DEBT
STRATEGIES
FUND III, INC.
STRATEGIC
Performance
[GRAPHIC OMITTED]
Annual Report
February 28, 1999
<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., February 28, 1999
DEAR SHAREHOLDER
Since inception (July 31, 1998) through February 28, 1999, the total investment
return on Debt Strategies Fund III, Inc.'s Common Stock was +4.89%, based on a
change in per share net asset value from $10.00 to $10.05, and assuming
reinvestment of $0.399 per share income dividends. During the same period, the
net annualized yield of the Fund's Common Stock was 7.99%. For the three-month
period ended February 28, 1999, the Fund was 13.7% leveraged as a percentage of
total assets, having borrowed $18 million of its $55 million credit facility at
an average rate of 5.21%. (For a complete explanation of the benefits and risks
of leverage, see page 1 of this report to shareholders.)
The Fund's benchmark, which is comprised of the average return of the unmanaged
Donaldson, Lufkin and Jenrette (DLJ) Loan Index (which returned +0.92% for the
period) and the unmanaged DLJ High Yield Index (which returned -3.42%) had a
total return of +1.25% for the period July 31, 1998 to February 28, 1999. The
variance between the Fund's return and the benchmark is generally attributable
to the Fund limiting its bond exposure until November, after the correction.
Portfolio Strategy
During the six months ended February 28, 1999, we repositioned the portfolio to
overweight high-yield bonds instead of loans. Bonds represented 60% of the
Fund's assets at the end of the current period compared to 33% last August. We
are also beginning to select more second-tier and third-tier bond issues where
we believe good value exists. Despite ongoing investor concerns after 1998's
correction, the underpinnings of the high-yield market remain sound with strong
mutual fund inflows and an expanding buyer base. Thus, we believe demand will
outweigh supply in 1999, which would lead to tighter yield spreads in the
high-yield market relative to late 1998 levels. However, we are prepared to
change our strategy and become more defensive if market conditions warrant.
Our shift in investment strategy reflects our optimism toward high-yield bonds
as we see a tremendous opportunity in the high-yield market against a backdrop
of an economy that continues to surprise economists and outperform their
consensus growth rates. Over the next few quarters, we believe the high-yield
market should continue to regain the value it lost last fall and spreads should
tighten to normalized levels. (We discuss the performance of high-yield debt and
corporate loans during last year's market correction in "The Environment"
section that follows.) With strong data on employment levels, income growth and
consumer confidence through February, gross domestic product growth should
continue at a pace that is very supportive to the high-yield market, in our
opinion. With the fragility of Brazil and Asia still a major concern, we believe
the Federal Reserve Board is unlikely to tighten its monetary policy and will
maintain a neutral policy for the near term.
Currently, there are some unique circumstances in the high-yield sector.
Absolute yields and spreads are relatively high compared to prior periods, yet
major drivers of the market, the economy and default rates, are demonstrative of
a very strong market. General interest rates are also relatively low compared to
previous years, which provides more cash flow and refinancing opportunities to
high-yield borrowers. In addition, the equity markets are at relatively high
levels and investor interest remains strong in initial public offerings,
providing financing alternatives not available to issuers in prior years. With
few fixed-income markets providing double-digit yields, we believe that the
high-yield asset class should attract more investors. If capital markets
continue to stabilize, we believe that the need to outperform will push
high-yield investors more aggressively down the credit spectrum as their
appetite for risk increases.
As of February 28, 1999, virtually all 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. LIBOR
historically has been strongly correlated to the Federal Funds rate. Since the
average reset on the Fund's floating rate investments is 38 days, the yield on
the Fund's bank loan investments is likely to move up or down within a one
month-two month period after any LIBOR rate change. Therefore, bank loans tend
to provide a good hedge against rising interest rates.
As of February 28, 1999, the weighted average maturity of the Fund's loan
investments was 5.8 years and the bond portfolio was 7.9 years. Because the
loans in the portfolio are prepayable at no cost to the borrower, on average
they are likely to prepay in two years. However, borrowers are under no
obligation to repay their loans until maturity. The LIBOR spread (averaging
3.33% on February 28, 1999) on each loan is a contractual percentage and cannot
change unless legally amended. LIBOR was 5.0% at the end of February; therefore,
the average gross yield on our bank loan investments was 8.33%.
At February 28, 1999, the Fund was fully invested, but had the ability to borrow
on its credit line. As of period-end, $37 million remained available for the
Fund to borrow under its $55 million credit facility. By period-end, the Fund's
floating rate loan investments were spread across 21 borrowers in 16 industries.
Fixed-rate investments were spread across 103 borrowers in 33 industries.
The Environment
Since our last report to shareholders, the credit markets virtually shut down
through mid-October. Fallout in the emerging markets and hedge fund arena spread
to the domestic high-yield bond and leveraged loan markets, reducing demand and
trading liquidity to levels not seen since the recession in 1990. However,
market circumstances were different in 1998 compared to 1990. In 1990, the
economy was in a recession, the corporate debt default rate exceeded 10%, and
the high-yield bond and loan markets were much smaller and more susceptible to
drastic swings. In 1998, these markets had strong fundamentals with domestic
economic growth of 3.9% and a below-average default rate of 1.6% (incorporating
only domestic and non-emerging market issues). Consequently, the correction was
largely technical and poised for a recovery when confidence and liquidity
returned to the marketplace.
However, the most recent correction had a major impact on the market indexes and
prices of the bonds and loans in our portfolio. High-yield bond prices fell
sharply as high-yield spreads relative to credit risk-free US Treasury bonds
widened to levels last experienced in the 1990-1991 recession. At the same time,
demand only existed for the largest issuers with the strongest credit
fundamentals. In July 1998, 1.7% of the outstanding bonds in the high-yield
market yielded more than 20%; in October, 8.4% of high-yield issues yielded over
20%. The market experienced a credit crunch, and no new high-yield debt was
issued for several weeks last fall. During the correction, the leveraged loan
market was also punished. Although we cannot compare recent experience to
1990-1991 since the leveraged loan market was then at its infancy, 1998 was the
worst year in the past five.
After the Federal Reserve Board's third interest rate cut in October, the
fixed-income markets began to recover. However, market conditions remain fragile
as investors are wary that a new set of negative events could trigger another
liquidity crisis. Therefore, as discussed, we are monitoring economic and market
conditions carefully to determine if we should adopt a more defensive strategy.
For 1998, leverage loan new-issue volume grew 45% to $316 billion, a new record.
Loan trading volume also reached record levels, increasing approximately 10% to
nearly $70 billion. The new-issue and trading volumes in the loan market were
particularly impressive given the market's correction last fall. Investor
interest in corporate loans continued to broaden, including high-yield mutual
funds, new loan mutual funds, insurance companies, hedge funds, pension plans
and leveraged vehicles focused exclusively on loans known as collateralized loan
obligations. The number of buyers of institutional leveraged loans (excluding
the loans taken by commercial banks) has grown from less than 10 in 1990 to over
100 as of February 28, 1999. The stability and returns of the asset class have
attracted numerous institutions.
With leveraged buyouts providing the majority of financings for our markets, the
$55 billion raised by buyout sponsors in 1998 has the potential to produce
another record year for new loans in 1999. Recently, cash inflows into the
leveraged loan market have made it very competitive. Trading volume increased
markedly since the 1998 correction and 1999 trading volumes are likely to
surpass 1998 levels, potentially reaching $100 billion.
The high-yield market also had a record year in 1998 in terms of overall size
and new issuance, with a record high in new issuance for the third consecutive
year. Media and telecommunications continued to dominate new issuance,
accounting for $60 billion of the total primary market. The overall high-yield
market (limited to US dollar-denominated issues) grew 26.5% to $572 billion,
also a record level. Dealers estimated trading volume reached a record $300
billion.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Joseph T. Monagle Jr.
Joseph T. Monagle Jr.
Senior Vice President
April 20, 1999
================================================================================
We are pleased to announce that Richard C. Kilbride, Paul Travers and Gilles
Marchand have each been appointed Vice President and Portfolio Manager of Debt
Strategies Fund III, Inc. Mr. Kilbride has almost 20 years experience in the
fixed-income markets and has previously served as a Managing Director of Fixed
Income for Merrill Lynch Asset Management, L.P. (MLAM) and its affiliated asset
management companies in London and in Los Angeles. Mr. Travers joined MLAM's
Bank Loan Portfolio Group last year, bringing with him 15 years of diversified
professional experience in the bank loan industry. He was previously Head of
U.S. Corporate Banking in the New York branch of BHF-BANK. Mr. Marchand has been
a Bank Loan Credit Analyst for MLAM for the last three years and has almost 10
years buy side experience in a wide range of fixed-income securities.
These appointments follow the resignation of R. Douglas Henderson as Senior
Portfolio Manager. Mr. Henderson has left MLAM to pursue opportunities on the
sell side of the loan participation market. We appreciate the contribution Mr.
Henderson made to the growth of the Fund and we wish him well for the future. We
continue to have an excellent team of portfolio managers and analysts in place,
and we look forward to building upon the successful performance of the Fund to
date. You will be hearing directly from Messrs. Kilbride, Travers and Marchand
in subsequent reports.
================================================================================
2 & 3
<PAGE>
Debt Strategies Fund III, Inc., February 28, 1999
- --------------------------------------------------------------------------------
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 & B- B3 US$ 500,000 Argo-Tech Corp., 8.625% due 10/01/2007 (c) $ 475,373 $ 470,000
Parts--1.8% B B1 500,000 BE Aerospace, 9.50% due 11/01/2008 (c) 500,000 526,250
B- Caa1 1,000,000 Compass Aerospace Corp., 10.125% due
4/15/2005 (c) 963,048 955,000
------------ ------------
1,938,421 1,951,250
====================================================================================================================================
Amusement & B- B3 450,000 AMC Entertainment, Inc., 9.50% due
Recreational 2/01/2011 (c) 450,000 444,375
Services--3.6% B- B3 1,000,000 Bell Sports Inc., 11% due 8/15/2008 1,000,000 1,020,000
B B2 200,000 Carmike Cinemas Inc., 9.375% due
2/01/2009 (c) 200,000 203,000
CCC+ B3 500,000 Hollywood Entertainment, 10.625% due
8/15/2004 (c) 511,250 507,500
BB+ B1 1,250,000 Intrawest Corp., 9.75% due 8/15/2008 1,242,407 1,289,062
B B3 500,000 Loews Cineplex Entertainment, 8.875% due
8/01/2008 496,072 501,250
------------ ------------
3,899,729 3,965,187
====================================================================================================================================
Apparel--2.7% NR* NR* 2,000,000 CS Brooks, Term, due 6/25/2006 (a) 1,990,274 1,985,000
NR* NR* 997,500 Norcross Safety Products, Term, due
12/31/2005 (a) 997,500 997,500
------------ ------------
2,987,774 2,982,500
====================================================================================================================================
Automotive BB B1 1,000,000 Breed Technologies Inc., Term B, due
Equipment--4.6% 4/27/2006 (a) 820,187 840,000
BB+ Ba2 570,000 Federal-Mogul Corp., 7.50% due 1/15/2009 (c) 567,544 553,274
B B2 250,000 Hayes Lemmerz International Inc., 8.25%
due 12/15/2008 (c) 250,000 251,250
B- B3 2,000,000 Key Plastics, Inc., 10.25% due 3/15/2007 1,980,772 1,950,000
B- B3 400,000 Special Devices Inc., 11.375% due
12/15/2008 (c) 400,000 404,000
B+ B2 1,100,000 Venture Holdings Trust, 9.50% due 7/01/2005 1,101,250 1,067,000
------------ ------------
5,119,753 5,065,524
====================================================================================================================================
Broadcast-- B B2 2,925,000 Ackerley Group Inc., 9% due 1/15/2009 (c) 2,952,328 2,998,125
Radio & B- B3 300,000 Citadel Broadcasting Co., 9.25% due
Television--5.1% 11/15/2008 (c) 312,750 319,500
CCC+ B3 1,000,000 Paxson Communications Corporation, 11.625%
due 10/01/2002 1,010,000 1,002,500
NR* Caa1 2,500,000 Radio Unica Corp., 14.774% due 8/01/2006 (b) 1,410,011 1,375,000
------------ ------------
5,685,089 5,695,125
====================================================================================================================================
Building & B- B2 325,000 Webb (Del E.) Corp., 10.25% due 2/15/2010 319,775 323,781
Construction--0.3%
====================================================================================================================================
Building B B3 1,050,000 Amatek Industries Property Ltd., 12% due
Materials--1.7% 2/15/2008 (c) 995,229 1,005,375
B B2 900,000 Republic Group Inc., 9.50% due 7/15/2008 885,247 911,250
------------ ------------
1,880,476 1,916,625
====================================================================================================================================
Cable--7.5% B B3 250,000 @ Entertainment Inc., 17.50% due
2/01/2009 (b)(c) 98,983 102,500
NR* Ba3 1,000,000 Charter Communications Entertainment, Term,
due 9/30/2007 (a) 995,149 1,001,250
B B3 3,500,000 Coaxial Communications/Phoenix, 10% due
8/15/2006 3,496,358 3,710,000
CCC+ Caa1 2,000,000 Coaxial LLC/Coaxial Finance, 11.864% due
8/15/2008 (b) 1,240,724 1,200,000
B- B3 950,000 Rifkin Acquisition Partners LP, 11.125%
due 1/15/2006 1,036,437 1,064,000
B+ B1 1,000,000 Telewest Communications PLC, 11.25% due
11/01/2008 (c) 1,000,000 1,180,000
------------ ------------
7,867,651 8,257,750
====================================================================================================================================
Chemicals--4.6% BBB- Baa3 1,000,000 Equistar Chemicals LP, 8.75% due
2/15/2009 (c) 997,186 1,021,250
BB Ba2 2,086,325 Huntsman Corporation, Term, due
12/31/2002 (a) 2,083,980 2,055,031
NR* B1 1,941,486 Pioneer America's, Inc., Term, due
12/05/2006 (a) 1,941,486 1,941,486
------------ ------------
5,022,652 5,017,767
====================================================================================================================================
Consumer B+ B2 250,000 Evenflo Co. Inc., 11.75% due 8/15/2006 (c) 250,000 255,000
Products--1.6% B+ B2 360,000 Scotts Company, 8.625% due 1/15/2009 (c) 360,000 370,800
B+ Ba3 1,000,000 Shop Vac Corp., 10.625% due 9/01/2003 1,101,250 1,093,750
------------ ------------
1,711,250 1,719,550
====================================================================================================================================
Diversified--2.7% NR* NR* 3,000,000 Bridge Information Systems, Term B, due
5/29/2005 (a) 3,015,000 2,994,375
====================================================================================================================================
Drilling--4.3% B+ B1 500,000 Parker Drilling Co., 9.75% due 11/15/2006 448,352 380,000
R&B Falcon Corp.:
BB+ Ba2 3,000,000 10.25% due 5/15/2003 3,120,000 3,060,000
BB+ Ba1 1,300,000 9.50% due 12/15/2008 (c) 1,300,000 1,261,000
------------ ------------
4,868,352 4,701,000
====================================================================================================================================
Electronics/Electronic B B2 395,000 BGF Industries Inc., 10.25% due
Components--4.0% 1/15/2009 (c) 387,148 398,950
B B1 300,000 Filtronic PLC, 10% due 12/01/2005 (c) 300,000 307,500
B+ B1 750,000 Flextronics International Ltd., 8.75% due
10/15/2007 778,125 778,125
B+ B3 995,000 High Voltage Engineering, 10.50% due
8/15/2004 959,533 945,250
NR* NR* 1,995,000 SPX Corporation, Term B, due 9/30/2006 (a) 1,985,376 2,009,963
------------ ------------
4,410,182 4,439,788
====================================================================================================================================
Energy--3.7% B B1 500,000 Belco Oil & Gas Corp., 8.875% due 9/15/2007 455,667 465,000
B B2 500,000 Canadian Forest Oil Ltd., 8.75% due 9/15/2007 460,602 445,000
B B3 500,000 Chesapeake Energy Corp., 9.625% due 5/01/2005 419,236 320,000
B B2 500,000 Energy Corp. of America, 9.50% due 5/15/2007 463,078 462,500
CCC- Caa2 500,000 Forcenergy, Inc., 8.50% due 2/15/2007 391,600 180,000
B B2 250,000 Forest Oil Corporation, 10.50% due 1/15/2006 247,046 251,250
B+ B1 500,000 Nuevo Energy Co., 8.875% due 6/01/2008 477,807 460,000
B+ B2 1,000,000 Pool Energy Services Co., 8.625% due 4/01/2008 1,002,819 1,005,000
B+ B1 500,000 Vintage Petroleum, Inc., 9% due 12/15/2005 486,540 460,000
------------ ------------
4,404,395 4,048,750
====================================================================================================================================
Financial B+ Ba3 600,000 Willis Corroon Corporation, 9% due
Services--0.5% 2/01/2009 (c) 600,000 600,000
====================================================================================================================================
Food & Kindred B+ B1 450,000 Canandaigua Brands Inc., 8.50% due 3/01/2009 450,000 450,000
Products--4.4% B- B3 500,000 Luigino's Inc., 10% due 2/01/2006 (c) 500,000 501,250
B B2 1,000,000 SC International Services, Inc., 9.25% due
9/01/2007 970,735 1,020,000
Specialty Foods Corporation (a):
NR* NR* 1,075,207 Revolving Credit, due 1/31/2000 1,075,207 1,069,831
NR* NR* 1,854,055 Term, due 1/31/2000 1,820,309 1,843,617
------------ ------------
4,816,251 4,884,698
====================================================================================================================================
</TABLE>
4 & 5
<PAGE>
Debt Strategies Fund III, Inc., February 28, 1999
- --------------------------------------------------------------------------------
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>
Forest Products--0.7% B+ B1 US$ 500,000 Doman Industries Ltd., 8.75% due 3/15/2004 $ 362,343 $ 362,500
B+ B3 500,000 Millar Western Forest, 9.875% due 5/15/2008 343,129 410,000
------------ ------------
705,472 772,500
====================================================================================================================================
Furniture & B- B3 625,000 Formica Corp., 10.875% due 3/01/2009 (c) 625,000 621,094
Fixtures--0.6%
====================================================================================================================================
Gaming--9.2% Argosy Gaming Co.:
B- B3 500,000 12% due 6/01/2001 510,000 511,250
B+ B1 1,000,000 13.25% due 6/01/2004 1,015,000 1,127,500
B B1 500,000 Eldorado Resorts LLC, 10.50% due 8/15/2006 527,500 525,000
B+ B1 1,500,000 Empress Entertainment, 8.125% due 7/01/2006 1,496,597 1,503,750
BB+ Ba2 500,000 Harrah's Operating Co. Inc., 7.875% due
12/15/2005 500,000 503,750
B B2 1,000,000 Harvey Casino Resorts, 10.625% due
6/01/2006 1,052,500 1,042,500
B B2 250,000 Hollywood Park Inc., 9.25% due 2/15/2007 (c) 250,000 250,938
B B2 250,000 Hollywood Park/Operating, 9.50% due
8/01/2007 252,656 250,000
Horseshoe Gaming LLC:
BB- B1 1,700,000 12.75% due 9/30/2000 1,813,750 1,804,125
B+ B3 300,000 9.375% due 6/15/2007 303,000 306,000
B+ B1 1,000,000 Isle of Capri Casinos, 12.50% due 8/01/2003 1,065,000 1,122,500
BB- Ba3 275,000 Mohegan Tribal Gaming Authority, 8.75% due
1/01/2009 (c) 275,000 275,000
BB+ Ba2 625,000 Park Place Entertainment, 7.875% due
12/15/2005 (c) 625,000 612,500
B B2 375,000 Trump Atlantic City Associates/Funding
Inc., 11.25% due 5/01/2006 321,682 318,750
------------ ------------
10,007,685 10,153,563
====================================================================================================================================
Health Care B+ Ba3 2,970,000 Integrated Health Services, Inc., Term B,
Providers--2.4% due 9/15/2003 (a) 2,973,713 2,680,425
====================================================================================================================================
Hotels & B- B2 500,000 Extended Stay America, 9.15% due 3/15/2008 477,640 485,000
Motels--4.9% BB Ba2 1,000,000 HMH Properties, Inc., 8.45% due 12/01/2008 996,688 980,000
NR* NR* 4,000,000 Starwood Hotels and Resorts Worldwide,
Inc., Term, due 2/23/2003 (a) 3,986,843 3,998,750
------------ ------------
5,461,171 5,463,750
====================================================================================================================================
Industrials--0.7% B B2 775,000 Advanced Glassfiber Yarn, 9.875% due
1/15/2009 (c) 759,596 780,812
====================================================================================================================================
Leasing & Rental B B3 250,000 National Equipment Services, Inc., 10% due
Services--4.0% 11/30/2004 (c) 244,720 255,000
B B3 2,000,000 Neff Corp., 10.25% due 6/01/2008 1,922,416 1,980,000
B- B3 500,000 Penhall International, 12% due 8/01/2006 475,257 500,000
B B3 250,000 Universal Hospital Services, 10.25% due
3/01/2008 (c) 212,701 222,500
NR* Ba3 1,496,250 Williams Scotsman, Inc., Term, due
5/21/2005 (a) 1,496,250 1,499,991
------------ ------------
4,351,344 4,457,491
====================================================================================================================================
Manufacturing--6.5% BB- B1 2,000,000 Environmental Systems Products Holdings,
Inc., Term B, due 9/30/2005 (a) 1,990,359 2,010,000
B- B2 2,500,000 Fairfield Manufacturing, 11.375% due
7/01/2001 2,571,875 2,575,000
NR* NR* 2,000,000 Metokote Corporation, Term B, due
11/02/2005 (a) 1,985,448 2,012,500
B B3 500,000 Morris Materials Handling, 9.50% due
4/01/2008 373,119 292,500
B- B3 300,000 Russell-Stanley Holdings Inc., 10.875% due
2/15/2009 (c) 297,750 294,000
------------ ------------
7,218,551 7,184,000
====================================================================================================================================
Medical B1 B+ 1,912,814 Alaris Medical Systems Inc., Term D, due
Equipment--1.7% 5/01/2005 (a) 1,912,814 1,912,814
====================================================================================================================================
Metals & B B3 2,430,000 AEI Resources Inc., 10.50% due 12/15/2005 (c) 2,403,629 2,372,286
Mining--5.3% BB- B2 500,000 Golden Northwest Aluminum, 12% due
12/15/2006 (c) 500,000 506,250
BB- B1 3,000,000 Ormet Corporation, Term, due 8/15/2008 (a) 3,000,000 3,000,000
------------ ------------
5,903,629 5,878,536
====================================================================================================================================
On-Line B- B3 250,000 Verio Inc., 11.25% due 12/01/2008 (c) 250,000 268,750
Services--0.2%
====================================================================================================================================
Packaging--0.2% BB- B1 250,000 Consumers Packaging Inc., 9.75% due
2/01/2007 (c) 250,000 257,812
====================================================================================================================================
Paging--0.2% CCC+ B3 250,000 Metrocall Inc., 11% due 9/15/2008 (c) 248,279 235,000
====================================================================================================================================
Paper--4.8% NR* NR* 2,000,000 Cellular Tissue Holdings, Inc., Term C,
due 3/24/2005 (a) 2,000,000 2,000,000
B+ B2 450,000 Norampac Inc., 9.50% due 2/01/2008 460,875 468,000
NR* NR* 3,000,000 Repap New Brunswick, Inc., Term B, due
6/01/2004 (a) 3,030,000 2,872,500
------------ ------------
5,490,875 5,340,500
====================================================================================================================================
Printing & B+ B2 500,000 Big Flower Press Holdings, 8.625% due
Publishing--1.6% 12/01/2008 (c) 500,000 505,000
B+ B1 450,000 Mail-Well Corp., 8.75% due 12/15/2008 (c) 448,890 461,250
B- B3 325,000 Phoenix Color Corporation, 10.375% due
2/01/2009 (c) 325,000 330,688
B B3 250,000 Premier Graphics Inc., 11.50% due
12/01/2005 (c) 250,000 243,750
BB- B1 250,000 World Color Press Inc., 8.375% due
11/15/2008 (c) 250,000 250,000
------------ ------------
1,773,890 1,790,688
====================================================================================================================================
Refineries--1.7% BB Ba3 2,000,000 Clark Refining and Marketing, Inc., Term,
due 11/15/2004 (a) 2,000,000 1,840,000
====================================================================================================================================
Satellite Echostar DBS Corp. (c):
Telecommunication B B2 200,000 9.25% due 2/01/2006 200,000 202,500
Distribution B B2 800,000 9.375% due 2/01/2009 800,000 802,000
Systems--1.9% CCC+ B3 750,000 Golden Sky Systems, 12.375% due 8/01/2006 (c) 819,375 819,375
B- B3 250,000 Pegasus Communications, 9.75% due
12/01/2006 (c) 250,000 261,250
------------ ------------
2,069,375 2,085,125
====================================================================================================================================
Telecommunications-- B- Caa2 425,000 Global Telesystems Group, 9.875% due
6.9% 2/15/2005 415,476 408,000
B B3 120,000 Hermes Europe Railtel BV, 10.375% due
1/15/2009 (c) 120,000 127,500
B B2 750,000 Intermedia Communications Inc., 9.50% due
3/01/2009 (c) 746,635 748,125
B B3 500,000 Level 3 Communications, 10.50% due
12/01/2008 (b)(c) 307,340 291,250
B B2 250,000 Metromedia Fiber Network, 10% due
11/15/2008 (c) 250,000 260,000
NR* NR* 2,000,000 Pacific Crossing, Term B, due 7/28/2006 (a) 2,000,000 1,980,000
B- B3 500,000 Primus Telecommunications Group, 11.25%
due 1/15/2009 (c) 500,000 507,500
</TABLE>
6 & 7
<PAGE>
Debt Strategies Fund III, Inc., February 28, 1999
- --------------------------------------------------------------------------------
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>
Telecommunications NR* Ba3 US$3,000,000 Superior/Essex Corp., Term, due
(concluded) 11/27/2006 (a) $ 2,970,394 $ 2,979,375
B- B3 360,000 Worldwide Fiber Inc., 12.50% due
12/15/2005 (c) 360,000 372,600
------------ ------------
7,669,845 7,674,350
====================================================================================================================================
Telephone B- Caa1 250,000 Dolphin Telecom PLC, 16.331% due
Communications-- 6/01/2008 (b) 108,568 110,000
0.6% B- Caa1 (euro) 511,292 Esprit Telecom Group PLC, 11% due 6/15/2008 579,461 579,486
------------ ------------
688,029 689,486
====================================================================================================================================
Textiles--0.4% B B3 US$ 600,000 Galey & Lord, Inc., 9.125% due 3/01/2008 474,754 453,000
====================================================================================================================================
Utilities--0.3% BB Ba3 350,000 CMS Energy Corp., 7.50% due 1/15/2009 350,000 347,484
====================================================================================================================================
Waste BB Ba2 500,000 Allied Waste North America, 7.875% due
Management--1.5% 1/01/2009 (c) 499,141 512,500
BB- B3 1,000,000 Norcal Waste Systems, Series B, 13.50% due
11/15/2005 (b) 1,092,500 1,125,000
------------ ------------
1,591,641 1,637,500
====================================================================================================================================
Wireless ESAT Telecom Group PLC:
Communications-- B+ Caa1 625,000 12.427% due 2/01/2007 (b) 441,102 448,438
2.5% B+ Caa1 1,375,000 11.875% due 12/01/2008 (c) 1,454,061 1,457,500
CCC+ B3 1,050,000 Nextel Partners Inc., 14% due 2/01/2009 (b)(c) 539,370 546,000
B+ Ba3 250,000 Orange PLC, 8% due 8/01/2008 250,938 258,750
------------ ------------
2,685,471 2,710,688
====================================================================================================================================
Total Investments in Corporate Debt
Obligations--111.9% 124,007,884 123,799,038
====================================================================================================================================
<CAPTION>
Shares
Held Preferred Stocks
====================================================================================================================================
<S> <C> <C> <C> <C>
Tower Construction 2,000 Crown Castle International Corp. (d) 2,000,000 2,230,000
& Leasing--2.0%
====================================================================================================================================
Wireless 1,000 Centaur Funding Corp. 1,000,000 1,101,250
Communications--
1.0%
====================================================================================================================================
Total Investments in Preferred Stocks--3.0% 3,000,000 3,331,250
====================================================================================================================================
<CAPTION>
Face
Amount Short-Term Investments
====================================================================================================================================
<S> <C> <C> <C> <C>
Commercial US$ 318,000 Burlington Santa Fe Corporation, 4.98%
Paper**--0.3% due 3/01/1999 318,000 318,000
====================================================================================================================================
Total Short-Term Investments--0.3% 318,000 318,000
====================================================================================================================================
Total Investments--115.2% $127,325,884 127,448,288
============
Unrealized Appreciation on Forward
Foreign Exchange Contracts--Net***--0.0% 32,472
Liabilities in Excess of Other Assets--(15.2%) (16,823,052)
------------
Net Assets--100.0% $110,657,708
============
====================================================================================================================================
</TABLE>
(a) 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 41.1% of the Fund's net assets.
(b) Represents a zero coupon or step bond; the interest rates shown reflect
the effective yields at the time of purchase by the Fund.
(c) The security may be offered and sold to "qualified institutional buyers"
under Rule 144A of the Securities Act of 1933.
(d) Represents a pay-in-kind security which may pay interest/dividends in
additional face/shares.
* Not Rated.
** 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 February 28, 1999 were as
follows:
See Notes to Financial Statements.
- --------------------------------------------------------------------------------
Unrealized
Foreign Expiration Appreciation
Currency Sold Date (Note 1c)
- --------------------------------------------------------------------------------
(euro) 532,851 March 1999 $ 32,472
- --------------------------------------------------------------------------------
Total Unrealized Appreciation on
Forward Foreign Exchange Contracts--Net
(US$ Commitment--$617,740) $ 32,472
========
- --------------------------------------------------------------------------------
Ratings of issues shown have not been audited by Deloitte & Touche LLP.
Portfolio Profile
As of February 28, 1999
Percent of
Quality Ratings Long-Term
S&P/Moody's Investments
- --------------------------------------------------------------------------------
BBB/Baa .............................................................. 0.8%
BB/Ba ................................................................ 26.8
B/B .................................................................. 51.0
CCC/Caa .............................................................. 2.2
NR (Not Rated) ....................................................... 19.2
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
Percent of
Five Largest Industries Total Assets
- --------------------------------------------------------------------------------
Gaming ............................................................... 7.8%
Cable ................................................................ 6.4
Telecommunications ................................................... 5.9
Manufacturing ........................................................ 5.5
Automotive Equipment ................................................. 3.9
- --------------------------------------------------------------------------------
Percent of
Ten Largest Holdings Total Assets
- --------------------------------------------------------------------------------
R&B Falcon Corp., 10.25% due 5/15/2003 ............................... 3.5%
Coaxial Communications/Phoenix, 10% due 8/15/2006 .................... 2.9
Ormet Corporation, Term, due 8/15/2008 ............................... 2.4
Ackerley Group Inc., 9% due 1/15/2009 ................................ 2.4
Bridge Information Systems, Term B, due 5/29/2005 .................... 2.4
Superior/Essex Corp., Term, due 11/27/2006 ........................... 2.4
Repap New Brunswick, Inc., Term B, due 6/01/2004 ..................... 2.3
Integrated Health Services, Inc., Term, due 9/15/2003 ................ 2.1
Fairfield Manufacturing, 11.375% due 7/01/2001 ....................... 2.0
AEI Resources Inc., 10.50% due 12/15/2005 ............................ 1.9
- --------------------------------------------------------------------------------
8 & 9
<PAGE>
Debt Strategies Fund III, Inc., February 28, 1999
- --------------------------------------------------------------------------------
STATEMENT OF ASSETS, LIABILITIES AND CAPITAL
<TABLE>
<CAPTION>
As of February 28, 1999
=============================================================================================================
<S> <C> <C> <C>
Assets: Investments, at value (identified cost--$127,325,884) (Note 1b) $127,448,288
Unrealized appreciation on forward foreign exchange
contracts--net (Note 1c) ....................................... 32,472
Cash ........................................................... 326
Interest receivable ............................................ 2,375,743
Deferred organization expenses (Note 1g) ....................... 12,500
Deferred facility fees ......................................... 1,134
Prepaid expenses and other assets .............................. 32,873
------------
Total assets ................................................... 129,903,336
------------
=============================================================================================================
Liabilities: Payables:
Loans (Note 5) ............................................... $ 18,000,000
Securities purchased ......................................... 725,000
Dividends to shareholders (Note 1h) .......................... 216,173
Interest on loans (Note 5) ................................... 52,800
Investment adviser (Note 2) .................................. 43,057
Commitment fees .............................................. 8,017 19,045,047
------------
Deferred income (Note 1f) ...................................... 13,033
Accrued expenses and other liabilities ......................... 187,548
------------
Total liabilities .............................................. 19,245,628
------------
=============================================================================================================
Net Assets: Net assets ..................................................... $110,657,708
============
=============================================================================================================
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 ........................... 738,803
Accumulated realized capital losses on investments and foreign
currency transactions--net ..................................... (40,395)
Unrealized appreciation on investments and foreign currency
transactions--net .............................................. 154,300
------------
Total--Equivalent to $10.05 per share based on 11,010,000 shares
of capital stock outstanding (market price--$8.875) ............ $110,657,708
============
=============================================================================================================
</TABLE>
See Notes to Financial Statements.
STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
For the Period July 31, 1998+ to February 28, 1999
=================================================================================================================
<S> <C> <C> <C>
Investment Income Interest and discount earned .............................. $ 5,379,148
(Note 1f): Facility and other fees ................................... 29,571
-----------
Total income .............................................. 5,408,719
-----------
=================================================================================================================
Expenses: Investment advisory fees (Note 2) ......................... $ 386,101
Professional fees ......................................... 96,459
Loan interest expense (Note 5) ............................ 52,800
Accounting services (Note 2) .............................. 52,751
Directors' fees and expenses .............................. 23,929
Listing fees .............................................. 23,371
Borrowing costs (Note 5) .................................. 16,906
Transfer agent fees (Note 2) .............................. 13,242
Printing and shareholder reports .......................... 8,292
Custodian fees ............................................ 7,558
Pricing services .......................................... 1,917
Amortization of organization expenses (Note 1g) ........... 1,458
Other ..................................................... 16,844
-----------
Total expenses before reimbursement ....................... 701,628
Reimbursement of expenses (Note 2) ........................ (451,752)
-----------
Total expenses after reimbursement ........................ 249,876
-----------
Investment income--net .................................... 5,158,843
-----------
=================================================================================================================
Realized & Unrealized Realized loss from:
Gain (Loss) on Investments--net ........................................ (40,395)
Investments & Foreign currency transactions--net ...................... (22,084) (62,479)
Foregein Currency -----------
Transactions--Net Unrealized appreciation on:
(Notes 1c, 1d, 1f & 3): Investments--net ........................................ 122,404
Foreign currency transactions--net ...................... 31,896 154,300
----------- -----------
Net realized and unrealized gain on investments and foreign
currency transactions ..................................... 91,821
-----------
Net Increase in Net Assets Resulting from Operations ...... $ 5,250,664
===========
=================================================================================================================
</TABLE>
+ Commencement of operations.
See Notes to Financial Statements.
10 & 11
<PAGE>
Debt Strategies Fund III, Inc., February 28, 1999
- --------------------------------------------------------------------------------
STATEMENT OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
For the Period
July 31, 1998+ to
Increase (Decrease) in Net Assets: February 28, 1999
==============================================================================================
<S> <C> <C>
Operations: Investment income--net .................................... $ 5,158,843
Realized loss on investments and foreign currency
transactions--net ......................................... (62,479)
Unrealized appreciation on investments and foreign
currency transactions--net ................................ 154,300
-------------
Net increase in net assets resulting from operations ...... 5,250,664
-------------
==============================================================================================
Dividends to Investment income--net .................................... (4,397,956)
Shareholders Net decrease in net assets resulting from dividends to -------------
(Note 1h): shareholders .............................................. (4,397,956)
-------------
==============================================================================================
Capital Share Proceeds from issuance of Common Stock .................... 110,000,000
Transactions Offering costs resulting from the issuance of
(Notes 1g & 4) Common Stock .............................................. (295,000)
-------------
Net increase in net assets resulting from capital share
transactions .............................................. 109,705,000
-------------
==============================================================================================
Net Assets: Total increase in net assets .............................. 110,557,708
Beginning of period ....................................... 100,000
-------------
End of period* ............................................ $ 110,657,708
=============
==============================================================================================
* Undistributed investment income--net (Note 1i) ........... $ 738,803
=============
==============================================================================================
</TABLE>
+ Commencement of operations.
See Notes to Financial Statements.
- --------------------------------------------------------------------------------
STATEMENT OF CASH FLOWS
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
For the Period July 31, 1998+ to February 28, 1999
===============================================================================================
<S> <C> <C>
Cash Provided by Net increase in net assets resulting from operations $ 5,250,664
Operating Activities: Adjustments to reconcile net increase in net assets
resulting from operations to net cash provided by
operating activities:
Increase in receivables .......................... (2,375,743)
Increase in other assets ......................... (46,507)
Increase in other liabilities .................... 304,456
Realized and unrealized gain on investments and
foreign currency transactions--net ............... (91,821)
Amortization of discount--net .................... (1,410,058)
---------------
Net cash provided by operating activities .......... 1,630,991
---------------
===============================================================================================
Cash Used for Proceeds from sales of long-term investments ....... 37,844,503
Investing Activities: Purchases of long-term investments ................. (164,054,186)
Purchases of short-term investments ................ (1,045,096,269)
Proceeds from sales and maturities of short-term
investments ........................................ 1,046,052,070
---------------
Net cash used for investing activities ............. (125,253,882)
---------------
===============================================================================================
Cash Provided by Cash receipts on capital shares sold ............... 110,000,000
Financing Activities: Cash payments resulting from the issuance of shares (295,000)
Cash receipts of borrowings ........................ 26,000,000
Cash payments on borrowings ........................ (8,000,000)
Dividends paid to shareholders ..................... (4,181,783)
---------------
Net cash provided by financing activities .......... 123,523,217
---------------
===============================================================================================
Cash: Net increase in cash ............................... (99,674)
Cash at beginning of period ........................ 100,000
---------------
Cash at end of period .............................. $ 326
===============
===============================================================================================
</TABLE>
+ Commencement of operations.
See Notes to Financial Statements.
12 & 13
<PAGE>
Debt Strategies Fund III, Inc., February 28, 1999
- --------------------------------------------------------------------------------
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: February 28, 1999
================================================================================================
<S> <C> <C>
Per Share Net asset value, beginning of period ........................ $ 10.00
Operating ------------
Performance: Investment income--net ...................................... .47
Realized and unrealized gain on investments--net ............ .01
------------
Total from investment operations ............................ .48
------------
Less dividends from investment income--net .................. (.40)
------------
Capital charge resulting from the issuance of Common Stock .. (.03)
------------
Net asset value, end of period .............................. $ 10.05
============
Market price per share, end of period ....................... $ 8.875
============
================================================================================================
Total Investment Based on market price per share ............................. (7.37%)++
Return:** ============
Based on net asset value per share .......................... 4.89%++
============
================================================================================================
Ratios to Average Expenses, net of reimbursement and excluding interest expense .31%*
Net Assets: ============
Expenses, net of reimbursement .............................. .39%*
============
Expenses .................................................... 1.09%*
============
Investment income--net ...................................... 8.02%*
============
================================================================================================
Leverage: Amount of borrowings, end of period (in thousands) .......... $ 18,000
============
Average amount of borrowings outstanding during the period
(in thousands) .............................................. $ 1,737
============
Average amount of borrowings outstanding per share during
the period .................................................. $ .16
============
================================================================================================
Supplemental Net assets, end of period (in thousands) .................... $ 110,658
Data: ============
Portfolio turnover .......................................... 50.99%
============
================================================================================================
</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.
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.
The Fund's financial statements are prepared in accordance with generally
accepted accounting principles which may require the use of management accruals
and estimates. Prior to commencement of operations on July 31, 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 July 24, 1998. 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 for which an active secondary market exists and for
which the Investment Adviser can obtain at least two quotations from banks or
dealers in Corporate Loans will be valued by calculating the mean of the last
available bid and asked prices in the markets for such Corporate Loans, and then
using the mean of those two means. If only one quote for a particular Corporate
Loan is available, such Corporate Loan will be valued on the basis of the mean
of the last available bid and asked prices in the market. For Corporate Loans
for which an active secondary market does not exist to a reliable degree in the
opinion of the Investment Adviser, such Corporate Loans will be valued by the
Investment Adviser at fair value, which is intended to approximate market value.
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 and currency 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
14 & 15
<PAGE>
Debt Strategies Fund III, Inc., February 28, 1999
NOTES TO FINANCIAL STATEMENTS (concluded)
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.
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.
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.
(i) Reclassification--Generally accepted accounting principles require that
certain components of net assets be adjusted to reflect permanent differences
between financial and tax reporting. Accordingly, current year's permanent
book/tax differences of $22,084 have been reclassified between accumulated net
realized capital losses and undistributed net investment income. These
reclassifications have no effect on net assets or net asset value per share.
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 February 28, 1999, FAM earned fees of $386,101, of which
$322,625 was voluntarily waived. FAM also reimbursed the Fund for additional
expenses of $129,127.
For the period July 31, 1998 to February 28, 1999, the Fund paid Merrill Lynch
Security Pricing Service, an affiliate of Merrill Lynch, Pierce, Fenner & Smith
Incorporated, $155 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 July 31, 1998 to February 28, 1999 were $164,779,186 and $37,844,503,
respectively.
Net realized gains (losses) for the period July 31, 1998 to February 28, 1999
and net unrealized gains (losses) as of February 28, 1999 were as follows:
- --------------------------------------------------------------------------------
Realized Unrealized
Gains (Losses) Gains (Losses)
- --------------------------------------------------------------------------------
Long-term investments ........................ $ (41,725) $ 122,404
Short-term investments ....................... 1,330 --
Forward foreign exchange contracts ........... (25,353) 32,472
Foreign currency transactions ................ 3,269 (576)
--------- ---------
Total ........................................ $ (62,479) $ 154,300
========= =========
- --------------------------------------------------------------------------------
As of February 28, 1999, net unrealized appreciation for Federal income tax
purposes aggregated $118,707, of which $1,800,365 related to appreciated
securities and $1,681,658 related to depreciated securities. The aggregate cost
of investments at February 28, 1999 for Federal income tax purposes was
$127,329,581.
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
February 28, 1999 increased by 11,000,000 from shares sold.
5. Short-Term Borrowings:
On December 18, 1998, the Fund entered into a one-year credit agreement with
State Street Bank and Trust Company and Fleet National Bank. The agreement is a
$55,000,000 credit facility bearing interest at the Prime rate, the Federal
Funds rate plus 0.50% and/or LIBOR plus 0.50%. For the period July 31, 1998 to
February 28, 1999, the average amount borrowed was $1,737,089 and the daily
weighted average interest rate was 5.21%. For the period July 31, 1998 to
February 28, 1999, facility and commitment fees aggregated $16,906.
6. Subsequent Event:
On March 8, 1999, the Fund's Board of Directors declared an ordinary income
dividend to Common Stock shareholders in the amount of $.069108 per share,
payable on March 31, 1999 to shareholders of record as of March 24, 1999.
16 & 17
<PAGE>
Debt Strategies Fund III, Inc., February 28, 1999
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders,
Debt Strategies Fund III, Inc.:
We have audited the accompanying statement of assets, liabilities and capital,
including the schedule of investments, of Debt Strategies Fund III, Inc. as of
February 28, 1999, the related statements of operations, changes in net assets,
cash flows, and the financial highlights for the period July 31, 1998
(commencement of operations) to February 28, 1999. These financial statements
and the financial highlights are the responsibility of the Fund's management.
Our responsibility is to express an opinion on these financial statements and
the financial highlights based on our audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements and the financial highlights
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. Our
procedures included confirmation of securities owned at February 28, 1999 by
correspondence with the custodian, brokers and financial intermediaries or other
alternative procedures. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audit provides a reasonable basis for our opinion.
In our opinion, such financial statements and financial highlights present
fairly, in all material respects, the financial position of Debt Strategies Fund
III, Inc. as of February 28, 1999, the results of its operations, the changes in
its net assets, its cash flows, and the financial highlights for the period July
31, 1998 (commencement of operations) to February 28, 1999 in conformity with
generally accepted accounting principles.
Deloitte & Touche llp
Princeton, New Jersey
April 22, 1999
YEAR 2000 ISSUES
Many computer systems were designed using only two digits to designate years.
These systems may not be able to distinguish the Year 2000 from the Year 1900
(commonly known as the "Year 2000 Problem"). The Fund could be adversely
affected if the computer systems used by the Fund's management or other Fund
service providers do not properly address this problem before January 1, 2000.
The Fund's management expects to have addressed this problem before then, and
does not anticipate that the services it provides will be adversely affected.
The Fund's other service providers have told the Fund's management that they
also expect to resolve the Year 2000 Problem, and the Fund's management will
continue to monitor the situation as the Year 2000 approaches. However, if the
problem has not been fully addressed, the Fund could be negatively affected. The
Year 2000 Problem could also have a negative impact on the securities in which
the Fund invests, and this could hurt the Fund's investment returns.
OFFICERS AND DIRECTORS
Terry K. Glenn, President and Director
Ronald Forbes, Director
Cynthia A. Montgomery, Director
Charles C. Reilly, Director
Kevin A. Ryan, Director
Richard R. West, Director
Arthur Zeikel, Director
Joseph T. Monagle Jr., Senior Vice President
Richard C. Kilbride, Vice President
Gilles Marchand, Vice President
Paul Travers, Vice President
Donald C. Burke, Vice President and Treasurer
Patrick D. Sweeney, Secretary
Custodian & Transfer Agent
State Street Bank and Trust Company
225 Franklin Street
Boston, MA 02110
NYSE Symbol
DBU
After more than 20 years of service, Arthur Zeikel recently retired as Chairman
of Merrill Lynch Asset Management, L.P. (MLAM). Mr. Zeikel served as President
of MLAM from 1977 to 1997 and as Chairman since December 1997. Mr. Zeikel is one
of the country's most respected leaders in asset management and presided over
the growth of Merrill Lynch's asset management business. During his tenure,
client assets under management grew from $300 million to over $500 billion. Mr.
Zeikel will remain on Debt Strategies Fund III, Inc.'s Board of Directors. We
are pleased to announce that Terry K. Glenn has been elected President and
Director of the Fund. Mr. Glenn has held the position of Executive Vice
President of MLAM since 1983.
Mr. Zeikel's colleagues at MLAM join the Fund's Board of Directors in wishing
him well in his retirement from Merrill Lynch and are pleased that he will
continue as a member of the Fund's Board of Directors.
Gerald M. Richard, Treasurer of Debt Strategies Fund III, Inc. has also recently
retired. His colleagues at Merrill Lynch Asset Management, L.P. join the Fund's
Board of Directors in wishing Mr. Richard well in his retirement.
18 & 19
<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--2/99
[LOGO] Printed on post-consumer recycled paper
