DEBT
STRATEGIES
FUND II, INC.
[GRAPHIC OMITTED]
STRATEGIC
Performance
Semi-Annual Report
August 31, 1998
<PAGE>
DEBT STRATEGIES FUND II, INC.
The Benefits and Risks of Leveraging
Debt Strategies Fund II, Inc. has the ability to utilize leverage through
borrowings or issuance of short-term debt securities or shares of Preferred
Stock. The concept of leveraging is based on the premise that the cost of assets
to be obtained from leverage will be based on short-term interest rates, which
normally will be lower than the return earned by the Fund on its longer-term
portfolio investments. Since the total assets of the Fund (including the assets
obtained from leverage) are invested in higher-yielding portfolio investments,
the Fund's Common Stock shareholders are the beneficiaries of the incremental
yield. Should the differential between the underlying interest rates narrow, the
incremental yield "pick up" will be reduced. Furthermore, if long-term interest
rates rise, the Common Stock's net asset value will reflect the full decline in
the entire portfolio holdings resulting therefrom since the assets obtained from
leverage do not fluctuate.
Leverage creates risks for holders of Common Stock including the likelihood of
greater net asset value and market price volatility. In addition, there is the
risk that fluctuations in interest rates on borrowings (or in the dividend rates
on any Preferred Stock, if the Fund were to issue Preferred Stock) may reduce
the Common Stock's yield and negatively impact its market price. If the income
derived from securities purchased with assets received from leverage exceeds the
cost of leverage, the Fund's net income will be greater than if leverage had not
been used. Conversely, if the income from the securities purchased is not
sufficient to cover the cost of leverage, the Fund's net income will be less
than if leverage had not been used, and therefore the amount available for
distribution to Common Stock shareholders will be reduced. In this case, the
Fund may nevertheless decide to maintain its leveraged position in order to
avoid capital losses on securities purchased with leverage. However, the Fund
will not generally utilize leverage if it anticipates that its leveraged capital
structure would result in a lower rate of return for its Common Stock than would
be obtained if the Common Stock were unleveraged for any significant amount of
time.
<PAGE>
Debt Strategies Fund II, Inc., August 31, 1998
DEAR SHAREHOLDER
We are pleased to provide you with this first semi-annual report for Debt
Strategies Fund II, Inc. The Fund's investment objective is to seek to provide
current income by investing primarily in a diversified portfolio of US
companies' debt instruments, including corporate loans. The securities are rated
in the lower rating categories of the established rating services, Baa or lower
by Moody's Investors Service, Inc. (Moody's) or BBB or lower by Standard &
Poor's Rating Service (S&P), or unrated debt instruments of comparable quality.
As a secondary objective, the Fund will seek capital appreciation. Up to 20% of
the Fund's total assets may be invested in debt instruments which, at the time
of investment, are the subject of bankruptcy proceedings or otherwise in default
as to the repayment of principal or payment of interest or are rated in the
lowest rating categories, Ca or lower by Moody's and CC or lower by S&P, or
unrated instruments of comparable quality. In addition, the Fund may invest up
to 20% of its total assets in financial instruments of issuers domiciled outside
the United States or that are denominated in various foreign currencies and
multinational foreign currency units.
Since inception (March 27, 1998) through August 31, 1998, the total investment
return on the Fund's Common Stock was -1.75%, based on a change in per share net
asset value from $10.00 to $9.55, and assuming reinvestment of $0.272 per share
income dividends. During the same period, the net annualized yield of the Fund's
Common Stock was 8.32%. For the three-month period ended August 31, 1998, the
Fund's total investment return was -2.43%, based on a change in per share net
asset value from $10.07 to $9.55, and assuming reinvestment of $0.272 per share
income dividends. During the same period, the net annualized yield of the Fund's
Common Stock was 8.86%. At the end of the August quarter, the Fund was 8.9%
leveraged as a percentage of total assets, having borrowed $59.0 million of its
$100.0 million credit facility at an average rate of 6.18%. (For a complete
explanation of the benefits and risks of leverage, see page 1 of this report to
shareholders.)
The Environment
It has been a challenging time to invest the portfolio since its inception in
March. At inception, there was excess liquidity in both the high-yield and
leveraged loan markets, and investors paid a premium relative to historic
valuations to acquire any debt instruments. Demand for loans increased rapidly
as new investors, including hedge funds, insurance companies and collateralized
loan obligation vehicles, became drawn to the attractive relative yield and low
volatility of this asset class. Investors also were attracted to the high-yield
market's premium absolute yields. With demand outpacing supply in both markets,
yield spreads compressed markedly.
Starting in early summer, the tone and direction of the financial markets
reversed course. In the past few months, the financial markets have experienced
unprecedented volatility. The risk premium has increased dramatically, as
evidenced by a declining equity market, widening credit spreads and a general
flight to quality that drove down Treasury yields. In August, the high-yield
market's return was the worst in the last 15 years.
Portfolio Strategy
The volatility in the financial markets negatively affected the Fund's
performance during the five-month period ended August 31, 1998. In this
environment, we continued to maintain a majority of investments in bank loans.
On a relative value basis, high-yield bonds have become more attractive.
However, until we see more stability in the capital markets, we expect to
maintain at least a 50% weighting in floating rate secured loans.
By August 31, 1998, more than 97% of the Fund's investments in corporate loans
were accruing interest at a yield spread above the London Interbank Offered Rate
(LIBOR), the rate that major international banks charge each other for US
dollar-denominated deposits outside of the United States. Since the average
reset on the Fund's floating rate investments is 38 days, the yield on the bank
loan portion of the Fund is likely to move up or down within a
one-month-two-month period after any LIBOR rate changes. The LIBOR spread on
each loan (which averaged 2.4% on August 31, 1998) is a contractual percentage
and, unless tied to specific parameters (for example, interest coverage) of the
borrower, cannot change unless the contract is amended. By the end of August,
LIBOR stood at 5.5%. At August 31, 1998, floating rate securities made up 67.2%
of the market value of the Fund's investments, with an additional 32.5% invested
in fixed rate, high-yield bonds. Approximately $41 million remained available
under the leverage facility at the close of the period.
The leveraged loan market was strong through most of the five-month period ended
August 31, 1998, but weakened marginally in August. Demand for bank loans was
robust, as banks and other institutional investors competed for allocations of
new bank transactions. This demand continued the trend in growing liquidity and
the run up in prices for par names. However, as the liquidity in the capital
markets dried up with the increased volatility, bank transactions announced in
August offered wider LIBOR spreads than for those transactions closing in July.
This spread expansion, approximating 1%-1.5% for a typical liquid bank
transaction, caused existing loans in the market and in our portfolio to reprice
to the market equilibrium. Par loans on average have repriced up to two points
lower, or less than 2%, demonstrating the stability of this asset class in a
difficult global environment.
Leveraged loan new-issue volume increased to $140 billion during the six-month
period ended June 30, 1998, a 133% increase over the comparable period in 1997.
(Leveraged loans are those at a spread of at least 1.5% over LIBOR.) This is the
highest total of the 1990s. At the same time, secondary trading volume of
leveraged loans reached $35.6 billion in the first half of 1998, a pace that put
it on track to exceed the record $62.0 billion for all of 1997.
With almost uninterrupted inflows of investor assets, yield spreads in the
high-yield bond market remained at historically narrow levels through the first
half of 1998. The high-yield bond market benefited from strong demand, a good
economy, a record-breaking US stock market and low default rates. Beginning in
early summer, the high-yield market was pressured by the disruptions in the
Russian, Asian, Latin American and US equity markets. Liquidity became tight as
high-yield outflows totaled $1.5 billion in August and yield spreads widened 200
basis points-250 basis points (2.00%-2.50%). As measured by the unmanaged
Merrill Lynch High Yield Index, the high-yield market generated a return of
- -4.32% for the month of August, dragging the year-to-date total return down to
0.57%.
The high-yield market continued its record pace of new issuance through the
first half of 1998, nearly equaling the total record issuance during all of
1997. Total first half issuance was $106 billion, which surpassed last year's
comparable period by 83%, when $57 billion was issued. During the first half of
the year, investors' appetites for risk increased, as zero coupon and prefunded
cash-pay issues represented 21% of total issuance compared to 14% in 1997.
Telecommunications borrowers continued to dominate the market, representing
25.5% of total issuance, or $32 billion. Although telecommunications represents
a significant industry exposure for the Fund, we have gravitated to industry
borrowers who are conservatively capitalized, have an existing infrastructure
network and a growing subscriber base, and are mov-ing toward completing their
network expansion plans.
Overall, fundamentals for both the bank loan and high-yield bond market have
declined since the Fund's inception in March, but still remain positive.
Although downgrades by the credit rating agencies have exceeded upgrades in the
past six months, the default rate still remains below the historic average.
Downgrades have also been concentrated in the commodity sectors such as energy
and metals and mining, which have been impacted by weaker demand in the
developing global economies and more competitive imports. Our focus will
continue to be to invest in those companies that are generating improved
earnings trends or whose securities we believe are undervalued.
Our industry focus has been on those companies that have leading market shares,
strong management and improving cash flows. During the period, the
best-performing industry sectors included cable television, advertising,
publishing, and radio and television broadcasting. These industries not only had
more stable cash flows than many of their cyclical counterparts, but also
benefited from the substantial merger and acquisition activity in these sectors.
A number of cyclical sectors underperformed the market at large. Paper and
metals and mining were examples of such industry groups, resulting from the
concerns over the longer-term effects of the Asian currency crisis on these
industries. In certain cyclical areas we have been more willing to trade out of
the unsecured bonds and into the senior secured bank debt in order to seek to
limit the Fund's downside volatility. Underperforming sectors (exclusive of the
commodity sectors) included telecommunications and technology. The technology
group in general is suffering from oversupply and concomitant pricing pressure
in such products as printed circuit boards and memory chips. Telecommunications
issues underperformed primarily as a result of the large volume of zero-coupon
issues that usually fall out of favor in illiquid, volatile markets.
At August 31, 1998, the Fund was fully invested but had the ability to borrow an
additional $41 million on its credit line. At August 31, 1998, the Fund's
average stated maturity was 7.5 years but had an expected average life of
approximately 2 years-3 years as a result of the shorter average life of bank
loans which are freely prepayable without call protection. At August 31, 1998,
the Fund's floating rate investments were spread across 47 borrowers in 23
industries. Fixed rate investments were spread across 93 borrowers in 30
industries. (See page 19 of this report to shareholders for the Five Largest
Industries and Ten Largest Holdings represented in the Fund.)
New-issue volume in both the leveraged loan and high-yield bond markets has
slowed considerably. Investors are digesting the huge growth in supply in both
markets and the effect on domestic liquidity from the correction in the emerging
fixed-income markets. Secondary bond markets are strong for higher-quality,
2 & 3
<PAGE>
Debt Strategies Fund II, Inc., August 31, 1998
large-capitalization issues, but very shallow for smaller issues and issues with
any marginal credit deterioration.
Our outlook for the next six-month period is for continued volatility in the
high-yield bond market and a stabilizing leveraged loan market. Continued
Federal Reserve Board easing of the Federal Funds rate could be the catalyst
that will bring liquidity back to the high-yield markets. Because new supply has
been nonexistent, a return of confidence to the capital markets could produce an
abrupt recovery in the high-yield market. The loan market, which has fared well
in this correction, should continue to be less volatile than the high-yield
market and benefit from a recovery in the capital markets. In the interim period
before a rebound, demand is likely to remain dormant and constrain near-term
supply, exacerbating the credit crunch. Borrowers who have to come to market
will be forced to pay a premium spread. We will continue to be opportunistic in
our high-yield bond and loan purchases, selling overvalued issues and sectors
and buying undervalued ones.
We will try to divest the Fund of lower-yielding loans to take advantage of
forthcoming issues priced at wider LIBOR spreads. In the meantime, we expect to
maintain our defensive position in secured floating rate bank debt until we see
a turnaround beginning to occur in the high-yield market or until higher-quality
bonds become excessively oversold.
At August 31, 1998, we had 11% of the Fund's total assets invested in companies
domiciled outside of the United States, focused primarily in Latin America,
Canada and Western Europe. Approximately two-thirds of our foreign holdings, or
7% of total assets, were domiciled in emerging markets, defined as countries not
included in the Group of Seven Industrialized Nations. Emerging markets were
down significantly during the period ended August 31, 1998, negatively affecting
the Fund's performance. At August 31, 1998, the Fund's investments in distressed
securities were less than 1% of total assets. We continue to believe that this
market is less attractive near term after six years of sustained economic growth
and because of continued volatility in the equity markets. We expect to see more
attractive opportunities during the coming months.
In Conclusion
We appreciate your investment in Debt Strategies Fund II, Inc., and we look
forward to reviewing our strategy with you again in our next report to
shareholders.
Sincerely,
/s/ Arthur Zeikel
Arthur Zeikel
President
/s/ R. Douglas Henderson
R. Douglas Henderson
Senior Vice President and
Portfolio Manager
October 12, 1998
SCHEDULE OF INVESTMENTS
<TABLE>
<CAPTION>
S&P Moody's Face Value
INDUSTRIES Rating Rating Amount Corporate Debt Obligations Cost (Note 1b)
===================================================================================================================================
<S> <C> <C> <C> <C> <C> <C>
Aircraft & BB Ba2 US$ 5,000,000 Coltec Industries Inc., 7.50% due 4/15/2008 (c) $ 4,992,546 $ 4,756,250
Parts--1.1% B- Caa1 2,000,000 Compass Aerospace Corp., 10.125% due 4/15/2005
(c) 2,000,000 1,885,000
------------ ------------
6,992,546 6,641,250
===================================================================================================================================
Amusement & AMF Group, Inc.**:
Recreational NR* NR* 4,239,594 Term A, due 3/31/2003 4,266,091 4,230,320
Services--9.3% NR* NR* 2,632,947 Term B, due 3/31/2004 2,649,403 2,627,187
CCC+ B3 1,000,000 Hollywood Entertainment Corp., 10.625% due
8/15/2004 (c) 1,041,250 982,500
NR* NR* 4,987,500 Kerastotes, Term B, due 12/31/2004** 4,980,614 4,987,500
B B3 1,300,000 Loews Cineplex Entertainment Corp., 8.875% due
8/01/2008 1,289,452 1,228,500
Metro-Goldwyn-Mayer Co. (MGM)**:
NR* NR* 7,755,000 Revolving Credit, due 9/30/2003 7,755,000 7,561,125
NR* NR* 6,000,000 Term A, due 12/31/2005 5,941,493 5,977,500
NR* NR* 14,993,750 Patriot American Hospitality, Inc., Term B, due
3/31/2003** 14,966,172 14,993,750
NR* NR* 3,825,000 Premier Parks Inc., Term C, due 3/31/2006** 3,844,125 3,834,563
NR* NR* 5,000,000 Six Flags Entertainment Corp., Term B, due
11/30/2004** 5,050,000 5,025,000
B+ Ba3 4,000,000 Speedway Motorsports Inc., 8.50% due 8/15/2007 4,155,000 4,000,000
------------ ------------
55,938,600 55,447,945
===================================================================================================================================
Apparel--0.8% BB Ba2 5,000,000 Phillips-Van Heusen Corporation, 7.75% due
11/15/2023 4,556,579 4,550,000
===================================================================================================================================
Automotive B- B3 3,000,000 Newcor Inc., 9.875% due 3/01/2008 3,060,000 2,775,000
Equipment--1.5% Safelite Glass Corp.**:
NR* NR* 2,500,000 Term B, due 12/23/2003 2,512,500 2,503,125
NR* NR* 2,500,000 Term C, due 12/23/2004 2,512,500 2,503,125
B- B2 1,000,000 Trident Automotive, 10% due 12/15/2005 1,075,000 1,040,000
------------ ------------
9,160,000 8,821,250
===================================================================================================================================
Broadcast--Radio B- B3 1,325,000 Granite Broadcasting Corp., 8.875% due 5/15/2008 1,321,154 1,278,625
& Television--1.9% B B3 2,250,000 Jones International Networks Ltd., 11.75% due
7/01/2005 (c) 2,250,000 2,120,625
NR* NR* 1,350,000 Radio Unica Corp., 11.75% due 8/01/2006 (a)(c) 865,406 783,000
Regional Independent Media Group:
B- B3 850,000 10.50% due 7/01/2008 (c) 850,000 835,125
B- B3 (pound) 3,600,000 12.875% due 7/01/2008 (a) 3,333,430 3,014,460
B+ Ba3 US$ 2,250,000 TV Azteca, S.A. de C.V., 10.50% due 2/15/2007 (c) 2,376,562 1,777,500
B B2 1,500,000 Young Broadcasting Inc., 8.75% due 6/15/2007 1,593,750 1,537,500
------------ ------------
12,590,302 11,346,835
===================================================================================================================================
Building & NR* NR* DM 2,500,000 Thyssen AG, Term B, due 12/02/2003** 1,372,251 1,413,121
Construction--0.2%
===================================================================================================================================
Building BB- Ba3 US$ 5,000,000 American Standard Inc., 7.375% due 4/15/2005 4,975,485 5,036,275
Materials--4.3% Behr Process**:
NR* NR* 5,628,750 Term B, due 3/31/2004 5,663,930 5,628,750
NR* NR* 3,752,500 Term C, due 3/31/2005 3,775,953 3,757,191
NR* NR* 11,246,210 Walter Industries Inc., Term B, due 10/15/2003** 11,246,210 11,189,979
------------ ------------
25,661,578 25,612,195
===================================================================================================================================
</TABLE>
4 & 5
<PAGE>
Debt Strategies Fund II, Inc., August 31, 1998
SCHEDULE OF INVESTMENTS (continued)
<TABLE>
<CAPTION>
S&P Moody's Face Value
INDUSTRIES Rating Rating Amount Corporate Debt Obligations Cost (Note 1b)
===================================================================================================================================
<S> <C> <C> <C> <C> <C> <C>
Cable TV CSC Holdings Inc.:
Services--3.6% BB+ Ba2 US$ 1,025,000 7.25% due 7/15/2008 $ 1,025,000 $ 967,344
BB+ Ba2 1,275,000 7.625% due 7/15/2018 1,273,741 1,173,000
BB+ Ba3 4,300,000 Comcast Corporation, 9.375% due 5/15/2005 4,611,750 4,429,000
B B2 5,000,000 Falcon Holding Group L.P., 8.375% due 4/15/2010
(c) 4,989,497 4,775,000
BB- B1 2,500,000 Globo Comunicacoes e Participacoes S.A., 10.625%
due 12/05/2008 (c) 2,507,500 1,537,500
B+ B2 2,000,000 Mediacom LLC/Capital, 8.50% due 4/15/2008 (c) 2,000,000 1,900,000
BB+ Ba3 2,000,000 Multicanal S.A., 10.50% due 4/15/2018 (c) 2,050,000 1,360,000
NR* NR* 3,881,514 NTL Group Inc., Term, due 1/31/1999** 3,881,514 3,879,088
B B3 2,000,000 Supercanal Holdings S.A., 11.50% due 5/15/2005 (c) 2,000,000 1,677,200
------------ ------------
24,339,002 21,698,132
===================================================================================================================================
Chemicals--5.1% BB B1 4,500,000 Borden Chemicals and Plastics LP, 9.50% due
5/01/2005 4,736,250 4,342,500
NR* NR* 6,979,000 Exide Corp., Term B, due 3/19/2005** 7,031,343 6,987,724
Huntsman Corporation**:
NR* NR* 4,950,000 Term B, due 3/15/2006 4,992,075 4,962,375
NR* NR* 5,939,394 Term C, due 3/15/2005 5,989,879 5,954,242
B B3 2,700,000 LaRoche Industries Inc., Series B, 9.50% due
9/15/2007 2,673,173 2,322,000
NR* NR* 6,200,000 Lyondell Chemical Co., Term B, due 6/30/2005** 6,193,861 6,227,125
------------ ------------
31,616,581 30,795,966
===================================================================================================================================
Computer Related DecisionOne Corp.**:
Products--2.4% NR* NR* 9,600,000 Term A, due 8/07/2003 9,517,471 9,384,000
NR* NR* 4,962,500 Term B, due 8/07/2005 4,932,596 4,863,250
------------ ------------
14,450,067 14,247,250
===================================================================================================================================
Consumer Diamond Brands Operating Inc. (c):
Products--1.8% CCC+ B3 2,500,000 10.125% due 4/15/2008 2,500,000 2,312,500
CCC+ Caa1 2,500,000 12.875% due 4/15/2009 (a) 1,404,213 1,175,000
E & S Holdings Corp.**:
NR* NR* 1,080,980 Revolving Credit, due 9/30/2003 1,080,980 1,029,634
NR* NR* 281,490 Term A, due 9/30/2003 270,413 266,712
B+ B2 1,225,000 Evenflo Company Inc., 11.75% due 8/15/2006 (c) 1,225,000 1,194,375
B B3 1,325,000 Home Products International Inc., 9.625% due
5/15/2008 1,325,000 1,205,750
B+ Ba3 3,500,000 Shop-Vac Corp., 10.625% due 9/01/2003 (c) 3,865,938 3,692,500
------------ ------------
11,671,544 10,876,471
===================================================================================================================================
Defense--0.7% United Defense Industries, Inc.**:
NR* NR* 2,079,218 Term B, due 9/30/2005 2,084,416 2,072,720
NR* NR* 2,019,533 Term C, due 9/30/2006 2,024,582 2,015,746
------------ ------------
4,108,998 4,088,466
===================================================================================================================================
Drilling--0.9% B+ B1 5,000,000 Cliffs Drilling Company, 10.25% due 5/15/2003 5,425,000 5,300,000
===================================================================================================================================
Educational B- B3 1,325,000 La Petite Academy, 10% due 5/15/2008 (c) 1,325,000 1,258,750
Services--0.2%
===================================================================================================================================
Electronics/ Amphenol Corporation**:
Electrical NR* NR* 5,000,000 Term A, due 5/19/2003 5,000,000 5,000,000
Components--3.8% NR* NR* 17,667,500 Term B, due 5/19/2005 17,777,922 17,623,331
------------ ------------
22,777,922 22,623,331
===================================================================================================================================
Energy--1.4% B- B3 550,000 Belden & Blake Energy Company, 9.875% due
6/15/2007 551,375 456,500
B+ B1 1,000,000 Chesapeake Energy Corporation, 9.625% due
5/01/2005 1,000,000 820,000
B- B3 1,275,000 Continental Resources Inc., 10.25% due 8/01/2008
(c) 1,275,000 1,134,750
B B2 2,000,000 Energy Corp. of America, 9.50% due 5/15/2007 2,000,000 1,820,000
B- B3 1,850,000 Gothic Production Corp., 11.125% due 5/01/2005 1,850,000 1,480,000
B+ B2 3,200,000 Pool Energy Services Co., 8.625% due 4/01/2008 3,216,000 2,784,000
------------ ------------
9,892,375 8,495,250
===================================================================================================================================
Financial Outsourcing Solutions, Inc.**:
Services--0.6% NR* NR* 1,118,605 Revolving Credit, due 10/15/2001 1,118,605 1,106,020
NR* NR* 2,648,498 Term A, due 10/15/2001 2,639,443 2,631,945
------------ ------------
3,758,048 3,737,965
===================================================================================================================================
Food & Kindred NR* NR* 665,516 Mistic Beverage, Inc., Term A, due 6/01/2003** 660,003 661,357
Products--1.5% NR* NR* 1,996,548 Snapple Beverage Corp., Term A, due 6/01/2003** 1,980,010 1,984,070
Specialty Foods, Inc.**:
NR* NR* 3,173,516 Term, due 1/31/2000 3,175,499 3,173,516
NR* NR* 3,165,582 Term A, due 1/31/2000 3,165,582 3,165,582
------------ ------------
8,981,094 8,984,525
===================================================================================================================================
Forest Products-- B B3 2,000,000 Ainsworth Lumber Company, 12.50% due 7/15/2007
1.4% (b) 2,075,000 2,020,000
B+ B3 650,000 Millar Western Forest Products Ltd., 9.875% due
5/15/2008 (c) 650,000 500,500
NR* NR* 5,000,000 Strategic Distribution Inc., Term, due
10/27/1999** 4,965,095 4,962,500
B B3 1,000,000 Uniforet Inc., 11.125% due 10/15/2006 935,596 850,000
------------ ------------
8,625,691 8,333,000
===================================================================================================================================
Gaming--1.2% B- B3 4,250,000 Ameristar Casinos Inc., 10.50% due 8/01/2004 4,574,063 4,037,500
B- Caa1 3,000,000 Argosy Gaming Co., 12% due 6/01/2001
(Convertible) 2,972,775 2,962,500
------------ ------------
7,546,838 7,000,000
===================================================================================================================================
Grocery--3.3% BB Ba3 4,250,000 Disco S.A., 9.875% due 5/15/2008 (c) 4,222,545 2,762,500
NR* NR* 14,942,308 Fred Meyer, Inc., Term, due 2/28/2003** 14,851,027 14,830,240
NR* Ba3 2,500,000 Supermercados Norte S.A., 10.875% due
2/09/2004 (c) 2,571,875 1,975,000
------------ ------------
21,645,447 19,567,740
===================================================================================================================================
Health Services-- B- B3 1,500,000 Everest Healthcare Services, 9.75% due 5/01/2008
9.1% (c) 1,500,000 1,436,250
CC B3 2,500,000 Graham-Field Health Products, Inc., 9.75% due
8/15/2007 2,543,750 2,075,000
B- B3 4,000,000 Hudson Respiratory Care Inc., 9.125% due
4/15/2008 (c) 4,000,000 3,400,000
Integrated Health Services, Inc.**:
NR* NR* 10,375,000 Term B, due 9/15/2005 10,340,249 10,368,516
NR* NR* 7,500,000 Term C, due 9/15/2005 7,528,125 7,495,313
</TABLE>
6 & 7
<PAGE>
Debt Strategies Fund II, Inc., August 31, 1998
SCHEDULE OF INVESTMENTS (continued)
<TABLE>
<CAPTION>
S&P Moody's Face Value
INDUSTRIES Rating Rating Amount Corporate Debt Obligations Cost (Note 1b)
===================================================================================================================================
<S> <C> <C> <C> <C> <C> <C>
Health Services NR* NR* US$ 5,000,000 Paragon Health Network, Inc., Term B, due
(concluded) 3/31/2005** $ 5,037,500 $ 4,962,500
B- B3 4,000,000 Pediatric Services of America, Inc., 10% due
4/15/2008 4,000,000 2,000,000
Sun Health Care Group, Inc.**:
NR* NR* 2,759,319 Term B, due 11/12/2004 2,775,875 2,762,768
NR* NR* 2,759,319 Term C, due 11/12/2005 2,775,875 2,762,768
BB- Ba3 2,000,000 Tenet Healthcare Corp., 8.125% due 12/01/2008 (c) 1,992,372 1,935,000
NR* NR* 15,000,000 Total Renal Care Holdings, Term, due 3/31/2008** 14,981,682 15,004,687
------------ ------------
57,475,428 54,202,802
===================================================================================================================================
Hotels--3.0% BB Ba2 3,200,000 HMH Properties Inc., 7.875% due 8/01/2008 3,179,362 3,024,000
NR* NR* 15,000,000 Starwood Hotels & Resorts, 7.906% due 2/23/2003 15,007,500 15,000,000
------------ ------------
18,186,862 18,024,000
===================================================================================================================================
Leasing & Rental NR* NR* 4,000,000 American Tower Systems Co., Term C, due
Services--2.1% 12/16/2006** 3,990,162 3,960,000
NR* NR* 3,750,000 Anthony Crane Rentals, Term, due 7/22/2006** 3,745,357 3,735,936
NR* NR* 3,990,000 Coinmachine Laundry Corp., Term B, due
6/30/2005** 4,009,950 3,994,987
B- B3 900,000 Penhall Acquisition Corp., 12% due 8/01/2006 (c) 900,000 830,250
------------ ------------
12,645,469 12,521,173
===================================================================================================================================
Manufacturing-- B- B2 1,150,000 Globe Manufacturing Corp., 10% due 8/01/2008 1,150,000 1,101,125
1.3% NR* NR* 6,982,500 Terex Corp., Term B, due 3/06/2005** 6,986,864 6,995,592
------------ ------------
8,136,864 8,096,717
===================================================================================================================================
Metals & Mining-- BB- Ba2 3,350,000 AK Steel Holding Corp., 10.75% due 4/01/2004 3,597,062 3,509,125
5.3% B+ Ba3 5,000,000 Ameristeel Corp., 8.75% due 4/15/2008 5,000,000 4,825,000
B B1 1,050,000 Bayou Steel Corp., 9.50% due 5/15/2008 (c) 1,040,172 960,750
B B2 1,625,000 G.S. Technologies Operating Co., 12% due
9/01/2004 1,780,391 1,755,000
B- B2 5,000,000 Geneva Steel Company, 9.50% due 1/15/2004 4,513,868 3,750,000
BB Ba2 4,000,000 Great Central Mines Ltd., 8.875% due 4/01/2008 4,000,000 3,720,000
NR* NR* 4,961,539 Koppers Industries, Term B, due 11/30/2004** 4,986,346 4,955,337
B Caa2 2,400,000 Lonestar Holdings Inc., 11.50% due 5/15/2005 (c) 2,400,000 2,208,000
B- B3 1,975,000 Metal Management Inc., 10% due 5/15/2008 (c) 1,975,000 1,639,250
B B3 5,000,000 WHX Corporation, 10.50% due 4/15/2005 5,000,000 4,450,000
------------ ------------
34,292,839 31,772,462
===================================================================================================================================
Packaging--0.6% B- B3 1,000,000 Indesco International Inc., 9.75% due 4/15/2008
(c) 1,000,000 950,000
B B3 2,750,000 Spinnaker Industries Inc., 10.75% due 10/15/2006 2,853,125 2,640,000
------------ ------------
3,853,125 3,590,000
===================================================================================================================================
Paper--2.0% Riverwood International, Inc.**:
NR* NR* 4,260,896 Term B, due 2/28/2004 4,287,526 4,276,874
NR* NR* 1,526,042 Term C, due 8/31/2004 1,535,580 1,531,765
NR* NR* 6,200,827 Stone Container Corp., Term E, due 10/01/2003** 6,216,329 6,216,329
------------ ------------
12,039,435 12,024,968
===================================================================================================================================
Printing & NR* NR* 750,000 Hurst Group PLC, 11.125% due 8/06/2008 (c) 1,217,635 1,067,621
Publishing--0.2%
===================================================================================================================================
Property NR* NR* 2,500,000 Rockefeller Center Properties Trust, 10.573%
Management--0.3% due 12/31/2000 (Convertible) (a) 1,980,801 1,962,500
===================================================================================================================================
Restaurants--0.5% CCC+ B3 4,000,000 Planet Hollywood International, 12% due 4/01/2005 3,971,130 2,780,000
===================================================================================================================================
Retail-- NR* NR* 5,000,000 Asbury Auto, Term B, due 3/31/2005** 4,957,749 4,987,500
Specialty--1.2% B B2 2,000,000 TM Group Holdings, 11% due 5/15/2008 (c) 2,000,000 1,975,000
------------ ------------
6,957,749 6,962,500
===================================================================================================================================
Shipping--0.1% B+ B3 750,000 TBS Shipping International Ltd., 10% due
5/01/2005 (c) 698,565 615,000
===================================================================================================================================
Telephone NR* NR* 5,000,000 Comtel Brasileira Ltd., 10.75% due 9/26/2004 (c) 5,193,750 3,800,000
Communications-- NR* NR* 4,275,000 E. Spire Communications Inc., 10.521% due
5.2% 7/01/2008 (a)(c) 2,614,593 1,987,875
B B2 4,000,000 Intermedia Communications Inc., 9.046% due
7/15/2007 (a) 3,061,736 2,720,000
B B3 3,250,000 Level 3 Communications Inc., 9.125% due 5/01/2008 3,236,608 2,892,500
NR* B3 5,000,000 NEXTLINK Communications, Inc., 9.45% due
4/15/2008 (a) 3,262,665 2,600,000
B- B3 1,000,000 Primus Telecommunications Group Inc., 11.75% due
8/01/2004 1,035,000 980,000
B- B3 DM 5,000,000 RSL Communications PLC, 10.039% due 3/15/2008
(a)(c) 1,723,182 1,276,596
NR* NR* US$ 3,000,000 Splitrock Services Inc., 11.75% due 7/15/2008 3,000,000 2,820,000
BBB- Ba3 1,700,000 Telefonica de Argentina S.A., 9.125% due
5/07/2008 (c) 1,689,668 1,249,500
B- B2 3,000,000 Time-Warner Telecom LLC, 9.75% due 7/15/2008 3,000,000 2,857,500
Viatel Inc. (c):
NR* Caa1 3,000,000 11.25% due 4/15/2008 2,999,920 3,060,000
NR* Caa1 DM 10,000,000 11.50% due 4/15/2008 5,698,692 5,106,383
------------ ------------
36,515,814 31,350,354
===================================================================================================================================
Textile Mill B B3 US$ 3,500,000 Galey & Lord Inc., 9.125% due 3/01/2008 3,539,375 3,027,500
Products--1.8% NR* NR* 8,018,723 Joan Fabrics, Term A, due 6/30/2003** 8,038,770 8,013,712
------------ ------------
11,578,145 11,041,212
===================================================================================================================================
Transportation-- NR* NR* 7,066,216 Atlas Freight, Term, due 5/29/2004** 7,070,633 7,075,049
2.3% BB- NR* 1,000,000 Autopistas del Sol S.A., 10.25% due 8/01/2009 (c) 986,525 735,000
BB Ba3 2,500,000 Enterprises ShipHolding Corp., 8.875% due
5/01/2008 (c) 2,494,351 2,206,250
B NR* 5,000,000 MRS Logistica S.A., 10.625% due 8/15/2005 (c) 4,915,862 3,487,500
------------ ------------
15,467,371 13,503,799
===================================================================================================================================
Utilities--1.3% BB- Ba3 2,500,000 Cathay International Ltd., 13% due 4/15/2008 (c) 2,525,000 1,675,000
BB+ Baa3 2,300,000 Empresa Electrica del Norte S.A., 7.75% due
3/15/2006 (c) 2,077,128 2,037,131
B- Caa1 2,500,000 JTM Industries Inc., 10% due 4/15/2008 (c) 2,500,000 2,450,000
BB Ba2 2,750,000 Monterrey Power S.A. de C.V., 9.625% due
11/15/2009 (c) 2,749,195 1,925,000
------------ ------------
9,851,323 8,087,131
===================================================================================================================================
Wireless NR* NR* 9,428,571 American PCS, Term, due 2/07/2006** 9,428,571 9,357,857
Communications-- B B3 8,750,000 CTI Holdings S.A., 11.316% due 4/15/2008 (a)(c) 5,292,618 3,959,375
24.8% NR* NR* 15,000,000 Cellular Inc., Term A, due 9/30/2005** 14,987,883 14,953,125
NR* NR* 10,000,000 Cox Communications, Inc., Term B, due
12/31/2006** 10,025,000 9,981,250
NR* NR* 10,000,000 Metrocall Inc., Term B, due 12/31/2004** 10,000,000 9,993,750
</TABLE>
8 & 9
<PAGE>
Debt Strategies Fund II, Inc., August 31, 1998
SCHEDULE OF INVESTMENTS (concluded)
<TABLE>
<CAPTION>
S&P Moody's Face Value
INDUSTRIES Rating Rating Amount Corporate Debt Obligations Cost (Note 1b)
===================================================================================================================================
<S> <C> <C> <C> <C> <C> <C>
Wireless Nextel Communications, Inc.**:
Communications NR* NR* US$ 1,330,000 Revolving Credit, due 6/30/2003 $ 1,330,000 $ 1,308,388
(concluded) NR* NR* 1,250,000 Term A, due 3/31/2003 1,229,044 1,251,562
NR* NR* 25,000,000 Term B, due 9/30/2006 25,167,500 25,054,687
NR* NR* 30,000,000 Nortel, Term A, due 3/31/2006** 30,102,500 30,009,375
Omnipoint Communications Corp.**:
NR* NR* 3,876,617 Term A, due 2/17/2006 3,891,154 3,886,309
NR* NR* 1,123,383 Term B, due 2/17/2006 1,127,596 1,126,191
B+ B3 3,500,000 PTC International Finance B.V., 9.623% due
7/01/2007 (a) 2,538,179 2,292,500
NR* NR* 5,220,000 Paging Network, Inc., Revolving Credit, due
12/31/2004** 5,220,000 5,089,500
B Ba3 750,000 Price Communications Corp., 9.125% due
12/15/2006 (c) 750,000 701,250
BB+ Ba3 5,000,000 Rogers Cantel Inc., 9.375% due 6/01/2008 5,300,000 4,900,000
Sprint Spectrum L.P.**:
NR* NR* 17,791,736 Term 1, due 3/31/2006 17,862,874 17,813,976
NR* NR* 2,819,465 Term 2, due 6/29/2001 2,832,152 2,822,989
NR* NR* 1,210,241 Term 3, due 3/31/2006 1,215,687 1,211,754
NR* NR* 78,558 Term 4, due 3/31/2006 78,911 78,656
CCC+ Caa1 4,250,000 Telesystems International Wireless, Inc.,
10.052% due 11/01/2007 (a) 2,870,600 2,337,500
------------ ------------
151,250,269 148,129,994
===================================================================================================================================
Total Investments in Corporate Debt Obligations--
108.1% 678,554,287 646,571,675
===================================================================================================================================
<CAPTION>
Shares
Held Convertible Preferred Stock
===================================================================================================================================
<S> <C> <C> <C> <C>
Telephone 1,449 Viatel Inc. (b) 144,980 79,695
Communications--
0.0%
===================================================================================================================================
Total Investments in Convertible Preferred
Stock--0.0% 144,980 79,695
===================================================================================================================================
<CAPTION>
Face
Amount Short-Term Securities
===================================================================================================================================
<S> <C> <C> <C> <C>
Commercial US$ 767,000 Bombardier Capital Inc., 6.10% due 9/01/1998 767,000 767,000
Paper***--0.1%
===================================================================================================================================
Total Investments in Short-Term Securities--0.1% 767,000 767,000
===================================================================================================================================
Total Investments--108.2% $679,466,267 647,418,370
============
Unrealized Depreciation on Forward Foreign
Exchange Contracts--Net****--0.0% (55,352)
Liabilities in Excess of Other Assets--(8.2%) (49,255,441)
------------
Net Assets--100.0% $598,107,577
============
===================================================================================================================================
</TABLE>
(a) Represents a zero coupon bond or step bond; the interest rate shown
is the effective yield at the time of purchase by the Fund.
(b) Represents a pay-in-kind security which may pay interest/dividends
in additional face/shares.
(c) The security may be offered and sold to "qualified institutional
buyers" under Rule 144A of the Securities Act of 1933.
* Not Rated.
** Floating or Variable Rate Corporate Debt--The interest rates on
floating or variable rate corporate debt are subject to change
periodically based on the change in the prime rate of a US Bank,
LIBOR (London Interbank Offered Rate), or, in some cases, another
base lending rate. Corporate loans represent 71.4% of the Fund's net
assets.
*** Commercial Paper is traded on a discount basis; the interest rate
shown reflects the discount rate paid at the time of purchase by the
Fund.
**** Forward foreign exchange contracts as of August 31, 1998 were as
follows:
- --------------------------------------------------------------------------------
Unrealized
Foreign Expiration Depreciation
Currency Sold Date (Notes 1b & 1c)
- --------------------------------------------------------------------------------
(pound) 742,000 September 1998 $(29,784)
(pound) 695,175 November 1998 $(25,568)
- --------------------------------------------------------------------------------
Total Unrealized Depreciation on Forward Foreign
Exchange Contracts--Net
(US$ Commitment--$2,344,427) $(55,352)
========
- --------------------------------------------------------------------------------
See Notes to Financial Statements.
STATEMENT OF ASSETS, LIABILITIES AND CAPITAL
<TABLE>
<CAPTION>
As of August 31, 1998
==============================================================================================================================
<S> <C> <C> <C>
Assets: Investments, at value (identified cost--$679,466,267) (Note 1b) ........... $647,418,370
Foreign cash (Note 1d) .................................................... 17,730
Receivables:
Interest ................................................................ $ 8,925,454
Securities sold ......................................................... 4,052,186 12,977,640
-----------
Deferred facility fees .................................................... 20,197
Deferred organization expenses (Note 1g) .................................. 54,933
Prepaid expenses and other assets ......................................... 168,969
------------
Total assets .............................................................. 660,657,839
------------
==============================================================================================================================
Liabilities: Loans (Note 6) ............................................................ 59,000,000
Unrealized depreciation on forward foreign exchange contracts (Note 1c) ... 55,352
Payables:
Dividends to shareholders (Note 1h) ..................................... 1,545,703
Custodian bank (Note 1i) ................................................ 1,282,325
Interest on loans (Note 6) .............................................. 354,287
Investment adviser (Note 2) ............................................. 160,035
Commitment fees ......................................................... 8,637 3,350,987
-----------
Accrued expenses and other liabilities .................................... 143,923
------------
Total liabilities ......................................................... 62,550,262
------------
==============================================================================================================================
Net Assets: Net assets ................................................................ $598,107,577
============
==============================================================================================================================
Capital: Common Stock, $.10 par value, 200,000,000 shares authorized ............... $ 6,261,000
Paid-in capital in excess of par .......................................... 619,216,933
Undistributed investment income--net ...................................... 4,523,053
Undistributed realized capital gains on investments and foreign currency
transactions--net ......................................................... 281,897
Unrealized depreciation on investments and foreign currency
transactions--net ......................................................... (32,175,306)
------------
Net Assets--Equivalent to $9.55 per share based on 62,610,000 shares of
capital stock outstanding (market price--$8.375) .......................... $598,107,577
============
==============================================================================================================================
</TABLE>
See Notes to Financial Statements.
10 & 11
<PAGE>
Debt Strategies Fund II, Inc., August 31, 1998
STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
For the Period March 27, 1998+ to August 31, 1998
==============================================================================================================================
<S> <C> <C> <C>
Investment Income Interest and discount earned .............................................. $ 22,502,225
(Note 1f): Facility and other fees ................................................... 200,476
------------
Total income .............................................................. 22,702,701
------------
==============================================================================================================================
Expenses: Investment advisory fees (Note 2) ......................................... $ 1,630,253
Loan interest expense (Note 6) ............................................ 354,287
Borrowing costs (Note 6) .................................................. 99,030
Professional fees ......................................................... 49,007
Listing fees .............................................................. 28,183
Accounting services (Note 2) .............................................. 26,070
Directors' fees and expenses .............................................. 19,774
Custodian fees ............................................................ 18,047
Transfer agent fees (Note 2) .............................................. 17,314
Printing and shareholder reports .......................................... 11,663
Commitment fees ........................................................... 8,636
Pricing services .......................................................... 2,797
Amortization of organization expenses (Note 1g) ........................... 2,044
Other ..................................................................... 7,255
-----------
Total expenses before reimbursement ....................................... 2,274,360
Reimbursement of expenses (Note 2) ........................................ (1,100,652)
-----------
Expenses after reimbursement .............................................. 1,173,708
------------
Investment income--net .................................................... 21,528,993
------------
==============================================================================================================================
Realized & Realized gain from:
Unrealized Gain (Loss) Investments--net ........................................................ 248,694
On Investments & Foreign currency transactions--net ...................................... 33,203 281,897
Foreign Currency -----------
Transactions--Net Unrealized depreciation on:
(Notes 1c, 1d, 1f & 3): Investments--net ........................................................ (32,047,897)
Foreign currency transactions--net ...................................... (127,409) (32,175,306)
----------- ------------
Net Decrease in Net Assets Resulting from Operations ...................... $(10,364,416)
============
==============================================================================================================================
</TABLE>
+ Commencement of operations.
See Notes to Financial Statements.
STATEMENT OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
For the Period
March 27, 1998+ to
Increase (Decrease) in Net Assets: August 31, 1998
==============================================================================================================================
<S> <C> <C>
Operations: Investment income--net ............................................................. $ 21,528,993
Realized gain on investments and foreign currency transactions--net ................ 281,897
Unrealized depreciation on investments and foreign currency transactions--net ...... (32,175,306)
------------
Net decrease in net assets resulting from operations ............................... (10,364,416)
------------
==============================================================================================================================
Dividends to Investment income--net ............................................................. (17,005,940)
Shareholders ------------
(Note 1h): Net decrease in net assets resulting from dividends to shareholders ................ (17,005,940)
------------
==============================================================================================================================
Capital Share Proceeds from issuance of Common Stock ............................................. 626,000,000
Transactions Offering costs resulting from the issuance of Common Stock ......................... (622,067)
(Notes 1g & 4): ------------
Net increase in net assets resulting from capital share transactions ............... 625,377,933
------------
==============================================================================================================================
Net Assets: Total increase in net assets ....................................................... 598,007,577
Beginning of period ................................................................ 100,000
------------
End of period* ..................................................................... $598,107,577
============
==============================================================================================================================
* Undistributed investment income--net ............................................... $ 4,523,053
============
==============================================================================================================================
</TABLE>
+ Commencement of operations.
See Notes to Financial Statements.
12 & 13
<PAGE>
Debt Strategies Fund II, Inc., August 31, 1998
STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
For the Period
March 27, 1998+ to
August 31, 1998
==============================================================================================================================
<S> <C> <C>
Cash Provided by Net decrease in net assets resulting from operations .................................. $ (10,364,416)
Operating Activities: Adjustments to reconcile net decrease in net assets resulting from operations to net
cash provided by operating activities:
Increase in receivables ............................................................. (8,925,454)
Increase in other assets ............................................................ (244,099)
Increase in other liabilities ....................................................... 1,949,207
Realized and unrealized loss on investments and foreign currency transactions--net .. 31,893,409
Amortization of discount ............................................................ (3,730,981)
-------------
Net cash provided by operating activities ............................................. 10,577,666
-------------
==============================================================================================================================
Cash Used for Proceeds from sales of long-term investments .......................................... 178,558,201
Investing Activities: Purchases of long-term investments .................................................... (860,108,959)
Purchases of short-term investments ................................................... 2,224,657,138)
Proceeds from sales and maturities of short-term investments .......................... 2,226,630,264
-------------
Net cash used for investing activities ................................................ (679,577,632)
-------------
==============================================================================================================================
Cash Provided by Cash receipts on capital shares sold .................................................. 626,000,000
Financing Activities: Cash payments resulting from the issuance of shares ................................... (622,067)
Cash receipts from borrowings ......................................................... 67,000,000
Cash payments on borrowings ........................................................... (8,000,000)
Dividends paid to shareholders ........................................................ (15,460,237)
-------------
Net cash provided by financing activities ............................................. 668,917,696
-------------
==============================================================================================================================
Cash: Net decrease in cash .................................................................. (82,270)
Cash at beginning of period ........................................................... 100,000
-------------
Cash at end of period ................................................................. $ 17,730
=============
==============================================================================================================================
Cash Flow Cash paid for interest ................................................................ $ 0
Information: =============
==============================================================================================================================
</TABLE>
+ Commencement of operations.
See Notes to Financial Statements.
FINANCIAL HIGHLIGHTS
<TABLE>
<CAPTION>
The following per share data and ratios have been derived
from information provided in the financial statements. For the Period
March 27, 1998+ to
Increase (Decrease) in Net Asset Value: August 31, 1998
==============================================================================================================================
<S> <C> <C>
Per Share Net asset value, beginning of period .................................................. $ 10.00
Operating -------------
Performance: Investment income--net ................................................................ .34
Realized and unrealized loss on investments and foreign currency transactions--net .... (.51)
-------------
Total from investment operations ...................................................... (.17)
-------------
Less dividends from investment income--net ............................................ (.27)
-------------
Capital charge resulting from the issuance of Common Stock ............................ (.01)
-------------
Net asset value, end of period ........................................................ $ 9.55
=============
Market price per share, end of period ................................................. $ 8.375
=============
==============================================================================================================================
Total Investment Based on market price per share ....................................................... (13.83%)++
Return**: =============
Based on net asset value per share .................................................... (1.75%)++
=============
==============================================================================================================================
Ratios to Average Expenses, net of reimbursement and excluding interest expense ......................... .31%*
Net Assets: =============
Expenses, net of reimbursement ........................................................ .44%*
=============
Expenses .............................................................................. .85%*
=============
Investment income--net ................................................................ 8.06%*
=============
==============================================================================================================================
Leverage: Amount of borrowings, end of period (in thousands) .................................... $ 59,000
=============
Average amount of borrowings outstanding during the period (in thousands) ............. $ 13,241
=============
Average amount of borrowings outstanding per share during the period .................. $ 2.20
=============
==============================================================================================================================
Supplemental Net assets, end of period (in thousands) .............................................. $ 598,108
Data: =============
Portfolio turnover .................................................................... 34.13%
=============
==============================================================================================================================
</TABLE>
+ Commencement of operations.
++ Aggregate total investment return.
* Annualized.
** Total investment returns based on market value, which can be
significantly greater or lesser than the net asset value, may result
in substantially different returns. Total investment returns exclude
the effects of sales loads.
See Notes to Financial Statements.
14 & 15
<PAGE>
Debt Strategies Fund II, Inc., August 31, 1998
NOTES TO FINANCIAL STATEMENTS
1. Significant Accounting Policies:
Debt Strategies Fund II, Inc. (the "Fund") is registered under the Investment
Company Act of 1940 as a diversified, closed-end management investment company.
Prior to commencement of operations on March 27, 1998, the Fund had no
operations other than those relating to organizational matters and the issuance
of 10,000 shares of Common Stock to Fund Asset Management, L.P. ("FAM") for
$100,000 on March 20, 1998. These unaudited financial statements reflect all
adjustments which are, in the opinion of management, necessary to a fair
statement of the results for the interim period presented. All such adjustments
are of a normal recurring nature. The Fund determines and makes available for
publication the net asset value of its Common Stock on a weekly basis. The
Fund's Common Stock is listed on the New York Stock Exchange under the symbol
DSU.
(a) Corporate debt obligations--The Fund invests principally in debt obligations
of companies, including corporate loans made by banks and other financial
institutions and both privately and publicly offered corporate bonds and notes.
Because agents and intermediaries are primarily commercial banks, the Fund's
investment in corporate loans could be considered concentrated in financial
institutions.
(b) Valuation of investments--Corporate loans will be valued in accordance with
guidelines established by the Board of Directors. Under the Fund's current
guidelines, corporate loans will be valued at the average of the mean between
the bid and asked quotes received by one or more brokers, if available.
Other portfolio securities may be valued on the basis of prices furnished by one
or more pricing services which determines prices for normal, institutional-size
trading units of such securities using market information, transactions for
comparable securities and various relationships between securities which are
generally recognized by institutional traders. In certain circumstances,
portfolio securities are valued at the last sale price on the exchange that is
the primary market for such securities, or the last quoted bid price for those
securities for which the over-the-counter market is the primary market or for
listed securities in which there were no sales during the day. The value of
interest rate swaps, caps, and floors is determined in accordance with a formula
and then confirmed periodically by obtaining a bank quotation. Positions in
options are valued at the last sale price on the market where any such option is
principally traded. Short-term securities with remaining maturities of sixty
days or less are valued at amortized cost, which approximates market value.
Securities and assets for which market price quotations are not readily
available are valued at fair value as determined in good faith by or under the
direction of the Board of Directors of the Fund.
(c) Derivative financial instruments--The Fund may engage in various portfolio
strategies to seek to increase its return by hedging its portfolio against
adverse movements in the debt markets. Losses may arise due to changes in the
value of the contract or if the counterparty does not perform under the
contract.
o Financial futures contracts--The Fund may purchase or sell financial futures
contracts and options on such futures contracts for the purpose of hedging the
market risk on existing securities or the intended purchase of securities.
Futures contracts are contracts for delayed delivery of securities at a specific
future date and at a specific price or yield. Upon entering into a contract, the
Fund deposits and maintains as collateral such initial margin as required by the
exchange on which the transaction is effected. Pursuant to the contract, the
Fund agrees to receive from or pay to the broker an amount of cash equal to the
daily fluctuation in value of the contract. Such receipts or payments are known
as variation margin and are recorded by the Fund as unrealized gains or losses.
When the contract is closed, the Fund records a realized gain or loss equal to
the difference between the value of the contract at the time it was opened and
the value at the time it was closed.
o Forward foreign exchange contracts--The Fund is authorized to enter into
forward foreign exchange contracts as a hedge against either specific
transactions or portfolio positions. Such contracts are not entered on the
Fund's records. However, the effect on operations is recorded from the date the
Fund enters into such contracts. Premium or discount is amortized over the life
of the contracts.
o Options--The Fund is authorized to write covered call and put options and
purchase call and put options. When the Fund writes an option, an amount equal
to the premium received by the Fund is reflected as an asset and an equivalent
liability. The amount of the liability is subsequently marked to market to
reflect the current market value of the option written. When a security is
purchased or sold through an exercise of an option, the related premium paid (or
received) is added to (or deducted from) the basis of the security acquired or
deducted from (or added to) the proceeds of the security sold. When an option
expires (or the Fund enters into a closing transaction), the Fund realizes a
gain or loss on the option to the extent of the premiums received or paid (or
gain or loss to the extent the cost of the closing transaction exceeds the
premium paid or received).
Written and purchased options are non-income producing investments.
o Interest rate transactions--The Fund is authorized to enter into interest rate
swaps and purchase or sell interest rate caps and floors. In an interest rate
swap, the Fund exchanges with another party their respective commitments to pay
or receive interest on a specified notional principal amount. The purchase of an
interest rate cap (or floor) entitles the purchaser, to the extent that a
specified index exceeds (or falls below) a predetermined interest rate, to
receive payments of interest equal to the difference between the index and the
predetermined rate on a notional principal amount from the party selling such
interest rate cap (or floor).
(d) Foreign currency transactions--Transactions denominated in foreign
currencies are recorded at the exchange rate prevailing when recognized. Assets
and liabilities denominated in foreign currencies are valued at the exchange
rate at the end of the period. Foreign currency transactions are the result of
settling (realized) or valuing (unrealized) assets or liabilities expressed in
foreign currencies into US dollars. Realized and unrealized gains or losses from
investments include the effects of foreign exchange rates on investments.
(e) Income taxes--It is the Fund's policy to comply with the requirements of the
Internal Revenue Code applicable to regulated investment companies and to
distribute substantially all of its taxable income to its shareholders.
Therefore, no Federal income tax provision is required. Under the applicable
foreign tax law, a withholding tax may be imposed on interest, dividends and
capital gains at various rates.
(f) Security transactions and investment income--Security transactions are
recorded on the dates the transactions are entered into (the trade dates).
Dividend income is recorded on the ex-dividend dates. Interest income (including
amortization of discount) is recognized on the accrual basis. Realized gains and
losses on security transactions are determined on the identified cost basis.
Facility fees are accreted to income over the term of the related loan.
(g) Deferred organization expenses--Deferred organization expenses are amortized
on a straight-line basis over a period not exceeding five years. In accordance
with Statement of Position 98-5, any unamortized organization expenses will be
expensed on the first day of the next fiscal year beginning after December 15,
1998. This charge will not have any material impact on the operations of the
Fund. Direct expenses relating to the public offering of the Fund's Common Stock
were charged to capital at the time of issuance of the shares.
(h) Dividends and distributions--Dividends from net investment income are
declared and paid monthly. Distributions of capital gains are recorded on the
ex-dividend dates.
(i) Custodian bank--The Fund recorded an amount payable to the Custodian Bank
reflecting an overnight overdraft which resulted from an unprojected payment of
net investment income dividends.
2. Investment Advisory Agreement and Transactions with Affiliates:
The Fund has entered into an Investment Advisory Agreement with FAM. The general
partner of FAM is Princeton Services, Inc. ("PSI"), an indirect wholly-owned
subsidiary of Merrill Lynch & Co., Inc. ("ML & Co."), which is the limited
partner.
FAM is responsible for the management of the Fund's portfolio and provides the
necessary personnel, facilities, equipment and certain other services necessary
to perform the investment advisory function. For such services the Fund pays a
monthly fee at an annual rate of 0.60% of the Fund's
16 & 17
<PAGE>
Debt Strategies Fund II, Inc., August 31, 1998
NOTES TO FINANCIAL STATEMENTS (concluded)
average weekly net assets plus the proceeds of any outstanding borrowings used
for leverage. For the period March 27, 1998 to August 31, 1998, FAM earned fees
of $1,630,253, of which $1,053,859 was voluntarily waived. In addition, FAM also
reimbursed the Fund for additional expenses of $46,793.
For the period March 27, 1998 to August 31, 1998, the Fund paid Merrill Lynch
Security Pricing Service, an affiliate of Merrill Lynch, Pierce, Fenner & Smith
Inc. ("MLPF&S"), $21 for security price quotations to compute the net asset
value of the Fund.
Accounting services are provided to the Fund by FAM at cost.
Certain officers and/or directors of the Fund are officers and/or directors of
FAM, PSI, and/or ML & Co.
3. Investments:
Purchases and sales of investments, excluding short-term securities, for the
period March 27, 1998 to August 31, 1998 were $860,108,959 and $182,610,387,
respectively.
Net realized gains (losses) for the period March 27, 1998 to August 31, 1998 and
net unrealized losses as of August 31, 1998 were as follows:
- --------------------------------------------------------------------------------
Realized Unrealized
Gains (Losses) Losses
- --------------------------------------------------------------------------------
Long-term investments $ .................... 247,862 $(32,047,897)
Short-term investments ..................... 832 --
Forward foreign exchange contracts ......... (18,644) (55,352)
Foreign currency transactions .............. 51,847 (72,057)
------------ ------------
Total ...................................... $ 281,897 $(32,175,306)
============ ============
- --------------------------------------------------------------------------------
As of August 31, 1998, net unrealized depreciation for Federal income tax
purposes aggregated $32,047,897, of which $358,996 related to appreciated
securities and $32,406,893 related to depreciated securities. The aggregate cost
of investments at August 31, 1998 for Federal income tax purposes was
$679,466,267.
4. Capital Stock Transactions:
The Fund is authorized to issue 200,000,000 shares of Common Stock, par value
$.10 per share. Shares issued and outstanding during the period March 27, 1998
to August 31, 1998 increased by 62,600,000 from shares sold.
5. Unfunded Loan Interests:
As of August 31, 1998, the Fund had unfunded loan commitments of $19,869,000,
which would be extended at the option of the borrower, pursuant to the following
loan agreements:
- --------------------------------------------------------------------------------
Unfunded
Commitment
Borrower (in thousands)
- --------------------------------------------------------------------------------
E & S Holdings Corp. ........................................ $ 1,721
Metro Goldwyn Mayer Co. (MGM) ............................... 1,245
Mistic Beverage, Inc. ....................................... 142
NTL Group Inc. .............................................. 2,823
Nextel Communications, Inc. ................................. 1,185
Outsourcing Solutions, Inc. ................................. 2,223
PageNet ..................................................... 4,750
Snapple Beverage Corp. ...................................... 2,127
Specialty Foods, Inc. ....................................... 3,653
- --------------------------------------------------------------------------------
6. Short-Term Borrowings:
On July 15, 1998, the Fund entered into a one-year credit agreement with The
Bank of New York, Harris Trust and Savings Bank and certain other institutions
party thereto. The agreement is a $100,000,000 credit facility bearing interest
at the Prime Rate, the Federal Funds rate plus 0.48% and/or LIBOR plus 0.48%. On
September 10, 1998, the amount of the credit facility was increased to
$300,000,000. For the period March 27, 1998 to August 31, 1998, the average
amount borrowed was approximately $13,241,000 and the daily weighted average
interest rate was 6.18%. For the period March 27, 1998 to August 31, 1998,
facility and commitment fees aggregated approximately $99,000.
7. Commitments:
At August 31, 1998, the Fund had entered into foreign exchange contracts, in
addition to the contracts listed on the Schedule of Investments, under which it
had agreed to sell various foreign currencies with an approximate value of
$3,719,000.
8. Subsequent Event:
On September 8, 1998, the Fund's Board of Directors declared an ordinary income
dividend to Common Stock shareholders in the amount of $.072241 per share,
payable on September 30, 1998 to shareholders of record as of September 22,
1998.
PORTFOLIO INFORMATION
As of August 31, 1998
Percent of
Quality Ratings Long-Term
S&P/Moody's Investments
- --------------------------------------------------------------------------------
BBB/Baa ....................................................... 0.5%
BB/Ba ......................................................... 10.9
B/B ........................................................... 18.9
CCC/Caa ....................................................... 1.8
NR (Not Rated) ................................................ 67.9
- --------------------------------------------------------------------------------
* In cases when bonds are rated differently by Standard & Poor's Corporation
and Moody's Investors Service, Inc., bonds are categorized according to
the higher of the two ratings.
- --------------------------------------------------------------------------------
Percent of
Five Largest Industries Total Assets
- --------------------------------------------------------------------------------
Wireless Communications ....................................... 22.4%
Amusement & Recreational Services ............................. 8.4
Health Services ............................................... 8.2
Metals & Mining ............................................... 4.8
Telephone Communications ...................................... 4.7
- --------------------------------------------------------------------------------
Percent of
Ten Largest Holdings Total Assets
- --------------------------------------------------------------------------------
Nortel ........................................................ 4.5%
Nextel Communications, Inc. ................................... 4.2
Amphenol Corporation .......................................... 3.4
Sprint Spectrum L.P. .......................................... 3.3
Integrated Health Services, Inc. .............................. 2.7
Total Renal Care Holdings ..................................... 2.3
Starwood Hotels & Resorts ..................................... 2.3
Cellular Inc. ................................................. 2.3
Fred Meyer, Inc. .............................................. 2.2
Huntsman Corporation .......................................... 1.7
- --------------------------------------------------------------------------------
18 & 19
<PAGE>
Officers and Directors
Arthur Zeikel, President and Director
Ronald Forbes, Director
Cynthia A. Montgomery, Director
Charles C. Reilly, Director
Kevin A. Ryan, Director
Richard R. West, Director
Terry K. Glenn, Executive Vice President
R. Douglas Henderson, Senior Vice President
Joseph T. Monagle Jr., Senior Vice President
Donald C. Burke, Vice President
Gerald M. Richard, Treasurer
Patrick D. Sweeney, Secretary
Custodian and Transfer Agent
The Bank of New York
110 Washington Street
New York, NY 10286
NYSE Symbol
DSU
This report, including the financial information herein, is transmitted to the
shareholders of Debt Strategies Fund II, Inc. for their information. It is not a
prospectus, circular or representation intended for use in the purchase of
shares of the Fund or any securities mentioned in the report. Past performance
results shown in this report should not be considered a representation of future
performance. The Fund has the ability to leverage its Common Stock to provide
Common Stock shareholders with a potentially higher rate of return. Leverage
creates risk for Common Stock shareholders, including the likelihood of greater
volatility of net asset value and market price of Common Stock shares, and the
risk that fluctuations in short-term interest rates may reduce the Common
Stock's yield. Statements and other information herein are as dated and are
subject to change.
Debt Strategies
Fund II, Inc.
Box 9011
Princeton, NJ
08543-9011 #DEBTII--8/98
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