DEBT
STRATEGIES
FUND III, INC.
[GRAPHIC OMITTED]
STRATEGIC
Performance
Semi-Annual Report
August 31, 1998
<PAGE>
DEBT STRATEGIES FUND III, INC.
The Benefits and Risks of Leveraging
Debt Strategies Fund III, 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 III, Inc., August 31, 1998
DEAR SHAREHOLDER
We are pleased to provide you with this first semi-annual report for Debt
Strategies Fund III, 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 (July 31, 1998) through August 31, 1998, the total investment
return on the Fund's Common Stock was -0.10%, based on a change in per share net
asset value from $10.00 to $9.99. During the same period, the net annualized
yield of the Fund's Common Stock was 6.26%.
The Environment
The capital markets have been volatile since the Fund's inception in July.
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
In this environment, we expect to be conservatively opportunistic in selecting
prospective investments. As of August 31, 1998, we continued to hold a large
cash position, anticipating further yield spread expansion in both the
high-yield and leveraged loan markets. We are beginning to see compelling values
in both markets, and plan on investing our cash position during the coming
months. 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 40% weighting in floating rate secured loans.
Market Overview
Demand for bank loans was robust through July; however, as the liquidity in the
capital markets dried up with the increased volatility, bank transactions
announced in August offered wider London Interbank Offered Rate (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 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 vol ume increased to $140 billion during the first six
months of 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 puts 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.
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,
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 a
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, and we intend to take advantage of our very
liquid position.
In Conclusion
We appreciate your investment in Debt Strategies Fund III, 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 13, 1998
2 & 3
<PAGE>
Debt Strategies Fund III, Inc., August 31, 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>
Amusement & B- B3 US $1,000,000 Bell Sports, Inc., 11% due 8/15/2008 (a) $ 1,000,000 $ 962,500
Recreational B B3 500,000 Loews Cineplex Entertainment Corp., 8.875% due 8/01/2008 495,943 472,500
Services--1.3% ----------- -----------
1,495,943 1,435,000
====================================================================================================================================
Automotive B- B3 2,000,000 Key Plastics, Inc., 10.25% due 3/15/2007 1,980,020 1,980,000
Equipment--
1.8%
====================================================================================================================================
Cable--2.6% B B3 3,000,000 Coaxial Communications of Ohio, Inc., 10% due 8/15/2006 3,000,000 2,910,000
====================================================================================================================================
Chemicals--9.0% NR* NR* 5,000,000 AOC LLC, Term B, due 9/30/2006 (b) 4,987,500 4,987,500
NR* Ba2 3,000,000 Huntsman Corp., Term, due 12/31/2002 (b) 2,996,256 2,985,000
NR* B1 1,961,297 Pioneer American Holding Corporation, Term,
due 12/05/2006 (b) 1,961,297 1,958,845
----------- -----------
9,945,053 9,931,345
====================================================================================================================================
Consumer B+ B2 250,000 Evenflo Company Inc., 11.75% due 8/15/2006 (a) 250,000 243,750
Products--1.2% B+ Ba3 1,000,000 Shop-Vac Corp., 10.625% due 9/01/2003 (a) 1,101,250 1,055,000
----------- -----------
1,351,250 1,298,750
====================================================================================================================================
Drilling--2.9% B+ B1 3,000,000 Cliffs Drilling Company, 10.25% due 5/15/2003 3,120,000 3,180,000
====================================================================================================================================
Energy--1.8% NR* Ba2 2,000,000 Clark Refining, Term, due 11/15/2004 (b) 2,000,000 1,972,500
====================================================================================================================================
Gaming--3.8% B+ B1 1,000,000 Argosy Gaming Co., 13.25% due 6/01/2004 1,015,000 1,015,000
B B1 1,000,000 Casino America, Inc., 12.50% due 8/01/2003 1,065,000 1,065,000
BB- B1 1,000,000 Horshoe Gaming LLC, 12.75% due 9/30/2000 1,070,000 1,070,000
B+ B2 1,000,000 Lady Luck Gaming, 11.875% due 3/01/2001 1,015,000 1,002,500
----------- -----------
4,165,000 4,152,500
====================================================================================================================================
Hotels & B+ B1 1,000,000 Intrawest Corporation, 9.75% due 8/15/2008 984,440 965,000
Motels--0.9%
====================================================================================================================================
Metals & B- B2 2,430,000 AEI Holding Co., 10% due 11/15/2007 (a) 2,463,826 2,308,500
Mining--6.6% B B3 2,000,000 Neff Corporation, 10.25% due 6/01/2008 (a) 1,920,038 1,920,000
NR* NR* 3,000,000 Ormet Corporation, Term, due 8/15/2008 (b) 2,992,514 3,000,000
----------- -----------
7,376,378 7,228,500
====================================================================================================================================
Packaging-- NR* NR* 1,285,714 Graham Packaging, Term, due 1/31/2007 (b) 1,285,714 1,285,714
1.2%
====================================================================================================================================
Paper--2.7% NR* NR* 3,000,000 Repap New Brunswick, Inc., Term, due 6/01/2004 (b) 3,030,000 3,030,000
====================================================================================================================================
Telephone NR* Caa1 DM 1,000,000 Espirit Telecom Group PLC, 11% due 6/15/2008 (a) 579,461 527,660
Communications--
0.5%
====================================================================================================================================
Total Investments in Corporate Debt Obligations--36.3% 40,313,259 39,896,969
====================================================================================================================================
</TABLE>
<TABLE>
<CAPTION>
Short-Term Investments
===================================================================================================================================
<S> <C> <C> <C> <C>
Commercial US $5,000,000 American Stores Company, 5.70% due 9/09/1998 4,993,667 4,993,667
Paper**--58.2% 4,000,000 Armstrong World Industries, Inc., 5.70% due 9/03/1998 3,998,733 3,998,733
5,000,000 Atlas Funding Corporation, 5.75% due 9/02/1998 4,999,201 4,999,201
5,042,000 Cincinnati Bell Inc., 5.70% due 9/15/1998 5,030,824 5,030,824
4,666,000 Cox Enterprises Inc., 5.68% due 10/14/1998 4,634,344 4,634,344
5,000,000 El Paso Natural Gas Co., 5.70% due 9/16/1998 4,988,125 4,988,125
5,000,000 ITT Financial Corp., 5.70% due 9/25/1998 4,981,000 4,981,000
5,000,000 Lockheed Martin Corp., 5.67% due 9/04/1998 4,997,637 4,997,637
5,000,000 Occidental Petroleum Corp., 5.74% due 9/03/1998 4,998,406 4,998,406
5,500,000 Sumitomo Bank Ltd., 5.88% due 10/01/1998 5,473,050 5,473,050
5,000,000 Texas Utilities Co., 5.70% due 9/14/1998 4,989,708 4,989,708
5,000,000 Union Pacific Corp., 5.70% due 9/01/1998 5,000,000 5,000,000
5,000,000 Volvo Group Treasury, N.A., 5.70% due 10/01/1998 4,976,250 4,976,250
----------- -----------
64,060,945 64,060,945
===================================================================================================================================
US Government 8,691,000 Federal National Mortgage Association, 5.45%
Agency due 9/18/1998 8,668,633 8,668,633
Obligations**--7.9%
===================================================================================================================================
Total Short-Term Investments--66.1% 72,729,578 72,729,578
===================================================================================================================================
Total Investments--102.4% $113,042,837 112,626,547
=============
Time Deposit+--2.7% 3,020,000
Liabilities in Excess of Other Assets--(5.1%) (5,654,620)
------------
Net Assets--100.0% $109,991,927
============
===================================================================================================================================
</TABLE>
(a) The security may be offered and sold to "qualified
institutional buyers" under Rule 144A of the Securities Act of
1933.
(b) 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
17.5% of the Fund's net assets.
+ Time deposit bears interest at 5.75% with maturity on
9/01/1998.
* Not Rated.
** Commercial Paper and certain US Government Agency Obligations
are traded on a discount basis; the interest rates shown
reflect the discount rates paid at the time of purchase by the
Fund.
See Notes to Financial Statements.
4 & 5
<PAGE>
Debt Strategies Fund III, Inc., August 31, 1998
STATEMENT OF ASSETS, LIABILITIES AND CAPITAL
<TABLE>
<CAPTION>
As of August 31, 1998
===================================================================================================================================
<S> <C> <C> <C>
Assets: Investments, at value (identified cost--$113,042,837) (Note 1b) ................. $ 112,626,547
Cash ............................................................................ 311,175
Time deposits ................................................................... 3,020,000
Receivables:
Interest ...................................................................... $ 546,202
Investment adviser (Note 2) ................................................... 37,569 583,771
------------
Deferred organization expenses (Note 1g) ........................................ 13,000
-------------
Total assets .................................................................... 116,554,493
-------------
===================================================================================================================================
Liabilities: Payables:
Securities purchased .......................................................... 6,236,618
Offering costs (Note 1g) ...................................................... 295,000 6,531,618
------------
Accrued expenses and other liabilities .......................................... 30,948
-------------
Total liabilities ............................................................... 6,562,566
-------------
===================================================================================================================================
Net Assets: Net assets ...................................................................... $ 109,991,927
=============
===================================================================================================================================
Capital: Common Stock, $.10 par value, 200,000,000 shares authorized ..................... $ 1,101,000
Paid-in capital in excess of par ................................................ 108,704,000
Undistributed investment income--net ............................................ 605,725
Undistributed realized capital gains on investments and
foreign currency transactions--net .............................................. 1,881
Unrealized depreciation on investments and foreign
currency transactions--net ...................................................... (420,679)
-------------
Total--Equivalent to $9.99 per share based on 11,010,000
shares of capital stock outstanding (market price--$9.00) ..................... $ 109,991,927
=============
===================================================================================================================================
</TABLE>
See Notes to Financial Statements.
STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
For the Period July 31, 1998+ to August 31, 1998
===================================================================================================================================
<S> <C> <C> <C>
Investment Income Interest and discount earned ................................................ $ 606,975
(Note 1f):
===================================================================================================================================
Expenses: Investment advisory fees (Note 2) ........................................... $ 57,890
Professional fees ........................................................... 15,291
Accounting services (Note 2) ................................................ 6,175
Directors' fees and expenses ................................................ 5,390
Custodian fees .............................................................. 4,176
Listing fees ................................................................ 3,766
Transfer agent fees (Note 2) ................................................ 1,695
Printing and shareholder reports ............................................ 1,221
Pricing services ............................................................ 261
Amortization of organization expenses (Note 1g) ............................. 235
Other ....................................................................... 609
---------
Total expenses before reimbursement ......................................... 96,709
Reimbursement of expenses (Note 2) .......................................... (95,459)
---------
Total expenses after reimbursement .......................................... 1,250
------------
Investment income--net ...................................................... 605,725
------------
===================================================================================================================================
Realized & Unrealized Realized gain (loss) from:
Gain (Loss) on Investments--net .......................................................... (183)
Investments & Foreign currency transactions--net ........................................ 2,064 1,881
Foreign Currency ---------
Transactions--Net Unrealized depreciation on:
(Notes 1c, 1d, 1f & 3): Investments--net .......................................................... (416,290)
Foreign currency transactions--net ........................................ (4,389) (420,679)
--------- ------------
Net realized and unrealized loss on investments and
foreign currency transactions ............................................... (418,798)
------------
Net Increase in Net Assets Resulting from Operations ........................ $ 186,927
============
===================================================================================================================================
</TABLE>
+ Commencement of operations.
See Notes to Financial Statements.
6 & 7
<PAGE>
Debt Strategies Fund III, Inc., August 31, 1998
STATEMENT OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
For the Period
July 31, 1998+ to
Increase (Decrease) in Net Assets: August 31, 1998
===================================================================================================================================
<S> <C> <C>
Operations: Investment income--net ...................................................... $ 605,725
Realized gain on investments and foreign currency transactions--net ......... 1,881
Unrealized depreciation on investments and foreign currency
transactions--net ........................................................... (420,679)
-------------
Net increase in net assets resulting from operations ........................ 186,927
-------------
===================================================================================================================================
Capital Share Proceeds from issuance of Common Stock ...................................... 110,000,000
Transactions Offering costs resulting from the issuance of Common Stock .................. (295,000)
(Notes 1g & 4): -------------
Net increase in net assets resulting from capital share transactions ........ 109,705,000
-------------
===================================================================================================================================
Net Assets: Total increase in net assets ................................................ 109,891,927
Beginning of period ......................................................... 100,000
-------------
End of period* .............................................................. $ 109,991,927
=============
===================================================================================================================================
* Undistributed investment income--net ........................................ $ 605,725
=============
===================================================================================================================================
</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
July 31, 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 .......................................................... .06
Realized and unrealized loss on investments and
foreign currency transactions--net .............................................. (.04)
---------
Total from investment operations ................................................ .02
---------
Capital charge resulting from the issuance of Common Stock ...................... (.03)
---------
Net asset value, end of period .................................................. $ 9.99
=========
Market price per share, end of period ........................................... $ 9.00
=========
================================================================================================================================
Total Investment Based on market price per share ................................................. (10.00%)++
Return:** =========
Based on net asset value per share .............................................. (.10%)++
=========
================================================================================================================================
Ratios to Average Expenses, net of reimbursement .................................................. .01%*
Net Assets: =========
Expenses ........................................................................ 1.00%*
=========
Investment income--net .......................................................... 6.28%*
=========
================================================================================================================================
Supplemental Net assets, end of period (in thousands) ........................................ $ 109,992
Data: =========
Portfolio turnover .............................................................. 6.24%
=========
================================================================================================================================
</TABLE>
* 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.
+ Commencement of operations.
++ Aggregate total investment return.
See Notes to Financial Statements.
8 & 9
<PAGE>
Debt Strategies Fund III, Inc., August 31, 1998
NOTES TO FINANCIAL STATEMENTS
1. Significant Accounting Policies:
Debt Strategies Fund III, 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 July 31, 1998, the Fund had no operation
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
July 24, 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 DBU.
(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 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 and offering 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.
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 average weekly net assets
plus the proceeds of any outstanding borrowings used for leverage. For the
period July 31, 1998 to August 31, 1998, FAM earned fees of $57,890 all of which
was voluntarily waived. FAM also reimbursed the Fund for additional expenses of
$37,569.
Accounting services are provided to the Fund by FAM at cost.
10 & 11
<PAGE>
Debt Strategies Fund III, Inc., August 31, 1998
NOTES TO FINANCIAL STATEMENTS (concluded)
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 July 31, 1998 to August 31, 1998 were $47,304,383 and $6,991,250,
respectively.
Net realized gains (losses) for the period July 31, 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 ...................... -- $(416,290)
Short-term investments ..................... $ (183) --
Foreign currency transactions .............. 2,064 (4,389)
--------- ---------
Total $ 1,881 $(420,679)
========= =========
- --------------------------------------------------------------------------------
As of August 31, 1998, net unrealized depreciation for Federal income tax
purposes aggregated $416,290, of which $67,486 related to appreciated securities
and $483,776 related to depreciated securities. The aggregate cost of
investments at August 31, 1998 for Federal income tax purposes was $113,042,837.
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 July 31, 1998 to
August 31, 1998 increased by 11,000,000 from shares sold.
5. Commitments:
On August 31, 1998, the Fund had entered into foreign exchange contracts, under
which it had agreed to sell various foreign currency with an approximate value
of $591,000.
6. Subsequent Event:
On October 8, 1998, the Fund's Board of Directors declared an ordinary income
dividend to Common Stock shareholders in the amount of $.118714 per share,
payable on October 30, 1998 to shareholders of record as of October 22, 1998.
PORTFOLIO PROFILE
As of August 31, 1998
Percent of
Quality Ratings Long-Term
S&P/Moody's* Investments
- --------------------------------------------------------------------------------
BB/Ba .................................................... 17.8%
B/B ...................................................... 50.1
CCC/Caa .................................................. 1.3
NR (Not Rated) ........................................... 30.8
- --------------------------------------------------------------------------------
* 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
- --------------------------------------------------------------------------------
Chemicals ............................................... 8.5%
Metals & Mining ......................................... 6.2
Gaming .................................................. 3.6
Drilling ................................................ 2.7
Paper ................................................... 2.6
- --------------------------------------------------------------------------------
Percent of
Ten Largest Holdings Total Assets
- --------------------------------------------------------------------------------
AOC LLC, Term B, due 9/30/2006 .......................... 4.3%
Cliffs Drilling Company, 10.25% due 5/15/2003 .......... 2.7
Repap New Brunswick, Inc., Term, due 6/01/2004 .......... 2.6
Ormet Corporation, Term, due 8/15/2008 .................. 2.6
Huntsman Corp., Term, due 12/31/2002 .................... 2.6
Coaxial Communications of Ohio, Inc., 10% due 8/15/2006 . 2.5
AEI Holding Co., 10% due 11/15/2007 ..................... 2.0
Key Plastics, Inc., 10.25% due 3/15/2007 ................ 1.7
Clark Refining, Term, due 11/15/2004 .................... 1.7
Pioneer American Holding Corporation, Term, due
12/05/2006 ............................................ 1.7
- --------------------------------------------------------------------------------
12 & 13
<PAGE>
Debt Strategies Fund III, Inc., August 31, 1998
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 & Transfer Agent
State Street Bank and Trust Company
225 Franklin Street
Boston, MA 02110
NYSE Symbol
DBU
14
<PAGE>
This report, including the financial information herein, is transmitted to the
shareholders of Debt Strategies Fund III, 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 III, Inc.
Box 9011
Princeton, NJ
08543-9011 #DEBT03--8/98
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