DEBT
STRATEGIES
FUND III, INC.
[GRAPHIC OMITTED]
STRATEGIC
Performance
Semi-Annual Report
August 31, 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., August 31, 1999
DEAR SHAREHOLDER
For the six-month period ended August 31, 1999, Debt Strategies Fund III, Inc.'s
total investment return was +3.61%, based on a change in per share net asset
value from $10.05 to $9.87, and assuming reinvestment of $0.493 per share income
dividends. During the same six-month period, the net annualized yield of the
Fund's Common Stock was 10.41%. Since inception (July 31, 1998) through August
31, 1999, the total investment return on the Fund's Common Stock was +8.68%,
based on a change in per share net asset value from $10.00 to $9.87, and
assuming reinvestment of $0.892 per share income dividends. At the end of the
August period, the Fund was 28.4% leveraged as a percentage of total assets.
(For a complete explanation of the benefits and risks of leverage, see page 1 of
this report to shareholders.)
Investment Approach
The Fund's performance reflects the ongoing difficulties experienced since 1998
in the markets in which the Fund invests. We would like to remind shareholders
that Debt Strategies Fund III, Inc. is a diversified, closed-end Fund that seeks
to provide current income by investing primarily in a diversified portfolio of
debt securities, including leveraged bank loans and high-yield bonds that are
rated in the lower rating categories of the established rating services, or
unrated obligations of comparable quality. The leveraged bank loans in which the
Fund invests are often senior secured obligations that offer investors greater
principal protection than unsecured bonds. In addition, bank loans are floating
rate instruments whose principal value generally does not move conversely with
interest rate fluctuations, as is the case with fixed-income bonds. The
high-yield bonds in which the Fund invests are often unsecured debt securities
with a fixed rate of interest.
Market Review
Late in the summer of 1999, the high-yield bond market was pressured by
disruptions in the equity and emerging markets, which resulted in a marked
decrease in liquidity and, in turn, a decrease in prices in all three markets
virtually across the board. These events negatively impacted the leveraged bank
loan market as well.
After a brief period in early 1998 when the high-yield bond and bank loan
markets had begun to stabilize, a combination of rising interest rates and
widening credit spreads (that is, the spread over a risk-free investment that an
investor requires to invest in high-yield bonds or leveraged loans) pushed the
price of existing high-yield bond issues and bank loans (which were issued at
narrower spreads) down. In addition, certain sectors experienced extreme
difficulties.
During the latter half of the six-month period ended August 31, 1999, the
interest rate environment dominated the US capital markets. Investors were
concerned that the ongoing strength in the economy would prompt the Federal
Reserve Board into a round of increasing of the Federal Funds rate. At the end
of June, there was relief when the Federal Reserve Board only raised interest
rates by 25 basis points (0.25%). However, there were continued signs of
strength in the economy, and the Federal Reserve Board raised short-term
interest rates another 0.25% on August 24, 1999. During the six-month period
ended August 31, 1999, the bellwether ten-year Treasury yield increased 0.68% to
5.97%, while credit spreads in both the high-yield bond and bank loan markets
increased throughout the period to near historic highs.
During the same period, a number of cyclical industries including paper, steel,
and energy began to show signs of improvement. However, certain sectors such as
healthcare and mining continued to experience difficulties resulting in credit
deterioration and principal losses (realized and unrealized) for some of the
Fund's holdings. The healthcare situation is particularly problematic in the
long-term care sector (for example, nursing homes) as a result of Federal
legislation that effectively cut Medicaid/Medicare reimbursement payments to
these service providers by as much as 40%. The mining industry is suffering
through cyclical troughs in a number of commodities.
This difficult market environment resulted in high-yield market outflows rather
consistently since July, which, in turn, dampened investor interest in new
issues. Despite a strong US economy, a rebound in the equity markets and default
rates at near historic averages, the high-yield bond sector (as measured by the
unmanaged Donaldson, Lufkin and Jenrette High Yield Index) generated a total
return for the six-month period ended August 31, 1999 of +1.31%. Bank loans (as
measured by the unmanaged Donaldson, Lufkin and Jenrette Leveraged Loan Index)
fared better, given the floating rate nature of the asset class, and generated a
total return of +3.86% for the same period. There continues to be a convergence
of the leveraged bank loan market and the high-yield bond market.
Correlation Between Markets
There is a growing correlation between the leveraged loan market and the
high-yield bond market. This correlation can be explained by the fact that
high-yield bond and bank loan markets are comprised of similar industry sectors
and often contain overlapping issuers. As a result, general economic events and
trends tend to move the two markets in the same direction, although the bonds
typically move to a greater degree than the bank loans.
In fact, an analysis by Donaldson, Lufkin and Jenrette suggests that the
correlation is approximately 25% and that over time the loan market has produced
80% of the return of the high-yield bond market with only 30% of the volatility.
That same study suggests that the leveraged loan market has virtually no
correlation to any other major asset class (equities, investment-grade corporate
bonds, government securities or emerging market bonds), thus providing investors
with an attractive investment diversification alternative.
The "Risk/Reward of Various Assets" graph that appears on page 5 of this report
to shareholders plots the annualized return and volatility experienced by
several asset classes averaged over the last seven years, eight months. Asset
classes resting on the line experienced a proportionate amount of return for the
corresponding amount of risk. Asset classes falling below the capital markets
line endured a disproportionate amount of risk relative to the return they
achieved. Finally, asset classes lying above the line achieved higher returns
than justified by the risk they experienced. Leveraged bank loans and high-yield
bonds are the only asset classes to fall above the line, which illustrates that,
compared to other asset classes, the bank loan and high-yield markets provide
superior risk/reward characteristics. For these reasons, we are optimistic about
the Fund's investment potential.
Investment Strategy
Throughout the six months ended August 31, 1999, the Fund's investment
philosophy remained unchanged: to invest in leveraged transactions in which
borrowers have strong market shares, experienced managements, consistent cash
flows and appropriate risk/reward characteristics. In addition, we look for
companies with significant underlying asset and franchise value, strong capital
structures and equity sponsors that support their investments. It is these
characteristics that we believe provide optimal downside protection to the
Fund's net asset value.
During the six months ended August 31, 1999, we focused on the new-issue market.
These new issues were clearing the market at spreads higher than those required
by investors earlier in the year. The new-issue transactions were also much more
conservatively structured, with lower leverage and higher interest coverage as
investors became more demanding. We continuously monitor our positions and
manage the Fund's composition to reflect our views on industries and specific
issuers.
At August 31, 1999, 49% of the Fund's assets were allocated to bonds and 51% to
bank loans. This position reflected our belief that bonds were very compelling
given the very wide credit spreads. More than 97% of the Fund's bank loan
2 & 3
<PAGE>
Debt Strategies Fund III, Inc., August 31, 1999
holdings were accruing interest at a yield spread above the London Interbank
Offered Rate (LIBOR), the rate that major banks charge each other for US
dollar-denominated deposits outside of the United States. LIBOR tracks very
closely with other short-term interest rates, such as the Federal Funds rate.
Since the average interest rate reset across the bank loan portion of the Fund
is about 45 days, the yield on that portion of the Fund will move within a
two-month period of any change in the Federal Funds rate. The Fund's stated
average maturity was approximately 7.2 years at August 31, 1999, but based on
our experience, the Fund's holdings can be expected to have an actual average
life of approximately 3 years - 4 years in response to the freely prepayable
nature of the bank loans.
The Fund was approximately 28% leveraged as of August 31, 1999. While we have
the ability to adjust leverage to react to market conditions, we believe the
current level is appropriate given our strategy, and we expect leverage to
remain at present levels.
The Fund's investments were spread across 150 issuers in 44 industries. See the
"Portfolio Profile" section on page 22 of this report to shareholders, which
provides listings of the Fund's ten largest holdings and five largest industries
at August 31, 1999.
While we expect that the Federal Reserve Board may increase short-term interest
rates by another 0.25% before year-end, and we acknowledge that this may put
pressure on high-yield bond prices over the next few months, we are optimistic
about the Fund as we enter the year 2000. This is based on our expectations for
a continuation of the strong economy in the United States with a relatively
stable interest rate environment, a gradual improvement in the Asian economies
and a gradual decline in credit spreads to a more normal range.
In Conclusion
As difficult as the months of July and August 1999 were for the high-yield bond
and leveraged loan markets and the Fund, their performances illustrate the bank
loan market's ability to weather market fluctuations with less volatility than
the high-yield bond market. This is what differentiates the Fund from a pure
high-yield bond fund. This attribute continues to draw many new institutional
buyers to the bank loan market. We believe that both the technical and
fundamental aspects are improving in both the high-yield bond and bank loan
sectors. We also believe we have positively positioned the Fund to follow
further expected improvements in the marketplace in an effort to seek to enhance
total return potential over the coming months.
We thank you for your investment in Debt Strategies Fund III, Inc., and we look
forward to reviewing our outlook and strategy with you again in our next report
to shareholders.
Sincerely,
/s/ Terry K. Glenn
Terry K. Glenn
President and Director
/s/ Richard C. Kilbride
Richard C. Kilbride
Vice President and
Co-Portfolio Manager
/s/ Gilles Marchand
Gilles Marchand
Vice President and
Co-Portfolio Manager
/s/ Paul Travers
Paul Travers
Vice President and
Co-Portfolio Manager
October 15, 1999
Risk/Reward of Various Assets 1992 - July 1999
A line graph depicting the annualized return and volatility for various assets
from 1992 to July 1999.
[GRAPHIC OMITTED]
Volatility Return
Broad Equity Market 14.68% 19.94%
Emerging Market Bonds 20.61% 14.08%
High Yield Bonds 5.78% 10.56%
Leveraged Loans 1.92% 8.44%
U.S. Long-Term Treasury Bonds 9.17% 8.81%
Investment Grade Bonds 5.13% 7.73%
U.S. Intermediate Treasury Bonds 4.81% 6.25%
Mortgage Secs 3.27% 6.85%
Money Market Secs .30% 4.46%
U.S. Inflation .56% 2.57%
Source: Calculated by Merrill Lynch using information and data presented in
Ibbotson Investment Analysis Software, (C)1999 Ibbotson Associates, Inc. All
rights reserved. Used with permission.
The assets used in the above analysis are represented by the following indexes:
US 30-day Treasury bill Index (Money Market Securities); Merrill Lynch Mortgage
Index (Mortgage Securities); Ibbotson's U.S. IT (Intermediate Treasuries);
Ibbotson's U.S. LT Index (Long-Term Treasuries); Merrill Lynch Corporate Index
(Investment Grade Bonds); Donaldson, Lufkin & Jenrette HY Index (High Yield
Bonds); Donaldson, Lufkin & Jenrette Leveraged Loan Index (Leveraged Loans);
EMBI Fixed Rate Index (Emerging Market Bonds); and Standard & Poor's 500 Index
(Broad Equity Market).
4 & 5
<PAGE>
Debt Strategies Fund III, Inc., August 31, 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 & Parts--1.7% B - B3 $ 500,000 Argo-Tech Corporation, 8.625% due 10/01/2007 $ 476,340 $ 440,000
B B1 500,000 BE Aerospace, 9.50% due 11/01/2008 500,000 500,000
B - B3 1,000,000 Compass Aerospace Corp., 10.125% due 4/15/2005 (c) 965,257 895,000
------------ ------------
1,941,597 1,835,000
====================================================================================================================================
Amusement & B - B3 450,000 AMC Entertainment Inc., 9.50% due 2/01/2011 450,000 382,500
Recreational B B2 200,000 Carmike Cinemas Inc., 9.375% due 2/01/2009 200,000 185,000
Services--1.4% B - B3 500,000 Hollywood Entertainment, 10.625% due 8/15/2004 511,250 482,500
B B3 500,000 Loews Cineplex Entertainment, 8.875% due 8/01/2008 496,211 441,250
------------ ------------
1,657,461 1,491,250
====================================================================================================================================
Apparel--2.7% NR* NR* 2,000,000 CS Brooks Canada, Inc., Term, due 6/25/2006 (a) 1,990,748 1,985,000
NR* NR* 992,500 Norcross Safety Products, Term, due 12/31/2005 (a) 984,384 972,650
------------ ------------
2,975,132 2,957,650
====================================================================================================================================
Automotive B B2 750,000 American Axle and Manufacturing Inc., 9.75%
Equipment--5.2% due 3/01/2009 744,323 755,625
BB - Ba3 500,000 American Bumper, Term B, due 10/31/2002 (a) 498,832 500,469
BB - Ba3 1,500,000 Collins & Aikman Corp., Term C, due 12/31/2005 (a) 1,496,377 1,495,313
B B2 500,000 Group 1 Automotive Inc., 10.875% due 3/01/2009 489,211 485,000
B - B3 2,000,000 Key Plastics, Inc., 10.25% due 3/15/2007 1,981,566 1,890,000
B - B3 400,000 Special Devices Inc., 11.375% due 12/15/2008 400,000 330,000
B B2 250,000 Venture Holdings Trust, 11% due 6/01/2007 (c) 250,000 247,500
------------ ------------
5,860,309 5,703,907
====================================================================================================================================
Broadcast--Radio & B B2 3,260,000 Ackerley Group Inc., 9% due 1/15/2009 3,297,378 3,194,800
Television--7.6% NR* NR* 1,500,000 Benedek Broadcasting, Term, due 11/20/2007 (a) 1,497,788 1,498,125
CCC+ NR* 600,000 CD Radio Inc., 14.50% due 5/15/2009 (c) 600,000 606,750
B - B3 300,000 Citadel Broadcasting Company, 9.25% due 11/15/2008 312,750 298,500
CCC+ B3 1,000,000 Paxson Communications Corporation, 11.625%
due 10/01/2002 1,010,000 1,030,000
NR* Caa1 2,800,000 Radio Unica Corp., 14.77% due 8/01/2006 (b) 1,734,589 1,694,000
------------ ------------
8,452,505 8,322,175
====================================================================================================================================
Building & B - B2 325,000 Webb (Del E.) Corp., 10.25% due 2/15/2010 319,909 305,500
Construction--0.3%
====================================================================================================================================
Building B B3 1,050,000 Amatek Industries Property Limited, 12%
Materials--1.7% due 2/15/2008 (c) 996,957 987,000
B B2 900,000 Republic Group Inc., 9.50% due 7/15/2008 885,875 864,000
------------ ------------
1,882,832 1,851,000
====================================================================================================================================
Business B - Caa1 1,875,000 Muzak Holdings LLC, 13% due 3/15/2010 (b)(c) 1,058,361 1,059,375
Services--1.0%
====================================================================================================================================
Cable--7.8% B B3 250,000 @ Entertainment Inc., 17.50% due 2/01/2009 (b) 101,603 149,062
Charter Communications Holdings LLC (c):
B+ B2 500,000 8.625% due 4/01/2009 498,520 468,750
B+ B2 470,000 9.922% due 4/01/2011 (b) 301,585 282,000
B - B3 250,000 Classic Cable Inc., 9.375% due 8/01/2009 (c) 250,000 242,500
B B3 3,500,000 Coaxial Communications/Phoenix, 10% due 8/15/2006 3,496,529 3,500,000
CCC+ Caa1 2,000,000 Coaxial LLC/Coaxial Finance, 11.864% due 8/15/2008 (b) 1,307,319 1,340,000
B - B3 950,000 Rifkin Acquisition Partners LP, 11.125% due 1/15/2006 1,036,438 1,049,750
Telewest Communications PLC:
B+ B1 1,000,000 11.25% due 11/01/2008 1,000,000 1,092,500
B+ B1 600,000 8.97% due 4/15/2009 (b)(c) 403,921 366,750
------------ ------------
8,395,915 8,491,312
====================================================================================================================================
Chemicals--8.5% BBB - Baa3 1,000,000 Equistar Chemicals LP, 8.75% due 2/15/2009 (c) 997,278 982,502
BB Ba2 2,086,325 Huntsman Corporation, Term, due 12/31/2002 (a) 2,084,249 2,081,110
Huntsman ICI Chemical (a):
NR* Ba3 750,000 Term B, due 6/30/2007 747,225 752,500
NR* Ba3 750,000 Term C, due 6/30/2008 747,219 752,500
NR* Ba3 2,992,500 Lyondell Petrochemical Co., Term E, due 5/17/2006 (a) 2,988,867 3,004,344
NR* B2 1,946,439 Pioneer America's, Inc., Term, due 12/05/2006 (a) 1,946,439 1,625,277
------------ ------------
9,511,277 9,198,233
====================================================================================================================================
Computer-Related NR* NR* 3,000,000 Bridge Information Systems, Term B, due 5/29/2005 (a) 3,015,000 3,001,875
Services--2.8%
====================================================================================================================================
Consumer B+ B2 250,000 Evenflo Company Inc., 11.75% due 8/15/2006 250,000 247,812
Products--1.5% B+ B2 360,000 Scotts Company, 8.625% due 1/15/2009 (c) 360,000 349,200
B+ B1 997,500 United Industries, Term B, due 1/20/2006 (a) 996,313 991,266
------------ ------------
1,606,313 1,588,278
====================================================================================================================================
Diversified--1.8% BB Ba3 1,985,000 SPX Corporation, Term B, due 9/30/2006 (a) 1,975,872 1,997,406
====================================================================================================================================
Drilling--5.8% BB - B1 3,000,000 Cliffs Drilling, 10.25% due 5/15/2003 3,120,000 2,932,500
B - B1 1,500,000 Key Energy Services Inc., Term B, due 9/14/2004 (a) 1,481,730 1,488,750
BB - Ba3 1,300,000 RBF Finance Company, 11.375% due 3/15/2009 1,370,720 1,365,000
B+ B1 500,000 Parker Drilling Co., 9.75% due 11/15/2006 450,510 478,750
------------ ------------
6,422,960 6,265,000
====================================================================================================================================
Electronics/Electronic B B2 775,000 Advanced Glassfiber Yarn, 9.875% due 1/15/2009 760,072 744,968
Components--2.8% B B2 395,000 BGF Industries Inc., 10.25% due 1/15/2009 387,386 353,525
B B1 300,000 Filtronic PLC, 10% due 12/01/2005 (c) 300,000 288,000
B+ B1 750,000 Flextronics International Ltd., 8.75% due 10/15/2007 778,125 735,000
B+ B3 995,000 High Voltage Engineering, 10.50% due 8/15/2004 961,999 925,350
------------ ------------
3,187,582 3,046,843
====================================================================================================================================
Energy--3.7% B B1 500,000 Belco Oil & Gas Corp., 8.875% due 9/15/2007 457,338 480,000
B B2 500,000 Canadian Forest Oil Ltd., 8.75% due 9/15/2007 462,107 486,250
B B3 500,000 Chesapeake Energy Corp., 9.625% due 5/01/2005 423,650 465,000
B B2 500,000 Energy Corp. of America, 9.50% due 5/15/2007 464,537 443,750
NR* Ca 500,000 +Forcenergy, Inc., 8.50% due 2/15/2007 392,105 410,000
B B2 250,000 Forest Oil Corporation, 10.50% due 1/15/2006 247,198 257,500
</TABLE>
6 & 7
<PAGE>
Debt Strategies Fund III, Inc., August 31, 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>
Energy (concluded) B+ B2 $1,000,000 Pool Energy Services Co., 8.625% due 4/01/2008 $ 1,003,625 $ 975,000
B+ B1 500,000 Vintage Petroleum, Inc., 9% due 12/15/2005 487,273 498,750
------------ ------------
3,937,833 4,016,250
====================================================================================================================================
Environmental URS Corporation (a):
Services--0.9% BB Ba3 500,000 Term B, due 6/09/2006 499,509 502,500
BB Ba3 500,000 Term C, due 6/09/2007 499,507 502,500
------------ ------------
999,016 1,005,000
====================================================================================================================================
Financial B+ Ba3 600,000 Willis Corroon Corporation, 9% due 2/01/2009 (c) 600,000 558,000
Services--0.5%
====================================================================================================================================
Food & Kindred B+ B1 1,000,000 B & G Foods, Term B, due 3/15/2006 (a) 998,097 1,000,000
Products--7.3% B - B3 500,000 Luigino's Inc., 10% due 2/01/2006 (c) 500,000 475,000
B B2 1,000,000 SC International Services, Inc., 9.25% due 9/01/2007 971,879 993,750
Snapple, Term B (a):
NR* NR* 724,927 due 2/25/2006 720,634 727,193
NR* NR* 1,768,823 due 2/25/2007 1,758,246 1,774,718
Specialty Foods, Inc. (a):
NR* B3 1,075,207 Revolving Credit, due 1/31/2000 1,075,207 1,073,191
NR* B3 1,844,504 Term, due 1/31/2000 1,846,808 1,841,046
------------ ------------
7,870,871 7,884,898
====================================================================================================================================
Forest Products--0.4% B+ B3 500,000 Millar Western Forest, 9.875% due 5/15/2008 347,040 476,250
====================================================================================================================================
Furniture & B - B3 625,000 Formica Corp., 10.875% due 3/01/2009 (c) 625,000 588,281
Fixtures--0.5%
====================================================================================================================================
Gaming--4.2% B - B3 325,000 Argosy Gaming Co., 10.75% due 6/01/2009 (c) 325,000 332,312
B B1 500,000 Eldorado Resorts LLC, 10.50% due 8/15/2006 527,500 512,500
B B2 1,000,000 Harvey Casino Resorts, 10.625% due 6/01/2006 1,052,500 1,030,000
B B2 250,000 Hollywood Park Inc., 9.25% due 2/15/2007 250,000 241,250
B B2 250,000 Hollywood Park/Operating, 9.50% due 8/01/2007 252,656 243,750
B+ B3 300,000 Horseshoe Gaming LLC, 9.375% due 6/15/2007 303,000 299,250
B B3 1,040,000 Isle of Capri Casinos, 8.75% due 4/15/2009 (c) 1,048,053 956,800
BB+ Ba2 625,000 Park Place Entertainment, 7.875% due 12/15/2005 625,000 593,750
B B2 375,000 Trump Atlantic City Associates/Funding Inc., 11.25%
due 5/01/2006 323,930 318,750
------------ ------------
4,707,639 4,528,362
====================================================================================================================================
Health Care B+ Ba3 2,955,000 Integrated Health Services, Inc., Term,
Providers--2.3% due 9/15/2003 (a) 2,958,694 2,541,300
====================================================================================================================================
Hotels & Motels--6.8% B - B2 500,000 Extended Stay America, 9.15% due 3/15/2008 478,434 475,000
BB Ba2 1,000,000 HMH Properties, Inc., 8.45% due 12/01/2008 996,800 922,500
NR* NR* 1,000,000 Starwood Hotels & Resorts Trust, Term,
due 2/23/2003 (a) 990,522 991,875
NR* Ba1 2,000,000 Starwood Hotels & Resorts Worldwide, Inc., Bridge,
due 2/23/2003 (a) 1,991,295 2,000,416
Wyndham International (a):
B+ B3 1,000,000 Term, due 6/30/2004 995,133 994,063
B+ B3 2,000,000 Term, due 6/30/2006 1,995,086 1,989,688
------------ ------------
7,447,270 7,373,542
====================================================================================================================================
Industrial B B2 350,000 Building One Services, 10.50% due 5/01/2009 342,262 325,500
Services--0.3%
====================================================================================================================================
Leasing & Rental Avis Rent A Car (a):
Services--5.4% B+ B3 1,500,000 Term B, due 6/30/2006 1,496,316 1,488,750
B+ B3 1,500,000 Term C, due 6/30/2007 1,496,304 1,489,688
B B3 250,000 National Equipment Services, 10% due 11/30/2004 245,069 250,000
B B3 2,000,000 Neff Corp., 10.25% due 6/01/2008 1,924,965 2,020,000
B - B3 500,000 Penhall International, 12% due 8/01/2006 476,308 495,000
B B3 250,000 Universal Hospital Services, 10.25% due 3/01/2008 213,844 185,000
------------ ------------
5,852,806 5,928,438
====================================================================================================================================
Manufacturing--4.5% BB - B1 1,990,000 Environmental Systems Product, Inc., Term B,
due 9/30/2005 (a) 1,980,987 1,970,100
B - B2 475,000 Fairfield Manufacturing Company Inc., 9.625%
due 10/15/2008 475,000 450,656
NR* NR* 2,000,000 Metokote Corp., Term B, due 11/02/2005 (a) 1,986,257 2,003,750
CCC - Ca 500,000 Morris Materials Handling, 9.50% due 4/01/2008 376,700 200,000
B - B3 300,000 Russell-Stanley Holdings Inc., 10.875%
due 2/15/2009 (c) 297,816 298,500
------------ ------------
5,116,760 4,923,006
====================================================================================================================================
Medical B+ B1 1,908,111 Alaris Medical Systems Inc., Term D, due 5/01/2005 (a) 1,908,111 1,910,496
Equipment--3.6% B+ B1 2,000,000 Hanger Ortho, Term B, due 12/30/2006 (a) 1,995,078 2,005,626
------------ ------------
3,903,189 3,916,122
====================================================================================================================================
Metals & NR* NR* 1,000,000 AEI Resources, Term B, due 12/31/2004 (a) 992,761 987,500
Mining--4.1% BB - B2 500,000 Golden Northwest Aluminum, 12% due 12/15/2006 500,000 509,375
NR* B1 3,000,000 Ormet Corporation, Term, due 8/15/2008 (a) 2,992,970 2,992,970
------------ ------------
4,485,731 4,489,845
====================================================================================================================================
Online B - B3 300,000 PSINet Inc., 11% due 8/01/2009 (c) 300,000 297,000
Services--0.5% B - B3 250,000 Verio Inc., 11.25% due 12/01/2008 250,000 253,750
------------ ------------
550,000 550,750
====================================================================================================================================
Packaging--2.1% B B1 250,000 Consumers Packaging Inc., 9.75% due 2/01/2007 250,000 232,500
NR* NR* 1,500,000 Kerr Group, Term B, due 3/12/2006 (a) 1,492,876 1,499,063
B B3 500,000 Packaging Corporation of America, 9.625%
due 4/01/2009 (c) 500,000 505,000
------------ ------------
2,242,876 2,236,563
====================================================================================================================================
</TABLE>
8 & 9
<PAGE>
Debt Strategies Fund III, Inc., August 31, 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>
Paging--0.1% CCC+ B3 $ 100,000 Metrocall Inc., 11% due 9/15/2008 $ 99,333 $ 76,000
====================================================================================================================================
Paper--7.6% NR* NR* 1,993,750 Cellular Tissue Holdings, Inc., Term C,
due 3/24/2005 (a) 1,987,163 1,968,828
BB B2 450,000 Norampac Inc., 9.50% due 2/01/2008 460,875 452,250
NR* Ba2 2,000,000 Pacifica Papers, Term B, due 12/31/2006 (a) 1,997,607 2,005,000
Packaging Corp. (a):
NR* Ba3 464,876 Term B, due 4/12/2007 463,193 466,547
NR* Ba3 464,876 Term C, due 4/12/2008 463,183 466,910
NR* NR* 3,000,000 Repap New Brunswick, Inc., Term B, due 6/01/2004 (a) 3,030,000 2,902,500
------------ ------------
8,402,021 8,262,035
====================================================================================================================================
Petroleum NR* Ba3 2,000,000 Clark Refining & Marketing, Inc., Term,
Refineries--1.7% due 11/15/2004 (a) 2,000,000 1,900,000
====================================================================================================================================
Printing & B+ B2 500,000 Big Flower Press Holdings, 8.625% due 12/01/2008 500,000 470,625
Publishing--1.3% B+ B1 450,000 Mail-Well I Corp., 8.75% due 12/15/2008 448,927 432,000
B B3 250,000 Premier Graphics Inc., 11.50% due 12/01/2005 250,000 227,500
BB - Baa3 250,000 World Color Press Inc., 8.375% due 11/15/2008 250,000 242,500
------------ ------------
1,448,927 1,372,625
====================================================================================================================================
Property NR* Ba1 2,000,000 Prison Realty, Term C, due 12/31/2002 (a) 1,987,727 1,991,666
Management--2.0% B+ Ba1 150,000 Prison Realty Trust Inc., 12% due 6/01/2006 150,000 151,500
------------ ------------
2,137,727 2,143,166
====================================================================================================================================
Retail--0.4% B - Caa1 450,000 United Auto Group, Inc., 11% due 7/15/2007 421,193 405,000
====================================================================================================================================
Satellite Echostar DBS Corporation:
Telecommunication B B2 200,000 9.25% due 2/01/2006 200,000 196,000
Distribution B B2 800,000 9.375% due 2/01/2009 800,000 788,000
Systems--1.9% CCC B3 750,000 Golden Sky Systems, 12.375% due 8/01/2006 819,375 820,312
B - B3 250,000 Pegasus Communications, 9.75% due 12/01/2006 250,000 248,750
------------ ------------
2,069,375 2,053,062
====================================================================================================================================
Textiles--0.3% B Caa3 600,000 Galey & Lord, Inc., 9.125% due 3/01/2008 478,590 312,000
====================================================================================================================================
Tower Construction & Crown Castle International Corporation:
Leasing--1.5% B B3 150,000 9% due 5/15/2011 150,000 139,500
B B3 345,000 10.375% due 5/15/2011 (b) 214,324 191,475
NR* NR* 500,000 Spectrasite Holdings Inc., 11.25% due 4/15/2009 (b)(c) 301,464 252,500
NR* NR* 1,000,000 Spectrasite, Term B, due 6/30/2006 (a) 1,007,500 1,002,188
------------ ------------
1,673,288 1,585,663
====================================================================================================================================
Transportation-- BB - Ba3 1,000,000 Transport Manufacturing, Term B, due 6/15/2006 (a) 997,554 1,000,000
Services--0.9%
====================================================================================================================================
Waste Management-- BB - B3 1,300,000 Norcal Waste Systems, 13.50% due 11/15/2005 1,426,250 1,397,500
1.6% B+ B3 300,000 Safety-Kleen Corporation, 9.25% due 5/15/2009 (c) 300,000 296,250
------------ ------------
1,726,250 1,693,750
====================================================================================================================================
Wired BB - B2 400,000 Call-Net Enterprises Inc., 9.375% due 5/15/2009 399,102 373,000
Telecommunications-- B B3 775,000 Caprock Communications, 11.50% due 5/01/2009 (c) 763,870 775,000
5.9% B - Caa2 925,000 Global Telesystems Group, 9.875% due 2/15/2005 897,282 888,000
B B3 120,000 Hermes Europe Railtel BV, 10.375% due 1/15/2009 120,000 120,300
B B2 750,000 Intermedia Communications Inc., 9.50% due 3/01/2009 746,739 703,125
B B3 500,000 Level 3 Communications Inc., 10.50% due 12/01/2008 (b) 323,612 287,500
B B2 250,000 Metromedia Fiber Network, 10% due 11/15/2008 250,000 247,500
B B3 300,000 Netia Holdings II BV, 13.125% due 6/15/2009 (c) 300,000 305,250
B B3 2,000,000 Nextlink Communications, 12.25% due 6/01/2009 (b) 1,136,814 1,170,000
B - B3 500,000 Primus Telecommunications Group, 11.25% due 1/15/2009 500,000 477,500
B - B2 400,000 RSL Communications PLC, 9.875% due 11/15/2009 (c) 390,635 348,000
NR* NR* 200,000 Versatel Telecom BV, 11.875% due 7/15/2009 (c) 198,553 191,652
Worldwide Fiber Inc.:
B B3 360,000 12.50% due 12/15/2005 360,000 367,200
B B3 200,000 12% due 8/01/2009 (c) 200,000 200,500
------------ ------------
6,586,607 6,454,527
====================================================================================================================================
Wireless B B3 675,000 ClearNet Communications, 10.125% due 5/01/2009 (b) 425,641 394,875
Telecommunications-- Dolphin Telecom PLC (b):
10.1% CCC+ Caa1 250,000 11.50% due 6/01/2008 122,275 110,000
CCC+ Caa1 330,000 14% due 5/15/2009 (c) 174,554 135,713
ESAT Telecom Group PLC:
B+ Caa1 625,000 12.427% due 2/01/2007 (b) 468,486 450,000
B+ Caa1 1,375,000 11.875% due 12/01/2008 1,454,062 1,409,375
B - B3 400,000 Microcell Telecommunications, 12% due 6/01/2009 (b) 229,989 238,000
NR* Ba3 2,500,000 Nextel Communications Inc., Term C, due 3/31/2007 (a) 2,500,000 2,498,438
CCC+ B3 1,050,000 Nextel Partners Inc., 14% due 2/01/2009 (b)(c) 577,647 630,000
NR* B2 1,497,334 Omnipoint, Term C, due 2/17/2006 (a) 1,405,678 1,482,985
NR* NR* 2,000,000 PowerTel PCS, Term B, due 3/04/2001 (a) 1,994,720 1,985,626
CCC+ Caa1 650,000 Telesystem International Wireless Inc., 16.147%
due 6/30/2007 (b) 388,014 318,500
NR* B2 1,000,000 Tritel Holdings, Term B, due 12/31/2007 (a) 987,882 998,958
NR* B3 525,000 Tritel PCS Inc., 12.75% due 5/15/2009 (b)(c) 293,437 299,250
------------ ------------
11,022,385 10,951,720
====================================================================================================================================
Total Investments in Corporate Debt
Obligations--135.0% 149,313,262 146,666,459
====================================================================================================================================
</TABLE>
10 & 11
<PAGE>
Debt Strategies Fund III, Inc., August 31, 1999
SCHEDULE OF INVESTMENTS (concluded)
<TABLE>
<CAPTION>
Shares Value
INDUSTRIES Held Preferred Stocks Cost (Note 1b)
====================================================================================================================================
<S> <C> <C> <C> <C>
Packaging--0.5% 5,000 Packaging Corporation of America (c)(d) $ 500,000 $ 547,500
====================================================================================================================================
Tower Construction & 2,197 Crown Castle International Corporation (d) 2,208,485 2,207,573
Leasing--2.1%
====================================================================================================================================
Wireless 1,000 Centaur Funding Corp. 1,000,000 1,051,875
Telecommunications-- 500 Dobson Communications (d) 481,250 480,000
1.4% ------------ ------------
1,481,250 1,531,875
====================================================================================================================================
Total Investments in Preferred Stocks--4.0% 4,189,735 4,286,948
====================================================================================================================================
Face
Amount Short-Term Securities
====================================================================================================================================
Commercial Paper**-- $ 582,000 General Motors Acceptance Corp., 5.56% due 9/01/1999 582,000 582,000
0.5%
====================================================================================================================================
Total Investments in Short-Term Securities--0.5% 582,000 582,000
====================================================================================================================================
Total Investments--139.5% $154,084,997 151,535,407
============
Liabilities in Excess of Other Assets--(39.5%) (42,884,033)
------------
Net Assets--100.0% $108,651,374
============
====================================================================================================================================
</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 69.1% of the Fund's net assets.
(b) Represents a zero coupon or step bond; the interest rate shown reflects
the effective yield 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 amount/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.
+ Non-income producing security.
See Notes to Financial Statements.
STATEMENT OF ASSETS, LIABILITIES AND CAPITAL
<TABLE>
<CAPTION>
As of August 31, 1999
====================================================================================================================================
<S> <C> <C> <C>
Assets: Investments, at value (identified cost--$154,084,997) (Note 1b) ................. $151,535,407
Receivables:
Interest ...................................................................... $ 2,499,386
Securities sold ............................................................... 593,791
Dividends ..................................................................... 87,930
Forward foreign exchange contracts ............................................ 7,439 3,188,546
------------
Deferred organization expenses (Note 1g) ........................................ 2,836
Prepaid expenses and other assets ............................................... 33,749
------------
Total assets .................................................................... 154,760,538
------------
====================================================================================================================================
Liabilities: Payables:
Loans (Note 5) ................................................................ 44,000,000
Custodian bank (Note 1i) ...................................................... 1,171,102
Interest on loans ............................................................. 456,487
Dividends to shareholders (Note 1h) ........................................... 215,855
Investment adviser (Note 2) ................................................... 76,332
Securities purchased .......................................................... 68,000
Commitment fees ............................................................... 1,322 45,989,098
------------
Deferred income (Note 1f) ....................................................... 1,717
Accrued expenses and other liabilities .......................................... 118,349
------------
Total liabilities ............................................................... 46,109,164
------------
====================================================================================================================================
Net Assets: Net assets ...................................................................... $108,651,374
============
====================================================================================================================================
Capital: Common Stock, $.10 par value, 200,000,000 shares authorized ..................... $ 1,101,000
Paid-in capital in excess of par ................................................ 108,740,136
Undistributed investment income--net ............................................ 1,040,393
Undistributed realized capital gains on investments and foreign currency
transactions--net ............................................................... 325,981
Unrealized depreciation on investments and foreign currency transactions--net ... (2,556,136)
------------
Total--Equivalent to $9.87 per share based on 11,010,000 shares of capital
stock outstanding (market price--$8.9375) ....................................... $108,651,374
============
====================================================================================================================================
</TABLE>
See Notes to Financial Statements.
12 & 13
<PAGE>
Debt Strategies Fund III, Inc., August 31, 1999
STATEMENT OF OPERATIONS
<TABLE>
<CAPTION>
For the Six Months Ended August 31, 1999
====================================================================================================================================
<S> <C> <C> <C>
Investment Income Interest and discount earned .......................................... $ 7,133,476
(Note 1f): Dividends ............................................................. 292,729
Facility and other fees ............................................... 38,363
------------
Total income .......................................................... 7,464,568
------------
====================================================================================================================================
Expenses: Loan interest expense (Note 5) ........................................ $ 1,082,714
Investment advisory fees (Note 2) ..................................... 456,701
Accounting services (Note 2) .......................................... 46,788
Professional fees ..................................................... 43,848
Borrowing costs (Note 5) .............................................. 29,391
Transfer agent fees (Note 2) .......................................... 14,893
Directors' fees and expenses .......................................... 14,188
Printing and shareholder reports ...................................... 10,233
Organization expenses (Note 1g) ....................................... 9,954
Listing fees .......................................................... 9,474
Custodian fees ........................................................ 9,201
Pricing services ...................................................... 6,553
Other ................................................................. 3,521
------------
Total expenses ........................................................ 1,737,459
------------
Investment income--net ................................................ 5,727,109
------------
====================================================================================================================================
Realized & Unrealized Realized gain from:
Gain (Loss) on Investments--net .................................................... 318,591
Investments & Foreign currency transactions--net .................................. 47,785 366,376
Foreign Currency ------------
Transactions--Net Change in unrealized appreciation/depreciation on:
(Notes 1c, 1d, 1f & 3): Investments--net .................................................... (2,671,994)
Foreign currency transactions--net .................................. (38,442) (2,710,436)
------------ ------------
Net realized and unrealized loss on investments and
foreign currency transactions ......................................... (2,344,060)
------------
Net Increase in Net Assets Resulting from Operations .................. $ 3,383,049
============
====================================================================================================================================
</TABLE>
See Notes to Financial Statements.
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
For the Six For the Period
Months Ended July 31, 1998+
August 31, to February 28,
Increase (Decrease) in Net Assets: 1999 1999
====================================================================================================================================
<S> <C> <C> <C>
Operations: Investment income--net ....................................................... $ 5,727,109 $ 5,158,843
Realized gain (loss) on investments and foreign currency transactions--net ... 366,376 (62,479)
Change in unrealized appreciation/depreciation on investments
and foreign currency transactions--net ....................................... (2,710,436) 154,300
------------ ------------
Net increase in net assets resulting from operations ......................... 3,383,049 5,250,664
------------ ------------
====================================================================================================================================
Dividends to Investment income--net ....................................................... (5,425,519) (4,397,956)
Shareholders ------------ ------------
(Note 1h): Net decrease in net assets resulting from dividends to shareholders .......... (5,425,519) (4,397,956)
------------ ------------
====================================================================================================================================
Capital Share Proceeds from issuance of Common Stock ....................................... -- 110,000,000
Transactions Offering costs resulting from the issuance of Common Stock ................... 36,136 (295,000)
(Notes 1g & 4): ------------ ------------
Net increase in net assets resulting from capital share transactions 36,136 109,705,000
------------ ------------
====================================================================================================================================
Net Assets: Total increase (decrease) in net assets ...................................... (2,006,334) 110,557,708
Beginning of period .......................................................... 110,657,708 100,000
------------ ------------
End of period* ............................................................... $108,651,374 $110,657,708
============ ============
====================================================================================================================================
* Undistributed investment income--net ......................................... $ 1,040,393 $ 738,803
============ ============
====================================================================================================================================
</TABLE>
+ Commencement of operations.
See Notes to Financial Statements.
14 & 15
<PAGE>
Debt Strategies Fund III, Inc., August 31, 1999
STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
For the Six Months Ended August 31, 1999
====================================================================================================================================
<S> <C> <C>
Cash Provided by Net increase in net assets resulting from operations .................................... $ 3,383,049
Operating Activities: Adjustments to reconcile net increase in net assets resulting from operations to net
cash provided by operating activities:
Increase in receivables ............................................................... (219,012)
Decrease in other assets .............................................................. 9,922
Increase in other liabilities ......................................................... 1,520,854
Realized and unrealized loss on investments and foreign currency transactions--net .... 2,344,059
Amortization of discount--net ......................................................... (585,499)
--------------
Net cash provided by operating activities ............................................... 6,453,373
--------------
====================================================================================================================================
Cash Used for Proceeds from sales of long-term investments ............................................ 44,925,113
Investing Activities: Purchases of long-term investments ...................................................... (71,737,438)
Purchases of short-term investments ..................................................... (62,683,673)
Proceeds from sales and maturities of short-term investments ............................ 62,432,000
--------------
Net cash used for investing activities .................................................. (27,063,998)
--------------
====================================================================================================================================
Cash Provided by Cash receipts on capital shares sold .................................................... 36,136
Financing Activities: Cash receipts of borrowings ............................................................. 56,000,000
Cash payment on borrowings .............................................................. (30,000,000)
Dividends paid to shareholders .......................................................... (5,425,837)
--------------
Net cash provided by financing activities ............................................... 20,610,299
--------------
====================================================================================================================================
Cash: Net decrease in cash .................................................................... (326)
Cash at beginning of period ............................................................. 326
--------------
Cash at end of period ................................................................... $ --
==============
====================================================================================================================================
Cash Flow Cash paid for interest .................................................................. $ 679,027
Information: ==============
====================================================================================================================================
</TABLE>
See Notes to Financial Statements.
FINANCIAL HIGHLIGHTS
<TABLE>
<CAPTION>
The following per share data and ratios have been derived For the Six For the Period
from information provided in the financial statements. Months Ended July 31, 1998+
August 31, to February 28,
Increase (Decrease) in Net Asset Value: 1999 1999
====================================================================================================================================
<S> <C> <C> <C>
Per Share Net asset value, beginning of period ....................................... $ 10.05 $ 10.00
Operating ----------- -----------
Performance: Investment income--net ..................................................... .51 .47
Realized and unrealized gain (loss) on investments and foreign
currency transactions--net ................................................. (.20) .01
----------- -----------
Total from investment operations ........................................... .31 .48
----------- -----------
Less dividends from investment income--net ................................. (.49) (.40)
----------- -----------
Capital charge resulting from the issuance of Common Stock ................. -- (.03)
----------- -----------
Net asset value, end of period ............................................. $ 9.87 $ 10.05
=========== ===========
Market price per share, end of period ...................................... $ 8.9375 $ 8.875
=========== ===========
====================================================================================================================================
Total Investment Based on market price per share ............................................ 6.24%++ (7.37%)++
Return:** =========== ===========
Based on net asset value per share ......................................... 3.61%++ 4.89%++
=========== ===========
====================================================================================================================================
Ratios to Average Expenses, net of reimbursement and excluding interest expense .............. 1.18%* .31%*
Net Assets: =========== ===========
Expenses, net of reimbursement ............................................. 3.13%* .39%*
=========== ===========
Expenses ................................................................... 3.13%* 1.09%*
=========== ===========
Investment income--net ..................................................... 10.33%* 8.02%*
=========== ===========
====================================================================================================================================
Leverage: Amount of borrowings, end of period (in thousands) ......................... $ 44,000 $ 18,000
=========== ===========
Average amount of borrowings outstanding during the period (in thousands) .. $ 39,902 $ 1,737
=========== ===========
Average amount of borrowings outstanding per share during the period ....... $ 3.63 $ .16
=========== ===========
====================================================================================================================================
Supplemental Net assets, end of period (in thousands) ................................... $ 108,651 $ 110,658
Data: =========== ===========
Portfolio turnover ......................................................... 31.29% 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
charges.
+ Commencement of operations.
++ Aggregate total investment return.
See Notes to Financial Statements.
16 & 17
<PAGE>
Debt Strategies Fund III, Inc., August 31, 1999
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. 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. Until July 9, 1999,
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 were 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 was
available, such Corporate Loan was valued on the basis of the mean of the last
available bid and asked prices in the market. As of July 12, 1999, pursuant to
the approval of the Board of Directors, the Corporate Loans are valued at the
mean between the last available bid and asked prices from one or more brokers or
dealers as obtained from Loan Pricing Corporation. 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 that are
generally recognized by institutional traders. In certain circumstances,
portfolio securities are valued at the last sale price on the exchange that is
the primary market for such securities, or the last quoted bid price for those
securities for which the over-the-counter market is the primary market or for
listed securities in which there were no sales during the day. The value of
interest rate swaps, caps and floors is determined in accordance with a formula
and then confirmed periodically by obtaining a bank quotation. Positions in
options are valued at the last sale price on the market where any such option is
principally traded. Short-term securities with remaining maturities of sixty
days or less are valued at amortized cost, which approximates market value.
Securities and assets for which market price quotations are not readily
available are valued at fair value as determined in good faith by or under the
direction of the Board of Directors of the Fund.
(c) Derivative financial instruments -- The Fund may engage in various portfolio
strategies to seek to increase its return by hedging its portfolio against
adverse movements in the debt markets. Losses may arise due to changes in the
value of the contract or if the counterparty does not perform under the
contract.
o Financial futures contracts -- The Fund may purchase or sell financial futures
contracts and options on such futures contracts for the purpose of hedging the
market risk on existing securities or the intended purchase of securities.
Futures contracts are contracts for delayed delivery of securities at a specific
future date and at a specific price or yield. Upon entering into a contract, the
Fund deposits and maintains as collateral such initial margin as required by the
exchange on which the transaction is effected. Pursuant to the contract, the
Fund agrees to receive from or pay to the broker an amount of cash equal to the
daily fluctuation in value of the contract. Such receipts or payments are known
as variation margin and are recorded by the Fund as unrealized gains or losses.
When the contract is closed, the Fund records a realized gain or loss equal to
the difference between the value of the contract at the time it was opened and
the value at the time it was closed.
o Forward foreign exchange contracts -- The Fund is authorized to enter into
forward foreign exchange contracts as a hedge against either specific
transactions or portfolio positions. Such contracts are not entered on the
Fund's records. However, the effect on operations is recorded from the date the
Fund enters into such contracts.
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 -- In accordance with Statement
of Position 98-5, unamortized organization expenses of $9,954 were expensed
during the six months ended August 31, 1999. The remaining unamortized
organization expenses will be expensed by February 29, 2000. This is considered
to be a change in accounting principle and had no material impact on the
operations of the Fund. Direct expenses relating to the public offering of the
Fund's Common Stock were charged to capital at the time of issuance of the
shares.
(h) Dividends and distributions -- Dividends from net investment income are
declared and paid monthly. Distributions of capital gains are recorded on the
ex-dividend dates.
(i) Custodian bank -- The Fund recorded an amount payable to the custodian bank
reflecting an overdraft which resulted from a failed trade.
2. Investment Advisory Agreement and Transactions with Affiliates:
The Fund has entered into an Investment Advisory Agreement with Fund Asset
Management, L.P. ("FAM"). The
18 & 19
<PAGE>
Debt Strategies Fund III, Inc., August 31, 1999
NOTES TO FINANCIAL STATEMENTS (concluded)
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 .60% of the Fund's average weekly net assets
plus the proceeds of any outstanding borrowings used for leverage.
For the six months ended August 31, 1999, the Fund paid Merrill Lynch Security
Pricing Service, an affiliate of Merrill Lynch, Pierce, Fenner & Smith
Incorporated, $360 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 six
months ended August 31, 1999 were $71,080,438 and $45,518,904, respectively.
Net realized gains for the six months ended August 31, 1999 and net unrealized
losses as of August 31, 1999 were as follows:
- --------------------------------------------------------------------------------
Realized Unrealized
Gains Losses
- --------------------------------------------------------------------------------
Long-term investments ..................... $ 318,591 $(2,549,590)
Foreign currency transactions ............. 47,785 (6,546)
----------- -----------
Total ..................................... $ 366,376 $(2,556,136)
=========== ===========
- --------------------------------------------------------------------------------
As of August 31, 1999, net unrealized depreciation for Federal income tax
purposes aggregated $2,549,590, of which $1,149,782 related to appreciated
securities and $3,699,372 related to depreciated securities. The aggregate cost
of investments at August 31, 1999 for Federal income tax purposes was
$154,084,997.
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 six months ended August
31, 1999 remained constant and for 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 .50% and/or LIBOR plus .50%. For the six months ended August 31,
1999, the average amount bor-rowed was approximately $39,902,000 and the daily
weighted average interest rate was 5.38%. For the six months ended August 31,
1999, facility and commitment fees aggregated approximately $29,000.
6. Subsequent Event:
On September 8, 1999, the Fund's Board of Directors declared an ordinary income
dividend to Common Stock shareholders in the amount of $.094495 per share,
payable on September 30, 1999 to shareholders of record as of September 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 issuers of securities
in which the Fund invests. This negative impact may be greater for companies in
foreign markets, particularly emerging markets, since they may be less prepared
for the Year 2000 Problem than domestic companies and markets. If the companies
in which the Fund invests have Year 2000 Problems, the Fund's returns could be
adversely affected.
20 & 21
<PAGE>
Debt Strategies Fund III, Inc., August 31, 1999
PORTFOLIO PROFILE
As of August 31, 1999
Percent of
Quality Ratings Long-Term
S&P/Moody's Investments
- --------------------------------------------------------------------------------
BBB/Baa ............................................................... 0.8%
BB/Ba ................................................................. 25.7
B/B ................................................................... 54.0
CCC/Caa ............................................................... 3.0
CC/Ca ................................................................. 0.3
NR (Not Rated) ........................................................ 16.2
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
Percent of
Long-Term
Breakdown of Investments by Country Investments
- --------------------------------------------------------------------------------
United States ......................................................... 93.3%
Canada ................................................................ 2.1
United Kingdom ........................................................ 1.9
Ireland ............................................................... 1.2
Cayman Islands ........................................................ 0.7
Australia ............................................................. 0.3
Poland ................................................................ 0.3
Netherlands ........................................................... 0.1
Belgium ............................................................... 0.1
- --------------------------------------------------------------------------------
Percent of
Ten Largest Holdings Total Assets
- --------------------------------------------------------------------------------
Coaxial Communications/Phoenix ........................................ 2.3%
Ackerley Group Inc. ................................................... 2.1
Lyondell Petrochemical Co. ............................................ 2.0
Bridge Information Systems ............................................ 2.0
Ormet Corporation ..................................................... 1.9
Starwood Hotels & Resorts Worldwide, Inc. ............................. 1.9
Wyndham International ................................................. 1.9
Avis Rent A Car ....................................................... 1.9
Cliffs Drilling ....................................................... 1.9
Specialty Foods, Inc. ................................................. 1.9
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
Percent of
Five Largest Industries Total Assets
- --------------------------------------------------------------------------------
Wireless Telecommunications ........................................... 8.1%
Chemicals ............................................................. 6.0
Cable ................................................................. 5.5
Broadcast--Radio & Television ......................................... 5.4
Paper ................................................................. 5.4
- --------------------------------------------------------------------------------
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
22 & 23
<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--8/99
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