract to sell the
security, could result in possible liability to the purchaser.
Rules adopted under the 1940 Act permit a Fund to maintain its foreign
securities and cash in the custody of certain eligible non-U.S. banks and
securities depositories. Certain banks in foreign countries may not be 'eligible
sub-custodians,' as defined in the 1940 Act, for a Fund, in which event the Fund
may be precluded from purchasing securities in certain foreign countries in
which it otherwise would invest or which may result in the Fund's incurring
additional costs and delays in providing transportation and custody services for
such securities outside of such countries. A Fund may encounter difficulties in
effecting on a timely basis portfolio transactions with respect to any
securities of issuers held outside their countries. Other banks that are
eligible foreign sub-custodians may be recently organized or otherwise lack
extensive operating experience. In addition, in certain countries there may be
legal restrictions or limitations on the ability of a Fund to recover assets
held in custody by foreign sub-custodians in the event of the bankruptcy of the
sub-custodian.
U.S. GOVERNMENT OBLIGATIONS
In addition to the U.S. Treasury obligations described in the Prospectus, a
Fund may invest in separately traded interest components of securities issued or
guaranteed by the U.S. Treasury. The interest components of selected securities
are traded independently under the Separate Trading of Registered Interest and
Principal of Securities program ('STRIPS'). Under the STRIPS program, the
interest components are individually numbered and separately issued by the U.S.
Treasury at the request of depository financial institutions, which then trade
the component parts independently.
Securities issued or guaranteed by U.S. government agencies and
instrumentalities include obligations that are supported by: (a) the full faith
and credit of the U.S. Treasury (e.g., direct pass-through certificates of the
Government National Mortgage Association ('Ginnie Maes')); (b) the limited
authority of the issuer or guarantor to borrow from the U.S. Treasury (e.g.,
obligations of Federal Home Loan Banks); or (c) only the credit of the issuer or
guarantor (e.g., obligations of the Federal Home Loan Mortgage Corporation
('Freddie Macs')). In the case of obligations not backed by the full faith and
credit of the U.S. Treasury, the agency issuing or guaranteeing the obligation
is principally responsible for ultimate repayment.
Agencies and instrumentalities that issue or guarantee debt securities and
that have been established or sponsored by the U.S. government include, in
addition to those identified above, the Bank for Cooperatives, the Export-Import
Bank, the Federal Farm Credit
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System, the Federal Intermediate Credit Banks, the Federal Land Banks, the
Federal National Mortgage Association and the Student Loan Marketing
Association.
BANK OBLIGATIONS
Banks are subject to extensive governmental regulations which may limit
both the amounts and types of loans and other financial commitments which may be
made and interest rates and fees which may be charged. The profitability of this
industry is largely dependent upon the availability and cost of capital funds
for the purpose of financing lending operations under prevailing money market
conditions. Also, general economic conditions play an important part in the
operations of this industry and exposure to credit losses arising from possible
financial difficulties of borrowers might affect a bank's ability to meet its
obligations.
Investors should also be aware that securities issued or guaranteed by
foreign banks, foreign branches of U.S. banks, and foreign government and
private issuers may involve investment risks in addition to those relating to
domestic obligations. See ' -- Foreign Securities' above. None of the Funds will
purchase bank obligations which SBAM or the applicable sub-adviser believes, at
the time of purchase, will be subject to exchange controls or foreign
withholding taxes; however, there can be no assurance that such laws may not
become applicable to certain of the Funds' investments. In the event unforeseen
exchange controls or foreign withholding taxes are imposed with respect to a
Fund's investments, the effect may be to reduce the income received by the Fund
on such investments.
Bank obligations that may be purchased by a Fund include certificates of
deposit, banker's acceptances and fixed time deposits. A certificate of deposit
is a short-term negotiable certificate issued by a commercial bank against funds
deposited in the bank and is either interest-bearing or purchased on a discount
basis. A bankers' acceptance is a short-term draft drawn on a commercial bank by
a borrower, usually in connection with an international commercial transaction.
The borrower is liable for payment as is the bank, which unconditionally
guarantees to pay the draft at its face amount on the maturity date. Fixed time
deposits are obligations of branches of U.S. banks or foreign banks which are
payable at a stated maturity date and bear a fixed rate of interest. Although
fixed time deposits do not have a market, there are no contractual restrictions
on the right to transfer a beneficial interest in the deposit to a third party.
Bank obligations may be general obligations of the parent bank or may be
limited to the issuing branch by the terms of the specific obligations or by
government regulation.
FLOATING AND VARIABLE RATE INSTRUMENTS
Certain Funds may invest in floating and variable rate obligations.
Floating or variable rate obligations bear interest at rates that are not fixed,
but vary with changes in specified market rates or indices, such as the prime
rate, and at specified intervals. Certain of the floating or variable rate
obligations that may be purchased by a Fund may carry a demand feature that
would permit the holder to tender them back to the issuer at par value prior to
maturity. Such obligations include variable rate master demand notes, which are
unsecured instruments issued pursuant to an agreement between the issuer and the
holder that permit the indebtedness thereunder to vary and provide for periodic
adjustments in the interest rate. A Fund will limit its purchases of floating
and variable rate obligations to those of the same quality as it otherwise is
allowed to purchase. SBAM or the applicable sub-adviser will monitor on an
ongoing basis the ability of an issuer of a demand instrument to pay principal
and interest on demand.
Certain of the floating or variable rate obligations that may be purchased
by a Fund may carry a demand feature that would permit the holder to tender them
back to the issuer of the instrument or to a third party at par value prior to
maturity. Some of the demand instruments purchased by a Fund are not traded in a
secondary market and derive their liquidity solely from the ability of the
holder to demand repayment from the issuer or third party providing credit
support. If a demand instrument is not traded in a secondary market, each Fund
will nonetheless treat the instrument as 'readily marketable' for the purposes
of
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its investment restriction limiting investments in illiquid securities unless
the demand feature has a notice period of more than seven days in which case the
instrument will be characterized as 'not readily marketable' and therefore
illiquid.
A Fund's right to obtain payment at par on a demand instrument could be
affected by events occurring between the date such Fund elects to demand payment
and the date payment is due that may affect the ability of the issuer of the
instrument or third party providing credit support to make payment when due,
except when such demand instruments permit same day settlement. To facilitate
settlement, these same day demand instruments may be held in book entry form at
a bank other than a Fund's custodian subject to a sub-custodian agreement
approved by such Fund between that bank and the Fund's custodian.
FIXED-INCOME SECURITIES
Many fixed-income securities contain call or buy-back features that permit
their issuers to call or repurchase the securities from their holders. Such
securities may present risks based on payment expectations. Although a Fund
would typically receive a premium if an issuer were to redeem a security, if an
issuer exercises such a 'call option' and redeems the security during a time of
declining interest rates, a Fund may realize a capital loss on its investment if
the security was purchased at a premium and a Fund may have to replace the
called security with a lower yielding security, resulting in a decreased rate of
return to the Fund.
ASSET-BACKED SECURITIES
Asset-backed securities are generally issued as pass through certificates,
which represent undivided fractional ownership interests in the underlying pool
of assets, or as debt instruments, which are generally issued as the debt of a
special purpose entity organized solely for the purpose of owning such assets
and issuing such debt. The pool of assets generally represents the obligations
of a number of different parties. Asset-backed securities frequently carry
credit protection in the form of extra collateral, subordinated certificates,
cash reserve accounts, letters of credit or other enhancements. For example,
payments of principal and interest may be guaranteed up to certain amounts and
for a certain time period by a letter of credit or other enhancement issued by a
financial institution unaffiliated with the entities issuing the securities.
Assets which, to date, have been used to back asset-backed securities include
motor vehicle installment sales contracts or installment loans secured by motor
vehicles, and receivables from revolving credit (credit card) agreements.
Asset-backed securities present certain risks which are, generally, related
to limited interests, if any, in related collateral. Credit card receivables are
generally unsecured and the debtors are entitled to the protection of a number
of state and federal consumer credit laws, many of which give such debtors the
right to set off certain amounts owed on the credit cards, thereby reducing the
balance due. Most issuers of automobile receivables permit the servicers to
retain possession of the underlying obligations. If the servicer were to sell
these obligations to another party, there is a risk that the purchaser would
acquire an interest superior to that of the holders of the related automobile
receivables. In addition, because of the large number of vehicles involved in a
typical issuance and technical requirements under state laws, the trustee for
the holders of the automobile receivables may not have a proper security
interest in all of the obligations backing such receivables. Therefore, there is
the possibility that recoveries on repossessed collateral may not, in some
cases, be available to support payments on these securities. Other types of
asset-backed securities will be subject to the risks associated with the
underlying assets. If a letter of credit or other form of credit enhancement is
exhausted or otherwise unavailable, holders of asset-backed securities may also
experience delays in payments or losses if the full amounts due on underlying
assets are not realized. Because asset-backed securities are relatively new, the
market experience in these securities is limited and the market's ability to
sustain liquidity through all phases of the market cycle has not been tested.
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LOANS OF PORTFOLIO SECURITIES
Each of the Funds may lend portfolio securities to brokers or dealers or
other financial institutions. The procedure for the lending of securities will
include the following features and conditions. The borrower of the securities
will deposit cash with the Fund in an amount equal to a minimum of 100% of the
market value of the securities lent. The Fund will invest the collateral in
short-term debt securities or cash equivalents and earn the interest thereon. A
negotiated portion of the income so earned may be paid to the borrower or the
broker who arranged the loan. If the deposit drops below the required minimum at
any time, the borrower may be called upon to post additional cash. If the
additional cash is not paid, the loan will be immediately due and the Fund may
use the collateral or its own cash to replace the securities by purchase in the
open market charging any loss to the borrower. These will be 'demand' loans and
may be terminated by the Fund at any time. A Fund will receive any dividends and
interest paid on the securities lent and the loans will be structured to assure
that the Fund will be able to exercise its voting rights on the securities. Such
loans will be authorized only to the extent that the receipt of income from such
activity would not cause any adverse tax consequences to a Fund's shareholders
and only in accordance with applicable rules and regulations. With the exception
of the Capital Fund and the Investors Fund, none of the Funds presently intends
to lend any of its portfolio securities in 1998.
RULE 144A SECURITIES
As indicated in the Prospectus, certain Funds may purchase certain
restricted securities ('Rule 144A securities') for which there is a secondary
market of qualified institutional buyers, as defined in Rule 144A promulgated
under the Securities Act of 1933, as amended (the '1933 Act'). Rule 144A
provides an exemption from the registration requirements of the 1933 Act for the
resale of certain restricted securities to qualified institutional buyers.
One effect of Rule 144A is that certain restricted securities may now be
liquid, though there is no assurance that a liquid market for Rule 144A
securities will develop or be maintained. In promulgating Rule 144A, the
Securities and Exchange Commission (the 'Commission') stated that the ultimate
responsibility for liquidity determinations is that of an investment company's
board of directors. However, the Commission stated that the board may delegate
the day-to-day function of determining liquidity to the fund's investment
adviser, provided that the board retains sufficient oversight. The Board of
Directors of each Fund has adopted policies and procedures for the purpose of
determining whether securities that are eligible for resale under Rule 144A are
liquid or illiquid. Pursuant to those policies and procedures, each Board of
Directors has delegated to the investment manager the determination as to
whether a particular security is liquid or illiquid, requiring that
consideration be given to, among other things, the frequency of trades and
quotes for the security, the number of dealers willing to sell the security and
the number of potential purchasers, dealer undertakings to make a market in the
security, the nature of the security and the time needed to dispose of the
security. The Board of Directors periodically reviews Fund purchases and sales
of Rule 144A securities.
To the extent that liquid Rule 144A securities that a Fund holds become
illiquid, due to the lack of sufficient qualified institutional buyers or market
or other conditions, the percentage of a Fund's assets invested in illiquid
assets would increase. The investment manager, under the supervision of the
Boards of Directors, will monitor Fund investments in Rule 144A securities and
will consider appropriate measures to enable a Fund to maintain sufficient
liquidity for operating purposes and to meet redemption requests.
MORTGAGE-BACKED SECURITIES
The following describes certain characteristics of mortgage-backed
securities. Mortgage-backed securities acquired by the U.S. Government Income
Fund will be limited to those issued or guaranteed by the U.S. government, its
agencies and instrumentalities. The Strategic Bond Fund and the Total Return
Fund may, in addition, purchase privately issued mortgage securities which are
not guaranteed by the U.S. government, its agencies or instrumentalities. It
should be noted that new types of mortgage-backed securities are
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developed and marketed from time to time and that, consistent with its
investment limitations, a Fund may invest in those new types of mortgage-backed
securities that the investment manager believes may assist it in achieving its
investment objective(s).
Background. Mortgage-backed securities were introduced in the 1970s when
the first pool of mortgage loans was converted into a mortgage pass-through
security. Since the 1970s, the mortgage-backed securities market has vastly
expanded and a variety of structures have been developed to meet investor needs.
Yield Characteristics. Interest and principal payments on mortgage-backed
securities are typically made monthly, and principal may be prepaid at any time
because the underlying mortgage loans or other assets generally may be prepaid
at any time. As a result, if a Fund purchases such a security at a premium, a
prepayment rate that is faster than expected will reduce yield to maturity,
while a prepayment rate that is slower than expected will have the opposite
effect of increasing yield to maturity. Conversely, if a Fund purchases these
securities at a discount, faster than expected prepayments will increase, while
slower than expected prepayments will reduce, yield to maturity. A slower than
expected prepayment rate may effectively change a security which was considered
short or intermediate-term at the time of purchase into a long-term security.
Long-term securities generally fluctuate more widely in response to changes in
interest rates than short or intermediate-term securities.
Prepayments on a pool of mortgage loans are influenced by a variety of
economic, geographic, social and other factors, including changes in mortgagors'
housing needs, job transfers, unemployment, mortgagors' net equity in the
mortgaged properties and servicing decisions. Generally, however, prepayments on
fixed rate mortgage loans will increase during a period of falling interest
rates. Accordingly, amounts available for reinvestment by a Fund are likely to
be greater during a period of relatively low interest rates and, as a result,
likely to be reinvested at lower interest rates than during a period of
relatively high interest rates. This prepayment effect has been particularly
pronounced during recent years as borrowers have refinanced higher interest rate
mortgages into lower interest rate mortgages available in the marketplace.
Mortgage-backed securities may decrease in value as a result of increases in
interest rates and may benefit less than other fixed income securities from
declining interest rates because of the risk of prepayment.
Guaranteed Mortgage Pass-Through Securities. The Total Return, Strategic
Bond and U.S. Government Income Funds may invest in mortgage pass-through
securities representing participation interests in pools of residential mortgage
loans originated by U.S. governmental or private lenders and guaranteed, to the
extent provided in such securities, by the U.S. government or one of its
agencies or instrumentalities. Any guarantee of such securities runs only to
principal and interest payments on the securities and not to the market value of
such securities or the principal and interest payments on the underlying
mortgages. In addition, the guarantee only runs to the portfolio securities held
by a Fund and not to the purchase of shares of the Fund. Such securities, which
are ownership interests in the underlying mortgage loans, differ from
conventional debt securities, which provide for periodic payment of interest in
fixed amounts (usually semi-annually) and principal payments at maturity or on
specified call dates. Mortgage pass-through securities provide for monthly
payments that are a 'pass-through' of the monthly interest and principal
payments (including any prepayments) made by the individual borrowers on the
pooled mortgage loans, net of any fees paid to the guarantor of such securities
and the servicer of the underlying mortgage loans. Guaranteed mortgage
pass-through securities are often sold on a to-be-acquired or 'TBA' basis. Such
securities are typically sold one to three months in advance of issuance, prior
to the identification of the underlying pools of mortgage securities but with
the interest payment provisions fixed in advance. The underlying pools of
mortgage securities are identified shortly before settlement and must meet
certain parameters.
The guaranteed mortgage pass-through securities in which a Fund may invest
may include those issued or guaranteed by Ginnie Mae, the Federal National
Mortgage Association ('Fannie Mae') and Freddie Mac.
Ginnie Mae Certificates. Ginnie Mae is a wholly-owned corporate
instrumentality of the United States within the Department of Housing and Urban
Development. The full faith and credit of the U.S. government is pledged to the
payment of amounts that may be required to
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be paid under any guarantee, but not as to the market value of such securities.
The Ginnie Mae Certificates will represent a pro rata interest in one or more
pools of the following types of mortgage loans: (i) fixed rate level payment
mortgage loans; (ii) fixed rate graduated payment mortgage loans; (iii) fixed
rate growing equity mortgage loans; (iv) fixed rate mortgage loans secured by
manufactured (mobile) homes; (v) mortgage loans on multifamily residential
properties under construction; (vi) mortgage loans on completed multifamily
projects; (vii) fixed rate mortgage loans as to which escrowed funds are used to
reduce the borrower's monthly payments during the early years of the mortgage
loans ('buydown' mortgage loans); (viii) mortgage loans that provide for
adjustments in payments based on periodic changes in interest rates or in other
payment terms of the mortgage loans; and (ix) mortgage-backed serial notes. All
of these mortgage loans will be Federal Housing Administration Loans ('FHA
Loans') or Veterans' Administration Loans ('VA Loans') and, except as otherwise
specified above, will be fully amortizing loans secured by first liens on one-
to four-family housing units.
Fannie Mae Certificates. Fannie Mae is a federally chartered and privately
owned corporation organized and existing under the Federal National Mortgage
Association Charter Act. Each Fannie Mae Certificate will entitle the registered
holder thereof to receive amounts representing such holder's pro rata interest
in scheduled principal payments and interest payments (at such Fannie Mae
Certificate's pass-through rate, which is net of any servicing and guarantee
fees on the underlying mortgage loans), and any principal prepayments on the
mortgage loans in the pool represented by such Fannie Mae Certificate and such
holder's proportionate interest in the full principal amount of any foreclosed
or otherwise finally liquidated mortgage loan. The full and timely payment of
principal of and interest on each Fannie Mae Certificate, but not the market
value thereof, will be guaranteed by Fannie Mae, which guarantee is not backed
by the full faith and credit of the U.S. government. Each Fannie Mae Certificate
will represent a pro rata interest in one or more pools of FHA Loans, VA Loans
or conventional mortgage loans (i.e., mortgage loans that are not insured or
guaranteed by any governmental agency) of the following types: (i) fixed rate
level payment mortgage loans; (ii) fixed rate growing equity mortgage loans;
(iii) fixed rate graduated payment mortgage loans; (iv) variable rate California
mortgage loans; (v) other adjustable rate mortgage loans; and (vi) fixed rate
mortgage loans secured by multifamily projects.
Freddie Mac Certificates. Freddie Mac is a corporate instrumentality of the
United States created pursuant to the Emergency Home Finance Act of 1970, as
amended (the 'FHLMC Act'). Freddie Mac guarantees to each registered holder of a
Freddie Mac Certificate ultimate collection of all principal of the related
mortgage loans, without any offset or deduction, but does not, generally,
guarantee the timely payment of scheduled principal or the market value of the
securities. Freddie Mac may remit the amount due on account of its guarantee of
collection of principal at any time after default on an underlying mortgage
loan, but not later than 30 days following: (i) foreclosure sale; (ii) payment
of a claim by any mortgage insurer; or (iii) the expiration of any right of
redemption, whichever occurs later, but in any event no later than one year
after demand has been made upon the mortgagor for accelerated payment of
principal. The obligations of Freddie Mac under its guarantee are obligations
solely of Freddie Mac and are not backed by the full faith and credit of the
U.S. government.
Freddie Mac Certificates represent a pro rata interest in a group of
mortgage loans (a 'Freddie Mac Certificate group') purchased by Freddie Mac. The
mortgage loans underlying the Freddie Mac Certificates will consist of fixed
rate or adjustable rate mortgage loans with original terms to maturity of
between ten and thirty years, substantially all of which are secured by first
liens on one- to four-family residential properties or multifamily projects.
Each mortgage loan must meet the applicable standards set forth in the FHLMC
Act. A Freddie Mac Certificate group may include whole loans, participation
interests in whole loans and undivided interests in whole loans and
participations comprising another Freddie Mac Certificate group.
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BRADY BONDS
Brady Bonds are debt securities, generally denominated in U.S. dollars,
issued under the framework of the Brady Plan. The Brady Plan is an initiative
announced by former U.S. Treasury Secretary Nicholas F. Brady in 1989 as a
mechanism for debtor nations to restructure their outstanding external
commercial bank indebtedness. In restructuring its external debt under the Brady
Plan framework, a debtor nation negotiates with its existing bank lenders as
well as multilateral institutions such as the International Bank for
Reconstruction and Development (the 'World Bank') and the International Monetary
Fund (the 'IMF'). The Brady Plan framework, as it has developed, contemplates
the exchange of external commercial bank debt for newly issued bonds known as
'Brady Bonds.' Brady Bonds may also be issued in respect of new money being
advanced by existing lenders in connection with the debt restructuring. The
World Bank and/or the IMF support the restructuring by providing funds pursuant
to loan agreements or other arrangements which enable the debtor nation to
collateralize the new Brady Bonds or to repurchase outstanding bank debt at a
discount. Under these arrangements with the World Bank and/or the IMF, debtor
nations have been required to agree to the implementation of certain domestic
monetary and fiscal reforms. Such reforms have included the liberalization of
trade and foreign investment, the privatization of state-owned enterprises and
the setting of targets for public spending and borrowing. These policies and
programs seek to promote the debtor country's economic growth and development.
Investors should also recognize that the Brady Plan only sets forth general
guiding principles for economic reform and debt reduction, emphasizing that
solutions must be negotiated on a case-by-case basis between debtor nations and
their creditors. The investment manager believes that economic reforms
undertaken by countries in connection with the issuance of Brady Bonds may make
the debt of countries which have issued or have announced plans to issue Brady
Bonds an attractive opportunity for investment. However, there can be no
assurance that SBAM's expectations with respect to Brady Bonds will be realized.
Investors should recognize that Brady Bonds have been issued only recently,
and accordingly, do not have a long payment history. Brady Bonds which have been
issued to date are rated in the categories 'BB' or 'B' by Standard & Poor's
Corporation ('S&P') or 'Ba' or 'B' by Moody's Investors Service, Inc.
('Moody's') or, in cases in which a rating by S&P or Moody's has not been
assigned, are generally considered by the investment manager to be of comparable
quality.
Agreements implemented under the Brady Plan to date are designed to achieve
debt and debt-service reduction through specific options negotiated by a debtor
nation with its creditors. As a result, the financial packages offered by each
country differ. The types of options have included the exchange of outstanding
commercial bank debt for bonds issued at 100% of face value of such debt which
carry a below-market stated rate of interest (generally known as par bonds),
bonds issued at a discount from the face value of such debt (generally known as
discount bonds), bonds bearing an interest rate which increases over time and
bonds issued in exchange for the advancement of new money by existing lenders.
Discount bonds issued to date under the framework of the Brady Plan have
generally borne interest computed semiannually at a rate equal to 13/16 of 1%
above the then current six month London Inter-Bank Offered Rate ('LIBOR') rate.
Regardless of the stated face amount and stated interest rate of the various
types of Brady Bonds, the applicable Funds will purchase Brady Bonds in
secondary markets, as described below, in which the price and yield to the
investor reflect market conditions at the time of purchase. Brady Bonds issued
to date have traded at a deep discount from their face value. Certain sovereign
bonds are entitled to 'value recovery payments' in certain circumstances, which
in effect constitute supplemental interest payments but generally are not
collateralized. Certain Brady Bonds have been collateralized as to principal due
at maturity (typically 30 years from the date of issuance) by U.S. Treasury zero
coupon bonds with a maturity equal to the final maturity of such Brady Bonds,
although the collateral is not available to investors until the final maturity
of the Brady Bonds. Collateral purchases are financed by the IMF, the World Bank
and the debtor nations' reserves. In addition, interest payments on certain
types of Brady Bonds may be collateralized by cash or high-grade securities in
amounts that typically represent between 12 and 18 months of interest accruals
on these instruments with the balance of the interest
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accruals being uncollateralized. The applicable Funds may purchase Brady Bonds
with no or limited collateralization, and will be relying for payment of
interest and (except in the case of principal collateralized Brady Bonds)
principal primarily on the willingness and ability of the foreign government to
make payment in accordance with the terms of the Brady Bonds. Brady Bonds issued
to date are purchased and sold in secondary markets through U.S. securities
dealers and other financial institutions and are generally maintained through
European transnational securities depositories. A substantial portion of the
Brady Bonds and other sovereign debt securities in which these Funds may invest
are likely to be acquired at a discount, which involves certain considerations
discussed below under 'Additional Information Concerning Taxes.'
INVERSE FLOATING RATE OBLIGATIONS
Certain Funds may invest in inverse floating rate obligations, or 'inverse
floaters.' Inverse floaters have coupon rates that vary inversely at a multiple
of a designated floating rate (which typically is determined by reference to an
index rate, but may also be determined through a dutch auction or a remarketing
agent) (the 'reference rate'). Inverse floaters may constitute a class of
Collateralized Mortgage Obligations ('CMOs ') with a coupon rate that moves
inversely to a designated index, such as LIBOR or COFI (Cost of Funds Index).
Any rise in the reference rate of an inverse floater (as a consequence of an
increase in interest rates causes a drop in the coupon rate while any drop in
the reference rate of an inverse floater causes an increase in the coupon rate.
In addition, like most other fixed income securities, the value of inverse
floaters will generally decrease as interest rates increase.
Inverse floaters exhibit substantially greater price volatility than fixed
rate obligations having similar credit quality, redemption provisions and
maturity, and inverse floater CMOs exhibit greater price volatility than the
majority of mortgage pass-through securities or CMOs. In addition, some inverse
floater CMOs exhibit extreme sensitivity to changes in prepayments. As a result,
the yield to maturity of an inverse floater CMO is sensitive not only to changes
in interest rates but also to changes in prepayment rates on the related
underlying mortgage assets.
INVESTMENT FUNDS
Each Fund may invest in unaffiliated investment funds which invest
principally in securities in which that Fund is authorized to invest, in
accordance with the limits of the 1940 Act. Each Fund may invest a maximum of
10% of its total assets in the securities of other investment companies. In
addition, under the 1940 Act, not more than 5% of the Fund's total assets may be
invested in the securities of any one investment company. To the extent a Fund
invests in other investment funds, the Fund's shareholders will incur certain
duplicative fees and expenses, including investment advisory fees. A Fund's
investment in certain investment funds will result in special U.S. Federal
income tax consequences described below under 'Taxation.'
HIGH YIELD SECURITIES
Changes by recognized rating services in their ratings of any fixed-income
security and in the ability of an issuer to make payments of interest and
principal may also affect the value of high yield securities. A description of
the ratings used by Moody's and S&P is set forth in Appendix A to each
Prospectus. The ratings of Moody's and S&P generally represent the opinions of
those organizations as to the quality of the securities that they rate. Such
ratings, however, are relative and subjective, are not absolute standards of
quality, are subject to change and do not evaluate the market risk or liquidity
of the securities. Ratings of a non-U.S. debt instrument, to the extent that
those ratings are undertaken, are related to evaluations of the country in which
the issuer of the instrument is located. Ratings generally take into account the
currency in which a non-U.S. debt instrument is denominated. Instruments issued
by a foreign government in other than the local currency, for example, typically
have a lower rating than local currency instruments due to the existence of an
additional risk that the government will be unable to obtain the required
foreign currency to
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service its foreign currency-denominated debt. In general, the ratings of debt
securities or obligations issued by a non-U.S. public or private entity will not
be higher than the rating of the currency or the foreign currency debt of the
central government of the country in which the issuer is located, regardless of
the intrinsic creditworthiness of the issuer.
The secondary markets for high yield securities are concentrated in
relatively few market makers and participants in the market are mostly
institutional investors, including insurance companies, banks, other financial
institutions and mutual funds. In addition, the trading volume for high yield
securities is generally lower than that for higher-rated securities and the
secondary markets could contract under adverse market or economic conditions
independent of any specific adverse changes in the condition of a particular
issuer. These factors may have an adverse effect on the ability of a Fund
holding such securities to dispose of particular portfolio investments, may
adversely affect the Fund's net asset value per share and may limit the ability
of such a Fund to obtain accurate market quotations for purposes of valuing
securities and calculating net asset value. Less liquid secondary markets may
also affect the ability of a Fund to sell securities at their fair value. If the
secondary markets for high yield securities contract due to adverse economic
conditions or for other reasons, certain liquid securities in a Fund's portfolio
may become illiquid and the proportion of the Fund's assets invested in illiquid
securities may significantly increase.
Prices for high yield securities may be affected by legislative and
regulatory developments. These laws could adversely affect a Fund's net asset
value and investment practices, the secondary market for high yield securities,
the financial condition of issuers of these securities and the value of
outstanding high yield securities. For example, federal legislation requiring
the divestiture by federally insured savings and loan associations of their
investments in high yield bonds and limiting the deductibility of interest by
certain corporate issuers of high yield bonds adversely affected the market in
recent years.
Issuers of these securities are often highly leveraged and may not have
more traditional methods of financing available to them, so that their ability
to service their debt obligations during an economic downturn or during
sustained periods of rising interest rates may be impaired. The risk of loss due
to default by such issuers is significantly greater than with investment grade
securities because such securities generally are unsecured and frequently are
subordinated to the prior payment of senior indebtedness. A Fund also may incur
additional expenses to the extent that it is required to seek recovery upon a
default in the payment of principal or interest on its portfolio holdings.
The development of a market for high yield non-U.S. corporate securities
has been a relatively recent phenomenon. On the other hand, the market for high
yield U.S. corporate debt securities is more established than that for high
yield non-U.S. corporate debt securities, but has undergone significant changes
in the past and may undergo significant changes in the future.
High yield non-U.S. and U.S. corporate securities in which the applicable
Funds may invest include bonds, debentures, notes, commercial paper and
preferred stock and will generally be unsecured. Most of the debt securities
will bear interest at fixed rates. However, a Fund may also invest in corporate
debt securities with variable rates of interest or which 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).
Investing in fixed and floating rate high yield foreign sovereign debt
securities will expose Funds investing in such securities to the direct or
indirect consequences of political, social or economic changes in the countries
that issue the securities. See ' -- Foreign Securities' above. The ability and
willingness of sovereign obligors in developing and emerging market countries or
the governmental authorities that control repayment of their external debt to
pay principal and interest on such debt when due may depend on general economic
and political conditions within the relevant country. Countries such as those in
which a Fund may invest have historically experienced, and may continue to
experience, high rates of inflation, high interest rates, exchange rate trade
difficulties and extreme poverty and unemployment. Many of these countries are
also characterized by political uncertainty or
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instability. Additional factors which may influence the ability or willingness
to service debt include, but are not limited to, a country's cash flow
situation, the availability of sufficient foreign exchange on the date a payment
is due, the relative size of its debt service burden to the economy as a whole,
and its government's policy towards the International Monetary Fund, the World
Bank and other international agencies.
The ability of a foreign sovereign obligor to make timely payments on its
external debt obligations will also be strongly influenced by the obligor's
balance of payments, including export performance, its access to international
credits and investments, fluctuations in interest rates and the extent of its
foreign reserves. A country whose exports are concentrated in a few commodities
or whose economy depends on certain strategic imports could be vulnerable to
fluctuations in international prices of these commodities or imports. To the
extent that a country receives payment for its exports in currencies other than
U.S. dollars, its ability to make debt payments denominated in U.S. dollars
could be adversely affected. If a foreign sovereign obligor cannot generate
sufficient earnings from foreign trade to service its external debt, it may need
to depend on continuing loans and aid from foreign governments, commercial banks
and multilateral organizations, and inflows of foreign investment. The
commitment on the part of these foreign governments, multilateral organizations
and others to make such disbursements may be conditioned on the government's
implementation of economic reforms and/or economic performance and the timely
service of its obligations. Failure to implement such reforms, achieve such
levels of economic performance or repay principal or interest when due may
result in the cancellation of such third parties' commitments to lend funds,
which may further impair the obligor's ability or willingness to timely service
its debts. The cost of servicing external debt will also 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. The ability to service external debt will also depend on the
level of the relevant government's international currency reserves and its
access to foreign exchange. Currency devaluations may affect the ability of a
sovereign obligor to obtain sufficient foreign exchange to service its external
debt.
As a result of the foregoing, a governmental obligor may default on its
obligations. If such an event occurs, a Fund may have limited legal recourse
against the issuer and/or guarantor. Remedies must, in some cases, be pursued in
the courts of the defaulting party itself, and the ability of the holder of
foreign sovereign debt securities to obtain recourse may be subject to the
political climate in the relevant country. In addition, no assurance can be
given that the holders of commercial bank debt will not contest payments to the
holders of other foreign sovereign debt obligations in the event of default
under their commercial bank loan agreements.
Brady Bonds have been issued only recently, and, accordingly, do not have a
long payment history. They may be collateralized or uncollateralized and issued
in various currencies (although most are dollar-denominated) and they are
actively traded in the over-the-counter secondary market. Dollar-denominated,
collateralized Brady Bonds, which may be fixed rate par bonds or floating rate
discount bonds, are generally collateralized in full as to principal due at
maturity by U.S. Treasury zero coupon obligations which have the same maturity
as the Brady Bonds. Certain interest payments on these Brady Bonds may be
collateralized by cash or securities in an amount that, in the case of fixed
rate bonds, is typically equal to between 12 and 18 months of rolling interest
payments or, in the case of floating rate bonds, initially is typically equal to
between 12 and 18 months rolling interest payments based on the applicable
interest rate at that time and is adjusted at regular intervals thereafter with
the balance of interest accruals in each case being uncollateralized. The
applicable Funds may purchase Brady Bonds with no or limited collateralization,
and will be relying for payment of interest and (except in the case of principal
collateralized Brady Bonds) principal primarily on the willingness and ability
of the foreign government to make payment in accordance with the terms of the
Brady Bonds. In the event of a default with respect to collateralized Brady
Bonds as a result of which the payment obligations of the issuer are
accelerated, the U.S. Treasury zero coupon obligations held as collateral for
the payment of principal will not be distributed to investors, nor will such
obligations be sold and the proceeds distributed. The collateral will be held by
the collateral agent to the
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scheduled maturity of the defaulted Brady Bonds, which will continue to be
outstanding, at which time the face amount of the collateral will equal the
principal payments which would have then been due on the Brady Bonds in the
normal course. Based upon current market conditions, a Fund would not intend to
purchase Brady Bonds which, at the time of investment, are in default as to
payments. However, in light of the residual risk of the Brady Bonds and, among
other factors, the history of default with respect to commercial bank loans by
public and private entities of countries issuing Brady Bonds, investments in
Brady Bonds are to be viewed as speculative. A substantial portion of the Brady
Bonds and other sovereign debt securities in which the High Yield Bond and
Strategic Bond Funds invest are likely to be acquired at a discount, which
involves certain considerations discussed below under 'Additional Information
Concerning Taxes.'
Sovereign obligors in developing and emerging market countries are among
the world's largest debtors to commercial banks, other governments,
international financial organizations and other financial institutions. These
obligors have in the past experienced substantial difficulties in servicing
their external debt obligations, which led to defaults on certain obligations
and the restructuring of certain indebtedness. Restructuring arrangements have
included, among other things, reducing and rescheduling interest and principal
payments by negotiating new or amended credit agreements or converting
outstanding principal and unpaid interest to Brady Bonds, and obtaining new
credit to finance interest payments. Holders of certain foreign sovereign debt
securities may be requested to participate in the restructuring of such
obligations and to extend further loans to their issuers. There can be no
assurance that the Brady Bonds and other foreign sovereign debt securities in
which certain of the Funds may invest will not be subject to similar
restructuring arrangements or to requests for new credit which may adversely
affect a Fund's holdings. Furthermore, certain participants in the secondary
market for such debt may be directly involved in negotiating the terms of these
arrangements and may therefore have access to information not available to other
market participants.
DERIVATIVES
A detailed discussion of Derivatives (as defined below) that may be used by
the investment manager on behalf of certain Funds follows below. The description
in the Prospectus of the Variable Series Fund indicates which, if any, of these
types of transactions may be used by that Fund. A Fund will not be obligated,
however, to use any Derivatives and makes no representation as to the
availability of these techniques at this time or at any time in the future.
'Derivatives,' as used in the Prospectus and this Statement of Additional
Information, refers to interest rate, currency or stock or bond index futures
contracts, currency forward contracts and currency swaps, the purchase and sale
(or writing) of exchange listed and over-the-counter ('OTC') put and call
options on debt and equity securities, currencies, interest rate, currency or
stock index futures and fixed-income and stock indices and other financial
instruments, entering into various interest rate transactions such as swaps,
caps, floors, collars, entering into equity swaps, caps, floors, the purchase
and sale of indexed debt securities or trading in other similar types of
instruments.
Derivatives may be used to attempt to protect against possible changes in
the market value of securities held or to be purchased for a Fund's portfolio
resulting from securities markets or currency exchange rate fluctuations, to
protect a Fund's unrealized gains in the value of its securities, to facilitate
the sale of those securities for investment purposes, to manage the effective
maturity or duration of a Fund's portfolio or to establish a position in the
derivatives markets as a temporary substitute for purchasing or selling
particular securities or to seek to enhance a Fund's income or gain. A Fund may
use any or all types of Derivatives which it is authorized to use at any time;
no particular strategy will dictate the use of one type of transaction rather
than another, as use of any authorized Derivative will be a function of numerous
variables, including market conditions. The ability of a Fund to utilize
Derivatives successfully will depend on numerous factors including the
investment manager's ability to predict pertinent market movements, which cannot
be assured. These skills are different from those needed to select a Fund's
portfolio securities.
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A Fund's ability to pursue certain of these strategies may be limited by
the Commodity Exchange Act, as amended, applicable regulations of the Commodity
Futures Trading Commission ('CFTC') thereunder and the federal income tax
requirements applicable to regulated investment companies which are not operated
as commodity pools.
Currency Transactions. A Fund may engage in currency transactions with
Counterparties to hedge the value of portfolio securities denominated in
particular currencies against fluctuations in relative value or to generate
income or gain. Currency transactions include currency forward contracts,
exchange-listed currency futures contracts and options thereon, exchange-listed
and OTC options on currencies, and currency swaps. A forward currency contract
involves a privately negotiated obligation to purchase or sell (with delivery
generally required) a specific currency at a future date, which may be any fixed
number of days from the date of the contract agreed upon by the parties, at a
price set at the time of the contract. A currency swap is an agreement to
exchange cash flows based on the notional difference among two or more
currencies and operates similarly to an interest rate swap, which is described
below under 'Swaps, Caps, Floors and Collars.' A Fund may enter into currency
transactions only with Counterparties that the investment manager deems to be
creditworthy.
A Fund may enter into forward currency exchange contracts when the
investment manager believes that the currency of a particular country may suffer
a substantial decline against the U.S. dollar. In those circumstances, a Fund
may enter into a forward contract to sell, for a fixed amount of U.S. dollars,
the amount of that currency approximating the value of some or all of the Fund's
portfolio securities denominated in such currency. Forward contracts may limit
potential gain from a positive change in the relationship between the U.S.
dollar and foreign currencies.
Transaction hedging is entering into a currency transaction with respect to
specific assets or liabilities of the Fund, which will generally arise in
connection with the purchase or sale of the Fund's portfolio securities or the
receipt of income from them. Position hedging is entering into a currency
transaction with respect to portfolio securities positions denominated or
generally quoted in that currency. A Fund will not enter into a transaction to
hedge currency exposure to an extent greater, after netting all transactions
intended wholly or partially to offset other transactions, than the aggregate
market value (at the time of entering into the transaction) of the securities
held by the Fund that are denominated or generally quoted in or currently
convertible into the currency, other than with respect to proxy hedging as
described below.
A Fund may cross-hedge currencies by entering into transactions to purchase
or sell one or more currencies that are expected to increase or decline in value
relative to other currencies to which the Fund has or in which the Fund expects
to have exposure. To reduce the effect of currency fluctuations on the value of
existing or anticipated holdings of its securities, a Fund may also engage in
proxy hedging. Proxy hedging is often used when the currency to which the Fund's
holdings is exposed is difficult to hedge generally or difficult to hedge
against the dollar. Proxy hedging entails entering into a forward contract to
sell a currency, the changes in the value of which are generally considered to
be linked to a currency or currencies in which some or all of the Fund's
securities are or are expected to be denominated, and to buy dollars. The amount
of the contract would not exceed the market value of the Fund's securities
denominated in linked currencies.
Currency transactions are subject to risks different from other portfolio
transactions, as discussed below under 'Risk Factors.' If a Fund enters into a
currency hedging transaction, the Fund will comply with the asset segregation
requirements described below under 'Use of Segregated and Other Special
Accounts.'
Futures Contracts. A Fund may trade futures contracts: (1) on domestic and
foreign exchanges on currencies, interest rates and bond indices; and (2) on
domestic and, to the extent permitted by the CFTC, foreign exchanges on stock
indices. Futures contracts are generally bought and sold on the commodities
exchanges on which they are listed with payment of initial and variation margin
as described below. The sale of a futures contract creates a firm obligation by
the Fund, as seller, to deliver to the buyer the specific type of financial
instrument called for in the contract at a specific future time for a specified
price (or, with respect to certain instruments, the net cash amount). None of
the Funds is a
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commodity pool, and each Fund, where permitted, will use futures contracts and
options thereon solely: (i) for bona fide hedging purposes; and (ii) for other
purposes in amounts permitted by the rules and regulations promulgated by the
CFTC. A Fund's use of financial futures contracts and options thereon will in
all cases be consistent with applicable regulatory requirements and in
particular the rules and regulations of the CFTC. Maintaining a futures contract
or selling an option on a futures contract will typically require the Fund to
deposit with a financial intermediary, as security for its obligations, an
amount of cash or other specified assets ('initial margin') that initially is
from 1% to 10% of the face amount of the contract (but may be higher in some
circumstances). Additional cash or assets ('variation margin') may be required
to be deposited thereafter daily as the mark-to-market value of the futures
contract fluctuates. A Fund will not enter into a futures contract or option
thereon other than for bona fide hedging purposes if, immediately thereafter,
the sum of the amount of its initial margin and premiums required to maintain
permissible non-bona fide hedging positions in futures contracts and options
thereon would exceed 5% of the liquidation value of the Fund's portfolio, after
taking into account unrealized profits and losses on existing contracts;
however, in the case of an option that is in-the-money at the time of the
purchase, the in-the-money amount may be excluded in calculating the 5%
limitation. The value of all futures contracts sold by the Fund (adjusted for
the historical volatility relationship between the Fund and the contracts) will
not exceed the total market value of the Fund's securities. In addition, the
value of a Fund's long futures and options positions (futures contracts on stock
or bond indices, interest rates or foreign currencies and call options on such
futures contracts) will not exceed the sum of: (a) liquid assets segregated for
this purpose; (b) cash proceeds on existing investments due within thirty days;
and (c) accrued profits on the particular futures or options positions. The
segregation requirements with respect to futures contracts and options thereon
are described below under 'Use of Segregated and Other Special Accounts.'
Interest Rate Futures Contracts. A Fund may enter into interest rate
futures contracts in order to protect it from fluctuations in interest rates
without necessarily buying or selling fixed income securities. An interest rate
futures contract is an agreement to take or make delivery of either: (i) an
amount of cash equal to the difference between the value of a particular index
of debt securities at the beginning and at the end of the contract period; or
(ii) a specified amount of a particular debt security at a future date at a
price set at time of the contract. For example, if a Fund owns bonds, and
interest rates are expected to increase, the Fund might sell futures contracts
on debt securities having characteristics similar to those held in the
portfolio. Such a sale would have much the same effect as selling an equivalent
value of the bonds owned by the Fund. If interest rates did increase, the value
of the debt securities in the portfolio would decline, but the value of the
futures contracts to the Fund would increase at approximately the same rate,
thereby keeping the net asset value of each class of the Fund from declining as
much as it otherwise would have. A Fund could accomplish similar results by
selling bonds with longer maturities and investing in bonds with shorter
maturities when interest rates are expected to increase. However, since the
futures market may be more liquid than the cash market, the use of futures
contracts as a risk management technique allows a Fund to maintain a defensive
position without having to sell its portfolio securities.
Similarly, when the investment manager expects that interest rates may
decline, a Fund may purchase interest rate futures contracts in an attempt to
hedge against having to make subsequently anticipated purchases of bonds at the
higher prices subsequently expected to prevail. Since the fluctuations in the
value of appropriately selected futures contracts should be similar to that of
the bonds that will be purchased, a Fund could take advantage of the anticipated
rise in the cost of the bonds without actually buying them until the market had
stabilized. At that time, a Fund could make the intended purchase of the bonds
in the cash market and the futures contracts could be liquidated.
At the time of delivery of securities pursuant to an interest rate futures
contract, adjustments are made to recognize differences in value arising from
the delivery of securities with a different interest rate from that specified in
the contract. In some (but not many) cases, securities called for by a futures
contract may have a shorter term than the term of the
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futures contract and, consequently, may not in fact have been issued when the
futures contract was entered.
Options. As indicated in the Prospectus, in order to hedge against adverse
market shifts or to increase income or gain, certain Funds may purchase put and
call options or write 'covered' put and call options on futures contracts on
stock indices, interest rates and currencies. In addition, in order to hedge
against adverse market shifts or to increase its income, a Fund may purchase put
and call options and write 'covered' put and call options on stocks, stock
indices and currencies. A Fund may utilize options on currencies in order to
hedge against currency exchange rate risks. A call option is 'covered' if, so
long as the Fund is obligated as the writer of the option, it will own: (i) the
underlying investment subject to the option; (ii) securities convertible or
exchangeable without the payment of any consideration into the securities
subject to the option; or (iii) a call option on the relevant security or
currency with an exercise price no higher than the exercise price on the call
option written. A put option is 'covered' if, to support its obligation to
purchase the underlying investment if a put option that a Fund writes is
exercised, the Fund will either (a) deposit with its custodian in a segregated
account cash, cash equivalents, U.S. government securities or other high grade
liquid debt obligations having a value at least equal to the exercise price of
the underlying investment or (b) continue to own an equivalent number of puts of
the same 'series' (that is, puts on the same underlying investment having the
same exercise prices and expiration dates as those written by the Fund), or an
equivalent number of puts of the same 'class' (that is, puts on the same
underlying investment) with exercise prices greater than those that it has
written (or, if the exercise prices of the puts it holds are less than the
exercise prices of those it has written, it will deposit the difference with its
custodian in a segregated account). Parties to options transactions must make
certain payments and/or set aside certain amounts of assets in connection with
each transaction, as described in the Prospectus.
In all cases except for certain options on interest rate futures contracts,
by writing a call, a Fund will limit its opportunity to profit from an increase
in the market value of the underlying investment above the exercise price of the
option for as long as the Fund's obligation as writer of the option continues.
By writing a put, a Fund will limit its opportunity to profit from a decrease in
the market value of the underlying investment below the exercise price of the
option for as long as the Fund's obligation as writer of the option continues.
Upon the exercise of a put option written by a Fund, the Fund may suffer an
economic loss equal to the difference between the price at which the Fund is
required to purchase the underlying investment and its market value at the time
of the option exercise, less the premium received for writing the option. Upon
the exercise of a call option written by a Fund, the Fund may suffer an economic
loss equal to an amount not less than the excess of the investment's market
value at the time of the option exercise over the Fund's acquisition cost of the
investment, less the sum of the premium received for writing the option and the
positive difference, if any, between the call price paid to the Fund and the
Fund's acquisition cost of the investment.
In all cases except for certain options on interest rate futures contracts,
in purchasing a put option, a Fund will seek to benefit from a decline in the
market price of the underlying investment, while in purchasing a call option, a
Fund will seek to benefit from an increase in the market price of the underlying
investment. If an option purchased is not sold or exercised when it has
remaining value, or if the market price of the underlying investment remains
equal to or greater than the exercise price, in the case of a put, or remains
equal to or below the exercise price, in the case of a call, during the life of
the option, the Fund will lose its investment in the option. For the purchase of
an option to be profitable, the market price of the underlying investment must
decline sufficiently below the exercise price, in the case of a put, and must
increase sufficiently above the exercise price, in the case of a call, to cover
the premium and transaction costs.
In the case of certain options on interest rate futures contracts, a Fund
may purchase a put option in anticipation of a rise in interest rates, and
purchase a call option in anticipation of a fall in interest rates. By writing a
covered call option on interest rate futures contracts, a Fund will limit its
opportunity to profit from a fall in interest rates. By writing a covered put
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option on interest rate futures contracts, a Fund will limit its opportunity to
profit from a rise in interest rates.
A Fund may choose to exercise the options it holds, permit them to expire
or terminate them prior to their expiration by entering into closing
transactions. A Fund may enter into a closing purchase transaction in which the
Fund purchases an option having the same terms as the option it had written or a
closing sale transaction in which the Fund sells an option having the same terms
as the option it had purchased. A covered option writer unable to effect a
closing purchase transaction will not be able to sell the underlying security
until the option expires or the underlying security is delivered upon exercise,
with the result that the writer will be subject to the risk of market decline in
the underlying security during such period. Should a Fund choose to exercise an
option, the Fund will purchase in the open market the securities, commodities or
commodity futures contracts underlying the exercised option.
Exchange-listed options on securities and currencies, with certain
exceptions, generally settle by physical delivery of the underlying security or
currency, although in the future, cash settlement may become available.
Frequently, rather than taking or making delivery of the underlying instrument
through the process of exercising the option, listed options are closed by
entering into offsetting purchase or sale transactions that do not result in
ownership of the new option. Index options are cash settled for the net amount,
if any, by which the option is 'in-the-money' (that is, the amount by which the
value of the underlying instrument exceeds, in the case of a call option, or is
less than, in the case of a put option, the exercise price of the option) at the
time the option is exercised.
Put options and call options typically have similar structural
characteristics and operational mechanics regardless of the underlying
instrument on which they are purchased or sold. Thus, the following general
discussion relates to each of the particular types of options discussed in
greater detail below. In addition, many Derivatives involving options require
segregation of Fund assets in special accounts, as described below under 'Use of
Segregated and Other Special Accounts.'
A put option gives the purchaser of the option, upon payment of a premium,
the right to sell, and the writer of the obligation to buy, the underlying
security, index, currency or other instrument at the exercise price. A Fund's
purchase of a put option on a security, for example, might be designed to
protect its holdings in the underlying instrument (or, in some cases, a similar
instrument) against a substantial decline in the market value of such instrument
by giving the Fund the right to sell the instrument at the option exercise
price. A call option, upon payment of a premium, gives the purchaser of the
option the right to buy, and the seller the obligation to sell, the underlying
instrument at the exercise price. A Fund's purchase of a call option on a
security, financial futures contract, index, currency or other instrument might
be intended to protect the Fund against an increase in the price of the
underlying instrument that it intends to purchase in the future by fixing the
price at which it may purchase the instrument. An 'American' style put or call
option may be exercised at any time during the option period, whereas a
'European' style put or call option may be exercised only upon expiration or
during a fixed period prior to expiration. Exchange-listed options are issued by
a regulated intermediary such as the Options Clearing Corporation ('OCC'), which
guarantees the performance of the obligations of the parties to the options. The
discussion below uses the OCC as an example, but is also applicable to other
similar financial intermediaries.
OCC-issued and exchange-listed options, with certain exceptions, generally
settle by physical delivery of the underlying security or currency, although in
the future, cash settlement may become available. Index options are cash settled
for the net amount, if any, by which the option is 'in-the-money' (that is, the
amount by which the value of the underlying instrument exceeds, in the case of a
call option, or is less than, in the case of a put option, the exercise price of
the option) at the time the option is exercised. Frequently, rather than taking
or making delivery of the underlying instrument through the process of
exercising the option, listed options are closed by entering into offsetting
purchase or sale transactions that do not result in ownership of the new option.
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A Fund's ability to close out its position as a purchaser or seller of an
OCC-issued or exchange-listed put or call option is dependent, in part, upon the
liquidity of the particular option market. Among the possible reasons for the
absence of a liquid option market on an exchange are: (1) insufficient trading
interest in certain options, (2) restrictions on transactions imposed by an
exchange, (3) trading halts, suspensions or other restrictions imposed with
respect to particular classes or series of options or underlying securities,
including reaching daily price limits, (4) interruption of the normal operations
of the OCC or an exchange, (5) inadequacy of the facilities of an exchange or
the OCC to handle current trading volume or (6) a decision by one or more
exchanges to discontinue the trading of options (or a particular class or series
of options), in which event the relevant market for that option on that exchange
would cease to exist, although any such outstanding options on that exchange
would continue to be exercisable in accordance with their terms.
The hours of trading for listed options may not coincide with the hours
during which the underlying financial instruments are traded. To the extent that
the option markets close before the markets for the underlying financial
instruments, significant price and rate movements can take place in the
underlying markets that would not be reflected in the corresponding option
markets.
OTC options are purchased from or sold to securities dealers, financial
institutions or other parties (collectively referred to as 'Counterparties' and
individually referred to as a 'Counterparty') through a direct bilateral
agreement with the Counterparty. In contrast to exchange-listed options, which
generally have standardized terms and performance mechanics, all of the terms of
an OTC option, including such terms as method of settlement, term, exercise
price, premium, guaranties and security, are determined by negotiation of the
parties. It is anticipated that any Portfolio authorized to use OTC options will
generally only enter into OTC options that have cash settlement provisions,
although it will not be required to do so.
Unless the parties provide for it, no central clearing or guaranty function
is involved in an OTC option. As a result, if a Counterparty fails to make or
take delivery of the security, currency or other instrument underlying an OTC
option it has entered into with the Fund or fails to make a cash settlement
payment due in accordance with the terms of that option, the Fund will lose any
premium it paid for the option as well as any anticipated benefit of the
transaction. Thus, the investment manager must assess the creditworthiness of
each such Counterparty or any guarantor or credit enhancement of the
Counterparty's credit to determine the likelihood that the terms of the OTC
option will be met. A Fund will enter into OTC option transactions only with
U.S. Government securities dealers recognized by the Federal Reserve Bank of New
York as 'primary dealers,' or broker-dealers, domestic or foreign banks, or
other financial institutions that the investment manager deems to be
creditworthy. In the absence of a change in the current position of the staff of
the SEC, OTC options purchased by a Fund and the amount of a Fund's obligation
pursuant to an OTC option sold by the Fund (the cost of the sell-back plus the
in-the-money amount, if any) or the value of the assets held to cover such
options will be deemed illiquid.
If a Fund sells a call option, the premium that it receives may serve as a
partial hedge, to the extent of the option premium, against a decrease in the
value of the underlying securities or instruments held by the Fund or will
increase the Fund's income. Similarly, the sale of put options can also provide
gains for a Fund.
A Fund may purchase and sell call options on securities that are traded on
U.S. and foreign securities exchanges and in the OTC markets, and on securities
indices, currencies and futures contracts. All calls sold by a Fund must be
'covered' (that is, the Fund must own the securities or futures contract subject
to the call), or must otherwise meet the asset segregation requirements
described below for so long as the call is outstanding. Even though the Fund
will receive the option premium to help protect it against loss, a call sold by
a Fund will expose the Fund during the term of the option to possible loss of
opportunity to realize appreciation in the market price of the underlying
security or instrument and may require the Fund to hold a security or instrument
that it might otherwise have sold.
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A Fund reserves the right to purchase or sell options on instruments and
indices which may be developed in the future to the extent consistent with
applicable law, the Fund's investment objective and the restrictions set forth
herein.
A Fund may purchase and sell put options on securities (whether or not it
holds the securities in its portfolio) and on securities indices, currencies and
futures contracts. In selling put options, a Fund faces the risk that it may be
required to buy the underlying security at a disadvantageous price above the
market price.
(a) Options on Stocks and Stock Indices. A Fund may purchase put and call
options and write covered put and call options on stocks and stock indices
listed on domestic and foreign securities exchanges in order to hedge against
movements in the equity markets or to increase income or gain to the Fund. In
addition, the Fund may purchase options on stocks that are traded
over-the-counter. Options on stock indices are similar to options on specific
securities. However, because options on stock indices do not involve the
delivery of an underlying security, the option represents the holder's right to
obtain from the writer cash in an amount equal to a fixed multiple of the amount
by which the exercise price exceeds (in the case of a put) or is less than (in
the case of a call) the closing value of the underlying stock index on the
exercise date. Currently, options traded include the Standard & Poor's 100 Index
of Composite Stocks, Standard & Poor's 500 Index of Composite Stocks (the 'S&P
500 Index'), the New York Stock Exchange ('NYSE') Composite Index, the American
Stock Exchange ('AMEX') Market Value Index, the National Over-the-Counter Index
and other standard broadly based stock market indices. Options are also traded
in certain industry or market segment indices such as the Oil Index, the
Computer Technology Index and the Transportation Index. Stock index options are
subject to position and exercise limits and other regulations imposed by the
exchange on which they are traded.
If the investment manager expects general stock market prices to rise, a
Fund might purchase a call option on a stock index or a futures contract on that
index as a hedge against an increase in prices of particular equity securities
it wants ultimately to buy. If the stock index does rise, the price of the
particular equity securities intended to be purchased may also increase, but
that increase would be offset in part by the increase in the value of the Fund's
index option or futures contract resulting from the increase in the index. If,
on the other hand, the investment manager expects general stock market prices to
decline, it might purchase a put option or sell a futures contract on the index.
If that index does decline, the value of some or all of the equity securities in
a Fund's portfolio may also be expected to decline, but that decrease would be
offset in part by the increase in the value of the Fund's position in such put
option or futures contract.
(b) Options on Currencies. A Fund may invest in options on currencies
traded on domestic and foreign securities exchanges in order to hedge against
currency exchange rate risks or to increase income or gain, as described above
in 'Forward Currency Exchange Contracts.'
(c) Options on Futures Contracts. A Fund may purchase put and call options
and write covered put and call options on futures contracts on stock indices,
interest rates and currencies traded on domestic and, to the extent permitted by
the CFTC, foreign exchanges, in order to hedge all or a portion of its
investments or to increase income or gain and may enter into closing
transactions in order to terminate existing positions. There is no guarantee
that such closing transactions can be effected. An option on a stock index
futures contract, interest rate futures contract or currency futures contract,
as contrasted with the direct investment in such a contract, gives the purchaser
the right, in return for the premium paid, to assume a position in the
underlying contract at a specified exercise price at any time on or before the
expiration date of the option. Upon exercise of an option, the delivery of the
futures position by the writer of the option to the holder of the option will be
accompanied by delivery of the accumulated balance in the writer's futures
margin account. The potential loss related to the purchase of an option on a
futures contract is limited to the premium paid for the option (plus transaction
costs). While the price of the option is fixed at the point of sale, the value
of the option does change daily and the change would be reflected in the net
asset value of the Fund.
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The purchase of an option on a financial futures contract involves payment
of a premium for the option without any further obligation on the part of the
Fund. If the Fund exercises an option on a futures contract it will be obligated
to post initial margin (and potentially variation margin) for the resulting
futures position just as it would for any futures position. Futures contracts
and options thereon are generally settled by entering into an offsetting
transaction, but no assurance can be given that a position can be offset prior
to settlement or that delivery will occur.
Interest Rate and Equity Swaps and Related Transactions. Certain Funds may
enter into interest rate and equity swaps and may purchase or sell (i.e., write)
interest rate and equity caps, floors and collars. A Fund expects to enter into
these transactions in order to hedge against either a decline in the value of
the securities included in the Fund's portfolio, or against an increase in the
price of the securities which it plans to purchase, or in order to preserve or
maintain a return or spread on a particular investment or portion of its
portfolio or to achieve a particular return on cash balances, or in order to
increase income or gain. Interest rate and equity swaps involve the exchange by
a Fund with another party of their respective commitments to make or receive
payments based on a notional principal amount. The purchase of an interest rate
or equity cap entitles the purchaser, to the extent that a specified index
exceeds a predetermined level, to receive payments on a contractually-based
principal amount from the party selling the interest rate or equity cap. The
purchase of an interest rate or equity floor entitles the purchaser, to the
extent that a specified index falls below a predetermined rate, to receive
payments on a contractually-based principal amount from the party selling the
interest rate or equity floor. A collar is a combination of a cap and a floor
which preserve a certain return within a predetermined range of values.
A Fund may enter into interest rate and equity swaps, caps, floors and
collars on either an asset-based or liability-based basis, depending on whether
it is hedging its assets or its liabilities, and will usually enter into
interest rate and equity swaps on a net basis (i.e., the two payment streams are
netted out), with the Fund receiving or paying, as the case may be, only the net
amount of the two payments. The net amount of the excess, if any, of a Fund's
obligations over its entitlements with respect to each interest rate or equity
swap will be accrued on a daily basis, and an amount of liquid assets having an
aggregate net asset value at least equal to the accrued excess will be
maintained in a segregated account by the Fund's custodian in accordance with
procedures established by the Board of Directors. If a Fund enters into an
interest rate or equity swap on other than a net basis, the Fund will maintain a
segregated account in the full amount accrued on a daily basis of the Fund's
obligations with respect to the swap. A Fund will only enter into interest rate
and equity swap, cap, floor or collar transactions with counterparties the
investment manager deems to be creditworthy. The investment manager will monitor
the creditworthiness of counterparties to its interest rate and equity swap,
cap, floor and collar transactions on an ongoing basis. If there is a default by
the other party to such a transaction, a Fund will have contractual remedies
pursuant to the agreements related to the transaction. The swap market has grown
substantially in recent years with a large number of banks and investment
banking firms acting both as principals and agents utilizing standardized swap
documentation. The investment manager has determined that, as a result, the swap
market is liquid. Caps, floors and collars are more recent innovations for which
standardized documentation has not yet been developed and, accordingly, they are
less liquid than swaps. To the extent a Fund sells caps, floors and collars it
will maintain in a segregated account cash and/or, cash equivalents or other
liquid high grade debt securities having an aggregate net asset value at least
equal to the full amount, accrued on a daily basis, of the Fund's obligations
with respect to the caps, floors or collars. The use of interest rate and equity
swaps is a highly specialized activity which involves investment techniques and
risks different from those associated with ordinary portfolio securities
transactions. If the investment manager is incorrect in its forecasts of market
values, interest rates and other applicable factors, the investment performance
of a Fund would diminish compared with what it would have been if these
investment techniques were not utilized. Moreover, even if the investment
manager is correct in its forecasts, there is a risk that the swap position may
correlate imperfectly with the price of the asset or liability being hedged.
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The liquidity of swap agreements will be determined by the investment
manager based on various factors, including (1) the frequency of trades and
quotations, (2) the number of dealers and prospective purchasers in the
marketplace, (3) dealer undertakings to make a market, (4) the nature of the
security (including any demand or tender features), and (5) the nature of the
marketplace for trades (including the ability to assign or offset the Fund's
rights and obligations relating to the investment). Such determination will
govern whether a swap will be deemed within the percentage restriction on
investments in securities that are not readily marketable.
A Fund will maintain liquid assets in a segregated custodial account to
cover its current obligations under swap agreements. If a Fund enters into a
swap agreement on a net basis, it will segregate assets with a daily value at
least equal to the excess, if any, of the Fund's accrued obligations under the
swap agreement over the accrued amount the Fund is entitled to receive under the
agreement. If a Fund enters into a swap agreement on other than a net basis, it
will segregate assets with a value equal to the full amount of the Fund's
accrued obligations under the agreement. See 'Use of Segregated and Other
Special Accounts' below.
There is no limit on the amount of interest rate and equity swap
transactions that may be entered into by a Fund. These transactions do not
involve the delivery of securities or other underlying assets or principal.
Accordingly, the risk of loss with respect to interest rate and equity swaps is
limited to the net amount of payments that a Fund is contractually obligated to
make, if any. The effective use of swaps and related transactions by a Fund may
depend, among other things, on the Fund's ability to terminate the transactions
at times when the investment manager deems it desirable to do so. Because swaps
and related transactions are bilateral contractual arrangements between a Fund
and counterparties to the transactions, the Fund's ability to terminate such an
arrangement may be considerably more limited than in the case of an exchange
traded instrument. To the extent a Fund does not, or cannot, terminate such a
transaction in a timely manner, the Fund may suffer a loss in excess of any
amounts that it may have received, or expected to receive, as a result of
entering into the transaction. If the other party to a swap defaults, a Fund's
risk of loss is the net amount of payments that the Fund contractually is
entitled to receive, if any. A Fund may purchase and sell caps, floors and
collars without limitation, subject to the segregated account requirement
described above.
Indexed Securities. A Fund may purchase securities whose prices are indexed
to the prices of other securities, securities indices, currencies, or other
financial indicators. Indexed securities typically, but not always, are debt
securities or deposits whose value at maturity or coupon rate is determined by
reference to a specific instrument or statistic. Currency-indexed securities
typically are short-term to intermediate-term debt securities whose maturity
values or interest rates are determined by reference to the values of one or
more specified foreign currencies, and may offer higher yields than U.S.
dollar-denominated securities of equivalent issuers. Currency-indexed securities
may be positively or negatively indexed; that is, their maturity value may
increase when the specified currency value increases, resulting in a security
that performs similarly to a foreign currency-denominated instrument, or their
maturity value may decline when foreign currencies increase, resulting in a
security whose price characteristics are similar to a put on the underlying
currency. Currency-indexed securities may also have prices that depend on the
values of a number of different foreign currencies relative to each other.
Combined Transactions. A Fund may enter into multiple transactions,
including multiple options transactions, multiple futures transactions, multiple
currency transactions (including forward currency contracts), multiple interest
rate transactions and any combination of futures, options, currency and interest
rate transactions, instead of a single Derivative, as part of a single or
combined strategy when, in the judgment of the investment manager, it is in the
best interests of the Fund to do so. A combined transaction will usually contain
elements of risk that are present in each of its component transactions.
Although combined transactions will normally be entered into by a Fund based on
the investment manager's judgment that the combined strategies will reduce risk
or otherwise more effectively achieve
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the desired portfolio management goal, it is possible that the combination will
instead increase the risks or hinder achievement of the Fund management
objective.
Risk Factors. Derivatives have special risks associated with them,
including possible default by the Counterparty to the transaction, illiquidity
and, to the extent the investment manager's view as to certain market movements
is incorrect, the risk that the use of the Derivatives could result in losses
greater than if they had not been used. Use of put and call options could result
in losses to a Fund, force the sale or purchase of portfolio securities at
inopportune times or for prices higher than (in the case of put options) or
lower than (in the case of call options) current market values, or cause a Fund
to hold a security it might otherwise sell.
The use of futures and options transactions entails certain special risks.
In particular, the variable degree of correlation between price movements of
futures contracts and price movements in the related securities position of a
Fund could create the possibility that losses on the hedging instrument are
greater than gains in the value of the Fund's position. In addition, futures and
options markets could be illiquid in some circumstances and certain
over-the-counter options could have no markets. As a result, in certain markets,
a Fund might not be able to close out a transaction without incurring
substantial losses. Although a Fund's use of futures and options transactions
for hedging should tend to minimize the risk of loss due to a decline in the
value of the hedged position, at the same time it will tend to limit any
potential gain to the Fund that might result from an increase in value of the
position. There is also the risk of loss by a Fund of margin deposits in the
event of bankruptcy of a broker with whom the Fund has an open position in a
futures contract or option thereon. Finally, the daily variation margin
requirements for futures contracts create a greater ongoing potential financial
risk than would purchases of options, in which case the exposure is limited to
the cost of the initial premium. However, because option premiums paid by a Fund
are small in relation to the market value of the investments underlying the
options, buying options can result in large amounts of leverage. The leverage
offered by trading in options could cause a Fund's net asset value to be subject
to more frequent and wider fluctuation than would be the case if the Fund did
not invest in options.
As is the case with futures and options strategies, the effective use of
swaps and related transactions by a Fund may depend, among other things, on a
Fund's ability to terminate the transactions at times when SBAM deems it
desirable to do so. To the extent a Fund does not, or cannot, terminate such a
transaction in a timely manner, a Fund may suffer a loss in excess of any
amounts that it may have received, or expected to receive, as a result of
entering into the transaction.
Currency hedging involves some of the same risks and considerations as
other transactions with similar instruments. Currency transactions can result in
losses to a Fund if the currency being hedged fluctuates in value to a degree or
in a direction that is not anticipated. Further, the risk exists that the
perceived linkage between various currencies may not be present or may not be
present during the particular time that the Fund is engaging in proxy hedging.
Currency transactions are also subject to risks different from those of other
portfolio transactions. Because currency control is of great importance to the
issuing governments and influences economic planning and policy, purchases and
sales of currency and related instruments can be adversely affected by
government exchange controls, limitations or restrictions on repatriation of
currency, and manipulations or exchange restrictions imposed by governments.
These forms of governmental actions can result in losses to a Fund if it is
unable to deliver or receive currency or monies in settlement of obligations and
could also cause hedges it has entered into to be rendered useless, resulting in
full currency exposure as well as incurring transaction costs. Buyers and
sellers of currency futures contracts are subject to the same risks that apply
to the use of futures contracts generally. Further, settlement of a currency
futures contract for the purchase of most currencies must occur at a bank based
in the issuing nation. Trading options on currency futures contracts is
relatively new, and the ability to establish and close out positions on these
options is subject to the maintenance of a liquid market that may not always be
available. Currency exchange rates may fluctuate based on factors extrinsic to
that country's economy.
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Because the amount of interest and/or principal payments which the issuer
of indexed debt securities is obligated to make is linked to the prices of other
securities, securities indices, currencies, or other financial indicators, such
payments may be significantly greater or less than payment obligations in
respect of other types of debt securities. As a result, an investment in indexed
debt securities may be considered speculative. Moreover, the performance of
indexed securities depends to a great extent on the performance of and may be
more volatile than the security, currency, or other instrument to which they are
indexed, and may also be influenced by interest rate changes in the United
States and abroad. At the same time, indexed securities are subject to the
credit risks associated with the issuer of the security, and their values may
decline substantially if the issuer's creditworthiness deteriorates.
Losses resulting from the use of Derivatives will reduce a Fund's net asset
value, and possibly income, and the losses can be greater than if Derivatives
had not been used.
Risks of Derivatives Outside the United States. When conducted outside the
United States, Derivatives may not be regulated as rigorously as in the United
States, may not involve a clearing mechanism and related guarantees, and will be
subject to the risk of governmental actions affecting trading in, or the prices
of, foreign securities, currencies and other instruments. In addition, the price
of any foreign futures or foreign options contract and, therefore, the potential
profit and loss thereon, may be affected by any variance in the foreign exchange
rate between the time an order is placed and the time it is liquidated, offset
or exercised. The value of positions taken as part of non-U.S. Derivatives also
could be adversely affected by: (1) other complex foreign political, legal and
economic factors, (2) lesser availability of data on which to make trading
decisions than in the United States, (3) delays in the Fund's ability to act
upon economic events occurring in foreign markets during nonbusiness hours in
the United States, (4) the imposition of different exercise and settlement terms
and procedures and margin requirements than in the United States and (5) lower
trading volume and liquidity.
Use of Segregated and Other Special Accounts. Use of many Derivatives by a
Fund will require, among other things, that the Fund segregate liquid assets
with its custodian, or a designated sub-custodian, to the extent the Fund's
obligations are not otherwise 'covered' through ownership of the underlying
security, financial instrument or currency. In general, either the full amount
of any obligation by a Fund to pay or deliver securities or assets must be
covered at all times by the securities, instruments or currency required to be
delivered, or, subject to any regulatory restrictions, an amount of liquid
assets at least equal to the current amount of the obligation must be segregated
with the custodian or sub-custodian in accordance with procedures established by
the Board of Directors. The segregated assets cannot be sold or transferred
unless equivalent assets are substituted in their place or it is no longer
necessary to segregate them. A call option on securities written by a Fund, for
example, will require the Fund to hold the securities subject to the call (or
securities convertible into the needed securities without additional
consideration) or to segregate liquid high grade debt obligations sufficient to
purchase and deliver the securities if the call is exercised. A call option sold
by a Fund on an index will require the Fund to own portfolio securities that
correlate with the index or to segregate liquid high grade debt obligations
equal to the excess of the index value over the exercise price on a current
basis. A put option on securities written by a Fund will require the Fund to
segregate liquid high grade debt obligations equal to the exercise price. Except
when a Fund enters into a forward contract in connection with the purchase or
sale of a security denominated in a foreign currency or for other
non-speculative purposes, which requires no segregation, a currency contract
that obligates the Fund to buy or sell a foreign currency will generally require
the Fund to hold an amount of that currency or liquid securities denominated in
that currency equal to the Fund's obligations or to segregate liquid high grade
debt obligations equal to the amount of the Fund's obligations.
OTC options entered into by a Fund, including those on securities,
currency, financial instruments or indices, and OCC-issued and exchange-listed
index options will generally provide for cash settlement, although the Fund will
not be required to do so. As a result, when a Fund sells these instruments it
will segregate an amount of assets equal to its
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obligations under the options. OCC-issued and exchange-listed options sold by a
Fund other than those described above generally settle with physical delivery,
and the Fund will segregate an amount of assets equal to the full value of the
option. OTC options settling with physical delivery or with an election of
either physical delivery or cash settlement will be treated the same as other
options settling with physical delivery.
In the case of a futures contract or an option on a futures contract, a
Fund must deposit initial margin and, in some instances, daily variation margin
in addition to segregating liquid assets sufficient to meet its obligations to
purchase or provide securities or currencies, or to pay the amount owed at the
expiration of an index-based futures contract. A Fund will accrue the net amount
of the excess, if any, of its obligations relating to swaps over its
entitlements with respect to each swap on a daily basis and will segregate with
its custodian, or designated sub-custodian, an amount of liquid assets having an
aggregate value equal to at least the accrued excess. Caps, floors and collars
require segregation of liquid assets with a value equal to the Fund's net
obligation, if any.
Derivatives may be covered by means other than those described above when
consistent with applicable regulatory policies. A Fund may also enter into
offsetting transactions so that its combined position, coupled with any
segregated assets, equals its net outstanding obligation in related Derivatives.
A Fund could purchase a put option, for example, if the strike price of that
option is the same or higher than the strike price of a put option sold by the
Fund. Moreover, instead of segregating assets if it holds a futures contract or
forward contract, a Fund could purchase a put option on the same futures
contract or forward contract with a strike price as high or higher than the
price of the contract held. Other Derivatives may also be offset in
combinations. If the offsetting transaction terminates at the time of or after
the primary transaction, no segregation is required, but if it terminates prior
to that time, assets equal to any remaining obligation would need to be
segregated.
PORTFOLIO TURNOVER
Purchases and sales of portfolio securities may be made as considered
advisable by the investment manager in the best interests of the shareholders.
Each Fund intends to limit portfolio trading to the extent practicable and
consistent with its investment objectives. Each Fund's portfolio turnover rate
may vary from year to year, as well as within a year. Short-term gains realized
from portfolio transactions are taxable to shareholders as ordinary income. In
addition, higher portfolio turnover rates can result in corresponding increases
in portfolio transaction costs for a Fund. See 'Portfolio Transactions.'
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INVESTMENT LIMITATIONS
Unless otherwise indicated, the investment restrictions described below as
well as those described under 'Investment Limitations' in the Variable Series
Funds' Prospectus are fundamental investment policies which may be changed only
when permitted by law, if applicable, and approved by the holders of a majority
of the applicable Fund's outstanding voting securities, which, as defined by the
1940 Act means the lesser of: (i) 67% of the shares represented at a meeting at
which more than 50% of the outstanding shares are represented; or (ii) more than
50% of the outstanding shares. Except for: (i) the investment restrictions set
forth below; (ii) the investment restrictions set forth in 'Investment
Limitations' in the Prospectus; and (iii) each Fund's investment objective(s) as
described in the Prospectus, the other policies and percentage limitations
referred to in this Statement of Additional Information and in the Prospectus
are not fundamental policies of the Funds and may be changed by vote of the
Board of Directors without shareholder approval.
If a percentage restriction on investment or utilization of assets set
forth in this Statement of Additional Information or the Prospectus is adhered
to at the time a transaction is effected, a later change in percentage resulting
from changing values will not be considered a violation.
Each Fund may not:
(1) underwrite securities of other issuers, except to the extent that
the purchase of investments directly from the issuer thereof or from an
underwriter for an issuer and the later disposition of such securities in
accordance with a Fund's investment program may be deemed to be an
underwriting;
(2) purchase or sell real estate, although a Fund may purchase and
sell securities of companies which deal in real estate, may purchase and
sell securities which are secured by interests in real estate and may
invest in mortgages and mortgage-backed securities;
(3) purchase or sell commodities or commodity contracts except that a
Fund may engage in derivative transactions to the extent permitted by its
investment policies as stated in the Prospectus and this Statement of
Additional Information;
(4) make loans, except that (a) a Fund may purchase and hold debt
securities in accordance with its investment objective(s) and policies, (b)
a Fund may enter into repurchase agreements with respect to portfolio
securities, (c) a Fund may lend portfolio securities with a value not in
excess of one-third of the value of its total assets, provided that
collateral arrangements with respect to options, forward currency and
futures transactions will not be deemed to involve loans of securities, and
(d) delays in the settlement of securities transactions will not be
considered loans; or
(5) purchase the securities of other investment companies except as
permitted under the 1940 Act or in connection with a merger, consolidation,
acquisition or reorganization.
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MANAGEMENT
DIRECTORS AND OFFICERS
The directors and executive officers of the Company are listed below. The
address of each, unless otherwise indicated, is Seven World Trade Center, New
York, New York 10048. Certain of the directors and officers are also directors
and officers of one or more other investment companies for which SBAM, the
Fund's investment manager, acts as investment adviser. 'Interested directors' of
the Fund (as defined in the 1940 Act) are indicated by an asterisk.
VARIABLE SERIES FUND
<TABLE>
<CAPTION>
NAME, ADDRESS AND AGE POSITION(S) HELD PRINCIPAL OCCUPATION(S) PAST 5 YEARS
- ------------------------------------ ------------------- -----------------------------------------
<S> <C> <C>
Charles F. Barber .................. Director and Consultant. Formerly, Chairman of the
66 Glenwood Drive Chairman, Audit Board of ASARCO Incorporated.
Greenwich, CT 06830 Committee
Age: 80
Carol L. Colman .................... Director and Audit President of Colman Consulting Co., Inc.
Colman Consulting Co., Inc. Committee Member
278 Hawley Road
North Salem, NY 10560
Age: 51
Daniel P. Cronin ................... Director and Audit Vice President and General Counsel of
Pfizer, Inc Committee Member Pfizer International Inc. Senior
235 East 42nd Street Assisting General Counsel of Pfizer,
New York, NY 10017 Inc.
Age: 51
Heath B. McClendon ................. Director Managing Director, Smith Barney Inc.,
Age: 63 from 1993 to present. Chairman, Smith
Barney Mutual Funds Management Inc.
from 1993 to present.
Michael S. Hyland* ................. President President and Managing Director of SBAM
Age: 51 and Managing Director and Member of the
Management Board of Salomon Brothers
Inc ('SBI').
Giampaolo G. Guarnieri ............. Executive Vice Member of Board of Directors and Head of
Salomon Brothers Asset Management President SBAM AP from January 1997 to present.
Asia Pacific Limited Director of SBAM AP since July 1996.
Three Exchange Square, Vice President and Senior Portfolio
Hong Kong Manager of SBAM AP from April 1995 to
Age: 33 June 1996. From April 1995 to January
1996, Vice President and Senior Vice
President of Salomon Brothers Hong Kong
Limited. From January 1992 to March
1995, Senior Portfolio Investment
Manager of Credit Agricole Asset
Management (South East Asia) Limited.
Steven Guterman .................... Executive Vice Managing Director of SBAM and SBI since
Age: 43 President January 1996. Prior to January 1996,
Director of SBAM and SBI.
Peter J. Wilby ..................... Executive Vice Managing Director of SBAM and SBI since
Age: 38 President January 1996. Prior to January 1996,
Director of SBAM and SBI.
</TABLE>
27
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<PAGE>
<TABLE>
<CAPTION>
NAME, ADDRESS AND AGE POSITION(S) HELD PRINCIPAL OCCUPATION(S) PAST 5 YEARS
- ------------------------------------ ------------------- -----------------------------------------
<S> <C> <C>
Richard E. Dahlberg ................ Executive Vice Managing Director of SBAM and SBI since
Age: 57 President January 1996. From July 1995 to January
1996, Director of SBAM and SBI. Prior
to July 1995, Senior Vice President and
Senior Portfolio Manager of
Massachusetts Financial Services
Company.
Beth A. Semmel ..................... Executive Vice Director of SBAM and SBI since January
Age: 36 President 1996. From May 1993 to December 1995,
Vice President of SBAM and SBI. From
January 1989 to May 1993, Vice
President of Morgan Stanley Asset
Management.
Allan R. White, III ................ Executive Vice Managing Director of SBAM and SBI since
Age: 37 President January 1996. Prior to January 1996,
Director of SBAM and SBI.
Ross S. Margolies .................. Executive Vice Managing Director of SBAM since November
Age: 38 President 1997. Prior to November 1997, Director
of SBAM and SBI.
Pamela P. Milunovich ............... Vice President Director of SBAM and SBI since January
Age: 34 1997. Vice President of SBAM and SBI
from June 1992 to December 1996. Prior
to June 1992, an associate with James
Capel.
Eliza Lau .......................... Vice President Vice President and Portfolio Manager of
Salomon Brothers Asset SBAM AP since March 1996. From July
Management Asia 1994 to March 1996, Vice President and
Pacific Limited Portfolio Manager of Salomon Brothers
Three Exchange Square Hong Kong Limited; from October 1991 to
Hong Kong July 1994, research analyst with SBI.
Age: 34
Noel B. Daugherty .................. Secretary Employee of SBAM since November 1996.
Age: 32 From August 1993 to October 1996, an
employee of Chancellor LGT Asset
Management. From October 1989 to August
1993, an employee of The Dreyfus
Corporation.
Jennifer G. Muzzey ................. Assistant Secretary Employee of SBAM since June 1994. Prior
Age: 37 to June 1994, Vice President of
SunAmerica Asset Management
Corporation.
Alan M. Mandel ..................... Treasurer Vice President of SBAM and SBI since
Age: 40 January 1995. Prior to January 1995,
Chief Financial Officer and Vice
President of Hyperion Capital
Management Inc.
Amy Yeung .......................... Assistant Treasurer Investment Accounting Manager of SBAM.
Age: 33
</TABLE>
28
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It is estimated that each Director of Variable Series Funds, except those
deemed 'interested persons' under the 1940 Act will receive $6,000 per per year
plus $500 for each meeting attended as compensation for serving as director.
Variable Series Funds does not provide any pension or retirement benefits to
directors. No remuneration will be paid by the Variable Series Funds to
Directors who are employees of SBAM or its affiliates, and may therefore be
considered interested persons under the 1940 Act.
As of the date hereof directors and officers of the Variable Series Funds,
individually and as a group, beneficially owned less than 1% of the outstanding
shares of the Funds.
INVESTMENT MANAGER
Each Fund retains SBAM to act as its investment manager. SBAM, a
wholly-owned subsidiary of Salomon Brothers Holding Company Inc, which is
wholly-owned by Salomon Smith Barney Holdings Inc, which is in turn wholly-owned
by Travelers Group Inc. ('Travelers'), serves as the investment manager to
numerous individuals and institutions and other investment companies.
The management contract between SBAM and each respective Fund provides that
SBAM shall manage the operations of the Fund, subject to policy established by
the Board of Directors. Pursuant to the applicable management contract, SBAM
manages each Fund's investment portfolio, directs purchases and sales of
portfolio securities and reports thereon to the Fund's officers and directors
regularly. SBAM also provides the office space, facilities, equipment and
personnel necessary to perform the following services for each Fund: Commission
compliance, including record keeping, reporting requirements and registration
statements and proxies; supervision of Fund operations, including coordination
of functions of administrator, transfer agent, custodian, accountants, counsel
and other parties performing services or operational functions for each Fund;
certain administrative and clerical services, including certain accounting
services, facilitation of redemption requests, exchange privileges, and account
adjustments, development of new shareholder services and maintenance of certain
books and records; and certain services to each Fund's shareholders, including
assuring that investments and redemptions are completed efficiently, responding
to shareholder inquiries and maintaining a flow of information to shareholders.
In connection with SBAM's service as investment manager to the Strategic
Bond Fund, Salomon Brothers Asset Management Limited ('SBAM Limited'), whose
business address is Victoria Plaza, 111 Buckingham Palace Road, London SW1W OSB,
England, provides certain advisory services to SBAM relating to currency
transactions and investments in non-dollar-denominated debt securities for the
benefit of the Strategic Bond Fund pursuant to a subadvisory consulting
agreement. At no additional expense to the Strategic Bond Fund, SBAM pays SBAM
Limited, as full compensation for all services provided under the subadvisory
consulting agreement, a fee in an amount equal to the fee payable to SBAM under
its management contract with respect to the Strategic Bond Fund multiplied by
the current value of the net assets of the portion of the assets of the
Strategic Bond Fund as SBAM shall allocate and divided by the current value of
the net assets of the Strategic Bond Fund. Like SBAM, SBAM Limited is a
wholly-owned subsidiary of Salomon Brothers Holding Company Inc. SBAM Limited is
a member of the Investment Management Regulatory Organization Limited in the
United Kingdom and is registered as an investment adviser in the United States
pursuant to the Advisers Act.
Pursuant to a sub-advisory agreement, SBAM has retained SBAM AP as
sub-adviser to the Asia Growth Fund (the 'Asia Subadvisory Agreement'). Subject
to the supervision of SBAM, SBAM AP will have responsibility for the day-to-day
management of the Fund's portfolio. For its services under the Asia Subadvisory
Agreement, SBAM AP is compensated at no additional cost to the Asia Growth Fund
at a rate agreed to between SBAM and SBAM AP from time to time. Like SBAM, SBAM
AP is a wholly-owned subsidiary of Salomon Brothers Holding Company Inc. SBAM AP
is a member of the Hong Kong Securities and Futures Commission and is registered
as an investment adviser in the United States pursuant to the Advisers Act.
Pursuant to a sub-administration agreement, SBAM has retained SBAM Limited to
provide certain administrative services to SBAM relating to the
29
<PAGE>
<PAGE>
Asia Growth Fund (the 'Subadministration Agreement'). For its services under the
Subadministration Agreement, SBAM Limited is compensated by SBAM at no
additional cost to the Asia Growth Fund at an annual rate of .10% of the Asia
Growth Fund's daily net assets.
Investment decisions for a particular Fund are made independently from
those of other funds or accounts managed by SBAM, SBAM AP or SBAM Limited. Such
other funds or accounts may also invest in the same securities as a Fund. If
those funds or accounts are prepared to invest in, or desire to dispose of, the
same security at the same time as a Fund, however, transactions in such
securities will be made, insofar as feasible, for the respective funds and
accounts in a manner deemed equitable to all. In some cases, this procedure may
adversely affect the size of the position obtained for or disposed of by a Fund
or the price paid or received by a Fund. In addition, because of different
investment objectives, a particular security may be purchased for one or more
funds or accounts when one or more funds or accounts are selling the same
security.
As compensation for its services, SBAM receives, on behalf of each Fund, as
described below, a monthly management fee, at an annual rate based upon the
average daily net assets of the Fund as follows: .70% for the Investors Fund;
.85% for the Capital Fund; .80% for the Total Return Fund; .75% for the High
Yield Bond Fund and the Strategic Bond Fund; 60% for the U.S. Government Income
Fund; and 1.00% for the Asia Growth Fund.
With respect to all Funds except the Asia Growth Fund, for the 1998 fiscal
year, SBAM has voluntarily agreed to impose an expense cap on total fund
operating expenses (exclusive of taxes, interest and extraordinary expenses such
as litigation and indemnification expenses) at 1.00%. With respect to the Asia
Growth Fund, for the 1998 fiscal year, SBAM has voluntarily agreed to impose an
expense cap on total Fund operating expenses (exclusive of taxes, interest and
extraordinary expenses such as litigation and indemnification expenses) at
1.50%.
The management contract for each of the Funds provides that it will
continue for an initial two year period and thereafter for successive annual
periods; provided that, with respect to each such contract, such continuance is
specifically approved at least annually: (a) by the vote of a majority of the
directors not parties to the management contract or 'interested persons' of such
parties, as defined in the 1940 Act, cast in person at a meeting called for the
specific purpose of voting on such management contract and (b) either by the
Board of Directors or a majority of the outstanding voting securities. The
management contract may be terminated on 60 days' written notice by either party
and will terminate automatically if assigned.
Under the terms of the management contract between each Fund and SBAM,
neither SBAM nor its affiliates shall be liable for losses or damages incurred
by the Fund (including, with respect to the Asia Growth Fund, the imposition of
certain Hong Kong tax liabilities on the Fund), unless such losses or damages
are attributable to the willful misfeasance, bad faith or gross negligence on
either the part of SBAM or its affiliate or from reckless disregard by it of its
obligations and duties under the Management Contract ('disabling conduct'). In
addition, the Asia Growth Fund will indemnify SBAM and its affiliates and hold
each of them harmless against any losses or damages, including the imposition of
certain Hong Kong tax liabilities on the Fund, not resulting from disabling
conduct.
Rule 17j-1 under the 1940 Act requires all registered investment companies
and their investment advisers and principal underwriters to adopt written codes
of ethics and institute procedures designed to prevent 'access persons' (as
defined in Rule 17j-1) from engaging in any fraudulent, deceptive or
manipulative trading practices. The Board of Directors for the Variable Series
Fund has adopted a code of ethics (the 'Fund Code') that incorporates personal
trading policies and procedures applicable to access persons of each Fund, which
includes officers, directors and other specified persons who may make,
participate in or otherwise obtain information concerning the purchase or sale
of securities by the Fund. In addition, the Fund Code attaches and incorporates
personal trading policies and procedures applicable to access persons of the
investment manager and if applicable, any sub-adviser to each Fund, which
policies serve as such adviser's code of ethics (the 'Adviser Code'). The Fund
and Adviser Codes have been designed to address potential conflict of interests
that
30
<PAGE>
<PAGE>
can arise in connection with the personal trading activities of investment
company and investment advisory personnel.
Pursuant to the Fund and Adviser Codes, access persons are generally
permitted to engage in personal securities transactions, provided that a
transaction does not involve securities that are being purchased or sold, are
being considered for purchase or sale, or are being recommended for purchase or
sale by or for a Fund. In addition, the Adviser Code contains specified
prohibitions and blackout periods for certain categories of securities and
transactions, including a prohibition on short-term trading and purchasing
securities during an initial public offering. The Adviser Code, with certain
exceptions, also requires that access persons obtain preclearance to engage in
personal securities transactions. Finally, the Fund and Adviser Codes require
access persons to report all personal securities transactions periodically.
ADMINISTRATOR
SBAM (in such capacity, the 'Administrator') provides certain
administrative services to each Fund. The services provided by the Administrator
under the applicable administration agreement include certain accounting,
clerical and bookkeeping services, Blue Sky compliance, corporate secretarial
services and assistance in the preparation and filing of tax returns and reports
to shareholders and the Commission. Each Fund pays the Administrator a fee,
calculated daily and payable monthly, at an annual rate of .05% of the
applicable Fund's average daily net assets. The Administrator has delegated its
responsibilities under the administration agreements to one of its affiliates.
DISTRIBUTOR
Salomon Brothers Inc, located at 7 World Trade Center, New York, New York
10048, serves as each Fund's distributor pursuant to a distribution contract.
Salomon Brothers Inc is a wholly owned subsidiary of Salomon Brothers Holding
Company Inc.
EXPENSES
Each Fund's expenses include taxes, interest, fees and salaries of such
Fund directors and officers who are not directors, officers or employees of the
Fund's service contractors, Commission fees, state securities qualification
fees, costs of preparing and printing prospectuses for regulatory purposes and
for distribution to existing shareholders, advisory and administration fees,
charges of the custodian and of the transfer and dividend disbursing agent,
certain insurance premiums, outside auditing and legal expenses, costs of
shareholder reports and shareholder meetings and any extraordinary expenses.
Each Fund also pays for brokerage fees and commissions (if any) in connection
with the purchase and sale of portfolio securities.
31
<PAGE>
<PAGE>
PORTFOLIO TRANSACTIONS
Subject to policy established by the Board of Directors, the investment
manager is primarily responsible for each Fund's portfolio decisions and the
placing of the Fund's portfolio transactions.
Fixed-income, certain short-term securities and certain equities normally
will be purchased or sold from or to issuers directly or to dealers serving as
market makers for the securities at a net price, which may include dealer
spreads and underwriting commissions. Equity securities may also be purchased or
sold through brokers who will be paid a commission.
The general policy of each Fund in selecting brokers and dealers is to
obtain the best results taking into account factors such as the general
execution and operational facilities of the broker or dealer, the type and size
of the transaction involved, the creditworthiness of the broker or dealer, the
stability of the broker or dealer, execution and settlement capabilities, time
required to negotiate and execute the trade, research services and the
investment manager's arrangements related thereto (as described below), overall
performance, the dealer's risk in positioning the securities involved, and the
broker's commissions and dealer's spread or mark-up. While the investment
manager generally seeks the best price in placing its orders, a Fund may not
necessarily be paying the lowest price available.
Notwithstanding the above, in compliance with Section 28(e) of the
Securities Exchange Act of 1934, the investment manager may select brokers who
charge a commission in excess of that charged by other brokers, if the
investment manager determines in good faith that the commission to be charged is
reasonable in relation to the brokerage and research services provided to the
investment manager by such brokers. Research services generally consist of
research or statistical reports or oral advice from brokers and dealers
regarding particular companies, industries or general economic conditions. The
investment manager may also have arrangements with brokers pursuant to which
such brokers provide research services to the investment manager in exchange for
a certain volume of brokerage transactions to be executed by such broker. While
the payment of higher commissions increases a Fund's costs, the investment
manager does not believe that the receipt of such brokerage and research
services significantly reduces its expenses as a Fund's investment manager.
Arrangements for the receipt of research services from brokers may create
conflicts of interest.
Research services furnished to the investment manager by brokers who effect
securities transactions for a Fund may be used by the investment manager in
servicing other investment companies and accounts which it manages. Similarly,
research services furnished to the investment manager by brokers who effect
securities transactions for other investment companies and accounts which the
investment manager manages may be used by the investment manager in servicing a
Fund. Not all of these research services are used by the investment manager in
managing any particular account, including the Funds.
Under the 1940 Act, 'affiliated persons' of a Fund are prohibited from
dealing with it as a principal in the purchase and sale of securities unless an
exemptive order allowing such transactions is obtained from the SEC. However,
each Fund may purchase securities from underwriting syndicates of which the
investment manager or any of its affiliates as defined in the 1940 Act, is a
member under certain conditions, in accordance with Rule 10f-3 promulgated under
the 1940 Act.
Each Fund contemplates that, consistent with the policy of obtaining the
best net results, brokerage transactions may be conducted through 'affiliated
broker/dealers,' as defined in the 1940 Act. The Board of Directors has adopted
procedures in accordance with Rule 17e-1 promulgated under the 1940 Act to
ensure that all brokerage commissions paid to such affiliates are reasonable and
fair in the context of the market in which such affiliates operate. Any such
compensation will be paid in accordance with applicable SEC regulations.
NET ASSET VALUE
In calculating net asset value, portfolio securities listed or traded on
national securities exchanges, or reported by the National Association of
Securities Dealers Automated Quotation System ('Nasdaq') National Market
reporting system, are valued at the last sale
32
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<PAGE>
price, or, if there have been no sales on that day, at the mean of the current
bid and ask price which represents the current value of the security.
Over-the-counter securities are valued at the mean of the current bid and ask
price.
Securities that are primarily traded on foreign exchanges generally are
valued at the closing price of such securities on their respective exchanges,
except that if the investment manager is of the opinion that such price would
result in an inappropriate value for a security, including as a result of an
occurrence subsequent to the time a value was so established then the fair value
of those securities may be determined by consideration of other factors by or
under the direction of the Board of Directors or its delegates. In valuing
assets, prices denominated in foreign currencies are converted to U.S. dollar
equivalents at the current exchange rate. Securities may be valued by
independent pricing services which use prices provided by market-makers or
estimates of market values obtained from yield data relating to instruments or
securities with similar characteristics. Short-term obligations with maturities
of 60 days or less are valued at amortized cost, which constitutes fair value as
determined by the Board of Directors. Amortized cost involves valuing an
instrument at its original cost to a Fund and thereafter assuming a constant
amortization to maturity of any discount or premium, regardless of the impact of
fluctuating interest rates on the market value of the instrument. All other
securities and other assets of a Fund will be valued at fair value as determined
in good faith pursuant to procedures adopted by the Board of Directors of each
Fund.
ADDITIONAL PURCHASE INFORMATION
Each Fund offers its shares to the separate accounts of Participating
Insurance Companies on a continuous basis. The offering price per share of each
Fund is equal to the net asset value per share at the time of purchase.
Individuals may not place orders directly with the Funds. See the prospectus of
the separate account of the Participating Insurance Company or the relevant Plan
documents for more information on the purchase of Fund shares and with respect
to the availability for investment in each Fund.
ADDITIONAL REDEMPTION INFORMATION
Fund shares may be redeemed at any time by the separate accounts of the
Participating Insurance Companies and the Plans. Individuals may not place
redemption orders directly with the Funds. It is the responsibility of the
Participating Insurance Company to properly transmit redemption requests in
accordance with applicable requirements. VA contract holders and VLI policy
holders and Plan Participants should consult their Participating Insurance
Company in this regard. Redemption requests will be effected at the net asset
value of each Fund next determined after receipt of redemption instructions by
such Fund in proper form and in accordance with applicable requirements. The
value of the shares redeemed may be more or less than their original cost,
depending on each Fund's then-current net asset value. No charges are imposed by
the Funds when shares are redeemed.
If the Board of Directors shall determine that it is in the best interests
of the remaining shareholders of a Fund, such Fund may pay the redemption price
in whole, or in part, by a distribution in kind from the portfolio of the Fund,
in lieu of cash, taking such securities at their value employed for determining
such redemption price, and selecting the securities in such manner as the Board
of Directors may deem fair and equitable.
Under the 1940 Act, a Fund may suspend the right of redemption or postpone
the date of payment upon redemption for any period during which the NYSE is
closed, other than customary weekend and holiday closings, or during which
trading on said Exchange is restricted, or during which (as determined by the
SEC by rule or regulation) an emergency exists as a result of which disposal or
valuation of portfolio securities is not reasonably practicable, or for such
other periods as the SEC may permit. (A Fund may also suspend or postpone the
recordation of the transfer of its shares upon the occurrence of any of the
foregoing conditions.)
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ADDITIONAL INFORMATION CONCERNING TAXES
TAXATION OF A FUND
The following discussion is a brief summary of certain additional tax
considerations affecting a Fund and its shareholders. No attempt is made to
present a detailed explanation of all federal, state, local and foreign tax
concerns, and the discussions set forth here and in the Prospectus do not
constitute tax advice. Investors are urged to consult their own tax advisers
with specific questions relating to federal, state, local or foreign taxes.
Each Fund intends to elect to be treated as a regulated investment company
(a 'RIC') under Subchapter M of the Internal Revenue Code of 1986, as amended
(the 'Code'). Qualification as a RIC requires, among other things, that a Fund:
(a) derive at least 90% of its gross income in each taxable year from dividends,
interest, payments with respect to securities loans and gains from the sale or
other disposition of stock or securities, foreign currencies or other income
(including gains from options, futures or forward contracts) derived with
respect to its business of investing in such stock, securities or currencies;
and (b) diversify its holdings so that, at the end of each quarter of each
taxable year: (i) at least 50% of the market value of a Fund's assets is
represented by cash, cash items, U.S. government securities, securities of other
RICs 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 a Fund's assets and
10% of the outstanding voting securities of such issuer; and (ii) not more than
25% of the value of its assets is invested in the securities of any one issuer
(other than U.S. government securities or the securities of other RICs).
As a RIC, a Fund will not be subject to federal income tax on its 'net
investment income' (i.e., its investment company taxable income, as that term is
defined in the Code, determined without regard to the deduction for dividends
paid) and 'net capital gain' (the excess of the Fund's net realized long-term
capital gain over net realized short-term capital loss), if any, that it
distributes in each taxable year to its shareholders, provided that it
distributes 90% of its net investment income for such taxable year. However, a
Fund would be subject to corporate income tax (currently at a maximum rate of
35%) on any undistributed net investment income and net capital gain.
A Fund will be subject to a non-deductible 4% excise tax to the extent that
a Fund does not distribute by the end of each calendar year: (a) at least 98% of
its ordinary income for such calendar year; (b) at least 98% of its capital gain
net income for the one-year period ending, as a general rule, on October 31 of
each year; and (c) 100% of the undistributed ordinary income and capital gain
net income from the preceding calendar years (if any) pursuant to the
calculations in (a) and (b). For this purpose, any income or gain retained by a
Fund that is subject to corporate tax will be considered to have been
distributed by year-end. Each Fund intends to make sufficient distributions to
avoid imposition of both the corporate level tax and the excise tax.
A Fund may make investments that produce income that is not matched by a
corresponding cash distribution to the Fund, such as investments in pay-in-kind
bonds or in obligations such as certain Brady Bonds or zero-coupon securities
having original issue discount (i.e., an amount equal to the excess of the
stated redemption price of the security at maturity over its issue price), or
market discount (i.e., an amount equal to the excess of the stated redemption
price of the security over the basis of such bond immediately after it was
acquired) if the Fund elects to accrue market discount on a current basis. A
Fund may engage in hedging or derivatives transactions involving foreign
currencies, forward contracts, options and futures contracts (including options,
futures and forward contracts on foreign currencies) and short sales that may
require the inclusion of income in advance of cash receipts. In addition, income
may continue to accrue for federal income tax purposes with respect to a
non-performing investment. Any such income would be treated as income earned by
a Fund and therefore would be subject to the distribution requirements of the
Code. Because such income may not be matched by a corresponding cash
distribution to a Fund, such Fund may be required to borrow money or dispose of
other securities to be able to make distributions to its investors. In addition,
if an election is not made to currently accrue market discount with respect to a
market discount bond, all or a portion of any
34
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deduction for any interest expense incurred to purchase or hold such bond may be
deferred until such bond is sold or otherwise disposed.
A Fund purchases shares in a 'passive foreign investment company' (a
'PFIC'), the Fund may be subject to U.S. federal income tax on a portion of any
'excess distribution' or gain from the disposition of such shares even if such
income is distributed as a taxable dividend by the Fund to its shareholders.
Additional charges in the nature of interest may be imposed on the Fund in
respect of deferred taxes arising from such distributions or gains. If the Fund
were to invest in a PFIC and elected to treat the PFIC as a 'qualified electing
fund' under the Code (a 'QEF'), in lieu of the foregoing requirements, the Fund
would be required to include in income each year a portion of the ordinary
earnings and net capital gain of the QEF, even if not distributed to the Fund.
Alternatively, under recently enacted legislation, the Fund can elect to
mark-to-market at the end of each taxable year its shares in a PFIC; in this
case, the Fund would recognize as ordinary income any increase in the value of
such shares, and as ordinary loss any decrease in such value to the extent it
did not exceed prior increases included in income. Under either election, the
Fund might be required to recognize in a year income in excess of its
distributions from PFICs and its proceeds from dispositions of PFIC stock during
that year, and such income would nevertheless be subject to the 90% distribution
requirement and would be taken into account for purposes of the 4% excise tax.
Since the Funds' shareholders are the separate accounts of Participating
Insurance Companies and the Plans, no discussion is included herein as to the
Federal income tax consequences to VA contract holders, VLI policy holders and
Plan Participants. For information concerning the Federal income tax
consequences to such holders, see the prospectus for such contract or policy or
the applicable Plan documents. VA contract holders, VLI policy holders and Plan
Participants should consult their tax advisers about the application of the
provisions of the tax law described in this statement of additional information
in light of their particular tax situations.
PERFORMANCE DATA
As indicated in the Prospectus, from time to time, a Fund may quote its
'yield,' 'tax-equivalent yield,' 'effective yield,' 'average annual total
return' and/or 'aggregate total return' in advertisements or in reports and
other communications to shareholders and compare its performance figures to
those of other funds or accounts with similar objectives and to relevant
indices.
AVERAGE ANNUAL TOTAL RETURN
A Fund's 'average annual total return' figures, as described and shown in
each Prospectus, are computed according to a formula prescribed by the
Commission. The formula can be expressed as follows:
P(1+T)'pp'n = ERV
Where: P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = Ending Redeemable Value of a hypothetical $1,000 payment made at the
beginning of a 1-5 or 10-year period at the end of such period (or
fractional portion thereof), assuming reinvestment of all dividends
and distributions.
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AGGREGATE TOTAL RETURN
The 'aggregate total return' figures for each Fund, as described in the
Prospectus, represent the cumulative change in the value of an investment in
Fund shares of such Fund for the specified period and are computed by the
following formula:
AGGREGATE TOTAL RETURN = ERV - P
-------
P
Where: P = a hypothetical initial payment of $10,000.
ERV = Ending Redeemable Value of a hypothetical $10,000 investment made
at the beginning of a 1-, 5-, or 10-year period at the end of such
period (or fractional portion thereof), assuming reinvestment of
all dividends and distributions.
THIRTY DAY YIELD
Certain Funds may advertise the yields for such Funds based on a 30-day (or
one month) period according to the following formula:
a-b
-----
Yield = 2 [( cd + 1)'pp'6 - 1]
Any quotation of performance stated in terms of yield (whether or not based
on a 30-day period) will be given no greater prominence than the information
prescribed under Commission rules. In addition, all advertisements containing
performance data of any kind will include a legend disclosing that such
performance data represents past performance and that the investment return and
principal value of an investment will fluctuate so that an investor's shares,
when redeemed, may be worth more or less than their original cost.
Advertisements and communications may compare a Fund's performance with
that of other mutual funds, as reported by Lipper Analytical Services, Inc. or
similar independent services or financial publications. From time to time,
advertisements and other Fund materials and communications may cite statistics
to reflect a Fund's performance over time utilizing, comparisons to indices.
A Fund's performance will vary from time to time depending upon market
conditions, the composition of its portfolio and operating expenses.
Consequently, any given performance quotation should not be considered
representative of the performance of Fund shares for any specified period in the
future. Because performance will vary, it may not provide a basis for comparing
an investment in Fund shares with certain bank deposits or other investments
that pay a fixed return for a stated period of time. Investors comparing a
Fund's performance with that of other mutual funds should give consideration to
the nature, quality and maturity of the respective investment companies'
portfolio securities and market conditions. An investor's principal is not
guaranteed by any Fund.
CAPITAL STOCK
Pursuant to current interpretations of the 1940 Act, the Fund anticipates
that each Participating Insurance Company will solicit voting instructions from
VA contract and VLI policy owners with respect to any matters that are presented
to a vote of shareholders, and will vote shares in proportion to the voting
instructions received. Plans will vote shares as required by applicable law and
governing Plan documents.
As used in this Statement of Additional Information and the Prospectus, the
term 'majority', when referring to the approvals to be obtained from
shareholders in connection with matters affecting a particular Fund or any other
single portfolio (e.g., approval of investment management contracts) and
requiring a vote under the 1940 Act means the vote of the lesser of: (i) 67% of
the shares of that particular portfolio, represented at a meeting if the holders
of more than 50% of the outstanding shares of such portfolio are present in
person or by proxy; or (ii) more than 50% of the outstanding shares of such
portfolio. Shareholders are entitled to one vote for each full share held and
fractional votes for fractional shares held.
36
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Shares of each Fund are entitled to such dividends and distributions out of
the assets belonging to that Fund as are declared in the discretion of the Board
of Directors. In determining the net asset value of a Fund, assets belonging to
a Fund are charged with the direct liabilities in respect of that Fund and with
a share of the general liabilities of the investment company which are normally
allocated in proportion to the relative net asset values of the respective Funds
at the time of allocation.
In the event of the liquidation or dissolution of the investment company,
shares of each Fund are entitled to receive the assets attributable to it that
are available for distribution, and a proportionate distribution, based upon the
relative net assets of the Fund, of any general assets not attributable to a
portfolio that are available for distribution. Shareholders are not entitled to
any preemptive rights. All shares, when issued, will be fully paid, non-
assessable, fully transferable and redeemable at the option of the holder.
Subject to the provisions of the Variable Series Funds' charter,
determinations by the Board of Directors as to the direct and allocable
liabilities and the allocable portion of any general assets of the investment
company, with respect to a particular Fund are conclusive.
CUSTODIAN AND TRANSFER AGENT
PNC Bank, N.A., located at Airport Business Center, International Court 2,
200 Stevens Drive, Lester, Pennsylvania 19113, serves as each Fund's custodian
except the Asia Growth Fund. The Chase Manhattan Bank, located at 4 Chase
MetroTech Center, Brooklyn, New York 11245, serves as the Asia Growth Fund's
custodian. PNC Bank and The Chase Manhattan Bank (each, a 'Custodian' and
collectively, the 'Custodians'), among other things: maintain a custody account
or accounts in the name of each Fund; receive and deliver all assets for each
Fund upon purchase and upon sale or maturity; collect and receive all income and
other payments and distributions on account of the assets of each Fund; and make
disbursements on behalf of each Fund. The Custodians neither determine the
Funds' investment policies, nor decide which securities each Fund will buy or
sell. For their services, each Custodian receives a monthly fee based upon the
daily average market value of securities held in custody and also receives
securities transaction charges, including out-of-pocket expenses. A Fund may
also periodically enter into arrangements with other qualified custodians with
respect to certain types of securities or other transactions such as repurchase
agreements or derivatives transactions.
First Data Investors Services Group, Inc. (the 'Transfer Agent'), located
at P.O. Box 5127, Westborough, Massachusetts 01581-5127, serves as each Fund's
transfer agent. The Transfer Agent registers and processes transfers of the
Fund's stock, processes purchase and redemption orders, acts as dividend
disbursing agent for the Fund and maintains records and handles correspondence
with respect to shareholder accounts, pursuant to a transfer agency agreement.
For these services, the Transfer Agent receives a monthly fee computed
separately for each Fund and is reimbursed for out-of-pocket expenses.
INDEPENDENT ACCOUNTANTS
Price Waterhouse LLP ('Price Waterhouse') provides audit services, tax
return preparation and assistance and consultation in connection with review of
Commission filings. Price Waterhouse's address is 1177 Avenue of the Americas,
New York, New York 10036.
COUNSEL
Simpson Thacher & Bartlett (a partnership which includes professional
corporations) serves as counsel to each Fund, and is located at 425 Lexington
Avenue, New York, New York 10017-3954.
Piper & Marbury L.L.P. of Baltimore, Maryland has issued an opinion
regarding the valid issuance of shares being offered for sale pursuant to the
Funds' Prospectus.
37
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REPORT OF INDEPENDENT ACCOUNTANTS
To the Shareholder and Board of Directors of
Salomon Brothers Variable Series Funds, Inc.
In our opinion, the accompanying statements of assets and liabilities
present fairly, in all material respects, the financial position of Salomon
Brothers Variable Strategic Bond Fund, Salomon Brothers Variable Total Return
Fund, Salomon Brothers Variable Investors Fund and Salomon Brothers Variable
Capital Fund (four of the portfolios constituting Salomon Brothers Variable
Series Funds, Inc., hereafter referred to as the 'Funds) at December 12, 1997,
in conformity with generally accepted accounting principles. These financial
statements are the responsibility of the Funds' management; our responsibility
is to express an opinion on these financial statements based on our audit. We
conducted our audit of these financial statements in accordance with generally
accepted auditing standards which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for the opinion expressed above.
PRICE WATERHOUSE LLP
1177 Avenue of the Americas
New York, New York 10036
December 12, 1997
38
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SALOMON BROTHERS VARIABLE SERIES FUNDS INC
STATEMENTS OF ASSETS AND LIABILITIES
DECEMBER 12, 1997
<TABLE>
<CAPTION>
STRATEGIC TOTAL
BOND RETURN INVESTORS CAPITAL
FUND FUND FUND FUND
--------- -------- --------- -------
<S> <C> <C> <C> <C>
Assets:
Cash................................................ $ 10 $ 99,970 $ 10 $ 10
Deferred organization expenses (Note 3)............. 31,250 31,250 31,250 31,250
--------- -------- --------- -------
Total assets................................... 31,260 131,220 31,260 31,260
--------- -------- --------- -------
Liabilities:
Organization expenses payable....................... 31,250 31,250 31,250 31,250
--------- -------- --------- -------
Net assets.......................................... $ 10 $ 99,970 $ 10 $ 10
--------- -------- --------- -------
--------- -------- --------- -------
Net Assets consist of:
Paid-in capital..................................... $ 10 $ 99,970 $ 10 $ 10
--------- -------- --------- -------
Net assets.......................................... $ 10 $ 99,970 $ 10 $ 10
--------- -------- --------- -------
--------- -------- --------- -------
Shares outstanding....................................... 1 9,997 1 1
--------- -------- --------- -------
--------- -------- --------- -------
Net asset value, offering and redemption price per
share.................................................. $ 10.00 $ 10.00 $ 10.00 $ 10.00
--------- -------- --------- -------
--------- -------- --------- -------
</TABLE>
See accompanying notes to financial statement.
39
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SALOMON BROTHERS VARIABLE SERIES FUNDS INC
NOTES TO FINANCIAL STATEMENTS
NOTE 1. ORGANIZATION
Salomon Brothers Variable Series Funds Inc (the 'Series'), an open-end
management investment company, consists of Salomon Brothers Variable U.S.
Government Income Fund (the 'U.S. Government Income Fund'), Salomon Brothers
Variable High Yield Bond Fund (the 'High Yield Bond Fund'), Salomon Brothers
Variable Strategic Bond Fund (the 'Strategic Bond Fund'), Salomon Brothers
Variable Total Return Fund (the 'Total Return Fund'), Salomon Brothers Variable
Asia Growth Fund (the 'Asia Growth Fund'), Salomon Brothers Variable Investors
Fund (the 'Investors Fund') and Salomon Brothers Variable Capital Fund (the
'Capital Fund) (each a 'Fund' and collectively, the 'Funds'). The Series was
incorporated in Maryland on October 1, 1997. Each of the Funds, except Asia
Growth Fund and Capital Fund, is classified as a diversified fund under the
Investment Company Act of 1940, as amended (the '1940 Act'). The Funds are
offered exclusively as funding vehicles for Variable Annuity ('VA') contracts
and Variable Life Insurance ('VLI) Policies offered through separate accounts of
various Life Insurance Companies ('Participating Insurance Companies') and for
Qualified Pension and Retirement Plans.
As of December 12, 1997, the Series had no other activity except for
matters relating to its organization and the purchase by SBAM, the Funds'
investment adviser, of 10 shares in each of the Strategic Bond Fund, the
Investors Fund and the Capital Fund and 9,997 shares of the Total Return Fund.
The preparation of financial statements in accordance with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts and disclosures. Actual results
could differ from those estimates.
NOTE 2. MANAGEMENT AND ADVISORY FEES AND OTHER TRANSACTIONS
Each Fund has entered into an investment management contract with Salomon
Brothers Asset Management Inc. ('SBAM'), a wholly-owned subsidiary of Salomon
Brothers Holding Company Inc, which is a wholly-owned subsidiary of Salomon
Smith Barney Holdings, Inc. ('Salomon Smith Barney'), which is in turn
wholly-owned by Travelers Group ('Travelers'). Pursuant to the respective
contracts, SBAM manages the investment and reinvestment of each Fund's assets.
SBAM also furnishes office space, personnel and certain facilities required for
the performance by SBAM of certain additional services provided by it to each
Fund under the applicable management contract.
As compensation for its services, each Fund will pay SBAM a monthly fee at
an annual rate based on its average daily net assets as follows:
<TABLE>
<CAPTION>
ANNUAL RATE
-----------
<S> <C>
U.S. Government Income Fund......................................... .60%
High Yield Bond Fund................................................ .75%
Strategic Bond Fund................................................. .75%
Total Return Fund................................................... .80%
Asia Growth Fund.................................................... 1.00%
Investors Fund...................................................... .70%
Capital Fund........................................................ 0.85%
</TABLE>
In connection with SBAM's service as investment manager to the Strategic
Bond Fund, SBAM Limited, whose business address is in London, England, provides
certain advisory services to SBAM in currency transactions and investments in
non-dollar debt securities for that Fund's benefit at no additional cost.
SBAM has retained SBAM AP, whose business address is in Hong Kong, to act
as sub-advisor to the Asia Growth Fund at no additional cost to the Fund.
Like SBAM, both SBAM Limited and SBAM AP are each indirect, wholly-owned
subsidiaries of Travelers.
40
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SALOMON BROTHERS VARIABLE SERIES FUNDS INC
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
SBAM has voluntarily agreed to impose an expense cap on the total operating
expenses (exclusive of taxes, interest and extraordinary expenses such as
litigation and indemnification expenses) for each Fund, except the Asia Growth
Fund, at 1.00% for the year ending December 31, 1998. With respect to the Asia
Growth Fund, SBAM has agreed to impose an expense cap on total operating
expenses (exclusive of taxes, interest and extraordinary expenses such as
litigation and indemnification expenses) at 1.50% for the year ending December
31, 1998.
Salomon Brothers Inc, a wholly-owned subsidiary of Salomon Brothers Holding
Company Inc, serves as the Funds Distributor. Salomon Brothers Inc and its
affiliates from time to time may receive commissions from the Funds in
connection with the execution of portfolio transactions on behalf of the Funds.
Each Fund will enter into an Administration agreement with SBAM. Under
these agreements, SBAM will provide certain accounting, clerical, and
bookkeeping services, Blue Sky reports, corporate secretarial and assistance in
the preparation and filing of tax returns and reports to shareholders and
various regulatory agencies. As compensation for its services, each Fund will
pay SBAM a monthly fee at an annual rate of .05% of the applicable Fund's
average daily net assets.
NOTE 3. ORGANIZATION EXPENSES
Organization expenses estimated at $125,000 have been allocated
appropriately to and capitalized by the respective Funds. These expenses will be
deferred and amortized ratably over a five-year period from commencement of
operations. In the event that any of the shares representing initial capital of
the Funds are redeemed during the amortization period by any holder thereof,
then such Fund's remaining unamortized organization costs will be reduced in the
same ratio as the number of such shares being redeemed bears to the number of
initial shares outstanding immediately prior to redemption.
41
STATEMENT OF DIFFERENCE
The dagger symbol shall be expressed as................................'D'
Characters normally expressed as superscript shall be preceded by......'pp'
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