PAGE 1
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T. Rowe Price
Tax-Free Fimds
July 1, 1996
Prospectus
Contents
<TABLE>
<CAPTION>
<S> <C>
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1 About the Funds
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Transaction and Fund Expenses 2
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Financial Highlights 4
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Fund, Market, and Risk
Characteristics 6
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2 About Your Account
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Pricing Shares and Receiving Sale Proceeds 13
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Distributions and Taxes 14
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Transaction Procedures and Special Requirements 16
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3 More About the Funds
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Organization and Management 18
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Understanding Performance Information 20
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Investment Policies and Practices 21
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4 Investing With T. Rowe Price
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Account Requirements and Transaction Information 30
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Opening a New Account 30
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Purchasing Additional Shares 31
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Exchanging and Redeeming 32
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Shareholder Services 33
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</TABLE>
This prospectus contains information you should know before investing. Please
keep it for future reference. A Statement of Additional Information about
the funds, dated July 1, 1996, has been filed with the Securities and Exchange
Commission and is incorporated by reference in this prospectus. To obtain a
free copy, call 1-800-638-5660.
<PAGE>
1 About the Funds
1 About the Funds
Transaction and Fund Expenses
Like all T. Rowe Price funds, these funds are 100% no load.
These tables should help you understand the kinds of expenses you will bear
directly or indirectly as a fund shareholder.
In Table 1 below, "Shareholder Transaction Expenses," shows that you pay no
sales charges. All the money you invest in a fund goes to work for you, subject
to the fees explained below. "Annual Fund Expenses" shows how much it will cost
to operate each fund for a year, based on 1996 fiscal year expenses. These are
costs you pay indirectly, because they are deducted from each fund's total
assets before the daily share price is calculated and before dividends and other
distributions are made. In other words, you will not see these expenses on your
account statement.
<TABLE>
<CAPTION>
========================================================================================================================
Shareholder Transaction Expenses
Money Short- Insured Income High
Intermediate Intermediate Yield
- ------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Sales charge "load" on purchases None None None None None
- ------------------------------------------------------------------------------------------------------------------------
Sales charge "load" on reinvested dividends None None None None None
- ------------------------------------------------------------------------------------------------------------------------
Redemption fees None None None None None
- ------------------------------------------------------------------------------------------------------------------------
Exchange fees None None None None None
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<CAPTION>
Annual Fund Expenses Percentage of Fiscal 1996 Average Net Assets
Money Short- Insured Income High
Intermediate Intermediate Yield
(after reduction)/a/
- ------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Management fee 0.44% 0.44% 0.31%/a/ 0.49% 0.64%
- ------------------------------------------------------------------------------------------------------------------------
Marketing fees (12b-1) None None None None None
- ------------------------------------------------------------------------------------------------------------------------
Total other (shareholder servicing,
custodial, auditing, etc.) 0.12% 0.13% 0.34% 0.10% 0.11%
- ------------------------------------------------------------------------------------------------------------------------
Total fund expenses 0.56% 0.57% 0.65%/a/ 0.59% 0.75%
- ------------------------------------------------------------------------------------------------------------------------
</TABLE>
/a/ The Insured Intermediate Fund's management fee and its total expense ratio
would have been 0.39% and 0.73%, respectively, had T. Rowe Price not agreed
to reduce management fees in accordance with the expense limitation
described below. From March 1, 1994, through February 29, 1996, T. Rowe
Price agreed to waive its fees and bear any expenses to the extent such fees
and expenses would cause the fund's ratio of expenses to average net assets
to exceed 0.65%. Fees waived or expenses paid or assumed under this
agreement are subject to reimbursement to T. Rowe Price by the fund whenever
the fund's expense ratio is below 0.65%. However, no reimbursement will be
made after February 28, 1998, or if it would result in the expense ratio
exceeding 0.65%.
Note: The funds charge a $5 fee for wire redemptions under $5,000, subject to
change without notice, and a $10 fee is charged for small accounts when
applicable (see "Small Account Fee" under "Transaction Procedures and Special
Requirements").
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Table 1
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2 T. Rowe Price
<PAGE>
1 About the Funds
The main types of expenses, which all mutual funds may charge against fund
assets, are:
. A management fee: the percent of fund assets paid to the fund's investment
manager. Each fund's fee comprises both a group fee, described later, and an
individual fund fee, as follows: Money 0.10%; Short-Intermediate 0.10%;
Insured Intermediate 0.05%; Income 0.15%; and High Yield 0.30%.
. "Other" administrative expenses: primarily the servicing of shareholder
accounts, such as providing statements, reports, disbursing dividends as well
as custodial services. For the fiscal year ended February 29, 1996, the funds
paid the following fees to T. Rowe Price Services, Inc. for transfer and
dividend disbursing functions and shareholder services, and to
T. Rowe Price for accounting services.
==============================================================================
Fund Transfer Agent and Accounting
Shareholder Services Services
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Money $407,000 $ 93,000
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Short-Intermediate $250,000 $ 86,000
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Insured Intermediate $ 93,000 $ 61,000
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Income $590,000 $110,000
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High Yield $504,000 $110,000
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Table 2
. Marketing or distribution fees: an annual charge ("12b-1") to existing
shareholders to defray the cost of selling shares to new shareholders. T. Rowe
Price funds do not levy 12b-1 fees.
For further details on fund expenses, please see "Organization and
Management."
. Hypothetical example: Assume you invest $1,000, the fund returns 5% annually,
expense ratios remain as listed previously, and you close your account at the
end of the time periods shown.
Your expenses would be:
==============================================================================
Fund 1 year 3 years 5 years 10 years
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Money $6 $19 $33 $74
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Short-Intermediate $6 $18 $32 $71
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Insured Intermediate $7 $21 $36 $81
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Income $6 $19 $33 $74
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High Yield $8 $24 $42 $93
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Table 3
The table at right is just an example; actual expenses can be higher or lower
than those shown.
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T. Rowe Price 3
<PAGE>
1 About the Funds
Financial Highlights
The following table provides information about each fund's financial history. It
is based on a single share outstanding throughout each fiscal year. The
respective table is part of each fund's financial statements which are included
in each fund's annual report and are incorporated by reference into the
Statement of Additional Information. This document is available to shareholders
upon request. The financial statements in the annual report have been audited by
the funds' independent accountants whose respective unqualified reports cover
the periods shown.
<TABLE>
<CAPTION>
Investment Activities Distributions
Net
Investment Net Realized and Total From Net Investment
Period Ended Net Asset Value, Income Unrealized Gain (loss) Investment Income Net Realized Total
February 28 Beginning of Period (Loss) of Investments Activities (Loss) Gain (Loss) Distributions
====================================================================================================================================
Money
<S> <C> <C> <C> <C> <C> <C> <C>
1987 $1.000 $0.042 -- $0.042 $(0.042) -- $(0.042)
1988/d/ 1.000 0.044 -- 0.044 (0.044) -- (0.044)
1989 1.000 0.050 -- 0.050 (0.050) -- (0.050)
1990 1.000 0.057 -- 0.057 (0.057) -- (0.057)
1991 1.000 0.051 -- 0.051 (0.051) -- (0.051)
1992/d/ 1.000 0.036 -- 0.036 (0.036) -- (0.036)
1993 1.000 0.023 -- 0.023 (0.023) -- (0.023)
1994 1.000 0.020 -- 0.020 (0.020) -- (0.020)
1995 1.000 0.026 -- 0.026 (0.026) -- (0.026)
1996/d/ 1.000 0.033 -- 0.033 (0.033) -- (0.033)
- ------------------------------------------------------------------------------------------------------------------------------------
Short-
Intermediate
1987 $ 5.20 $ 0.29 $0.13 $0.42 $ (0.29) -- $ (0.29)
1988/d/ 5.33 0.27 (0.16) 0.11 (0.27) $(0.02) (0.29)
1989 5.15 0.28 (0.12) 0.16 (0.28) -- (0.28)
1990 5.03 0.30 0.06 0.36 (0.30) -- (0.30)
1991 5.09 0.29 0.06 0.35 (0.29) -- (0.29)
1992/d/ 5.15 0.28 0.07 0.35 (0.28) -- (0.28)
1993 5.22 0.24 0.14 0.38 (0.24) -- (0.24)
1994 5.36 0.22 (0.04) 0.18 (0.22) -- (0.22)
1995 5.32 0.22 (0.07) 0.15 (0.22) -- (0.22)
1996/d/ 5.25 0.23 0.12 0.35 (0.23) -- (0.23)
<CAPTION>
Ratio of Net
Total Return Ratio of Investment
(Includes Expenses to Income to Portfolio
Period Ended Net Asset Value, Reinvested Net Assets Average Net Average Net Turnover
February 28 End of Period Dividends) ($ Thousands Assets Assets Rate
====================================================================================================================================
Money
<S> <C> <C> <C> <C> <C> <C>
1987 $1.000 4.30% $1,131,755 0.60% 4.23% --
1988/d/ 1.000 4.47% 1,247,256 0.60% 4.41% --
1989 1.000 5.08% 1,157,246 0.60% 4.97% --
1990 1.000 5.87% 1,064,141 0.60% 5.75% --
1991 1.000 5.22% 977,638 0.60% 5.12% --
1992/d/ 1.000 3.69% 801,846 0.61% 3.65% --
1993 1.000 2.36% 695,699 0.60% 2.35% --
1994 1.000 2.05% 732,900 0.59% 2.04% --
1995 1.000 2.63% 687,022 0.58% 2.59% --
1996/d/ 1.000 3.38% 679,143 0.56% 3.33% --
<CAPTION>
<S> <C> <C> <C> <C> <C> <C>
1987 $5.33 8.41% $405,092 0.73% 5.60% 119.5%
1988/d/ 5.15 2.25% 291,850 0.74% 5.29% 225.2%
1989 5.03 3.14% 249,489 0.74% 5.46% 53.4%
1990 5.09 7.36% 223,180 0.75% 5.93% 190.8%
1991 5.15 7.06% 232,923 0.74% 5.67% 190.1%
1992/d/ 5.22 6.94% 328,312 0.67% 5.34% 81.3%
1993 5.36 7.51% 454,162 0.63% 4.61% 38.5%
1994 5.32 3.49% 540,728 0.60% 4.18% 51.1%
1995 5.25 2.91% 454,084 0.59% 4.19% 93.1%
1996/d/ 5.37 6.87% 445,228 0.57% 4.39% 69.9%
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(continued on next page)
</TABLE>
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4 T. Rowe Price
<PAGE>
<TABLE>
<CAPTION>
====================================================================================================================================
Investment Activities Distributions
Net
Investment Net Realized and Total From Net Investment
Period Ended Net Asset Value, Income Unrealized Gain (Loss) Investment Income Net Realized Total
February 28 Beginning of Period (Loss) on Investments Activities (Loss) Gain (Loss) Distributions
====================================================================================================================================
Insured
Intermediate
<S> <C> <C> <C> <C> <C> <C> <C>
1993/a/ $10.00 $0.13/b/ $ 0.55 $ 0.68 $(0.13) -- $(0.13)
1994 10.55 0.48/b/ 0.09 0.57 (0.48) $(0.06) (0.54)
1995 10.58 0.46/b/ (0.20) 0.26 (0.46) (0.03) (0.49)
1996/d/ 10.35 0.48/b/ 0.49 0.97 (0.48) -- (0.48)
- ------------------------------------------------------------------------------------------------------------------------------------
Income
1987 $ 9.73 $0.68 $ 0.54 $ 1.22 $(0.68) -- $(0.68)
1988/d/ 10.27 0.59 (0.92) (0.33) (0.59) $(0.54) (1.13)
1989 8.81 0.59 (0.24) 0.35 (0.59) -- (0.59)
1990 8.57 0.59 0.09 0.68 (0.59) -- (0.59)
1991 8.66 0.57 0.13 0.70 (0.57) -- (0.57)
1992/d/ 8.79 0.57 0.30 0.87 (0.57) -- (0.57)
1993 9.09 0.56 0.75 1.31 (0.56) -- (0.56)
1994 9.84 0.54 -- 0.54 (0.54) (0.18) (0.72)
1995 9.66 0.53 (0.37) 0.16 (0.53) (0.04) (0.57)
1996/d/ 9.25 0.52 0.41 0.93 (0.52) -- (0.52)
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High Yield
1987 $11.43 $0.87 $ 0.78 $ 1.65 $(0.87) -- $(0.87)
1988/d/ 12.21 0.83 (0.77) 0.06 (0.83) $(0.25) (1.08)
1989 11.19 0.83 0.06 0.89 (0.83) -- (0.83)
1990 11.25 0.84 0.20 1.04 (0.84) (0.06) (0.90)
1991 11.39 0.83 0.04 0.87 (0.83) (0.03) (0.86)
1992/d/ 11.40 0.81 0.35 1.16 (0.81) (0.10) (0.91)
1993 11.65 0.78 0.78 1.56 (0.78) (0.10) (0.88)
1994 12.33 0.74 0.16 0.90 (0.74) (0.23) (0.97)
1995 12.26 0.73 (0.60) 0.13 (0.73) (0.04) (0.77)
1996/d/ 11.62 0.72 0.48 1.20 (0.72) -- (0.72)
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<CAPTION>
End of Period
Ratio of Net
Total Return Ratio of Investment
(Includes Expenses to Income to Portfolio
Period Ended Net Asset Value, Reinvested Net Assets Average Net Average Net Turnover
February 28 End of Period Dividends) ($ Thousands) Assets Assets Rate
====================================================================================================================================
<S> <C> <C> <C> <C> <C> <C>
1993/a/ $10.55 6.81% $ 37,960 0.00%/bc/ 5.08%/c/ 65.3%/c/
1994 10.58 5.49% 99,162 0.33%/b/ 4.45% 74.8%
1995 10.35 2.65% 83,517 0.65%/b/ 4.53% 170.8%
1996/d/ 10.84 9.57% 92,153 0.65%/b/ 4.52% 63.8%
- ------------------------------------------------------------------------------------------------------------------------------------
Income
1987 $10.27 13.07% $1,558,795 0.61% 6.94% 236.6%
1988/d/ 8.81 (3.17)% 1,094,430 0.65% 6.72% 180.6%
1989 8.57 4.11% 1,023,204 0.66% 6.81% 115.9%
1990 8.66 8.15% 1,123,143 0.64% 6.80% 140.5%
1991 8.79 8.40% 1,128,635 0.63% 6.59% 79.7%
1992/d/ 9.09 10.17% 1,245,297 0.62% 6.34% 57.9%
1993 9.84 14.88% 1,441,646 0.61% 5.98% 76.7%
1994 9.66 5.50% 1,452,581 0.59% 5.40% 71.2%
1995 9.25 1.90% 1,328,675 0.59% 5.80% 49.3%
1996/d/ 9.66 10.31% 1,375,507 0.58% 5.49% 48.7%
- ------------------------------------------------------------------------------------------------------------------------------------
High Yield
1987 $12.21 15.04% $ 324,094 0.98% 7.45% 111.4%
1988/d/ 11.19 0.83% 280,580 0.96% 7.49% 127.6%
1989 11.25 8.27% 331,329 0.92% 7.45% 61.8%
1990 11.39 9.54% 443,372 0.88% 7.38% 72.4%
1991 11.40 7.93% 505,025 0.85% 7.30% 51.2%
1992/d/ 11.65 10.56% 623,877 0.83% 7.01% 51.0%
1993 12.33 13.94% 853,185 0.81% 6.58% 34.7%
1994 12.26 7.49% 941,295 0.79% 5.95% 59.3%
1995 11.62 1.26% 873,546 0.79% 6.29% 59.6%
1996/d/ 12.10 10.62% 989,534 0.75% 6.07% 39.3%
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</TABLE>
/a/ For the period November 30, 1992 (commencement of operations) to February
28, 1993.
/b/ T. Rowe Price voluntarily agreed to bear all expenses of the fund through
June 30, 1993. Excludes expenses in excess of a 0.20% voluntary expense
limitation in effect July 1, 1993, through July 31, 1993, a 0.30%
voluntary expense limitation in effect August 1, 1993, through August 31,
1993, a 0.40% voluntary expense limitation in effect September 1, 1993,
through September 30, 1993, and a 0.50% voluntary expense limitation in
effect October 1, 1993, through February 28, 1994, and a 0.65% voluntary
expense limitation in effect March 1, 1994, through February 29, 1996.
/c/ Annualized.
/d/ Year ended February 29.
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Table 4
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T. Rowe Price 5
<PAGE>
1 About the Funds
Fund, Market, and Risk Characteristics: What to Expect
To help you decide whether the funds are appropriate for you, this section takes
a closer look at their investment objectives and approaches.
What are the funds' objectives and investment programs?
The fund or funds you select should not be relied upon as a complete investment
program, nor be used for short-term trading purposes.
Tax-Exempt Money Fund. The fund's objective is to seek preservation of capital,
liquidity, and consistent with this objective, the highest current income exempt
from federal income taxes. The fund's yield will fluctuate in response to
changes in the general level of interest rates, but the share price is managed
to remain stable at $1.00. Although the fund has maintained a constant share
price since its inception, and fund managers will make every effort to continue
to meet this objective, the price could drop below $1.00 under certain
circumstances, such as a major change in interest rates or default on one or
more fund holdings. Unlike a bank account or certificate of deposit, your
investment is not insured or guaranteed by the U.S. government.
The fund purchases securities with maturities of 397 days or less, and its
dollar-weighted average maturity will not exceed 90 days. All securities
purchased by the fund will generally have ratings in the two highest categories
established by nationally recognized rating agencies, or, if unrated, will be of
equivalent quality as determined by T. Rowe Price analysts. The fund may retain
a security that is downgraded after purchase, but only in accordance with Rule
2a-7 under the Investment Company Act of 1940.
For further details on the funds' investment programs, risks, and fundamental
policies, please see the section, "Investment Policies and Practices."
Tax-Free Short-Intermediate Fund. The fund's objective is to seek a high level
of income exempt from federal income taxes consistent with modest price
fluctuation by investing primarily in municipal securities in the four highest
credit categories. The fund will not purchase any bonds rated below investment
grade (e.g., BBB) by a national rating agency (or, if unrated, the T. Rowe Price
equivalent). Investment-grade securities include a range of securities from the
highest rated to medium quality (BBB). Securities in the BBB category may be
more susceptible to adverse economic conditions or changing circumstances and
securities at the lower end of the BBB category have certain speculative
characteristics. This is the most conservative of the four T. Rowe Price tax-
free bond funds. Under normal market conditions, its dollar-weighted average
maturity will not exceed five years and is expected to range between two and
five years. As a result, its price fluctuation should be modest in response to
changes in interest rates. Its interest income should be above the money fund
but lower than the other bond funds.
The bond funds may retain a security whose credit quality is downgraded after
purchase.
Tax-Free Insured Intermediate Bond Fund. The fund's objective is to seek a high
level of income exempt from federal income taxes and moderate price fluctuation
while minimizing credit risk by investing primarily in insured municipal
securities. The fund is expected to maintain a dollar-weighted average maturity
between 5 and 10 years. This fund should provide higher income and volatility
than the Short-Intermediate Fund and lower income and volatility than the other
bond funds.
- -----------------------
6 T. Rowe Price
<PAGE>
1 About the Funds
For extra credit-quality protection, the fund will invest at least 65% of its
total assets in municipals insured by companies carrying the highest credit
rating from a national rating organization, e.g., AAA by Standard & Poor's or
Aaa by Moody's Investors Service. (The insurer's rating determines the rating of
the insured bond.) Up to 35% of assets may also be invested in other municipals
rated at least AA or Aa by rating agencies, or, if unrated, believed to be of
comparable quality at the time of purchase.
Tax-Free Income Fund. The fund's objective is to seek a high level of income
exempt from federal income taxes by investing primarily in long-term,
investment-grade municipal securities. The fund's dollar-weighted average
maturity is expected to exceed 15 years. As such, the fund is suitable for more
aggressive investors than the other funds with shorter average maturities. It
will be actively managed to seek capital appreciation and minimize losses due to
interest rate movements. From time to time, the fund may purchase below-
investment-grade securities (including those that have received the lowest
rating or are not rated by a national rating agency). However, no such purchase
will be made if it would cause the fund's investments in noninvestment-grade
bonds to exceed 5% of net assets.
The combination of long maturity and lower credit quality makes the High Yield
Fund potentially the most risky as well as potentially the most rewarding of the
tax-free funds. (See "High-Yield/High-Risk Investing.")
Tax-Free High Yield Fund. The fund's objective is to seek a high level of income
exempt from federal income tax by investing primarily in long-term, low- to
upper-medium-quality municipal securities. This is the most aggressive of our
bond funds and should provide the highest income, because the average credit
quality of its holdings is lower than our other funds. Less creditworthy
borrowers must offer higher interest payments to compensate investors for taking
greater risk. The fund may invest a substantial portion of assets in
noninvestment-grade municipal bonds, which have a higher risk of default than
investment-grade bonds. Similar bonds in the taxable bond market are called
"junk" bonds. The fund may also purchase bonds that are in default, but such
bonds are not expected to exceed 10% of the fund's total assets. Lower-quality
municipals are more vulnerable to real or perceived changes in the business
climate than higher-quality bonds, and they may also be considerably less liquid
and more volatile in price. As a result, we rely heavily on our proprietary
research when selecting investments, and judgment may play a bigger role in
valuing the fund's securities. The fund's dollar-weighted average maturity is
expected to exceed 15 years.
A more detailed discussion of these and other risk considerations is contained
in the funds' Statement of Additional Information.
What are the main risks of investing in municipal bond and money market funds?
Since they are managed to maintain a $1.00 share price, money market funds
should have little risk of principal loss. However, the potential for realizing
a loss of principal in a bond or money market fund could derive from:
. Interest rate or market risk: the decline in the prices of fixed income
securities and funds that may accompany a rise in the overall level of interest
rates (please see Table 5). A sharp and unexpected rise in interest rates could
cause a money fund's price to drop below one dollar. However, the extremely
short-term securities held in money market portfolios--a means of achieving an
overall fund objective of principal safety--reduces their potential for price
fluctuation.
-----------------------
T. Rowe Price 7
<PAGE>
1 About the Funds
. Credit risk: the chance that any of a fund's holdings will have its credit
rating downgraded or will default (fail to make scheduled interest and principal
payments), potentially reducing a fund's income level and share price. Money
funds invest in very high-rated securities, thus reducing this risk.
. Political risk: the chance that a significant restructuring of federal income
tax rates, or even serious discussion on the topic in Congress, could cause
municipal bond prices to fall. The demand for municipal bonds is strongly
influenced by the value of tax-exempt income to investors. Broadly lower tax
rates could reduce the advantage of owning municipal bonds.
. Geographical risk: the chance of price declines resulting from developments
in a single state.
The yield of each fund will fluctuate with changing market conditions and
interest rate levels. The share price of the bond funds will also fluctuate;
when you sell your shares, you may lose money.
How does the portfolio manager try to reduce risk?
Consistent with each fund's objective, the portfolio manager actively seeks to
reduce risk and increase total return. Risk management tools include:
. Diversification of assets to reduce the impact of a single holding on the
funds' net asset value.
. Thorough credit research by our own analysts.
. Adjustment of fund duration to try to reduce the negative impact of rising
interest rates or take advantage of the benefits of falling rates.
What are derivatives and can the funds invest in them?
The term derivative is used to describe financial instruments whose value is
derived from an underlying security (e.g., a stock or bond) or a market
benchmark (e.g., an interest rate index). Many types of investments representing
a wide range of potential risks and rewards fall under the "derivatives"
umbrella--from conventional instruments such as callable bonds, futures, and
options, to more exotic investments such as stripped mortgage securities and
structured notes. While the term "derivative" has only recently become widely
known among the investing public, derivatives have in fact been employed by
investment managers for many years.
Each fund will invest in derivatives only if the expected risks and rewards are
consistent with its objective, policies, and overall risk profile as described
in this prospectus. The money fund does not invest in high-risk, highly
leveraged derivatives. The bond funds limit their use of derivatives to
situations in which they may enable the fund to accomplish the following:
increase yield; hedge against a decline in principal value; invest in eligible
asset classes with greater efficiency and lower cost than is possible through
direct investment; or adjust the fund's duration.
The bond funds will not invest in any high-risk, highly leveraged derivative
instrument that is expected to cause the price volatility of the portfolio to be
meaningfully different from that of 1) a five-year investment-grade bond for the
Short-Intermediate Fund; 2) an intermediate-term investment-grade bond for the
Insured Intermediate Bond Fund; or, 3) a long-term investment-grade bond for
both the Income and High Yield Funds.
- -----------------------
8 T. Rowe Price
<PAGE>
1 About the Funds
Before choosing a fund, you may wish to review these characteristics of
municipal securities.
Who issues municipal securities?
State and local governments and governmental authorities sell notes and bonds
(usually called "municipals") to pay for public projects and services.
Who buys municipal securities?
Individuals are the primary investors, and a principal way they invest is
through mutual funds. Prices of municipals may be affected by major changes in
cash flows of money into or out of municipal funds. For example, substantial and
sustained redemptions from municipal bond funds could result in lower prices for
these securities.
What is "tax-free" about municipal bonds and bond funds?
The regular income dividends you receive from the fund are exempt from regular
federal income taxes. In addition, your state may not tax that portion of the
fund's income earned on the state's own obligations (if any). However, capital
gains distributed by the funds are taxable to you. (See "Useful Information on
Distributions and Taxes" for details.)
Municipal securities are also called "tax-exempts" because the interest income
they provide is usually exempt from federal income taxes.
Is interest income from municipal issues always exempt from federal taxes?
No. For example, since 1986, income from so-called "private activity" municipals
has been subject to the federal alternative minimum tax (AMT). For instance,
some bonds financing airports, stadiums, and student loan programs fall into
this category. Shareholders subject to the AMT must include income derived from
private activity bonds in their AMT calculation. Relatively few taxpayers are
required to pay the tax. Normally, the funds will not purchase any security if,
as a result, more than 20% of the fund's income would be subject to the AMT. The
funds will report annually to shareholders the portion of income, if any,
subject to the AMT. (Please see "Distributions and Taxes--Taxes on Fund
Distributions.")
Why are yields on municipals usually below those on otherwise comparable taxable
securities?
Since the income provided by most municipals is exempt from federal taxation,
investors are willing to accept lower yields on a municipal bond than on an
otherwise similar (in quality and maturity) taxable bond.
How can I tell if a tax-free or taxable fund is more suitable for me?
The primary factor is your expected federal income tax rate. The higher your tax
bracket, the more likely tax-frees will be appropriate. If the after-tax yield
on a taxable bond or money market security is less than a municipal fund's tax-
exempt yield, then your income will be higher in the municipal fund. To find
what a taxable fund would have to yield to equal the tax-free yield on a
municipal bond, divide the municipal bond's yield by one minus your tax rate.
What are the major differences between money market and bond funds?
. Price: Bond funds have fluctuating share prices. Money market funds are
managed to maintain a stable share price.
. Maturity: Short- and intermediate-term bond funds have longer average
maturities (from 1 to 10 years) than money market funds (90 days or less).
Longer-term bond funds have the longest average maturities (10 years or more).
-----------------------
T. Rowe Price 9
<PAGE>
1 About the Funds
. Income: Short- and intermediate-term bond funds typically offer more income
than money market funds and less income than longer-term bond funds.
You may want to review some fundamentals that apply to all fixed income
investments.
Is a fund's yield fixed or will it vary?
It will vary. The yield is calculated every day by dividing a fund's net income
per share, expressed at annual rates, by the share price. Since both income and
share price will fluctuate, a fund's yield will also vary. (Although money fund
prices are stable, income is variable.)
Is a fund's "yield" the same thing as the "total return"?
Not for bond funds. The total return reported for a fund is the result of
reinvested distributions (income and capital gains) and the change in share
price for a given time period. Income is always a positive contributor to total
return and can enhance a rise in share price or serve as an offset to a drop in
share price. Since money funds are managed to maintain a stable share price,
their yield and total return should be the same.
What is "credit quality" and how does it affect a fund's yield?
Credit quality refers to a bond issuer's expected ability to make all required
interest and principal payments in a timely manner. Because highly rated issuers
represent less risk, they can borrow at lower interest rates than less
creditworthy issuers. Therefore, a fund investing in high credit-quality
securities should have a lower yield than an otherwise comparable fund investing
in lower credit-quality securities.
What is meant by a bond fund's "maturity"?
Every bond has a stated maturity date when the issuer must repay the security's
entire principal value to the investor. However, many bonds are "callable,"
meaning their principal can be repaid before their stated maturity dates on (or
after) specified call dates. Bonds are most likely to be called when interest
rates are falling, because the issuer wants to refinance at a lower rate. In
such an environment, a bond's "effective maturity" is calculated using its
nearest call date.
A bond mutual fund has no maturity in the strict sense of the word, but it does
have an average maturity and an average effective maturity. This number is an
average of the stated or effective maturities of the underlying bonds, with each
bond's maturity "weighted" by the percentage of fund assets it represents. Funds
that target effective maturities would use the effective (rather than stated)
maturities of the underlying instruments when computing the average. Targeting
effective maturity provides additional flexibility in portfolio management but,
all else being equal, could result in higher volatility than a fund targeting a
stated maturity or maturity range.
What is meant by a bond fund's "duration"?
Duration is a calculation that seeks to measure the price sensitivity of a bond
or a bond fund to changes in interest rates. It measures bond price sensitivity
to interest rate changes more accurately than maturity because it takes into
account the time value of cash flows generated over the bond's life. Future
interest and principal payments are discounted to reflect their present value
and then are multiplied by the number of years they will be received to produce
a value that is expressed in years, i.e., the duration. Effective duration takes
into account call features and sinking fund payments that may shorten a bond's
life.
- -----------------------
10 T. Rowe Price
<PAGE>
1 About the Funds
Since duration can also be computed for bond funds, you can estimate the effect
of interest rates on a fund's share price. Simply multiply the fund's duration
(available for T. Rowe Price bond funds in our shareholder reports) by an
expected change in interest rates. For example, the price of a bond fund with a
duration of five years would be expected to fall approximately 5% if rates rose
by one percentage point.
How is a municipal's price affected by changes in interest rates?
In general, the longer a bond's maturity, the greater the price increase or
decrease in response to a given change in interest rates, as shown in the table
at right.
When interest rates rise, a municipal's price usually falls, and vice versa.
================================================================================
How Interest Rates Affect Bond Prices
<TABLE>
<CAPTION>
Bond Maturity Coupon Price per $1,000 of a Municipal Bond if
Interest Rates:
Increase Decrease
1% 2% 1% 2%
<S> <C> <C> <C> <C> <C>
- ------------------------------------------------------------------------------
1 year 3.65% $990 $981 $1,010 $1,020
- ------------------------------------------------------------------------------
5 years 4.55 957 916 1,045 1,093
- ------------------------------------------------------------------------------
10 years 5.05 926 858 1,082 1,171
- ------------------------------------------------------------------------------
20 years 5.75 891 798 1,128 1,280
- ------------------------------------------------------------------------------
30 years 5.80 873 769 1,158 1,356
- ------------------------------------------------------------------------------
Table 5 Coupons reflect yields on AAA-rated municipals as of April 30, 1996.
This is an illustration and does not represent expected yields or
share price changes of any T. Rowe Price fund.
</TABLE>
Do money market securities react to changes in interest rates?
Yes. As interest rates change, the prices of some money market securities
fluctuate, but changes are usually small because of their very short maturities.
Investments are typically held until maturity in a money fund to help it
maintain a $1.00 share price.
How can I decide which investments are most appropriate for me?
Review your own financial objectives, time horizon, and risk tolerance. Use
Table 6, which summarizes the funds' main characteristics, to help choose a fund
(or funds) for your particular needs. For example, only the money fund provides
principal stability, which makes it a good choice for money you may need for
contingencies. However, if you are investing for the highest possible tax-free
income and can tolerate some price fluctuation, you should consider a longer-
term bond fund.
-----------------------
T. Rowe Price 11
<PAGE>
1 About the Funds
<TABLE>
<CAPTION>
========================================================================================================================
Differences Among Funds
<S> <C> <C> <C> <C>
Fund Credit- Income Risk of Expected
Quality Share Price Average Maturity
Categories Fluctuation
- ------------------------------------------------------------------------------------------------------------------------
Money Two highest Low Stable Not more than 90 days
- ------------------------------------------------------------------------------------------------------------------------
Short-Intermediate Four highest Low to moderate Low to moderate 2 to 5 years
- ------------------------------------------------------------------------------------------------------------------------
Insured Intermediate Two highest Moderate Moderate 5 to 10 years
- ------------------------------------------------------------------------------------------------------------------------
Income Predominantly Moderate Greater 15+ years
four highest
- ------------------------------------------------------------------------------------------------------------------------
High Yield Generally High Highest 15+ years
upper-medium
to low quality
- ------------------------------------------------------------------------------------------------------------------------
</TABLE>
Table 6
Is there other information I need to review before making a decision?
You should review "Investment Policies and Practices'' in Section 3, which
discusses the following: Types of Portfolio Securities (municipal securities,
private activity bonds, municipal lease obligations, municipal warrants,
securities with "puts" or other demand features, securities with credit
enhancements, synthetic or derivative securities, and private placements); and
Types of Management Practices (cash position, when-issued securities and
forwards, interest rate futures, borrowing money and transferring assets,
portfolio turnover, sector concentration, high-yield/high-risk investing,
credit-quality considerations, and credit quality and the High Yield Fund).
- -----------------------
12 T. Rowe Price
<PAGE>
2 About Your Account
2 About Your Account
Pricing Shares and Receiving Sale Proceeds
Here are some procedures you should know when investing in a T. Rowe Price
tax-free fund.
- --------------------------------------------------------------------------------
The various ways you can buy, sell, and exchange shares are explained at the end
of this prospectus and on the New Account Form. These procedures may differ
from institutional accounts.
- --------------------------------------------------------------------------------
When filling out the New Account Form, you may wish to give yourself the widest
range of options for receiving proceeds from a sale.
- --------------------------------------------------------------------------------
If for some reason we cannot accept your request to sell shares, we will contact
you.
How and when shares are priced
Bond and money funds. The share price (also called "net asset value" or NAV
per share) for each fund is calculated at 4 p.m. ET each day the New York
Stock Exchange is open for business. To calculate the NAV, a fund's assets are
valued and totaled, liabilities are subtracted, and the balance, called net
assets, is divided by the number of shares outstanding. Amortized cost is used
to value money fund securities.
How your purchase, sale, or exchange price is determined
If we receive your request in correct form by 4 p.m. ET, your transaction will
be priced at that day's NAV. If we receive it after 4 p.m., it will be
priced at the next business day's NAV.
We cannot accept orders that request a particular day or price for your
transaction or any other special conditions.
Note: The time at which transactions and shares are priced and the time until
which orders are accepted may be changed in case of an emergency or if the New
York Stock Exchange closes at a time other than 4 p.m. ET.
How you can receive the proceeds from a sale
If your request is received by 4 p.m. ET in correct form, proceeds are usually
sent on the next business day. Proceeds can be sent to you by mail or to your
bank account by ACH transfer or bank wire. Proceeds sent by ACH transfer
should be credited the second day after the sale. ACH (Automated Clearing
House) is an automated method of initiating payments from and receiving
payments in your financial institution account. ACH is a payment system
supported by over 20,000 banks, savings banks, and credit unions, which
electronically exchanges the transactions primarily through the Federal
Reserve Banks. Proceeds sent by bank wire should be credited to your account
the next business day.
Exception:
. Under certain circumstances and when deemed to be in the fund's best
interests, your proceeds may not be sent for up to five business days after
receiving your sale or exchange request. If you were exchanging into a bond or
money fund, your new investment would not begin to earn dividends until the
sixth business day.
-----------------------
T. Rowe Price 13
<PAGE>
2 About Your Account
Useful Information on Distributions and Taxes
All net investment income and realized capital gains are distributed to
shareholders.
Dividends and Other Distributions
Dividend and capital gain distributions are reinvested in additional fund shares
in your account unless you select another option on your New Account Form. The
advantage of reinvesting distributions arises from compounding; that is, you
receive income dividends and capital gain distributions on a rising number of
shares.
Distributions not reinvested are paid by check or transmitted to your bank
account via ACH. If the Post Office cannot deliver your check, or if your check
remains uncashed for six months, a fund reserves the right to reinvest your
distribution check in your account at the NAV on the business day of the
reinvestment and to reinvest all subsequent distributions in shares of the fund.
Income dividends
. Bond funds declare income dividends daily at 4 p.m. ET to shareholders of
record at that time provided payment has been received on the previous business
day.
. Money funds declare income dividends daily to shareholders of record as of
12:00 noon ET on that day. Wire purchase orders received before 12:00 noon ET
receive the dividend for that day. Other purchase orders receive the dividend on
the next business day after payment has been received.
. Bond and money funds pay dividends on the first business day of each month.
. Bond and money fund shares will earn dividends through the date of
redemption; also, shares redeemed on a Friday or prior to a holiday will
continue to earn dividends until the next business day. Generally, if you redeem
all of your shares at any time during the month, you will also receive all
dividends earned through the date of redemption in the same check. When you
redeem only a portion of your shares, all dividends accrued on those shares will
be reinvested, or paid in cash, on the next dividend payment date.
Capital gains
. A capital gain or loss is the difference between the purchase and sale price
of a security.
. If a fund has net capital gains for the year (after subtracting any capital
losses), they are usually declared and paid in December to shareholders of
record on a specified date that month. If a second distribution is necessary,
it is usually declared and paid during the first quarter of the following year.
Tax Information
You will be sent timely information for your tax filing needs.
Although the regular monthly income dividends you receive from the funds are
expected to be exempt from federal income taxes, you need to be aware of the
possible tax consequences when:
. You sell fund shares, including an exchange from one fund to another.
. The fund makes a distribution to your account.
Due to 1993 tax legislation, a portion of the capital gains realized on the sale
of market discount bonds with maturities beyond one year may be treated as
ordinary income and cannot
- -----------------------
14 T. Rowe Price
<PAGE>
2 About Your Account
be offset by other capital losses. Therefore, to the extent the fund invests in
these securities, the likelihood of a taxable gain distribution will be
increased.
Note: You must report your total tax-exempt income on IRS Form 1040. The IRS
uses this information to help determine the tax status of any Social Security
payments you may have received during the year.
Taxes on fund redemptions. When you sell shares in any fund, you may realize a
gain or loss. An exchange from one fund to another is still a sale for tax
purposes. If you realize a loss on the sale or exchange of fund shares held six
months or less, your capital loss is reduced by the tax-exempt dividends
received on those shares.
In January, you will be sent Form 1099-B, indicating the date and amount of each
sale you made in the fund during the prior year. This information will also be
reported to the IRS. For accounts opened new or by exchange in 1983 or later, we
will provide you with the gain or loss of the shares you sold during the year,
based on the "average cost" method. This information is not reported to the IRS,
and you do not have to use it. You may calculate the cost basis using other
methods acceptable to the IRS, such as "specific identification."
To help you maintain accurate records, we send you a confirmation immediately
following each transaction (except for systematic purchases and redemptions) you
make and a year-end statement detailing all your transactions in each fund
account during the year.
Distributions are taxable whether reinvested in additional shares or received in
cash.
Taxes on fund distributions. In January, the funds will send you Form 1099-DIV
indicating the tax status of any capital gain distribution made to you. This
information will also be reported to the IRS. All capital gain distributions are
taxable to you for the year in which they are paid. The only exception is that
dividends declared during the last three months of the year and paid in January
are taxed as though they were paid by December 31. Dividends are expected to be
tax-exempt.
Short-term capital gains are taxable as ordinary income and long-term gains are
taxable at the applicable long-term gain rate. The gain is long- or short-term
depending on how long the fund held the securities, not how long you held shares
in the fund. If you realize a loss on the sale or exchange of fund shares held
six months or less, your short-term loss recognized is reclassified to long-term
to the extent of any long-term capital gain distribution received.
If the funds invest in certain "private activity" bonds, shareholders who are
subject to the alternative minimum tax (AMT) must include income generated by
these bonds in their AMT computation. The portion of your fund's income which
should be included in your AMT calculation, if any, will be reported to you in
January.
Tax effect of buying shares before a capital gain distribution. If you buy
shares shortly before or on the "record date"--the date that establishes you as
the person to receive the upcoming distribution--you will receive, in the form
of a taxable distribution, a portion of the money you just invested. Therefore,
you may also wish to find out the fund's record date before investing. Of
course, the fund's share price may, at any time, reflect undistributed capital
gains or income and unrealized appreciation. When these amounts are eventually
distributed, they are taxable.
-----------------------
T. Rowe Price 15
<PAGE>
2 About Your Account
Note: For shareholders who receive Social Security benefits, the receipt of tax-
exempt interest may increase the portion of benefits that are subject to tax.
Transaction Procedures and Special Requirements
Purchase Conditions
Following these procedures helps assure timely and accurate transactions.
Nonpayment. If your payment is not received or you pay with a check or ACH
transfer that does not clear, your purchase will be canceled. You will be
responsible for any losses or expenses incurred by the fund or transfer agent,
and the fund can redeem shares you own in this or another identically registered
T. Rowe Price fund as reimbursement. The fund and its agents have the right to
reject or cancel any purchase, exchange, or redemption due to nonpayment.
U.S. dollars. All purchases must be paid for in U.S. dollars; checks must be
drawn on U.S. banks.
Sale (Redemption) Conditions
10-day hold. If you sell shares that you just purchased and paid for by check or
ACH transfer, a fund will process your redemption, but will generally delay
sending you the proceeds for up to 10 calendar days to allow the check or
transfer to clear. If your redemption request was sent by mail or mailgram,
proceeds will be mailed no later than the seventh calendar day following receipt
unless the check or ACH transfer has not cleared. If during the clearing period,
we receive a check drawn against your bond or money market account, it will be
returned marked "uncollected." (The 10-day hold does not apply to the
following: purchases paid for by bank wire; cashier's, certified, or treasurer's
checks; or automatic purchases through your paycheck.)
Telephone, Tele*Access(R), and personal computer transactions. These exchange
and redemption services are established automatically when you sign the New
Account Form unless you check the box which states that you do not want these
services. Each fund uses reasonable procedures (including shareholder identity
verification) to confirm that instructions given by telephone are genuine and is
not liable for acting on these instructions. If these procedures are not
followed, it is the opinion of certain regulatory agencies that a fund may be
liable for any losses that may result from acting on the instructions given. A
confirmation is sent promptly after the telephone transaction. All
conversations are recorded.
Redemptions over $250,000. Large sales can adversely affect a portfolio
manager's ability to implement a fund's investment strategy by causing the
premature sale of securities that would otherwise be held. If, in any 90-day
period, you redeem (sell) more than $250,000, or your sale amounts to more than
1% of the fund's net assets, the fund has the right to delay sending your
proceeds for up to five business days after receiving your request, or to pay
the difference between the redemption amount and the lesser of the two
previously mentioned figures with securities from the fund.
- -----------------------
16 T. Rowe Price
<PAGE>
2 About Your Account
Excessive Trading
T. Rowe Price may bar excessive traders from purchasing shares.
Frequent trades, involving either substantial fund assets or a substantial
portion of your account or accounts controlled by you, can disrupt management of
the fund and raise its expenses. We define "excessive trading" as exceeding one
purchase and sale involving the same fund within any 120-day period.
For example, you are in fund A. You can move substantial assets from fund A to
fund B and, within the next 120 days, sell your shares in fund B to return to
fund A or move to fund C.
If you exceed the number of trades described above, you may be barred
indefinitely from further purchases of T. Rowe Price funds.
Three types of transactions are exempt from excessive trading guidelines: 1)
trades solely between money market funds; 2) redemptions that are not part of
exchanges; and 3) systematic purchases or redemptions (see "Shareholder
Services").
Keeping Your Account Open
Due to the relatively high cost to a fund of maintaining small accounts, we ask
you to maintain an account balance of at least $1,000. If your balance is below
$1,000 for three months or longer, we have the right to close your account after
giving you 60 days in which to increase your balance.
Small Account Fee
Because of the disproportionately high costs of servicing accounts with low
balances, a $10 fee, paid to T. Rowe Price Services, the fund's transfer agent,
will automatically be deducted from nonretirement accounts with balances falling
below a minimum level. The valuation of accounts and the deduction are expected
to take place during the last five business days of September. The fee will be
deducted from accounts with balances below $2,000, except for UGMA/UTMA
accounts, for which the limit is $500. The fee will be waived for any investor
whose aggregate T. Rowe Price mutual fund investments total $25,000 or more.
Accounts employing automatic investing (e.g., payroll deduction, automatic
purchase from a bank account, etc.) are also exempt from the charge. The fee
will not apply to IRAs and other retirement plan accounts. (A separate custodial
fee may apply to IRAs and other retirement plan accounts.)
Signature Guarantees
A signature guarantee is designed to protect you and the T. Rowe Price funds
from fraud by verifying your signature.
You may need to have your signature guaranteed in certain situations, such as:
. Written requests 1) to redeem over $50,000, or 2) to wire redemption
proceeds.
. Remitting redemption proceeds to any person, address, or bank account not on
record.
. Transferring redemption proceeds to a T. Rowe Price fund account with a
different registration (name/ownership) from yours.
. Establishing certain services after the account is opened.
You can obtain a signature guarantee from most banks, savings institutions,
broker-dealers, and other guarantors acceptable to T. Rowe Price. We cannot
accept guarantees from notaries public or organizations that do not provide
reimbursement in the case of fraud.
-----------------------
T. Rowe Price 17
<PAGE>
3 More About the Funds
3 More About the Funds
Organization and Management
How are the funds organized?
Shareholders benefit from T. Rowe Price's 59 years of investment management
experience.
The funds are "diversified, open-end investment companies," or mutual funds, and
were incorporated in Maryland as follows: 1) Tax-Exempt Money Fund, 1980; 2)
Tax-Free Short-Intermediate Fund, 1983; 3) Tax-Free Insured Intermediate Bond
Fund, 1992; 4) Tax-Free Income Fund, 1976; and 5) Tax-Free High Yield Fund,
1984. Mutual funds pool money received from shareholders and invest it to try to
achieve specified objectives.
What is meant by "shares"?
As with all mutual funds, investors purchase shares when they put money in a
fund. These shares are part of a fund's authorized capital stock, but share
certificates are not issued.
Each share and fractional share entitles the shareholder to:
. Receive a proportional interest in the fund's income and capital gain
distributions.
. Cast one vote per share on certain fund matters, including the election of
fund directors, changes in fundamental policies, or approval of changes in the
fund's management contract.
Do T. Rowe Price funds have annual shareholder meetings?
The funds are not required to hold annual meetings and in order to avoid
unnecessary costs to fund shareholders, do not intend to do so except when
certain matters, such as a change in a fund's fundamental policies, are to be
decided. In addition, shareholders representing at least 10% of all eligible
votes may call a special meeting if they wish for the purpose of voting on the
removal of any fund director or trustee. If a meeting is held and you cannot
attend, you can vote by proxy. Before the meeting, the fund will send you proxy
materials that explain the issues to be decided and include a voting card for
you to mail back.
Who runs the funds?
All decisions regarding the purchase and sale of fund investments are made by
T. Rowe Price -- specifically by each fund's portfolio manager.
General Oversight. Each fund is governed by a Board of Directors that elects the
funds' officers and meets regularly to review the funds' investments,
performance, expenses, and other business affairs. The policy of each fund is
that a majority of the Board members will be independent of T. Rowe Price.
Portfolio Management. Each fund has an Investment Advisory Committee whose
chairman has day-to-day responsibility for managing the fund and works with the
committee in developing and executing the fund's investment program. The
Investment Advisory Committees are composed of the following members:
Tax-Exempt Money Fund. Patrice L. Berchtenbreiter, Chairman, Paul W. Boltz,
Patricia S. Deford, Joseph K. Lynagh, Mary J. Miller, William T. Reynolds,
Theodore E. Robson, and Edward A. Wiese. Ms. Berchtenbreiter has been chairman
of the fund since 1992. She joined T. Rowe Price in 1972 and has been managing
investments since 1987.
- -----------------------
18 T. Rowe Price
<PAGE>
3 More About the Funds
Tax-Free Short-Intermediate Fund. Charles B. Hill, Chairman, Janet G. Albright,
Paul W. Boltz, Patricia S. Deford, Laura L. McAree, Mary J. Miller, and William
T. Reynolds. Mr. Hill was appointed chairman of the fund's committee in 1996.
He joined T. Rowe Price in 1991 and has been managing investments since 1986.
Tax-Free Insured Intermediate Bond Fund. Charles B. Hill, Chairman, Janet G.
Albright, Paul W. Boltz, Patricia S. Deford, Konstantine B. Mallas, Laura L.
McAree, Mary J. Miller, and William T. Reynolds. Mr. Hill was appointed chairman
of the fund in 1996. He joined T. Rowe Price in 1991 and has been managing
investments since 1986.
Tax-Free Income Fund. William T. Reynolds, Chairman, Paul W. Boltz, Patricia S.
Deford, Konstantine B. Mallas, Hugh D. McGuirk, Mary J. Miller, and William F.
Snider, Jr. Mr. Reynolds has been chairman of the fund since 1990. He joined T.
Rowe Price in 1981 and has been managing investments since 1978.
Tax-Free High Yield Fund. C. Stephen Wolfe II, Chairman, A. Gene Caponi,
Patricia S. Deford, Charles O. Holland, Konstantine B. Mallas, William T.
Reynolds, and Alan P. Richman. Mr. Wolfe has been chairman of the fund since
1994. He joined T. Rowe Price in 1985 and has been managing investments since
1991.
Marketing. T. Rowe Price Investment Services, Inc., a wholly owned subsidiary of
T. Rowe Price, distributes (sells) shares of these and all other T. Rowe Price
funds.
Shareholder Services. T. Rowe Price Services, Inc., another wholly owned
subsidiary, acts as the funds' transfer and dividend disbursing agent and
provides shareholder and administrative services. The address for T. Rowe Price
Investment Services, Inc. and T. Rowe Price Services, Inc. is 100 East Pratt
St., Baltimore, MD 21202.
How are fund expenses determined?
The management agreement spells out the expenses to be paid by each fund.
In addition to the management fee, each fund pays for the following: shareholder
service expenses; custodial, accounting, legal, and audit fees; costs of
preparing and printing prospectuses and reports sent to shareholders;
registration fees and expenses; proxy and annual meeting expenses (if any); and
director/trustee fees and expenses.
The Management Fee. This fee has two parts--an "individual fund fee" (discussed
under "Transaction and Fund Expenses"), which reflects a fund's particular
investment management costs, and a "group fee." The group fee, which is
designed to reflect the benefits of the shared resources of the T. Rowe Price
investment management complex, is calculated daily based on the combined net
assets of all T. Rowe Price funds (except Equity Index and the Spectrum Funds
and any institutional or private label mutual funds). The group fee schedule
(shown below) is graduated, declining as the asset total rises, so shareholders
benefit from the overall growth in mutual fund assets.
<TABLE>
<S> <C> <C>
0.480% First $1 billion 0.370% Next $1 billion 0.330% Next $10 billion
0.450% Next $1 billion 0.360% Next $2 billion 0.320% Next $10 billion
0.420% Next $1 billion 0.350% Next $2 billion 0.310% Next $16 billion
0.390% Next $1 billion 0.340% Next $5 billion 0.305% Thereafter
</TABLE>
-----------------------
T. Rowe Price 19
<PAGE>
3 More About the Funds
Each fund's portion of the group fee is determined by the ratio of its daily net
assets to the daily net assets of all the Price funds described previously.
Based on combined Price funds' assets of approximately $53.5 billion at March
31, 1996, the group fee was 0.33%.
Understanding Performance Information
This section should help you understand the terms used to describe fund
performance. You will come across them in shareholder reports you receive from
us, in our newsletter, The Price Report, in Insights articles, in T. Rowe Price
advertisements, and in the media.
Total Return
Total return is the most widely used performance measure. Detailed performance
information is included in the funds' annual and semiannual shareholder reports
and in the quarterly Performance Update, which are all available without charge.
This tells you how much an investment in a fund has changed in value over a
given time period. It reflects any net increase or decrease in the share price
and assumes that all dividends and capital gains (if any) paid during the period
were reinvested in additional shares. Including reinvested distributions means
that total return numbers include the effect of compounding, i.e., you receive
income and capital gain distributions on a rising number of shares.
Advertisements for a fund may include cumulative or compound average annual
total return figures, which may be compared with various indices, other
performance measures, or other mutual funds.
Cumulative Total Return
This is the actual rate of return on an investment for a specified period. A
cumulative return does not indicate how much the value of the investment may
have fluctuated between the beginning and the end of the period specified.
Average Annual Total Return
This is always hypothetical. Working backward from the actual cumulative return,
it tells you what constant year-by-year return would have produced the actual,
cumulative return. By smoothing out all the variations in annual performance, it
gives you an idea of the investment's annual contribution to your portfolio
provided you held it for the entire period in question.
Yield
You will see frequent references to a fund's yield in our reports, in
advertisements, in media stories, and so on.
The current or "dividend" yield on a fund or any investment tells you the
relationship between the investment's current level of annual income and its
price on a particular day. The dividend yield reflects the actual income paid
to shareholders for a given period, annualized, and divided by the average price
during the given period. For example, a fund providing $5 of annual income per
share and a price of $50 has a ''current'' yield of 10%. Yields can be
calculated for any time period. The money fund may advertise a current yield,
reflecting the latest seven-day income annualized, or an ''effective'' yield,
which assumes the income has been reinvested in the fund.
For the bond funds, the advertised or "SEC" yield is found by determining the
net income per share (as defined by the SEC) earned by the fund during a 30-day
base period and dividing this amount by the per share price on the last day of
the base period. The SEC yield may differ from the dividend yield.
- -----------------------
20 T. Rowe Price
<PAGE>
3 More About the Funds
Investment Policies and Practices
Fund managers have considerable leeway in choosing investment strategies and
selecting securities they believe will help the funds achieve their objectives.
This section takes a detailed look at some of the types of securities the funds
may hold in their portfolios and the various kinds of investment practices that
may be used in day-to-day portfolio management. Each fund's investment program
is subject to further restrictions and risks described in the Statement of
Additional Information.
Shareholder approval is required to substantively change a fund's objective and
certain investment restrictions noted in the following section as "fundamental
policies." The managers also follow certain "operating policies" which can be
changed without shareholder approval. However, significant changes are discussed
with shareholders in fund reports. Each fund adheres to applicable investment
restrictions and policies at the time it makes an investment. A later change in
circumstances will not require the sale of an investment if it was proper at the
time it was made.
The funds' holdings of certain kinds of investments cannot exceed maximum
percentages of total assets, which are set forth herein. For instance, the bond
funds are not permitted to invest more than 10% of total assets in residual
interest bonds. While these restrictions provide a useful level of detail about
the funds' investment programs, investors should not view them as an accurate
gauge of the potential risk of such investments. For example, in a given period,
a 5% investment in residual interest bonds could have significantly more of an
impact on a fund's share price than its weighting in the portfolio. The net
effect of a particular investment depends on its volatility and the size of its
overall return in relation to the performance of all the funds' other
investments.
Changes in the funds' holdings, the funds' performance, and the contribution of
various investments are discussed in the shareholder reports sent to you.
Types of Portfolio Securities
In seeking to meet their investment objectives, the funds may invest in any type
of municipal security or instrument (including certain potentially high-risk
derivatives) whose investment characteristics are consistent with the funds'
investment programs. The following pages describe the principal types of
portfolio securities and investment management practices of the funds.
Fundamental policy: Each fund will not purchase a security if, as a result, with
respect to 75% of its total assets, more than 5% of its total assets would be
invested in securities of a single issuer or more than 10% of the outstanding
voting securities of the issuer would be held by a fund; provided that these
limitations do not apply to a fund's purchase of securities issued or guaranteed
by the U.S. government, its agencies, or instrumentalities.
Operating policy (money fund only): Effective October 3, 1996, or at such other
time as required by Rule 2a-7 under the Investment Company Act of 1940, the
money market fund will not purchase a security if, as a result, more than 5% of
its total assets would be invested in securities of a single issuer, provided
that this limitation does not apply to purchases of U.S. government securities
or securities subject to certain types of guarantees, and further
-----------------------
T. Rowe Price 21
<PAGE>
3 More About the Funds
provided that the fund may invest up to 25% of its total assets in the first
tier securities (as defined by Rule 2a-7) of a single issuer for a period of up
to three business days.
In purchasing municipals, the funds rely on the opinion of the issuer's bond
counsel regarding the tax-exempt status of the investment.
Municipal Securities. Each fund's assets are invested primarily in various tax-
free municipal debt securities. The issuers have a contractual obligation to pay
interest at a stated rate on specific dates and to repay principal (the bond's
face value) on a specified date or dates. An issuer may have the right to redeem
or "call" a bond before maturity, and the fund may have to reinvest the proceeds
at lower rates.
There are two broad categories of municipal bonds. General obligation bonds are
backed by the issuer's "full faith and credit," that is, its full taxing and
revenue raising power. Revenue bonds usually rely exclusively on a specific
revenue source, such as charges for water and sewer service, to generate money
for debt service.
Private Activity Bonds. While income from most municipals is exempt from federal
income taxes, the income from certain types of so-called private activity bonds
(a type of revenue bond) may be subject to the alternative minimum tax (AMT).
However, only persons subject to the AMT pay this tax. Private activity bonds
may be issued for purposes such as housing or airports or to benefit a private
company. (Being subject to the AMT does not mean the investor necessarily pays
this tax. For further information, please see "Distributions and Taxes.")
Fundamental policy: Under normal market conditions, the funds will not purchase
any security if, as a result, less than 80% of the funds' income would be exempt
from federal income taxes. The income included under the 80% test does not
include income from securities subject to the alternative minimum tax.
Operating policy: During periods of abnormal market conditions, for temporary
defensive purposes, the funds may invest without limit in high-quality, short-
term securities whose income is subject to federal income tax.
In addition to general obligation and revenue bonds, the funds' investments may
include, but are not limited to, the following types of securities:
Municipal Lease Obligations. A lease is not a full faith and credit obligation
of the issuer and is usually backed only by the borrowing government's unsecured
pledge to make annual appropriations for lease payments. There have been
challenges to the legality of lease financing in numerous states and, from time
to time, certain municipalities have considered not appropriating money for
lease payments. In deciding whether to purchase a lease obligation, the funds
would assess the financial condition of the borrower, the merits of the project,
the level of public support for the project, and the legislative history of
lease financing in the state. These securities may be less readily marketable
than other municipals. The funds may also purchase unrated lease obligations.
Municipal Warrants (bond funds). Municipal warrants are essentially call options
on municipal bonds. In exchange for a premium, they give the purchaser the
right, but not the obligation, to purchase a municipal bond in the future. The
funds might purchase a warrant to lock in forward supply in an environment where
the current issuance of bonds is sharply reduced. Like options, warrants may
expire worthless and they may have reduced liquidity.
- -----------------------
22 T. Rowe Price
<PAGE>
3 More About the Funds
Operating policy: Each bond fund will not invest more than 2% of its total
assets in municipal warrants.
Securities With "Puts" or Other Demand Features. Some longer-term municipals
give the investor the right to "put" or sell the security at par (face value)
within a specified number of days following the investor's request--usually one
to seven days. This demand feature enhances a security's liquidity by shortening
its effective maturity and enables it to trade at a price equal to or very close
to par. If the demand feature were terminated prior to being exercised, the
funds would hold the longer-term security.
Securities With Credit Enhancements.
. Letters of Credit. Letters of credit are issued by a third party, usually a
bank, to enhance liquidity and ensure repayment of principal and any accrued
interest if the underlying municipal security should default.
T. Rowe Price periodically reviews the credit quality of the insurer.
. Municipal Bond Insurance. This insurance, which is usually purchased by the
bond issuer from a private, nongovernmental insurance company, provides an
unconditional and irrevocable guarantee that the insured bond's principal and
interest will be paid when due. Insurance does not guarantee the price of the
bond or the share price of any fund. The credit rating of an insured bond
reflects the credit rating of the insurer, based on its claims-paying ability.
The obligation of a municipal bond insurance company to pay a claim extends over
the life of each insured bond. Although defaults on insured municipal bonds have
been low to date and municipal bond insurers have met their claims, there is no
assurance this will continue. A higher than expected default rate could strain
the insurer's loss reserves and adversely affect its ability to pay claims to
bondholders, such as the funds. The number of municipal bond insurers is
relatively small, and not all of them have the highest rating.
While all funds may buy insured bonds from time to time, such bonds will compose
at least 65% of the total assets of the Insured Intermediate Fund. The Insured
Intermediate Fund's purchase of insured bonds will be limited to those which, at
the time of purchase, have the highest credit rating from a national rating
agency. There is no guarantee that this rating will be maintained.
. Standby Purchase Agreements. A Standby Bond Purchase Agreement (SBPA) is a
liquidity facility provided to pay the purchase price of bonds that cannot be
remarketed. The obligation of the liquidity provider (usually a bank) is only to
advance funds to purchase tendered bonds that cannot be remarketed and does not
cover principal or interest under any other circumstances. The liquidity
provider's obligations under the SBPA are usually subject to numerous
conditions, including the continued creditworthiness of the underlying borrower.
-----------------------
T. Rowe Price 23
<PAGE>
3 More About the Funds
Synthetic or Derivative Securities. These securities are created from existing
municipal bonds:
. Residual Interest Bonds (bond funds) (a potentially high-risk derivative).
The income stream provided by an underlying bond is divided to create two
securities, one short-term and one long-term. The interest rate on the short-
term component is reset by an index or auction process normally every 7 to 35
days. After income is paid on the short-term securities at current rates, the
residual income goes to the long-term securities. Therefore, rising short-term
interest rates result in lower income for the longer-term portion, and vice
versa. The longer-term bonds can be very volatile and may be less liquid than
other municipals of comparable maturity.
Operating policy: Each bond fund will not invest more than 10% of its total
assets in residual interest bonds.
. Participation Interests. This term covers various types of securities created
by converting fixed rate bonds into short-term, variable rate certificates.
These securities have been developed in the secondary market to meet demand for
short-term, tax-exempt securities. The funds will invest only in securities
deemed tax-exempt by a nationally recognized bond counsel, but there is no
guarantee the interest will be exempt because the IRS has not issued a
definitive ruling.
. Embedded Interest Rate Swaps and Caps (bond funds). Embedded interest rate
swaps enhance yields, but also increase interest rate risk.
In a fixed rate, long-term municipal bond with an interest rate swap attached to
it, the bondholder usually receives the bond's fixed coupon payment as well as a
variable rate payment that represents the difference between a fixed rate for
the term of the swap (which is typically shorter than the bond it is attached
to) and a variable rate short-term municipal index. The bondholder receives
excess income when short-term rates remain below the fixed interest rate swap
rate. If short-term rates rise above the fixed income swap rate, the
bondholder's income is reduced. At the end of the interest rate swap term, the
bond reverts to a single fixed coupon payment.
An embedded interest rate cap allows the bondholder to receive payments whenever
short-term rates rise above a level established at the time of purchase. They
normally are used to hedge against rising short-term interest rates.
Both instruments may be volatile and of limited liquidity and their use may
adversely affect a fund's total return.
Operating policy: Each bond fund will not invest more than 10% of its total
assets in embedded interest rate swaps and caps.
Private Placements. The funds may seek to enhance their yield through the
purchase of private placements. These securities are sold through private
negotiations, usually to institutions or mutual funds, and may have resale
restrictions. Their yields are usually higher than comparable public securities
to compensate the investor for their limited marketability.
Operating policy: The bond funds may not invest more than 15% (10% for the money
fund) of its net assets in illiquid securities, including unmarketable private
placements.
- -----------------------
24 T. Rowe Price
<PAGE>
3 More About the Funds
Types of Management Practices
Cash reserves provide flexibility and serve as a short-term defense during
periods of unusual market volatility.
Cash Position (bond funds). Each fund will hold a certain portion of its assets
in short-term, tax-exempt money market securities maturing in one year or less.
The reserve position accomplishes the following: provides flexibility in meeting
redemptions, expenses, and the timing of new investments; can help in
structuring a fund's weighted average maturity; and serves as a short-term
defense during periods of unusual market volatility. Each fund's cash reserve
position will be composed of short-term, investment-grade securities including
tax-exempt commercial paper, municipal notes, and short-term maturity bonds.
Some of these securities may have adjustable, variable, or floating rates.
When-Issued Securities (all funds) and Forwards (bond funds). New issues of
municipals are often sold on a "when-issued" basis, that is, delivery and
payment take place 15-45 days after the buyer has agreed to the purchase. Some
bonds, called "forwards," have longer-than-standard settlement dates, typically
6 to 24 months. When buying these securities, each fund will maintain cash or
high-grade marketable securities held by its custodian equal in value to its
commitment for these securities. The funds do not earn interest on when-issued
and forward securities until settlement, and the value of the securities may
fluctuate between purchase and settlement. Municipal "forwards" typically carry
a substantial yield premium to compensate the buyer for their greater interest
rate, credit, and liquidity risks.
Interest Rate Futures (bond funds). Futures (a type of potentially high-risk
derivative) are often used to manage risk, because they enable the investor to
buy or sell an asset in the future at an agreed upon price. Specifically, the
funds may use futures (and options on futures) for any number of reasons,
including: to hedge against a potentially unfavorable change in interest rates
and to adjust their exposure to the municipal bond market; to protect portfolio
value; in an effort to enhance income; and to adjust the portfolios' duration.
The use of futures for hedging and non-hedging purposes may not always be
successful. Their prices can be highly volatile, using them could lower a fund's
total return, and the potential loss from their use could exceed a fund's
initial exposure to such contracts.
Operating policy: Initial margin deposits on futures and premiums on options
used for non-hedging purposes will not equal more than 5% of the bond funds' net
asset value.
Borrowing Money and Transferring Assets. Each fund can borrow money from banks
as a temporary measure for emergency purposes, to facilitate redemption
requests, or for other purposes consistent with each fund's investment objective
and program. Such borrowings may be collateralized with fund assets, subject to
restrictions.
Fundamental policy: Borrowings may not exceed 33 1/3% of total fund assets.
Operating policy: Each fund may not transfer as collateral any portfolio
securities except as necessary in connection with permissible borrowings or
investments, and then such transfers may not exceed 33 1/3% of fund's total
assets. A fund may not purchase additional securities when borrowings exceed 5%
of total assets.
-----------------------
T. Rowe Price 25
<PAGE>
3 More About the Funds
<TABLE>
<CAPTION>
Portfolio Turnover Rates
1994 1995 1996
<S> <C> <C> <C>
Short-Intermediate 51.1% 93.1% 69.9%
Insured Intermediate 74.8% 170.8% 63.8%
Income 71.2% 49.3% 48.7%
High Yield 59.3% 59.6% 39.3%
Table 7
</TABLE>
The funds' portfolio turnover rates for the previous three fiscal years are
shown in Table 7.
Portfolio Turnover (bond funds). Each fund generally purchases securities with
the intention of holding them for investment; however, when market conditions or
other circumstances warrant, securities may be purchased and sold without regard
to the length of time held. Due to the nature of each fund's investment
program, a fund's portfolio turnover rate may exceed 100%. Although the funds
do not expect to generate any taxable income, a high turnover rate may increase
transaction costs and may effect taxes paid by shareholders to the extent short-
term gains are distributed.
Sector Concentration. It is possible that each fund could have a considerable
amount of assets (25% or more) in securities that would tend to respond
similarly to particular economic or political developments. An example would be
securities of issuers related to a single industry, such as health care or
nuclear energy.
Operating policy: Each fund will not invest more than 25% of total assets in any
single state or in industrial development bonds of projects in the same industry
(such as solid waste, nuclear utility, or airlines). Bonds which are refunded
with escrowed U.S. government securities are not subject to the 25% limitation.
High-Yield/High-Risk Investing (High Yield Fund). The total return and yield of
lower-quality (high-yield/high-risk) bonds, commonly referred to as "junk"
bonds, can be expected to fluctuate more than the total return and yield of
higher-quality bonds. Junk bonds (those rated below BBB or in default) are
regarded as predominantly speculative with respect to the issuer's ability to
meet principal and interest payments. Successful investment in lower-medium- and
low-quality bonds involves greater investment risk and is highly dependent on T.
Rowe Price's credit analysis. A real or perceived economic downturn or rising
interest rates could cause a decline in high-yield bond prices, by lessening the
ability of issuers to make principal and interest payments. These bonds are
often thinly traded and can be more difficult to sell and value accurately than
high-quality bonds. Because objective pricing data may be less available,
judgment may play a greater role in the valuation process.
Credit-Quality Considerations. The credit quality of most bond issues is
evaluated by rating agencies such as Moody's and Standard & Poor's. Credit
quality refers to the issuer's ability to meet all required interest and
principal payments. The highest ratings are assigned to issuers perceived to be
the best credit risks. T. Rowe Price research analysts also evaluate all
portfolio holdings of each fund, including those rated by outside agencies. The
lower the rating on a bond, the higher the yield, other things being equal.
Table 8 shows the rating scale used by the major rating agencies. T. Rowe Price
considers publicly available ratings, but emphasizes its own credit analysis
when selecting investments.
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26 T. Rowe Price
<PAGE>
3 More About the Funds
<TABLE>
<CAPTION>
===================================================================================================================================
Ratings of Municipal Debt Securities
Moody's Standard Fitch Investors Definition
Investors & Poor's Service, Inc.
Service, Inc. Corporation
<S> <C> <C> <C> <C>
- ------------------------------------------------------------------------------------------------------------------------------------
Long-Term Aaa AAA AAA Highest quality
-------------------------------------------------------------------------------------------------------
Aa AA AA High quality
-------------------------------------------------------------------------------------------------------
A A A Upper medium grade
-------------------------------------------------------------------------------------------------------
Baa BBB BBB Medium grade
-------------------------------------------------------------------------------------------------------
Ba BB BB Speculative
-------------------------------------------------------------------------------------------------------
B B B Highly speculative
-------------------------------------------------------------------------------------------------------
Caa CCC, CC CCC, CC Vulnerable to default
-------------------------------------------------------------------------------------------------------
Ca C C Default is imminent
-------------------------------------------------------------------------------------------------------
C D DDD, DD, D Probably in default
-------------------------------------------------------------------------------------------------------
<CAPTION>
Moody's S&P Fitch
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Short-Term MIG1/VMIG1 Best quality SP1+ Very strong quality F-1+ Exceptionally strong quality
SP1 Strong grade F-1 Very strong quality
-------------------------------------------------------------------------------------------------------
MIG2/VMIG2 High quality SP2 Satisfactory grade F-2 Good credit quality
-------------------------------------------------------------------------------------------------------
MIG3/VMIG3 Favorable quality F-3 Fair credit quality
-------------------------------------------------------------------------------------------------------
MIG4/VMIG4 Adequate quality
-------------------------------------------------------------------------------------------------------
SG Speculative quality SP3 Speculative grade F-S Weak credit quality
- ------------------------------------------------------------------------------------------------------------------------------------
Commercial P-1 Superior quality A-1+ Extremely strong quality F-1+ Exceptionally strong quality
Paper A-1 Strong quality F-1 Very strong quality
-------------------------------------------------------------------------------------------------------
P-2 Strong quality A-2 Satisfactory quality F-2 Good credit quality
-------------------------------------------------------------------------------------------------------
P-3 Acceptable quality A-3 Adequate quality F-3 Fair credit quality
-------------------------------------------------------------------------------------------------------
B Speculative quality F-S Weak credit quality
-------------------------------------------------------------------------------------------------------
C Doubtful quality
- ------------------------------------------------------------------------------------------------------------------------------------
</TABLE>
Table 8
-----------------------
T. Rowe Price 27
<PAGE>
3 More About the Funds
<TABLE>
<CAPTION>
====================================================================================================================================
Explanation of Quality Ratings
Bond
Rating Explanation
<S> <C> <C>
- ------------------------------------------------------------------------------------------------------------------------------------
Moody's Investors Aaa Highest quality, smallest degree of investment risk.
----------------------------------------------------------------------------------------------------------------
Service, Inc. Aa High quality; together with Aaa bonds, they compose the high-grade bond group.
----------------------------------------------------------------------------------------------------------------
A Upper-medium-grade obligations; many favorable investment attributes.
----------------------------------------------------------------------------------------------------------------
Baa Medium-grade obligations; neither highly protected nor poorly secured. Interest and principal appear
adequate for the present but certain protective elements may be lacking or may be unreliable over any
great length of time.
----------------------------------------------------------------------------------------------------------------
Ba More uncertain, with speculative elements. Protection of interest and principal payments not well
safeguarded during good and bad times.
----------------------------------------------------------------------------------------------------------------
B Lack characteristics of desirable investment; potentially low assurance of timely interest and
principal payments or maintenance of other contract terms over time.
----------------------------------------------------------------------------------------------------------------
Caa Poor standing, may be in default; elements of danger with respect to principal or interest payments.
----------------------------------------------------------------------------------------------------------------
Ca Speculative in a high degree; could be in default or have other marked shortcomings.
----------------------------------------------------------------------------------------------------------------
C Lowest rated; extremely poor prospects of ever attaining investment standing.
- ------------------------------------------------------------------------------------------------------------------------------------
Standard & Poor's AAA Highest rating; extremely strong capacity to pay principal and interest.
----------------------------------------------------------------------------------------------------------------
Corporation AA High quality; very strong capacity to pay principal and interest.
----------------------------------------------------------------------------------------------------------------
A Strong capacity to pay principal and interest; somewhat more suspectible to the adverse effects of
changing circumstances and economic conditions.
----------------------------------------------------------------------------------------------------------------
BBB Adequate capacity to pay principal and interest; normally exhibit adequate protection parameters, but
adverse economic conditions or changing circumstances more likely to lead to a weakened capacity to
pay principal and interest than for higher-rated bonds.
----------------------------------------------------------------------------------------------------------------
BB, B, Predominantly speculative with respect to the issuer's capacity to meet required
CCC, interest and principal payments. BB-lowest degree of speculation; CC-the highest
CC degree of speculation. Quality and protective characteristics outweighed by large uncertainties or
major risk exposure to adverse conditions.
----------------------------------------------------------------------------------------------------------------
D In default.
- ------------------------------------------------------------------------------------------------------------------------------------
Fitch Investors AAA Highest quality; obligor has exceptionally strong ability to pay interest and repay
Service, Inc. principal, which is unlikely to be affected by reasonably foreseeable events.
----------------------------------------------------------------------------------------------------------------
AA Very high quality; obligor's ability to pay interest and repay principal is very strong. Because bonds
rated in the AAA and AA categories are not significantly vulnerable to foreseeable future
developments, short-term debt of these issuers is generally rated F-1+.
----------------------------------------------------------------------------------------------------------------
A High quality; obligor's ability to pay interest and repay principal is considered to be strong, but
may be more vulnerable to adverse changes in economic conditions and circumstances than higher-rated
bonds.
----------------------------------------------------------------------------------------------------------------
BBB Satisfactory credit quality; obligor's ability to pay interest and repay principal is considered
adequate. Unfavorable changes in economic conditions and circumstances are more likely to adversely
affect these bonds and impair timely payment. The likelihood that the ratings of these bonds will fall
below investment grade is higher than for higher-rated bonds.
----------------------------------------------------------------------------------------------------------------
BB, Not investment grade; predominantly speculative with respect to the issuer's
CCC, capacity to repay interest and repay principal in accordance with the terms of the
CC, C obligation for bond issues not in default. BB is the least speculative. C is the most speculative.
- ------------------------------------------------------------------------------------------------------------------------------------
</TABLE>
Table 9
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28 T. Rowe Price
<PAGE>
3 More About the Funds
Credit Quality and the High Yield Fund. In seeking its primary objective of high
income, the Tax-Free High Yield Fund invests a portion of its assets in bonds
rated below investment grade (BB or lower). Such bonds are regarded as
speculative with respect to the issuer's ability to meet interest and principal
payments.
For the fiscal year ended February 29, 1996, the Tax-Free High Yield Fund's
assets were invested in the credit categories shown at right. Percentages are
computed on a dollar-weighted basis and are an average of 12 monthly
calculations.
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------
Tax-Free High Yield Fund: Asset Composition
Standard & Poor's Percentage of TRPA's
Rating* Total Assets Assessment of
Not Rated
Securities
<S> <C> <C>
- --------------------------------------------------------------------------------
AAA 9.9% 2.4%
- --------------------------------------------------------------------------------
AA 12.4% 0.3%
- --------------------------------------------------------------------------------
A 9.5% 1.8%
- --------------------------------------------------------------------------------
BBB 25.7% 7.4%
- --------------------------------------------------------------------------------
BB 9.0% 13.6%
- --------------------------------------------------------------------------------
B -- 2.3%
- --------------------------------------------------------------------------------
CCC-D -- 0.1% (CC)
- --------------------------------------------------------------------------------
Not rated 27.9% --
- --------------------------------------------------------------------------------
Reserves 5.6% --
- --------------------------------------------------------------------------------
100.0% 27.9%
- --------------------------------------------------------------------------------
</TABLE>
*Equivalent ratings by Moody's used in the absence of a S&P rating.
- --------------------------------------------------------------------------------
Table 10
-----------------------
T. Rowe Price 29
<PAGE>
4 Investing With T. Rowe Price
4 Investing With T. Rowe Price
Account Requirements and Transaction Information
- --------------------------------------------------------------------------------
Always verify your transactions by carefully reviewing the confirmation we send
you. Please report any discrepancies to Shareholder Services promptly
Tax Identification Number
We must have your correct Social Security or corporate tax identification number
on a signed New Account Form or W-9 Form. Otherwise, federal law requires the
funds to withhold a percentage (currently 31%) of your dividends, capital gain
distributions, and redemptions, and may subject you to an IRS fine. If this
information is not received within 60 days after your account is established,
your account may be redeemed, priced at the NAV on the date of redemption.
Unless you request otherwise, one shareholder report will be mailed to multiple
account owners with the same tax identification number and same ZIP code and to
shareholders who have requested that their account be combined with someone
else's for financial reporting.
Institutional Accounts
Transaction procedures in the following sections may not apply to institutional
accounts. For institutional account procedures, please call your designated
account manager or service representative.
Opening a New Account: $2,500 minimum initial investment;
$1,000 for gifts or transfers to minors (UGMA/UTMA) accounts
- --------------------------------------------------------------------------------
Regular Mail
T. Rowe Price
Account Services
P.O. Box 17300
Baltimore, MD
21298-9353
- --------------------------------------------------------------------------------
Mailgram, Express,
Registered, or
Certified Mail
T. Rowe Price
Account Services
10090 Red Run Blvd.
Owings Mills, MD 21117
Account Registration
If you own other T. Rowe Price funds, be sure to register any new account just
like your existing accounts so you can exchange among them easily. (The name and
account type would have to be identical.)
By Mail
Please make your check payable to T. Rowe Price Funds (otherwise it will be
returned) and send your check together with the New Account Form to the address
at left. We do not accept third party checks to open new accounts.
- -----------------------
30 T. Rowe Price
<PAGE>
4 Investing With T. Rowe Price
By Wire
. Call Investor Services for an account number and give the following wire
address to your bank:
Morgan Guaranty Trust Co. of New York
ABA# 021000238
T. Rowe Price [fund name]
AC-00153938
account name(s) and account number
. Complete a New Account Form and mail it to one of the appropriate addresses
listed on the previous page.
Note: No services will be established and IRS penalty withholding may occur
until a signed New Account Form is received.
By Exchange
Call Shareholder Services or use Tele*Access or your personal computer (see
"Automated Services" under "Shareholder Services"). The new account will have
the same registration as the account from which you are exchanging. Services
for the new account may be carried over by telephone request if preauthorized
on the existing account. (See explanation of "Excessive Trading" under
"Transaction Procedures.")
In Person
Drop off your New Account Form at any of the locations listed on the cover
and obtain a receipt.
Purchasing Additional Shares: $100 minimum purchase;
$50 minimum for Automatic Asset Builder and gifts or transfers
to minors (UGMA/UTMA) accounts
By ACH Transfer
Use Tele*Access, your personal computer, or call Investor Services if you
have established electronic transfers using the ACH network.
By Wire
Call Shareholder Services or use the wire address in "Opening a New Account."
- --------------------------------------------------------------------------------
Regular Mail
T. Rowe Price Funds
Account Services
P.O. Box 89000
Baltimore, MD
21289- 1500
(For mailgrams,
express, registered,
or certified mail, see
previous section)
By Mail
. Make your check payable to T. Rowe Price Funds (otherwise it may be
returned).
. Mail the check to us at the address shown at left with either a fund
reinvestment slip or a note indicating the fund you want to buy and your fund
account number.
. Remember to provide your account number and the fund name on your check.
By Automatic Asset Builder
Fill out the Automatic Asset Builder section on the New Account or
Shareholder Services Form.
-----------------------
T. Rowe Price 31
<PAGE>
4 Investing With T. Rowe Price
Exchanging and Redeeming Shares
By Phone
Call Shareholder Services. If you find our phones busy during unusually volatile
markets, please consider placing your order by your personal computer,
Tele*Access (if you have previously authorized telephone services), mailgram, or
by express mail. For exchange policies, please see "Transaction Procedures and
Special Requirements--Excessive Trading."
Redemption proceeds can be mailed to your account address, sent by ACH transfer,
or wired to your bank (provided your bank information is already on file). For
charges, see "Electronic Transfers--By Wire" under "Shareholder Services."
By Mail
For each account involved, provide the account name, number, fund name, and
exchange or redemption amount. For exchanges, be sure to indicate any fund you
are exchanging out of and the fund or funds you are exchanging into. Please mail
to the appropriate address below. T. Rowe Price requires the signatures of all
owners exactly as registered, and possibly a signature guarantee (see
"Transaction Procedures and Special Requirements--Signature Guarantees").
Mailgram, Express,
Registered, or Certified Mail: Regular Mail:
T. Rowe Price Account Services T. Rowe Price Account Services
10090 Red Run Boulevard P.O. Box 89000
Owings Mills, MD 21117 Baltimore, MD 21289-0220
Rights Reserved by the Fund
The fund and its agents reserve the right to waive or lower investment minimums;
to accept initial purchases by telephone or mailgram; to cancel or rescind any
purchase or exchange (for example, if an account has been restricted due to
excessive trading or fraud) upon notice to the shareholder within five business
days of the trade or if the written confirmation has not been received by the
shareholder, whichever is sooner; to freeze any account and suspend account
services when notice has been received of a dispute between the registered or
beneficial account owners or there is reason to believe a fraudulent transaction
may occur; to otherwise modify the conditions of purchase and any services at
any time; or to act on instructions believed to be genuine.
- -----------------------
32 T. Rowe Price
<PAGE>
4 Investing With T. Rowe Price
Shareholder Services
Shareholder Services
1-800-225-5132
1-410-625-6500
Many services are available to you as a T. Rowe Price shareholder; some you
receive automatically and others you must authorize on the New Account Form. By
signing up for services on the New Account Form rather than later on, you avoid
having to complete a separate form and obtain a signature guarantee. This
section reviews some of the principal services currently offered. Our Services
Guide contains detailed descriptions of these and other services.
If you are a new T. Rowe Price investor, you will receive a Services Guide with
our Welcome Kit.
Investor Services
1-800-638-5660
1-410-547-2308
Note: Corporate and other entity accounts require an original or certified
resolution to establish services and to redeem by mail. For more information,
call Investor Services.
Retirement Plans
We offer a wide range of plans for individuals and institutions, including large
and small businesses: IRAs, SEP-IRAs, Keoghs (profit sharing and money purchase
pension), 401(k), and 403(b)(7). For information on IRAs, call Investor
Services. For information on all other retirement plans, please call our Trust
Company at 1-800-492-7670.
Exchange Service
You can move money from one account to an existing identically registered
account, or open a new identically registered account. Remember, exchanges are
purchases and sales for tax purposes. (Exchanges into a state tax-free fund are
limited to investors living in states where the funds are registered.) Some of
the T. Rowe Price funds may impose a redemption fee of .50% to 2%, payable to
such funds, on shares held for less than one year, or in some funds, six months.
Automated Services
Tele*Access
1-800-638-2587
1-410-625-7676
Tele*Access. 24-hour service via a toll-free number provides information on fund
yields and prices, dividends, account balances, and your latest transaction, as
well as the ability to request prospectuses, account and tax forms, duplicate
statements, and checks, and to initiate purchase, redemption, and exchange
orders in your accounts (see "Electronic Transfers" below).
Personal Computer Access. 24-hour service via a dial-up modem provides the same
information as Tele*Access, but on a personal computer. Please call Investor
Services to order.
Telephone and Walk-In Services
Buy, sell, or exchange shares by calling one of our service representatives or
by visiting one of our investor center locations whose addresses are listed on
the cover.
Electronic Transfers
By ACH. With no charges to pay, you can initiate a purchase or redemption for as
little as $100 or as much as $100,000 between your bank account and fund account
using the ACH network. Enter instructions via Tele*Access or your personal
computer, or call Shareholder Services.
-----------------------
T. Rowe Price 33
<PAGE>
4 Investing With T. Rowe Price
By Wire. Electronic transfers can also be conducted via bank wire. There is
currently a $5 fee for wire redemptions under $5,000, and your bank may charge
for incoming or outgoing wire transfers regardless of size.
Checkwriting (not available for equity funds, or the High Yield Fund or Emerging
Markets Bond Fund)
You may write an unlimited number of free checks on any money market fund, and
most bond funds, with a minimum of $500 per check. Keep in mind, however, that a
check results in a redemption; a check written on a bond fund will create a
taxable event which you and we must report to the IRS.
Automatic Investing ($50 minimum)
You can invest automatically in several different ways, including:
Automatic Asset Builder. You instruct us to move $50 or more from your bank
account, or you can instruct your employer to send all or a portion of your
paycheck to the fund or funds you designate.
Note: If you are moving money from your bank account, and if the date you select
for your transactions falls on a Sunday or a Monday which is a holiday, your
order will be priced on the second business day following this date.
Automatic Exchange. You can set up systematic investments from one fund account
into another, such as from a money fund into a stock fund.
Discount Brokerage
Discount Brokerage is a division of T. Rowe Price Investment Services, Inc.,
Member NASD/SIPC.
This additional service gives you the opportunity to easily consolidate all of
your investments with one company. Through our discount brokerage, you can buy
and sell individual securities--stocks, bonds, options, and others--at
considerable commission savings. We also provide a wide range of services,
including:
Automated telephone and on-line services. You can enter trades, access quotes,
and review account information 24 hours a day, seven days a week. Any trades
executed through these programs save you an additional 10% on commissions.
To open an account:
1-800-638-5660
For existing discount brokerage investors:
1-800-225-7720
Note: Discount applies to our current commission schedule, subject to our $35
minimum commission.
Investor information. A variety of informative reports, such as our Brokerage
Insights series, S&P Market Month Newsletter, and optional stock reports can
help you better evaluate economic trends and investment opportunities.
Dividend Reinvestment Service. Virtually all stocks held in customer accounts
are eligible for this service--free of charge.
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34 T. Rowe Price
<PAGE>
Prospectus
T. Rowe Price
Tax-Free Funds
July 1, 1996
Prospectus
To Open an Account
Investor Services
1-800-638-5660
1-410-547-2308
For Existing Accounts
Shareholder Services
1-800-225-5132
1-410-625-6500
For Yields and Prices
Tele*Access(R)
1-800-638-2587
1-410-625-7676
24 hours, 7 days
Investor Centers
101 East Lombard St.
Baltimore, MD 21202
T. Rowe Price
Financial Center
10090 Red Run Blvd.
Owings Mills, MD 21117
Farragut Square
900 17th Street, N.W.
Washington, D.C. 20006
ARCO Tower
31st Floor
515 South Flower St.
Los Angeles, CA 90071
4200 West Cypress St.
10th Floor
Tampa, FL 33607
Internet Address
http://www.troweprice.com
Invest With Confidence
To help you achieve your financial goals, T. Rowe Price offers a wide range of
stock, bond, and money market investments, as well as convenient services and
timely, informative reports.
T. Rowe Price
Tax-Free Funds
T. Rowe Price
Tax-Free Funds
July 1, 1996
- ----------------------------
A family of municipal bond and money funds for investors seeking income that is
exempt from federal income taxes.
[LOGO OF T. ROWE PRICE APPEARS HERE]
Facts at a Glance
Investment Goals
The highest possible levels of income exempt from federal income taxes,
consistent with each fund's prescribed investment program. As with all mutual
funds, these funds may not meet their goals.
Strategy and Risk/Reward
Tax-Exempt Money Fund, Inc.(R) Invests in high-quality, short-term municipal
securities, and its average maturity will not exceed 90 days. Your investment in
the fund is neither insured nor guaranteed by the U.S. government, and there is
no assurance that the fund will be able to maintain a stable net asset value of
$1.00 per share. Risk/Reward: Lowest potential risk and reward.
Tax-Free Short-Intermediate Fund, Inc.(R) Invests primarily in investment-grade
short- and intermediate-term municipal bonds. Maturity range: 2-5 years.
Risk/Reward: Moderate income level and share price fluctuation.
Tax-Free Insured Intermediate Bond Fund, Inc. Invests primarily in intermediate-
term municipal bonds whose interest and principal payments are insured by
private insurance companies. Insurance does not apply to the fund's share price,
which will fluctuate. Maturity range: 5-10 years. Risk/Reward: Somewhat higher
income and potential share price fluctuations than the Short-Intermediate Fund.
Prospectus
(See discussion on insurance in the section entitled "Types of Portfolio
Securities.")
Tax-Free Income Fund, Inc.(R) Invests primarily in longer-term, investment-
grade municipal bonds. Maturity expected to exceed 15 years. Risk/Reward: Higher
income and potential share price fluctuation than the shorter-term funds.
Tax-Free High Yield Fund, Inc.(R) Can invest entirely in lower-quality, long-
term municipal bonds often called high yield or "junk" bonds. These bonds
represent greater default risk than higher rated bonds. Before investing, you
should carefully consider the greater risks of junk bonds as explained in
"Investment Policies and Practices." Maturity: over 15 years. Risk/Reward:
Highest income, greatest credit risk, and highest potential share price
volatility.
Investor Profile
Investors whose income tax level enables them to benefit from tax-exempt income.
Not appropriate for tax-deferred retirement plans, such as IRAs.
Fees and Charges
100% no load. No fees or charges to buy or sell shares or to reinvest dividends;
no 12b-1 marketing fees; free telephone exchange.
Investment Manager
Founded in 1937 by the late Thomas Rowe Price, Jr., T. Rowe Price Associates,
Inc. ("T. Rowe Price") and its affiliates managed over $82 billion, including
over $5.7 billion in municipal bond assets, for over four million individual and
institutional investor accounts as of March 31, 1996.
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION, OR ANY STATE SECURITIES COMMISSION, NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION, OR ANY STATE SECURITIES COMMISSION, PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS
A CRIMINAL OFFENSE.
PAGE 2
STATEMENT OF ADDITIONAL INFORMATION
T. Rowe Price Tax-Exempt Money Fund, Inc.
T. Rowe Price Tax-Free Short-Intermediate Fund, Inc.
T. Rowe Price Tax-Free Insured Intermediate Bond Fund, Inc.
T. Rowe Price Tax-Free Income Fund, Inc.
T. Rowe Price Tax-Free High Yield Fund, Inc.
(the "Funds")
This Statement of Additional Information is not a
prospectus but should be read in conjunction with the Funds'
prospectus dated July 1, 1996, which may be obtained from T. Rowe
Price Investment Services, Inc., 100 East Pratt Street,
Baltimore, Maryland 21202.
The date of this Statement of Additional Information is
July 1, 1996.
PAGE 3
TABLE OF CONTENTS
Page Page
Capital Stock . . . . . . Management of Funds . . . .
Code of Ethics . . . . . Municipal Securities . . .
Custodian . . . . . . . . Net Asset Value Per Share .
Determination of Maturity of Options . . . . . . . . . .
Money Market Securities Participation Interests . .
Distributor for Funds . . Portfolio Transactions . .
Dividends . . . . . . . . Pricing of Securities . . .
Federal and State Principal Holders of
Registration of Shares Securities . . . . . . .
Forwards . . . . . . . . Ratings of Commercial Paper
Futures Contracts . . . . Ratings of Municipal Debt
General Information Securities . . . . . . .
and History . . . . . . Ratings of Municipal Notes and
Independent Accountants . Variable Rate Securities
Investment Management Residual Interest Bonds . .
Services . . . . . . . Risk Factors . . . . . . .
Investment in Taxable Money Tax-Exempt vs. Taxable
Market Securities . . . Yields . . . . . . . . .
Investment Objectives Tax Status . . . . . . . .
and Policies . . . . . Variable and Floating Rate
Investment Performance . Securities . . . . . . .
Investment Programs . . . When-Issued Securities . .
Investment Restrictions . Yield Information . . . . .
Legal Counsel . . . . . .
INVESTMENT OBJECTIVES AND POLICIES
The following information supplements the discussion of
each Fund's investment objectives and policies discussed in the
prospectus. The Funds will not make a material change in their
investment objectives without obtaining shareholder approval.
Unless otherwise specified, the investment programs and
restrictions of the Funds are not fundamental policies. Each
Fund's operating policies are subject to change by its Board of
Directors without shareholder approval. However, shareholders
will be notified of a material change in an operating policy.
Each Fund's fundamental policies may not be changed without the
approval of at least a majority of the outstanding shares of the
Fund or, if it is less, 67% of the shares represented at a
meeting of shareholders at which the holders of 50% or more of
the shares are represented.
PAGE 4
RISK FACTORS
All Funds
The Funds are designed for investors who, because of
their tax bracket, can benefit from investment in municipal bonds
whose income is exempt from federal taxes. The Funds are not
appropriate for qualified retirement plans where income is
already tax deferred.
Municipal Securities
There can be no assurance that the Funds will achieve
their investment objectives. Yields on municipal securities are
dependent on a variety of factors, including the general
conditions of the money market and the municipal bond market, the
size of a particular offering, the maturity of the obligation,
and the rating of the issue. Municipal securities with longer
maturities tend to produce higher yields and are generally
subject to potentially greater capital appreciation and
depreciation than obligations with shorter maturities and lower
yields. The market prices of municipal securities usually vary,
depending upon available yields. An increase in interest rates
will generally reduce the value of portfolio investments, and a
decline in interest rates will generally increase the value of
portfolio investments. The ability of all the Funds to achieve
their investment objectives is also dependent on the continuing
ability of the issuers of municipal securities in which the Funds
invest to meet their obligations for the payment of interest and
principal when due. The ratings of Moody's, S&P, and Fitch
represent their opinions as to the quality of municipal
securities which they undertake to rate. Ratings are not
absolute standards of quality; consequently, municipal securities
with the same maturity, coupon, and rating may have different
yields. There are variations in municipal securities, both
within a particular classification and between classifications,
depending on numerous factors. It should also be pointed out
that, unlike other types of investments, municipal securities
have traditionally not been subject to regulation by, or
registration with, the SEC, although there have been proposals
which would provide for regulation in the future.
The federal bankruptcy statutes relating to the debts
of political subdivisions and authorities of states of the United
States provide that, in certain circumstances, such subdivisions
or authorities may be authorized to initiate bankruptcy
proceedings without prior notice to or consent of creditors,
which proceedings could result in material and adverse changes in
the rights of holders of their obligations.
Proposals have been introduced in Congress to restrict
or eliminate the federal income tax exemption for interest on
municipal securities, and similar proposals may be introduced in
PAGE 5
the future. Proposed "Flat Tax" and "Valued Added Tax" proposals
would also have the effect of eliminating the tax preference for
municipal securities. Some of the past proposals would have
applied to interest on municipal securities issued before the
date of enactment, which would have adversely affected their
value to a material degree. If such a proposal were enacted, the
availability of municipal securities for investment by the Funds
and the value of a Fund's portfolio would be affected and, in
such an event, a Fund would reevaluate its investment objectives
and policies.
Although the banks and securities dealers with which
the Funds will transact business will be banks and securities
dealers that T. Rowe Price believes to be financially sound,
there can be no assurance that they will be able to honor their
obligations to the Funds with respect to such securities.
After purchase by the Funds, a security may cease to be
rated or its rating may be reduced below the minimum required for
purchase by the Funds. For the Money Fund, the procedures set
forth in Rule 2a-7, under the Investment Company Act of 1940, may
require the prompt sale of any such security. For the other
Funds, neither event would require a sale of such security by the
Fund. However, T. Rowe Price Associates, Inc. ("T. Rowe Price")
will consider such event in its determination of whether the Fund
should continue to hold the security. To the extent that the
ratings given by Moody's Investors Service, Inc. ("Moody's"),
Standard & Poor's Corporation ("S&P"), or Fitch Investors
Service, Inc. ("Fitch") may change as a result of changes in such
organizations or their rating systems, the Fund will attempt to
use comparable ratings as standards for investments in accordance
with the investment policies contained in the prospectus. When
purchasing unrated securities, T. Rowe Price, under the
supervision of the Fund's Board of Directors, determines whether
the unrated security is of a qualify comparable to that which the
Fund is allowed to purchase.
Municipal Bond Insurance. All of the Funds may
purchase insured bonds from time to time. The Tax-Free Insured
Intermediate Fund must purchase such bonds. Municipal bond
insurance provides an unconditional and irrevocable guarantee
that the insured bond's principal and interest will be paid when
due. The guarantee is purchased from a private, non-governmental
insurance company.
There are two types of insured securities that may be
purchased by the Funds, bonds carrying either (1) new issue
insurance or (2) secondary insurance. New issue insurance is
purchased by the issuer of a bond in order to improve the bond's
credit rating. By meeting the insurer's standards and paying an
insurance premium based on the bond's total debt service, the
issuer is able to obtain a higher credit rating for the bond.
Once purchased, municipal bond insurance cannot be cancelled, and
PAGE 6
the protection it affords continues as long as the bonds are
outstanding and the insurer remains solvent.
The Funds may also purchase bonds which carry secondary
insurance purchased by an investor after a bond's original
issuance. Such policies insure a security for the remainder of
its term. Generally, the Funds expect that portfolio bonds
carrying secondary insurance will have been insured by a prior
investor. However, the Funds may, on occasion, purchase
secondary insurance on their own behalf.
Each of the municipal bond insurance companies has
established reserves to cover estimated losses. Both the method
of establishing these reserves and the amount of the reserves
vary from company to company. The obligation of a municipal bond
insurance company may have to pay a claim extends over the life
of each insured bond. Municipal bond insurance companies are
obligated to pay a bond's interest and principal when due if the
issuing entity defaults on the insured bond. Although defaults
on insured municipal bonds have been low to date and municipal
insurers have met these claims, there is no assurance this low
rate will continue in the future. A higher than expected default
rate could deplete loss reserves and adversely affect the ability
of a municipal bond insurer to pay claims to holders of insured
bonds, such as the Fund.
Money Fund
The Fund will limit its purchases of portfolio
instruments to those U.S. dollar-denominated securities which the
Fund's Board of Directors determines present minimal credit risk,
and which are Eligible Securities as defined in Rule 2a-7 under
the Investment Company Act of 1940 (1940 Act). Eligible
Securities are generally securities which have been rated (or
whose issuer has been rated or whose issuer has comparable
securities rated) in one of the two highest short-term rating
categories by nationally recognized statistical rating
organizations or, in the case of any instrument that is not so
rated, is of comparable high quality as determined by T. Rowe
Price pursuant to written guidelines established in accordance
with Rule 2a-7 under the Investment Company Act of 1940 under the
supervision of the Fund's Board of Directors. In addition, the
Funds may treat variable and floating rate instruments with
demand features as short-term securities pursuant to Rule 2a-7
under the 1940 Act.
There can be no assurance that the Money Fund will
achieve its investment objectives or be able to maintain its net
asset value per share at $1.00. The price stability and
liquidity of the Money Fund may not be equal to that of a taxable
money market fund which exclusively invests in short-term taxable
money market securities. The taxable money market is a broader
and more liquid market with a greater number of investors,
PAGE 7
issuers, and market makers than the short-term municipal
securities market. The weighted average maturity of the Fund
varies (subject to a 90 day maximum under Rule 2a-7): the
shorter the average maturity of a portfolio, the less its price
will be impacted by interest rate fluctuations.
Bond Funds
Because of their investment policies, the Bond Funds
may not be suitable or appropriate for all investors. The Funds
are designed for investors who wish to invest in non-money market
funds for income, and who would benefit, because of their tax
bracket, from receiving income that is exempt from federal income
taxes. The Funds' investment programs permit the purchase of
investment grade securities that do not meet the high quality
standards of the Money Fund. Since investors generally perceive
that there are greater risks associated with investment in lower
quality securities, the yields from such securities normally
exceed those obtainable from higher quality securities. In
addition, the principal value of long term lower-rated securities
generally will fluctuate more widely than higher quality
securities. Lower quality investments entail a higher risk of
default--that is, the nonpayment of interest and principal by the
issuer than higher quality investments. The value of the
portfolio securities of the Bond Funds will fluctuate based upon
market conditions. Although these Funds seek to reduce credit
risk by investing in a diversified portfolio, such
diversification does not eliminate all risk. The Funds are also
not intended to provide a vehicle for short-term trading
purposes.
Special Risks of High Yield Investing.
Junk bonds are regarded as predominantly speculative
with respect to the issuer's continuing ability to meet principal
and interest payments. Because investment in low and lower-
medium quality bonds involves greater investment risk, to the
extent the Funds invest in such bonds, achievement of their
investment objectives will be more dependent on T. Rowe Price's
credit analysis than would be the case if the Funds were
investing in higher quality bonds. High yield bonds may be more
susceptible to real or perceived adverse economic conditions than
investment grade bonds. A projection of an economic downturn, or
higher interest rates, for example, could cause a decline in high
yield bond prices because the advent of such events could lessen
the ability of highly leverage issuers to make principal and
interest payments on their debt securities. In addition, the
secondary trading market for high yield bonds may be less liquid
than the market for higher grade bonds, which can adversely
affect the ability of a Fund to dispose of its portfolio
securities. Bonds for which there is only a "thin" market can be
more difficult to value inasmuch as objective pricing data may be
less available and judgment may play a greater role in the
PAGE 8
valuation process.
Reference is also made to the sections entitled "Types
of Securities" and "Portfolio Management Practices" for
discussions of the risks associated with the investments and
practices described therein.
INVESTMENT PROGRAMS
(Throughout the discussion on Investments, the term "the Fund" is
intended to refer to each of the Funds eligible to invest in the
security or engage in the practice being described.)
Type of Securities
Municipal Securities
Subject to the investment objectives and programs
described in the prospectus and the additional investment
restrictions described in this Statement of Additional
Information, each Fund's portfolio may consist of any combination
of the various types of municipal securities described below or
other types of municipal securities that may be developed. The
amount of each Fund's assets invested in any particular type of
municipal security can be expected to vary.
The term "municipal securities" means obligations
issued by or on behalf of states, territories, and possessions of
the United States and the District of Columbia and their
political subdivisions, agencies and instrumentalities, as well
as certain other persons and entities, the interest from which is
exempt from federal income tax. In determining the tax-exempt
status of a municipal security, the Fund relies on the opinion of
the issuer's bond counsel at the time of the issuance of the
security. However, it is possible this opinion could be
overturned, and as a result, the interest received by the Fund
from such a security might not be exempt from federal income tax.
Municipal securities are classified by maturity as notes, bonds,
or adjustable rate securities.
Municipal Notes. Municipal notes generally are used to
provide for short-term operating or capital needs and generally
have maturities of one year or less. Municipal notes include the
following:
Tax Anticipation Notes. Tax anticipation notes are
issued to finance working capital needs of
municipalities. Generally, they are issued in
anticipation of various seasonal tax revenue, such as
income, property, use and business taxes, and are
payable from these specific future taxes.
PAGE 9
Revenue Anticipation Notes. Revenue anticipation notes
are issued in expectation of receipt of other types of
revenue, such as federal or state revenues available
under the revenue sharing or grant programs.
Bond Anticipation Notes. Bond anticipation notes are
issued to provide interim financing until long-term
financing can be arranged. In most cases, the
long-term bonds then provide the money for the
repayment of the notes.
Tax-Exempt Commercial Paper. Tax-exempt commercial
paper is a short-term obligation with a stated maturity
of 270 days or less. It is issued by state and local
governments or their agencies to finance seasonal
working capital needs or as short-term financing in
anticipation of longer term financing.
Municipal Bonds. Municipal bonds, which meet longer
term capital needs and generally have maturities of
more than one year when issued, have two principal
classifications: general obligation bonds and revenue
bonds. Two additional categories of potential
purchases are lease revenue bonds and pre-
refunded/escrowed to maturity bonds. Another type of
municipal bond is referred to as an Industrial
Development Bond.
General Obligation Bonds. Issuers of general
obligation bonds include states, counties, cities,
towns, and special districts. The proceeds of these
obligations are used to fund a wide range of public
projects, including construction or improvement of
schools, public buildings, highways and roads, and
general projects not supported by user fees or
specifically identified revenues. The basic security
behind general obligation bonds is the issuer's pledge
of its full faith and credit and taxing power for the
payment of principal and interest. The taxes that can
be levied for the payment of debt service may be
limited or unlimited as to the rate or amount of
special assessments. In many cases voter approval is
required before an issuer may sell this type of bond.
Revenue Bonds. The principal security for a revenue
bond is generally the net revenues derived from a
particular facility, or enterprise, or in some cases,
the proceeds of a special charge or other pledged
revenue source. Revenue bonds are issued to finance a
wide variety of capital projects including: electric,
gas, water and sewer systems; highways, bridges, and
tunnels; port and airport facilities; colleges and
universities; and hospitals. Revenue bonds are
PAGE 10
sometimes used to finance various privately operated
facilities provided they meet certain tests established
for tax-exempt status.
Although the principal security behind these bonds
may vary, many provide additional security in the form
of a mortgage or debt service reserve fund. Some
authorities provide further security in the form of the
state's ability (without obligation) to make up
deficiencies in the debt service reserve fund. Revenue
bonds usually do not require prior voter approval
before they may be issued.
Lease Revenue Bonds. Municipal borrowers may also
finance capital improvements or purchases with
tax-exempt leases. The security for a lease is
generally the borrower's pledge to make annual
appropriations for lease payments. The lease payment
is treated as an operating expense subject to
appropriation risk and not a full faith and credit
obligation of the issuer. Lease revenue bonds are
generally considered less secure than a general
obligation or revenue bond and often do not include a
debt service reserve fund. To the extent the Fund's
Board determines such securities are illiquid, they
will be subject to the Fund's 15% limit on illiquid
securities (10% limit for the Money Fund). There have
also been certain legal challenges to the use of lease
revenue bonds in various states.
The liquidity of such securities will be determined
based on a variety of factors which may include, among
others: (1) the frequency of trades and quotes for the
obligation; (2) the number of dealers willing to
purchase or sell the security and the number of other
potential buyers; (3) the willingness of dealers to
undertake to make a market in the security; (4) the
nature of the marketplace trades, including, the time
needed to dispose of the security, the method of
soliciting offers, and the mechanics of transfer; and
(5) the rating assigned to the obligation by an
established rating agency or T. Rowe Price.
Pre-refunded/Escrowed to Maturity Bonds. Certain
municipal bonds have been refunded with a later bond
issue from the same issuer. The proceeds from the
later issue are used to defease the original issue. In
many cases the original issue cannot be redeemed or
repaid until the first call date or original maturity
date. In these cases, the refunding bond proceeds
typically are used to buy U.S. Treasury securities that
are held in an escrow account until the original call
date or maturity date. The original bonds then become
PAGE 11
"pre-refunded" or "escrowed to maturity" and are
considered as high quality investments. While still
tax-exempt, the security is the proceeds of the escrow
account. To the extent permitted by the Securities and
Exchange Commission and the Internal Revenue Service, a
Fund's investment in such securities refunded with U.S.
Treasury securities will, for purposes of
diversification rules applicable to the Fund, be
considered as an investment in the U.S. Treasury
securities.
Private Activity Bonds. Under current tax law all
municipal debt is divided broadly into two groups:
governmental purpose bonds and private activity bonds.
Governmental purpose bonds are issued to finance
traditional public purpose projects such as public
buildings and roads. Private activity bonds may be
issued by a state or local government or public
authority but principally benefit private users and are
considered taxable unless a specific exemption is
provided.
The tax code currently provides exemptions for
certain private activity bonds such as not-for-profit
hospital bonds, small-issue industrial development
revenue bonds and mortgage subsidy bonds, which may
still be issued as tax-exempt bonds. Some, but not
all, private activity bonds are subject to alternative
minimum tax.
Industrial Development Bonds. Industrial development
bonds are considered Municipal Bonds if the interest
paid is exempt from federal income tax. They are
issued by or on behalf of public authorities to raise
money to finance various privately operated facilities
for business and manufacturing, housing, sports, and
pollution control. These bonds are also used to
finance public facilities such as airports, mass
transit systems, ports, and parking. The payment of the
principal and interest on such bonds is dependent
solely on the ability of the facility's user to meet
its financial obligations and the pledge, if any, of
real and personal property so financed as security for
such payment.
Adjustable Rate Securities. Municipal securities may
be issued with adjustable interest rates that are reset
periodically by pre-determined formulas or indexes in
order to minimize movements in the principal value of
the investment. Such securities may have long-term
maturities, but may be treated as a short-term
investment under certain conditions. Generally, as
interest rates decrease or increase, the potential for
PAGE 12
capital appreciation or depreciation on these
securities is less than for fixed-rate obligations.
These securities may take the following forms:
Variable Rate Securities. Variable rate securities
are those whose terms provide for the adjustment of
their interest rates on set dates and which, upon
each adjustment until the final maturity of the
instrument or the period remaining until the
principal amount can be recovered through demand,
can reasonably be expected to have a market value
that approximates its amortized cost. Subject to
the provisions of Rule 2a-7 under the Investment
Company Act of 1940 (1940 Act): (1) a variable rate
security, the principal amount of which is
scheduled to be paid in 397 calendar days or less,
is deemed to have a maturity equal to the earlier
of the period remaining until the next readjustment
of the interest rate or the period remaining until
the principal amount can be recovered through
demand; (2) a variable rate security, the principal
amount of which is scheduled to be paid in more
than 397 calendar days, which is subject to a
demand feature, as defined in Rule 2a-7, is deemed
to have a maturity equal to the longer of the
period remaining until the next readjustment of the
interest rate or the period remaining until the
principal amount can be recovered through demand;
and (3) a security that is issued or guaranteed by
the U.S. Government or any agency thereof which has
a variable rate of interest readjusted no less
frequently than every 762 calendar days may be
deemed to have a maturity equal to the period
remaining until the next readjustment of the
interest rate. Should the provisions of Rule 2a-7
change, the Fund will determine the maturity of
these securities in accordance with the amended
provisions of such Rule.
Floating Rate Securities. Floating rate securities are
those whose terms provide for the adjustment of their
interest rates whenever a specified interest rate
changes and which, at any time until the final maturity
of the instrument or the period remaining until the
principal amount can be recovered through demand, can
reasonably be expected to have a market value that
approximates its amoritized cost. Subject to the
provisions of Rule 2a-7 under the 1940 Act: (1) the
maturity of a floating rate security, the principal
amount of which must be unconditionally paid in 397
calendar days or less, is deemed to be one day; and (2)
a floating rate security, the principal amount of which
is scheduled to be paid in more than 397 calendar days,
PAGE 13
that is subject to a demand feature, is deemed to have
a maturity equal to the period remaining until the
principal amount can be recovered through demand.
Should the provisions of Rule 2a-7 change, the Fund
will determine the maturity of these securities in
accordance with the amended provisions of such Rule.
Put Option Bonds. Long-term obligations with
maturities longer than one year may provide
purchasers an optional or mandatory tender of the
security at par value at predetermined intervals,
often ranging from one month to several years
(e.g., a 30-year bond with a five-year tender
period). These instruments are deemed to have a
maturity equal to the period remaining to the put
date.
Residual Interest Bonds (These are a type of high-
risk derivative) (Bond Funds). The Funds may
purchase municipal bond issues that are structured
as two-part, residual interest bond and variable
rate security offerings. The issuer is obligated
only to pay a fixed amount of tax-free income that
is to be divided among the holders of the two
securities. The interest rate for the holders of
the variable rate securities will be determined by
an index or auction process held approximately
every 7 to 35 days while the bond holders will
receive all interest paid by the issuer minus the
amount given to the variable rate security holders
and a nominal auction fee. Therefore, the coupon
of the residual interest bonds, and thus the income
received, will move inversely with respect to
short-term, 7 to 35 day tax-exempt interest rates.
There is no assurance that the auction will be
successful and that the variable rate security will
provide short-term liquidity. The issuer is not
obligated to provide such liquidity. In general,
these securities offer a significant yield
advantage over standard municipal securities, due
to the uncertainty of the shape of the yield curve
(i.e., short term versus long term rates) and
consequent income flows.
Unlike many adjustable rate securities, residual
interest bonds are not necessarily expected to
trade at par and in fact present significant market
risks. In certain market environments, residual
interest bonds may carry substantial premiums or be
at deep discounts. This is a relatively new
product in the municipal market with limited
liquidity to date.
PAGE 14
Participation Interests. The Funds may purchase
from third parties participation interests in all
or part of specific holdings of municipal
securities. The purchase may take different forms:
in the case of short-term securities, the
participation may be backed by a liquidity facility
that allows the interest to be sold back to the
third party (such as a trust, broker or bank) for a
predetermined price of par at stated intervals.
The seller may receive a fee from the Funds in
connection with the arrangement.
In the case of longer term bonds, the Intermediate
and Income Funds may purchase interests in a pool
of municipal bonds or a single municipal bond or
lease without the right to sell the interest back
to the third party.
The Funds will not purchase participation interests
unless a satisfactory opinion of counsel or ruling
of the Internal Revenue Service has been issued
that the interest earned from the municipal
securities on which the Funds holds participation
interests is exempt from federal income tax to the
Funds. However, there is no guarantee the IRS
would treat such interest income as tax-exempt.
Embedded Interest Rate Swaps and Caps (Bond Funds).
In a fixed-rate, long-term municipal bond with an
interest rate swap attached to it, the bondholder
usually receives the bond's fixed-coupon payment as
well as a variable rate payment that represents the
difference between a fixed rate for the term of the
swap (which is typically shorter than the bond it
is attached to) and a variable rate short-term
municipal index. The bondholder receives excess
income when short-term rates remain below the fixed
interest rate swap rate. If short-term rates rise
above the fixed-income swap rate, the bondholder's
income is reduced. At the end of the interest rate
swap term, the bond reverts to a single
fixed-coupon payment. Embedded interest rate swaps
enhance yields, but also increase interest rate
risk.
An embedded interest rate cap allows the bondholder
to receive payments whenever short-term rates rise
above a level established at the time of purchase.
They normally are used to hedge against rising
short-term interest rates.
Both instruments may be volatile and of limited
liquidity and their use may adversely affect a
PAGE 15
fund's total return.
The Funds may invest in other types of derivative
instruments as they become available.
There are, of course, other types of municipal
securities that are, or may become, available, and the Funds
reserve the right to invest in them.
For the purpose of the Funds' investment restrictions,
the identification of the "issuer" of municipal securities which
are not general obligation bonds is made by the Funds' investment
manager, T. Rowe Price, on the basis of the characteristics of
the obligation as described above, the most significant of which
is the source of funds for the payment of principal and interest
on such securities.
When-Issued Securities
New issues of municipal securities are often offered on
a when-issued basis; that is, delivery and payment for the
securities normally takes place 15 to 45 days or more after the
date of the commitment to purchase. The payment obligation and
the interest rate that will be received on the securities are
each fixed at the time the buyer enters into the commitment. A
Fund will only make a commitment to purchase such securities with
the intention of actually acquiring the securities. However, a
Fund may sell these securities before the settlement date if it
is deemed advisable as a matter of investment strategy. Each
Fund will maintain cash and/or high-grade marketable debt
securities with its custodian bank equal in value to commitments
for when-issued securities. Such securities either will mature
or, if necessary, be sold on or before the settlement date.
Securities purchased on a when-issued basis and the securities
held in a Fund's portfolio are subject to changes in market value
based upon the public perception of the creditworthiness of the
issuer and changes in the level of interest rates (which will
generally result in similar changes in value; i.e., both
experiencing appreciation when interest rates decline and
depreciation when interest rates rise). Therefore, to the extent
a Fund remains fully invested or almost fully invested at the
same time that it has purchased securities on a when-issued
basis, there will be greater fluctuations in its net asset value
than if it solely set aside cash to pay for when-issued
securities. In the case of the Money Fund, this could increase
the possibility that the market value of the Fund's assets could
vary from $1.00 per share. In addition, there will be a greater
potential for the realization of capital gains, which are not
exempt from federal income tax. When the time comes to pay for
when-issued securities, a Fund will meet its obligations from
then-available cash flow, sale of securities or, although it
would not normally expect to do so, from sale of the when-issued
securities themselves (which may have a value greater or less
PAGE 16
than the payment obligation). The policies described in this
paragraph are not fundamental and may be changed by a Fund upon
notice to its shareholders.
Forwards
Bond Funds
The Funds may purchase bonds on a when-issued basis
with longer than standard settlement dates, in some cases
exceeding one to two years. In such cases, the Funds must
execute a receipt evidencing the obligation to purchase the bond
on the specified issue date, and must segregate cash internally
to meet that forward commitment. Municipal "forwards" typically
carry a substantial yield premium to compensate the buyer for the
risks associated with a long when-issued period, including:
shifts in market interest rates that could materially impact the
principal value of the bond, deterioration in the credit quality
of the issuer, loss of alternative investment options during the
when-issued period, changes in tax law or issuer actions that
would affect the exempt interest status of the bonds and prevent
delivery, failure of the issuer to complete various steps
required to issue the bonds, and limited liquidity for the buyer
to sell the escrow receipts during the when-issued period.
Investment in Taxable Money Market Securities
Although the Funds expect to be solely invested in
municipal securities, for temporary defensive purposes they may
elect to invest in the taxable money market securities listed
below (without limitation) when such action is deemed to be in
the best interests of shareholders. The interest earned on these
money market securities is not exempt from federal income tax and
may be taxable to shareholders as ordinary income.
U.S. Government Obligations - direct obligations of
the government and its agencies and instrumentalities;
U.S. Government Agency Securities - obligations
issued or guaranteed by U.S. government sponsored enterprises,
federal agencies, and international institutions. Some of these
securities are supported by the full faith and credit of the U.S.
Treasury; others are supported by the right of the issuer; and
the remainder are supported only by the credit of the
instrumentality;
Bank Obligations - certificates of deposit,
bankers' acceptances, and other short-term obligations of U.S.
and Canadian banks and their foreign branches;
Commercial Paper - paper rated A-2 or better by
S&P, Prime-2 or better by Moody's, or F-2 or better by Fitch, or,
if not rated, is issued by a corporation having an outstanding
PAGE 17
debt issue rated A or better by Moody's, S&P or Fitch and, with
respect to the Money Fund, is of equivalent investment quality as
determined by the Board of Directors; and
Short-Term Corporate Debt Securities - short-term
corporate debt securities rated at least AA by S&P, Moody's or
Fitch.
Determination of Maturity of Money Market Securities
The Money Fund may only purchase securities which at
the time of investment have remaining maturities of 397 calendar
days or less. The other Funds may also purchase money-market
securities. In determining the maturity of money market
securities, the Funds will follow the provisions of Rule 2a-7
under the Investment Company Act of 1940.
PORTFOLIO MANAGEMENT PRACTICES
Futures Contracts (Bond Funds only)
Futures are a potentially high-risk derivative.
Transactions in Futures
The Fund may enter into interest rate futures contracts
("futures" or "futures contracts"). Interest rate futures
contracts may be used as a hedge against changes in prevailing
levels of interest rates in order to establish more definitely
the effective return on securities held or intended to be
acquired by the Fund. The Fund could sell interest rate futures
as an offset against the effect of expected increases in interest
rates and purchase such futures as an offset against the effect
of expected declines in interest rates. Futures can also be used
as an efficient means of regulating a Fund's exposure to the
market.
The Fund will enter into futures contracts which are
traded on national futures exchanges and are standardized as to
maturity date and underlying financial instrument. A public
market exists in futures contracts covering various taxable fixed
income securities as well as municipal bonds. Futures exchanges
and trading in the United States are regulated under the
Commodity Exchange Act by the Commodity Futures Trading
Commission ("CFTC"). Although techniques other than the sale and
purchase of futures contracts could be used for the above-
referenced purposes, futures contracts offer an effective and
relatively low cost means of implementing the Fund's objectives
in these areas.
Regulatory Limitations
The Fund will engage in futures contracts and options
thereon only for bona fide hedging, yield enhancement, and risk
PAGE 18
management purposes, in each case in accordance with rules and
regulations of the CFTC and applicable state law.
The Fund may not purchase or sell futures contracts or
related options if, with respect to positions which do not
quality as bona fide hedging under applicable CFTC rules, the sum
of the amounts of initial margin deposits and premiums paid on
those positions would exceed 5% of the net asset value of the
Fund after taking into account unrealized profits and unrealized
losses on any such contracts it has entered into; provided,
however, that in the case of an option that is in-the-money at
the time of purchase, the in-the-money amount may be excluded in
calculating the 5% limitation. For purposes of this policy,
options on futures contracts traded on a commodities exchange
will be considered "related options." This policy may be
modified by the Board of Directors without a shareholder vote and
does not limit the percentage of the Fund's assets at risk to 5%.
In accordance with the rules of the State of
California, the Fund will apply the above 5% test without
excluding the value of initial margin and premiums paid for bona
fide hedging purposes.
The Fund's use of futures will not result in leverage.
Therefore, to the extent necessary, in instances involving the
purchase of futures contracts or the writing of calls or put
options thereon by the Fund, an amount of cash, U.S. government
securities or other liquid, high-grade debt obligations, equal to
the market value of the futures contracts and options thereon
(less any related margin deposits), will be identified in an
account with the Fund's custodian to cover the position, or
alternative cover (such as owning an offsetting position) will be
employed. Assets used as cover or held in an identified account
cannot be sold while the position in the corresponding option or
future is open, unless they are replaced with similar assets. As
a result, the commitment of a large portion of a Fund's assets to
cover or identified accounts could impede portfolio management or
the Fund's ability to meet redemption requests or other current
obligations.
If the CFTC or other regulatory authorities adopt
different (including less stringent) or additional restrictions,
the Fund would comply with such new restrictions.
Trading in Futures Contracts
A futures contract provides for the future sale by one
party and purchase by another party of a specified amount of a
specific financial instrument (e.g., units of a debt security)
for a specified price, date, time and place designated at the
time the contract is made. Brokerage fees are incurred when a
futures contract is bought or sold and margin deposits must be
maintained. Entering into a contract to buy is commonly referred
PAGE 19
to as buying or purchasing a contract or holding a long position.
Entering into a contract to sell is commonly referred to as
selling a contract or holding a short position.
It is possible that the Fund's hedging activities will
occur primarily through the use of municipal bond index futures
contracts since the uniqueness of that index contract should
better correlate with the Fund's portfolio and thereby be more
effective. However, there may be times when it is deemed in the
best interest of shareholders to engage in the use of Treasury
bond futures, and the Fund reserves to right to use Treasury bond
futures at any time. Use of these futures could occur, as an
example, when both the Treasury bond contract and municipal bond
index futures contract are correlating well with municipal bond
prices, but the Treasury bond contract is trading at a more
advantageous price making the hedge less expensive with the
Treasury bond contract than would be obtained with the municipal
bond index futures contract. The Fund's activity in futures
contracts generally will be limited to municipal bond index
futures contracts and Treasury bond and note contracts.
Unlike when the Fund purchases or sells a security, no
price would be paid or received by the Fund upon the purchase or
sale of a futures contract. Upon entering into a futures
contract, and to maintain the Fund's open positions in futures
contracts, the Fund would be required to deposit with its
custodian in a segregated account in the name of the futures
broker an amount of cash, U.S. government securities, suitable
money market instruments, or liquid, high-grade debt securities,
known as "initial margin." The margin required for a particular
futures contract is set by the exchange on which the contract is
traded, and may be significantly modified from time to time by
the exchange during the term of the contract. Futures contracts
are customarily purchased and sold on margins that may range
upward from less than 5% of the value of the contract being
traded.
If the price of an open futures contract changes (by
increase in the case of a sale or by decrease in the case of a
purchase) so that the loss on the futures contract reaches a
point at which the margin on deposit does not satisfy margin
requirements, the broker will require an increase in the margin.
However, if the value of a position increases because of
favorable price changes in the futures contract so that the
margin deposit exceeds the required margin, the broker will pay
the excess to the Fund.
These subsequent payments, called "variation margin,"
to and from the futures broker, are made on a daily basis as the
price of the underlying assets fluctuate making the long and
short positions in the futures contract more or less valuable, a
process known as "marking to the market." The Fund expects to
earn interest income on its margin deposits.
PAGE 20
Although certain futures contracts, by their terms,
require actual future delivery of and payment for the underlying
instruments, in practice most futures contracts are usually
closed out before the delivery date. Closing out an open futures
contract purchase or sale is effected by entering into an
offsetting futures contract sale or purchase, respectively, for
the same aggregate amount of the identical securities and the
same delivery date. If the offsetting purchase price is less
than the original sale price, the Fund realizes a gain; if it is
more, the Fund realizes a loss. Conversely, if the offsetting
sale price is more than the original purchase price, the Fund
realizes a gain; if it is less, the Fund realizes a loss. The
transaction costs must also be included in these calculations.
There can be no assurance, however, that the Fund will be able to
enter into an offsetting transaction with respect to a particular
futures contract at a particular time. If the Fund is not able
to enter into an offsetting transaction, the Fund will continue
to be required to maintain the margin deposits on the futures
contract.
As an example of an offsetting transaction in which the
underlying instrument is not delivered, the contractual
obligations arising from the sale of one contract of September
municipal bond index futures on an exchange may be fulfilled at
any time before delivery of the contract is required (i.e., on a
specified date in September, the "delivery month") by the
purchase of one contract of September municipal bond index
futures on the same exchange. In such instance, the difference
between the price at which the futures contract was sold and the
price paid for the offsetting purchase, after allowance for
transaction costs, represents the profit or loss to the Fund.
Special Risks of Transactions in Futures Contracts
Volatility and Leverage. The prices of futures
contracts are volatile and are influenced, among other things, by
actual and anticipated changes in the market and interest rates,
which in turn are affected by fiscal and monetary policies and
national and international political and economic events.
Most United States futures exchanges limit the amount
of fluctuation permitted in futures contract prices during a
single trading day. The daily limit establishes the maximum
amount that the price of a futures contract may vary either up or
down from the previous day's settlement price at the end of a
trading session. Once the daily limit has been reached in a
particular type of futures contract, no trades may be made on
that day at a price beyond that limit. The daily limit governs
only price movement during a particular trading day and therefore
does not limit potential losses, because the limit may prevent
the liquidation of unfavorable positions. Futures contract
prices have occasionally moved to the daily limit for several
consecutive trading days with little or no trading, thereby
PAGE 21
preventing prompt liquidation of futures positions and subjecting
some futures traders to substantial losses.
Because of the low margin deposits required, futures
trading involves an extremely high degree of leverage. As a
result, a relatively small price movement in a futures contract
may result in immediate and substantial loss, as well as gain, to
the investor. For example, if at the time of purchase, 10% of
the value of the futures contract is deposited as margin, a
subsequent 10% decrease in the value of the futures contract
would result in a total loss of the margin deposit, before any
deduction for the transaction costs, if the account were then
closed out. A 15% decrease would result in a loss equal to 150%
of the original margin deposit, if the contract were closed out.
Thus, a purchase or sale of a futures contract may result in
losses in excess of the amount invested in the futures contract.
However, the Fund would presumably have sustained comparable
losses if, instead of the futures contract, it had invested in
the underlying financial instrument and sold it after the
decline. Furthermore, in the case of a futures contract
purchase, in order to be certain that the Fund has sufficient
assets to satisfy its obligations under a futures contract, the
Fund earmarks to the futures contract money market instruments
equal in value to the current value of the underlying instrument
less the margin deposit.
Liquidity. The Fund may elect to close some or all of
its futures positions at any time prior to their expiration. The
Fund would do so to reduce exposure represented by long futures
positions or short futures positions. The Fund may close its
positions by taking opposite positions which would operate to
terminate the Fund's position in the futures contracts. Final
determinations of variation margin would then be made, additional
cash would be required to be paid by or released to the Fund, and
the Fund would realize a loss or a gain.
Futures contracts may be closed out only on the
exchange or board of trade where the contracts were initially
traded. Although the Fund intends to purchase or sell futures
contracts only on exchanges or boards of trade where there
appears to be an active market, there is no assurance that a
liquid market on an exchange or board of trade will exist for any
particular contract at any particular time. In such event, it
might not be possible to close a futures contract, and in the
event of adverse price movements, the Fund would continue to be
required to make daily cash payments of variation margin.
However, in the event futures contracts have been used to hedge
the underlying instruments, the Fund would continue to hold the
underlying instruments subject to the hedge until the futures
contracts could be terminated. In such circumstances, an
increase in the price of underlying instruments, if any, might
partially or completely offset losses on the futures contract.
However, as described below, there is no guarantee that the price
PAGE 22
of the underlying instruments will, in fact, correlate with the
price movements in the futures contract and thus provide an
offset to losses on a futures contract.
Hedging Risk. A decision of whether, when, and how to
hedge involves skill and judgment, and even a well-conceived
hedge may be unsuccessful to some degree because of unexpected
market behavior, market or interest rate trends. There are
several risks in connection with the use by the Fund of futures
contracts as a hedging device. One risk arises because of the
imperfect correlation between movements in the prices of the
futures contracts and movements in the prices of the underlying
instruments which are the subject of the hedge. T. Rowe Price
will, however, attempt to reduce this risk by entering into
futures contracts whose movements, in its judgment, will have a
significant correlation with movements in the prices of the
Fund's underlying instruments sought to be hedged.
Successful use of futures contracts by the Fund for
hedging purposes is also subject to T. Rowe Price's ability to
correctly predict movements in the direction of the market. It
is possible that, when the Fund has sold futures to hedge its
portfolio against a decline in the market, the index, indices, or
instruments underlying futures are written might advance and the
value of the underlying instruments held in the Fund's portfolio
might decline. If this were to occur, the Fund would lose money
on the futures and also would experience a decline in value in
its underlying instruments. However, while this might occur to a
certain degree, T. Rowe Price believes that over time the value
of the Fund's portfolio will tend to move in the same direction
as the market indices used to hedge the portfolio. It is also
possible that if the Fund were to hedge against the possibility
of a decline in the market (adversely affecting the underlying
instruments held in its portfolio) and prices instead increased,
the Fund would lose part or all of the benefit of increased value
of those underlying instruments that it has hedged, because it
would have offsetting losses in its futures positions. In
addition, in such situations, if the Fund had insufficient cash,
it might have to sell underlying instruments to meet daily
variation margin requirements. Such sales of underlying
instruments might be, but would not necessarily be, at increased
prices (which would reflect the rising market). The Fund might
have to sell underlying instruments at a time when it would be
disadvantageous to do so.
In addition to the possibility that there might be an
imperfect correlation, or no correlation at all, between price
movements in the futures contracts and the portion of the
portfolio being hedged, the price movements of futures contracts
might not correlate perfectly with price movements in the
underlying instruments due to certain market distortions. First,
all participants in the futures market are subject to margin
deposit and maintenance requirements. Rather than meeting
PAGE 23
additional margin deposit requirements, investors might close
futures contracts through offsetting transactions, which could
distort the normal relationship between the underlying
instruments and futures markets. Second, the margin requirements
in the futures market are less onerous than margin requirements
in the securities markets, and as a result the futures market
might attract more speculators than the securities markets do.
Increased participation by speculators in the futures market
might also cause temporary price distortions. Due to the
possibility of price distortion in the futures market and also
because of the imperfect correlation between price movements in
the underlying instruments and movements in the prices of futures
contracts, even a correct forecast of general market trends by T.
Rowe Price might not result in a successful hedging transaction
over a very short time period.
Options on Futures Contracts
The Fund might trade in municipal bond index option
futures or similar options on futures developed in the future.
In addition, the Fund may also trade in options on futures
contracts on U.S. government securities and any U.S. government
securities futures index contract which might be developed. In
the opinion of T. Rowe Price, there is a high degree of
correlation in the interest rate, and price movements of U.S.
government securities and municipal securities. However, the
U.S. government securities market and municipal securities
markets are independent and may not move in tandem at any point
in time.
The Fund will purchase put options on futures contracts
to hedge its portfolio of municipal securities against the risk
of rising interest rates, and the consequent decline in the
prices of the municipal securities it owns. The Funds will also
write call options on futures contracts as a hedge against a
modest decline in prices of the municipal securities held in the
Fund's portfolio. If the futures price at expiration of a
written call option is below the exercise price, the Fund will
retain the full amount of the option premium, thereby partially
hedging against any decline that may have occurred in the Fund's
holdings of debt securities. If the futures price when the
option is exercised is above the exercise price, however, the
Fund will incur a loss, which may be wholly or partially offset
by the increase of the value of the securities in the Fund's
portfolio which were being hedged.
Writing a put option on a futures contract serves as a
partial hedge against an increase in the value of securities the
Fund intends to acquire. If the futures price at expiration of
the option is above the exercise price, the Fund will retain the
full amount of the option premium which provides a partial hedge
against any increase that may have occurred in the price of the
debt securities the Fund intends to acquire. If the futures
PAGE 24
price when the option is exercised is below the exercise price,
however, the Fund will incur a loss, which may be wholly or
partially offset by the decrease in the price of the securities
the Fund intends to acquire.
Options on futures are similar to options on underlying
instruments except that options on futures give the purchaser the
right, in return for the premium paid, to assume a position in a
futures contract (a long position if the option is a call and a
short position if the option is a put), rather than to purchase
or sell the futures contract, at a specified exercise price at
any time during the period of the option. Upon exercise of the
option, the delivery of the futures position by the writer of the
option to the holder of the option will be accompanied by
delivery of the accumulated balance in the writer's futures
margin account which represents the amount by which the market
price of the futures contract, at exercise, exceeds (in the case
of a call) or is less than (in the case of a put) the exercise
price of the option on the futures contract. Purchasers of
options who fail to exercise their options prior to the exercise
date suffer a loss of the premium paid.
From time to time a single order to purchase or sell
futures contracts (or options thereon) may be made on behalf of
the Fund and other T. Rowe Price Funds. Such aggregated orders
would be allocated among the Fund and the other T. Rowe Price
Funds in a fair and non-discriminatory manner.
Special Risks of Transactions in Options on Futures Contracts
The risks described under "Special Risks of
Transactions on Futures Contracts" are substantially the same as
the risks of using options on futures. In addition, where the
Fund seeks to close out an option position by writing or buying
an offsetting option covering the same index, underlying
instrument or contract and having the same exercise price and
expiration date, its ability to establish and close out positions
on such options will be subject to the maintenance of a liquid
secondary market. Reasons for the absence of a liquid secondary
market on an exchange include the following: (i) there may be
insufficient trading interest in certain options; (ii)
restrictions may be imposed by an exchange on opening
transactions or closing transactions or both; (iii) trading
halts, suspensions or other restrictions may be imposed with
respect to particular classes or series of options, or underlying
instruments; (iv) unusual or unforeseen circumstances may
interrupt normal operations on an exchange; (v) the facilities of
an exchange or a clearing corporation may not at all times be
adequate to handle current trading volume; or (vi) one or more
exchanges could, for economic or other reasons, decide or be
compelled at some future date to discontinue the trading of
options (or a particular class or series of options), in which
event the secondary market on that exchange (or in the class or
PAGE 25
series of options) would cease to exist, although outstanding
options on the exchange that had been issued by a clearing
corporation as a result of trades on that exchange would continue
to be exercisable in accordance with their terms. There is no
assurance that higher than anticipated trading activity or other
unforeseen events might not, at times, render certain of the
facilities of any of the clearing corporations inadequate, and
thereby result in the institution by an exchange of special
procedures which may interfere with the timely execution of
customers' orders. In the event no such market exists for a
particular contract in which the Fund maintains a position, in
the case of a written option, the Fund would have to wait to sell
the underlying securities or futures positions until the option
expires or is exercised. The Fund would be required to maintain
margin deposits on payments until the contract is closed.
Options on futures are treated for accounting purposes in the
same way as the analogous option on securities are treated.
In addition, the correlation between movements in the
price of options on futures contracts and movements in the price
of the securities hedged can only be approximate. This risk is
significantly increased when an option on a U.S. government
securities future or an option on a municipal securities index
future is used to hedge a municipal bond portfolio. Another risk
is that the movements in the price of options on futures
contracts may not move inversely with changes in interest rates.
If the Fund has written a call option on a futures contract and
the value of the call increases by more than the increase in the
value of the securities held as cover, the Fund may realize a
loss on the call which is not completely offset by the
appreciation in the price of the securities held as cover and the
premium received for writing the call.
The successful use of options on futures contracts
requires special expertise and techniques different from those
involved in portfolio securities transactions. A decision of
whether, when and how to hedge involves skill and judgment, and
even a well-conceived hedge may be unsuccessful to some degree
because of unexpected market behavior or interest rate trends.
During periods when municipal securities market prices are
appreciating, the Fund may experience poorer overall performance
than if it had not entered into any options on futures contracts.
General Considerations
Transactions by the Fund in options on futures will be
subject to limitations established by each of the exchanges,
boards of trade or other trading facilities governing the maximum
number of options in each class which may be written or purchased
by a single investor or group of investors acting in concert,
regardless of whether the options are written on the same or
different exchanges, boards of trade or other trading facilities
or are held or written in one or more accounts or through one or
PAGE 26
more brokers. Thus, the number of contracts which the Fund may
write or purchase may be affected by contracts written or
purchased by other investment advisory clients of T. Rowe Price.
An exchange, board of trade or other trading facility may order
the liquidations of positions found to be in excess of these
limits, and it may impose certain other sanctions.
Additional Futures and Options Contracts
Although the Fund has no current intention of engaging
in futures or options transactions other than those described
above, it reserves the right to do so. Such futures and options
trading might involve risks which differ from those involved in
the futures and options described above.
Federal Tax Treatment of Futures Contracts
Although the Fund invests almost exclusively in
securities which generate income which is exempt from federal
income taxes, the instruments described above are not exempt from
such taxes. Therefore, use of the investment techniques
described above could result in taxable income to shareholders of
the Fund.
Generally, the Fund is required, for federal income tax
purposes, to recognize as income for each taxable year its net
unrealized gains and losses on futures contracts as of the end of
the year as well as those actually realized during the year.
Gain or loss recognized with respect to a futures contract will
generally be 60% long-term capital gain or loss and 40% short-
term capital gain or loss, without regard to the holding period
of the contract.
Futures contracts which are intended to hedge against a
change in the value of securities may be classified as "mixed
straddles," in which case the recognition of losses may be
deferred to a later year. In addition, sales of such futures
contracts on securities may affect the holding period of the
hedged security and, consequently, the nature of the gain or loss
on such security on disposition.
In order for the Fund to continue to qualify for
federal income tax treatment as a regulated investment company,
at least 90% of its gross income for a taxable year must be
derived from qualifying income; i.e., dividends, interest, income
derived from loans of securities, and gains from the sale of
securities. Gains realized on the sale or other disposition of
securities, including futures contracts on securities held for
less than three months, must be limited to less than 30% of the
Fund's annual gross income. In order to avoid realizing
excessive gains on securities held less than three months, the
Fund may be required to defer the closing out of futures
contracts beyond the time when it would otherwise be advantageous
PAGE 27
to do so. It is anticipated that unrealized gains on futures
contracts, which have been open for less than three months as of
the end of the Fund's fiscal year and which are recognized for
tax purposes, will not be considered gains on securities held
less than three months for purposes of the 30% test.
The Fund will distribute to shareholders annually any
net gains which have been recognized for federal income tax
purposes from futures transactions (including unrealized gains at
the end of the Fund's fiscal year). Such distributions will be
combined with distributions of ordinary income or capital gains
realized on the Fund's other investments. Shareholders will be
advised of the nature of the payments. The Fund's ability to
enter into transactions in options on futures contracts may be
limited by the Internal Revenue Code's requirements for
qualification as a regulated investment company.
Options on Securities
Options are another type of potentially high-risk
derivative.
Bond Funds
The Funds have no current intention of investing in
options on securities, although they reserve the right to do so.
Appropriate disclosure would be added to the Funds' prospectus
and Statement of Additional Information when and if the Funds
decide to invest in options.
INVESTMENT RESTRICTIONS
All Funds
Fundamental policies may not be changed without the
approval of the lesser of (1) 67% of a Fund's shares present at a
meeting of shareholders if the holders of more than 50% of the
outstanding shares are present in person or by proxy or (2) more
than 50% of a Fund's outstanding shares. Other restrictions in
the form of operating policies are subject to change by a Fund's
Board of Directors without shareholder approval. Any investment
restriction which involves a maximum percentage of securities or
assets shall not be considered to be violated unless an excess
over the percentage occurs immediately after, and is caused by,
an acquisition of securities or assets of, or borrowings by, a
Fund.
Fundamental Policies
As a matter of fundamental policy, the Fund may not:
(1) Borrowing. Borrow money except that the Fund may (i)
PAGE 28
borrow for non-leveraging, temporary or emergency
purposes and (ii) engage in reverse repurchase
agreements and make other investments or engage in
other transactions, which may involve a borrowing, in
a manner consistent with the Fund's investment
objective and program, provided that the combination
of (i) and (ii) shall not exceed 33 1/3% of the value
of the Fund's total assets (including the amount
borrowed) less liabilities (other than borrowings) or
such other percentage permitted by law. Any
borrowings which come to exceed this amount will be
reduced in accordance with applicable law. The Fund
may borrow from banks, other Price Funds or other
persons to the extent permitted by applicable law;
(2) Commodities. Purchase or sell physical commodities;
except that the Fund (other than the Money Fund) may
enter into futures contracts and options thereon;
(3) Industry Concentration. Purchase the securities of
any issuer if, as a result, more than 25% of the
value of the Fund's total assets would be invested in
the securities of issuers having their principal
business activities in the same industry;
(4) Loans. Make loans, although the Fund may (i) lend
portfolio securities and participate in an interfund
lending program with other Price Funds provided that
no such loan may be made if, as a result, the
aggregate of such loans would exceed 33 1/3% of the
value of the Fund's total assets; (ii) purchase money
market securities and enter into repurchase
agreements; and (iii) acquire publicly-distributed or
privately-placed debt securities and purchase debt;
(5) Percent Limit on Assets Invested in Any One Issuer.
Purchase a security if, as a result, with respect to
75% of the value of its total assets, more than 5% of
the value of the Fund's total assets would be
invested in the securities of a single issuer, except
securities issued or guaranteed by the U.S.
Government or any of its agencies or
instrumentalities;
(6) Percent Limit on Share Ownership of Any One Issuer.
Purchase a security if, as a result, with respect to
75% of the value of the Fund's total assets, more
than 10% of the outstanding voting securities of any
issuer would be held by the Fund (other than
obligations issued or guaranteed by the U.S.
Government, its agencies or instrumentalities);
(7) Real Estate. Purchase or sell real estate, including
PAGE 29
limited partnership interests therein, unless
acquired as a result of ownership of securities or
other instruments (but this shall not prevent the
Fund from investing in securities or other
instruments backed by real estate or in securities of
companies engaged in the real estate business);
(8) Senior Securities. Issue senior securities except in
compliance with the Investment Company Act of 1940;
(9) Taxable Securities. During periods of normal market
conditions, purchase any security if, as a result,
less than 80% of the Fund's income would be exempt
from federal income tax. The income included under
the 80% test doesn't include income from securities
subject to the alternative minimum tax (AMT); or
(10) Underwriting. Underwrite securities issued by other
persons, except to the extent that the Fund may be
deemed to be an underwriter within the meaning of the
Securities Act of 1933 in connection with the
purchase and sale of its portfolio securities in the
ordinary course of pursuing its investment program.
NOTES
The following Notes should be read in connection with the
above-described fundamental policies. The Notes are not
fundamental policies.
With respect to investment restrictions (1) and (4) the
Fund will not borrow from or lend to any other T. Rowe
Price Fund unless they apply for and receive an exemptive
order from the SEC or the SEC issues rules permitting
such transactions. The Fund has no current intention of
engaging in any such activity and there is no assurance
the SEC would grant any order requested by the Fund or
promulgate any rules allowing the transactions.
With respect to investment restriction (1), the Money
Fund has no current intention of engaging in any
borrowing transactions.
With respect to investment restriction (2), the Fund does
not consider hybrid instruments to be commodities.
For purposes of investment restriction (3), U.S., state
or local governments, or related agencies or
instrumentalities, are not considered an industry.
Industrial development bonds issued by nongovernmental
users are subject to the restriction on concentration.
Operating Policies
PAGE 30
As a matter of operating policy, the Fund may not:
(1) Borrowing. The Fund will not purchase additional
securities when money borrowed exceeds 5% of its
total assets;
(2) Control of Portfolio Companies. Invest in companies
for the purpose of exercising management or control;
(3) Equity Securities. Purchase any equity security or
security convertible into an equity security provided
that the Fund (other than the Money Fund) may invest
up to 10% of its total assets in equity securities
which pay tax-exempt dividends and which are
otherwise consistent with the Fund's investment
objective and, further provided, that the Money Fund
may invest up to 10% of its total assets in equity
securities of other tax-free open-end money market
funds;
(4) Futures Contracts. Purchase a futures contract or an
option thereon if, with respect to positions in
futures or options on futures which do not represent
bona fide hedging, the aggregate initial margin and
premiums on such positions would exceed 5% of the
Fund's net asset value;
(5) Illiquid Securities. Purchase illiquid securities
if, as a result, more than 15% (10% for the Money
Fund) of its net assets would be invested in such
securities;
(6) Investment Companies. Purchase securities of open-
end or closed-end investment companies except in
compliance with the Investment Company Act of 1940
and applicable state law provided that, the Money
Fund may only purchase the securities of other tax-
free open-end money market investment companies;
(7) Margin. Purchase securities on margin, except (i)
for use of short-term credit necessary for clearance
of purchases of portfolio securities and (ii) it may
make margin deposits in connection with futures
contracts or other permissible investments;
(8) Mortgaging. Mortgage, pledge, hypothecate or, in any
manner, transfer any security owned by the Fund as
security for indebtedness except as may be necessary
in connection with permissible borrowings or
investments and then such mortgaging, pledging or
hypothecating may not exceed 33 1/3% of the Fund's
total assets at the time of borrowing or investment;
PAGE 31
(9) Oil and Gas Programs. Purchase participations or
other direct interests or enter into leases with
respect to, oil, gas, or other mineral exploration or
development programs;
(10) Options, Etc. Invest in puts, calls, straddles,
spreads, or any combination thereof, except to the
extent permitted by the prospectus and Statement of
Additional Information;
(11) Ownership of Portfolio Securities by Officers and
Directors. Purchase or retain the securities of any
issuer if, those officers and directors of the Fund,
and of its investment manager, who each own
beneficially more than .5% of the outstanding
securities of such issuer, together own beneficially
more than 5% of such securities;
(12) Short Sales. Effect short sales of securities;
(13) Unseasoned Issuers. Purchase a security (other than
obligations issued or guaranteed by the U.S., any
foreign, state or local government, their agencies or
instrumentalities) if, as a result, more than 5% of
the value of the Fund's total assets would be
invested in the securities issuers which at the time
of purchase had been in operation for less than three
years (for this purpose, the period of operation of
any issuer shall include the period of operation of
any predecessor or unconditional guarantor of such
issuer). This restriction does not apply to
securities of pooled investment vehicles or mortgage
or asset-backed securities; or
(14) Warrants. Invest in warrants if, as a result
thereof, more than 2% of the value of the net assets
of the Fund would be invested in warrants which are
not listed on the New York Stock Exchange, the
American Stock Exchange, or a recognized foreign
exchange, or more than 5% of the value of the net
assets of the Fund would be invested in warrants
whether or not so listed. For purposes of these
percentage limitations, the warrants will be valued
at the lower of cost or market and warrants acquired
by the Fund in units or attached to securities may be
deemed to be without value.
For purposes of investment restriction (6), the Fund has no
current intention of purchasing the securities of other
investment companies. Duplicate fees could result from any
such purchases.
For purposes of investment restriction (13), the Fund will
PAGE 32
not consider industrial development bonds issued by
nongovernmental users as municipal securities.
RATINGS OF MUNICIPAL DEBT SECURITIES
Moody's Investors Service, Inc.
Aaa - Bonds rated Aaa are judged to be of the best quality.
They carry the smallest degree of investment risk and are
generally referred to as "gilt edge."
Aa - Bonds rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are
generally known as high grade bonds.
A - Bonds rated A possess many favorable investment
attributes and are to be considered as upper medium grade
obligations.
Baa - Bonds rated Baa are considered as medium grade
obligations, i.e., they are neither highly protected nor poorly
secured. Interest payments and principal security appear
adequate for the present but certain protective elements may be
lacking or may be characteristically unreliable over any great
length of time. Such bonds lack outstanding investment
characteristics and in fact have speculative characteristics as
well.
Ba - Bonds rated Ba are judged to have speculative elements:
their futures cannot be considered as well assured. Often the
protection of interest and principal payments may be very
moderate and thereby not well safeguarded during both good and
bad times over the future. Uncertainty of position characterize
bonds in this class.
B - Bonds rated B generally lack the characteristics of a
desirable investment. Assurance of interest and principal
payments or of maintenance of other terms of the contract over
any long period of time may be small.
Caa - Bonds rated Caa are of poor standing. Such issues may
be in default or there may be present elements of danger with
respect to principal or interest.
Ca - Bonds rated Ca represent obligations which are
speculative in a high degree. Such issues are often in default
or have other marked short-comings.
C - Lowest-rated; extremely poor prospects of ever attaining
investment standing.
Standard & Poor's Corporation
PAGE 33
AAA - This is the highest rating assigned by Standard &
Poor's to a debt obligation and indicates an extremely strong
capacity to pay principal and interest.
AA - Bonds rated AA also qualify as high-quality debt
obligations. Capacity to pay principal and interest is very
strong.
A - Bonds rated A have a strong capacity to pay principal
and interest, although they are somewhat more susceptible to the
adverse effects of changes in circumstances and economic
conditions.
BBB - Bonds rated BBB are regarded as having an adequate
capacity to pay principal and interest. Whereas they normally
exhibit adequate protection parameters, adverse economic
conditions or changing circumstances are more likely to lead to a
weakened capacity to pay principal and interest for bonds in this
category than for bonds in the A category.
BB, C, CCC, CC - Bonds rated BB, B, CCC, and CC are regarded
on balance, as predominantly speculative with respect to the
issuer's capacity to pay interest and repay principal. BB
indicates the lowest degree of speculation and CC the highest
degree of speculation. While such bonds will likely have some
quality and protective characteristics, these are outweighed by
large uncertainties or major risk exposures to adverse
conditions.
D - In default.
Fitch Investors Service, Inc.
AAA - Bonds rated AAA are considered to be investment grade and
of the highest credit quality. The obligor has an exceptionally
strong ability to pay interest and repay principal, which is
unlikely to be affected by reasonably foreseeable events.
AA - Bonds rated AA are considered to be investment grade and of
very high credit quality. The obligor's ability to pay interest
and repay principal is very strong, although not quite as strong
as bonds rated AAA. Because bonds rated in the AAA and AA
categories are not significantly vulnerable to foreseeable future
developments, short-term debt of these issuers is generally rate
F-1+.
A - Bonds rated A are considered to be investment grade and of
high credit quality. The obligor's ability to pay interest and
repay principal is considered to be strong, but may be more
vulnerable to adverse changes in economic conditions and
circumstances than bonds with higher ratings.
BBB - Bonds rated BBB are considered to be investment grade and
of satisfactory credit quality. The obligor's ability to pay
interest and repay principal is considered to be adequate.
Adverse changes in economic conditions and circumstances,
PAGE 34
however, are more likely to have adverse impact on these bonds,
and therefore impair timely payment. The likelihood that the
ratings of these bonds will fall below investment grade is higher
than for bonds with higher ratings.
BB, B, CCC, CC, and C are regarded on balance as predominantly
speculative with respect to the issuer's capacity to repay
interest and repay principal in accordance with the terms of the
obligation for bond issues not in default. BB indicates the
lowest degree of speculation and C the highest degree of
speculation. The rating takes into consideration special
features of the issue, its relationship to other obligations of
the issuer, and the current and prospective financial condition
and operating performance of the issuer.
RATINGS OF MUNICIPAL NOTES AND VARIABLE SECURITIES
Moody's Investors Services, Inc.
VMIG-1/MIG-1: the best quality. VMIG-2/MIG-2: high quality,
with margins of protection ample though not so large as in the
preceding group.
VMIG-3/MIG-3: favorable quality, with all security elements
accounted for, but lacking the undeniable strength of the
preceding grades. Market access for refinancing, in particular,
is likely to be less well established. VMIG-4/MIG-4: adequate
quality but there is specific risk.
Standard & Poor's Corporation
SP-1: very strong or strong capacity to pay principal and
interest. Those issues determined to possess overwhelming safety
characteristics will be given a plus (+) designation. SP-2:
satisfactory capacity to pay principal and interest.
SP-3: speculative capacity to pay principal and interest.
Fitch Investors Service, Inc.
F-1+: exceptionally strong credit quality, strongest degree of
assurance for timely payment. F-1: very strong credit quality.
F-2: good credit quality, having a satisfactory degree of
assurance for timely payment. F-3: fair credit quality,
assurance for timely payment is adequate but adverse changes
could cause the securities to be rated below investment grade.
F-S: weak credit quality, having characteristics suggesting a
minimal degree of assurance for timely payment.
RATINGS OF COMMERCIAL PAPER
PAGE 35
Moody's Investors Service, Inc.
P-1: Superior capacity for repayment. P-2: strong capacity for
repayment.
P-3: acceptable capacity for repayment of short-term promissory
obligations.
Standard & Poor's Corporation
A-1: highest category, degree of safety regarding timely payment
is strong. Those issues determined to possess extremely strong
safety characteristics are denoted with a plus sign (+)
designation. A-2: satisfactory capacity to pay principal and
interest.
A-3: adequate capacity for timely payment, but are vulnerable to
adverse effects of changes in circumstances than higher rated
issues. B, and C: speculative capacity to pay principal and
interest.
Fitch Investors Service, Inc.
F-1+: exceptionally strong credit quality, strongest degree of
assurance for timely payment. F-1: very strong credit quality.
F-2: good credit quality, having a satisfactory degree of
assurance for timely payment. F-3: fair credit quality,
assurance for timely payment is adequate but adverse changes
could cause the securities to be rated below investment grade.
F-5: weak credit quality, having characteristics suggesting a
minimal degree of assurance for timely payment.
MANAGEMENT OF FUNDS
The officers and directors of each of the Funds are listed
below. Unless otherwise noted, the address of each is 100 East
Pratt Street, Baltimore, Maryland 21202. Except as indicated,
each has been an employee of T. Rowe Price for more than five
years. In the list below, the Funds' directors who are
considered "interested persons" of T. Rowe Price as defined under
Section 2(a)(19) of the Investment Company Act of 1940 are noted
with an asterisk (*). These directors are referred to as inside
directors by virtue of their officership, directorship, and/or
employment with T. Rowe Price.
All Funds
Independent Directors/Trustees
ROBERT P. BLACK, Retired; formerly President, Federal Reserve
PAGE 36
Bank of Richmond; Address: 10 Dahlgren Road, Richmond, Virginia
23233
CALVIN W. BURNETT, PH.D., President, Coppin State College;
Board of Directors, McDonogh School, Inc. and Provident Bank of
Maryland; Past President, Baltimore Area Council Boy Scouts of
America; Vice President, Board of Directors, The Walters Art
Gallery; Address: 2000 North Warwick Avenue, Baltimore, Maryland
21216
ANTHONY W. DEERING,Director, President and Chief Executive
Officer, The Rouse Company, real estate developers, Columbia,
Maryland; Advisory Director, Kleinwort, Benson (North America)
Corporation, a registered broker-dealer; Address: 10275 Little
Patuxent Parkway, Columbia, Maryland 21044
F. PIERCE LINAWEAVER, President, F. Pierce Linaweaver &
Associates, Inc., Consulting Environmental & Civil Engineer(s);
formerly (1987-1991) Executive Vice President, EA Engineering,
Science, and Technology, Inc., and (1987-1990) President, EA
Engineering, Inc., Baltimore, Maryland; Address: The Legg Mason
Tower, 111 South Calvert Street, Suite 2700, Baltimore, Maryland
21202
JOHN G. SCHREIBER, President, Schreiber Investments, Inc., a real
estate investment company; Director and formerly (1/80-12/90)
Executive Vice President, JMB Realty Corporation, a national real
estate investment manager and developer; Address: 1115 East
Illinois Road, Lake Forest, Illinois 60045
Officers
JANET G. ALBRIGHT, Vice President--Vice President, T. Rowe Price
PATRICIA S. DEFORD, Vice President--Vice President, T. Rowe Price
CHARLES O. HOLLAND, Vice President--Vice President, T. Rowe Price
HENRY H. HOPKINS, Vice President--Vice President, Price-Fleming
and T. Rowe Price Retirement Plan Services, Inc.; Managing
Director, T. Rowe Price; Vice President and Director, T. Rowe
Price Investment Services, Inc., T. Rowe Price Services, Inc. and
T. Rowe Price Trust Company
ALAN P. RICHMAN, Vice President--Vice President, T. Rowe Price;
formerly (10/89-6/91) Manager, Public Finance, Credit Local de
France, New York, New York and Public Finance, Tokai Bank, New
York, New York
LENORA V. HORNUNG, Secretary--Vice President, T. Rowe Price
CARMEN F. DEYESU, Treasurer--Vice President, T. Rowe Price, T.
Rowe Price Services, Inc., and T. Rowe Price Trust Company
DAVID S. MIDDLETON, Controller--Vice President, T. Rowe Price,
and T. Rowe Price Trust Company
PATRICIA S. BUTCHER, Assistant Secretary--Assistant Vice
President, T. Rowe Price and T. Rowe Price Investment Services,
Inc.
EDWARD T. SCHNEIDER, Assistant Vice President--Vice President,
T. Rowe Price
PAGE 37
INGRID I. VORDEMBERGE, Assistant Vice President--Employee, T.
Rowe Price
Tax-Exempt Money Fund
*GEORGE J. COLLINS, Chairman of the Board--President, Chief
Executive Officer and Managing Director, T. Rowe Price; Director,
Price-Fleming, T. Rowe Price Retirement Plan Services, Inc. and
T. Rowe Price Trust Company; Chartered Investment Counselor
*WILLIAM T. REYNOLDS, Director and Vice President--Managing
Director, T. Rowe Price
*JAMES S. RIEPE, Director and Vice President--Managing
Director, T. Rowe Price; Chairman of the Board, T. Rowe Price
Services, Inc., T. Rowe Price Retirement Plan Services, Inc., T.
Rowe Price Trust Company, and T. Rowe Price Investment Services,
Inc.; Director, Rhone-Poulenc Rorer, Inc.
PATRICE L. BERCHTENBREITER, President--Vice President, T. Rowe
Price
PAUL W. BOLTZ, Vice President--Vice President and Financial
Economist, T. Rowe Price
JOSEPH K. LYNAGH, Vice President--Assistant Vice President, T.
Rowe Price
MARY J. MILLER, Vice President--Managing Director, T. Rowe Price
THEODORE E. ROBSON, Vice President--Employee, T. Rowe Price
C. STEPHEN WOLFE, II, Vice President--Vice President, T. Rowe
Price
LAURA L. MCAREE, Assistant Vice President--Assistant Vice
President, T. Rowe Price; formerly (4/90-11/90) trader, Boeing
Company, Seattle, Washington and (8/87-3/90) financial analyst,
Harvard Management Company, Boston, Massachusetts
Tax-Free Short-Intermediate Fund
*WILLIAM T. REYNOLDS, Chairman of the Board--Managing
Director, T. Rowe Price
*GEORGE J. COLLINS, Director--President, Chief Executive
Officer and Managing Director, T. Rowe Price; Director, Price-
Fleming, T. Rowe Price Retirement Plan Services, Inc. and T. Rowe
Price Trust Company; Chartered Investment Counselor
*MARY J. MILLER, President and Director--Managing Director, T.
Rowe Price
*JAMES S. RIEPE, Director and Vice President--Managing
Director, T. Rowe Price; Chairman of the Board, T. Rowe Price
Services, Inc., T. Rowe Price Retirement Plan Services, Inc., T.
Rowe Price Trust Company, and T. Rowe Price Investment Services,
Inc.; Director, Rhone-Poulenc Rorer, Inc.
CHARLES B. HILL, Executive Vice President--Assistant Vice
President, T. Rowe Price; formerly (9/86-11/91) managed municipal
bonds at Riggs National Bank, Washington, D.C.
PATRICE L. BERCHTENBREITER, Vice President--Vice President, T.
Rowe Price
KONSTANTINE B. MALLAS, Vice President-- Vice President, T.
Rowe Price
PAGE 38
LAURA L. MCAREE, Vice President--Assistant Vice President, T.
Rowe Price; formerly (4/90-11/90) trader, Boeing Company,
Seattle, Washington and (8/87-3/90) financial analyst, Harvard
Management Company, Boston, Massachusetts
HUGH D. MCGUIRK, Vice President--Vice President, T. Rowe
Price; (1991-1993) municipal underwriter, Alex. Brown & Sons,
Inc., Baltimore, Maryland
C. STEPHEN WOLFE, II, Vice President--Vice President, T. Rowe
Price
Tax-Free Insured Intermediate Bond Fund
*GEORGE J. COLLINS, Director--President, Chief Executive
Officer and Managing Director, T. Rowe Price; Director, Price-
Fleming, T. Rowe Price Retirement Plan Services, Inc. and T. Rowe
Price Trust Company; Chartered Investment Counselor
*WILLIAM T. REYNOLDS, Director--Managing Director, T. Rowe
Price
*JAMES S. RIEPE, Director--Managing Director, T. Rowe Price;
Chairman of the Board, T. Rowe Price Services, Inc., T. Rowe
Price Retirement Plan Services, Inc., T. Rowe Price Trust
Company, and T. Rowe Price Investment Services, Inc.; Director,
Rhone-Poulenc Rorer, Inc.
MARY J. MILLER, President--Managing Director, T. Rowe
Price
CHARLES B. HILL, Executive Vice President--Assistant Vice
President, T. Rowe Price; formerly (9/86-11/91) managed municipal
bonds at Riggs National Bank, Washington, D.C.
KONSTANTINE B. MALLAS, Vice President--Assistant Vice President,
T. Rowe Price
HUGH D. MCGUIRK, Vice President--Vice President, T. Rowe
Price; formerly (1991-1993) municipal underwriter, Alex. Brown &
Sons, Inc., Baltimore, Maryland
LAURA L. MCAREE, Vice President--Assistant Vice President, T.
Rowe Price; formerly (4/90-11/90) trader, Boeing Company,
Seattle, Washington and (8/87-3/90) financial analyst, Harvard
Management Company, Boston, Massachusetts
WILLIAM F. SNIDER, JR., Vice President--Vice President, T.
Rowe Price
Tax-Free Income Fund
*WILLIAM T. REYNOLDS, Chairman of the Board--Managing
Director, T. Rowe Price
*GEORGE J. COLLINS, Director--President, Chief Executive
Officer and Managing Director, T. Rowe Price; Director, Price-
Fleming, T. Rowe Price Retirement Plan Services, Inc. and T. Rowe
Price Trust Company; Chartered Investment Counselor
*JAMES S. RIEPE, Director and Vice President--Managing
Director, T. Rowe Price; Chairman of the Board, T. Rowe Price
Services, Inc., T. Rowe Price Retirement Plan Services, Inc., T.
Rowe Price Trust Company, and T. Rowe Price Investment Services,
Inc.; Director, Rhone-Poulenc Rorer, Inc.
PAGE 39
MARY J. MILLER, President--Managing Director, T. Rowe
Price
PATRICE L. BERCHTENBREITER, Vice President--Vice President, T.
Rowe Price
A. GENE CAPONI, Vice President--Vice President and Analyst, T.
Rowe Price
CHARLES B. Hill, Vice President--Assistant Vice President, T.
Rowe Price; formerly (9/86-11/91) managed municipal bonds at
Riggs National Bank, Washington, D.C.
KONSTANTINE B. MALLAS, Vice President--Vice President, T. Rowe
Price
HUGH D. MCGUIRK, Vice President--Vice President, T. Rowe
Price; (1991-1993) municipal underwriter, Alex. Brown & Sons,
Inc., Baltimore, Maryland
WILLIAM F. SNIDER, JR., Vice President--Vice President, T.
Rowe Price
C. STEPHEN WOLFE, II, Vice President--Vice President, T. Rowe
Price
Tax-Free High Yield Fund
*WILLIAM T. REYNOLDS, Chairman of the Board--Managing Director,
T. Rowe Price
*GEORGE J. COLLINS, Director--President, Chief Executive
Officer and Managing Director, T. Rowe Price; Director, Price-
Fleming, T. Rowe Price Retirement Plan Services, Inc. and T. Rowe
Price Trust Company; Chartered Investment Counselor
*JAMES S. RIEPE, Director and Vice President--Managing
Director, T. Rowe Price; Chairman of the Board, T. Rowe Price
Services, Inc., T. Rowe Price Retirement Plan Services, Inc., T.
Rowe Price Trust Company, and T. Rowe Price Investment Services,
Inc.; Director, Rhone-Poulenc Rorer, Inc.
C. STEPHEN WOLFE, II, President--Vice President, T. Rowe Price
A. GENE CAPONI, Vice President--Vice President and Analyst, T.
Rowe Price
CHARLES B. HILL, Vice President--Assistant Vice President, T.
Rowe Price; formerly (9/86-11/91) managed municipal bonds at
Riggs National Bank, Washington, D.C.
KONSTANTINE B. MALLAS, Vice President--Vice President, T. Rowe
Price
HUGH D. MCGUIRK, Vice President--Vice President, T. Rowe
Price; (1991-1993) municipal underwriter, Alex. Brown & Sons,
Inc., Baltimore, Maryland
MARY J. MILLER, Vice President--Managing Director, T. Rowe Price
WILLIAM F. SNIDER, JR., Vice President--Vice President, T.
Rowe Price
The Executive Committee of the Money, Income, High
Yield, and Insured Intermediate Bond Funds is comprised of
Messrs. Collins, Reynolds, and Riepe; and the Executive Committee
of the Short-Intermediate Fund, is comprised of Mrs. Miller and
Messrs. Collins, Reynolds, and Riepe. These Executive Committees
have been authorized by their respective Board of Directors to
PAGE 40
exercise all powers of the Board to manage the Fund in the
intervals between meetings of the Board, except the powers
prohibited by statute from being delegated.
COMPENSATION TABLE
The Funds do not pay pension or retirement benefits to
its officers or directors/trustees. Also, any director/trustee
of a Fund who is an officer or employee of T. Rowe Price does not
receive any remuneration from a Fund.
_________________________________________________________________
Total Compensation
Aggregate from Fund and
Name of Compensation Fund Group
Person, from Paid to
Position Fund(a) Directors(b)
_________________________________________________________________
Tax-Exempt Money Fund
Robert P. Black 2,077 56,000
Director
Calvin W. Burnett 2,077 56,000
Director
Anthony W. Deering 2,077 68,250
Director
F. Pierce Linaweaver 2,077 56,000
Director
John Schreiber 2,077 56,000
Director
_________________________________________________________________
Tax-Free Short-Intermediate Fund
Robert P. Black 1,680 56,000
Director
Calvin W. Burnett 1,680 56,000
Director
Anthony W. Deering 1,680 68,250
Director
F. Pierce Linaweaver 1,680 56,000
Director
John G. Schreiber 1,680 56,000
PAGE 41
Director
_________________________________________________________________
Tax-Free Insured Intermediate Bond Fund
Robert P. Black 1,050 56,000
Director
Calvin W. Burnett 1,050 56,000
Director
Anthony W. Deering 1,050 68,250
Director
F. Pierce Linaweaver 1,050 56,000
Director
John Schreiber 1,050 56,000
Director
_________________________________________________________________
Tax-Free Income Fund
Robert P. Black 3,102 56,000
Director
Calvin W. Burnett 3,102 56,000
Director
Anthony W. Deering 3,102 68,250
Director
F. Pierce Linaweaver 3,102 56,000
Director
John G. Schreiber 3,102 56,000
Director
_________________________________________________________________
Tax-Free High Yield Fund
Robert P. Black 2,456 56,000
Director
Calvin W. Burnett 2,456 56,000
Director
Anthony W. Deering 2,456 68,250
Director
F. Pierce Linaweaver 2,456 56,000
Director
PAGE 42
John G. Schreiber 2,456 56,000
Director
a Amounts in this Column are for the period March 1, 1995
through February 29, 1996.
b Amounts in this column are for fiscal year 1996. The T. Rowe
Price Fund complex included 72 funds as of February 29,
1996.
PRINCIPAL HOLDERS OF SECURITIES
As of the date of the prospectus, the officers and directors
of the Funds, as a group, owned less than 1% of the outstanding
shares of each Fund.
As of May 31, 1996, no shareholder beneficially owned more
than 5% of the outstanding shares of the Funds.
INVESTMENT MANAGEMENT SERVICES
Services Provided by T. Rowe Price
Under each Fund's Management Agreement, T. Rowe Price
provides each Fund with discretionary investment services.
Specifically, T. Rowe Price is responsible for supervising and
directing the investments of each Fund in accordance with its
investment objectives, programs, and restrictions as provided in
the prospectus and this Statement of Additional Information. T.
Rowe Price is also responsible for effecting all security
transactions on behalf of each Fund, including the allocation of
principal business and portfolio brokerage and the negotiation of
commissions. In addition to these services, T. Rowe Price
provides each Fund with certain corporate administrative
services, including: maintaining the Fund's corporate existence,
corporate records, and registering and qualifying the Fund's
shares under federal and state laws; monitoring the financial,
accounting, and administrative functions of each Fund;
maintaining liaison with the agents employed by each Fund such as
the Fund's custodian and transfer agent; assisting each Fund in
the coordination of such agents' activities; and permitting T.
Rowe Price's employees to serve as officers, directors, and
committee members of each Fund without cost to the Fund.
The Management Agreements also provide that T. Rowe Price,
its directors, officers, employees, and certain other persons
performing specific functions for the Fund will only be liable to
the Fund for losses resulting from willful misfeasance, bad
faith, gross negligence, or reckless disregard of duty.
Management Fee
PAGE 43
Each Fund pays T. Rowe Price a fee ("Fee") which consists of
two components: a Group Management Fee ("Group Fee") and an
Individual Fund Fee ("Fund Fee"). The Fee is paid monthly to the
T. Rowe Price on the first business day of the next succeeding
calendar month and is calculated as described below.
The monthly Group Fee ("Monthly Group Fee") is the sum of the
daily Group Fee accruals ("Daily Group Fee Accruals") for each
month. The Daily Group Fee Accrual for any particular day is
computed by multiplying the Price Funds' group fee accrual as
determined below ("Daily Price Funds' Group Fee Accrual") by the
ratio of the Fund's net assets for that day to the sum of the
aggregate net assets of the Price Funds for that day. The Daily
Price Funds' Group Fee Accrual for any particular day is
calculated by multiplying the fraction of one (1) over the number
of calendar days in the year by the annualized Daily Price Funds'
Group Fee Accrual for that day as determined in accordance with
the following schedule:
Price Funds'
Annual Group Base Fee
Rate for Each Level of Assets
_____________________________
0.480% First $1 billion
0.450% Next $1 billion
0.420% Next $1 billion
0.390% Next $1 billion
0.370% Next $1 billion
0.360% Next $2 billion
0.350% Next $2 billion
0.340% Next $5 billion
0.330% Next $10 billion
0.320% Next $10 billion
0.310% Next $16 billion
0.305% Thereafter
For the purpose of calculating the Group Fee, the Price
Funds include all the mutual funds distributed by T. Rowe Price
Investment Services, Inc. (excluding T. Rowe Price Spectrum Fund,
Inc., T. Rowe Price Equity Index Fund, and any institutional or
any private label mutual funds). For the purpose of calculating
the Daily Price Funds' Group Fee Accrual for any particular day,
the net assets of each Price Fund are determined in accordance
with the Fund's prospectus as of the close of business on the
previous business day on which the Fund was open for business.
The monthly Fund Fee ("Monthly Fund Fee") is the sum of
the daily Fund Fee accruals ("Daily Fund Fee Accruals") for each
month. The Daily Fund Fee Accrual for any particular day is
computed by multiplying the fraction of one (1) over the number
of calendar days in the year by the Individual Fund Fee Rate and
multiplying this product by the net assets of the Fund for that
PAGE 44
day, as determined in accordance with the Fund's prospectus as of
the close of business on the previous business day on which the
Fund was open for business.
The following chart sets forth the total management
fees, if any, paid to T. Rowe Price by the Funds, for each of the
last three fiscal years.
PAGE 45
Short- Insured
Inter- Inter- High
Money mediate mediate Income Yield
Year Fund Fund Bond Fund Fund Fund
____ _____ _________ ________ ________ ______
1996 $2,993,000 $1,975,000 $274,000 $6,613,000 $5,968,000
1995 $3,346,000 $2,171,000 $206,000 $6,547,000 $5,561,000
1994 $3,132,000 $2,256,000 $9,000 $7,362,000 $5,954,000
Limitation on Fund Expenses
The Management Agreement between each Fund and T. Rowe
Price provides that each Fund will bear all expenses of its
operations not specifically assumed by T. Rowe Price. However,
in compliance with certain state regulations, T. Rowe Price will
reimburse a Fund for any expenses (excluding interest, taxes,
brokerage, other expenditures which are capitalized in accordance
with generally accepted accounting principles, and extraordinary
expenses) which in any year exceed the limits prescribed by any
state in which a Fund's shares are qualified for sale.
Presently, the most restrictive expense ratio limitation imposed
by any state is 2.5% of the first $30 million of the Fund's
average daily net assets, 2% of the next $70 million of such
assets, and 1.5% of net assets in excess of $100 million.
Money, Short-Intermediate, Income, and High Yield Funds
For the purpose of determining whether a Fund is
entitled to reimbursement, the expenses of a Fund are calculated
on a monthly basis. If a Fund is entitled to reimbursement, that
month's advisory fee will be reduced or postponed, with any
adjustment made after the end of the year.
Insured Intermediate Bond Fund
Pursuant to the present expense limitation, $69,000 of
management fees were not accrued by the fund for the year ended
February 29, 1996. Additionally, $140,000 of unaccrued fees and
expenses from the prior period are subject to reimbursement.
DISTRIBUTOR FOR FUNDS
T. Rowe Price Investment Services, Inc. ("Investment
Services"), a Maryland corporation formed in 1980 as a wholly-
owned subsidiary of T. Rowe Price, serves as the distributor of
the Funds. Investment Services is registered as a broker-dealer
under the Securities Exchange Act of 1934 and is a member of the
National Association of Securities Dealers, Inc. The offering of
each Fund's shares is continuous.
PAGE 46
Investment Services is located at the same address as
the Funds and T. Rowe T. Rowe Price -- 100 East Pratt Street,
Baltimore, Maryland 21202.
Investment Services serves as distributor to the Funds
pursuant to individual Underwriting Agreements ("Underwriting
Agreements"), which provide that each Fund will pay all fees and
expenses in connection with: registering and qualifying its
shares under the various state "blue sky" laws; preparing,
setting in type, printing, and mailing its prospectuses and
reports to shareholders; and issuing its shares, including
expenses of confirming purchase orders.
The Underwriting Agreements provide that Investment
Services will pay all fees and expenses in connection with:
printing and distributing prospectuses and reports for use in
offering and selling shares for each Fund; preparing, setting in
type, printing, and mailing all sales literature and advertising;
Investment Services' federal and state registrations as a
broker-dealer; and offering and selling shares for each Fund,
except for those fees and expenses specifically assumed by the
Funds. Investment Services' expenses are paid by T. Rowe Price.
Investment Services acts as the agent of the Funds in
connection with the sale of their shares in all states in which
the shares are qualified and in which Investment Services is
qualified as a broker-dealer. Under the Underwriting Agreement,
Investment Services accepts orders for Fund shares at net asset
value. No sales charges are paid by investors or the Funds.
CUSTODIAN
State Street Bank and Trust Company is the custodian
for each Fund's securities and cash, but it does not participate
in the Funds' investment decisions. The Funds have authorized
the Bank to deposit certain portfolio securities in central
depository systems as allowed by federal law. In addition, the
Funds are authorized to maintain certain of their securities, in
particular variable rate demand notes in uncertificated form in
the proprietary deposit systems of various dealers in municipal
securities. The Bank's main office is 225 Franklin Street,
Boston, Massachusetts 02107.
CODE OF ETHICS
The Fund's investment adviser (T. Rowe Price) has a
written Code of Ethics which requires all employees to obtain
prior clearance before engaging in personal securities
transactions. Transactions must be executed within three business
days of their clearance. In addition, all employees must report
their personal securities transactions within ten days of their
PAGE 47
execution. Employees will not be permitted to effect
transactions in a security: If there are pending client orders in
the security; the security has been purchased or sold by a client
within seven calendar days; the security is being considered for
purchase for a client; a change has occurred in T. Rowe Price's
rating of the security within seven calendar days prior to the
date of the proposed transaction; or the security is subject to
internal trading restrictions. In addition, employees are
prohibited from profiting from short-term trading (e.g.,
purchases and sales involving the same security within 60 days).
Any material violation of the Code of Ethics is reported to the
Board of the Fund. The Board also reviews the administration of
the Code of Ethics on an annual basis.
PORTFOLIO TRANSACTIONS
Investment or Brokerage Discretion
Decisions with respect to the purchase and sale of
portfolio securities on behalf of the Fund are made by T. Rowe
Price. T. Rowe Price is also responsible for implementing these
decisions, including the negotiation of commissions and the
allocation of portfolio brokerage and principal business. The
Fund's purchases and sales of portfolio securities are normally
done on a principal basis and do not involve the payment of a
commission although they may involve the designation of selling
concessions. That part of the discussion below relating solely
to brokerage commissions would not normally apply to the Funds.
However, it is included because T. Rowe Price does manage a
significant number of common stock portfolios which do engage in
agency transactions and pay commissions and because some research
and services resulting from the payment of such commissions may
benefit the Funds.
How Brokers and Dealers are Selected
Fixed Income Securities
Fixed income securities are generally purchased from
the issuer or a primary market-maker acting as principal for the
securities on a net basis, with no brokerage commission being
paid by the client although the price usually includes an
undisclosed compensation. Transactions placed through dealers
serving as primary market-makers reflect the spread between the
bid and asked prices. Securities may also be purchased from
underwriters at prices which include underwriting fees.
T. Rowe Price may effect principal transactions on
behalf of the Fund with a broker or dealer who furnishes
brokerage and/or research services, designate any such broker or
dealer to receive selling concessions, discounts or other
allowances, or otherwise deal with any such broker or dealer in
PAGE 48
connection with the acquisition of securities in underwritings.
T. Rowe Price may receive brokerage and research services in
connection with such designations in fixed price underwritings.
How Evaluations are Made of the Overall Reasonableness of
Brokerage Commissions Paid
On a continuing basis, T. Rowe Price seeks to determine
what levels of commission rates are reasonable in the marketplace
for transactions executed on behalf of the Fund. In evaluating
the reasonableness of commission rates, T. Rowe Price considers:
(a) historical commission rates, both before and since rates have
been fully negotiable; (b) rates which other institutional
investors are paying, based on available public information; (c)
rates quoted by brokers and dealers; (d) the size of a particular
transaction, in terms of the number of shares, dollar amount, and
number of clients involved; (e) the complexity of a particular
transaction in terms of both execution and settlement; (f) the
level and type of business done with a particular firm over a
period of time; and (g) the extent to which the broker or dealer
has capital at risk in the transaction.
Description of Research Services Received from Brokers and
Dealers
T. Rowe Price receives a wide range of research
services from brokers and dealers. These services include
information on the economy, industries, groups of securities,
individual companies, statistical information, accounting and tax
law interpretations, political developments, legal developments
affecting portfolio securities, technical market action, pricing
and appraisal services, credit analysis, risk measurement
analysis, performance analysis and analysis of corporate
responsibility issues. These services provide both domestic and
international perspective. Research services are received
primarily in the form of written reports, computer generated
services, telephone contacts and personal meetings with security
analysts. In addition, such services may be provided in the form
of meetings arranged with corporate and industry spokespersons,
economists, academicians and government representatives. In some
cases, research services are generated by third parties but are
provided to T. Rowe Price by or through broker-dealers.
Research services received from brokers and dealers are
supplemental to T. Rowe Price's own research effort and, when
utilized, are subject to internal analysis before being
incorporated by T. Rowe Price into its investment process. As a
practical matter, it would not be possible for T. Rowe Price to
generate all of the information presently provided by brokers and
dealers. T. Rowe Price pays cash for certain research services
received from external sources. T. Rowe Price also allocates
brokerage for research services which are available for cash.
While receipt of research services from brokerage firms has not
PAGE 49
reduced T. Rowe Price's normal research activities, the expenses
of T. Rowe Price could be materially increased if it attempted to
generate such additional information through its own staff. To
the extent that research services of value are provided by
brokers or dealers, T. Rowe Price may be relieved of expenses
which it might otherwise bear.
T. Rowe Price has a policy of not allocating brokerage
business in return for products or services other than brokerage
or research services. In accordance with the provisions of
Section 28(e) of the Securities Exchange Act of 1934, T. Rowe
Price may from time to time receive services and products which
serve both research and non-research functions. In such event,
T. Rowe Price makes a good faith determination of the anticipated
research and non-research use of the product or service and
allocates brokerage only with respect to the research component.
Commissions to Brokers who Furnish Research Services
Certain brokers and dealers who provide quality
brokerage and execution services also furnish research services
to T. Rowe Price. With regard to the payment of brokerage
commissions, T. Rowe Price has adopted a brokerage allocation
policy embodying the concepts of Section 28(e) of the Securities
Exchange Act of 1934, which permits an investment adviser to
cause an account to pay commission rates in excess of those
another broker or dealer would have charged for effecting the
same transaction, if the adviser determines in good faith that
the commission paid is reasonable in relation to the value of the
brokerage and research services provided. The determination may
be viewed in terms of either the particular transaction involved
or the overall responsibilities of the adviser with respect to
the accounts over which it exercises investment discretion.
Accordingly, while T. Rowe Price cannot readily determine the
extent to which commission rates or net prices charged by broker-
dealers reflect the value of their research services, T. Rowe
Price would expect to assess the reasonableness of commissions in
light of the total brokerage and research services provided by
each particular broker. T. Rowe Price may receive research, as
defined in Section 28(e), in connection with selling concessions
and designations in fixed price offerings in which the Funds
participate.
Internal Allocation Procedures
T. Rowe Price has a policy of not precommitting a
specific amount of business to any broker or dealer over any
specific time period. Historically, the majority of brokerage
placement has been determined by the needs of a specific
transaction such as market-making, availability of a buyer or
seller of a particular security, or specialized execution skills.
However, T. Rowe Price does have an internal brokerage allocation
procedure for that portion of its discretionary client brokerage
PAGE 50
business where special needs do not exist, or where the business
may be allocated among several brokers or dealers which are able
to meet the needs of the transaction.
Each year, T. Rowe Price assesses the contribution of
the brokerage and research services provided by brokers or
dealers, and attempts to allocate a portion of its brokerage
business in response to these assessments. Research analysts,
counselors, various investment committees, and the Trading
Department each seek to evaluate the brokerage and research
services they receive from brokers or dealers and make judgments
as to the level of business which would recognize such services.
In addition, brokers or dealers sometimes suggest a level of
business they would like to receive in return for the various
brokerage and research services they provide. Actual brokerage
received by any firm may be less than the suggested allocations
but can, and often does, exceed the suggestions, because the
total business is allocated on the basis of all the
considerations described above. In no case is a broker or dealer
excluded from receiving business from T. Rowe Price because it
has not been identified as providing research services.
Miscellaneous
T. Rowe Price's brokerage allocation policy is
consistently applied to all its fully discretionary accounts,
which represent a substantial majority of all assets under
management. Research services furnished by brokers or dealers
through which T. Rowe Price effects securities transactions may
be used in servicing all accounts (including non-Fund accounts)
managed by T. Rowe Price. Conversely, research services received
from brokers or dealers which execute transactions for the Fund
are not necessarily used by T. Rowe Price exclusively in
connection with the management of the Fund.
From time to time, orders for clients may be placed
through a computerized transaction network.
The Fund does not allocate business to any broker-
dealer on the basis of its sales of the Fund's shares. However,
this does not mean that broker-dealers who purchase Fund shares
for their clients will not receive business from the Fund.
Some of T. Rowe Price's other clients have investment
objectives and programs similar to those of the Fund. T. Rowe
Price may occasionally make recommendations to other clients
which result in their purchasing or selling securities
simultaneously with the Fund. As a result, the demand for
securities being purchased or the supply of securities being sold
may increase, and this could have an adverse effect on the price
of those securities. It is T. Rowe Price's policy not to favor
one client over another in making recommendations or in placing
orders. T. Rowe Price frequently follows the practice of
PAGE 51
grouping orders of various clients for execution which generally
results in lower commission rates being attained. In certain
cases, where the aggregate order is executed in a series of
transactions at various prices on a given day, each participating
client's proportionate share of such order reflects the average
price paid or received with respect to the total order. T. Rowe
Price has established a general investment policy that it will
ordinarily not make additional purchases of a common stock of a
company for its clients (including the T. Rowe Price Funds) if,
as a result of such purchases, 10% or more of the outstanding
common stock of such company would be held by its clients in the
aggregate.
To the extent possible, T. Rowe Price intends to
recapture solicitation fees paid in connection with tender offers
through T. Rowe Price Investment Services, Inc., the Fund's
distributor. At the present time, T. Rowe Price does not
recapture commissions or underwriting discounts or selling group
concessions in connection with taxable securities acquired in
underwritten offerings. T. Rowe Price does, however, attempt to
negotiate elimination of all or a portion of the selling-group
concession or underwriting discount when purchasing tax-exempt
municipal securities on behalf of its clients in underwritten
offerings.
Other
The Funds engaged in portfolio transactions involving
broker-dealers in the following amounts for the fiscal years
ended February 29, 1996, February 28, 1995, and February 28,
1994:
1996 1995 1994
Tax-Exempt
Money Fund $3,101,344,000 $3,476,545,000$3,503,548,000
Tax-Free Short-
Intermediate Fund 1,184,341,000 1,879,637,000 1,368,139,000
Tax-Free Insured Inter-
mediate Bond Fund 249,376,000 490,025,000 383,604,000
Tax-Free Income Fund 2,558,129,000 2,465,423,000 3,905,016,000
Tax-Free High
Yield Fund 1,643,296,000 1,961,416,000 2,185,765,000
The following amounts consisted of principal
transactions as to which the Funds have no knowledge of the
profits or losses realized by the respective broker-dealers for
the fiscal years ended February 29, 1996, February 28, 1995, and
February 28, 1994:
1996 1995 1994
Tax-Exempt
Money Fund $3,084,964,000 $3,476,545,000$3,503,548,000
PAGE 52
Tax-Free Short-
Intermediate Fund 1,113,118,000 1,849,318,000 1,250,892,000
Tax-Free Insured Inter-
mediate Bond Fund 233,485,000 480,566,000 343,890,000
Tax-Free Income Fund 2,318,802,000 2,296,647,000 3,412,068,000
Tax-Free High
Yield Fund 1,501,879,000 1,855,103,000 1,944,568,000
The following amounts involved trades with brokers
acting as agents or underwriters for the fiscal years ended
February 29, 1996, February 28, 1995, and February 28, 1994:
1996 1995 1994
Tax-Exempt Money Fund $16,380,000 $0 $0
Tax-Free Short-
Intermediate Fund 71,223,000 30,319,000 117,247,000
Tax-Free Insured Inter-
mediate Bond Fund 15,891,000 9,459,000 39,714,000
Tax-Free Income Fund 239,327,000 168,776,000 492,947,000
Tax-Free High Yield Fund 141,417,000 106,313,000 241,196,000
The following amounts involved trades with brokers
acting as agents or underwriters, in which such brokers received
total commissions, including discounts received in connection
with underwritings for the fiscal years ended February 29, 1996,
February 28, 1995, and February 28, 1994:
1996 1995 1994
Tax-Exempt Money Fund $70,000 $0 $0
Tax-Free Short-
Intermediate Fund 281,000 68,000 582,000
Tax-Free Insured Inter-
mediate Bond Fund 61,000 44,000 256,000
Tax-Free Income Fund 1,608,000 932,000 488,000
Tax-Free High Yield Fund 970,000 379,000 1,910,000
Of all such portfolio transactions, none were placed
with firms which provided research, statistical, or other
services to T. Rowe Price in connection with the management of
the Funds, or in some cases, to the Funds.
The portfolio turnover rates of the Funds for the
fiscal years ended February 29, 1996, February 28, 1995, and
February 28, 1994:
1996 1995 1994
Tax-Free Short-Intermediate Fund 69.9% 93.1% 51.1%
Tax-Free Insured Intermediate
Bond Fund 63.8% 170.8% 74.8%
PAGE 53
Tax-Free Income Fund 48.7% 49.3% 71.2%
Tax-Free High Yield Fund 39.3% 59.6% 59.3%
PRICING OF SECURITIES
Fixed income securities are generally traded in the over-
the-counter market. With the exception of the Money Fund,
investments in securities are stated at fair market value using a
bid-side valuation as furnished by dealers who make markets in
such securities or by an independent pricing service, which
considers yield or price of bonds of comparable quality, coupon,
maturity, and type, as well as prices quoted by dealers who make
markets in such securities. Securities held by the Money Fund
are valued at amortized cost.
There are a number of pricing services available, and the
Directors of the Funds, on the basis of ongoing evaluation of
these services, may use or may discontinue the use of any pricing
service in whole or in part.
Securities or other assets for which the above valuation
procedures are inappropriate or are deemed not to reflect fair
value will be appraised at prices deemed best to reflect their
fair value. Such determinations will be made in good faith by or
under the supervision of officers of each Fund as authorized by
the Board of Directors.
Maintenance of Money Fund's Net Asset Value Per Share at $1.00
It is the policy of the Fund to attempt to maintain a net
asset value of $1.00 per share by using the amortized cost method
of valuation permitted by Rule 2a-7 under the Investment Company
Act of 1940. Under this method, securities are valued by
reference to the Fund's acquisition cost as adjusted for
amortization of premium or accumulation of discount rather than
by reference to their market value. Under Rule 2a-7:
(a)The Board of Directors must establish written
procedures reasonably designed, taking into account
current market conditions and the fund's investment
objectives, to stabilize the fund's net asset value per
share, as computed for the purpose of distribution,
redemption and repurchase, at a single value;
(b)The Fund must (i) maintain a dollar-weighted average
portfolio maturity appropriate to its objective of
maintaining a stable price per share, (ii) not purchase
any instrument with a remaining maturity greater than
397 days, and (iii) maintain a dollar-weighted average
portfolio maturity of 90 days or less;
PAGE 54
(c)The Fund must limit its purchase of portfolio
instruments, including repurchase agreements, to those
U.S. dollar-denominated instruments which the Fund's
Board of Directors determines present minimal credit
risks, and which are eligible securities as defined by
Rule 2a-7 (eligible Securities are generally securities
which have been rated or whose issuer has been rated or
whose issuer has comparable securities rated in one of
the two highest rating categories by nationally
recognized statistical rating organizations or, in the
case of any instrument that is not so rated, is of
comparable quality as determined by procedures adopted
by the Fund's Board of Directors); and
(d)The Board of Directors must determine that (i) it is
in the best interest of the Fund and its shareholders
to maintain a stable net asset value per share under
the amortized cost method; and (ii) the Fund will
continue to use the amortized cost method only so long
as the Board of Directors believes that it fairly
reflects the market based net asset value per
share.
Although the Fund believes that it will be able to
maintain its net asset value at $1.00 per share under most
conditions, there can be no absolute assurance that it will be
able to do so on a continuous basis. If the Fund's net asset
value per share declined, or was expected to decline, below $1.00
(rounded to the nearest one cent), the Board of Directors of the
Fund might temporarily reduce or suspend dividend payments in an
effort to maintain the net asset value at $1.00 per share. As a
result of such reduction or suspension of dividends, an investor
would receive less income during a given period than if such a
reduction or suspension had not taken place. Such action could
result in an investor receiving no dividend for the period during
which he holds his shares and in his receiving, upon redemption,
a price per share lower than that which he paid. On the other
hand, if the Fund's net asset value per share were to increase,
or were anticipated to increase above $1.00 (rounded to the
nearest one cent), the Board of Directors of the Fund might
supplement dividends in an effort to maintain the net asset value
at $1.00 per share.
PAGE 55
NET ASSET VALUE PER SHARE
The purchase and redemption price of the Funds' shares
is equal to the Funds' net asset value per share or share price.
Each Fund determines its net asset value per share by subtracting
the Funds' liabilities (including accrued expenses and dividends
payable) from its total assets (the market value of the
securities the Fund holds plus cash and other assets, including
income accrued but not yet received) and dividing the result by
the total number of shares outstanding. The net asset value per
share of each Fund is calculated as of the close of trading on
the New York Stock Exchange ("NYSE") every day the NYSE is open
for trading. The net asset value of the Money Fund is also
calculated as of 12:00 noon (Eastern time) every day the NYSE is
open for trading. The NYSE is closed on the following days: New
Year's Day, Washington's Birthday, Good Friday, Memorial Day,
Independence Day, Labor Day, Thanksgiving Day, and Christmas Day.
Determination of net asset value (and the offering,
sale redemption and repurchase of shares) for a Fund may be
suspended at times (a) during which the NYSE is closed, other
than customary weekend and holiday closings, (b) during which
trading on the NYSE is restricted, (c) during which an emergency
exists as a result of which disposal by a Fund of securities
owned by it is not reasonably practicable or it is not reasonably
practicable for the Fund fairly to determine the value of its net
assets, or (d) during which a governmental body having
jurisdiction over the Fund may by order permit such a suspension
for the protection of the Fund's shareholders; provided that
applicable rules and regulations of the Securities and Exchange
Commission (or any succeeding governmental authority) shall given
as to whether the conditions prescribed in (b), (c), or (d)
exist.
DIVIDENDS
Unless you elect otherwise, the Fund's annual capital
gain distributions, if any, will be reinvested on the
reinvestment date using the NAV per share of that date. The
reinvestment date normally precedes the payment date by about 10
days although the exact timing is subject to change.
TAX STATUS
Each Fund intends to qualify as a "regulated investment
company" under Subchapter M of the Internal Revenue Code of 1986,
as amended ("Code").
Dividends and distributions paid by the Funds are not
eligible for the dividends-received deduction for corporate
shareholders. For tax purposes, it does not make any difference
PAGE 56
whether dividends and capital gain distributions are paid in cash
or in additional shares. Each Fund must declare by its year-end
dividends equal to at least 90% of net tax-exempt income (as of
its year-end) to permit pass-through of tax-exempt income to
shareholders, and declare by December 31 98% of capital gains (as
of October 31) in order to avoid a federal excise tax and
distribute within 12 months 100% of capital gains (as of its tax
year-end) to avoid federal income tax.
At the time of your purchase, a Fund's net asset value
may reflect undistributed capital gains or net unrealized
appreciation of securities held by the Fund. A subsequent
distribution to you of such amounts, although constituting a
return of your investment, would be taxable as a capital gain
distribution. For federal income tax purposes, a Fund is
permitted to carry forward its net realized capital losses, if
any, for eight years and realize net capital gains up to the
amount of such losses without being required to pay taxes on, or
distribute such gains. On April 30, 1996, the books of each Fund
indicated that the Fund's aggregate net assets included:
Realized Unrealized
Capital Appreciation/
Gains/(Losses) Depreciation
________________ ___________________
Tax-Exempt Money Fund $(216,299) $ 0
Tax-Free Short-
Intermediate Fund (1,298,300) 5,282,791
Tax-Free Insured Inter-
mediate Bond Fund (677,733) 1,628,166
Tax-Free Income Fund (9,378,648) 50,717,923
Tax-Free High Yield Fund (13,517,641) 37,414,363
If, in any taxable year, the Funds should not qualify as
regulated investment companies under the Code: (i) each Fund
would be taxed at normal corporate rates on the entire amount of
its taxable income, if any, without deduction for dividends or
other distributions to shareholders; and (ii) each Fund's
distributions to the extent made out of the Fund's current or
accumulated earnings and profits would be taxable to shareholders
as ordinary dividends (regardless of whether they would otherwise
have been considered capital gain or tax-exempt dividends).
The Funds anticipate acquiring bonds after initial
issuance at a price less than the principal amount of such bonds
("market discount bonds"). Gain on the disposition of such bonds
is treated as taxable ordinary income to the extent of accrued
market discount. Such gains cannot be offset by losses on the
sale of other securities but must be distributed to shareholders
annually and taxed as ordinary income.
PAGE 57
Each year, the Funds will mail you information on the tax
status of dividends and distributions. The Funds anticipate that
substantially all of the dividends to be paid by each Fund will
be exempt from federal income taxes. If any portion of a Fund's
dividends is not exempt from federal income taxes, you will
receive a Form 1099 stating the taxable portion. The Funds will
also advise you of the percentage of your dividends, if any,
which should be included in the computation of alternative
minimum tax. Social security recipients who receive interest
from tax-exempt securities may have to pay taxes on a portion of
their social security benefit.
Because the interest on municipal securities is tax
exempt, any interest on money you borrow that is directly or
indirectly used to purchase Fund shares is not deductible. (See
Section 265(2) of the Internal Revenue Code.) Further, entities
or persons who are "substantial users" (or persons related to
"substantial users") of facilities financed by industrial
development bonds should consult their tax advisers before
purchasing shares of a Fund. The income from such bonds may not
be tax exempt for such substantial users.
YIELD INFORMATION
Money Fund
The Fund's current and historical yield for a period is
calculated by dividing the net change in value of an account
(including all dividends accrued and dividends reinvested in
additional shares) by the account value at the beginning of the
period to obtain the base period return. This base period return
is divided by the number of days in the period then multiplied by
365 to arrive at the annualized yield for that period. The
Fund's annualized compound yield for such period is compounded by
dividing the base period return by the number of days in the
period, and compounding that figure over 365 days.
The Money Fund's current yield was 2.91% and the compound
yield was 2.95% for the seven days ended February 29, 1996.
Bond Funds
From time to time, a Fund may advertise a yield figure
calculated in the following manner:
An income factor is calculated for each security in the
portfolio based upon the security's market value at the beginning
of the period and yield as determined in conformity with
regulations of the Securities and Exchange Commission. The
income factors are then totalled for all securities in the
portfolio. Next, expenses of the Fund for the period net of
expected reimbursements are deducted from the income to arrive at
PAGE 58
net income, which is then converted to a per-share amount by
dividing net income by the average number of shares outstanding
during the period. The net income per share is divided by the
net asset value on the last day of the period to produce a
monthly yield which is then annualized. A taxable equivalent
yield is calculated by dividing this yield by one minus the
effective federal income tax rate. Quoted yield factors are for
comparison purposes only, and are not intended to indicate future
performance or forecast the dividend per share of the Fund.
The yield of each Fund calculated under the above-
described method for the month ended February 29, 1996 was:
Tax-Free Short-Intermediate 3.51%
Tax-Free Insured Intermediate Bond 3.82%
Tax-Free Income 4.83%
Tax-Free High Yield 5.40%
The tax equivalent yields for these funds for the
same period were 5.09% (Short-Intermediate), 5.54% (Insured
Intermediate), 7.00% (Income), and 7.83% (High Yield). This
assumes a federal tax bracket of 31.0%. Assuming a federal tax
bracket of 28.0%, the tax-equivalent yields for the period would
be 4.88% (Short-Intermediate), 5.31% (Insured Intermediate),
6.71% (Income), and 7.50% (High Yield).
TAX-EXEMPT VS. TAXABLE YIELDS
From time to time, a Fund may also illustrate the
effect of tax equivalent yields using information such as that
set forth below:
_________________________________________________________________
Taxable Income (1995)*
Federal
Joint Return Single Return Tax Rates+
_________________________________________________________________
$40,101- $96,900 $24,001- $58,150 28.0%
96,901- 147,700 58,151- 121,300 31.0
147,701- 263,750 121,301- 263,750 36.0
263,751 and above 263,751 and above 39.6
_________________________________________________________________
A Tax-Exempt Yield Of:
3% 4% 5% 6% 7% 8% 9% 10%
Is Equivalent to a Taxable Yield of:
_________________________________________________________________
4.17 5.56 6.94 8.33 9.72 11.11 12.50 13.89
4.35 5.80 7.25 8.70 10.14 11.59 13.04 14.49
4.69 6.25 7.81 9.38 10.94 12.50 14.06 15.63
4.97 6.62 8.28 9.93 11.59 13.25 14.90 16.56
PAGE 59
* Net amount subject to federal income tax after deductions and
exemptions.
+ Federal rates may vary depending on family size and amount
and nature of itemized deductions.
INVESTMENT PERFORMANCE
Total Return Performance
Each Fund's calculation of total return performance includes
the reinvestment of all capital gain distributions and income
dividends for the period or periods indicated, without regard to
tax consequences to a shareholder in the Fund. Total return is
calculated as the percentage change between the beginning value
of a static account in the Fund and the ending value of that
account measured by the then current net asset value, including
all shares acquired through reinvestment of income and capital
gains dividends. The results shown are historical and should not
be considered indicative of the future performance of the Fund.
Each average annual compound rate of return is derived from the
cumulative performance of the Fund over the time period
specified. The annual compound rate of return for the Fund over
any other period of time will vary from the average.
Cumulative Performance Percentage Change
Since
1 Yr. 5 Yrs. 10 Yrs. Inception
Ended Ended Ended Ended
2/29/96 2/29/96 2/29/96 2/29/96
Short-Intermediate Fund 6.87 30.85 71.93 105.53%
12/23/83
Insured Intermediate
Bond Fund 9.57 26.72
11/30/92
Income Fund 10.31 50.08 100.54 293.20
10/26/76
High Yield Fund 10.62 51.70 125.26 179.86
3/01/85
Average Annual Compound Rates of Return
1 Yr. 5 Yrs. 10 Yrs. Since
Ended Ended Ended Inception
2/29/96 2/29/96 2/29/96 2/29/96
Short-Intermediate
Fund 6.87 5.52 5.57 6.09%
12/23/83
Insured Intermediate
PAGE 60
Bond Fund 9.57 7.57
11/30/92
Income Fund 10.31 8.46 7.21 7.34
10/26/76
High Yield Fund 10.62 8.69 8.46 9.81
3/01/85
All Funds
Outside Sources of Information
From time to time, in reports and promotional literature, the
Funds' performance will be compared to (1) indices of broad
groups of managed and unmanaged securities considered to be
representative of or similar to Fund portfolio holdings (2) other
mutual funds, or (3) other measures of performance set forth in
publications such as:
Bond Buyer 20 - an estimation of the yield which would be
offered on 20-year general obligation bonds with a composite
rating of approximately "A." Published weekly by The Bond
Buyer, a trade paper of the municipal securities industry;
Shearson Lehman/American Express Municipal Bond Index - a
composite measure of the total return performance of the
municipal bond market. Based upon approximately 1500 bonds;
Lipper General Purpose Municipal Bond Avg. - an average of
municipal mutual funds which invest 60% or more of their assets
in the top four tax-exempt credit ratings;
Lipper Analytical Services, Inc. - a widely used independent
research firm which ranks mutual funds by overall performance,
investment objectives, and assets;
Lipper Intermediate Municipal Avg. - an average of municipal
mutual funds which restrict their holdings to bonds with
maturities between 5 and 10 years;
Lipper Insured Municipal Avg. - an average of municipal mutual
funds which utilize insured municipal securities for 65% of
their portfolios.
Lipper High-Yield Municipal Bond Avg. - an average of municipal
mutual funds which may utilize lower rated bonds for 50% of
their portfolio;
Lipper Short Municipal Debt Avg. - an average of municipal
mutual funds that invest in municipal debt issues with dollar-
weighted average maturities of less than five years.
Donoghue's Tax-Exempt Money Fund Avg. - an average of municipal
money market funds as reported in Donoghue's Money Fund Report,
PAGE 61
which tracks the performance of all money market mutual funds;
Prime General Obligations - bonds with maturities from 1-30
years which are secured by the full faith and credit of issuers
with taxing power;
Morningstar, Inc. - a widely used independent research firm
which rates mutual funds by overall performance, investment
objectives, and assets.
Indices prepared by the research departments of such financial
organizations as Merrill Lynch, Pierce, Fenner & Smith, Inc.,
will be used, as well as information provided by the Federal
Reserve Board.
Information reported in the Bank Rate Monitor, an independent
publication which tracks the performance of certain bank
products, such as money market deposit accounts and certificates
of deposit, will also be used. Bank certificates of deposit
differ from mutual funds in several ways: the interest rate
established by the sponsoring bank is fixed for the term of a CD;
there are penalties for early withdrawal from CDs; and the
principal on a CD is insured.
Performance rankings and ratings reported periodically in
national financial publications such as MONEY, FORBES, BUSINESS
WEEK, BARRON'S, etc. may also be used.
Other Features and Benefits
The Fund is a member of the T. Rowe Price Family of Funds
and may help investors achieve various long-term investment
goals, such as investing money for retirement, saving for a down
payment on a home, or paying college costs. To explain how the
Fund could be used to assist investors in planning for these
goals and to illustrate basic principles of investing, various
worksheets and guides prepared by T. Rowe Price Associates, Inc.
and/or T. Rowe Price Investment Services, Inc. may be made
available. These currently include: the Asset Mix Worksheet
which is designed to show shareholders how to reduce their
investment risk by developing a diversified investment plan; the
College Planning Guide which discusses various aspects of
financial planning to meet college expenses and assists parents
in projecting the costs of a college education for their
children; the Retirement Planning Kit (also available in a PC
version) includes a detailed workbook to determine how much money
you may need for retirement and suggests how you might invest to
achieve your objectives; and the Retirees Financial Guide which
includes a detailed workbook to determine how much money you can
afford to spend and still preserve your purchasing power and
suggests how you might invest to reach your goal; Tax
Considerations for Investors discusses the tax advantages of
annuities and municipal bonds and how to access whether they are
PAGE 62
suitable for your portfolio, reviews pros and cons of placing
assets in a gift to minors account and summarizes the benefits
and types of tax-deferred retirement plans currently available;
the Personal Strategy Planner simplifies investment decision
making by helping investors define personal financial goals,
established length of time the investor intends to invest,
determine risk "comfort zone" and select a diversified investment
mix; and the How to Choose a Bond Fund guide which discusses how
to choose an appropriate bond fund for your portfolio. From time
to time, other worksheets and guides may be made available as
well. Of course, an investment in the Fund cannot guarantee that
such goals will be met.
To assist investors in understanding the different returns
and risk characteristics of various investments, the
aforementioned guides will include presentation of historical
returns of various investments using published indices. An
example of this is shown below.
Historical Returns for Different Investments
Annualized returns for periods ended 12/31/95
50 years 20 years 10 years 5 years
Small-Company Stocks 13.8% 19.6% 11.9% 24.5%
Large-Company Stocks 11.9 14.6 14.8 16.6
Foreign Stocks N/A 15.1 13.9 9.7
Long-Term Corporate Bonds 5.7 10.5 11.2 12.1
Intermediate-Term U.S.
Gov't. Bonds 5.9 9.7 9.1 8.8
Treasury Bills 4.8 7.3 5.5 4.3
U.S. Inflation 4.4 5.2 3.5 2.8
Sources: Ibbotson Associates, Morgan Stanley. Foreign stocks
reflect performance of The Morgan Stanley Capital International
EAFE Index, which includes some 1,000 companies representing the
stock markets of Europe, Australia, New Zealand, and the Far
East. This chart is for illustrative purposes only and should
not be considered as performance for, or the annualized return
of, any T. Rowe Price Fund. Past performance does not guarantee
future results.
Also included will be various portfolios demonstrating how
these historical indices would have performed in various
combinations over a specified time period in terms of return. An
example of this is shown below.
PAGE 63
Performance of Retirement Portfolios*
Asset Mix Average Annualized Value
Returns 20 Years of
Ended 12/31/95 $10,000
Investment
After Period
________________ __________________ ____________
Nominal Real BestWorst
Portfolio Growth IncomeSafety ReturnReturn** YearYear
I. Low
Risk 40% 40% 20% 11.8% 6.5% 24.9% 0.1% $ 92,675
II. Moderate
Risk 60% 30% 10% 13.1% 7.9% 29.1% -1.8%$116,826
III. High
Risk 80% 20% 0% 14.3% 9.1% 33.4% -5.2%$145,611
Source: T. Rowe Price Associates; data supplied by Lehman
Brothers, Wilshire Associates and Ibbotson Associates.
* Based on actual performance for the 20 years ended 1995 of
stocks (85% Wilshire 5000 and 15% Europe, Australia, Far
East [EAFE] Index), bonds (Lehman Brothers Aggregate Bond
Index from 1976-95 and 30-day Treasury bills from January
1976 through December 1995. Past performance does not
guarantee future results. Figures include changes in
principal value and reinvested dividends and assume the same
asset mix is maintained each year. This exhibit is for
illustrative purposes only and is not representative of the
performance of any T. Rowe Price fund.
** Based on inflation rate of 5.2% for the 20-year period ended
12/31/95.
Insights
From time to time, Insights, a T. Rowe Price publication of
reports on specific investment topics and strategies, may be
included in the Fund's fulfillment kit. Such reports may include
information concerning: calculating taxable gains and losses on
mutual fund transactions, coping with stock market volatility,
benefiting from dollar cost averaging, understanding
international markets, investing in high-yield "junk" bonds,
growth stock investing, conservative stock investing, value
investing, investing in small companies, tax-free investing,
fixed income investing, investing in mortgage-backed securities,
as well as other topics and strategies.
Other Publications
PAGE 64
From time to time, in newsletters and other publications
issued by T. Rowe Price Investment Services, Inc., T. Rowe Price
mutual fund portfolio managers may discuss economic, financial
and political developments in the U.S. and abroad and how these
conditions have affected or may affect securities prices or the
Fund; individual securities within the Fund's portfolio; and
their philosophy regarding the selection of individual stocks,
including why specific stocks have been added, removed or
excluded from the Fund's portfolio.
CAPITAL STOCK
Shareholders are entitled to one vote for each full share
held (and fractional votes for fractional shares held) and will
vote in the election of or removal of directors (to the extent
hereinafter provided) and on other matters submitted to the vote
of shareholders. There will normally be no meetings of
shareholders for the purpose of electing directors unless and
until such time as less than a majority of the directors holding
office have been elected by shareholders, at which time the
directors then in office will call a shareholders' meeting for
the election of directors. Except as set forth above, the
directors shall continue to hold office and may appoint successor
directors. Voting rights are not cumulative, so that the holders
of more than 50% of the shares voting in the election of
directors can, if they choose to do so, elect all the directors
of the Fund, in which event the holders of the remaining shares
will be unable to elect any person as director. The Board of
Directors of each Fund may increase or decrease the aggregate
number of shares of stock or the number of shares of stock of any
class or series authorized to be issued without shareholder
approval.
As set forth in the By-Laws of each Fund, a special meeting
of shareholders of a Fund shall be called by the Secretary of the
Fund on the written request of shareholders entitled to cast at
least 10% of all the votes of the Fund entitled to be cast at
such meeting. Shareholders requesting such a meeting must pay to
the Fund the reasonably estimated costs of preparing and mailing
the notice of the meeting. Each Fund, however, will otherwise
assist the shareholders seeking to hold the special meeting in
communicating to the other shareholders of the Fund to the extent
required by Section 16(c) of the Investment Company Act of 1940.
Short-Intermediate, Insured Intermediate Bond, Income and High
Yield Funds
Each Fund's Charter authorizes the Board of Directors to
classify and reclassify any and all shares which are then
unissued, including unissued shares of capital stock into any
number of classes or series, each class or series consisting of
such number of shares and having such designations, such powers,
PAGE 65
preferences, rights, qualifications, limitations, and
restrictions, as shall be determined by the Board subject to the
Investment Company Act and other applicable law. The shares of
any such additional classes or series might therefore differ from
the shares of the present class and series of capital stock and
from each other as to preferences, conversions or other rights,
voting powers, restrictions, limitations as to dividends,
qualifications or terms or conditions of redemption, subject to
applicable law, and might thus be superior or inferior to the
capital stock or to other classes or series in various
characteristics. The Board of Directors may increase or decrease
the aggregate number of shares of stock or the number of shares
of stock of any class or series that the Fund has authorized to
issue without shareholder approval.
Except to the extent that the Boards of Directors of these
Funds might provide by resolution that holders of shares of a
particular class are entitled to vote as a class on specified
matters presented for a vote of the holders of all shares
entitled to vote on such matters, there would be no right of
class vote unless and to the extent that such a right might be
construed to exist under Maryland law. The Funds' Charters
contain no provision entitling the holders of the present class
of capital stock to a vote as a class on any matter.
Accordingly, the preferences, rights, and other characteristics
attaching to any class of shares, including the present class of
capital stock, might be altered or eliminated, or the class might
be combined with another class or classes, by action approved by
the vote of the holders of a majority of all the shares of all
classes entitled to be voted on the proposal, without any
additional right of vote as a class by the holders of the capital
stock or of another affected class or classes.
Redemptions in Kind
In the unlikely event a shareholder were to receive an in
kind redemption of portfolio securities of the Funds, brokerage
fees could be incurred by the shareholder in a subsequent sale of
such securities.
Issuance of Fund Shares for Securities
Transactions involving issuance of Fund shares for
securities or assets other than cash will be limited to (1) bona
fide reorganizations; (2) statutory mergers; or (3) other
acquisitions of portfolio securities that: (a) meet the
investment objectives and policies of the Funds; (b) are acquired
for investment and not for resale except in accordance with
applicable law; (c) have a value that is readily ascertainable
via listing on or trading in a recognized United States or
international exchange or market; and (d) are not illiquid.
PAGE 66
GENERAL INFORMATION AND HISTORY
Money Fund
The Money Fund, which commenced operation under the name
Rowe Price Prime Reserve Fund II, Inc., was organized as a money
market mutual fund with an investment objective and program
substantially identical to that of the T. Rowe Price Prime
Reserve Fund, Inc. ("Prime Reserve Fund"), another T. Rowe Price
Fund. The Fund was initially established to make available
shares of a money market fund to those investors who were not
eligible to invest in the Prime Reserve Fund because of the
restrictions placed by the Board of the Prime Reserve Fund on the
sale of its shares as a result of the Credit Control Program
adopted by the Federal Reserve Board on March 14, 1980. When
that program was discontinued on July 28, 1980, the Board of
Directors concluded that the continued operation of the Fund as a
general purpose money market fund was unnecessary. On August 11,
1980, the sale of the Fund's shares was suspended and the shares
of all shareholders of the Fund (except T. Rowe Price) were
exchanged for shares in the Prime Reserve Fund. Subsequently, T.
Rowe Price, the sole shareholder of the Fund, recommended to the
Board of Directors of the Fund that the Fund's name be changed to
T. Rowe Price Tax-Exempt Money Fund, Inc. and that its investment
objective and investment program be amended for the purpose of
changing the Fund from a money market fund to a tax-exempt money
market fund. Such changes were approved by the Fund's sole
shareholder, T. Rowe Price, on January 8, 1981. The Fund
commenced operation as a tax-exempt money market fund on
March 30, 1981.
FEDERAL AND STATE REGISTRATION OF SHARES
The Funds' shares are registered for sale under the
Securities Act of 1933 and the Fund or their shares are
registered under the laws of all states which require
registration, as well as the District of Columbia and Puerto
Rico.
LEGAL COUNSEL
Shereff, Friedman, Hoffman & Goodman, LLP, whose address is
919 Third Avenue, New York, New York 10022, is legal counsel to
each of the Funds.
INDEPENDENT ACCOUNTANTS
Coopers & Lybrand L.L.P., 217 East Redwood Street,
Baltimore, Maryland 21202, are independent accountants to the
Funds. The financial statements of the Funds for the fiscal year
PAGE 67
ended February 29, 1996 and the report of independent accountants
are included in each Fund's Annual Report on pages 1-12, pages 1-
11, and pages 1-18, respectively. A copy of each Annual Report
accompanies this Statement of Additional Information. The
following financial statements and the report of independent
accountants appearing in each Annual Report for the fiscal year
ended February 29, 1996, are incorporated into this Statement of
Additional Information by reference:
Money Fund High Yield Fund
Annual Annual
Report Page Report Page
___________ _______________
Report of Independent Accountants 12 18
Statement of Net Assets,
February 29, 1996 1-7 1-12
Statement of Operations, year ended
February 29, 1996 8 13
Statement of Changes in Net Assets,
years ended February 29, 1996 and
February 28, 1995 9 14
Notes to Financial Statements,
February 29, 1996 10 15-16
Financial Highlights 11 17
Insured
Intermediate
Bond Fund
Annual Report Page
_________________
Report of Independent Accountants 11
Statement of Net Assets
February 29, 1996 1-5
Statement of Operations, year ended February 29, 1996 6
Statement of Changes in Net Assets, years ended
February 29, 1996 and February 28, 1995 7
Notes to Financial Statements, February 29, 1996 8-9
Financial Highlights, February 29, 1996 10
Short-Intermediate
Fund
Annual
Report Page
__________________
Report of Independent Accountants 14
Portfolio of Investments,
February 29, 1996 1-7
PAGE 68
Statement of Assets and Liabilities
February 29, 1996 8
Statement of Operations, year ended February 29, 1996 9
Statement of Changes in Net Assets, years ended
February 29, 1996 and February 28, 1995 10
Notes to Financial Statements,
February 29, 1996 11-12
Financial Highlights 13
PAGE 69
Income Fund
Annual
Report Page
_______________
Report of Independent Accountants 16
Statement of Net Assets,
February 29, 1996 1-11
Statement of Operations, year ended
February 29, 1996 12
Statement of Changes in Net Assets,
years ended February 29, 1996 and
February 28, 1995 13
Notes to Financial Statements,
February 29, 1996 13-15
Financial Highlights 15
Effective March 1, 1995, Coopers & Lybrand L.L.P. became the
independent accountants to the Short-Intermediate and Income
Funds.
PAGE 70
