Rule 497(c)
Registration No. 2-82710
NEW YORK MUNI FUND(R)
90 Washington Street
New York, New York 10006
1-800-225-6864
New York Muni Fund, "New York's Oldest Triple Tax-Free Mutual Fund", (the
"Fund") is a series of Fundamental Funds, Inc. (the "Company"), a Maryland
corporation. The Fund seeks to provide a high level of income that is excluded
from gross income for Federal income tax purposes and exempt from New York State
and New York City personal income taxes and is consistent with the preservation
of capital. Under normal market conditions, at least 80% of the Fund's assets
will be invested in securities that are free from Federal, New York State and
New York City income taxes. Of course, there can be no assurance that the Fund's
investment objective will be achieved.
The Fund intends to achieve its objective by investing substantially all
(and at least 80%) of its total assets in municipal obligations of New York
State, its political subdivisions, and its other duly constituted authorities
and corporations, that are rated within the four highest quality grades for
bonds as determined by Moody's Investors Service, Inc. ("Moody's"), Standard &
Poor's Corporation ("S&P"), Fitch Investors Service, Inc. ("Fitch") or Duff &
Phelps, Inc. ("Duff") or within the three highest quality grades for municipal
notes as determined by Moody's, S&P, Fitch or Duff or, if unrated, are judged by
Fund management to be of comparable quality. While municipal obligations in
these categories are generally deemed to have adequate to very strong protection
of principal and interest, municipal obligations rated within the lowest of
these categories have speculative characteristics as well.
This Prospectus sets forth concisely the information you should know before
investing in the Fund. You should read it and keep it for future reference. A
Statement of Additional Information containing additional information about the
Fund has been filed with the Securities and Exchange Commission. You may obtain
a copy of the Statement without charge by writing to the Fund at the address
listed above, or by calling (800) 322-6864. Shareholder inquiries may also be
placed through this number.
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TABLE OF CONTENTS
Highlights ............................................................. 2
Fee Table .............................................................. 3
Financial Highlights ................................................... 4
Investment Objective and Policies ...................................... 5
Investment Strategies .................................................. 8
Special Risks .......................................................... 13
Calculation of Yield and Performance Data .............................. 16
Purchase of Shares ..................................................... 17
Redemption of Shares ................................................... 19
Determination of Net Asset Value ....................................... 22
Distribution Expenses .................................................. 22
Management ............................................................. 24
Dividends and Tax Matters .............................................. 28
General Information .................................................... 30
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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.
THE STATEMENT OF ADDITIONAL INFORMATION DATED MAY 1, 1998
IS HEREBY INCORPORATED BY REFERENCE INTO THIS PROSPECTUS.
PROSPECTUS DATED MAY 1, 1998
<PAGE>
HIGHLIGHTS
What is New York Muni Fund?
New York Muni Fund is a non-diversified mutual fund which seeks to provide a
high level of income that is excluded from gross income for Federal income tax
purposes and exempt from New York State and New York City personal income taxes
and is consistent with the preservation of capital. There is no assurance,
however, that the Fund will achieve its stated objective. See "Investment
Objective and Policies".
Management
The Fund is a member of the Fundamental Family of Funds, a group of five
investment companies. Fundamental Portfolio Advisors, Inc. (the "Manager") is
the Fund's investment manager.
The Manager supervises and manages the Fund's investment portfolio and
directs the purchase and sales of its investment securities. The Manager
utilizes an investment committee to manage the assets of the Fund. See
"Management".
Investment Risks
To achieve its objective, the Fund invests primarily in municipal
obligations of New York issuers that are rated within the four highest quality
grades for bonds as determined by Moody's, S&P, Fitch or Duff or within the
three highest quality grades for municipal notes as determined by Moody's, S&P,
Fitch or Duff or, if unrated, are judged by Fund management to be of comparable
quality. While municipal obligations in these categories are generally deemed to
have adequate to very strong protection of principal and interest, municipal
obligations in the lowest of these categories have speculative characteristics
as well (see "Investment Objective and Policies" and "Special Risks").
In addition, the Fund may employ various investment strategies and
techniques which are designed to enhance income and liquidity or attempt to
hedge against market fluctuation and risk, such as buying and selling interest
rate futures contracts ("futures contracts"), using options to purchase or sell
such contracts, using options to purchase or sell debt securities, and writing
covered call options and cash-secured puts (see "Investment Strategies"). Such
strategies themselves involve certain additional risks (see "Special Risks").
Moreover, there are additional risk considerations associated with certain other
investment policies of, and strategies employed by, the Fund, such as those
relating to concentration of investments in New York issuers, investing in
variable and floating rate instruments, zero coupon bonds, pay-in-kind bonds,
lower quality municipal obligations, illiquid securities and borrowing for
investment (see "Investment Strategies" and "Special Risks").
Tax-Free Income
The interest earned by the Fund from municipal obligations that is paid as
exempt-interest dividends is not includable in your gross income for Federal
income tax purposes. Moreover, to the extent that dividends on shares of the
Fund are derived from interest received by the Fund on obligations of New York
and its political subdivisions, such dividends will also be exempt from a New
York shareholder's gross income for New York State and New York City personal
income tax purposes (see "Dividends and Tax Matters"). You should recognize,
however, that the Fund's investment in municipal obligations of New York issuers
may involve inherent risks (see "Special Risks").
How to Buy and Sell Shares of the Fund?
Shares of the Fund may be purchased on a continuous basis without any sales
charge at the next determined net asset value per share (see "Purchase of
Shares" and "Determination of Net Asset Value"). Your purchase order becomes
effective immediately if it is received before 4:00 P.M. (Eastern time) on any
business day.
Shares are redeemable (may be sold) at your option without charge at the
next determined net asset value per share (see "Redemption of Shares"). The Fund
reserves the right, however, to liquidate an account with a value of less than
$100 on 60 days' notice.
Shareholder Services and Privileges
For your convenience, the Fund provides certain services and privileges
which we have suited to your particular needs, including the Automatic
Investment Program and the Exchange, Check Redemption, Telephone Redemption and
Expedited Redemption Privileges (see "Purchase of Shares" and "Redemption of
Shares").
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Monthly Dividends
The Fund declares dividends daily and pays them on a monthly basis,
eliminating the need for you to hold your shares until quarter-end to receive
dividend income. Dividends are automatically reinvested at net asset value in
additional Fund shares without any charge. You may elect, however, to receive
them in cash (see "Dividends and Tax Matters").
Management and The Fundamental Family of Funds
Fundamental Portfolio Advisors, Inc., 90 Washington Street, New York, New
York 10006, the Fund's investment manager (the "Manager") determines overall
investment strategy for the Fund and provides the Fund with all necessary office
facilities, equipment and personnel for managing the Fund's affairs and
investments (see "Management").
The Manager also acts as investment manager to several other mutual fund
portfolios in The Fundamental Family of Funds, including The California Muni
Fund, and the High-Yield Municipal Bond Series, the Tax-Free Money Market Series
and the Fundamental U.S. Government Strategic Income Fund Series of Fundamental
Fixed-Income Fund. Shares of such funds are exchangeable for shares of the Fund
(minimum $1,000 value) at the respective net asset values per share without any
charge and may be exchanged by telephone (see "Purchase of Shares").
FEE TABLE
Shareholder Transaction Expenses
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Sales Load Imposed on Purchases .................... None
Sales Load Imposed on Reinvested Dividends ......... None
Redemption Fees* ................................... None
Exchange Fees ...................................... None
Annual Fund Operating Expenses (as a percentage of average net assets)
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Management Fees .................................... .49%
12b-1 Fees1 ........................................ .50%
Other Expenses:
Interest ......................................... 1.10%
Other ............................................ 1.65%
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Total Fund Operating Expenses ...................... 3.74%
=====
*The Transfer Agent charges a $12 service fee for each payment of redemption
proceeds made by wire.
Example: You would pay the following expenses on a $1,000 investment,
assuming (1) 5% annual return and (2) redemption at the end of each time period:
1 year 3 years 5 years 10 years
$38 $114 $193 $398
The purpose of the foregoing table is to assist you in understanding the
various costs and expenses that you will bear directly and indirectly. (For more
complete descriptions of the various costs and expenses, see "Management",
"Distribution Expenses" and the Financial Statements included at the end of the
Fund's Statement of Additional Information.) The expenses and example appearing
in the preceding table have been restated to reflect current fees and operating
expenses. The example shown in the table should not be considered a
representation of past or future expenses, and actual expenses may be greater or
less than those shown.
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1As a result of distribution fees of .50% per annum of the Fund's average daily
net assets, a long-term shareholder may pay more than the economic equivalent
of the maximum front-end sales charges permitted by the Rules of the National
Association of Securities Dealers, Inc.
3
<PAGE>
FINANCIAL HIGHLIGHTS
The following selected per share data and ratios for each of the years in
the ten-year period ended December 31, 1997 has been audited by McGladrey &
Pullen, LLP, independent certified public accountants whose report on the
Financial Statements and the related notes appear at the end of the Fund's
Statement of Additional Information.
<TABLE>
<CAPTION>
Year Ended December 31,
----------------------------------------------------------------------------------------
1997 1996 1995 1994 1993 1992 1991 1990 1989 1988
---- ---- ---- ---- ---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
PER SHARE OPERATING PERFORMANCE
(for a share outstanding
throughout the period)
Net Asset Value, Beginning of year ........ $0.87 $0.98 $0.88 $1.18 $1.21 $1.14 $1.04 $1.12 $1.09 $1.05
----- ----- ----- ----- ----- ----- ----- ----- ----- -----
Income from investment operations:
Net investment income ................... .021 .035 .035 .056 .065 .061 .059 .069 .072 .074
Net realized and unrealized gain (loss)
on investments ........................ (.009) (.110) .101 (.290) .082 .070 .100 (.080) .031 .040
----- ----- ----- ----- ----- ----- ----- ----- ----- -----
Total from investment operations .... .012 (.075) .136 (.234) .147 .131 .159 (.011) .103 .114
----- ----- ----- ----- ----- ----- ----- ----- ----- -----
Less: Distributions:
Dividends from net investment income .... (.019) (.035) (.035) (.056) (.065) (.060) (.059) (.069) (.072) (.074)
Return of capital distributions ......... (.003) - - - - - - - - -
Dividends from net realized gains ....... - - (.001) (.010) (.112) (.001) - - - -
----- ----- ----- ----- ----- ----- ----- ----- ----- -----
Total distributions ................. (.022) (.035) (.036) (.066) (.177) (.061) (.059) (.069) (.072) (.074)
----- ----- ----- ----- ----- ----- ----- ----- ----- -----
Net Asset Value, End of year .............. $0.86 $0.87 $0.98 $0.88 $1.18 $1.21 $1.14 $1.04 $1.12 $1.09
===== ===== ===== ===== ===== ===== ===== ===== ===== =====
Total Return ........................ 1.46% (7.73%) 15.67% (20.47%) 12.58% 11.83% 15.73% (.99%) 9.60% 11.22%
RATIOS/SUPPLEMENTAL DATA
Net Assets,End of Period (000) ...........$134,595 $196,746 $226,692 $212,665 $275,552 $196,516 $183,307 $182,282 $236,525 $230,356
Ratios to Average Net Assets:
Interest expenses ....................... 1.10% 2.11% 2.09% 1.59% .61% .19% .09% .17% .35% .55%
Operating expenses ...................... 2.64% 1.66% 1.55% 1.62% 1.44% 1.50% 1.69% 1.48% 1.34% 1.19%
----- ----- ----- ----- ----- ----- ----- ----- ----- -----
Total expenses ...................... 3.74%+ 3.77% 3.64% 3.21% 2.05% 1.69% 1.78% 1.65% 1.69% 1.74%
===== ===== ===== ===== ===== ===== ===== ===== ===== =====
Net investment income ............... 2.23%+ 3.89% 3.81% 5.34% 5.20% 5.16% 5.47% 6.43% 6.47% 6.94%
Portfolio turnover rate ...................399.38% 347.44% 347.50% 289.69% 404.05% 460.58% 365.12% 482.58% 386.48% 462.73%
BANK LOANS
Amount outstanding at end of period
(000 omitted) ...........................$38,178 $1,200 $64,575 $20,000 $20,873 $725 - $248 $9,758 -
Average amount of bank loans
outstanding during the year
(000 omitted) ...........................$20,631 $49,448 $49,603 $54,479 $24,100 $5,194 $1,483* $4,767* $9,581* $11,500*
Average number of shares outstanding
during the year (000 omitted) ...........153,535 178,456 191,692 206,323 184,664 161,404 167,206* 209,484* 211,210* 212,394*
Average amount of debt per share during
the year ................................ $ .134 $ .277 $ .259 $ .264 $ .131 $ .032 $ .009 $ .023 $ .045 $ .054
<FN>
- ----------
**Based on monthly averages.
+These ratios are after expense reimbursement of .03% for the year ended December 31, 1997.
</FN>
</TABLE>
4
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INVESTMENT OBJECTIVE AND POLICIES
The Fund's fundamental investment objective is to provide you with a high
level of income that is excluded from gross income for Federal income tax
purposes and exempt from New York State and New York City personal income taxes
and is consistent with the preservation of capital. Under normal market
conditions, at least 80% of the Fund's assets will be invested in securities
that are free from Federal, New York State and New York City income taxes.
The Fund's investment objective and its investment policies and strategies
with respect to futures, options, lending portfolio securities and borrowing
(described below) are fundamental policies that cannot be changed without the
approval of the holders of a majority of the Fund's outstanding shares. A more
detailed explanation of certain investment policies and the Fund's fundamental
investment restrictions is contained in the Statement of Additional Information.
As used in this Prospectus, the phrase majority of the Fund's outstanding
shares means the vote of the lesser of (1) 67% of the 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 at such a meeting or (2) more than 50%
of the Fund's outstanding shares.
The Fund attempts to achieve its objective by investing substantially all
(at least 80%) of its total assets in municipal obligations which are rated
within the four highest quality grades for bonds as determined by Moody's, S&P,
Fitch or Duff or within the three highest quality grades for municipal notes as
determined by Moody's, S&P, Fitch or Duff or, if unrated, are judged by Fund
management to be of comparable quality, and which are issued by the State of New
York, its political subdivisions, and its other duly constituted authorities and
corporations, the interest from which, in the opinion of counsel to the issuer,
is totally excluded from gross income for Federal income tax purposes, does not
constitute a preference item and, therefore, will not be subject to the Federal
alternative minimum tax on individuals and is exempt from New York State and New
York City personal income taxes. At least 65% of the value of the Fund's net
assets (except when maintaining a temporary defensive position) will be invested
in New York municipal obligations. There can be no assurance that the Fund's
objective will be achieved. The Fund's ability to achieve its objective is
subject to the continuing ability of the issuers of municipal obligations to
meet their principal and interest payments, and is further subject to
fluctuations in interest rates as well as other factors.
While the municipal obligations in which the Fund may invest are generally
deemed to have adequate to very strong protection of principal and interest,
those rated within the lowest of the quality grades described above are
considered medium-grade obligations which have speculative characteristics as
well. For example, obligations rated Baa by Moody's have been determined by
Moody's to be neither highly protected nor poorly secured, and although interest
payments and principal security appear adequate for the present, certain
protective elements may be lacking or may be characteristically unreliable over
any great length of time. Similarly, obligations rated BBB by S&P, Fitch or Duff
are regarded by S&P, Fitch and Duff as having adequate capacity to pay interest
and repay principal, and while such obligations normally exhibit adequate
protection parameters, adverse economic conditions or changing circumstances are
more likely to lead to a weakened capacity to pay interest and repay principal
for obligations in this category than in higher rated categories.
Although the Fund intends to invest primarily in higher quality municipal
obligations as described above, up to 10% of its total assets may be invested in
municipal obligations rated lower than Baa by Moody's or BBB by S&P, Fitch or
Duff and as low as Caa by Moody's or CC by S&P, Fitch or Duff, or if unrated,
are judged by Fund management to be of comparable quality. Investments rated Ba
or lower by Moody's and BB or lower by S&P, Fitch or Duff normally provide
higher yields, but involve greater risk because of their speculative
characteristics and are commonly referred to as "junk bonds." (See "Special
Risks-Special Risk Factors Relating to Lower Rated Securities.")
It should be noted that ratings are general and not absolute standards of
quality or guarantees of the creditworthiness of an issuer. The ratings of
Moody's, S&P, Fitch and Duff represent their opinions as to the quality of the
municipal obligations which they undertake to rate. It should be emphasized,
however, that ratings are relative and subjective and, although ratings may be
useful in
5
<PAGE>
evaluating the safety of interest and principal payments, they do not evaluate
the market value risk of these bonds. Therefore, although these ratings may be
an initial criterion for selection of portfolio investments, the Manager also
will evaluate these securities and the ability of the issuers of such securities
to pay interest and principal. The Fund's ability to achieve its investment
objective may be more dependent on the Manager's credit analysis than might be
the case for a fund that invested in higher rated securities only. Once the
rating of a portfolio security or the quality determination ascribed by Fund
management to an unrated portfolio security has been downgraded, the Fund will
consider all circumstances deemed relevant in determining whether to continue to
hold the security, but in no event will the Fund retain such securities if it
would cause the Fund to have 20% of the value of its total assets invested in
securities rated lower than Baa by Moody's or BBB by S&P, Fitch or Duff, or if
unrated, are judged by Fund management to be of comparable quality. The purchase
of unrated securities is subject to guidelines that may be set for Fund
management from time to time by the Fund's Board of Directors. A description of
the ratings of municipal obligations as determined by Moody's, S&P, Fitch and
Duff is included in the Statement of Additional Information. (See the Appendix
to this Prospectus for a summary of the Fund's asset composition, based on the
monthly weighted average of credit ratings of its portfolio securities.)
The Fund invests in municipal obligations that have remaining maturities
ranging from short-term maturities (less than one year) to long-term maturities
(in excess of fifteen years). Depending on market conditions, the Fund attempts
to achieve a favorable tradeoff between longer maturities that have higher
income as opposed to shorter maturities with relatively less income. Because the
Fund may purchase bonds that mature in more than one year, invests in inverse
floating variable rate bonds, assumes some credit risk and does not have a
stable net asset value (the value of its shares fluctuates), it is not a money
market fund. The longer the maturity of a municipal obligation, the greater the
impact of fluctuating interest rates on the market value of the instrument. In
periods of rising interest rates, the market value of municipal obligations
generally declines in order to bring the current yield in line with prevailing
interest rates. Conversely, in periods of declining interest rates, the market
value of municipal obligations generally rises. Although fluctuating interest
rates affect the market value of all municipal obligations, short-term
obligations are generally less sensitive to such factors than long-term
obligations. During periods of rapidly rising interest rates, the Fund intends
to adopt various corrective measures (i.e., shortening the average length of
maturities of portfolio securities, raising the overall quality of portfolio
investments) in order to minimize the effect of such rates on per share net
asset value during such periods.
As a non-diversified investment company, the Fund could conceivably invest
all of its assets in one issuer. However, in order to qualify as a "regulated
investment company" for Federal income tax purposes, the Fund must comply with
the provisions of Subchapter M of the Internal Revenue Code of 1986, as amended
(the "Code"), which limit the aggregate value of all holdings (except U.S.
Government and cash items, as defined in the Code), each of which exceeds 5% of
the Fund's total assets, to an aggregate amount of 50% of such assets, and which
further limit the holdings of a single issuer (with the same exceptions) to 25%
of the Fund's total assets. Therefore, for our purposes, non-diversification
means that, with regard to the Fund's total assets, 50% of such assets may be
invested in as few as two single issuers. (These limits are measured at the end
of each quarter.) In the event of decline of creditworthiness or default on the
obligations of one or more such issuers exceeding 5%, an investment in the Fund
will involve greater risk than in a fund that has a policy of diversification.
Many of the Fund's portfolio securities will be obligations which are
related in such a way that an economic, business or political development or
change affecting one such security also would affect the other portfolio
securities (e.g., securities the interest on which is paid from revenues of
similar types of projects). As a result, the Fund's portfolio may be subject to
greater risk as compared to a portfolio composed of more varied obligations or
issuers. Furthermore, the relatively high degree of similarities among the
issuers of obligations in the Fund's portfolio may result in a greater degree of
fluctuation in the market value of the portfolio. To offset such fluctuations,
Fund management will attempt to adopt a temporary defensive posture during
periods of economic difficulty affecting either the economy as a whole or, more
specifically, individual issuers involved in the Fund's portfolio. Such practice
may include, among other modifications, reducing or eliminating holdings in
securities of issuers such as state and local governments which the Fund
believes may be adversely affected by changing economic conditions or political
events, shortening average maturity and/or upgrading the average quality of the
Fund's portfolio. These defensive measures may have the effect of reducing the
income to the
6
<PAGE>
Fund from the portfolio. Moreover, notwithstanding the imposition of such
measures, Fund management may not be able to foresee developments in the economy
sufficiently in advance to avoid significant declines in market value. To the
extent that the Fund is in a temporary defensive posture, the Fund's objective
may not be achieved.
Municipal Obligations
Municipal obligations include debt obligations of states, territories and
possessions of the United States and of any political subdivisions thereof, such
as counties, cities, towns, districts and authorities. Municipal obligations are
issued to raise funds for a variety of purposes, including construction of a
wide range of public facilities, refunding of outstanding obligations, obtaining
funds for general operating expenses, and lending to other public institutions
and facilities. In addition, certain types of qualified private activity bonds
are issued by, or on behalf of, public authorities to obtain funds for privately
operated facilities.
Also included within the definition of municipal obligations are short-term,
tax-exempt debt obligations, known as municipal notes, which are generally
issued in anticipation of receipt by the issuer of revenues from taxes, the
issuance of longer term bonds, or other sources. States, municipalities, and
other issuers of tax-exempt securities may also issue short-term debt, often for
general purposes, known as "municipal commercial paper." All of these
obligations (excluding those just referred to as "municipal commercial paper")
are included within the term "municipal obligations," as used in this
Prospectus, if their interest payments are excluded for Federal income tax
purposes.
Yields on municipal obligations depend on a variety of factors, including
the general condition of the money and municipal securities markets, the size of
a particular offering, the maturity of the obligation and the rating of the
issue. Unlike other types of securities, municipal obligations have
traditionally not been subject to regulation by, or registration with, the
Securities and Exchange Commission.
The two principal classifications of municipal obligations are general
obligation bonds and revenue bonds. General obligation bonds are secured by the
issuer's pledge of its full faith, credit and taxing power for the payment of
principal and interest. Revenue bonds are payable from only the revenues derived
from a particular facility or class of facilities or, in some cases, from the
proceeds of a special excise tax or other specific revenue source. Qualified
private activity bonds that are municipal obligations are, in most cases,
revenue bonds and do not generally constitute the pledge of the credit of the
issuer of such bonds. The credit quality of qualified private activity bonds is
usually related to the credit standing of the industrial user involved. The Fund
reserves the right to invest up to 20% of its total assets in qualified private
activity bonds, if such bonds meet the Fund's investment criteria.
There are also a variety of hybrid and special types of municipal
obligations, as well as numerous differences in the security of municipal
obligations, both within and between the two principal classifications described
above (see the Statement of Additional Information for more details).
Portfolio Transactions and Turnover
The Manager provides the Fund with investment advice and recommendations for
the purchase and sale of portfolio securities. All orders for the purchase and
sale of portfolio securities are placed by the Manager, subject to the general
control of the Fund's directors. The Manager may sell portfolio securities prior
to their maturity if market conditions and other considerations indicate, in the
opinion of the Manager, that such sale would be advisable. In addition, the
Manager may engage in short-term trading when it believes it is consistent with
the Fund's investment objective. Also, a security may be sold and another of
comparable quality may be simultaneously purchased to take advantage of what the
Manager believes to be a temporary disparity in the normal yield relationships
of two securities. The frequency of portfolio transactions-the Fund's turnover
rates-will vary from year to year depending upon market conditions. Because a
high turnover rate (over 100%) increases transaction costs and the possibility
of taxable short-term gains (see "Dividends and Tax Matters"), the Manager
weighs the added costs of short-term investment against anticipated gains. The
Fund's portfolio turnover rate was approximately 347% for the year ended
December 31, 1996, and was approximately 399% for the year ended December 31,
1997.
7
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INVESTMENT STRATEGIES
In seeking to achieve its investment objective, the Fund utilizes various
investment strategies, including borrowing to purchase additional securities,
investing in participation interests, variable and floating rate instruments,
purchasing municipal obligations that are offered on a "when-issued" or "delayed
delivery" basis and, when deemed necessary in the opinion of Fund management,
making temporary investments in certain taxable obligations, as described below.
The Fund's fundamental investment restrictions also permit buying and selling of
interest rate futures contracts ("futures contracts"), using options to purchase
or sell such contracts, using options to purchase or sell debt securities, and
writing covered call options and cash-secured puts. The use of options and
futures contracts may benefit the Fund and its shareholders by improving the
Fund's liquidity and by helping to stabilize the value of its net assets. In
addition, the Fund is permitted to enter into repurchase agreement and reverse
repurchase agreement transactions, to lend its portfolio securities and to
invest up to 15% of its net assets in illiquid securities.
Each investment strategy is briefly described below with a short example of
how it can be used by the Fund.
Futures Contracts
A futures contract is an agreement between two parties to buy and sell a
security for a set price on a future date. Futures contracts are traded on
designated "contract markets" which, through their clearing corporations,
guarantee performance of the contracts. Presently, there are futures contracts
based on such debt securities as long-term U.S. Treasury Bonds, Treasury Notes,
Government National Mortgage Association modified pass-through mortgage-backed
securities, three-month U.S. Treasury Bills, and bank certificates of deposit.
Although most futures contracts call for actual delivery or acceptance of debt
securities, the contracts usually are closed out before the settlement date
without the making or taking of delivery. A futures contract sale is closed out
by effecting a futures contract purchase for the same aggregate amount of the
specific type of debt security and the same delivery date. If the sale price
exceeds the offsetting purchase price, the seller would be paid the difference
and would realize a gain. If the offsetting purchase price exceeds the sale
price, the seller would pay the difference and would realize a loss. Similarly,
a futures contract purchase is closed out by effecting a futures contract sale
for the same aggregate amount of the specific type of debt security and the same
delivery date. If the offsetting sale price exceeds the purchase price, the
purchaser would realize a gain, whereas if the purchase price exceeds the
offsetting sale price, the purchaser would realize a loss. There is no assurance
that the Fund will be able to enter into a closing transaction. In the unlikely
event that the Fund was unable to enter into a closing transaction of an open
futures or options position, the Fund could be forced to perform certain actions
as specified by the futures or options contract. This would depend on the type
of outstanding contract involved. The two types of methods by which futures and
options contracts are closed in the absence of offsetting trades are by index
value and by delivery.
Futures and options contracts in financial instruments such as municipal
bonds and LIBOR rates, settle by index value. That means that on the last
trading day of the contract, all outstanding contracts are automatically closed
out at the value of the index that day. The effect on the Fund would be exactly
the same as if a closing transaction had been effected at that price.
Futures and options in financial instruments such as Treasury bonds and
notes, if not closed out, will result in actual delivery of the securities in
question. The holder of a long futures contract or an option contract that was
exercised could be forced to purchase (take delivery of) a specified amount of
securities at a specified price. Likewise the entity that was short a futures
contract or option that did not enter into a closing transaction prior to
expiration, could be forced to deliver a specific amount of securities at a
specified price according to the terms of the futures or option contract.
The inability of the Fund to enter into a closing contract could result in
the Fund being forced to deliver or take delivery of a specific amount of
securities at a specific price. Disposing of or obtaining the specified
securities could involve considerable expense to the Fund and could affect the
Fund's net asset value.
When the futures contract is entered into, each party deposits with a broker
or in a segregated custodial account approximately 5% of the contract amount,
called the "initial margin." The segregated custodial account will be in an
amount equal to the total market value of the futures contract, less the initial
margin deposited therefor. Subsequent payments to and from the broker or
account, called "variation margin," will be made on a daily basis as the price
of the underlying debt security fluctuates making the long and short positions
of the futures contract more or less valuable, a process known as "mark to the
market."
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The purpose of a futures contract, in the case of a portfolio holding
long-term municipal debt securities, is to gain the benefit of changes in
interest rates without actually buying or selling long-term debt securities.
Generally, if market interest rates increase, the value of outstanding debt
securities declines (and vice versa). Entering into a futures contract for the
sale of debt securities has an effect similar to the actual sale of such
securities, although the sale of the futures contract might be accomplished more
easily and quickly given the greater liquidity in the futures market. For
example, if the Fund holds long-term debt securities and it anticipates a rise
in long-term interest rates, it could, in lieu of disposing of its portfolio
securities, enter into futures contracts for the sale of similar long-term
securities. If rates increased and the value of the Fund's portfolio securities
declined, the value of the Fund's futures contracts would increase, thereby
protecting the Fund by preventing net asset value from declining as much as it
otherwise would have declined. Similarly, entering into futures contracts for
the purchase of debt securities has an effect similar to the actual purchase of
the underlying securities, but permits the continued holding of securities other
than the underlying securities. For example, if the Fund expects long-term
interest rates to decline, it might enter into futures contracts for the
purchase of long-term securities in order to gain rapid market exposure that may
offset anticipated increases in the cost of securities it intends to purchase,
while continuing to hold higher-yield, short-term securities or waiting for the
long-term market to stabilize. The Board of Directors has adopted a percentage
restriction limiting the aggregate market value of the futures contracts the
Fund holds to an amount not to exceed 20% of the market value of its total
assets.
Options
An option gives the holder a right to buy or sell futures contracts, or
securities, in the future. The Fund will only buy options listed on national
securities exchanges except for agreements, sometimes called cash puts, which
may accompany the purchase of a new issue of bonds from a dealer. Unlike a
futures contract, which requires the parties to the contract to buy and sell a
security on a set date, an option on a futures contract, for example, merely
entitles its holder to decide on or before a future date whether to enter into
such a contract. If the holder decides not to enter into the contract, all that
is lost is the price, called the "premium," paid for the option. Further,
because the value of the option is fixed at the point of sale, there are no
daily cash payments to reflect the change in the value of the underlying
contract. However, since an option gives the buyer the right to enter into a
contract at a set price for a fixed period of time, its value does change daily,
and the change is reflected in the net asset value of the Fund.
In addition to options on futures contracts, there are options that give the
buyer the right to buy or sell actual debt securities, such as tax-exempt bonds.
Currently, the market for options on tax-exempt securities is very small. It is
anticipated that it will become substantially larger in the future. A put option
gives the buyer of the option the right to sell a designated security for a set
price, and a call option gives the buyer the right to buy a security for a set
price on or before a specified date. The "writer," or seller, of a call option,
for example, is required to sell the security described in the option to the
holder of the option, if the holder decides to buy such security. For
undertaking this obligation, the writer receives a premium, less the commission
charged by a broker, which the writer retains regardless of whether the option
is exercised. The Fund will only write call options on securities it holds in
its portfolio, (referred to as covered call writing) or will write "cash secured
puts," as defined below. The buyer of such a put pays the Fund a premium for the
option to sell to the Fund a specific bond at a specified price within a
specified period of time. The Fund will maintain adequate cash reserves to
purchase the underlying bond should the put option be exercised, by placing in a
segregated account, only liquid assets, such as cash, U.S. Government securities
or other appropriate high-grade debt obligations ("cash secured puts"). The Fund
retains the premium whether or not the option is exercised. However, the Fund
will be obligated to purchase the bond at the exercise price regardless of how
much the market value of the bond has declined below the exercise price. As a
covered call option writer, the Fund earns additional income from premiums, but
it risks losing any appreciation of the security covered by the option if
interest rates decline. Option writing can be used advantageously to generate
incremental income when the outlook is for relatively stable bond prices;
however, such income may be taxable. The aggregate market value of the options
on debt securities held or written by the Fund may not exceed 25% of the Fund's
total net assets. The risk involved in writing options (or selling futures) is
not limited to the value of the options, since the maximum potential loss to the
Fund is the cost of closing out the short options (or futures) positions which
theoretically has no limit. Participation in options transactions involves
certain risks (see "Special Risks").
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Investing in Other Investment Companies
The Fund may invest indirectly in municipal obligations by investing in
other investment companies. Such investments may involve the payment of premiums
above the net asset value of such issuers' portfolio securities, are subject to
limitations under the Investment Company Act of 1940 and are constrained by
market availability. As a shareholder in an investment company, the Fund would
bear its ratable share of that investment company's expenses, including its
advisory and administration fees. Fundamental Portfolio Advisors, Inc. has
agreed to waive its management (advisory) fees with respect to the portion of
the Fund's assets invested in shares of other open-end investment companies. The
Fund would continue to pay its own management fees and other expenses with
respect to its investments in shares of a closed-end investment company.
Repurchase Agreements
The Fund may enter into repurchase agreement transactions. Under a
repurchase agreement, the Fund acquires a debt instrument for a relatively short
period (usually not more than one week) subject to the obligation of the seller
to repurchase and the Fund to resell such debt instrument at a fixed price. The
resale price is in excess of the purchase price in that it reflects an
agreed-upon market interest rate effective for the period of time during which
the Fund's money is invested. The Fund's repurchase agreements will at all times
be fully collateralized in an amount at least equal to the purchase price
including accrued interest earned on the underlying securities. The instruments
held as collateral are valued daily, and as the value of instruments declines,
the Fund will require additional collateral. If the seller defaults and the
value of the collateral securing the repurchase agreement declines, the Fund may
incur a loss. Repurchase agreements are considered by the staff of the
Securities and Exchange Commission to be loans by the Fund.
Reverse Repurchase Agreements
The Fund may enter into reverse repurchase agreement transactions only in
amounts such that the total of the reverse repurchase agreements and all other
borrowings combined will not exceed 33-1/3% of the Fund's total assets at the
time it enters into a reverse repurchase agreement. Such transactions involve
the sale of securities held by the Fund, with an agreement that the Fund will
repurchase such securities at an agreed upon price and date. The Fund will
employ reverse repurchase agreements when necessary to meet unanticipated net
redemptions so as to avoid liquidating other portfolio investments during
unfavorable market conditions, or as a technique to enhance income. At the time
it enters into a reverse repurchase agreement, the Fund will place in a
segregated custodial account high-quality liquid debt securities having a dollar
value equal to the repurchase price. The Fund will utilize reverse repurchase
agreements when the interest income to be earned from portfolio investments is
greater than the interest expense incurred as a result of the reverse repurchase
transactions. Any reverse repurchase agreement entered into by the Fund
constitutes a borrowing, has leveraging effects and makes the Fund's net asset
value more volatile.
Lending of Portfolio Securities
In order to generate income, the Fund may lend its portfolio securities in
an amount up to 33-1/3% of total assets to broker-dealers, major banks or other
recognized domestic institutional borrowers of securities not affiliated with
the Manager. The borrower at all times during the loan must maintain cash or
cash equivalent collateral or provide to the Fund an irrevocable letter of
credit equal in value to at least 100% of the value of the securities loaned.
During the time portfolio securities are on loan, the borrower pays the Fund any
dividends or interest paid on such securities, and the Fund may invest the cash
collateral in high-grade, short-term, tax-exempt instruments and earn income, or
it may receive an agreed-upon amount of interest income from the borrower who
has delivered equivalent collateral or a letter of credit.
Temporary Investments
The Fund may from time to time invest a small portion of its total assets,
on a temporary basis, in high-grade fixed-income obligations, the interest on
which is subject to Federal, New York State and/or New York City income tax.
Such high-grade quality
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investments include obligations issued or guaranteed by the U.S. Government, its
agencies or instrumentalities, and obligations of domestic branches of U.S.
banks, including certificates of deposit and bankers' acceptances. A description
of high-grade municipal obligations is included in the Statement of Additional
Information.
Investments of this kind may be obtained by the Fund pending investment or
reinvestment in municipal obligations of the proceeds from the sale of Fund
shares or the sale by the Fund of portfolio securities. In addition, the Fund
may invest in highly liquid taxable obligations to avoid the necessity of
liquidating portfolio securities to meet redemptions by investors. Although
there are no specific limitations other than those imposed under the Code (see
"Dividends and Tax Matters") on the portion of Fund assets that may be invested
in taxable obligations, it is anticipated that on a 12-month average, taxable
obligations will constitute less than 10% of the value of the Fund's portfolio.
Fund management also anticipates that a cash reserve will be maintained for
purposes of meeting the day-to-day operating expenses of the Fund as well as
redemptions of Fund shares. Such cash reserve may be maintained in either
interest or non-interest bearing form, at the discretion of the Fund's
directors. Furthermore, if maintained in interest-bearing form, it is
anticipated that all or part of such interest will be subject to Federal, New
York State and/or New York City income tax. However, it is expected that, on a
12-month average, such reserve will constitute less than 5% of the Fund's total
assets.
Illiquid Securities
The Fund will not invest more than 15% of its net assets (taken at market
value) in illiquid securities, including repurchase agreements with maturities
in excess of seven days.
The Fund may invest in securities that are subject to restrictions on resale
because they have not been registered under the Securities Act of 1933 (the
"1933 Act"). These securities are sometimes referred to as private placements.
Although securities which may be resold only to "qualified institutional buyers"
in accordance with the provisions of Rule 144A under the 1933 Act are
technically considered "restricted securities", the Fund may purchase Rule 144A
securities without regard to the limitation on investments in illiquid
securities described above, provided that a determination is made that such
securities have a readily available trading market. Fund management will
determine the liquidity of Rule 144A securities under the supervision of the
Fund's Board of Directors. The liquidity of Rule 144A securities will be
monitored by Fund management and, if as a result of changed conditions, it is
determined that a Rule 144A security is no longer liquid, the Fund's holding of
illiquid securities will be reviewed to determine what, if any, action is
required to assure that the Fund does not exceed its applicable percentage
limitation for investments in illiquid securities.
Fund management anticipates that the market for certain restricted
securities such as inverse floaters that are created in the secondary market
will expand further as a result of this relatively new regulation and the
development of automated systems for the trading, clearing and settlement of
unregistered securities, as more institutions and dealers invest in and make
markets in these securities.
In reaching liquidity decisions, Fund management will consider, inter alia,
the following factors: (1) the frequency of trades and quotes for the security;
(2) the number of dealers wanting to purchase or sell the security and the
number of other potential purchasers; (3) dealer undertakings to make a market
in the security and (4) the nature of the security and the nature of the
marketplace trades (e.g., the time needed to dispose of the security, the method
of soliciting offers and the mechanics of the transfer).
When-lssued Purchases
Municipal securities are frequently offered on a "when-issued" basis. When
so offered, the price and coupon rate are fixed at the time the commitment to
purchase is made, but delivery and payment for the when-issued securities take
place at a later date. Normally, the settlement date occurs between 15-45 days
from the date of purchase. During the period between purchase and settlement, no
interest accrues to the purchase. The price that the Fund would be required to
pay may be in excess of the market value
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of the security on the settlement date. While securities may be sold prior to
the settlement date, the Fund intends to purchase such securities for the
purpose of actually acquiring them unless a sale becomes desirable for
investment reasons. At the time the Fund makes a commitment to purchase a
municipal security on a when-issued basis, it will record the transaction and
reflect the value of the security in determining its net asset value. That value
may fluctuate from day to day in the same manner as values of other municipal
securities held by the Fund. The Fund will establish a segregated account with
its custodian bank in which it will maintain cash or high-grade liquid debt
securities determined daily to be equal in value to its commitments for
when-issued securities. Generally, both the when-issued securities and the
securities held in the segregated account will tend to experience appreciation
when interest rates decline and depreciation when interest rates increase.
Accordingly, the purchase of when-issued securities may increase the volatility
of the Fund's net asset value. The Fund may invest in when-issued securities
without limitation.
At such time as the Fund is required to pay for when-issued securities, it
will meet its obligation from then-available cash flow, sale of the securities
held in the separate account, sale of other securities, or (although it would
not normally expect to do so) from the sale of the when-issued securities
themselves (which may have a market value greater or less than the Fund's
payment obligation). Sale of securities to meet such obligations carries with it
a greater potential for the realization of capital gains, which are not excluded
from gross income for Federal, state or local income tax purposes.
Delayed-Delivery Transactions
The Fund may buy and sell securities on a "delayed-delivery" basis, with
payment and delivery taking place at a future date. The market value of
securities purchased in this way may change before the delivery date, which
could affect the market value of the Fund's assets, and could increase
fluctuations in the Fund's yield and net asset value. Ordinarily, the Fund will
not earn interest on the securities purchased until they are delivered.
Participation Interests, Variable and Inverse Floating Rate Instruments
The Fund may purchase participation interests from financial institutions.
These participation interests give the purchaser an undivided interest in one or
more underlying municipal obligations.
The Fund may also invest in municipal obligations which have variable
interest rates that are readjusted periodically. Such readjustment may be based
either upon a predetermined standard, such as a bank prime rate or the U.S.
Treasury bill rate, or upon prevailing market conditions. Many variable rate
instruments are subject to redemption or repurchase at par on demand by the Fund
(usually upon no more than seven days' notice). All variable rate instruments
must meet the quality standards of the Fund. The Manager will monitor the
pricing, quality and liquidity of the variable rate municipal obligations held
by the Fund.
The Fund may purchase inverse floaters which are instruments whose interest
rates bear an inverse relationship to the interest rate on another security or
the value of an index. Changes in the interest rate on the other security or
index inversely affect the residual interest rate paid on the inverse floater,
with the result that the inverse floater's price will be considerably more
volatile than that of a fixed-rate bond. For example, a municipal issuer may
decide to issue two variable rate instruments instead of a single long-term,
fixed-rate bond. The interest rate on one instrument reflects short-term
interest rates. Typically, this component pays an interest rate that is reset
periodically through an auction process, while the interest rate on the other
instrument (the inverse floater) pays a current residual interest rate based on
the total difference between the total interest paid by the issuer on the
municipal obligation and the auction rate paid on the auction component. This
reflects the approximate rate the issuer would have paid on a fixed-rate bond,
multiplied by two, minus the interest rate paid on the short-term instrument.
Depending on market availability, the two portions may be recombined to form a
fixed-rate municipal bond. The Fund may purchase both the auction and the
residual components. (See "Special Risk Factors Relating to Inverse Floating
Rate Instruments").
The Fund may invest in municipal obligations that pay interest at a coupon
rate equal to a base rate, plus additional interest for a certain period of time
if short-term interest rates rise above a predetermined level or "cap". The
amount of such an additional interest payment typically is calculated under a
formula based on a short-term interest rate index multiplied by a designated
factor.
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The Fund may purchase various types of structured municipal bonds whose
interest rates fluctuate according to changes in other interest rates for some
period and then revert to a fixed rate. The relationship between the interest
rate on these bonds and the other interest rate or index may be direct or
inverse, or it may be based on the relationship between two other interest rates
such as the relationship between taxable and tax-exempt interest rates.
Borrowing For Investment and For Other Purposes
The Fund may borrow money from banks (including its custodian bank) or from
other lenders to the extent permitted under applicable law, for temporary or
emergency purposes, to meet redemptions or for purposes of leveraging and may
pledge its assets to secure such borrowings. Borrowing for investment increases
both investment opportunity and investment risk. Such borrowings in no way
affect the Federal or New York State tax status of the Fund or its dividends. If
the investment income on securities purchased with borrowed money exceeds the
interest paid on the borrowing, the net asset value of the Fund's shares will
rise faster than would otherwise be the case. On the other hand, if the
investment income fails to cover the Fund's costs, including the interest on
borrowings or if there are losses, the net asset value of the Fund's shares will
decrease faster than would otherwise be the case.
This is the speculative factor known as leverage.
The Investment Company Act of 1940 (the "1940 Act") requires the Fund to
maintain asset coverage of at least 300% for all such borrowings, and should
such asset coverage at any time fall below 300%, the Fund would be required to
reduce its borrowings within three days to the extent necessary to meet the
requirements of the 1940 Act. To reduce its borrowings, the Fund might be
required to sell securities at a time when it would be disadvantageous to do so.
In addition, because interest on money borrowed is a Fund expense that it
would not otherwise incur, the Fund may have less net investment income during
periods when its borrowings are substantial. The interest paid by the Fund on
borrowings may be more or less than the yield on the securities purchased with
borrowed funds, depending on prevailing market conditions.
SPECIAL RISKS
Special Risk Factors Relating to Non-Diversification
The Fund's portfolio is non-diversified (see "Investment Objective and
Policies") and may have greater risk than a diversified portfolio.
Special Risk Factors Relating to Futures and Options
There are certain risks in investing in options and interest rate futures
contracts. With respect to the use of futures contracts, although the Fund
intends to purchase or sell futures contracts only if there is an active market
for such contracts, no assurance can be given that a liquid market will exist
for any particular contract at any particular time. Many futures exchanges and
boards of trade limit the amount of fluctuation permitted in futures contract
prices during a single trading day. Once the daily limit has been reached in a
particular contract, no trades may be made that day at a price beyond that
limit. Futures contract prices could move to the daily limit for several
consecutive trading days with little or no trading, thereby preventing prompt
liquidation of futures positions and potentially subjecting the Fund to
substantial losses. If it is not possible, or the Fund determines not to close a
futures position in anticipation of adverse price movements, the Fund will be
required to make daily cash payments of variation margin. In such circumstances,
an increase in the value of the portion of the portfolio being hedged, if any,
may offset partially or completely losses on the futures contract.
In addition, no assurance can be given that the price of the securities
being hedged will correlate with the price movements in a futures contract and
thus provide an offset to losses on the futures contract. However, the risk of
imperfect correlation generally tends to diminish as the maturity date of the
futures contract approaches.
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The Manager could also be incorrect in its expectations about the direction
or degree of various interest rate movements in the time span within which the
movements take place. Predicting interest rate direction involves skills and
techniques different from those used in most investment strategies, and there is
no guarantee that such predictions will be accurate.
The risk the Fund assumes when it buys an option is the loss of the premium
paid for the option. In order to benefit from buying an option, the price of the
underlying security must change sufficiently to cover the premium paid, the
commissions paid, both in the acquisition of the option and in a closing
transaction, or the exercise of the option and subsequent sale of the underlying
security. (The Fund could enter into a closing transaction by purchasing an
option if it had previously sold one, or by selling an option if it had
previously bought one, with the same terms as the option previously acquired.)
Nevertheless, the price change in the underlying security does not assume a
profit, because prices in the options market may not reflect such a change.
The risk involved in writing options on futures contracts the Fund owns, or
on securities held in its portfolio, is that there could be an increase in the
market value of such contracts or securities. In such case, the option would be
exercised and the asset would be sold at a lower price than the cash market
price. To some extent, the risk of not realizing a gain could be reduced by
entering into a closing transaction. However, the cost of closing the option and
terminating the Fund's obligation might be more or less than the premium
received when it originally wrote the option. Further, the Fund might not be
able to close the option because of insufficient activity in the options market.
The risk involved in writing options (or selling futures) is not limited to the
value of the options, since the maximun potential loss to the Fund is the cost
of closing out the short options (or futures) positions which theoretically has
no limit.
Finally, in deciding whether to use futures contracts or options,
consideration must be given to brokerage commission costs, which are normally
higher than those associated with general securities transactions.
Special Risk Factors Relating to Lower Rated Municipal Bonds
You should carefully consider the relative risks of investing in the higher
yielding (and, therefore, higher risk) securities in which the Fund may invest.
These are bonds such as those rated Ba to Caa by Moody's or BB to CC by S&P,
Fitch or Duff or, if unrated, are judged by Fund management to be of comparable
quality. They generally are not meant for short-term investing and may be
subject to certain risks with respect to the issuing entity and to greater
market fluctuations than certain lower yielding, higher rated fixed-income
securities. Bonds rated Ba by Moody's are judged to have speculative elements;
their future cannot be considered as well assured and often the protection of
interest and principal payments may be very moderate. Bonds rated BB by S&P,
Fitch or Duff are regarded as having predominantly speculative characteristics
and, while such obligations have less near-term vulnerability to default than
other speculative grade debt, they face major ongoing uncertainties or exposure
to adverse business, financial or economic conditions which could lead to
inadequate capacity to meet timely interest and principal payments. Bonds rated
CC by S&P, Fitch or Duff are regarded as having the highest degree of
speculation; while such bonds may have some small degree of quality and
protective characteristics, these are outweighed by large uncertainties or major
risk exposures to adverse conditions. Bonds rated as low as Caa by Moody's may
be in default or may present elements of danger with respect to principal or
interest. The Fund will not purchase bonds in default.
Investments in bonds rated Ba or lower by Moody's and BB or lower by S&P,
Fitch or Duff, while generally providing greater income and opportunity for gain
than investments in higher rated bonds, usually entail greater risk of principal
and income (including the possibility of default or bankruptcy of the issuers of
such bonds), and may involve greater volatility of price (especially during
periods of economic uncertainty or change) than investments in higher rated
bonds. However, since yields may vary over time, no specific level of income can
be assured. These lower rated, high yielding securities generally tend to
reflect economic changes and short-term corporate and industry developments to a
greater extent than higher rated securities which react primarily to
fluctuations in the general level of interest rates. Lower rated securities will
also be affected by the market's perception of their credit quality (especially
during times of adverse publicity) and the outlook for economic growth. In the
past, economic downturns or an increase in interest rates have, under certain
circumstances, caused a higher incidence of default by the issuers of these
securities and may do so in the
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future, especially in the case of highly leveraged issuers. The prices for these
securities may be affected by legislative and regulatory developments. For
example, new Federal rules require that savings and loan associations gradually
reduce their holdings of high-yield securities. An effect of such legislation
may be to significantly depress the prices of outstanding lower rated high
yielding fixed-income securities. Factors adversely affecting the market price
and yield of these securities will adversely affect the Fund's net asset value.
In addition, the retail secondary market for these securities may be less liquid
than that of higher rated bonds; adverse conditions could make it difficult at
times for the Fund to sell certain securities or could result in lower prices
than those used in calculating the Fund's net asset value. Therefore, judgment
may at times play a greater role in valuing these securities than in the case of
investment grade fixed-income securities, and it also may be more difficult
during certain adverse market conditions to sell these lower rated securities at
their fair value to meet redemption requests or to respond to changes in the
market.
Special Risk Factors Relating to Zero Coupon Bonds
The Fund may invest in zero coupon bonds and pay-in-kind bonds (bonds which
pay interest through the issuance of additional bonds), which involve special
considerations. These securities may be subject to greater fluctuations in value
due to changes in interest rates than interest-bearing securities and thus may
be considered more speculative than comparably rated interest-bearing
securities. In addition, current Federal income tax law requires the holder of a
zero coupon security or of certain pay-in-kind bonds to accrue income with
respect to these securities prior to the receipt of cash payments. To maintain
its qualification as a regulated investment company and avoid liability for
Federal income taxes, the Fund may be required to distribute income accrued with
respect to these securities and may have to dispose of portfolio securities
under disadvantageous circumstances in order to generate cash to satisfy these
distribution requirements. Fund management anticipates that investments in zero
coupon securities and pay-in-kind bonds will not ordinarily exceed 25% of the
value of the Fund's total assets. (See "Additional Information Relating to Lower
Rated Securities" in the Statement of Additional Information.)
Special Risk Factors Relating to Inverse Floating Rate Instruments
Changes in interest rates inversely affect the rate paid on inverse floating
rate instruments ("inverse floaters"). The inverse floaters' price will be more
volatile than that of a fixed rate bond. Additionally, some inverse floaters
contain a "leverage factor" whereby the interest rate moves inversely by a
"factor" to the benchmark. For example, the rates on the inverse floating rate
note may move inversely at three times the benchmark rate. Certain interest rate
movements and other market factors can substantially affect the liquidity of
inverse floaters. These instruments are designed to be highly sensitive to
interest rate changes and may subject the holders thereof to extreme reductions
of yield and possibly loss of principal.
Special Risk Factors Relating to New York Issuers
You should carefully consider the special risks inherent in the Fund's
investment in municipal obligations of New York issuers. These risks result from
the financial condition of New York State and certain of its public bodies and
municipalities, including New York City. Beginning in early 1975, New York State
(the "State"), New York City (the "City") and other entities faced serious
financial difficulties which jeopardized the credit standing and impaired the
borrowing abilities of such entities and contributed to high interest rates on,
and lower market prices for, debt obligations issued by them. A recurrence of
such financial difficulties, as may be currently developing, or a failure of
certain financial recovery programs related thereto could result in defaults or
declines in the market values of various municipal obligations in which the Fund
may invest. If there should be a default or other financial crisis relating to
the State, the City, a State or City agency, or other municipality, the market
value and marketability of outstanding municipal obligations of New York issuers
in the Fund's portfolio and the interest income to the Fund could be adversely
affected. In addition, the effects of actual and proposed changes in Federal and
State tax laws, as well as the significant slowdown in the New York and regional
economy, have added substantial uncertainty to estimates of the State's tax
revenues, which resulted in the State's overestimate of General Fund tax
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receipts in the 1992 fiscal year by $575 million. The 1992 fiscal year was the
fourth consecutive year in which the State incurred a cash-basis operating
deficit in the General Fund and issued deficit notes. The State's 1992-93 fiscal
year, however, was characterized by national and regional economies that
performed better than projected in April 1992. National gross domestic product,
State personal income, and employment and unemployment in the State were
estimated to have performed better than originally projected in April 1992.
After reflecting a 1992-93 year-end deposit to the refund reserve account of
$671 million, reported 1992-93 General Fund receipts were $45 million higher
than originally projected in April 1992. If not for that year-end transaction,
General Fund receipts would have been $716 million higher than originally
projected. The State completed the 1994 fiscal year with an operating surplus of
$914 million. The State reported a General Fund operating deficit of $1.426
billion for the 1995 fiscal year. There can be no assurance that the State will
not face substantial potential budget gaps in future years. In 1990, Moody's and
S&P lowered their ratings of the State's general obligation debt from A-1 to A
and AA- to A, respectively. In addition, Moody's and S&P lowered their ratings
of New York's short-term notes from MIG-1 to MIG-2 and from SP-1+ to SP-1,
respectively. The rating changes reflected the rating agencies' concerns about
the State's financial condition, its heavy debt load and economic uncertainties
in the region. In February 1991, Moody's lowered its rating on New York City's
general obligation bonds from A to Baa1 and in July 1995, S&P lowered its rating
on such bonds from A+ to BBB+. On April 29, 1991, S&P downgraded the City's
general obligation revenue anticipation notes from SP-1 to SP-2, citing a budget
impasse at the State level that would leave the City at risk if the State was
unable to forward promised State aid before the end of the City's fiscal year
June 30. On January 6, 1992, Moody's lowered the ratings on certain
appropriation-backed debt of New York State and its agencies from A to Baa1. On
January 13, 1992, S&P lowered from A to A+ the ratings of New York State general
obligation bonds. The ratings of various agency debt, State moral obligations,
contractual obligations, lease purchase obligations and State guarantees also
were lowered. A complete discussion of the risks associated with investments in
obligations of New York issuers is contained in the Statement of Additional
Information.
A number of pending court actions have been brought against or involve the
State, its agencies, or other municipal subdivisions of the State, which actions
relate to financing, the use of tax or other revenues for the payment of
obligations and claims that would require additional public expenditures.
Adverse decisions in such cases could require extraordinary appropriations or
expenditure reductions or both and might have a materially adverse effect on the
financial condition of the State and its agencies and municipal subdivisions.
Any such adverse effect could affect, to some extent, all municipal securities
issued by the State, its agencies, or municipal subdivisions.
To the extent that State agencies and local governments seek special State
assistance, the ability of the State to pay its obligations as they become due
or to obtain additional financing could be adversely affected, and the
marketability of notes and bonds issued by the State, its agencies, and other
governmental entities may be impaired.
Other Considerations
It is expected that a substantial portion of the assets of the Fund will be
derived from professional money managers and investors who intend to invest in
the Fund as part of an asset-allocation or market-timing investment strategy.
These investors are likely to redeem or exchange their Fund shares frequently to
take advantage of anticipated changes in market conditions. The strategies
employed by investors in the Fund may result in considerable assets moving in
and out of the Fund. Consequently, the Company expects that the Fund will
generally experience significant portfolio turnover, which will likely cause
higher expenses and additional costs.
CALCULATION OF YIELD AND PERFORMANCE DATA
The Fund may from time to time include yield information in advertisements
or information furnished to existing or proposed shareholders. The Fund's yield
is computed by dividing the Fund's net investment income per share during a base
period of 30 days, or one month, by the net asset value per share of the Fund on
the last day of such base period. The resulting 30-day yield is then annualized
pursuant to the bond equivalent annualization method described below. The Fund's
net investment income per share is
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determined by dividing the Fund's net investment income during the base period
by the average number of shares of the Fund entitled to receive dividends during
the base period. The Fund's 30-day yield (computed as described above) is then
annualized by a computation that assumes the Fund's net investment income is
earned and reinvested for a six-month period at the same rate as during the
30-day base period and that the resulting six-month income will again be
generated over an additional period of six months.
The Fund may also advertise from time to time its taxable equivalent yield.
The Fund's taxable equivalent yield is determined by dividing that portion of
the Fund's yield (calculated as described above) that is tax-exempt by one minus
the stated marginal Federal income tax rate and adding the product to that
portion, if any, of the Fund's yield that is not tax-exempt.
The Fund may also furnish to existing or prospective shareholders
information concerning the average annual total return on an investment in the
Fund for a designated period of time. The average annual total return quotation
for a given period is computed by determining the average annual compounded rate
of return that would cause a hypothetical investment made on the first day of
the designated period (assuming all dividends and distributions are reinvested)
to equal the resulting net asset value of such hypothetical investment on the
last day of the designated period.
The yield and average annual total return quotations of the Fund do not take
into account any required payments for Federal or state income taxes.
The Fund's yield and average annual total return will vary from time to time
depending on market conditions, the composition of the Fund's portfolio, and the
Fund's operating expenses. These factors and possible differences in the methods
used in calculating yields and returns should be considered when comparing the
Fund's performance information to information published with respect to other
investment companies and other investment vehicles. Yields and return quotations
should also be considered relative to changes in the value of the Fund's shares
and the risks associated with the Fund's investment objective and policies. At
anytime in the future, yield and return quotations may be higher or lower than
past yields or return quotations, and there can be no assurance that any
historical yield or return quotation will continue in the future.
The Fund may also include comparative performance information in advertising
or marketing the Fund's shares. Such performance information may include data
from Lipper Analytical Services, Inc., and Morningstar, Inc., or other industry
publications.
For more information regarding the computation of yield or average annual
total return quotations, see the Statement of Additional Information.
PURCHASE OF SHARES
You may purchase shares directly from the Fund without a sales charge on any
day the New York Stock Exchange is open for business. The public offering price
for shares purchased is the net asset value per share of the Fund next
determined after a purchase order becomes effective. Orders for the purchase of
Fund shares become effective (i) immediately, if received prior to 4:00 P.M. New
York time on any business day. Shares being purchased will begin accruing
dividends on the day following the date of purchase and continue to earn
dividends until the date of redemption. Information regarding transmittal of
funds by bank wire and procurement of a Federal Reserve Draft may be obtained
from your bank. All payments (including checks from individual investors) must
be in U.S. dollars. If your check does not clear, Fundamental Shareholder
Services, Inc. will cancel your purchase and you could be liable for any losses
or fees incurred. Firstar Trust Company will charge a $20 fee against a
shareholders account for any payment check returned to the Custodian.
The minimum initial purchase is $1,000 and the minimum subsequent purchase
is $100. Subsequent investments are made in the same manner as an initial
purchase is made.
All shares purchased are confirmed to you and credited to your account at
the net asset value determined as described herein under the heading
"Determination of Net Asset Value." Share certificates are issued only on
written request by you to Fundamental Family of Funds, c/o Firstar Trust
Company, P.O. Box 701, Milwaukee, WI 53201-0701. There is no charge for share
certificates. Certificates are not issued
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for fractional shares. Certificates will only be issued in amounts of 1,000 or
more shares. The issuance of certificates may be discontinued at any time
without prior notice. The Fund reserves the right to reject any purchase order.
The Fund reserves the right to limit the number of purchase order checks
processed at any one time and will notify investors prior to exercising this
right. If this right is exercised, the Fund will return checks immediately.
Although shares of the Fund may be purchased without a sales charge if you
purchase them directly from the Fund, you may be charged a fee for effecting
transactions in the Fund's shares through securities dealers, banks, or other
financial institutions.
The Fundamental Automatic Investment Program offers a simple way to maintain
a regular investment program. The Fund has waived the initial investment minimum
for you when you open a new account and invest $100 or more per month through
the Fundamental Automatic Investment Program. The Program permits an existing
shareholder to purchase additional shares of any Fund (minimum $50 per
transaction) at regular intervals. Under the Automatic Investment Program,
shares are purchased by transferring funds from a shareholder's checking or bank
money market account in an amount of $50 or more designated by the shareholder.
At the shareholder's option, the account designated will be debited and shares
will be purchased on the date selected by the shareholder. There must be a
minimum of seven days between automatic purchases. If the date selected by the
shareholder is not a business day, funds will be transferred the next business
day thereafter. Only an account maintained at a domestic financial institution
which is an Automated Clearing House member may be so designated. To establish
an Automatic Investment Account, complete and sign Section F of the Purchase
Application and send it to the Transfer Agent. Shareholders may cancel this
privilege or change the amount of purchase at any time by calling 1-800-322-6864
or by mailing written notification to: Fundamental Family of Funds, c/o Firstar
Trust Company, P.O. Box 701, Milwaukee, WI 53201-0701. The change will be
effective five business days following receipt of notification by the Transfer
Agent. A Fund may modify or terminate this privilege at any time or charge a
service fee, although no such fee currently is contemplated. However, a $20 fee
will be imposed by Firstar Trust Company if sufficient funds are not available
in the shareholder's account at the time of the automatic transaction.
While investors may use this option to purchase shares in their IRA or other
retirement plan accounts, neither Fundamental Service Corporation nor the
Transfer Agent will monitor the amount of contributions to ensure that they do
not exceed the amount allowable for Federal tax purposes. Firstar Trust Company
will assume that all retirement plan contributions are being made for the tax
year in which they are received.
Methods of Payment
Payment by Wire: An expeditious method of investing in the Fund is through the
transmittal of Federal funds by bank wire to Firstar Bank Milwaukee, N.A. (the
"Bank"). Federal funds transmitted by bank wire to the Bank and received by it
prior to 4:00 P.M. New York time are priced at the net asset value determined on
such day. Federal funds received after 4:00 P.M. New York time will be available
on the next business day. Funds other than Federal funds transmitted by bank
wire may or may not be converted into Federal funds on the day received by the
Bank depending upon the time the funds are received and the bank wiring the
funds. We encourage you to make payment by wire in Federal funds. The Fund will
not be responsible for delays in the wiring system.
To purchase shares by wiring funds, instruct a commercial bank to wire your
money to:
Firstar Bank Milwaukee, N.A.
777 East Wisconsin Avenue
Milwaukee, Wisconsin 53202
ABA # 075000022
Credit: Firstar Trust Company
Account # 112952137
Further credit: The Fundamental Family of Funds
Name of shareholder and account number (if known)
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Instructions for new accounts should specify the name, address, and social
security number of each person in whose name the shares are to be registered and
the name of the Fund. If you are an existing shareholder, you need only furnish
your account number and the name of the Fund. Failure to submit required
information may delay investment.
Payment by Mail: Purchase orders for which remittance is to be made by check
may be submitted directly by mail to Fundamental Family of Funds, c/o Firstar
Trust Company, P.O. Box 701, Milwaukee, WI 53201-0701. The U.S. Postal Service
and other independent delivery services are not agents of the Fund. Therefore,
deposit of purchase requests in the mail or with such services does not
constitute receipt by Firstar Trust Company or the Fund. Please do not mail
letters by overnight courier to the post office box address. Purchase requests
sent by overnight or express mail should be directed to: Fundamental Family of
Funds, c/o Firstar Trust Company, Mutual Fund Services, Third Floor, 615 East
Michigan Street, Milwaukee, Wisconsin 53202. Checks should be made payable to
Fundamental Family of Funds.
When opening a new account, you must enclose a completed purchase
application. If you are an existing shareholder, you should enclose the
detachable stub from an account statement you have received or otherwise
indicate your account number and the name of the Fund.
Personal Delivery: For personal delivery instructions, please call the Fund
at (800) 322-6864.
Exchange for Municipal Securities: If you own municipal obligations meeting
the criteria for investment by the Fund, you may exchange such securities for
shares of the Fund. All such exchanges are discretionary with the Fund. If you
desire to make such an exchange, you should contact the Fund prior to delivering
any securities in order to establish that the securities are acceptable for
exchange, to determine what transaction charges, if any, may be imposed and to
obtain delivery instructions for such securities. The value of the securities
being exchanged will be determined in the same manner that the value of the
Fund's portfolio securities is determined (see "Determination of Net Asset
Value"); the specific method of determining the value will be provided to you on
request. The Fund reserves the right to refuse any such exchange, even if the
securities offered by an investor meet the general investment criteria of the
Fund. A capital gain or loss for Federal income tax purposes may be realized by
the investor following the exchange. Maturing bonds or detached coupons
submitted within five (5) business days of the payment date are credited on the
payment date.
Exchange Privilege. For your convenience, the Exchange Privilege permits you
to purchase shares in any of the other funds for which Fundamental Portfolio
Advisors, Inc. acts as the investment manager in exchange for shares of the Fund
at respective net asset values per share. Exchange instructions may be given in
writing to Firstar Trust Company, Agent, P.O. Box 701, Milwaukee, WI 53201-0701,
the Fund's transfer agent, and must specify the number of shares of the Fund to
be exchanged and the fund into which the exchange is being made. The telephone
exchange privilege will be made available to shareholders automatically. You may
telephone exchange instructions by calling Firstar Trust Company at (800)
322-6864. Before any exchange, you must obtain, and should review, a copy of the
current prospectus of the fund into which your exchange is being made.
Prospectuses may be obtained by calling or writing the Fund. See also "Telephone
Redemption Privilege" for a discussion of the Fund's policy with respect to
losses resulting from unauthorized telephone transactions.
The Exchange Privilege is only available in those states where such
exchanges can legally be made and exchanges may only be made between accounts
with identical account registration and account numbers. Prior to effecting an
exchange, you should consider the investment policies of the fund in which you
are seeking to invest. Any exchange of shares is, in effect, a redemption of
shares in one fund and a purchase of the other fund. You may recognize a capital
gain or loss for Federal income tax purposes in connection with an exchange. The
Exchange Privilege may be modified or terminated by the Fund after giving 60
days prior notice. The Fund reserves the right to reject any specific order,
including purchases by exchange.
A Completed Purchase Application must be received by the Transfer Agent
before the Exchange, Check Redemption, Telephone Redemption or Expedited
Redemption Privileges may be used.
REDEMPTION OF SHARES
Shares of the Fund are redeemable at your option without charge at the next
determined net asset value following receipt by Firstar Trust Company of a
redemption request in proper order. To effect a redemption, you may utilize the
Check Redemption Privilege,
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the Telephone Redemption Privilege, the Expedited Redemption Privilege, or the
regular redemption procedure. Due to the cost of maintaining an account, the
Fund reserves the right to redeem an account involuntarily, on not less than 60
days' written notice, at any time an investor has reduced his or her account to
less than $100. During the 60-day period, a shareholder may increase his or her
holdings to $100 or more, and thereby avoid an involuntary redemption.
When redemption requests are received by Firstar Trust Company by 4:00 P.M.
New York time on any day during which the net asset value is determined (see
"Determination of Net Asset Value"), the redemption will be effective on such
day, and payment will be made on the next business day based on the net asset
value next determined after receipt of the redemption instruction. If a
redemption notice is received after 4:00 P.M. New York time, the redemption will
be effective on the next business day, and payment will be made thereafter on
the second business day. In the event you wish to liquidate your holdings, you
will be entitled to all dividends declared through the date of redemption. At
times, the Fund may be requested to redeem shares for which it has not yet
received good payment. The Fund may delay, or cause to be delayed, the mailing
of a redemption check until such time as it has assured itself that good payment
has been received from the purchase of such shares, which may take up to 15 days
from the purchase date. In the case of payment by check, the determination of
whether the check has been paid by the paying institution generally takes up to
seven days, but may take longer. You may avoid this delay by purchasing shares
by wire or by using a certified or official bank check drawn on a U.S. bank. In
the event of delays in payment of redemption proceeds, the Fund will take all
available steps to expedite collection of the investment check. If shares were
purchased by check, you may write checks against such shares only after 15 days
from the date the purchase was executed. Shareholders who draw against shares
purchased fewer than 15 days from the date of original purchase, will be charged
usual and customary bank fees. The Fund reserves the right to suspend the right
of redemption or postpone the day of payment (1) during any period when the New
York Stock Exchange is closed (other than customary weekend and holiday
closings), (2) when the trading markets normally used by the Fund are restricted
or an emergency exists as determined by the Securities and Exchange Commission
(the "Commission") as to make the disposal of the Fund's investments or
determination of its net asset value unreasonably impracticable, or (3) for such
other periods as the Commission by order may permit to protect the Fund's
shareholders.
You may realize a taxable capital gain or loss when shares are redeemed,
depending on their net asset value. On all redemption requests (including
redemption checks) for joint accounts, the signatures of all joint owners are
required unless shareholders have designated otherwise.
Check Redemption Privilege
You may request that the Fund provide you with redemption checks ("Checks")
drawn on the Fund's account by either (i) completing the appropriate section of
the application order form or (ii) subsequent written request to the Fund. These
Checks will be sent only to the individuals in whose name the account is
registered and only to the address of record with the Fund. You may use the
Checks in any lawful manner and make them payable to the order of any person or
company in an amount of $100 or more. Dividends continue to be earned until the
Check clears the Fund account and is paid by Firstar Trust Company. The Fund may
delay, or cause to be delayed, payment of redemption proceeds until such time as
it or Firstar Trust Company has assured itself that good payment has been
collected for the purchase of such shares. In addition, the Fund reserves the
right not to honor Check redemption requests received by Firstar Trust Company
within 15 days from the purchase date if the shares to be redeemed have been
purchased by check. You will be subject to the same rules and regulations that
the Bank applies to checking accounts in general. There is currently no charge
to you for the use of the Checks, except that Firstar Trust Company imposes a
$20 charge if an investor requests that it stop payment of a Check or if it
cannot honor a Check due to insufficient funds or other valid reasons.
When a Check is presented for payment, Firstar Trust Company, as your agent,
will cause the Fund to redeem a sufficient number of shares in your account to
cover the amount of the Check. Shares for which stock certificates have been
issued may not be redeemed by Check. Since the net asset value of the Fund's
shares changes daily, you should make certain that the total value of your
account is sufficient to cover the amount of your Check. Otherwise, the Check
will be returned marked insufficient funds. Checks may not be used to close an
account. The Check Redemption Privilege may be modified or terminated by either
the Fund or Firstar Trust Company upon 60 days' written notice to shareholders.
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Telephone Redemption Privilege
You may direct redemptions of up to $150,000 worth of shares per day by
telephone either (i) by completing the appropriate section of the application
form or (ii) by later signature guaranteed* written request. Telephone calls
will be recorded. Firstar Trust Company will act on instructions that it
reasonably believes to be genuine. The proceeds of the redemption will only be
mailed to the address of record with the Fund, or a preauthorized bank address.
(Available only if established on the account application and if there has been
no change of address by telephone within the preceding 30 days.) The Fund
reserves the right to refuse a telephone redemption and may limit the amount and
frequency. The Telephone Redemption Privilege may be modified or terminated at
any time by either the Fund or Firstar Trust Company. Neither the Fund nor its
transfer agent will be liable for following instructions that they reasonably
believe to be genuine. It is the Fund's policy to provide that a written
confirmation statement of all telephone call transactions be mailed to
shareholders at their address of record within 3 business days after the
telephone call transaction. You should verify the accuracy of telephone call
transactions immediately upon receipt of your confirmation statement. As a
result of this policy, you will bear the risk of loss in the event of a
fraudulent telephone exchange or redemption transaction.
Expedited Redemption Privilege
Requests for expedited redemption may be made by letter or telephone for
amounts equal to or exceeding $5,000, if you have previously filed with Firstar
Trust Company a signed telephone authorization form available from the Fund, or
completed the appropriate Section of the Application Form. If the request is for
more than $5,000, proceeds of the expedited redemption will be transferred by
Federal Reserve wire to the commercial bank specified in the authorization form
or to a correspondent bank if your bank is not a member of the Federal Reserve
System. Firstar Trust Company charges a $12 service fee for each payment of
redemption proceeds made by Federal wire. This fee will be deducted from your
account. If the correspondent bank fails to notify your bank immediately, there
could be a delay in crediting the funds to your bank account. Proceeds of less
than $5,000 will be mailed to your address. The Fund reserves the right to
refuse an expedited redemption and may limit the amount and frequency.
This privilege may be modified or terminated at any time without prior
notice by either the Fund or Firstar Trust Company. Any time funds are wired by
the Bank, the proceeds of redemption may be subject to the deduction of the
Bank's usual and customary charges for wiring funds.
Requests by letter should be addressed to Fundamental Family of Funds, c/o
Firstar Trust Company, P.O. Box 701, Milwaukee, WI 53201-0701.
In order to qualify to use the Expedited Redemption Privilege, you must
complete the appropriate portion of the new account application and your initial
payment for purchase of the Fund's shares must be drawn on, and redemption
proceeds paid to, the same bank and account as designated on the application.
In order to change the commercial bank or account designated to receive the
redemption proceeds, you must send a written request to Fundamental Family of
Funds, c/o Firstar Trust Company, P.O. Box 701, Milwaukee, WI 53201-0701. Such
request must be signed by each shareholder with each signature guaranteed by an
eligible guarantor (see above).
- --------------
*A signature guarantee must be from an eligible guarantor institution approved
by Fundamental Shareholder Services, Inc. Signature guarantees in proper form
generally will be accepted from domestic banks, a member of a national
securities exchange, credit unions and savings associations, as well as from
participants in the Securities Transfer Agents Medallion Program ("STAMP"). If
you have any questions with respect to signature guarantees, please call the
transfer agent at (800) 322-6864.
Regular Redemption Procedure
You may redeem your shares by sending a written request, together with duly
endorsed stock certificates, if any, to Fundamental Fundamental Family of Funds,
c/o Firstar Trust Company, P.O. Box 701, Milwaukee, WI 53201-0701. All
certificates and all written requests for redemption must be endorsed by you.
For redemptions exceeding $50,000 (and for all written redemption requests,
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<PAGE>
regardless of amount, made within 30 days following any change in account
registration), your endorsement must be signature guaranteed, as described
above. Firstar Trust Company may, at its option, request further documentation
from corporations, executors, administrators, trustees or guardians. If
requested, redemption proceeds of more than $5,000 will be wired into any member
bank of the Federal Reserve System. However, such transaction may be subject to
a deduction of the Bank's usual and customary charges for wiring funds. The Fund
will accept other suitable verification arrangements for foreign investors. The
U.S. Postal Service and other independent delivery services are not agents of
the Fund. Therefore, deposit of redemption requests in the mail or with such
services does not constitute receipt by Firstar Trust Company or the Fund.
Please do not mail letters by overnight courier to the post office box address.
Redemption requests sent by overnight or express mail should be directed to:
Fundamental Family of Funds, c/o Firstar Trust Company, Mutual Fund Services,
Third Floor, 615 East Michigan Street, Milwaukee, Wisconsin 53202. Redemptions
by mail will not become effective until all documents in the form required have
been received by Firstar Trust Company.
Requests for redemption subject to any special condition, or which specify
an effective date other than as provided herein, cannot be accepted and will be
returned to you.
How to Transfer Shares
Shares may be transferred from one person to another by sending to Firstar
Trust Company a written request for such transfer, signed by the registered
owner(s) exactly as the account is registered with each signature guaranteed as
described above, with (i) the name(s) of the new registered owner(s), (ii) the
social security number or taxpayer identification number for the new
registration, and (iii) the redemption option elected. If the shares being
transferred are represented by certificates in the possession of the investor,
such certificates, properly signed with signature guarantees, must also be
forwarded to Firstar Trust Company. In addition, Firstar Trust Company reserves
the right to request any additional documents that may be required for transfer
by corporations, executors, administrators, trustees, and guardians.
Reopening an Account
You may reopen an account with a minimum investment of $100 or more without
filing a new application form during the year in which your account was closed
or during the following calendar year, provided that the information on your
original form is still applicable. The Fund may require you to file a statement
that all information on the original account application form remains
applicable.
DETERMINATION OF NET ASSET VALUE
The net asset value per share is determined as of the close of trading on
the New York Stock Exchange (currently 4:00 P.M., New York time) on each day
that both the New York Stock Exchange and the Fund's custodian bank are open for
business and on any other day during which there is a sufficient degree of
trading in the Fund's portfolio securities that the Fund's net asset value might
be materially affected by changes in the value of its portfolio securities,
unless there have been no shares tendered for redemption or orders to purchase
shares received. The net asset value per share is computed by taking the value
of all assets of the Fund, subtracting the liabilities of the Fund, and dividing
by the number of outstanding shares. For purposes of determining net asset
value, expenses of the Fund are accrued daily and taken into account.
The value used by the Fund in computing the current price per share for the
purpose of purchase and redemption of Fund shares (the net asset value per
share) means an amount which reflects calculations to the nearest 1/10th of one
cent.
The Fund's portfolio securities are valued on the basis of prices provided
by an independent pricing service when, in the opinion of persons designated by
the Fund's trustees, such prices are believed to reflect the fair market value
of such securities. Prices of non-exchange traded portfolio securities provided
by independent pricing services are generally determined without regard to bid
or last
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sale prices but take into account institutional size trading in similar groups
of securities, yield, quality, coupon rate, maturity, type of issue, trading
characteristics and other market data. Securities traded or dealt in upon a
securities exchange and not subject to restrictions against resale as well as
options and futures contracts listed for trading on a securities exchange or
board of trade are valued at the last quoted sales price, or, in the absence of
a sale, at the mean of the last bid and asked prices. Options not listed for
trading on a securities exchange or board of trade for which over-the-counter
market quotations are readily available are valued at the mean of the current
bid and asked prices. Money market and short-term debt instruments with a
remaining maturity of 60 days or less will be valued on an amortized cost basis.
Municipal daily or weekly variable rate demand instruments will be priced at par
value plus accrued interest. Securities not priced in a manner described above
and other assets are valued by persons designated by the Fund's trustees using
methods which the trustees believe accurately reflects fair value. The prices
realized from the sale of these securities could be less than those originally
paid by the Fund or less than what may be considered the fair value of such
securities.
Included in the portfolio of the Fund in determining net asset value is the
value of all when-issued securities that the Fund has committed itself to
purchase. However, the Fund's ability to purchase such securities remains
constant (see "Investment Objective and Policies").
The Fund's most recent asset value can be obtained by calling
1-800-322-6864 7 days a week, 24 hours a day. To obtain more detailed
information on the Fund's net asset value, yield, performance and portfolio
composition you can call 1-800-322-6864 weekdays 9:00 AM-8:00 PM Eastern time.
DlSTRlBUTlON EXPENSES
The Board of Directors and shareholders of the Fund have approved a plan of
distribution under Rule 12b-1 of the 1940 Act (the "Plan"). Pursuant to the
Plan, the Fund may pay certain promotional and advertising expenses and may
compensate certain registered securities dealers and financial institutions for
services provided in connection with processing orders for the purchase or
redemption of Fund shares, and for furnishing other shareholder services.
The Fund's Board of Directors approved the continuance of the Fund's Plan
for a period of sixty days following the date of its expiration in contemplation
of a transaction pursuant to which Tocqueville Asset Management L.P. would
assume management of the assets of the Fund. Otherwise, the Plan would have
expired on April 1, 1998. See ("Management").
Payments by the Fund shall not, in the aggregate, in any fiscal year of the
Fund, exceed one-half of 1% of daily net assets of the Fund for expenses
incurred in distributing and promoting the Fund's shares. The Plan will make
payments only for expenses actually incurred by such dealers and financial
institutions. Under the Plan, unreimbursed covered distribution expenses may be
carried forward for three consecutive fiscal years (without interest or any type
of finance or service charges) in the event such expenses exceed on an
annualized basis the amount that may be paid under the Plan in any one fiscal
year. If the Plan is terminated in accordance with its terms, the obligation of
the Fund to make payments pursuant to the Plan, including any prior expenses
carried forward, will cease and the Fund will not be required to make any
payments for expenses incurred after the date the Plan terminates. The Fund may
enter into shareholder processing and service agreements ("Shareholder Service
Agreements") with any securities dealer who is registered under the Securities
Exchange Act of 1934 and is a member in good standing of the National
Association of Securities Dealers, Inc., and with banks and other financial
institutions that may wish to establish accounts or sub-accounts on behalf of
their customers ("Shareholder Service Agents"). The Fund may pay such
Shareholder Service Agents for their services, and to cover expenses in
connection with advertising, sales literature and other promotional materials on
behalf of the Fund, and the fees payable therefor will be reviewed quarterly by
the Fund's Board of Directors. See "Distribution Plan" in the Statement of
Additional Information for more details.
The Board of Directors of the Fund, including a majority of the
disinterested directors who have no direct or indirect financial interest in the
operation of the Plan or any agreements relating thereto, authorized the Fund to
enter into an agreement with Fundamental Service Corporation, a Delaware
corporation, under the Plan. The agreement provides that the Fund may pay the
usual and customary agency's commission to Fundamental Service Corporation for
producing and placing Fund advertising in newspapers,
23
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magazines, or other periodicals, on radio or television, or in direct marketing
campaigns. In addition to the foregoing, the Fund may pay Fundamental Service
Corporation for marketing research and promotional services specifically
relating to the distribution of Fund shares, including employment expenses and
support services of personnel primarily responsible for responding to inquiries
from prospective investors.
The Plan will continue from year to year if specifically approved annually
by the Board of Directors of the Fund and the affirmative vote of a majority of
the directors who are not interested persons of the Fund, and with no direct or
indirect financial interest in the Plan, by votes cast in person at a meeting
called for such purpose. The Plan may not be amended to increase the maximum
amount of payments by the Fund without shareholder approval, and all material
amendments to the provisions of the Plan must be approved by a vote of the Board
of Directors and the directors who have no direct or indirect interest in the
Plan, cast in person at a meeting called for the purpose of such vote.
The Plan provides that Fund management shall provide, and the independent
directors shall review, quarterly reports setting forth the amounts expended
pursuant to the Plan and the purpose for which the amounts were expended. It
further provides that while the Plan is in effect, the selection and nomination
of those directors of the Fund who are not interested persons of the Fund, is
committed to the discretion of the independent directors. During the year ended
December 31, 1997, the Fund paid $647,839 under the Plan, including $307,200
paid to Fundamental Service Corporation under the Plan.
NASD Regulation, Inc. ("NASDR") entered into a Letter of Acceptance, Waiver
and Consent with Fundamental Service Corporation that imposed a total of
$125,000 in fines and other stipulated sanctions on Fundamental Service
Corporation and two of its officers for distributing advertising materials for
Fundamental U.S. Government Strategic Income Fund that NASDR deemed to be false
and misleading. Fundamental Service Corporation neither admitted nor denied the
allegations and filed a Mitigation Statement in response to the Letter of
Acceptance, Waiver and Consent.
The Glass-Steagall Act and other applicable laws, among other things,
generally prohibit Federally chartered or supervised banks from engaging in the
business of underwriting, selling, or distributing securities. Accordingly, the
Fund will engage banks as Shareholder Service Agents to perform only
administrative and shareholder servicing functions. While the matter is not free
from doubt, Fund management believes that such laws should not preclude a bank
from acting as a Shareholder Service Agent performing the above-referenced
administrative and shareholder servicing functions. However, judicial or
administrative decisions or interpretations of such laws, as well as changes in
either Federal or state statutes or regulations relating to the permissible
activities of banks or their subsidiaries or affiliates, could prevent a bank
from continuing to perform all or part of its servicing activities. If a bank
were prohibited from so acting, shareholder clients would be permitted to remain
as Fund shareholders and alternative means for continuing the servicing of such
shareholders would be sought. In such event, changes in the operation of the
Fund might occur, and shareholders serviced by such bank might no longer be able
to avail themselves of services then being provided by such a bank. It is not
expected that shareholders would suffer any adverse financial consequences as a
result of any of these occurrences.
MANAGEMENT
Under the laws of the State of Maryland, the Board of Directors is
responsible for managing the business and affairs of the Fund. Acting pursuant
to an investment management agreement adopted by the Board of Directors of the
Fund on October 3, 1990 and approved by shareholders on November 29, 1990,
Fundamental Portfolio Advisors, Inc. (the "Manager") serves as the investment
manager of the Fund. Its principal place of business is 90 Washington Street,
New York, NY 10006. The Manager has been providing investment advisory services
to the Fundamental Family of Funds since it was founded in 1986.
The Fund's Board of Directors approved the continuance of the Fund's current
Management Agreement for a period of sixty days following the date of its
expiration in contemplation of the consummation of a transaction pursuant to
which Tocqueville Asset Management L.P. ("Tocqueville") would assume management
of the assets of the Fund. Otherwise, the Management Agreement would have
expired on April 1, 1998. Tocqueville is the investment adviser to the
Tocqueville Funds.
24
<PAGE>
It is anticipated that shareholders of the Fund will be asked to consider
and approve an Agreement and Plan of Reorganization providing for the transfer
of the Fund's assets to a separate, newly-created Tocqueville Fund having the
same investment policies and objectives as those of the Fund at a special
meeting of shareholders scheduled to be held in late Spring. Subsequent to the
filing with the Securities and Exchange Commission of preliminary proxy
solicitation materials seeking shareholder approval of the Agreement and Plan of
Reorganization at the special meeting of shareholders, the Manager filed two
preliminary proxy statements with the Securities and Exchange Commission, one
opposing the transaction pursuant to which Tocqueville would assume management
of the assets of the Fund; the second, proposing to replace the two independent
Board Members of the Fundamental Funds and the election of six new nominees to
the Fund's Board (in addition to Vincent J. Malanga, a current Board Member).
The Manager manages and supervises the Fund's investment portfolio and
directs the purchase and sales of its investment securities. The Manager
utilizes an investment committee to manage the assets of the Fund. The committee
is currently composed of the following members: Vincent J. Malanga, a portfolio
strategist affiliated with the Manager and Jane Tubis, a trading assistant
affiliated with the Manager.
Vincent J. Malanga is, and has been for more than the past five years,
Chairman of the Board, Chief Executive Officer, President and Treasurer of the
Fundamental Family of Funds. He is, and has been for more than the past five
years, President, Treasurer, and a Director of the Manager, Executive Vice
President, Secretary and a Director of Fundamental Service Corporation (the
Distributor for certain of the Fundamental Family of Funds) and President of
LaSalle Economics, Inc., an economic consulting firm, and a managing director of
LaSalle Portfolio Management, Inc., a commodity trading adviser.
Jane Tubis is, and has been for more than the past five years, a trading
assistant with the Manager.
The Agreement provides that the Manager shall, at its own expense, furnish
to the Fund office space in the offices of the Manager or in such other place as
may be agreed upon from time to time, and all necessary office facilities,
equipment and personnel for managing the affairs and investments and supervising
the keeping of the Fund's books and shall arrange, if desired by the Fund, for
all directors and executive officers of the Manager's organization to serve as
officers or directors of the Fund. Under the terms of the Agreement, the Manager
assumes and shall pay or reimburse the Fund for: (1) the compensation (if any)
of the directors of the Fund who are affiliated with, or "interested persons"
of, the Manager and all officers of the Fund as such; and (2) all expenses not
specifically assumed by the Fund where such expenses are incurred by the Manager
or by the Fund in connection with the management of the investment and
reinvestment of the assets of the Fund, and the management of the affairs of the
Fund.
Under the terms of the Agreement, the following expenses, among others,
incurred in the operation of the Fund, will be borne by the Fund (1) charges and
expenses for determining from time to time the value of the net assets of the
Fund and the keeping of its books and records; (2) charges and expenses of
auditors; (3) charges and expenses of any custodian, transfer agent, plan agent,
dividend-disbursing agent, and registrar appointed by the Fund; (4) brokers'
commissions, and issue and transfer taxes, chargeable to the Fund in connection
with securities transactions to which the Fund is a party; (5) insurance
premiums, interest charges, dues and fees for membership in trade associations,
and all taxes and fees payable by the Fund to Federal, state, or other
governmental agencies; (6) the cost of share certificates representing shares of
the Fund; (7) fees and expenses involved in registering and maintaining
registrations of the Fund and of its shares with the Commission, including the
preparation of prospectuses for filing with the Commission and any application
for exemption whether or not relating to, or directed toward, the sale of the
Fund's shares; (8) all expenses of shareholders and directors meetings and of
preparing, printing, and distributing notices, proxy statements, and all reports
to shareholders and to governmental agencies; (9) charges and expenses of legal
counsel to the Fund; (10) compensation of those directors of the Fund as such
who are not affiliated with or "interested persons" of the Manager or the Fund
(other than as directors); (11) fees and expenses incurred pursuant to a plan
adopted pursuant to Rule 12b-1 under the 1940 Act; and (12) such nonrecurring or
extraordinary expenses as may arise, including litigation affecting the Fund and
any indemnification by the Fund of its directors, officers, employees, or agents
with respect thereto.
Pursuant to the Agreement, the Manager will provide the Fund with advice
and recommendations in the choice of investments and will execute the Fund's
security transactions. These services will be under the supervision of Dr.
Vincent J. Malanga, as director,
25
<PAGE>
president-treasurer, and chief executive officer of the Fund. The Agreement
provides that the Manager shall, subject to the supervision of the Board of
Directors of the Fund, generally attend, direct, and manage the affairs of the
Fund. In consideration for such services, the Fund has agreed to pay the Manager
an annual fee, accrued daily and paid monthly, at the following rate on the
average daily closing net asset value of the Fund:
Net Asset Value Annual Rate
- --------------------------------------------------------------------------------
For assets up to $100,000,000 50/100 of 1%
For assets in excess of S100,000,000 up to S200,000,000 48/100 of 1%
For assets in excess of $200,000,000 up to $300,000,000 46/100 of 1%
For assets in excess of $300,000,000 up to $400,000,000 44/100 of 1%
For assets in excess of $400,000,000 up to $5OO,OOO,OOO 42/100 of 1%
For assets in excess of $500,000,000 40/100 of 1%
Under the Agreement, the Manager is required to reimburse the Fund an amount
not exceeding the amount of fees payable to the Manager under the Agreement for
any fiscal year, if, and to the extent that the aggregate operating expenses of
the Fund for any fiscal year (including the fees payable to the Manager, but
excluding interest expenses, taxes, brokerage fees and commissions, expenses
paid pursuant to the Plan, and extraordinary expenses beyond the control of the
Manager) exceed, on an annual basis, 1.5% of the average daily net assets of the
Fund. During the year ended December 31, 1996, the Manager received fees from
the Fund in the amount of $787,962, which represented .49% of the Fund's average
net assets.
The Agreement terminates upon assignment and may be terminated without
penalty on 60 days' written notice by a vote of the majority of the Fund's Board
of Directors or by the holders of a majority of the Fund's outstanding shares.
Unless earlier terminated as described above, the Agreement will continue in
effect from year to year if its continuance is approved at least annually (1) by
the Board of Directors of the Fund or the vote of the holders of a majority of
the outstanding shares of the Fund and (2) in either event, by a majority of the
directors of the Fund who are not parties to the Agreement or "interested
persons" of any such party, by votes cast in person at a meeting called for the
purpose of voting on such approval.
On September 30, 1997, the Securities and Exchange Commission (the
"Commission") instituted administrative proceedings against the Manager,
Fundamental Service Corporation, and Drs. Lance M. Brofman and Vincent J.
Malanga (the "Parties"). The Commission's Order instituting the proceedings
alleges, among other things, certain violations of the Federal securities laws,
including the antifraud provisions, for failing to disclose the risks associated
with investments in inverse floating rate notes made on behalf of the
Fundamental U.S. Government Strategic Income Fund (the "Government Fund") in
1993 and 1994, marketing the Government Fund in a way that was contrary to the
administration of the Government Fund, exceeding the Government Fund's portfolio
duration of three years or less as stated in its prospectus, and failing to
disclose the Manager's soft dollar practices to the Fundamental Fund Boards. A
hearing has been scheduled to determine whether the allegations against the
Parties are true, and if so, whether remedial action is appropriate. Counsel to
the Parties have indicated that the Parties intend to vigorously contest the
charges. The Manager has indicated that the institution of the proceedings
against the Parties has not adversely affected the ability of the Manager or
Fundamental Service Corporation to continue to perform the day-to-day affairs of
the Fundamental Funds.
The Manager and Fundamental Service Corporation (on behalf of certain of
their directors, officers, shareholders, employees and control persons) (the
"Indemnitees") received payments during the fiscal year ended December 31, 1997
from three of the Fundamental Funds for attorneys' fees incurred by them in
defending certain proceedings. The payments were as follows: Fundamental U.S.
Government Strategic Income Fund (approximately $232,500); New York Muni Fund
(approximately $50,000); and the California Muni Fund (approximately $4,000).
Upon learning of the payments, the independent Board Members of the Fundamental
Funds directed that the Indemnitees return all of the payments to the Funds or
place them in escrow pending their receipt of an opinion of an independent legal
counsel to the effect that the Indemnitees are entitled to receive them.
26
<PAGE>
On April 30, 1998, the Indemnitees placed $106,863 into an escrow account
pending clarification of certain legal issues. The Manager and Fundamental
Service Corporation have asserted that they waived fees during the year ended
December 31, 1997 and that the amount placed in escrow should be net of any
reimbursements already made to the Funds in the form of fees forgone. Upon
learning that $106,863 was placed into an escrow account on behalf of the Funds,
the independent Board Members referred the Manager and Fundamental Service
Corporation to their prior directive and asked that the entire amount of all
payments received by such entities ($286,500) be placed into said escrow
account. For further information, see Notes to the December 31, 1997 Financial
Statements of Fundamental U.S. Government Strategic Income Fund, New York Muni
Fund and the California Muni Fund, attached to the Statement of Additional
Information.
To assist in the investment management of the Funds following the transfer
of portfolio management responsibilities from the Fund's former portfolio
manager to an investment committee, the Manager arranged for Mr. Christopher P.
Culp to join the investment committee responsible for the selection of specific
securities which the Fund may invest, hold, sell or exchange. Mr. Culp, a
portfolio co-manager affiliated with Tocqueville Asset Management L.P., joined
Dr. Vincent J. Malanga, a portfolio strategist affiliated with the Manager, and
Jane Tubis, a trading assistant affiliated with the Manager, as members of the
investment committee. Mr. Culp served on the Manager's investment committee on
an interim basis without compensation from February 18, 1997 until August 27,
1997, acting as the principal portfolio manager of the Fund. He did so in his
capacity as an employee of Fundamental, representing to the Boards that he was
working without salary or other compensation. At the same time, he continued to
be employed by Tocqueville Asset Management L.P.
Between April 17, 1997 and July 24, 1997, Mr. Culp engaged Tocqueville
Securities L.P. ("Tocqueville Securities"), an affiliate of Tocqueville, as
agent, to effect eight separate over-the-counter purchase transactions of
municipal obligations on behalf of the Fund. The Fund's Board has concluded that
the commissions paid to Tocqueville Securities in connection with these
transactions (a portion of which was paid to Mr. Culp) were not justified and
that the Fund bore unnecessary expenses as a result of the sale of its
securities to another party and the subsequent repurchase of them through
Tocqueville Securities. Based upon a report initiated by Tocqueville Securities
and prepared by the Fund's independent auditors, and upon the Board's own
analysis, the Board directed that the Manager terminate Mr. Culp's services as a
portfolio manager. At the Board's request and in order to reimburse the Fund for
all of its losses, Tocqueville Securities, on September 15, 1997, voluntarily
paid $260,000 to the Fund, an amount which significantly exceeds the total
commissions ($184,920.60) received by Tocqueville Securities in connection with
these transactions. The staff of the Commission and the Department of NASD
Regulation have been informed of these events by Tocqueville Securities.
The Fund, its Manager and Fundamental Service Corporation have agreed, in an
assurance of discontinuance (the "assurance") entered into with the Department
of Law of the State of New York, to refrain from making certain statements about
the Fund's investment objectives in advertisements and sales materials and to
disclose more about the risks involved in certain of the Fund's investment
strategies, particularly with respect to certain investment strategies employed
by the Fund that may differ from or may result in an increased level of risk not
present in some other tax-exempt mutual funds.
In addition, the Fund has agreed to establish a portfolio review committee,
consisting of no less than three independent directors of the Fund, to oversee
the Fund's investment performance and strategies, internal controls and
procedures, Prospectus review and compliance with the investment policies stated
therein, and review of annual and semi-annual reports to shareholders (See
"Management of the Fund-Portfolio Review Committee" in the Statement of
Additional Information). The Fund has also agreed to submit new sales material
for certain specified time periods to the staff of the Department of Law (the
"staff") for prior review and to submit to the staff, copies of any shareholder
complaints and Fund filings with, or submissions to, the Commission or the
National Association of Securities Dealers, Inc.
The assurance also requires (i) that a portfolio composition report
portraying the Fund's (a) principal asset categories, (b) use of leverage, (c)
effective portfolio duration or sensitivity to interest rate risk and (d) credit
ratings of portfolio securities be included in the Fund's annual and semi-annual
reports to shareholders and that a portfolio composition report be delivered to
potential investors along with the Fund's Prospectus.
27
<PAGE>
For further information concerning the management of the Fund, see the
Fund's Statement of Additional Information under the caption "Management of the
Fund."
Portfolio Brokerage
It is the Fund's policy to seek execution of its purchases and sales at the
most favorable prices through responsible broker-dealers and in agency
transactions, at competitive commission rates. The Fund's brokerage allocation
policy may permit the Fund to pay a broker-dealer which furnishes research
services a higher commission than that which might be charged by another
broker-dealer which does not furnish research services, provided that such
commission is deemed reasonable in relation to the value of the services
provided by such broker-dealer (see the Statement of Additional Information for
a complete discussion of the Fund's brokerage allocation policy). It is not the
Fund's practice to allocate principal business on the basis of sales of Fund
shares which may be made through brokers or dealers, although broker-dealers
effecting purchases of Fund shares for their customers may participate in
principal transactions or brokerage allocation. The Fund may, however, allocate
principal business or brokerage to obtain for the benefit of the Fund services
that the Fund would otherwise have to pay for directly.
The Fund's directors have authorized the Manager to effect portfolio
transactions on an agency basis with affiliated broker-dealers, subject to
quarterly determination of compliance by the board, including a majority of the
independent directors and have adopted certain procedures incorporating the
standards of Rule 17e-1 of the 1940 Act, which requires, among other things,
that the commissions paid to any affiliated broker-dealer must be "reasonable
and fair compared to the commission, fee, or other remuneration received, or to
be received, by other brokers in connection with comparable transactions
involving similar securities during a comparable period of time."
DIVIDENDS AND TAX MATTERS
Dividends and Distributions
The Fund declares all of its net investment income as a dividend, on a daily
basis, prior to calculating net asset value, on shares of record at the close of
business on the preceding day. Dividends are distributed monthly. Capital gains,
if any, will normally be distributed in December of each fiscal year of the
Fund. The amounts paid, and distribution dates thereof, are subject to
determination by the Fund's Board of Directors. All dividends paid and capital
gains distributed are paid in additional shares of the Fund's common stock,
which are credited to the shareholder's account. If you desire to receive such
distribution in cash, you must file an election with Firstar Trust Company,
which election will remain in effect until Firstar Trust Company is notified by
you in writing to change the election, at least ten (10) days prior to payment
date. Distributions declared in the months of October, November or December will
be treated as received by shareholders of record in such months as of December
31 even if they are not paid until the following January. Certificates will not
be issued for dividend distributions.
Tax Matters
The Fund intends to qualify as a regulated investment company by satisfying
the requirements under Subchapter M of the Code, including requirements with
respect to diversification of assets, distribution of income and sources of
income. It is the Fund's policy to distribute to shareholders all of its
investment income (net of expenses) and any capital gains (net of capital
losses) in accordance with the timing requirements imposed by the Code, so that
the Fund will satisfy the distribution requirement of Subchapter M and will not
be subject to Federal income tax or the 4% excise tax.
If the Fund fails to satisfy any of the Code requirements for qualification
as a regulated investment company, it will be taxed at regular corporate tax
rates on all its taxable income (including capital gains) without any deduction
for distributions to shareholders, and distributions to shareholders will be
taxable as ordinary dividends (even if derived from the Fund s net long-term
capital gains) to the extent of the Fund's current and accumulated earnings and
profits.
28
<PAGE>
The Fund intends to invest principally in tax-exempt municipal obligations
so that distributions by the Fund of its net tax-exempt interest income can be
designated as exempt-interest dividends, which are excludable from gross income
for Federal income tax purposes. However, shareholders are required to report
the receipt of exempt-interest dividends, together with other tax-exempt
interest, on their Federal income tax returns. In addition, these
exempt-interest dividends may be subject to the Federal alternative minimum tax
and will be taken into account in determining the portion, if any, of Social
Security benefits received which must be included in gross income for Federal
income tax purposes. Further, interest or indebtedness incurred or continued to
purchase or carry shares of the Fund (which indebtedness likely need not be
directly traceable to the purchase or carrying of such shares) will not be
deductible for Federal income tax purposes. Finally, a shareholder who is (or is
related to) a "substantial user" of a facility financed by industrial
development bonds held by the Fund will likely be subject to tax on dividends
paid by the Fund that are derived from interest on such bonds.
A small portion of the Fund's net investment income may under certain
circumstances be taxable, and distributions thereof, as well as distributions of
any net capital gain will be taxable to shareholders. Distributions by the Fund
of its taxable net investment income and the excess, if any, of its net
short-term capital gain over its net long-term capital loss are taxable to
shareholders as ordinary income. Such distributions are treated as dividends for
Federal income tax purposes but do not qualify for the 70% dividends-received
deduction for corporate shareholders. Distributions by the Fund of the excess,
if any, of its net long-term capital gain over its net short-term capital loss
are designated as capital gains dividends and are taxable to shareholders as
long-term capital gains, regardless of the length of time shareholders have held
their shares.
Tax-exempt interest on specified private activity bonds issued after August
7, 1986, is treated as a tax preference item for purposes of the Federal
alternative minimum tax ("AMT"). Thus, corporate and individual shareholders may
incur an AMT liability as a result of receiving exempt-interest dividends from
the Fund to the extent such dividends are attributable to interest from such
private activity bonds. In addition, because all exempt-interest dividends are
included in a corporate shareholder's adjusted current earnings (which is used
in computing a separate preference item for corporations), corporate
shareholders may incur an AMT liability as a result of receiving any
exempt-interest dividends from the Fund.
Distributions to shareholders will be treated in the same manner for Federal
income tax purposes whether received in cash or reinvested in additional shares
of the Fund. In general, distributions by the Fund are taken into account by the
shareholders in the year in which they are made. However, certain distributions
made during January will be treated as having been paid by the Fund and received
by the shareholders on December 31 of the preceding year.
Investors should carefully consider the tax implications of purchasing
shares just prior to the record date of any ordinary income dividend or capital
gain dividend. Those investors purchasing shares just prior to an ordinary
income or capital gain dividend will be taxed on the entire amount of the
dividend received, even though the net asset value per share on the date of such
purchase reflected the amount of such dividend and such dividend economically
constitutes a return of capital to such investors.
A shareholder will recognize gain or loss upon the sale or redemption of
shares of the Fund in an amount equal to the difference between the proceeds of
the sale or redemption and the shareholder's adjusted tax basis in the shares.
Any loss realized upon a taxable disposition of shares within six months from
the date of their purchase will be treated as a long-term capital loss to the
extent of any capital gain dividends received on such shares. All or a portion
of any loss realized upon a taxable disposition of shares of the Fund may be
disallowed if other shares of the Fund are purchased within 30 days before or
after such disposition.
If a shareholder is a non-resident alien or foreign entity shareholder,
ordinary income dividends paid to such shareholder generally will be subject to
United States withholding tax at a rate of 30% (or lower rate under an
applicable treaty). We urge non-United States shareholders to consult their own
tax adviser concerning the applicability of the United States withholding tax.
Under the backup withholding rules of the Code, certain shareholders may be
subject to 31% withholding of Federal income tax on ordinary income dividends
paid by the Fund. In order to avoid this backup withholding, a shareholder must
provide the Fund with a
29
<PAGE>
correct taxpayer identification number (which for most individuals is his or her
Social Security number) or certify that it is a corporation or otherwise exempt
from or not subject to backup withholding.
The exclusion from gross income for Federal income tax purposes of
exempt-interest dividends does not necessarily result in exclusion under the
income or other tax laws of any state or local taxing authority. However, to the
extent that exempt-interest dividends are derived from interest received by the
Fund on obligations of New York State, its political subdivisions or its duly
constituted authorities, they will be exempt from New York State and City
personal income taxes for a New York resident individual shareholder.
Exempt-interest dividends will not be excluded in determining New York State or
City franchise taxes applicable to corporations or financial institutions.
Statements regarding the tax status of distributions by the Fund will be
mailed annually by Firstar Trust Company. In the event that a distribution may
not be wholly excludable from gross income for Federal income tax purposes or
exempt from New York State and City personal income taxes, the statement will
provide information about the tax-exempt percentage, which may vary from
distribution to distribution.
The foregoing discussion of Federal income tax consequences is based on tax
laws and regulations in effect on the date of this Prospectus, and is subject to
change by legislative or administrative action. As the foregoing discussion is
for general information only, a prospective shareholder should also review the
more detailed discussion of Federal income tax considerations relevant to the
Fund that is contained in the Statement of Additional Information. In addition,
each prospective shareholder should consult with his own tax adviser as to the
tax consequences of investments in the Fund, including the application of state
and local taxes which may differ from the Federal income tax consequences
described above.
GENERAL INFORMATION
The Company, which was incorporated under the laws of the State of New York
on January 30, 1980, and which was reorganized as a Maryland corporation on
December 31, 1990, is an open-end, non-diversified management investment
company. The Fund's fiscal year begins January 1 and ends December 31. On April
24, 1996, the Company changed its name from New York Muni Fund, Inc. to
Fundamental Funds, Inc.
Annual and semi-annual reports of the Fund, together with the list of
securities held by the Fund in its portfolio, are mailed to each shareholder.
The Company is authorized to issue 1,000,000,000 shares of common stock, par
value $.001 per share, of which 500,000,000 shares are designated "New York Muni
Fund Series" and the balance of which are unclassified. All shares of the Fund
are entitled to equal participation in dividends and distributions declared by
the Fund and in its net assets on liquidation remaining after satisfaction of
all outstanding liabilities. The Fund's shares are fully paid and non-assessable
when issued and have no preemptive rights. Holders of common stock are entitled
to one vote for each full share and to such fraction of a vote that corresponds
to any fractional shares. The Fund will not normally hold annual shareholders'
meetings. Shareholders may remove directors from office by a majority of votes
entitled to be cast at a meeting of shareholders. Shareholders holding 10% or
more of the Fund's outstanding stock may call a special meeting of shareholders.
The Code of Ethics of Fundamental Portfolio Advisors, Inc. and the Fund
prohibits all affiliated personnel from engaging in personal investment
activities which compete with or attempt to take advantage of the Fund's planned
portfolio transactions. The objective of the Code of Ethics of both the Fund and
Fundamental Portfolio Advisors, Inc. is that their operations be carried out for
the exclusive benefit of the Fund's shareholders. Both organizations maintain
careful monitoring of compliance with the Code of Ethics.
The custodian for the assets of the Fund is Firstar Trust Company. Firstar
Trust Company also performs all services in connection with the transfer of the
shares of the Fund. Shareholder inquiries concerning the status of an account
should be directed to Firstar Trust Company by calling (800) 322-6864.
30
<PAGE>
This Prospectus omits certain information contained in the Fund's
Registration Statement, filed with the Securities and Exchange Commission.
Copies of the Registration Statement, including items omitted herein, may be
obtained from the Commission by paying the charges prescribed under its rules
and regulations. The Statement of Additional Information included in such
Registration Statement may be obtained without charge from the Fund.
APPENDIX
For the fiscal year ended December 31, 1997, the Fund's asset composition,
based on the monthly weighted average of credit ratings of portfolio securities,
was as follows:
S&P or Percentage of Percentage of assets
Moody's assets rated by unrated but determined to
Rating rating agency be of comparable quality*
- ------ ------------- -------------------------
AAA or Aaa 59.6% 0%
AA or Aa 1.3% 0%
A 13.4% 0%
BBB or Baa 19.2% 0%
BB or Ba 0% 0%
B 0% 0%
Below B 0% 6.5%
- --------------
*6.5% of the Fund's assets was invested in unrated securities during the fiscal
year ended December 31, 1997. Unrated securities are not necessarily
lower-quality securities. Issuers of municipal securities frequently choose not
to incur the expense of obtaining a rating. Please refer to the Fund's
Statement of Additional Information for a more complete discussion of these
ratings.
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(left column)
NEW YORK MUNI FUND(R)
90 Washington Street
New York NY 10006
1-800-225-6864
Transfer Agent
Firstar Trust Company
P.O. Box 701
Milwaukee, WI 53201-0701
1-800-322-6864
Counsel to the Fund
Kramer, Levin, Naftalis &Frankel
New York, New York
Independent Auditors
McGladrey &Pullen, LLP
New York, New York
No person has been authorized to give any information or
to make any representations other than those contained in
this Prospectus and in the Fund's official sales literature in
connection with the offer of the Fund's shares, and, if
given or made, such other information or representations
must not be relied upon as having been authorized by the
Fund. This Prospectus does not constitute an offer in any
State in which, or to any person to whom, such offering
may not lawfully be made.
(right column)
NEW YORK MUNI FUND(R)
Prospectus
May 1, 1998
NEW YORK (logo) MUNI FUND
(logo) FUNDAMENTAL
Family of Funds
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Rule 497(c)
Registration No. 2-82710
STATEMENT OF ADDITIONAL INFORMATION
NEW YORK MUNI FUND
90 Washington Street
New York, New York 10006
(800) 322-6864
NEW YORK MUNI FUND (the "Fund") is a series of Fundamental
Funds, Inc.(the "Company"), a Maryland corporation. The Fund seeks to provide a
high level of income that is excluded from gross income for Federal income tax
purposes and exempt from New York State and New York City personal income taxes
and is consistent with the preservation of capital. Of course, there can be no
assurance that this investment objective will be achieved. The Fund intends to
achieve its objective through investing primarily in municipal obligations of
New York State, its political subdivisions, and its other duly constituted
authorities and corporations, that are rated within the four highest quality
grades for bonds as determined by Moody's Investors Service, Inc.("Moody's"),
Standard & Poor's Corporation ("S&P"), Fitch Investors Service, Inc.("Fitch") or
Duff & Phelps, Inc.("Duff") or within the three highest quality grades for
municipal notes as determined by Moody's, S&P, Fitch or Duff or, if unrated, are
judged by Fund management to be of comparable quality. While municipal
obligations in these categories are generally deemed to have adequate to very
strong protection of principal and interest, municipal obligations rated within
the lowest of these categories may have speculative characteristics as well.
This Statement of Additional Information provides certain
detailed information concerning the Fund. It is not a Prospectus and should be
read in conjunction with the Fund's current Prospectus, a copy of which may be
obtained by writing to The Fund at the address listed above, or by calling (800)
322-6864. Shareholder inquiries may also be placed through this number.
THIS STATEMENT IS DATED MAY 1, 1998 AND
SUPPLEMENTS THE FUND'S PROSPECTUS OF THE SAME DATE.
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TABLE OF CONTENTS
PAGE
INVESTMENT OBJECTIVE, POLICIES AND RESTRICTIONS........................... 3
ADDITIONAL INFORMATION RELATING TO MUNICIPAL OBLIGATIONS.................. 6
ADDITIONAL INFORMATION RELATING TO LOWER RATED SECURITIES................. 9
ADDITIONAL INFORMATION CONCERNING NEW YORK ISSUERS........................ 11
MANAGEMENT OF THE FUND.................................................... 41
DISTRIBUTION PLAN......................................................... 45
.
CALCULATION OF YIELD...................................................... 47
CUSTODIAN AND INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS.................... 50
TAX MATTERS............................................................... 50
PORTFOLIO TRANSACTIONS.................................................... 58
OTHER INFORMATION......................................................... 61
FINANCIAL STATEMENTS...................................................... 61
APPENDIX.................................................................. A-1
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INVESTMENT OBJECTIVE, POLICIES AND RESTRICTIONS
As stated in the Fund's Prospectus, the objective of the Fund
is to provide investors with a high level of income that is excluded from gross
income for Federal income tax purposes and exempt from New York State and New
York City personal income taxes and is consistent with the preservation of
capital. Of course, there can be no assurance that this objective will be
achieved. The Fund intends to attempt to achieve its objective by investing
substantially all, and at least 80%, of its total assets in debt obligations
which are rated within the four highest quality grades for bonds as determined
by Moody's, S&P, Fitch or Duff or within the three highest quality grades for
municipal notes as determined by Moody's, S&P, Fitch or Duff or, if unrated, are
judged by Fund management to be of comparable quality, and which are issued by
the State of New York, its political subdivisions, and its other duly
constituted authorities and corporations, the interest from which is, in the
opinion of counsel to the issuer, totally excluded from gross income for Federal
income tax purposes and exempt from New York State and New York City personal
income taxes.
The investment restrictions described below have been adopted
by the Fund as fundamental policies which cannot be changed without approval of
a majority of the outstanding shares of the Fund.
1. The Fund will not issue any senior security (as defined in
the 1940 Act), except that (a) the Fund may enter into commitments to purchase
securities in accordance with the Fund's investment program, including reverse
repurchase agreements, delayed delivery and when-issued securities, which may be
considered the issuance of senior securities; (b) the Fund may engage in
transactions that may result in the issuance of a senior security to the extent
permitted under applicable regulations, interpretations of the 1940 Act or an
exemptive order; (c) the Fund may engage in short sales of securities to the
extent permitted in its investment program and other restrictions; (d) the
purchase or sale of futures contracts and related options shall not be
considered to involve the issuance of senior securities; and (e) subject to
fundamental restrictions, the Fund may borrow money as authorized by the 1940
Act.
2. The Fund will not underwrite any issue of securities,
except to the extent that the purchase of municipal obligations directly from
the issuer, in accordance with the Fund's investment objective, policies and
restrictions, may be deemed to be an underwriting.
3. The Fund will not purchase or sell real estate. This
restriction shall not prevent the Fund from investing in municipal obligations
secured by real estate or interests therein.
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4. The Fund will not invest in commodity contracts, except
that the Fund may, to the extent appropriate under its investment program,
purchase securities of companies engaged in whole or in part in such activities,
may enter into transactions in financial and index futures contracts and related
options and may engage in transactions on a when-issued or forward commitment
basis.
5. The Fund will not invest in oil, gas or thermal mineral
exploration, or development programs.
6. The Fund will not make loans, except that, to the extent
appropriate under its investment program, the Fund may (a) purchase debt
instruments, including bonds, debentures, notes and municipal commercial paper;
(b) enter into repurchase transactions; and (c) lend portfolio securities
provided that the value of such loaned securities does not exceed one-third of
the Fund's total assets.
7. The Fund may borrow money from banks (including its
custodian bank) or from other lenders to the extent permitted under applicable
law, for temporary or emergency purposes, to meet redemptions or for purposes of
leveraging, but only if, immediately after such borrowing, the value of the
Fund's assets, including the amount borrowed, less its liabilities, is equal to
at least 300% of the amount borrowed, plus all outstanding borrowings. If at any
time the value of the Fund's assets fails to meet the 300% asset coverage
requirement, the Fund will, within three days (not including Sundays and
holidays), reduce its borrowings to the extent necessary to meet the 300% test.
The Fund may enter into certain futures contracts and options related thereto
and the Fund may enter into commitments to purchase securities in accordance
with the Fund's investment program, including delayed delivery and when-issued
securities and reverse repurchase agreements.
8. The Fund will not invest 25% or more of its total assets in
securities of issuers in any one industry; provided, however, that such
limitation shall not be applicable to municipal obligations other than those
municipal obligations backed only by the assets and revenues of non-governmental
users, nor shall it apply to municipal obligations issued or guaranteed by the
U.S.
Government, its agencies or instrumentalities.
In addition to the foregoing, the Fund is subject to the
following non-fundamental restrictions:
1. The Fund will not purchase a qualified private activity
bond if as a result of such purchase more than 20% of the Fund's total assets,
determined at market value at the time of the proposed investment, would be
invested in qualified private activity bonds.
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2. The Fund may purchase and sell futures contracts and
related options under the following conditions: (a) the then-current aggregate
futures market prices of financial instruments required to be delivered and
purchased under open futures contracts shall not exceed 20% of the fund's total
assets, at market value; and (b) no more than 5% of the assets, at market value
at the time of entering into a contract, shall be committed to margin deposits
in relation to futures contracts.
3. The Fund will not invest more than 15% of its net assets in
illiquid investments, including repurchase agreements maturing in more than
seven days, securities that are not readily marketable and restricted securities
not eligible for resale pursuant to Rule 144A under the Securities Act of 1933.
4. The Fund will not make short sales of securities, other
than short sales "against the box", or purchase securities on margin except for
short-term credits necessary for clearance of portfolio transactions, provided
that this restriction will not be applied to limit the use of options, futures
contracts and related options, in the manner otherwise permitted by the
investment restrictions, policies and investment program of the Fund.
Since the Fund may invest in qualified private activity bonds,
its shares may not be an appropriate investment for "substantial users" of
facilities financed by industrial development bonds (as defined in Treasury
regulation section 1.103- 11), or "related persons" to such users (within the
meaning of section 147(a)of the Internal Revenue Code of 1986, as amended (the
"Code")).
The Fund, together with any of its "affiliated persons" (as
described in the 1940 Act), may only purchase up to 3% of the total outstanding
securities of any underlying investment company. Accordingly, when the Fund or
such "affiliated persons" hold shares of any of the underlying investment
companies, the Fund's ability to invest fully in shares of those investment
companies is restricted, and Fundamental Portfolio Advisors, Inc.must then, in
some instances, select alternative investments that would not have been its
first preference.
The 1940 Act also provides that an underlying investment
company whose shares are purchased by the Fund will be obligated to redeem
shares held by the Fund and its affiliates only in an amount up to 1% of the
underlying investment company's outstanding securities during any period of less
than 30 days. Shares held by the Fund and its affiliates in excess of 1% of an
underlying investment company's outstanding securities therefore will be
considered not readily marketable securities, which together with other such
illiquid securities may not exceed 15% of the Fund's net assets.
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In certain circumstances, an underlying investment company may
determine to make payment of a redemption by the Fund wholly or partly by a
distribution in kind of securities from its portfolio, in lieu of cash, in
conformity with rules of the Securities and Exchange Commission. In such cases,
the Fund may hold securities distributed by an underlying investment company
until Fundamental Portfolio Advisors, Inc.determines that it is appropriate to
dispose of such securities.
There can be no assurance that funds for investing in
municipal obligations will be available for investment. The Fund does not intend
to invest in such funds unless, in the judgment of Fundamental Portfolio
Advisors, Inc., the potential benefits of such investment justify the payment of
any applicable premium or sales charge.
Where relevant in this Statement of Additional Information,
the term "issuer" is defined as the entity which has either actually issued the
security or which is ultimately responsible for payment of the obligation. For
purposes of diversification of the Fund's investments, separate issues by the
same issuer will be considered as distinct or diverse investments provided that
such issues differ either with respect to collateral (i.e., the pledge of
specific revenue or taxes standing as security for the payment of the
obligation) or guarantor of ultimate payment.
ADDITIONAL INFORMATION RELATING TO MUNICIPAL OBLIGATIONS
MUNICIPAL BONDS
Municipal bonds are long-term debt obligations, generally with
a maturity at the time of issuance of greater than three years, of states and
their political subdivisions issued to obtain funds for various public purposes,
including construction of a wide range of public facilities, such as airports,
bridges, highways, housing, hospital, mass transportation, schools, streets and
water and sewer works. Other purposes for which municipal bonds may be issued
include refunding outstanding obligations; obtaining funds for general operating
expenses; or obtaining funds to lend to public or private institutions for
construction of such facilities as educational, hospital and housing facilities.
In addition, certain types of bonds may be issued by public authorities to
finance privately operated housing facilities, sports facilities, convention or
trade show facilities, and certain local facilities for water supply, gas,
electricity, or sewage or solid waste disposal. Other types of qualified private
activity bonds, the proceeds of which are used for the construction, equipment,
repair or improvement of privately operated industrial or commercial facilities,
may constitute municipal bonds, although current
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Federal tax laws place substantial limitations on the size of such issues.
The two principal classifications of municipal bonds are
general obligation and revenue bonds. General obligation bonds are secured by
the issuer's pledge of faith, credit and taxing power for the payment of
principal and interest. Revenue bonds are payable from only revenues derived
from a particular facility or class of facilities or, in some cases, from the
proceeds of a special excise tax or other specific revenue sources such as from
the user of the facility being financed. Qualified private activity bonds are,
in most cases, revenue bonds and do not generally constitute the pledge of the
credit or taxing power of the issuer of such bonds. The payment of the principal
and interest on such bonds depends solely on the ability of the user of the
facilities financed by the bonds to meet its financial obligations and the
pledge, if any, of real and personal property so financed as security for such
payment.
MUNICIPAL NOTES
Municipal notes are short-term obligations, generally with a
maturity at the time of issuance of six months to three years. The principal
types of municipal notes include tax anticipation notes, bond anticipation
notes, revenue anticipation notes, and project notes. Tax anticipation notes are
sold to provide working capital to states and municipalities in anticipation of
collection of taxes. Bond anticipation notes are issued to provide funds
temporarily in anticipation of a bond sale. Revenue anticipation notes are sold
in expectation of receipt of other revenues, such as funds under the Federal
Revenue Sharing Program. Project notes are issued by local agencies in
connection with such programs as construction of low-income housing in order to
provide construction financing prior to permanent financing. Project notes are
guaranteed by the U.S. Department of Housing and Urban Development and
consequently are secured by the full faith and credit of the United States.
VARIABLE RATE INSTRUMENTS
Municipal bonds and notes are sometimes issued with a variable
interest rate ("variable rate instruments"). The interest rate on variable rate
instruments is usually tied to an objective standard, such as the 90-day
Treasury Bill rate or the prime rate of a bank involved in the financing. Prime
rates can change daily; the auction for 90-day Treasury Bill rates is held
weekly. In addition to having a variable interest rate, any such instruments are
subject to repayment of principal on demand by the Fund, usually in not more
than five business days. Both the variable rate feature and the principal
repayment on demand feature tend to reduce fluctuations in the price of variable
rate instruments;
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these instruments are generally of interest and sold to institutional investors.
Also available are participation interests in loans to municipal issuers, which
are similar except that these loan participations are made available through a
commercial bank that arranges the tax-exempt loan. Participation interests are
frequently backed by an irrevocable bank letter of credit or a guarantee by a
financial institution and give the Fund the right to demand, on short notice
(usually not more than seven days), payment of all or any part of the principal
amount and accrued interest. The Board of Directors will determine that the
participation interest in the municipal securities meets the Fund's prescribed
quality standards. The Fund's management has been instructed by the Board of
Directors to monitor the pricing, quality and liquidity of any variable rate
demand instruments held, including participation interests supported by letters
of credit or guarantee, on the basis of published financial information and
reports of the rating agencies and other analytical sources. The Fund's
management will also monitor the creditworthiness of the guarantor. Banks retain
fees for their role in an amount equal to the excess of the interest paid on the
municipal securities over the negotiated yield at which the participation
interests were purchased. In the event that the participation interest that the
Fund acquires includes the right to demand payment of principal and accrued
interest from the issuer of the participation interest pursuant to a letter of
credit or other commitment, the maturity will be deemed to be equal to the time
remaining until the principal amount can be recovered from the issuer through
demand, although the stated maturity may be in excess of one year. To the extent
that variable rate instruments and loan participations may lack liquidity
(unless payable on demand or within seven days), they are subject to the
restriction on illiquid securities, described herein under the caption
"Investment Objective, Policies and Restrictions".
OTHER INFORMATION
A portion of the Fund's assets may be invested in qualified
hospital bonds. Such bonds are rated on the basis of feasibility studies that
project occupancy levels, revenues and expenses. The gross receipts and income
of hospitals are affected by many future events and conditions (including among
other things, demand for hospital services, the ability of the hospital to
provide such services, competition, actions by insurers and governmental
agencies, the cost and possible unavailability of malpractice insurance, and the
funding of medicare and medicaid programs), whose effects are often difficult to
predict. Changes or future developments in all of the foregoing areas may have
an adverse effect on the price or marketability of such bonds.
A part of the Fund's assets may be invested in obligations of
state and local housing authorities. Such
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obligations are not part of the general obligations of the state or the
municipality in question. To a large extent, such obligations are generally
supported by Federal housing subsidy programs. Any weakness in such programs or
their administration, or the failure by a state or local housing authority to
meet the qualifications required for coverage under such programs, may result in
a decrease or the elimination of such Federal subsidies and could adversely
affect payment of principal and interest on housing authority bonds. These
factors as well as general economic factors affecting housing in general could
cause a decrease in the value or marketability of such bonds.
A portion of the Fund's assets may be invested in municipal
obligations that are moral obligation bonds issued by agencies and authorities
of the State of New York (i.e., issued pursuant to the municipality's good faith
and credit to pay principal and interest). Under the statutes applicable to such
bonds, the State may be called on to restore any deficits in capital reserve
funds of such agencies or authorities created with respect to the bonds. Any
such restoration requires appropriation by the state legislature for such
purposes, and accordingly, the statutes do not constitute legally enforceable
obligations or debt of the State. The agencies or authorities in question have
no taxing power, and on a default by such agencies or authorities, there are no
guarantees that payments of principal and interest will be met.
ADDITIONAL INFORMATION RELATING TO LOWER RATED SECURITIES
The lower quality securities in which the Fund may invest
(i.e., those rated lower than Baa by Moody's or BBB by S&P, Fitch or Duff or
determined by Fund management to be a comparable quality if unrated) generally
produce a higher current yield than do securities of higher ratings. However,
these obligations are considered speculative because they involve greater price
volatility and risk than do higher rated securities and the yields on these
securities will tend to fluctuate over time. Although the market value of all
fixed-income securities varies as a result of changes in prevailing interest
rates (e.g., when interest rates rise, the market value of fixed-income
securities can be expected to decline), values of lower rated securities tend to
react differently than the values of higher rated securities. The prices of
lower rated securities are less sensitive to changes in interest rates than
higher rated securities. Conversely, lower rated securities also involve a
greater risk of default by the issuer in the payment of principal and income and
are more sensitive to economic downturns and recessions than higher rated
securities. The financial stress resulting from an economic downturn could have
a greater negative effect on the ability of issuers of lower rated securities to
service their principal and interest payments, to
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meet projected business goals and to obtain additional financing than on more
creditworthy issuers. In the event of an issuer's default in payment of
principal or interest on such securities, or any other securities in the Fund's
portfolio, the net asset value of the Fund will be negatively affected.
Moreover, as the market for lower rated securities is a relatively new one which
has not yet been tested through a recession, a severe economic downturn might
increase the number of defaults, thereby adversely affecting the value of all
outstanding lower rated municipal bonds and disrupting the market for such
securities. Securities purchased by the Fund as part of an initial underwriting
present an additional risk due to their lack of market history. These risks are
exacerbated with respect to securities rated CCC or lower by S&P, Fitch or Duff
or Caa or lower by Moody's. Unrated securities generally carry the same risks as
do lower rated securities.
The Fund may invest in lower rated securities that are
structured as zero coupon or pay-in-kind bonds. Such securities may be more
speculative and subject to greater fluctuation in value due to changes in
interest rates than lower rated, income-bearing securities. In addition, zero
coupon and pay-in-kind securities are also subject to the risk that in the event
of a default, a fund may realize no return on its investment, because these
securities do not pay cash interest. Zero coupon, or deferred interest,
securities are debt obligations that do not entitle the holder to any periodic
payment of interest prior to maturity or a specified date when the securities
begin paying current interest (the "cash payment date") and therefore are issued
and traded at a discount from their face amounts or par value. Pay-in-kind
securities are securities that pay interest through the issuance of additional
securities. Holders of zero coupon securities are considered to receive each
year the portion of the original issue discount on such securities that accrues
that year and must include such amount in gross income, even though the holders
receive no cash payments during the year. Consequently, as a fund is accruing
original issue discount on these securities prior to the receipt of cash
payment, it is still subject to the requirement that it distribute substantially
all of its income to its shareholders in order to qualify as a "regulated
investment company" under applicable tax law. Therefore, such fund may have to
dispose of its portfolio securities under disadvantageous circumstances or
leverage itself by borrowing to generate the cash necessary to satisfy its
distribution requirements.
Lower rated securities are typically traded among a smaller
number of broker-dealers rather than in a broad secondary market. Purchasers of
lower rated securities tend to be institutions, rather than individuals, a
factor that further limits the secondary market. To the extent that no
established retail secondary market exists, many lower rated securities may not
be as liquid as Treasury and investment grade securities. The ability of
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the Fund to sell lower rated securities will be adversely affected to the extent
that such securities are thinly traded or illiquid. Moreover, the ability of the
Fund to value lower rated securities becomes more difficult, and judgment plays
a greater role in valuation, as there is less reliable, objective data available
with respect to such securities that are thinly traded or illiquid.
Because investors may perceive that there are greater risks
associated with the medium to lower rated securities of the type in which the
Fund may invest, the yields and prices of such securities may tend to fluctuate
more than those for securities with a higher rating. Changes in perception of
issuers' creditworthiness tend to occur more frequently and in a more pronounced
manner in the lower quality segments of the fixed-income securities market than
do changes in higher quality segments of such market, resulting in greater yield
and price volatility.
The general legislative environment has included discussions
and legislative proposals relating to the tax treatment of high-yield
securities. Any or a combination of such proposals, if enacted into law, could
negatively affect the value of the high-yield securities in the Fund's
portfolio. The likelihood of any such legislation is uncertain.
Fund management believes that the risks of investing in such
high-yielding securities may be minimized through careful analysis of
prospective issuers. Although the opinion or ratings services such as Moody's,
S&P, Fitch and Duff is considered in selecting portfolio securities, they relate
to credit risk and evaluate the safety of the principal and the interest
payments of the security, not their market value risk. Additionally, credit
rating agencies may experience slight delays in updating ratings to reflect
current events. The Fund relies, primarily, on its own credit analysis, which
includes a study of the existing debt, capital structure, ability to service
debts and to pay dividends, and the current trend of earnings for any issuer
under consideration for the Fund's investment portfolio. This may suggest,
however, that the achievement of the Fund's investment objective is more
dependent on its proprietary credit analysis, than is otherwise the case for a
fund that invests in higher quality securities.
ADDITIONAL INFORMATION CONCERNING NEW YORK ISSUERS
The Fund will invest substantially all of its assets in New
York municipal securities. In addition, the specific New York municipal
securities in which the Fund will invest will change from time to time. The Fund
is therefore susceptible to political, economic, regulatory or other factors
affecting issuers of New York municipal securities. The following information
constitutes only a brief summary of a number of the complex factors which may
affect
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issuers of New York municipal securities and does not purport to be a complete
or exhaustive description of all adverse conditions to which issuers of New York
municipal securities may be subject. Such information is derived from official
statements utilized in connection with the issuance of New York municipal
securities, as well as from other publicly available documents. Such information
has not been independently verified by the Fund, and the Fund assumes no
responsibility for the completeness or accuracy of such information.
Additionally, many factors, including national, economic, social and
environmental policies and conditions, which are not within the control of such
issuers, could have a material adverse impact on the financial condition of such
issuers. The Fund cannot predict whether or to what extent such factors or other
factors may affect the issuers of New York municipal securities, the market
value or marketability of such securities or the ability of the respective
issuers of such securities acquired by the Fund to pay interest on or principal
of such securities. The creditworthiness of obligations issued by local New York
issuers may be unrelated to the creditworthiness of obligations issued by the
State of New York, and there is no responsibility on the part of the State of
New York to make payments on such local obligations. There may be specific
factors that are applicable in connection with investment in the obligations of
particular issuers located within New York, and it is possible the Fund will
invest in obligations of particular issuers as to which such specific factors
are applicable. However, the information set forth below is intended only as a
general summary and not as a discussion of any specific factors that may affect
any particular issuer of New York municipal securities.
The Fund may invest in municipal securities issued by New York
State (the "State"), by its various public bodies (the "Agencies") and/or by
other entities located within the State, including the City of New York (the
"City") and political subdivisions thereof and/or their agencies.
NEW YORK STATE. The State's current fiscal year commenced on
April 1, 1996, and ends on March 31, 1997, and is referred to herein as the
State's 1996-97 fiscal year. The State's budget for the 1996-97 fiscal year was
enacted by the Legislature on July 13, 1996, more than three months after the
start of the fiscal year. Prior to adoption of the budget, the Legislature
enacted appropriations for disbursements considered to be necessary for State
operations and other purposes, including necessary appropriations for all
State-supported debt service. The State Financial Plan for the 1996-97 fiscal
year was formulated on July 25, 1996 and is based on the State's budget as
enacted by the Legislature and signed into law by the Governor, as well as
actual results for the first quarter of the current fiscal year. The 1996-97
State Financial Plan will be updated in October and January.
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1996-97 FISCAL YEAR STATE FINANCIAL PLAN. The 1996-97 State
Financial Plan is projected to be balanced on a cash basis. As compared to the
Governor's proposed budget as revised on March 20, 1996, the State's adopted
budget for 1996-97 increases General Fund spending by $842 million, primarily
from increases for education, special education and higher education ($563
million). The balance represents funding increases to a variety of other
programs, including community projects and increased assistance to fiscally
distressed cities. Resources used to fund these additional expenditures include
$540 million in increased revenues projected for 1996-97 based on
higher-than-projected tax collections during the first half of calendar 1996,
$110 million in projected receipts from a new State tax amnesty program, and
other resources including certain non-recurring resources. The total amount of
non-recurring resources included in the 1996-97 State budget is projected by the
Division of Budget to be $1.3 billion, or 3.9 percent of total General Fund
receipts.
The economic and financial condition of the State may be
affected by various financial, social, economic and political factors. Those
factors can be very complex, may vary from fiscal year to fiscal year, and are
frequently the result of actions taken not only by the State and its agencies
and instrumentalities, but also by entities, such as the federal government,
that are not under the control of the State. In addition, the State Financial
Plan is based upon forecasts of national and State economic activity. Economic
forecasts have frequently failed to predict accurately the timing and magnitude
of changes in the national and the State economies. The Division of Budget
believes that its projections of receipts and disbursements relating to the
current State Financial Plan, and the assumptions on which they are based, are
reasonable. Actual results, however, could differ materially and adversely from
the projections set forth in this Statement of Additional Information, and those
projections may be changed materially and adversely from time to time. There are
also risks and uncertainties concerning the future-year impact of actions taken
in the 1996-97 budget.
The four government fund types that comprise the State
Financial Plan are the General Fund, the Special Revenue Funds, the Capital
Projects Funds, and the Debt Service Funds. This fund structure adheres to
accounting standards of the Governmental Accounting Standards Board. This
section discusses first the General Fund and then the other governmental funds.
Receipts and disbursements trends are presented in tabular form for each
component of the General Fund.
GENERAL FUND. The General Fund is the principal operating fund
of the State and is used to account for all financial transactions, except those
required to be accounted for in another fund. It is the State's largest fund and
receives
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almost all State taxes and other resources not dedicated to particular purposes.
In the State's 1996-97 fiscal year, the General Fund is expected to account for
approximately 47 percent of total Governmental Funds disbursements and 71
percent of total State Funds disbursements. General Fund moneys are also
transferred to other funds, primarily to support certain capital projects and
debt service payments in other fund types. The following are the projected
shares of General Fund receipts and disbursements: Receipts: Personal Income Tax
- - 51.55%, User Taxes and Fees - 29.51%, Business Taxes - 13.93%, Other Taxes -
2.86%, Miscellaneous - 7.16%; Disbursements: Local Assistance - 69.84%; State
Operations - 17.56%, Debt Service - 4.85%, General State Charges - 6.70%,
Capital/Other - 1.04%.
STATE FISCAL YEAR 1996-97. The General Fund is projected to be
balanced on a cash basis for the 1996-97 fiscal year. Total receipts and
transfers from other funds are projected to be $33.17 billion, an increase of
$365 million from the prior fiscal year. Total General Fund disbursements and
transfers to other funds are projected to be $33.12 billion, an increase of $444
million from the total in the prior fiscal year.
PROJECTED GENERAL FUND RECEIPTS. The discussion below
summarizes the State's projections of General Fund tax revenues and other
receipts for the 1996-97 fiscal year. Major statutory changes adopted with the
1996-97 budget that affect 1996-97 include: tax reductions totaling $83 million,
adoption of a tax amnesty program expected to increase receipts by $110 million,
and a variety of measures increasing miscellaneous receipts by approximately
$675 million.
THE PERSONAL INCOME TAX is imposed on the income of
individuals, estates and trusts and is based on federal definitions of income
and deductions with certain modifications. In 1995, the State enacted a
tax-reduction program designed to reduce receipts from the personal income tax
by 20 percent over three years. Prior to 1995, the tax had remained
substantially unchanged since 1989 as a result of annual deferrals of tax
reductions originally enacted in 1987. The tax-reduction program is estimated to
reduce receipts by $2.3 billion in the 1996-97 fiscal year, compared to what tax
receipts would have been under the pre-1995 rate structure. The maximum rate was
reduced from the 7.875 percent in effect between 1989 and 1994 to 7.59375
percent for 1995, to 7.125 percent for 1996, and is scheduled under current law
to be reduced to 6.85 percent for 1997 and thereafter. In addition to
significant reductions in overall tax rates, the program also includes increases
in the standard deduction, widening tax brackets to increase the income
thresholds to which higher tax rates apply, and modification of certain tax
credits.
The projected yield of the tax for the 1996-97 fiscal
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year is $17.1 billion, an increase of $103 million from reported collections in
the State's 1995-96 fiscal year. The increase reflects both the effects of the
tax reductions noted above and the fact that reported collections in the
preceding year were affected by net refund and tax refund reserve account
transactions that depressed collections in 1995-96 by $500 million. Without
these statutory and administrative changes, the yield of the tax would have
grown by more than $1 billion (nearly 7 percent), reflecting liability growth
for the 1996 tax year projected at approximately the same rate. The income base
for the tax is projected to rise approximately 5 percent for the 1996 tax year.
USER TAXES AND FEES are comprised of three-quarters of the
State four percent sales and use tax (the balance, one percent, flows to support
Local Government Assistance Corporation ("LGAC") debt service requirements),
cigarette, alcoholic beverage container, and auto rental taxes, and a portion of
the motor fuel excise levies. Also included in this category are receipts from
the motor vehicle registration fees and alcoholic beverage license fees.
Beginning in 1993-94, a portion of the motor fuel tax and motor vehicle
registration fees and all of the highway use tax are earmarked for dedicated
transportation funds.
Receipts in this category in the State's 1996-97 fiscal year
are expected to total $6.73 billion, an increase of $97 million from reported
1995-96 results. Underlying growth in the continuing sales tax base is forecast
to be 5 percent, accounting for the increase in the category as a whole.
Projected receipts in 1996-97 are adversely affected by the full-year effects of
reductions in the diesel motor fuel, container and beer taxes adopted in 1995 by
a temporary reduction of the sales tax on clothing enacted in 1996.
BUSINESS TAXES include franchise taxes based generally on net
income of general business, bank and insurance corporations, as well as
gross-receipts-based taxes on utilities and gallonage-based petroleum business
taxes. Through 1993, these levies had been subject to a 15 percent surcharge
initially imposed in 1990. Beginning in 1994, the surcharge rate has been phased
out and, for most taxpayers, there will be no surcharge liability for taxable
periods ending in 1997 and thereafter.
Total business tax receipts in the State's 1996-97 fiscal year
are projected at $4.62 billion, a decline of $360 million from reported 1995-96
results. The decline results from the continuing effects of tax reductions
originally enacted in 1994 and 1995, valued at approximately $300 million more
in 1996-97 than in 1995- 96, and the previously scheduled diversion of petroleum
business and other tax receipts to dedicated transportation funds (valued at
approximately $130 million more in 1996-97 than in 1995-96). These factors
outweigh the modest growth projected in the bases of the
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continuing tax structure. Tax reductions enacted in the preceding two years
included, in addition to a reduction in the surcharge rate, a lowering of the
alternative minimum tax rate and a variety of smaller changes to the tax on
general business corporations, as well as several changes to reduce the burden
of the petroleum business tax on selected industries.
OTHER TAXES include estate, gift and real estate transfer
taxes, a tax on gains from the sale or transfer of certain real estate where the
total consideration exceeds $1 million, a pari- mutuel tax and other minor
levies.
Total receipts from this category in the State's 1996-97
fiscal year are projected at $948 million, $151 million less than in the
preceding year. The estimates reflect pre-1996 legislation reducing the burden
of the real property gains tax and the estate tax as well as legislation enacted
in 1996 repealing the real property gains tax (valued at approximately $120
million more in 1996-97 than in 1995-96), and diversion of real estate transfer
tax proceeds to the Environmental Protection Fund (valued at approximately $44
million more in 1996-97 than in 1995-96).
MISCELLANEOUS RECEIPTS include investment income, abandoned
property receipts, medical provider assessments, receipts from public
authorities, and certain other license and fee revenues. Receipts in this
category in the State's 1996-97 fiscal year are expected to total $2.1 billion,
an increase of $683 million above the amount received in the prior State fiscal
year. This includes $481 million in surplus revenues from the Medical
Malpractice Insurance Association ("MMIA"), and other various non-recurring
resources. MMIA is a statutorily-created joint underwriting association of
property/casualty insurance companies authorized to write certain personal
liability insurance in the State which provides primary and excess medical
malpractice insurance for medical service providers in the State. It has been
reported that certain health care providers are considering a challenge to the
State's right to these surplus revenues.
TRANSFER FROM OTHER FUNDS to the General Fund consist
primarily of tax revenues in excess of debt service requirements, particularly
the one percent sales tax used to support payments to LGAC. In the 1996-97
fiscal year, excess sales tax revenues are projected to be $1.4 billion, $75
million more than in the 1995-96 fiscal year. All other transfers are projected
to decrease by $82 million, primarily reflecting the non-recurring transfer of
$117 million from the Mass Transportation Operating Assistance Fund to the
Revenue Accumulation Fund in 1995-96. As a result, total transfers are virtually
unchanged year-to-year.
PROJECTED GENERAL FUND DISBURSEMENTS. Grants to local
governments is the largest category of General Fund disbursements,
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and accounts for approximately 70 percent of overall General Fund spending.
Disbursements from this category are projected to total $23.13 billion in the
1996-97 State Financial Plan, an increase of $597 million (2.6 percent) from
1995-96 levels. Of this amount, approximately $300 million is attributable to
transactions which were not accounted for in a comparable way in 1995-96,
primarily $271 million in spending related to the issuance of LGAC bonds. This
category of the State Financial Plan includes $11.27 billion in aid for
elementary, secondary, and higher education, accounting for 49 cents of every
dollar spent in this category. On a school year basis, formula-based elementary
and secondary education aid increases $217 million from 1995-96 levels. General
Fund payments for Medicaid are projected to be $5.29 billion, virtually
unchanged from the level of $5.34 billion in 1995-96 and down from $5.79 billion
in 1994-95. This slow growth is due primarily to continuation of cost
containment measures enacted in 1995-96, new reforms included in the 1996-97
adopted budget, and forecasts for lower caseload based upon actual experience
through May 1996. Other social service spending is forecast to increase by only
$7 million to $3.17 billion in 1996-97, down from $3.34 billion in 1994-95.
Remaining disbursements primarily support community-based
mental hygiene programs, community and public health programs, local
transportation programs, and revenue sharing.
STATE OPERATIONS spending reflects the administrative costs of
operating the State's agencies, including the prison system, mental hygiene
institutions, the State University system ("SUNY"), the Legislature, and the
court system. Personal service costs account for approximately 76 percent of
this category in 1996-97. Since January 1995, the State's workforce has been
reduced by about 15,000 positions, with a decrease of 5,000 positions expected
in 1996-97. State employees will not receive a general salary increase this year
as part of the collective bargaining agreements recently negotiated for the
1995-96 through 1998-99 fiscal years. Collective bargaining agreements have been
ratified by employee bargaining units representing most State employees subject
to such agreements. Negotiations are ongoing with the remaining units. For more
information on the State's workforce, see the section entitled "State
Organization--State Government Employment."
Disbursements for State operations are projected at $5.82
billion, a decrease of $135 million or 2.3 percent. The lack of growth in this
category reflects the workforce reduction program for 1996-97 that will be
accomplished primarily through attrition, a continued hiring freeze and
implementation of a retirement incentive program. Most agencies will spend less
in 1996-97 than in 1995-96; however, criminal justice spending will increase
modestly to reflect the impact of stricter sentencing laws.
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GENERAL STATE CHARGES primarily reflect the costs of providing
fringe benefits for State employees, including contributions to pension systems,
the employer's share of social security contributions, employer contributions
toward the cost of health insurance, and the costs of providing worker's
compensation and unemployment insurance benefits. This category also reflects
certain fixed costs such as payments in lieu of taxes, and payments of judgments
against the State or its public officers. Disbursements in this category are
projected to total $2.22 billion in the 1996-97 State Financial Plan, an
increase of $138 million from the 1995-96 levels. Fringe benefit costs in
1995-96 are depressed by the one-time application of more than $100 million in
reimbursements traditionally budgeted in other categories of the Financial Plan.
Pension costs do not increase in 1996-97 assuming savings will be achieved as
planned from the refinancing of certain pension liabilities. Other fringe
benefit costs (including unemployment insurance) decline, due to workforce
reductions accomplished primarily through attrition and early retirements.
DEBT SERVICE paid from the General Fund for 1996-97 reflects
only the $10 million interest cost of the State's commercial paper program. No
cost is included for a TRAN borrowing, since none is expected to be undertaken.
The State's annual spring borrowing has been eliminated, as discussed in the
section entitled "Debt and Other Financing Activities--Local Government
Assistance Corporation." Debt service on long-term obligations is paid from Debt
Service Funds as described below.
TRANSFERS TO OTHER FUNDS from the General Fund are made
primarily to finance certain portions of State capital project spending and debt
service on long-term bonds, where these costs are not funded from other sources.
Transfers are projected to total $1.94 billion, a decrease of $161 million or
7.7 percent from 1995- 96 levels. Transfers in support of capital projects
decrease $210 million due to the availability of non-recurring revenues which
will be deposited directly to the Capital Projects Funds in 1996-97 and the
reclassification of economic development programs from capital projects to
grants to local governments. Transfers in support of debt service increase $60
million reflecting prior year bond sales for prisons, housing programs, and
SUNY. All other transfers decrease $11 million from previous year levels.
CAPITAL PROJECTS paid directly from the General Fund represent
pay-as-you-go capital expenditures for certain youth and environmental projects.
This is a new Financial Plan category created as a part of the 1996-97 adopted
budget. Other pay-as-you- go capital expenditures are accounted for in the
Capital Projects Fund type.
The 1996-97 State Financial Plan includes actions that will
have an effect on the budget outlook for the State fiscal year
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1996-97 and beyond. The Division of the Budget estimates that the 1996-97 State
Financial Plan contains actions that provide non-recurring resources or savings
totaling approximately $1.3 billion. These include the use of $481 million in
surplus funds available from MMIA, $134 million in savings from a refinancing of
certain pension obligations, $88 million in projected savings from bond
refundings, and $36 million in surplus fund transfers. The balance is composed
of $314 million in resources carried forward from the State's 1995-96 fiscal
year and various other actions, including that portion of the proposed tax
amnesty program that is projected to be non-recurring.
The State closed projected budget gaps of $5.0 billion and
$3.9 billion for its 1995-96 and 1996-97 fiscal years, respectively. The 1997-98
gap was projected at $1.44 billion, based on the Governor's proposed budget of
December 1995. As a result of changes made in the enacted budget, that gap is
now expected to be larger. However, the gap is not expected to be as large as
those faced in the prior two fiscal years. The Governor has indicated that he
will propose to close any potential imbalance primarily through General Fund
expenditure reductions and without increases in taxes or deferrals of scheduled
tax reductions.
The out-year projection will be impacted by a variety of
factors. Enacted tax reductions, which reduced receipts in the 1996-97 fiscal
year by an incremental $2.4 billion, are projected to reduce receipts in the
1997-98 fiscal year by an additional increment of $2.1 billion. The use of up to
$1.3 billion of non-recurring resources in 1996-97, and the annualized costs of
certain program increases in the 1996-97 enacted budget, will both add
additional pressure in closing the 1997-98 gap.
Actions undertaken in the State's 1996-97 fiscal year, such as
workforce reductions, health care and education reforms, and strict controls on
State agency spending, are expected to provide larger recurring savings in
1997-98. Sustained growth in the State's economy and continued declines in
welfare caseload and Medicaid costs would produce additional savings in the
1997-98 Financial Plan. Finally, future federal reforms of welfare and/or
Medicaid could potentially provide savings to the State in the State fiscal year
1997-98. See "Special Considerations" below in this section for a description of
the risks and uncertainties associated with the State Financial Plan process.
The 1996-97 opening fund balance of $287 million includes $237
million which is reserved in the Tax Stabilization Reserve Fund ("TSRF"), $41
million which is on deposit in the Contingency Reserve Fund ("CRF") (see the
discussion of this Fund under the heading "Prior Fiscal Years"), and $9 million
in the Revenue Accumulation Fund which has been drawn down for use in the
1996-97 fiscal year. The projected closing fund balance in the General
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Fund of $337 million reflects a balance of $252 million in the TSRF, following
an additional payment of $15 million during the year, and a balance of $85
million in the CRF.
In addition to the General Fund, the State Financial Plan
includes Special Revenue Funds, Capital Projects Funds and Debt Service Funds
which are discussed below. Amounts below do not include other sources and uses
of funds transferred to or from other fund types.
Special Revenue Funds are used to account for the proceeds of
specific revenue sources such as federal grants that are legally restricted,
either by the Legislature or outside parties, to expenditures for specified
purposes. Although activity in this fund type is expected to comprise
approximately 43 percent of total government funds receipts in the 1996-97
fiscal year, three-quarters of that activity relates to federally-funded
programs.
Projected receipts in this fund type total $28.04 billion, an
increase of $2.43 billion (9.5 percent) over the prior year. Projected
disbursements in this fund type total $28.51 billion, an increase of $2.25
billion (8.6 percent) over 1995-96 levels. Disbursements from federal funds,
primarily the federal share of Medicaid and other social services programs, are
projected to total $21.31 billion in the 1996-97 fiscal year. Remaining
projected spending of $7.20 billion primarily reflects aid to SUNY supported by
tuition and dormitory fees, education aid funded from lottery receipts,
operating aid payments to the Metropolitan Transportation Authority funded from
the proceeds of dedicated transportation taxes, and costs of a variety of
self-supporting programs which deliver services financed by user fees.
Capital Projects Funds are used to account for the financial
resources used for the acquisition, construction, or rehabilitation of major
State capital facilities and for capital assistance grants to certain local
governments or public authorities. This fund type consists of the Capital
Projects Fund, which is supported by tax receipts transferred from the General
Fund, and 37 other capital funds established to distinguish specific capital
construction purposes supported by other revenues. In the 1996-97 fiscal year,
activity in these funds is expected to comprise 6 percent of total governmental
receipts.
Total receipts in this fund type are projected at $3.58
billion. Disbursements from this fund type are projected to be $3.85 billion, a
decrease of $120 million (3.1 percent) over prior-year levels, due in part to a
reclassification of economic development projects to the category of grants to
local governments in the General Fund. The Dedicated Highway and Bridge Trust
Fund is the single largest dedicated fund, comprising an estimated $920
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million (24 percent) of the activity in this fund type. Total spending for
capital projects will be financed through a combination of sources: federal
grants (28 percent), public authority bond proceeds (34 percent), general
obligation bond proceeds (12 percent), and pay-as-you-go revenues (26 percent).
Debt Service Funds are used to account for the payment of
principal of, and interest on, long-term debt of the State and to meet
communications under lease-purchase and other contractual- obligation financing
arrangements. (See the section entitled "Debt and Other Financing
Activities--Outstanding Debt of the State and Certain Authorities" below.) This
fund type is expected to comprise 4 percent of total government fund receipts
and disbursements in the 1996-97 fiscal year. Receipts in these funds in excess
of debt service requirements may be transferred to the General Fund and Special
Revenue Funds, pursuant to law.
The Debt Service fund type consists of the General Debt
Service Fund, which is supported primarily by tax receipts transferred from the
General Fund, and other funds established to accumulate moneys for the payment
of debt service. In the 1996-97 fiscal year, total disbursements in this fund
type are projected at $2.58 billion, an increase of $164 million or 6.8 percent.
The projected transfer from the General Fund of $1.59 billion is expected to
finance 62 percent of these payments.
The remaining payments are expected to be financed by pledged
revenues, including $1.83 billion in taxes, $234 million in dedicated fees, and
$2.35 billion in patient revenues, including transfers of federal and state
reimbursements and state dedicated taxes. After required impoundment for debt
service, $3.7 billion is expected to be transferred to the General Fund and
other funds in support of State operations. The largest transfer - $1.9 billion
- - is made to the Special Revenue Fund type in support of operations of the
mental hygiene agencies. Another $1.4 billion in excess sales taxes is expected
to be transferred to the General Fund, following payment of projected debt
service on LGAC bonds.
SPECIAL CONSIDERATIONS. The economic and financial condition
of the State may be affected by various financial, social, economic and
political factors. These factors can be very complex, may vary from fiscal year
to fiscal year, and are frequently the result of actions taken not only by the
State and its agencies and instrumentalities, but also by entities, such as the
federal government, that are not under the control of the State. For example,
various proposals relating to federal tax and spending policies that are
currently being publicly discussed and debated could, if enacted, have a
significant impact on the State's financial condition in the current and future
fiscal years. Because of the uncertainty and unpredictability of the changes,
their impact cannot, as a practical matter, be included in the
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assumptions underlying the State's projections at this time.
The State Financial Plan is based upon forecasts and national
and State economic activity developed through both internal analysis and review
of State and national economic forecasts prepared by commercial forecasting
services and other public and private forecasters. Economic forecasts have
frequently failed to predict accurately the timing and magnitude of changes in
the national and the State economies. Many uncertainties exist in forecasts of
both the national and State economies, including consumer attitudes toward
spending, the extent of corporate and governmental restructuring, federal fiscal
and monetary policies, the level of interest rates, and the condition of the
world economy, which could have an adverse effect on the State. There can be no
assurance that the State economy will not experience results in the current
fiscal year that are worse than predicted, with corresponding material and
adverse effects on the State's projections of receipts and disbursements.
Projections of total State receipts in the State Financial
Plan are based on the State tax structure in effect during the fiscal year and
on assumptions relating to basic economic factors and their historical
relationships to State tax receipts. In preparing projections of State receipts,
economic forecasts relating to personal income, wages, consumption, profits and
employment have been particularly important. The projection of receipts from
most tax or revenue sources is generally made by estimating the change in yield
of such tax or revenue source caused by economic and other factors, rather than
by estimating the total yield of such tax or revenue source from its estimated
tax base. The forecasting methodology, however, ensures that State fiscal year
estimates for taxes that are based on computation of annual liability, such as
the business and personal income taxes, are consistent with estimates of total
liability under such taxes.
Projections of total State disbursements are based on
assumptions relating to economic and demographic factors, levels of
disbursements for various services provided by local governments (where the cost
is partially reimbursed by the State), and the results of various administrative
and statutory mechanisms in controlling disbursements for State operations.
Factors that may affect the level of disbursements in the fiscal year include
uncertainties relating to the economy of the nation and the State, the policies
of the federal government, and changes in the demand for and use of State
services.
The Division of the Budget believes that its projections of
receipts and disbursements relating to the current State Financial Plan, and the
assumptions on which they are based, are reasonable. Actual results, however,
could differ materially and adversely form the projections set forth in this
Annual Information
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Statement. In the past, the State has taken management actions and made use of
internal sources to address potential State Financial Plan shortfalls, and DOB
believes it could take similar actions should variances occur in its projections
for the current fiscal year.
In recent years, State actions affecting the level of receipts
and disbursements, the relative strength of the State and regional economy,
actions of the federal government and other factors, have created structural
budget gaps for the State. These gaps resulted from a significant disparity
between recurring revenues and the costs of maintaining or increasing the level
of support for State programs. To address a potential imbalance in any given
fiscal year, the State would be required to take actions to increase receipts
and/or reduce disbursements as it enacts the budget for that year, and under the
State Constitution, the Governor is required to propose a balanced budget each
year. There can be no assurance, however, that the Legislature will enact the
Governor's proposals or that the State's actions will be sufficient to preserve
budgetary balance in a given fiscal year or to align recurring receipts and
disbursements in future fiscal year.
CASH-BASIS RESULTS FOR PRIOR FISCAL YEARS. The State reports
its financial results on two bases of accounting: the cash basis, showing
receipts and disbursements; and the modified accrual basis, prescribed by GAAP,
showing revenues and expenditures. These financial terms are described in the
Glossary of Financial Terms in Exhibit A to this Annual Information Statement.
GENERAL FUND 1993-94 THROUGH 1995-96. The General Fund is the
principal operating fund of the State and is used to account for all financial
transactions, except those required to be accounted for in another fund. It is
the State's largest fund and receives almost all State taxes and other resources
not dedicated to particular purposes. General Fund moneys are also transferred
to other funds, primarily to support certain capital projects and debt service
payments in other fund types. A narrative description of cash-basis results in
the General Fund is presented below, followed by a tabular presentation of the
actual General Fund results for the prior three fiscal years. For a description
of the principal State taxes and fees, see Exhibit B to this Annual Information
Statement.
New York State's financial operations have improved during
recent fiscal years. During the period 1989-90 through 1991-92, the State
incurred General Fund operating deficits that were closed with receipts from the
issuance of tax and revenue anticipation notes ("TRANs"). A national recession,
followed by the lingering economic slowdown in the New York and regional
economy, resulted in repeated shortfalls in receipts and three budget deficits
during those years. During its last four fiscal
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years, however, the State has recorded balanced budget on a cash basis, with
positive fund balances as described below.
The State ended its 1995-96 fiscal year on March 31, 1996 with
a General Fund cash surplus. The Division of the Budget reported that revenues
exceeded projections by $270 million, while spending for social service programs
was lower than forecast by $120 million and all other spending was lower by $55
million. From the resulting benefit of $445 million, a $65 million voluntary
deposit was made into the TSRF, and $380 million was used to reduce 1996-97
Financial Plan liabilities by accelerating 1996-97 payments, deferring 1995-96
revenues, and making a deposit to the tax refund reserve account. (For more
information on the tax refund reserve account, see Table 5).
The General Fund closing fund balance was $287 million, an
increase of $129 million from 1994-95 levels. The $129 million change in fund
balance is attributable to the $65 million voluntary deposit to the TSRF, a $15
million required deposit to the TSRF, a $40 million deposit to the CRF, and a $9
million deposit to the Revenue Accumulation Fund. The closing fund balance
includes $237 million on deposit in the TSRF, to be used in the event of any
future General Fund deficit as provided under the State Constitution and State
Finance Law. In addition, $41 million is on deposit in the CRF. The CRF was
established in State fiscal year 1993-94 to assist the State in financing the
costs of extraordinary litigation. The remaining $9 million reflects amounts on
deposit in the Revenue Accumulation Fund. This fund was created to hold certain
tax receipts temporarily before their deposit to other accounts. In addition,
$678 million was on deposit in the tax refund reserve account, of which $521
million was necessary to complete the restructuring of the State's cash flow
under the LGAC program.
General Fund receipts totaled $32.81 billion, a decrease of
1.1 percent from 1994-95 levels. This decrease reflects the impact of tax
reductions enacted and effective in both 1994 and 1995. General Fund
disbursements totaled $32.68 billion for the 1995-96 fiscal year, a decrease of
2.2 percent from 1994-95 levels. Mid-year spending reductions, taken as part of
a management review undertaken in October at the direction of the Governor,
yielded savings from Medicaid utilization controls, office space consolidation,
overtime and contractual expense reductions, and statewide productivity
improvements achieved by State agencies. Together with decreased social services
spending, this management review accounts for the bulk of the decline in
spending.
The State ended its 1994-95 fiscal year with the General Fund
in balance. The $241 million decline in the fund balance reflects the planned
use of $264 million from the CRF, partially offset by the required deposit of
$23 million to the TSRF. In
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addition, $278 million was on deposit in the tax refund reserve account, $250
million of which was deposited to continue the process of restructuring the
State's cash flow as part of the LGAC program. The closing fund balance of $158
million reflects $157 million in the TSRF and $1 million in the CRF.
General Fund receipts totaled $33.16 billion, an increase of
2.9 percent from 1993-94 levels. General Fund disbursements totaled $33.40
billion for the 1994-95 fiscal year, an increase of 4.7 percent from the
previous fiscal year. The increase in disbursements was primarily the result of
one-time litigation costs for the State, funded by the use of the CRF, offset by
$188 million in spending reductions initiated in January 1995 to avert a
potential gap in the 1994-95 State Financial Plan. These actions included
savings from a hiring freeze, halting the development of certain services, and
the suspension of non-essential capital projects.
The State ended its 1993-94 fiscal year with a General Fund
cash surplus, primarily the result of an improving national economy, State
employment growth, tax collections that exceeded earlier projections and
disbursements that were below expectations. A deposit of $268 million was made
to the CRF, with a withdrawal during the year of $3 million, and a deposit of
$67 million was made to the TSRF. These three transactions result in the change
balance of $332 million. In addition, a deposit of $1.14 billion was made to the
tax refund reserve account, of which $1.03 billion was available for budgetary
purposes in the 1994-95 fiscal year. (For more information on the personal
income tax refund reserve account, see Table 5.) The remaining $114 million was
redeposited in the tax refund reserve account at the end of the State's 1994-95
fiscal year to continue the process of restructuring the State's cash flow as
part of the LGAC program. The General Fund closing balance was $399 million, of
which $265 million was on deposit in the CRF and $134 million in the TSRF. The
CRF was initially funded with a transfer of $100 million attributable to a
positive margin recorded in the 1992-93 fiscal year.
General Fund receipts totaled $32.23 billion, an increase of
2.6 percent from 1992-93 levels. General Fund disbursements totaled $31.90
billion for the 1993-94 fiscal year, 3.5 percent higher than the previous fiscal
year. Receipts were higher in part due to improved tax collections from renewed
State economic growth, although the State continued to lag behind the national
economic recovery. Disbursements were higher due in part to increased local
assistance costs for school aid and social services, accelerated payment of
certain Medicaid expenses, and the cost of an additional payroll for State
employees.
Activity in the three other governmental funds has remained
relatively stable over the last three fiscal years, with
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federally-funded programs comprising approximately two-thirds of these funds.
The most significant change in the structure of these funds has been the
redirection, beginning in the 1993-94 fiscal year, of a portion of
transportation-related revenues from the General Fund to two new dedicated funds
in the Special Revenue and Capital Projects Fund types. These revenues are used
to support the capital programs of the Department of Transportation and the
Metropolitan Transportation Authority ("MTA").
In the Special Revenue Funds, disbursements increased from
$22.72 billion to $26.26 billion over the last three years, primarily as a
result of increased costs for the federal share of Medicaid. Other activity
reflected dedication of taxes to a new fund for mass transportation, new lottery
games, and new fees for criminal justice programs.
Disbursements in the Capital Projects Funds grew from $3.10
billion to $3.97 billion over the last three years, as spending for
transportation and mental hygiene programs increased, partially offset by
declines for corrections and environmental programs. The composition of this
fund type's receipts also changed as the dedicated transportation taxes began to
be deposited, general obligation bond proceeds declined substantially, federal
grants remained stable, and reimbursements from public authority bonds
(primarily transportation related) increased. The increase in the negative fund
balance in 1994-95 resulted from delays in reimbursements caused by delays in
the timing of public authority bond sales.
Activity in the Debt Service Funds reflected increased use of
bonds during the three-year period for improvements to the State's capital
facilities and the continued implementation of the LGAC fiscal reform program.
The increases were moderated by the refunding savings achieved by the State over
the last several years using strict present value savings criteria. The growth
in LGAC debt service was offset by reduced short-term borrowing costs reflected
in the General Fund.
GAAP-BASIS RESULTS FOR PRIOR FISCAL YEARS. The Comptroller
prepares a comprehensive annual financial report on the basis of generally
accepted accounting principles ("GAAP") for governments as promulgated by the
Governmental Accounting Standards Board. The report, generally released in July
each year, contains general purpose financial statements with a Combined Balance
Sheet and its Combined Statement of Revenues, Expenditures and Changes in Fund
Balances. These statements are audited by independent certified public
accountants.
The State completed its 1995-96 fiscal year with a combined
Governmental Funds operating surplus of $432 million, which included an
operating surplus in the General Fund of $380
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million, in the Capital Projects Funds of $276 million and in the Debt Service
Funds of $185 million. There was an operating deficit of $409 million in the
Special Revenue Funds. The State's Combined Balance Sheet as of March 31, 1996
showed an accumulated deficit in its combined Governmental Funds of $1.23
billion, reflecting liabilities of $14.59 billion and assets of $13.35 billion.
This accumulated Governmental Funds deficit includes a $2.93 billion accumulated
deficit in the General Fund and an accumulated deficit of $712 million in the
Capital Projects Fund type as partially offset by accumulated surpluses of $468
million and $1.94 billion in the Special Revenue and Debt Service fund types,
respectively.
The State reported a General Fund operating surplus of $380
million for the 1995-96 fiscal year, as compared to an operating deficit of
$1.43 billion for the prior fiscal year. The 1995-96 fiscal year surplus
reflects several major factors, including the cash-basis surplus and the benefit
of $529 million in LGAC bond proceeds which were used to fund various local
assistance programs. This was offset in part by a $437 million increase in tax
refund liability primarily resulting from the effects of ongoing tax reductions
and (to a lesser extent) changes in accrual measurement policies, and increases
in various other expenditure accruals.
Revenues increased $530 million (nearly 1.7 percent) over the
prior fiscal year with an increase in personal income taxes and miscellaneous
revenues offset by decreases in business and other taxes. Personal income taxes
grew $715 million, an increase of 4.3 percent. The increase in personal income
taxes was caused by moderate employment and wage growth and the strong financial
markets during 1995. Business taxes declined $295 million or 5.8 percent,
resulting primarily from changes in the tax law that modified the distribution
of taxes between the General Fund and other fund types, and reduced business tax
liability. Miscellaneous revenues increased primarily because of an increase in
receipts from medical provider assessments.
Expenditures decreased $716 million (2.2 percent) from the
prior fiscal year with the largest decrease occurring in State aid for social
services program and State operations spending. Social services expenditures
decreased $739 million (7.5 percent) due mainly to implementation of cost
containment strategies by the State and local governments, and reduced
caseloads. General purpose and health and environment expenditures grew $139
million (20.2 percent) and $121 million (33.3 percent), respectively. Health and
environment spending increased as a result of increases enacted with the 1995-96
Budget. In State operations, personal service costs and fringe benefits declined
$241 million (3.8 percent) and $55 million (3.6 percent), respectively, due to
staffing reductions. The decline in non-personal service costs of $170 million
(8.6 percent) was caused by a decline in the
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litigation accrual. Pension contributions increased $103 million (66.4 percent)
as a result of the return to the aggregate cost method used to determine
employer contributions.
Net other financing sources nearly tripled, increasing $561
million, due primarily to an increase in bonds issued by LGAC, a transfer from
the Mass Transportation Operating Assistance Fund and transfers from public
benefit corporations.
An operating deficit of $409 million was reported for Special
Revenue Funds for the 1995-96 fiscal year which decreased the accumulated fund
balance to $468 million. Revenues increased $1.45 billion over the prior fiscal
year (5.8 percent) as a result of increases in federal grants and lottery
revenues. Expenditures increased $1.21 billion (5.4 percent) as a result of
increased costs for social services programs and an increase in the distribution
of lottery proceeds to school districts. Other financing uses increased $693
million (25.1 percent) primarily because of an increase in federal
reimbursements transferred to other funds.
Debt Service Funds ended the 1995-96 fiscal year with an
operating surplus of over $185 million and, as a result the accumulated fund
balance, increased to $1.94 billion. Revenues increased $10 million (0.5
percent) because of increases in both dedicated taxes and mental hygiene patient
fees. Debt service expenditures increased $201 million (9.5 percent). Net other
financing sources increased threefold to $299 million, due primarily to
increases in patient reimbursement revenues.
An operating surplus of $276 million was reported in the
Capital Projects Funds for the State's 1995-96 fiscal year and, as a result, the
accumulated deficit fund balance in this fund type decreased to $712 million.
Revenues increased $260 million (14.9 percent) primarily because a larger share
of the petroleum business tax was shifted from the General Fund to the Dedicated
Highway and Bridge Trust Fund, and by an increase in federal grant revenues for
transportation and local waste water treatment projects. Capital Projects Funds
expenditures increased $194 million (5.7 percent) in State fiscal year 1995-96
because of increased expenditures for education and health and environmental
projects. Net other financing sources increased by $577 million as a result of
an increased in proceeds from financing arrangements.
The State completed its 1994-95 fiscal year with a combined
Governmental Funds operating deficit of $1.79 billion, which included operating
deficits in the General Fund of $1.43 billion, in the Capital Projects Funds of
$366 million, and in the Debt Service Funds of $38 million. There was an
operating surplus in the Special Revenue Funds of $39 million.
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The State reported a General Fund operating deficit of $1.43
billion for the 1994-95 fiscal year, as compared to an operating surplus of $914
million for the prior fiscal year. The 1994-95 fiscal year deficit was caused by
several factors, including the use of $1.03 billion of the 1993-94 cash-based
surplus to fund operating expenses in 1994-95, and the adoption of changes in
accounting methodologies by the State Comptroller. These factors were offset by
net proceeds of $315 million in bonds issued by LGAC.
Total revenues for 1994-95 were $31.46 billion. Revenues
decreased by $173 million over the prior fiscal year, a decrease of less than
one percent. Personal income taxes grew by $103 million, an increase of 0.6
percent. Similarly, consumption and use taxes increased by $376 million or 6.0
percent. The increase in personal income and sales taxes was due to modest
growth in the State's economy. Business taxes declined by $751 million or 12.8
percent from the previous year. The decline in business taxes was caused
primarily by a decline in taxable earnings in the insurance, bank and petroleum
industries and the beginning of the phase-out of the corporate tax surcharges.
Other revenues and miscellaneous receipts showed modest increases.
Total 1994-95 expenditures were $33.08 billion, an increase of
$2.08 billion, or 6.7 percent over the prior fiscal year. In Grants to Local
Governments, social service and education expenditures grew by $927 million
(10.3 percent) and $727 million (7.6 percent), collectively. Social services
spending increased in Medicaid and Income Maintenance, while education spending
grew as a result of increases enacted with the 1994-95 budget. General purpose
local assistance declined by $205 million (22.9 percent) as a result of prior
year spending reductions. Other local assistance spending showed modest
increases. In State Operations, personal service costs grew by $322 million (5.4
percent) while non-personal service declined by $70 million (3.4 percent).
Pension contributions more than doubled, increasing by $95 million, while other
fringe benefit costs increased by $151 million (10.9 percent). State Operations
growth was primarily from labor contracts that resulted in salary increases and
retroactive payments.
Net other financing sources and uses declined from $282
million (as restated) to $198 million, and $84 million (29.8 percent) decline
from the previous year, primarily because of a reduction in bonds issued by
LGAC.
Special Revenue, Debt Services and Capital Projects Fund
Types
An operating surplus of $39 million was reported for Special
Revenue Funds for the 1994-95 fiscal year which increased
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the accumulated fund balance to $877 million. Revenues increased $1.62 billion
over the prior fiscal year (6.9 percent) as a result of increase in federal
grants and lottery revenues. Expenditures increased $1.89 billion (9.3 percent)
as a result of increased costs for social services programs and an increase in
the distribution of lottery proceeds to school districts. Other financing used
declined $166 million (5.7 percent) primarily because of a decline in federal
reimbursements and transferred to other funds.
Debt Service Funds ended the 1994-95 fiscal year with an
operation deficit of over $38 million and, as a result, the accumulated fund
balance declined to 41.75 billion. Revenues increased $145 million (7.1 percent)
because of increases in both dedicated taxes and mental hygiene patient fees.
Debt service expenditures increased $106 million (5.3 percent). Net other
financing uses increased $101 million, due primarily to a decrease in net
operating transfers of $158 million offset in part by a $57 million increase in
proceeds from other financing arrangements.
An operating deficit of $366 million was reported in the
Capital Projects Funds for the State's 1994-95 fiscal year and, as a result, the
accumulated deficit fund balance in this fund type increased to $988 million.
Revenues increased $256 million (17.3 percent) primarily because a larger share
of the petroleum business tax was shifted from the General Fund to the Dedicated
Highway and Bridge Trust fund, and by an increase in federal grant revenues for
transportation and local waste water treatment projects. Capital Projects Funds
expenditures increased $585 million (20.7 percent) in State fiscal year 1994-95
because of increased expenditures for transportation and correctional projects.
Net other financing sources (uses) declined by less than $2 million.
1994-95 FISCAL YEAR. The State reported a General Fund
operating surplus of $914 million for the 1993-94 fiscal year, as compared to an
operating surplus of $2.07 billion for the prior fiscal year. The 1993-94 fiscal
year surplus reflects several major factors, including the cash basis surplus
recorded in 1993- 94, the use of $671 million of the 1992-93 surplus to fund
operating expenses in 1993-94, net proceeds of $575 million in bonds issued by
LGAC and the accumulation of a $265 million balance in the CRF. Revenues
increased $543 million (1.7 percent) over prior fiscal year revenues with the
largest increase occurring in personal income taxes. Expenditures increased
$1.66 billion (5.6 percent) over the prior fiscal year, with the largest
increase occurring in State aid for social services programs. Other financing
sources declined more than 11 percent, with a net increase in operating
transfers from other funds more than offset by a decline in proceeds from
financing arrangements caused by lower LGAC bond sales.
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GENERAL FUND. Personal income and business taxes increased by
$847 million and $267 million, respectively, offset by reductions in consumption
and use taxes and miscellaneous revenues of $141 million and $318 million,
respectively. Personal income and business taxes increased primarily because the
economy performed at a higher level. General Fund revenues from consumption and
use taxes and fees declined primarily because revenues generated by both motor
fuel and highway and use taxes were earmarked instead for the Dedicated Highway
and Bridge Trust Fund which is reported in the Capital Projects Funds.
Miscellaneous revenues declined because certain receipts recorded in the prior
year were nonrecurring.
Expenditures for social services programs increased $1.05
billion primarily due to increases in Medicaid and Income Maintenance. A $365
million increase in departmental operations was caused primarily by the
settlement of outstanding labor contracts and unfavorable judicial decisions in
previously pending litigation.
Operating transfers from other funds increased, primarily
reflecting the receipt of $200 million from a prior-year claim settlement
associated with the federal government. In addition, transfers of excess sales
tax receipts from the Local Government Assistance Tax Fund increased by nearly
$166 million as a result of higher sales tax receipts in the Debt Service Funds.
The increase in operating transfers to other funds was caused by an increase in
operating subsidies provided to both the SUNY and the CUNY. Proceeds from
financing arrangements declined over $340 million, as a result of a decrease in
the issuance of LGAC bonds.
Special Revenue Funds ended with an operating surplus of $149
million for the 1993-94 fiscal year and, as a result, the accumulated fund
balance increased to $837 million. Revenues increased $2.06 billion over the
prior fiscal year primarily as a result of an increase in federal grants to
finance increased spending for social services programs, and in petroleum gross
receipt taxes. Expenditures increased by $1.57 billion primarily related to
social services programs. Other financing use increased by approximately $500
million, representing increases in federal reimbursement for Medicaid patient
services provided by various State health and mental hygiene facilities.
Debt Service Funds ended with an operating surplus of $23
million for the 1993-94 fiscal year, and as a result, the accumulated fund
balance increased to $1.79 billion. Revenues increased $34 million, primarily as
a result of an increase in dedicated taxes partially offset by a decrease in
mental hygiene patient fees. Debt service expenditures increased $31 million.
Net other financing sources decreased $361 million due to a net decline of $430
million in proceeds from financing arrangements
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offset in part by a $70 million increase in net operating transfers.
An operating deficit of $35 million was reported in the
Capital Projects Funds for the State's 1993-94 fiscal year, and, as a result,
the accumulated deficit fund balance increased to $622 million. Revenues
increased by $458 million which was primarily attributable to the shifting of
certain tax revenues from the General Fund to the Dedicated Highway and Bridge
Trust Fund. Capital Projects Funds expenditures increased by $61 million.
Expenditures for highway and bridge construction increased by approximately $223
million, but this increase was offset in large part by a decrease of $160
million relating to reductions in spending for water pollution control,
hazardous waste programs and various miscellaneous State aid programs. Net other
financing sources (uses) decreased $489 million primarily as a result of a
reduction in general obligation bond proceeds and a decrease in transfers from
the General Fund.
ECONOMICS AND DEMOGRAPHICS. This section presents economic
information about the State which may be relevant in evaluating the future
prospects of the State. However, the demographic information and statistical
data, which have been obtained from the sources indicated, do not present all
factors which may have a bearing on the State's fiscal and economic affairs.
Further, such information requires economic and demographic analysis in order to
assess the import of the data presented. The data analysis may be interpreted
differently, according to the economist or other expert consulted.
The State Financial Plan is based upon a June 1996 projection
by DOB of national and State economic activity. The information in this section
and in tables 15 and 16 below summarize the economic outlook upon which
projections of receipts and certain disbursements were made for the 1996-97
fiscal year.
The national economy has resumed a more robust rate of growth
after a "soft landing" in 1995, with over 11 million jobs added nationally since
early 1992. The State economy has continued to expand, but growth remains
somewhat slower than in the nation. Although the State has added approximately
240,000 jobs since late 1992, employment growth in the State has been hindered
during recent years by significant cutbacks in the computer and instrument
manufacturing, utility, defense, and banking industries. Government downsizing
has also moderated these job gains.
DOB forecasts that national economic growth will be quite
strong in the fist half of calendar 1996, but will moderate considerably as the
year progresses. The overall growth rate of the national economy during calendar
year 1996 is expected to be just slightly below the "consensus" of a widely
followed survey of
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national economic forecasters. Growth in real Gross Domestic Product during 1996
is projected to be moderate at 2.1 percent, with anticipated declines in federal
spending and net exports more than offset by increases in consumption and
investment. Inflation, as measured by the Consumer Price Index, is projected to
be contained at about 3 percent due to moderate wage growth and foreign
competition. Personal income and wages are projected to increase by about 5
percent.
The forecast of the State's economy shows modest expansion
during the first half of calendar 1996, but some slowdown is projected during
the second half of the year. Although industries that export goods and services
are expected to continue to do well, growth is expected to be slowed by
government cutbacks at all levels and by tight fiscal constraints on health and
social services. On an average annual basis, employment growth in the State is
expected to be up slightly from the 1995 rate. Personal income is expected to
record moderate gains in 1996. Bonus payments in the securities industry are
expected to increase further from last year's record level.
The forecast for continued slow growth, and any resultant
impact on the State's 1996-97 Financial Plan, contains some uncertainties.
Stronger-than-expected gains in employment could lead to a significant
improvement in consumption spending. Investments could also remain robust.
Conversely, the prospect of a continuing deadlock on federal budget deficit
reduction or fears of excessively rapid economic growth could create upward
pressures on interest rates. In addition, the State economic forecast could
over- or underestimate the level of future bonus payments or inflation growth,
resulting in forecasted average wage growth that could differ significantly from
actual growth. Similarly, the State forecast could fail to correctly account for
expected declines in government and banking employment and the direction of
employment change that is likely to accompany telecommunications deregulation.
THE NEW YORK ECONOMY. New York is the third most populous
state in the nation and has a relatively high level of personal wealth. The
State's economy is diverse, with a comparatively large share of the nation's
finance, insurance, transportation, communications and services employment, and
a very small share of the nation's farming and mining activity. The State's
location and its excellent air transport facilities and natural harbors have
made it an important link in international commerce. Travel and tourism
constitute an important part of the economy. Like the rest of the nation, New
York has a declining proportion of its workforce engaged in manufacturing, and
an increasing proportion engaged in service industries.
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Services: The services sector which includes entertainment,
personal services, such as health care and auto repairs, and business-related
services, such as information processing, law and accounting, is the State's
leading economic sector. The services sector accounts for more than three of
every ten nonagricultural jobs in New York. New York's economy is somewhat more
reliant than the rest of the nation on this sector; this sector has added more
jobs (825,000) than has the State's economy as a whole (665,000) since 1980.
Manufacturing: Manufacturing employment continues to decline
in importance in New York, as in most other states, and New York's economy is
less reliant on this sector than is the nation. Manufacturing's share of total
employment declined from 20.1 to 12.0 percent between 1980 and 1995. The
principal manufacturing industries in recent years produced printing and
publishing materials, instruments and related products, machinery, apparel and
finished fabric products, electronic and other electric equipment, food and
related products, chemicals and allied products, and fabricated metal products.
Trade: Wholesale and retail trade is the second largest sector
in terms of nonagricultural jobs in New York but is considerably smaller when
measured by income share. Trade consists of wholesale businesses and retail
businesses, such as department stores and eating and drinking establishments.
Finance, Insurance and Real Estate: New York City is the
nation's leading center of banking and finance and, as a result, this is a far
more important sector in the State than in the nation as a whole. Although this
sector accounts for under one-tenth of all nonagricultural jobs in the State, it
contributes one-seventh of all nonfarm labor and proprietors' income.
Agriculture: Farming is an important part of the economy of
large regions of the State, although it constitutes a very minor part of total
State output. Principal agricultural products of the State include milk and
dairy products, greenhouse and nursery products, apples and other fruits, and
fresh vegetables. New York ranks among the nation's leaders in the production of
these commodities.
Government: Federal, State and local government account for
almost 18 percent of nonagricultural State employment and 16 percent of nonfarm
labor income.
The importance of the different sectors of the State's economy
relative to the national economy is shown in the following table, which compares
nonagricultural employment and income by industrial categories for the State and
the nation as a whole. Relative to the nation, the State has a smaller share of
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manufacturing and construction and a larger share of service- related
industries. The State is likely to be less affected than the nation as a whole
during an economic recession that is concentrated in manufacturing and
construction, but likely to be more affected during a recession that is
concentrated more in the service-producing sector.
ECONOMIC AND DEMOGRAPHIC TRENDS. During the 1982-83 recession,
overall economic activity in the State declined less than that of the nation as
a whole. However, in the calendar years 1987 through 1995, the State's rate of
economic growth was somewhat slower than that of the nation. In particular,
during the 1990-91 recession and post-recession period, the economy of the
State, and that of the rest of the Northeast, was more heavily damaged than that
of the nation as a whole and has been slower to recover. The total employment
growth rate in the State has been below the national average since 1987. The
unemployment rate in the State dipped below the national rate in the second half
of 1981 and remained lower until 1991; since then, it has been higher. According
to data published by the US Bureau of Economic Analysis, during the past ten
years, total personal income in the State rose slightly faster than the national
average only from 1986 through 1988.
The State's population has grown since 1930, except for a
period of decline during the 1970s and a virtual standstill the past two years.
State per capita personal income has historically been
significantly higher than the national average, although the ratio has varied
substantially. Because the City is a regional employment center for a
multi-state region, state personal income measured on a residence basis
understates the relative importance of the State to the national economy and the
size of the base to which State taxation applies.
DEBT AND OTHER FINANCING ACTIVITIES
LEGAL CATEGORIES OF STATE DEBT AND OTHER FINANCINGS. State
financing activities include general obligation debt of the State and
State-guaranteed debt, to which the full faith and credit of the State has been
pledged, as well as lease-purchase and contractual-obligation financings, moral
obligation financings and other financings, through public authorities and
municipalities, where the State's legal obligation to make payments to those
public authorities and municipalities for their debt service is subject to
annual appropriation by the Legislature. These categories are described in the
Glossary of Financial Terms in Exhibit A to this Annual Information Statement
and in more detail below.
General Obligations and State-Guaranteed Financing.
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There are a number of methods by which the State itself may incur debt. The
State may issue general obligation bonds. Under the State Constitution, the
State may not, with limited exceptions for emergencies, undertake long-term
general obligation borrowing (i.e., borrowing for more than one year) unless the
borrowing is authorized in a specific amount for a single work or purpose by the
Legislature and approved by the voters. There is no limitation on the amount of
long-term general obligation debt that may be so authorized and subsequently
incurred by the State. With the exception of general obligation housing bonds
(which must be paid in equal annual installments or installments that result in
substantially level or declining debt service payments, within 50 years after
issuance, commencing no more than three years after issuance), general
obligation bonds must be paid in equal annual installments or installments that
result in substantially level or declining debt service payments, within 40
years after issuance, beginning not more than one year after issuance of such
bonds.
The State may undertake short-term borrowings without voter
approval (i) in anticipation of the receipt of taxes and revenues, by issuing
tax and revenue anticipation notes ("TRANs"), and (ii) in anticipation of the
receipt of proceeds from the sale of duly authorized but unissued general
obligation bonds, by issuing bond anticipation notes ("BANs"). TRANs must mature
within one year from their dates of issuance and may not be refunded or
refinanced beyond such period. BANs may only be issued for the purposes and
within the amounts for which bonds may be issued pursuant to voter
authorizations. Such BANs must be paid from the proceeds of the sale of bonds in
anticipation of which they were issued or from other sources within two years of
the date of issuance or, in the case of BANs for housing purposes, within five
years of the date of issuance.
Pursuant to specific constitutional authorization, the State
may also directly guarantee certain public authority obligations. The State
Constitution provides for the State guarantee of the repayment of certain
borrowings for designated projects of the New York State Thruway Authority, the
Job Development Authority and the Port Authority of New York and New Jersey. The
State has never been called upon to make any direct payments pursuant to such
guarantees. The constitutional provisions allowing a State guarantee of certain
Port Authority of New York and New Jersey debt stipulates that no such
guaranteed debt may be outstanding after December 31, 1996. State-guaranteed
bonds issued by the Thruway Authority were fully retired on July 1, 1995.
Payments of debt service on State general obligation and
State-guaranteed bonds and notes are legally enforceable obligations of the
State.
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Lease-Purchases and Contractual-Obligation Financing. The
State employs additional long-term financing mechanisms, lease-purchase and
contractual obligation financings, which involve obligations of public
authorities or municipalities that are State- supported but not general
obligations of the State. Under these financing arrangements, certain public
authorities and municipalities have issued obligations to finance the
construction and rehabilitation of facilities or the acquisition and
rehabilitation of equipment, and expect to meet their debt service requirements
through the receipt of rental or other contractual payments made by the State.
Although these financing arrangements involve a contractual agreement by the
State to make payments to a public authority, municipality or other entity, the
State's obligation to make such payments is generally expressly made subject to
appropriation by the Legislature and the actual availability of money to the
State for making the payments. The State has also entered into a
contractual-obligation financing arrangement with LGAC to restructure the way
the State makes certain local aid payments (see "Local Government Assistance
Corporation" below in this section).
The State also participates in the issuance of certificates of
participation ("COPs") in a pool of leases entered into by the State's Office of
General Services on behalf of several State departments and agencies interested
in acquiring operational equipment, or in certain cases, real property.
Legislation enacted in 1986 established restrictions upon and centralized State
control, through the Comptroller and the Director of the Budget, over the
issuance of COPs representing the State's contractual obligation, subject to
annual appropriation by the Legislature and availability of money, to make
installment or lease-purchase payments for the State's acquisition of such
equipment or real property.
The State has never defaulted on any of its general obligation
indebtedness or its obligations under lease-purchase or contractual-obligation
financing arrangements and has never been called upon to make any direct
payments pursuant to its guarantees.
Moral Obligation and Other Financing. Moral obligation
financing generally involves the issuance of debt by a public authority to
finance a revenue-producing project or other activity. The debt is secured by
project revenues and includes statutory provisions requiring the State, subject
to appropriation by the Legislature, to make up any deficiencies which may occur
in the issuer's debt service reserve fund. There has never been a default on any
moral obligation debt of any public authority. The State does not intend to
increase statutory authorizations for moral obligation bond programs. From 1976
through 1987, the State was called upon to appropriate and make payments
totaling $162.8 million to make up deficiencies in the debt service reserve
funds
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of the Housing Finance Agency pursuant to moral obligation provisions. In the
same period, the State also expended additional funds to assist the Project
Finance Agency, the Urban Development Corporation ("UDC") and other public
authorities which had moral obligation debt outstanding. The State has not been
called upon to make any payments pursuant to any moral obligations since the
1986- 87 fiscal year and no such requirements are anticipated during the 1996-97
fiscal year.
In addition to the moral obligation financing arrangements
described above, State law provides for the creation of State municipal
assistance corporations, which are public authorities established to aid
financially troubled localities. The Municipal Assistance Corporation for the
City of New York ("NYC MAC") was created in 1975 to provide financing assistance
to New York City. To enable NYC MAC to pay debt service on its obligations, NYC
MAC receives, subject to annual appropriation by the Legislature, receipts from
the 4 percent New York State sales tax for the benefit of New York City, the
State-imposed stock transfer tax and, subject to certain prior liens, certain
local assistance payments otherwise payable to New York City. The legislation
creating NYC MAC also includes a moral obligation provision. Under its enabling
legislation, NYC MAC's authority to issue moral obligation bonds and notes
(other than refunding bonds and notes) expired on December 31, 1984. In 1995,
the State created the Municipal Assistance Corporation for the City of Troy
("Troy MAC"). The bonds expected to be issued by Troy MAC would not be subject
to the State's moral obligation.
The State also provides for contingent contractual- obligation
financing for the Secured Hospital Program pursuant to legislation enacted in
1985. Under this financing method, the State contracts to pay debt service,
subject to annual appropriations, on bonds formerly issued by the New York State
Medical Care Facilities Finance Agency ("MCFFA") and now issued by the Dormitory
Authority of the State of New York ("DASNY") in the event there are shortfalls
of revenues from other sources. The State has never been required to make any
payments pursuant to this financing arrangement, nor does it anticipate being
required to do so during the 1996-97 fiscal year.
LOCAL GOVERNMENT ASSISTANCE CORPORATION. In 1990, as part of a
State fiscal reform program, legislation was enacted creating LGAC, a public
benefit corporation empowered to issue long-term obligations to fund certain
payments to local governments that had been traditionally funded through the
State's annual seasonal borrowing. The legislation authorized LGAC to issue its
bonds and notes in an amount to yield net proceeds not in excess of $4.7 billion
(exclusive of certain refunding bonds). Over a period of years, the issuance of
these long-term obligations, which are to be amortized over no more than 30
years, was expected to eliminate
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the need for continued short-term seasonal borrowing. The legislation also
dedicated revenues equal to one-quarter of the four cent State sales and use tax
to pay debt service on these bonds. The legislation also imposed a cap on the
annual seasonal borrowing of the State at $4.7 billion, less net proceeds of
bonds issued by LGAC and bonds issued to provide for capitalized interest,
except in cases where the Governor and the legislative leaders have certified
the need for additional borrowing and provided a schedule for reducing it to the
cap. If borrowing above the cap is thus permitted in any fiscal year, it is
required by law to be reduced to the cap by the fourth fiscal year after the
limit was first exceeded. This provision capping the seasonal borrowing was
included as a covenant with LGAC's bondholders in the resolution authorizing
such bonds.
As of June 1995, LGAC had issued bonds and notes to provide
net proceeds of $4.7 billion, completing the program. The impact of LGAC's
borrowing is that the State has been able to meet its cash flow needs throughout
the fiscal year without relying on short-term seasonal borrowings. The 1996-97
State Financial Plan includes no seasonal borrowing; this reflects the success
of the LGAC program in permitting the State to accelerate local aid payments
from the first quarter of the current fiscal year to the fourth quarter of the
previous fiscal year.
1996-97 BORROWING PLAN. The State anticipates that its capital
programs will be financed, in part, through borrowings by the State and public
authorities in the 1996-97 fiscal year. The State expects to issue $411 million
in general obligation bonds (including $153.6 million for purposes of redeeming
outstanding BANs) and $154 million in general obligation commercial paper. The
Legislature has also authorized the issuance of up to $101 million in COPs
during the State's 1996-97 fiscal year for equipment purchases. The projection
of the State regarding its borrowings for the 1996-97 fiscal year may change if
circumstances require.
Borrowings by other public authorities pursuant to
lease-purchase and contractual-obligation financings for capital programs of the
State are projected to total $2.15 billion, including costs of issuances,
reserve funds, and other costs, net of anticipated refundings and other
adjustments for 1996-97 capital projects. Included therein are borrowings by (i)
DASNY for SUNY, The City University of New York ("CUNY"), health facilities, and
mental health facilities; (ii) Thruway Authority for the Dedicated Highway and
Bridge Trust Fund and Consolidated Highway Improvement Program; (iii) UDC (doing
business as the Empire State Development Corporation) for prison and youth
facilities; (iv) the Housing Finance Agency ("HFA") for housing programs; and
(v) borrowings by the Environmental Facilities Corporation ("EFC") and other
authorities. In addition, the Legislature has authorized DASNY to refinance a
$787 million pension obligation of the State.
- 39 -
<PAGE>
In the 1996 legislative session, the Legislature approved the
Governor's proposal to present to the voters in November 1996 a $1.75 billion
State general obligation bond referendum to finance various environmental
improvement and remediation projects. If the Clean Water, Clean Air Bond Act is
approved by the voters, the amount of general obligation bonds issued during the
1996-97 fiscal year may increase above the $411 million currently included in
the 1996-97 Borrowing Plan to finance a portion of this new program.
OUTSTANDING DEBT OF THE STATE AND CERTAIN AUTHORITIES. For
purposes of analyzing the financial condition of the State, debt of the State
and of certain public authorities may be classified as State-supported debt,
which includes general obligation debt of the State and lease-purchase and
contractual obligations of public authorities (and municipalities) where debt
service is paid from State appropriations (including dedicated-tax sources, and
other revenues such as patient charges and dormitory facilities rentals). In
addition, a broader classification, referred to as State-related debt, includes
State-supported debt, as well as certain types of contingent obligations,
including moral-obligation financing, certain contingent contractual- obligation
financing arrangements, and State-guaranteed debt described above, where debt
service is expected to be paid from other sources and State appropriations are
contingent in that they may be made and used only under certain circumstances.
STATE-SUPPORTED DEBT OUTSTANDING. General Obligation Bond
Programs. The first type of State-supported debt, general obligation debt, is
currently authorized for three programmatic categories: transportation,
environmental and housing. The State has issued bonds only if the first two
categories in recent years, with the size of the issues generally decreasing as
existing authorizations are diminished. The amount of general obligation bonds
and BANs issued in the 1993-94 through 1995-96 fiscal years (excluding bonds
issued to redeem BANs) were $388 million, $250 million and $333 million,
respectively. Transportation-related bonds are issued for State highway and
bridge improvements, aviation, highway and mass transportation projects and
purposes, and rapid transit, rail, canal, port and waterway programs and
projects. Environmental bonds are issued to fund environmentally- sensitive land
acquisitions, air and water quality improvements, municipal non-hazardous waste
landfill closures and hazardous waste site cleanup projects. As of March 31,
1996, the total amount of outstanding general obligation debt was $5.05 billion,
including $293.6 million in BANs.
The foregoing information as to certain New York risk factors
is given to investors in view of the Fund's policy of concentrating its
investments in New York Issuers. Such information constitutes only a brief
summary and does not purport to be a complete description. See Appendix A to
this Statement of
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<PAGE>
Additional Information for a description of municipal securities ratings.
MANAGEMENT OF THE FUND
DIRECTORS AND OFFICERS
Directors and officers of the Fund, together with information
as to their principal business occupations during the last five years, are shown
below. Each director who is considered to be an "interested person" of the Fund,
as defined in the 1940 Act, is indicated by as asterisk (*).
JAMES C. ARMSTRONG: Director of the Fund. Mr. Armstrong is a
management consultant. He was formerly a partner in Armstrong/Seltzer
Communications Inc., a New York management, consulting and public relations
firm. Earlier he served as Executive Director, Global Public Affairs Institute
at New York University and Professor, Bell of Pennsylvania Chair in
Telecommunications, Temple University. He was with American Telephone and
Telegraph Company for 15 years. His last position with AT&T was Director,
Corporate Policy Analysis. Mr. Armstrong previously held positions at the
Institute for Defense Analysis, the Office of the Postmaster General, and on the
faculty of the University of Maryland. He has been a consultant to government,
academic and business organizations, and has served on various
government-industry task forces and committees. Mr. Armstrong was an Officer in
the United States Navy and holds a Ph.D. in nuclear physics. Mr. Armstrong's
address is 70 North Ravenwood Drive, Cape May Court House, New Jersey 08210.
L. GREG FERRONE: Director of the Fund. Mr. Ferrone is Senior
Manager of ARC Partners, a management and consulting firm. Previously he was a
consultant with IntraNet, Inc., a provider of computer systems to the domestic
and international banking industry. Prior thereto he was the Director of Sales &
Marketing for RAV Communications Inc., Vice President/Regional Manager with
National Westminster Bank USA and an officer at Security Pacific Bank. Mr.
Ferrone received a Bachelor of Science degree from Rensselaer Polytechnic
Institute in 1972 and studied at the Stonier Graduate School of Banking. Mr.
Ferrone's address is 83 Ronald Court, Ramsey, New Jersey 07446.
*VINCENT J. MALANGA: Chairman of the Board, Chief Executive
Officer, President and Treasurer of the Fund, The California Muni Fund and
Fundamental Fixed Income Fund. Mr. Malanga is President, Treasurer and a
Director of Fundamental Portfolio Advisors, Inc., Executive Vice President,
Secretary and a Director of Fundamental Service Corporation, and President,
LaSalle Economics Inc., an economic consulting firm. Prior thereto, he was a
Vice President and Senior Economist at A. Gary
- 41 -
<PAGE>
Shilling & Company, Inc., an economic consulting and brokerage firm. He
previously served as an Economist at White, Weld & Co. (an investment banking
and brokerage firm) and so served from 1976 to 1978. Prior thereto, Mr. Malanga,
who holds a Ph.D. in Economics from Fordham University, was an Economist at the
Federal Reserve Bank of New York. Mr. Malanga's address is 90 Washington Street,
19th Floor, New York, New York 10006.
All of the Directors of the Fund are also Trustees of The
California Muni Fund and Fundamental Fixed-Income Fund. Dr. Vincent J. Malanga,
an officer of the Fund, holds similar offices with The California Muni Fund and
Fundamental Fixed-Income Fund.
For services and attendance at board meetings and meetings of
committees which are common to the Fund, Fundamental Fixed-Income Fund and The
California Muni Fund (other affiliated mutual funds for which the Fund's
investment manager acts as the investment adviser), each Director of the Fund
who is not affiliated with the Fund's investment manager is compensated at the
rate of $6,500 per quarter prorated among the three funds based on their
respective net assets at the end of each quarter. Each such Director is also
reimbursed by the three funds, on the same basis, for actual out-of-pocket
expenses relating to his attendance at meetings. Some Directors received
additional compensation at a rate of $125 per hour for services related to
servicing on the Portfolio Review Committee. For the fiscal year ended December
31, 1997, Directors' fees totalling $102,427 were paid by the Fund to the
Directors and to former Directors as a group. As of the date of this Statement
of Additional Information, Directors and officers of the Fund as a group owned
beneficially less than 1% of the Fund's outstanding shares.
- 42 -
<PAGE>
<TABLE>
<CAPTION>
COMPENSATION TABLE
(FOR EACH CURRENT BOARD MEMBER
RECEIVING COMPENSATION FROM
A FUNDAMENTAL FUND FOR THE
MOST RECENTLY COMPLETED FISCAL YEAR)
AGGREGATE COMPENSATION FROM FUND
AGGREGATE
COMPENSATION
PAID BY ALL
FUNDS MANAGED
BY
HIGH-YIELD TAX-FREE U.S. GOV'T FUNDAMENTAL
CALIFORNIA MUNICIPAL MONEY STRATEGIC PORTFOLIO
NAME NY MUNI MUNI BOND MARKET INCOME ADVISERS, INC.
<S> <C> <C> <C> <C> <C> <C>
JAMES C. ARMSTRONG $29,684 $3,044 $496 $2,919 $2,207 $38,350
L. GREG FERRONE $20,124 $2,064 $336 $1,979 $1,497 $26,000
</TABLE>
PORTFOLIO REVIEW COMMITTEE
Pursuant to the terms of an assurance of discontinuance (the
"assurance") entered into with the Department of Law of the State of New York,
the Fund has established and will maintain for a period of at least five years
from April 15, 1994, a Portfolio Review Committee of its Board of Directors,
consisting of no fewer than three independent directors. All of the Independent
Directors currently serve on the Portfolio Review Committee.
The Portfolio Review Committee oversees the Fund's (i)
investment performance and strategies; (ii) the adequacy of internal controls
and procedures applicable to portfolio personnel and activity; (iii) the
amendment, as they may deem necessary in the exercise of their duties, of the
Fund's Prospectus; and (iv) compliance with investment policies stated in the
Fund's Prospectus, with such other policies as the Board of Directors may from
time to time establish, and with all applicable laws, rules and regulations. The
Portfolio Review Committee also reviews all annual and semi-annual reports prior
to their dissemination to shareholders.
The Portfolio Review Committee is required to keep a record of
its meetings and has the authority to retain such expert (legal, financial or
accounting) assistance as the Committee in its sole discretion deems necessary
in the exercise of their duties. Fundamental Service Corporation has designated
a Compliance Officer
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<PAGE>
who has day-to-day responsibility for the Fund's compliance with applicable
Federal and state laws, rules and regulations, the assurance entered into with
the Department of Law of the State of New York, and the rules, policies and
by-laws of the National Association of Securities Dealers, Inc., particularly as
they pertain to sales materials. The Compliance Officer also assists the work of
the Portfolio Review Committee.
INVESTMENT MANAGEMENT
As discussed in the Fund's Prospectus, a Management Agreement
(the "Agreement") between the Company, on behalf of the Fund, and Fundamental
Portfolio Advisors, Inc.(the "Manager"), was adopted by the Board of Directors
of the Fund on October 3, 1990, and was approved by shareholders on November 29,
1990. The Board of Directors last approved the continuation of the Management
Agreement on March 25, 1998 for a period of sixty days following March 31, 1998.
Vincent J. Malanga, Chairman of the Board, Chief Executive Officer, President
and Treasurer of the Fund, and Dr. Lance M. Brofman, each own approximately
48.5% of the outstanding shares of the voting capital stock of the Manager.
The Manager has agreed that it will notify the Fund's Board of
Directors before engaging any new clients of material significance; that, if
requested, each Director will receive a weekly portfolio transaction statement
from the Manager in order to review all trades made by the Manager; and that if
at any time three or more Directors who are "non-interested persons" of the Fund
desire to purchase or sell any security for or of the Fund, the Manager, at the
direction of the "non-interested" Directors, will immediately purchase or sell
such security, as the case may be, at the expense and risk of the Fund.
ADMINISTRATOR, TRANSFER AGENT,
CUSTODIAN AND ACCOUNTING AGENT
Firstar Trust Company, P.O. Box 701, Milwaukee, WI 53201- 0701
currently acts as Administrator, Transfer Agent, Custodian and Accounting Agent
of the Fund.
Fundamental Shareholder Services, Inc., P.O. Box 1013, Bowling
Green Station, New York, New York 10274-1013, an affiliate of Fundamental
Portfolio Advisors, Inc. and Fundamental Service Corporation, previously
performed all services in connection with the transfer of shares of the Fund,
acted as its dividend disbursing agent, and as administrator of the exchange,
check redemption, telephone redemption and expedited redemption privileges of
the Fund. During the fiscal year ended December 31, 1997, fees paid to
Fundamental Shareholder Services, Inc. by the Fund amounted to $260,717.
- 44 -
<PAGE>
DISTRIBUTION PLAN
The Board of Directors and shareholders of the Fund have
approved a plan of distribution under Rule 12b-1 of the 1940 Act (the "Plan").
Pursuant to the Plan, the Fund may pay certain promotional and advertising
expenses and may compensate certain registered securities dealers and financial
institutions for services provided in connection with the processing of orders
for purchase or redemption of the shares of the Fund and furnishing other
shareholder services. Payments by the Fund shall not in the aggregate in any
fiscal year of the Fund exceed 1/2 of 1% of daily net assets of the Fund. The
Fund may enter into shareholder processing and service agreements (the
"Shareholder Service Agreements") with any securities dealer who is registered
under the Securities Exchange Act of 1934 and a member in good standing of the
National Association of Securities Dealers, Inc., and with banks and other
financial institutions, who may wish to establish accounts or sub-accounts on
behalf of their customers ("Shareholder Service Agents"). For processing
investor purchase and redemption orders, responding to inquiries from Fund
shareholders concerning the status of their accounts and operations of the Fund
and communicating with the Fund, the Fund may pay each such Shareholder Service
Agent to cover expenditures for advertising, sales literature and other
promotional materials on behalf of the Fund.
The fees payable to Shareholder Service Agents under
Shareholder Service Agreements will be negotiated by the Fund's management. The
Fund's management will report quarterly to the Board of Directors on the rate to
be paid under each such agreement and the amounts paid or payable under such
agreements. It will be based upon the management's analysis of (1) the
contribution that the Shareholder Service Agent makes to the Fund by increasing
Fund assets and reducing expense ratios; (2) the nature, quality and scope of
services being provided by the Shareholder Service Agent; (3) the cost to the
Fund if shareholder services were provided directly by the Fund or other
authorized persons; (4) the costs incurred by the Shareholder Servicing Agent in
connection with providing services to shareholders; and (5) the need to respond
to competitive offers of others which could result in assets being withdrawn
from the Fund and an increase in the expense ratio for the Fund.
The Board of Directors of the Fund, including a majority of
the "disinterested" Directors who have no direct or indirect financial interest
in the operation of the Plan or any agreements relating thereto, authorized the
Fund to enter into an agreement with Fundamental Service Corporation, a Delaware
corporation, under the Plan. The agreement provides that the Fund may pay the
usual and customary agency's commission to Fundamental Service Corporation for
producing and placing Fund advertising in
- 45 -
<PAGE>
newspapers, magazines or other periodicals, on radio or television, or in direct
marketing campaigns. In addition to the foregoing, the Fund may pay Fundamental
Service Corporation for marketing research and promotional services specifically
relating to the distribution of Fund shares, including office space, facilities
and equipment, salaries, training and administrative expenses, computer systems
and software, communications, supplies, photocopying and similar types of
expenses. The following persons own of record 5% or more of the outstanding
shares of voting stock of Fundamental Service Corporation: Mr. Vincent J.
Malanga (43.71%); Mr. Thomas W. Buckingham (43.71%); and Dr. Lance M. Brofman
(9.90%).
The Plan will continue in effect for a period of sixty days
following March 31, 1998. The Plan will continue in effect from year to year if
specifically approved at least annually by the Board of Directors and the
affirmative vote of a majority of the Directors who are not parties to any
Shareholder Service Agreement or "interested persons" of any such party by votes
cast in person at a meeting called for such purpose. In approving the Plan, the
Directors determined, in the exercise of their business judgment and in light of
their fiduciary duties as Directors of the Fund, that there was a reasonable
likelihood that the Plan would benefit the Fund and its shareholders. The Plan
may only be renewed if the Directors make a similar determination for each
subsequent year. The Plan may not be amended to increase the maximum amount of
payments by the Fund to its Shareholder Service Agents without shareholder
approval, and all material amendments to the provisions of the Plan must be
approved by a vote of the Board of Directors and of the Directors who have no
direct or indirect interest in the Plan, cast in person at a meeting called for
the purpose of such vote.
The Plan provides that the Fund's management shall provide,
and that the independent Directors shall review, quarterly reports setting forth
the amounts expended pursuant to the Plan and the purpose for which the amounts
were expended. It further provides that while the Plan is in effect, the
selection and nomination of those Directors of the Fund who are not "interested
persons" of the Fund is committed to the discretion of the independent
Directors.
During the year ended December 31, 1997, the Fund paid
$647,839 for expenses incurred pursuant to the Plan, which amount was spent in
the distribution of the Fund's shares, including expenses for: advertising --
$174,850; printing and mailing of Prospectuses to other than current
shareholders -- $9,687; and sales, and shareholder servicing support services
and other distribution services, -- $463,302. Of the amount paid by the Fund
during last year, $307,200 was paid to Fundamental Service Corporation for
expenses incurred and services rendered by it pursuant to the Plan.
- 46 -
<PAGE>
CALCULATION OF YIELD
The Fund's yield quotations and average annual total return
quotations as they may appear in the Prospectus, this Statement of Additional
Information or in advertising and sales material, are calculated by standard
methods prescribed by the Securities and Exchange Commission.
The Fund's yield is computed by dividing the Fund's net
investment income per share during a base period of 30 days, or one month, by
the net asset value per share of the Fund on the last day of such base period in
accordance with the following formula:
a-b ^6
Yield = 2[(----+1) -1]
cd
Where: a = dividends and interest earned during the period
b = expenses accrued for the period (net of
reimbursements)
c = the average daily number of shares outstanding
during the period that were entitled to receive
dividends.
d = the maximum offering price per share on the last
day of the period.
For purposes of calculating interest earned on debt obligations as provided in
item "a" above:
1. The yield to maturity of each obligation held by the Fund
is computed based on the market value of the obligation (including actual
accrued interest, if any) at the close of business on the last day of each
month, or, with respect to obligations purchased during the month, the purchase
price (plus actual accrued interest, if any).
2. The yield to maturity of each obligation is then divided by
360 and the resulting quotient is multiplied by the market value of the
obligation (including actual accrued interest, if any) to determine the interest
income on the obligation for each day of the subsequent month that the
obligation is in the portfolio. For these purposes, it is assumed that each
month has 30 days.
3. Interest earned on all debt obligations during the 30-day
or one-month period is then totaled.
- 47 -
<PAGE>
4. The maturity of an obligation with a call provision(s) is
the next call date on which the obligation reasonably may be expected to be
called or, if none, the maturity date.
5. In the case of a tax-exempt obligation issued without
original issue discount and having a current market discount, the coupon rate of
interest of the obligation is used in lieu of yield to maturity to determine
interest income earned on the obligation.
In the case of a tax-exempt obligation with original issue discount where the
discount based on the current market value of the obligation exceeds the then
remaining portion of original issue discount (i.e. market discount), the yield
to maturity used to determine interest income earned on the obligation is the
imputed rate based on the original issue discount calculation. In the case of a
tax-exempt obligation with original issue discount where the discount based on
the current market value of the obligation is less than the then remaining
portion of the original issue discount (market premium), the yield to maturity
used to determine interest income earned on the obligation is based on the
market value of the obligation.
With respect to the treatment of discount and premium on
mortgage or other receivables-backed obligations which are expected to be
subject to monthly payments of principal and interest ("pay downs"), the Fund
accounts for gain or loss attributable to actual monthly pay downs as an
increase or decrease to interest income during the period. In addition, the Fund
may elect (1) to amortize the discount or premium on a remaining security, based
on the cost of the security, to the weighted average maturity date, if such
information is available, or to the remaining term of the security, if the
weighted average maturity date is not available, or (2) not to amortize the
discount or premium on a remaining security.
For the purposes of computing yield, dividend income is
recognized by accruing 1/360 of the stated dividend rate of each obligation in
the Fund's portfolio each day that the obligation is in the portfolio. The Fund
does not use equalization accounting in the calculation of yield. Expenses
accrued during any base period, if any, pursuant to the Plan are included among
the expenses accrued during the base period. Any reimbursement accrued pursuant
to the Plan during a base period, if any, will reduce expenses accrued pursuant
to such plan, but only to the extent the reimbursement does not exceed the
accrued expenses for the base period.
The Fund's yield for the one-month period ended December 31,
1997 determined in accordance with the above formula was 2.34%.
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<PAGE>
Average annual total return quotations are computed by finding
the average annual compounded rates of return that would cause a hypothetical
investment made on the first day of a designated period (assuming all dividends
and distributions are reinvested) to equal the ending redeemable value of such
hypothetical investment on the last day of the designated period in accordance
with the following formula:
P(1 + T)^n = ERV
Where: P = a hypothetical initial payment of $1000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical
$1000 payment made at the end of a designated
period (or fractional portion thereof)
For purposes of the above computation, it is assumed that all dividends and
distributions made by the Fund are reinvested at net asset value during the
designated period. The average annual total return quotation is determined to
the nearest 1/100 of 1%. The average annual total return for the year ended
December 31, 1997 was - 1.46%. For the five-year period ended December 31, 1997,
the average annual total return was (0.62)% and for the ten year period ended
December 31, 1997, the average annual total return was 4.24%.
In determining the average annual total return (calculated as
provided above), recurring fees, if any, that are charged to all shareholder
accounts are taken into consideration. For any account fees that vary with the
size of the account, the account fee used for purposes of the above computation
is assumed to be the fee that would be charged to the Fund's mean account size.
The Fund may also from time to time advertise its taxable
equivalent yield. The Fund's taxable equivalent yield is determined by dividing
that portion of the Fund's yield (calculated as described above) that is
tax-exempt by one minus the stated marginal Federal income tax rate and adding
the product to that portion, if any, of the yield of the Fund that is not
tax-exempt. The taxable equivalent yield of the Fund for the one-month period
ended December 31, 1997 was 4.37% for a taxpayer whose income was subject to the
then highest combined Federal, New York State and New York City income tax rate
of 46.43%.
The Fund's yield and average annual total return will vary
from time to time depending on market conditions, the composition of the Fund's
portfolio and operating expenses of the
- 49 -
<PAGE>
Fund. These factors and possible differences in the methods used in calculating
yields and returns should be considered when comparing performance information
regarding the Fund to information published for other investment companies and
other investment vehicles. Yields and return quotations should also be
considered relative to changes in the value of the Fund's shares and the risks
associated with the Fund's investment objectives and policies. At any time in
the future, yields and return quotations may be higher or lower than past yields
or return quotations and there can be no assurance that any historical yield or
return quotation will continue in the future.
CUSTODIAN AND INDEPENDENT CERTIFIED
PUBLIC ACCOUNTANTS
Firstar Trust Company (the "Bank"), 615 East Michigan Street,
Milwaukee, WI, acts as Custodian of the Fund's cash and securities. The Bank
also acts as transfer agent and bookkeeping agent for the Fund, and, as
bookkeeping agent, monitors the Fund's accounting records and calculates its net
asset value.
McGladrey & Pullen, LLP, 555 Fifth Avenue, New York, New York,
acts as independent certified public accountants for the Fund, performing an
annual audit of the Fund's financial statements and preparing its tax returns.
TAX MATTERS
The following is only a summary of certain additional federal
income tax considerations generally affecting the Fund and its shareholders that
are not described in the Prospectus. No attempt is made to present a detailed
explanation of the tax treatment of the Fund or its shareholders, and the
discussions here and in the Prospectus are not intended as substitutes for
careful tax planning.
Qualification as a Regulated Investment Company
The Fund has elected to be taxed as a regulated investment
company for federal income tax purposes under Subchapter M of the Code. As a
regulated investment company, the Fund is not subject to federal income tax on
the portion of its net investment income (i.e., taxable interest, dividends and
other taxable ordinary income, net of expenses) and capital gain net income
(i.e., the excess of capital gains over capital losses) that it distributes to
shareholders, provided that it distributes at least 90% of its investment
company taxable income (i.e., net investment income and the excess of net
short-term capital gain over net long-term capital loss) and at least 90% of its
tax-exempt income (net
- 50 -
<PAGE>
of expenses allocable thereto) for the taxable year (the "Distribution
Requirement"), and satisfies certain other requirements of the Code that are
described below. Distributions by the Fund made during the taxable year or,
under specified circumstances, within twelve months after the close of the
taxable year, will be considered distributions of income and gains of the
taxable year and will therefore count toward satisfaction of the Distribution
Requirement.
If the Fund has a net capital loss (i.e., the excess of
capital losses over capital gains) for any year, the amount thereof may be
carried forward up to eight years and treated as a short-term capital loss which
can be used to offset capital gains in such years. As of December 31, 1997, the
Fund has capital loss carryforwards of $24,147,000 expiring through December 31,
2005. Under Code Section 382, if the Fund has an "ownership change," the Fund's
use of its capital loss carryforwards in any year following the ownership change
will be limited to an amount equal to the net asset value of the Fund
immediately prior to the ownership change multiplied by the highest adjusted
long-term tax-exempt rate (which is published monthly by the Internal Revenue
Service (the "IRS")) in effect for any month in the 3-calendar-month period
ending with the calendar month in which the ownership change occurs (the rate
for April 1998 is 5.04%). The Fund will use its best efforts to avoid having an
ownership change. However, because of circumstances which may be beyond the
control of the Fund, there can be no assurance that the Fund will not have, or
has not already had, an ownership change. If the Fund has or has had an
ownership change, any capital gain net income for any year following the
ownership change in excess of the annual limitation on the capital loss
carryforwards will have to be distributed by the Fund and will be taxable to
shareholders as described under "Fund Distributions" below.
In addition to satisfying the Distribution Requirement, a
regulated investment company must derive at least 90% of its gross income from
dividends, interest, certain payments with respect to securities loans, gains
from the sale or other disposition of stock or securities or foreign currencies
(to the extent such currency gains are directly related to the regulated
investment company's principal business of investing in stock or securities) and
other income (including but not limited to gains from options, futures or
forward contracts) derived with respect to its business of investing in such
stock, securities or currencies (the "Income Requirement").
In general, gain or loss recognized by the Fund on the
disposition of an asset will be a capital gain or loss. In addition, gain will
be recognized as a result of certain constructive sales, including short sales
"against the box." However, gain recognized on the disposition of a debt
obligation
- 51 -
<PAGE>
(including municipal obligations) purchased by the Fund at a market discount
(generally, at a price less than its principal amount) will be treated as
ordinary income to the extent of the portion of the market discount which
accrued during the period of time the Fund held the debt obligation.
In general, for purposes of determining whether capital gain
or loss recognized by the Fund on the disposition of an asset is long-term or
short-term, the holding period of the asset may be affected if (1) the asset is
used to close a "short sale" (which includes for certain purposes the
acquisition of a put option) or is substantially identical to another asset so
used, (2) the asset is otherwise held by the Fund as part of a "straddle" (which
term generally excludes a situation where the asset is stock and the Fund grants
a qualified covered call option (which, among other things, must not be
deep-in-the-money) with respect thereto) or (3) the asset is stock and the Fund
grants an in-the-money qualified covered call option with respect thereto. In
addition, the Fund may be required to defer the recognition of a loss on the
disposition of an asset held as part of a straddle to the extent of any
unrecognized gain on the offsetting position. Any gain recognized by the Fund on
the lapse of, or any gain or loss recognized by the Fund from a closing
transaction with respect to, an option written by the Fund will be treated as a
short-term capital gain or loss.
Further, the Code also treats as ordinary income a portion of
the capital gain attributable to a transaction where substantially all of the
return realized is attributable to the time value of a Fund's net investment in
the transaction and: (1) the transaction consists of the acquisition of property
by the Fund and a contemporaneous contract to sell substantially identical
property in the future; (2) the transaction is a straddle within the meaning of
section 1092 of the Code; (3) the transaction is one that was marketed or sold
to the Fund on the basis that it would have the economic characteristics of a
loan but the interest-like return would be taxed as capital gain; or (4) the
transaction is described as a conversion transaction in the Treasury
Regulations. The amount of the gain recharacterized generally will not exceed
the amount of the interest that would have accrued on the net investment for the
relevant period at a yield equal to 120% of the federal long-term, mid-term, or
short-term rate, depending upon the type of instrument at issue, reduced by an
amount equal to: (1) prior inclusions of ordinary income items from the
conversion transaction and (2) the capital interest on acquisition indebtedness
under Code section 263(g). Built-in losses will be preserved where the Fund has
a built-in loss with respect to property that becomes a part of a conversion
transaction. No authority exists that indicates that the converted character of
the income will not be passed through to the Fund's shareholders.
- 52 -
<PAGE>
Certain transactions that may be engaged in by the Fund (such
as regulated futures contracts, certain foreign currency contracts, and options
on stock indexes and futures contracts) will be subject to special tax treatment
as "Section 1256 contracts." Section 1256 contracts are treated as if they are
sold for their fair market value on the last business day of the taxable year,
even though a taxpayer's obligations (or rights) under such contracts have not
terminated (by delivery, exercise, entering into a closing transaction or
otherwise) as of such date. Any gain or loss recognized as a consequence of the
year-end deemed disposition of Section 1256 contracts is taken into account for
that year together with any other gain or loss that was previously recognized
upon the termination of Section 1256 contracts during the year. Any capital gain
or loss for the taxable year with respect to Section 1256 contracts (including
any capital gain or loss arising as a consequence of the year-end deemed sale of
such contracts) is generally treated as 60% long-term capital gain or loss and
40% short-term capital gain or loss. The Fund, however, may elect not to have
this special tax treatment apply to Section 1256 contracts that are part of a
"mixed straddle" with other investments of the Fund that are not Section 1256
contracts.
Treasury Regulations permit a regulated investment company, in
determining its investment company taxable income and net capital gain (i.e.,
the excess of net long-term capital gain over net short-term capital loss) for
any taxable year, to elect (unless it made a taxable year election for excise
tax purposes as discussed below) to treat all or any part of any net capital
loss, any net long-term capital loss or any net foreign currency loss incurred
after October 31 as if it had been incurred in the succeeding year.
In addition to satisfying the requirements described above,
the Fund must satisfy an asset diversification test in order to qualify as a
regulated investment company. Under this test, at the close of each quarter of
the Fund's taxable year, at least 50% of the value of the Fund's assets must
consist of cash and cash items, U.S. Government securities, securities of other
regulated investment companies, and securities of other issuers (as to each of
which the Fund has not invested more than 5% of the value of the its total
assets in securities of such issuer and does not hold more than 10% of the
outstanding voting securities of such issuer), and no more than 25% of the value
of its total assets may be invested in the securities of any one issuer (other
than U.S. Government securities and securities of other regulated investment
companies), or in two or more issuers which the Fund controls and which are
engaged in the same or similar trades or businesses. Generally, an option (call
or put) with respect to a security is treated as issued by the issuer of the
security, not the issuer of the option.
- 53 -
<PAGE>
If for any taxable year the Fund does not qualify as a
regulated investment company, all of its taxable income (including its net
capital gain) will be subject to tax at regular corporate rates without any
deduction for distributions to shareholders, and such distributions will be
taxable to the shareholders as ordinary dividends to the extent of the Fund's
current and accumulated earnings and profits. Such distributions generally will
be eligible for the dividends-received deduction in the case of corporate
shareholders.
Excise Tax on Regulated Investment Companies
A 4% non-deductible excise tax is imposed on a regulated
investment company that fails to distribute in each calendar year an amount
equal to 98% of ordinary taxable income for the calendar year and 98% of capital
gain net income for the one-year period ended on October 31 of such calendar
year (or, at the election of a regulated investment company having a taxable
year ending November 30 or December 31, for its taxable year (a "taxable year
election")). (Tax-exempt interest on municipal obligations is not subject to the
excise tax.) The balance of such income must be distributed during the next
calendar year. For the foregoing purposes, a regulated investment company is
treated as having distributed any amount on which it is subject to income tax
for any taxable year ending in such calendar year.
For purposes of the excise tax, a regulated investment company
shall: (1) reduce its capital gain net income (but not below its net capital
gain) by the amount of any net ordinary loss for the calendar year; and (2)
exclude foreign currency gains and losses incurred after October 31 of any year
(or after the end of its taxable year if it has made a taxable year election) in
determining the amount of ordinary taxable income for the current calendar year
(and, instead, include such gains and losses in determining ordinary taxable
income for the succeeding calendar year).
The Fund intends to make sufficient distributions or deemed
distributions of its ordinary taxable income and capital gain net income prior
to the end of each calendar year to avoid liability for the excise tax. However,
investors should note that the Fund may in certain circumstances be required to
liquidate portfolio investments to make sufficient distributions to avoid excise
tax liability.
Fund Distributions
The Fund anticipates distributing substantially all of its
investment company taxable income for each taxable year. Such distributions will
be taxable to shareholders as ordinary income and treated as dividends for
federal income tax purposes, but will
- 54 -
<PAGE>
not qualify for the 70% dividends-received deduction for corporate shareholders.
The Fund may either retain or distribute to shareholders its
net capital gain for each taxable year. The Fund currently intends to distribute
any such amounts. Net capital gain that is distributed and designated as a
capital gain dividend will be taxable to shareholders as long-term capital gain,
regardless of the length of time a shareholder has held his shares or whether
such gain was recognized by the Fund prior to the date on which the shareholder
acquired his shares.
The Fund intends to qualify to pay exempt-interest dividends
by satisfying the requirement that at the close of each quarter of the Fund's
taxable year at least 50% of the Fund's total assets consists of tax-exempt
municipal obligations. Distributions from the Fund will constitute
exempt-interest dividends to the extent of the Fund's tax-exempt interest income
(net of expenses and amortized bond premium). Exempt-interest dividends
distributed to shareholders of the Fund are excluded by them from gross income
for federal income tax purposes. However, shareholders required to file federal
income tax returns will be required to report the receipt of exempt-interest
dividends on their returns. Moreover, while exempt-interest dividends are
excluded from gross income for federal income tax purposes, they may be subject
to alternative minimum tax ("AMT") in certain circumstances and may have other
collateral tax consequences discussed below. Distributions by the Fund of any
investment company taxable income or of any net capital gain will be taxable to
shareholders as discussed above.
AMT is imposed in addition to, but only to the extent it
exceeds, the regular tax and is computed -- at a maximum marginal rate of 28%
for noncorporate taxpayers and 20% for corporate taxpayers -- on the excess of
the taxpayer's alternative minimum taxable income ("AMTI") over an exemption
amount. Exempt-interest dividends derived from certain "private activity"
municipal obligations issued after August 7, 1986 generally will constitute an
item of tax preference includable in AMTI for both corporate and noncorporate
taxpayers. In addition, exempt-interest dividends derived from all municipal
obligations, regardless of the date of issue, must be included in adjusted
current earnings, which are used in computing an additional corporate preference
item (i.e., 75% of the excess of a corporate taxpayer's adjusted current
earnings over its AMTI (determined without regard to this item and the AMT net
operating loss deduction)) includable in AMTI.
Exempt-interest dividends must be taken into account in
computing the portion, if any, of social security or railroad retirement
benefits that must be included in an individual shareholder's gross income and
subject to federal income tax. Further, a shareholder of the Fund is denied a
deduction for
- 55 -
<PAGE>
interest on indebtedness incurred or continued to purchase or carry shares of
the Fund. Moreover, a shareholder who is (or is related to) a "substantial user"
of a facility financed by industrial development bonds held by the Fund will
likely be subject to tax on dividends paid by the Fund which are derived from
interest on such bonds. Receipt of exempt-interest dividends may result in other
collateral federal income tax consequences to certain taxpayers, including
financial institutions, property and casualty insurance companies and foreign
corporations engaged in a trade or business in the United States. Prospective
investors should consult their own tax advisers as to such consequences.
Distributions by the Fund that do not constitute ordinary
income dividends, exempt-interest dividends or capital gain dividends will be
treated as a return of capital to the extent of (and in reduction of) the
shareholder's tax basis in his shares; any excess will be treated as gain
realized from a sale of the shares, as discussed below.
Distributions by the Fund will be treated in the manner
described above regardless of whether such distributions are paid in cash or
reinvested in additional shares of the Fund (or of another fund). Shareholders
receiving a distribution in the form of additional shares will be treated as
receiving a distribution in an amount equal to the fair market value of the
shares received, determined as of the reinvestment date. In addition, if the net
asset value at the time a shareholder purchases shares of the Fund reflects
realized but undistributed income or gain, or unrealized appreciation in the
value of assets held by the Fund, a subsequent distribution of such amounts will
be taxable to the shareholder in the manner described above, although it
economically constitutes a return of capital.
Ordinarily, shareholders are required to take distributions by
the Fund into account in the year in which they are made. However, dividends
declared in October, November or December of any year and payable to
shareholders of record on a specified date in such a month will be deemed to
have been received by the shareholders (and made by the Fund) on December 31 of
such calendar year provided such dividends are actually paid in January of the
following year. Shareholders will be advised annually as to the U.S. federal
income tax consequences of distributions made (or deemed made) during the year.
The Fund will be required in certain cases to withhold and
remit to the U.S. Treasury 31% of ordinary income and capital gain dividends,
and the proceeds of redemption of shares, paid to any shareholder who (1) has
failed to provide a correct taxpayer identification number, (2) is subject to
backup withholding for failure properly to report the receipt of interest or
dividend
- 56 -
<PAGE>
income, or (3) has failed to certify to the Fund that it is not subject to
backup withholding or that it is an "exempt recipient" (such as a corporation).
Sale or Redemption of Shares
A shareholder will recognize gain or loss on the sale or
redemption of shares of the Fund in an amount equal to the difference between
the proceeds of the sale or redemption and the shareholder's adjusted tax basis
in the shares. All or a portion of any loss so recognized may be disallowed if
the shareholder purchases other shares of the Fund within 30 days before or
after the sale or redemption. In general, any gain or loss arising from (or
treated as arising from) the sale or redemption of shares of the Fund will be
considered capital gain or loss and will be long-term capital gain or loss if
the shares were held for longer than one year. Long-term capital gain recognized
by an individual shareholder will be taxed at the lowest rates applicable to
capital gains if the holder has held such shares for more than 18 months at the
time of the sale. However, any capital loss arising from the sale or redemption
of shares held for six months or less will be disallowed to the extent of the
amount of exempt-interest dividends received on such shares and (to the extent
not disallowed) will be treated as a long-term capital loss to the extent of the
amount of capital gain dividends received on such shares. For this purpose, the
special holding period rules of Code Section 246(c)(3) and (4) generally will
apply in determining the holding period of shares. Capital losses in any year
are deductible only to the extent of capital gains plus, in the case of a
noncorporate taxpayer, $3,000 of ordinary income.
Foreign Shareholders
Taxation of a shareholder who, as to the United States, is a
nonresident alien individual, foreign trust or estate, foreign corporation, or
foreign partnership ("foreign shareholder"), depends on whether the income from
the Fund is "effectively connected" with a U.S. trade or business carried on by
such shareholder.
If the income from the Fund is not effectively connected with
a U.S. trade or business carried on by a foreign shareholder, ordinary income
dividends paid to the shareholder will be subject to U.S. withholding tax at the
rate of 30% (or lower applicable treaty rate) on the gross amount of the
dividend. Such a foreign shareholder would generally be exempt from U.S. federal
income tax on gains realized on the sale or redemption of shares of the Fund,
capital gain dividends and exempt-interest dividends and amounts retained by the
Fund that are designated as undistributed capital
- 57 -
<PAGE>
gains.
If the income from the Fund is effectively connected with a
U.S. trade or business carried on by a foreign shareholder, then ordinary income
and capital gain dividends received in respect of, and any gains realized on the
sale of, shares of the Fund will be subject to U.S. federal income tax at the
rates applicable to U.S.
taxpayers.
In the case of a foreign noncorporate shareholder, the Fund
may be required to withhold U.S. federal income tax at a rate of 31% on
distributions that are otherwise exempt from withholding (or subject to
withholding at a reduced treaty rate), unless the shareholder furnishes the Fund
with proper notification of its foreign status.
The tax consequences to a foreign shareholder entitled to
claim the benefits of an applicable tax treaty may be different from those
described herein. Foreign shareholders are urged to consult their own tax
advisers with respect to the particular tax consequences to them of an
investment in the Fund, including the applicability of foreign taxes.
Effect of Future Legislation; Local Tax Considerations
The foregoing general discussion of U.S. federal income tax
consequences is based on the Code and Treasury Regulations issued thereunder as
in effect on the date of this Statement of Additional Information. Future
legislative or administrative changes or court decisions may significantly
change the conclusions
expressed herein, perhaps with retroactive effect.
Rules of state and local taxation of ordinary income
dividends, exempt-interest dividends and capital gain dividends from regulated
investment companies may differ from the rules for U.S. federal income taxation
described above. Shareholders are urged to consult their tax advisers as to the
consequences of these and other state and local tax rules affecting investment
in the Fund.
PORTFOLIO TRANSACTIONS
The Fund's management provides the Fund with investment advice
and recommendations for the purchase and sale of portfolio securities. Newly
issued securities are usually purchased from the issuer or an underwriter, at
prices including underwriting fees; other purchases and sales are usually placed
with those dealers from whom it appears that the best price or execution will be
obtained. All orders for the purchase and sale of portfolio
- 58 -
<PAGE>
securities are placed by the Fund's management, subject to the general control
of the Fund's Directors. The Fund's management may sell portfolio securities
prior to their maturity if market conditions and other considerations indicate,
in the opinion of the Fund's management, that such sale would be advisable. In
addition, the Fund's management may engage in short-term trading when it
believes it is consistent with the Fund's investment objective. Also, a security
may be sold and another of comparable quality may be simultaneously purchased to
take advantage of what the Fund's management believes to be a temporary
disparity in the normal yield relationships of two securities. The frequency of
portfolio transactions -- the Fund's turnover rates -- will vary from year to
year depending upon market conditions. For the years ended December 31, 1997 and
1996, the Fund's annual rate of portfolio turnover was approximately 399% and
347%, respectively. Because a high turnover rate increases transaction costs and
the possibility of taxable short-term gains (see "Dividends and Tax Status" in
the Fund's Prospectus), the Fund's management weighs the added costs of
short-term investment against anticipated gains. The Fund's management is
generally responsible for the implementation, or supervision of the
implementation, of investment decisions, including the allocation of principal
business and portfolio brokerage, and the negotiation of commissions.
It is the Fund's policy to seek execution of its purchases and
sales at the most favorable prices through responsible broker-dealers and in
agency transactions, at competitive commission rates. When considering
broker-dealers, the Fund will take into account such factors as the price of the
security, the size and difficulty of the order, the rate of commission, if any,
the reliability, financial condition, integrity and general execution and
operational capabilities of competing broker-dealers, and the brokerage and
research services which they provide to the Fund's management.
The Board of Directors of the Fund is authorized to adopt a
brokerage allocation policy pursuant to the Securities Exchange Act of 1934
which would permit the Fund to pay a broker-dealer which furnishes research
services a higher commission than that which might be charged by another
broker-dealer which does not furnish research services, or which furnishes
research services deemed to be of a lesser value, provided that such commission
is deemed reasonable in relation to the value of the brokerage and research
services provided by the broker-dealer.
Section 28(e)(3) of the Securities Exchange Act of 1934
defines "Brokerage and Research Services" as including, among other things,
advice as to the value of securities, the advisability of investing in,
purchasing or selling securities, the availability of securities or purchasers
or sellers of securities, furnishing analyses and reports concerning issuers,
industries, securities,
- 59 -
<PAGE>
economic factors and trends, portfolio strategy and performance of accounts, and
offering securities transactions and performing functions incidental thereto
(such as clearance and settlement).
It is not the Fund's practice to allocate principal business
or brokerage on the basis of sales of Fund shares which may be made through
brokers or dealers, although broker-dealers effecting purchases of Fund shares
for their customers may participate in principal transactions of brokerage
allocation as described above.
The Fund pays LAS Investments, Inc.("LAS") commissions or fees
for effecting, or participating in the effectuation of (but not executing),
transactions in futures contracts and options thereon on behalf of the Fund
("Fund Futures and Options Transactions"). LAS is located at 190 South LaSalle
Street, Chicago, Illinois. Mr. Donald E. Newell is the chief executive officer
of LAS and the owner of all of its outstanding shares. Messrs. Malanga and
Newell are each executive officers and 50% shareholders of LaSalle Portfolio
Management, Inc. As a result of Mr. Newell's business relationship with Mr.
Malanga, certain procedures incorporating the standards of Rule 17e-1 of the
1940 Act govern the computation and review of all commissions paid and payable
to LAS. The procedures limit the commissions or fees received, or to be
received, by LAS for Fund Futures and Options Transactions to an amount which is
reasonable and fair compared to the commissions, fees or other remuneration
received by other introducing brokers in connection with comparable transactions
involving similar futures contracts or options on futures contracts, as the case
may be, being purchased or sold on a commodities exchange during a comparable
period of time. The Fund's independent Board Members determine no less
frequently than quarterly that all transactions with LAS during the quarter were
effected in compliance with such procedures.
Beginning in July 1990, all of the Fund's transactions in
futures contracts and related options were effected through Sierra Securities,
Inc., a broker-dealer located at 190 South LaSalle Street, Chicago, Illinois
("Sierra"). The total amount of commissions paid to Sierra as introducing broker
on such transactions for the Fund's account during the years 1990 through 1995
and during January of 1996 was $11,298. The Manager has represented that during
such period, it believes that Mr. Donald Newell was a minority shareholder of
Sierra. As a result of Mr. Newell's business relationship with Mr. Malanga (see
discussion above), all of the futures and options transactions Sierra performed
on behalf of the Fund may have been subject to certain standards comparable to
those set forth in Rule 17e-1 of the 1940 Act (the "Rule"). On February 1, 1996,
the Manager commenced using LAS as its introducing broker for Fund transactions
in futures contracts and related options in place of Sierra. At a meeting
- 60 -
<PAGE>
held on May 2, 1996, the Fund's Board of Directors, including a majority of the
independent Directors, adopted new standards and procedures for the Fund
comparable to those set forth in the Rule for transactions in futures contracts
and related options through LAS, an affiliated broker-dealer. See above
discussion pertaining to LAS.
From January 1, 1990 to January 31, 1996, the Manager directed
syndicate designations in the aggregate dollar amount of $858,094 to Capital
Institutional Services, Inc. ("CIS") in connection with the Fundamental Funds'
bond purchases through underwriting syndicates. The Manager has represented that
CIS, a third-party research provider, at the Manager's direction, paid portions
of such syndicate designations to approximately 30 different firms that provided
research services used by the Manager in managing the Fundamental Funds,
including Capital Market Services, Inc. ("CMS"). Further, that CMS was paid by
CIS $115,000 for research provided to the Manager. The $115,000 dollar amount
paid by CIS to CMS for the following fiscal years of the Fund was: $35,000 in
1995; $55,000 in 1994; and $25,000 in 1993. The Manager has also represented
that it learned in 1996 that at all times during the years 1993, 1994 and 1995,
CMS was 100% owned by Mr. Donald E. Newell's wife. Mr. Vincent J. Malanga and
Mr. Donald E. Newell are each executive officers and 50% shareholders of LaSalle
Portfolio Management, Inc. In order to remove any appearance of impropriety
concerning all of the payments made by CIS to CMS in return for research the
Manager obtained from CMS, the Manager reimbursed Fundamental U. S. Government
Strategic Income Fund (the beneficiary of the research) $115,000 out of its own
resources.
OTHER INFORMATION
As of March 31, 1998, the Directors and Officers of the Fund
as a group beneficially owned less than 1% of the outstanding shares of the
Fund. As of such date, the following persons were known by Fund management to
have owned beneficially, directly or indirectly, 5% or more of the outstanding
shares of the Fund:
NAME & ADDRESS NUMBER OF SHARES PERCENTAGE OF
_______________ OWNED OUTSTANDING SHARES
Centre Reinsurance Limited 10,243,370.024 6.05%
1 Victoria Street
P.O. Box HM1788
Hamilton, Bermuda HMHX
FINANCIAL STATEMENTS
Audited financial statements of the Fund for the year ended
December 31, 1997 are attached hereto.
- 61 -
<PAGE>
(CHART MATERIAL)
New York Muni Fund
Portfolio Composition
December 31, 1997
(unaudited)
BY TYPE
(15.8%) FCSI
(51.4%) FCLT
(20.9%) LRIB
(11.9%) INLT
BY RATING+
(4.6%) Non-income
producing bonds
(1.3%) AA
(59.6%) AAA
(19.2%) BBB
(1.9%) Not Rated
FIXED COUPON BONDS
FCLT -- Long (maturity greater than 15 years) (includes long zero coupons)
FCSI -- Short or Intermediate (maturity less than 15 years) (includes zero
coupon bonds)
VARIABLE RATE BONDS
RIB(Residual Interest Bond) type inverse floaters. These are leveraged bonds
whose coupon varies inversely with rates on short term companion issues. The
inverse floater's price will be more volatile than that of a fixed coupon bond.
LRIB -- Long Term (maturity greater than 15 years)
IN (Index) based inverse floaters are bonds whose interest coupons vary
inversely with an index of short term interest rates and then revert to a fixed
rate mode. The inverse floater's price will be more volatile than that of a
fixed coupon bond.
INLT -- Long Term (maturity greater than 15 years)
+If a security has a split rating, the highest applicable rating is used,
including published ratings on identical credits for individual securities not
individually rated.
2
<PAGE>
(CHART MATERIAL)
$22,786
Lehman
Brothers
Municipal
Bond Index*
$15,144
Fundamental
New York
Muni
Fund, Inc.
$13,926
Consumer
Price Index
- --------------------------------------------------------------------------------
New York Muni Fund
- --------------------------------------------------------------------------------
Average Annual Total Return
Ended on 12/31/97
- --------------------------------------------------------------------------------
1 Year 5 Year 10 Year
- --------------------------------------------------------------------------------
1.46% (0.62)% 4.24%
- --------------------------------------------------------------------------------
Thousands ($)
24 22 20 18 16 14 12 10
12/31/87 12/31/88 12/31/89 12/31/90 12/31/91 12/31/92 12/31/93 12/31/94
12/31/95 12/31/96 12/31/97
Past performance is not predictive of future performance.
The above illustration compares a $10,000 investment made in the New York Muni
Fund on 12/31/87 to a $10,000 investment made in the Lehman Brothers Municipal
Bond Index on that date. All dividends and capital gain distributions are
reinvested.
The Fund invests primarily in New York municipal securities and its performance
takes into account fees and expenses. Unlike the Fund, the Lehman Brothers
Municipal Bond Index is an unmanaged total return performance benchmark for the
long-term, investment-grade tax exempt bond market, calculated by using
municipal bonds selected to be representative of the market. The Index does not
take into account fees and expenses. Further information relating to Fund
performance, including expense reimbursements, if applic able, is contained in
the Fund's Prospectus and elsewhere in this report.
*Source:Lehman Brothers.
The Consumer Price Index is a commonly used measure of inflation; it does not
represent an investment return.
3
<PAGE>
(LEFT COLUMN)
NEW YORK MUNI FUND
STATEMENT OF ASSETS AND LIABILITIES
December 31, 1997
- --------------------------------------------------------------------------------
ASSETS
Investment in securities at value
(Note 4) (cost $127,411,133)..................... $122,737,274
Receivables:
Interest......................................... 1,484,267
Fund shares sold................................. 58,146,118
-----------
Total assets.............................. 182,367,659
-----------
LIABILITIES
Notes payable (Note 6)............................. 38,177,582
Payables:
Fund shares redeemed............................. 347,948
Investment securities purchased.................. 8,826,774
Dividend declared................................ 27,444
Due to advisor................................... 24,366
Accrued expenses................................. 368,138
-----------
Total liabilities................................. 47,772,252
-----------
NET ASSETS consisting of:
Distributions in excess of net
investment income................... $ (27,444)
Accumulated net realized loss ........ (24,284,760)
Unrealized depreciation of securities. (4,673,859)
Paid-in-capital applicable to
156,836,372 shares of $.01
par value capital stock............... 163,581,470
----------
$134,595,407
============
NET ASSET VALUE PER SHARE................ $.86
====
(RIGHT COLUMN)
STATEMENT OF OPERATIONS
Year ended December 31, 1997
- --------------------------------------------------------------------------------
INVESTMENT INCOME
Interest income............................... $ 7,756,494
EXPENSES (Notes 2 and 3)
Management fee............... $640,975
Custodian and accounting fees 327,214
Transfer agent fees.......... 450,401
Professional fees............ 1,050,450
Directors' fees.............. 102,427
Printing and postage......... 31,395
Interest..................... 1,431,511
Distribution expenses........ 647,839
Operating expenses on
defaulted bonds.............. 72,000
Other........................ 143,176
---------
4,897,388
Expenses reimbursed........ (40,700)
---------
Total expenses........................ 4,856,688
----------
Net investment income................. 2,899,806
----------
REALIZED AND UNREALIZED GAIN (LOSS)
ON INVESTMENTS
Net realized loss on investments (2,367,322)
Net unrealized appreciation of
investments.............. 5,608,133
---------
Net gain on investments ...................... 3,240,811
----------
NET INCREASE IN NET ASSETS
FROM OPERATIONS.................................. $6,140,617
==========
(FULL COLUMN)
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------
Year Ended Year Ended
December 31, December 31,
1997 1996
------------ ------------
<S> <C> <C>
INCREASE (DECREASE) IN NET ASSETS FROM
OPERATIONS
Net investment income...................................................... $ 2,899,806 $ 6,229,467
Net realized loss on investments........................................... (2,367,322) (2,404,362)
Unrealized appreciation (depreciation) on investments ..................... 5,608,133 (4,292,643)
----------- -----------
Net (decrease) increase in net assets from operations...................... 6,140,617 (467,538)
DISTRIBUTIONS:
Distributions from investment income....................................... (2,899,806) (6,229,467)
Distributions in excess of net investment income........................... (27,444) --
Return of capital distribution............................................. (551,666) --
Distributions from net realized gain from investments...................... (24,556) --
CAPITAL SHARE TRANSACTIONS (Note 5)........................................ (64,787,531) (23,248,833)
----------- -----------
Total decrease............................................................. (62,150,386) (29,945,838)
NET ASSETS:
Beginning of year.......................................................... 196,745,793 226,691,631
----------- -----------
End of year................................................................ $134,595,407 $196,745,793
=========== ===========
</TABLE>
See Notes to Financial Statements.
4
<PAGE>
NEW YORK MUNI FUND
STATEMENT OF CASH FLOWS
Year Ended December 31, 1997
<TABLE>
- ---------------------------------------------------------------------------------------------------------------------
<S> <C>
Increase (Decrease) in Cash
Cash Flows From Operating Activities
Net increase to net assets from operations .................................................. $ 6,140,617
Adjustments to reconcile net increase in net assets from operations
to net cash provided by operating activities:
Purchase of investment securities ......................................................... (1,574,433,817)
Proceeds on sale of securities ............................................................ 1,659,325,144
Decrease in interest receivable ........................................................... 2,324,155
Decrease in accrued expenses .............................................................. (391,142)
Net accretion of discount on securities ................................................... (111,800)
Net realized loss:
Investments ............................................................................. 2,367,322
Unrealized appreciation on securities .................................................... (5,608,133)
-------------
Net cash provided by operating activities ............................................. 89,612,346
-------------
Cash Flows From Financing Activities:*
Increase in notes payable ................................................................. 36,846,239
Proceeds on shares sold ................................................................... 2,222,770,042
Payment on shares repurchased ............................................................. (2,348,578,756)
Cash dividends paid ....................................................................... (649,871)
-------------
Net cash used in financing activities ................................................. (89,612,346)
-------------
Net decrease in cash .................................................................. 0
Cash at beginning of year ..................................................................... 0
-------------
Cash at end of year ........................................................................... $ 0
=============
<FN>
- --------------
*Non-cash financing activities not included herein consist of reinvestment of dividends of $3,233,013.
Cash payments for interest expense totaled $1,672,606.
</FN>
</TABLE>
See Notes to Financial Statements.
5
<PAGE>
NEW YORK MUNI FUND
STATEMENT OF INVESTMENTS
December 31, 1997
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------
Principal
Amount Issue ooo Type o Rating oo Value
-------- ----- ---- ----- -----
<C> <S> <C> <C> <C>
$ 1,000,000## Amherst NY Industrial Development Agency Lease Rev, SurfaceRink Complex,
LOC Keyhawk, 5.65%, 10/01/22............................................ FCLT A $ 1,015,360
1,000,000 Metropolitan Transit Authority NY Commuter Facilities Rev, Series C-1,
FGIC Insured 5.375%, 07/01/27........................................... FCLT AAA 1,011,120
300,000 Metropolitan Transit Authority NY Transportation Facilities Rev SVC Contract
Series 8 5.375%, 07/01/21............................................... FCLT A- 300,000
14,600,000x## New York Inverse Floating Rate Notes*...................................... INLT A- 14,618,104
500,000 New York NY Series B, 5.25%,0 8/01/15...................................... FCLT A- 495,445
5,290,000x## New York City, ECF, MBIA Insured, STEP** 3.75%, 04/01/08................... FCSI Aaa 5,402,042
5,925,000x## New York City, ECF, MBIA Insured, STEP** 3.75%, 10/01/08................... FCSI Aaa 6,046,463
2,200,000x## New York City, IDA, Imclone Systems Inc Project AMT 11.25%, 07/01/04....... FCSI NR 2,296,404
2,000,000 New York City, IDA, Brooklyn Navy Yard Cogen Partners AMT 5.75%, 10/01/36 . FCLT Baa3 2,017,800
6,700,000 New York City, MWFA, Water &Sewer Systems Rev Residual Int Tr Rcpts,
Series 29, FGIC Insured, 6.562%, 06/15/30............................... LRIB Aaa 6,497,258
1,030,000 New York City, IDA, Civic Facilities Rev, Anti-Defamation League Foundation
Ser A, MBIA Insured, 5.375%, 06/01/27.................................. FCLT Aaa 1,042,226
3,500,000## New York City, IDA, Special Facilities Rev, United Airlines Inc. Project,
AMT, 5.65%, 10/01/32.................................................... FCLT Baa3 3,538,605
4,970,000## New York State, DAR, City University Systems Series C 5.00%, 07/01/17 ..... FCLT Baa1 4,784,270
850,000 New York State, DAR, City University Series F, FGIC TCRS Insured,
5.00%, 07/01/20......................................................... FCLT Aaa 827,611
7,550,000## New York State, DAR, Court Facilities Lease Series A 5.25%, 05/15/21 ..... FCLT Baa1 7,419,838
1,000,000 New York State, DAR, Nursing Home FHA, Rosalind &Joseph Gurwin
Jewish Geriatric, AMBAC Insured 5.70%, 02/01/37......................... FCLT Aaa 1,023,890
1,650,000 New York State, DAR, St. Vincent DePaul Residence, LOC Allied Banks PLC,
5.30%, 07/01/18......................................................... FCLT Aa3 1,639,803
4,500,000## New York State, DAR, City University System Residual Int Tr Recpts 27,
MBIA Insured, Liquidity The Bank of New York, 8.22%, 07/01/24........... LRIB Aaa 4,949,055
13,460,000## New York State, DAR, City University System Residual Int Tr Recpts 28,
AMBAC Insured, Liquidity The Bank of New York, 7.63%, 07/01/25.......... LRIB Aaa 14,170,553
2,510,000 New York State, DAR, Vassar Brothers Hospital, FSA Insured 5.375%, 07/01/25 FCLT Aaa 2,525,462
5,000,000 New York State, DAR, Mental Health Services Facilities Improvement
Series D, FSA Insured, 5.125%, 08/15/27................................. FCLT AAA 4,909,950
7,500,000## New York State, DAR, FHA, St Barnabas Hospital AMBAC Insured
5.45%, 08/01/35......................................................... FCLT Aaa 7,565,700
750,000 New York State, DAR, FHA, Sara Neuman Nursing Home AMBAC Insured
5.45%, 08/01/27......................................................... FCLT Aaa 755,730
1,000,000 New York State, DAR, FHA, Sara Neuman Nursing Home AMBAC Insured
5.50%, 08/01/37......................................................... FCLT Aaa 1,009,340
42,000,000 New York State, DAR, FHA, Presbyterian Hospital Series A AMBAC Insured
0.00%, 08/15/36......................................................... FCLT Aaa 5,404,560
2,000,000 New York State, DAR, FHA, Highland Hospital Rochester Series A,
MBIA Insured, 5.45%, 08/01/37........................................... FCLT Aaa 2,008,680
1,000,000 New York State, EFC, Pollution Control Rev, Ref-St Wtr-Sub-Revolving Fund
Series E, MBIA Insd, 5.00%, 06/15/11.................................... FCLT Aaa 1,009,710
2,000,000 New York State, EFC, Pollution Control Rev, Ref-St Wtr-Sub-Revolving Fund
Series E, MBIA Insd, 5.00%, 06/15/12.................................... FCLT Aaa 2,016,160
</TABLE>
6
<PAGE>
NEW YORK MUNI FUND
STATEMENT OF INVESTMENTS (continued)
December 31, 1997
<TABLE>
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------------------
Principal
Amount Issue ooo Type o Rating oo Value
-------- ----- ---- ----- -----
<C> <S> <C> <C> <C>
$ 4,040,000 New York State, HFA, Service Contract Obligation Rev Series C, 5.50%, 03/15/25. FCLT Baa1 $ 4,064,644
5,000,000## New York State, MCFFA, HFA, Rev, Presbyterian Hospital
MBIA-IBC Insured 5.375%, 02/15/25........................................... FCLT Aaa 5,045,500
9,805,000x# ## Niagara County NY, IDA Falls Street Faire Project AMT, 10.00% 09/01/06
(see Note 4 to Financial Statements)........................................ FCSI NR 3,509,700
5,870,000x# ## Niagara Falls NY, URA, Old Falls Street Improvement Project, 11.00% 05/01/09
(see Note 4 to Financial Statements).............................. ......... FCSI NR 2,101,167
1,760,000 Syracuse NY, IDA, Civic Facilities Rev, Crouse Health Hospital Project,
Series A 5.375%, 01/01/23................................................... FCLT BBB 1,715,124
------------
Total Investments (Cost $127,411,133 @)............................. $122,737,274
============
<FN>
* Inverse Floating Rate Notes (IFRN) are instruments whose interest rates bear an inverse relationship to the interest rate on
another security or value of an index. Rates shown are at December 31, 1997.
** Step Bonds (STEP) are instruments whose interest rate is fixed at an initial rate and then increases ("steps up") to another
fixed rate until maturity.
@ Cost for Federal income tax purposes is $127,989,424.
# The value of these non-income producing securities has been estimated by persons designated by the Fund's Board of Directors
using methods the Director's believe reflect fair value. See Note 4 to the financial statements.
## $82,462,761 market value of securities are segregated in whole or in part as collateral securing a line of credit.
x The Fund owns 100% of the security and therefore there is no trading in the security. See Note 4 to the financial
statements.
Legend
oType FCLT --Fixed Coupon Long Term
FCSI --Fixed Coupon Short or Intermediate Term
LRIB --Residual Interest Bond Long Term
INLT --Indexed Inverse Floating Rate Bond Long Term
ooRatings If a security has a split rating the highest applicable rating is used, including published ratings on identical
credits for individual securities not individually rated.
NR--Not Rated
ooolssue AMBAC American Municipal Bond Assurance Corporation
AMT Alternative Minimum Tax
CAB Capital Appreciation Bond
CFR Civic Facility Revenue
COP Certificates of Participation
DAR Dormitory Authority Revenue
ECF Educational Construction Fund
EFC Environmental Facilities Corp.
ETM Escrowed to Maturity
FGIC Financial Guaranty Insurance Corporation
FHA Federal Housing Administration
FSA Financial Security Association
GO General Obligation
HDA Housing Development Agency
HFA Housing Financing Agency
HIC Hospital Improvement Corporation
IDA Industrial Development Authority
ITEMECF Industrial, Tourist, Education, Medical and Environmental Control Facilities
LOC Letter of Credit
MBIA Municipal Bond Insurance Assurance Corporation
MCF Medical Care Facilities
MCFFA Medical Care Facilities Finance Agency
MTA Metropolitan Transit Authority
MWFA Municipal Water Finance Authority
NHRB Nursing Home Revenue Bond
RB Revenue Bond
RDA Research and Development Authority
SWMA Solid Waste Management Authority
URA Urban Renewal Authority
See Notes to Financial Statements.
</FN>
</TABLE>
7
<PAGE>
NEW YORK MUNI FUND
NOTES TO FINANCIAL STATEMENTS
December 31, 1997
- --------------------------------------------------------------------------------
1.Significant Accounting Policies
New York Muni Fund (the Fund) is a series of Fundamental Funds, Inc. (the
"Company"). The Company is an open-end management investment company registered
under the Investment Company Act of 1940. The Fund seeks to provide a high level
of income that is excluded from gross income for Federal income tax purposes and
exempt from New York State and New York City personal income taxes. The Fund
intends to achieve its objective by investing substantially all of its total
assets in municipal obligations of New York State, its political subdivisions
and its duly constituted authorities and corporations. The Fund employs leverage
in attempting to achieve this objective. The following is a summary of
significant accounting policies followed in the preparation of its financial
statements:
Valuation of Securities--The Fund's portfolio securities are valued on
the basis of prices provided by an independent pricing service when, in the
opinion of persons designated by the Fund's directors, such prices are
believed to reflect the fair market value of such securities. Prices of
non-exchange traded portfolio securities provided by independent pricing
services are generally determined without regard to bid or last sale prices
but take into account institutional size trading in similar groups of
securities, yield, quality, coupon rate, maturity, type of issue, trading
characteristics and other market data. Securities traded or dealt in upon a
securities exchange and not subject to restrictions against resale as well
as options and futures contracts listed for trading on a securities
exchange or board of trade are valued at the last quoted sales price, or,
in the absence of a sale, at the mean of the last bid and asked prices.
Options not listed for trading on a securities exchange or board of trade
for which over-the-counter market quotations are readily available are
valued at the mean of the current bid and asked prices. Money market and
short-term debt instruments with a remaining maturity of 60 days or less
will be valued on an amortized cost basis. Municipal daily or weekly
variable rate demand instruments will be priced at par value plus accrued
interest. Securities not priced in a manner described above and other
assets are valued by persons designated by the Fund's directors using
methods which the directors believe reflect fair value.
Futures Contracts and Options Written on Future Contracts--Initial
margin deposits with respect to these contracts are maintained by the
Fund's custodian in segregated asset accounts. Subsequent changes in the
daily valuation of open contracts are recognized as unrealized gains or
losses. Variation margin payments are made or received as daily
appreciation or depreciation in the value of these contracts occurs.
Realized gains or losses are recorded when a contract is closed.
Federal Income Taxes--It is the Fund's policy to comply with the
requirements of the Internal Revenue Code applicable to "regulated
investment companies" and to distribute all of its taxable and tax exempt
income to its shareholders. Therefore, no provision for federal income tax
is required.
Distributions--The Fund declares dividends daily from its net
investment income and pays such dividends on the last business day of each
month. Distributions of net capital gains, if any, realized on sales of
investments are made annually, as declared by the Fund's Board of
Directors. Dividends are reinvested at the net asset value unless
shareholders request payment in cash.
General--Securities transactions are accounted for on a trade date
basis. Interest income is accrued as earned. Premiums and original issue
discount on securities purchased are amortized over the life of the
respective securities. Realized gains and losses from the sale of
securities are recorded on an identified cost basis. Net operating expenses
incurred on properties collateralizing defaulted bonds are charged to
operating expenses as incurred. Costs incurred to restructure defaulted
bonds are charged to realized loss as incurred.
Accounting Estimates--The preparation of financial statements in
conformity with generally accepted accounting principles requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported
amounts of increases and decreases in net assets from operations during the
reporting period. Actual results could differ from those estimates.
8
<PAGE>
NEW YORK MUNI FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
2.Investment Advisory Fees and Other Transactions with Affiliates
Management Agreement
Under a Management Agreement, the Fund pays an investment management fee to
Fundamental Portfolio Advisors, Inc. (the Manager) equal to 0.5% of the Fund's
average daily net asset value up to $100 million and decreasing by .02% of each
$100 million increase in net assets down to 0.4% of net assets in excess of $500
million. The Manager has voluntarily agreed to reimburse the Fund an amount not
exceeding the amount of fees payable to the Manager under the agreement for any
fiscal year, if, and to the extent that the aggregate operating expenses of the
Fund for any fiscal year including the fees payable to the Manager, but
excluding interest expenses, taxes, brokerage fees and commissions, expenses
paid pursuant to the Distribution Plan, and extraordinary expenses exceeds, on
an annual basis, 1.5% of the average daily net assets of the Fund. No such
reimbursement was required for the year ended December 31, 1997 due to the
expense limitation. See Note 8.
SEC Administrative Action Against Manager
On September 30, 1997, the Securities & Exchange Commission announced that
it instituted public administrative and cease-and desist proceedings against the
Manager, the former portfolio manager of the Fund, the president of the Manager
and Fundamental Service Corporation (FSC). The proceeding arises from the
alleged failure of an affiliated mutual fund to disclose the risks of the
affiliated fund, and of the Manager's failure to disclose its soft dollar
arrangements to the Fund's Board of Directors. A hearing has been scheduled with
an admninistrative law judge to determine whether the allegations are true, and,
if so, what remedial action, if any, is appropriate.
Board's Termination of Portfolio Manager
Between April 17, 1997 and July 24, 1997, a representative of the Manager
engaged Tocqueville Securities L.P. ("Tocqueville Securities"), an affiliate of
Tocqueville (see Note 7), as agent, to effect eight separate over-the-counter
purchase transactions of municipal obligations on behalf of the Fund. The Fund's
Board has concluded that the commissions paid to Tocqueville Securities in
connection with these transactions (a portion of which was paid to the
representative) were not justified and that the Fund bore unnecessary expenses
as a result of the sale of its securities to another party and the subsequent
repurchase of them through Tocqueville Securities. Based upon a report initiated
by Tocqueville Securities and prepared by the Fund's independent auditors, and
upon the Board's own analysis, the Board directed that the Manager terminate the
representative's services as a portfolio manager. At the Board's request and in
order to reimburse the affiliated fund for all of its losses, Tocqueville
Securities, on September 15, 1997, voluntarily paid $260,000 to the Fund, an
amount which significantly exceeds the total commissions ($184,920.60) received
by Tocqueville Securities in connection with these transactions. $219,300 of the
proceeds from the reimbursement have been included in the realized gain on
investments and $40,700 have been included as an expense reimbursement in the
accompanying financial statements. The staff of the Securities and Exchange
Commission and the Department of NASD Regulation have been informed of these
events by Tocqueville Securities. See Note 7 regarding contemplated transaction
with the Tocqueville Trust.
Distribution Plan and Service Agreement
Pursuant to a Distribution Plan (the Plan) adopted pursuant to Rule 12b-1
promulgated under the Investment Company Act of 1940, the Fund may pay certain
promotional and advertising expenses and may compensate certain registered
securities dealers and financial institutions for services provided in
connection with the processing of orders for purchase or redemption of the
Fund's shares and furnishing other shareholder services. Payments by the Fund
shall not in the aggregate, in any fiscal year, exceed 0.5% of the average daily
net assets of the Fund.
Under a Service Agreement with FSC, an affiliate of the Manager, amounts
are paid under the Plan to compensate FSC for the services it provides and the
expenses it bears in distributing the Fund's shares to investors. Any cumulative
distribution expenses related to the Fund incurred by FSC in excess of the
annual maximum amount payable by the Fund under the Plan may be carried forward
for three years in anticipation of reimbursement by the Fund on a "first
in-first out" basis. If the Plan is terminated or discontinued in accordance
with its terms, the obligation of the Fund to make payments to FSC will cease
and the Fund will not be required to make payments past the termination date.
Amounts paid to FSC pursuant to the agreement totaled $307,200 for the year
ended December 31, 1997.
NASD Sanctions and Fines
On February 19, 1998, FSC and two of its executives, without admitting or
denying guilt, entered into an agreement with the National Association of
Securities Dealers, Inc. ("NASD") whereby they accepted fines totaling $125,000
and other stipulated sanctions as a result of the NASD's finding that they had
distributed advertising materials of an affiliated mutual fund which violated
NASD rules governing advertisements.
9
<PAGE>
NEW YORK MUNI FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
The Fund compensated Fundamental Shareholder Services, Inc. (FSSI), an
affiliate of the Manager, for the services it provided under a Transfer Agent
and Service Agreement which was terminated September 11, 1997. Transfer agent
fees paid to FSSI for the year ended December 31, 1997 amounted to $260,717.
3.Directors' Fees
All of the Directors of the Fund are also directors or trustees of two
other affiliated mutual funds for which the Manager acts as investment adviser.
For services and attendance at Board meetings and meetings of committees which
are common to each Fund, each Director who is not affiliated with the Manager is
compensated at the rate of $6,500 per quarter pro rated among the funds based on
their respective average net assets. The Directors also received additional
compensation for special services as requested by the Board. Additional
compensation totaled $40,923 pro rated among the funds based on their respective
average net assets.
4.Complex Securities, Concentrations of Credit Risk, and Investment Transactions
Inverse Floating Rate Notes (IFRN):
The Fund invests in variable rate securities commonly called "inverse
floaters". The interest rates on these securities have an inverse relationship
to the interest rate of other securities or the value of an index. Changes in
interest rate on the other security or index inversely affect the rate paid on
the inverse floater, and the inverse floater's price will be more volatile than
that of a fixed-rate bond. Additionally, some of these securities contain a
"leverage factor"whereby the interest rate moves inversely by a "factor" to the
benchmark rate. For example, the rates on the inverse floating rate note may
move inversely at three times the benchmark rate. Certain interest rate
movements and other market factors can substantially affect the liquidity of
IFRN's.
Concentration of Credit Risk and Transactions in Defaulted Bonds:
The Fund owned 100% of two Niagara Falls Industrial Development Agency
bonds ("IDA Bonds") due to mature on September 1, 2006, and 98.3% of a Niagara
Falls New York Urban Renewal Agency 11% bond ("URA Bond") due to mature on May
1, 2009 which are in default. The IDA Bonds are secured by commercial retail and
office buildings known as the Falls Street Faire and Falls Street Station
Projects ("Projects"). The URA Bond is secured by certain rental payments from
the Projects.
The Fund, through its investment banker and manager, negotiated the sale of
the Falls Street Station project. The net proceeds received on the sale of
approximately $2,800,000 were accounted for as a pro rata recovery of principal
of each of the bonds. The remaining principal value of the Fall Street Station
IDA Bond of approximately $3,887,000 was charged to realized loss on
investments.
The remaining two securities are being valued under methods approved by the
Board of Directors. The aggregate value of these securities is $5,610,867 (35.8%
to their aggregate face value of $15,675,000). There is uncertainty as to the
timing of events and the subsequent ability of the Projects to generate cash
flows sufficient to provide repayment of the bonds. No interest income was
accrued on these bonds during the year ended December 31, 1997. Legal,
investment banking, and other restructuring costs charged to realized loss
totaled approximately $153,000 for the year ended December 31, 1997 ($1,640,000
cumulatively from October 6, 1992 to December 31, 1997). The Fund through its
investment banker, engaged a property manager to maintain the Projects on its
behalf, and the Fund is paying the net operating expenses of the Project. Net
operating expenses related to the Projects for the year ended December 31, 1997
are disclosed in the statement of operations, and cumulatively from October 6,
1992 to December 31, 1997 totaled approximately $684,629
Additionally, the Fund owns 100% of several securities as indicated in the
Statement of Investments. As a result of its ownership position there is no
active trading in these securities. Valuations of these securities are provided
by a pricing service and are believed by the Manager to reflect fair value. The
market value of securities owned 100% by the Fund was approximately $33,973,880
(25% of net assets) at December 31, 1997.
Other Investment Transactions:
During the year ended December 31, 1997, purchases and sales of investment
securities, other than short-term obligations, were $554,177,076 and
$647,162,806, respectively.
10
<PAGE>
NEW YORK MUNI FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
As of December 31, 1997 net unrealized depreciation of portfolio securities
on a federal income tax basis amounted to $5,252,150 composed of unrealized
appreciation of $4,320,774 and unrealized depreciation of $9,572,924.
The Fund has capital loss carryforwards available to offset future capital
gains as follows:
Amount Expiration
------ ----------
$18,503,000 December 31, 2002
3,430,000 December 31, 2004
2,214,000 December 31, 2005
-----------
$24,147,000
===========
5.Capital Stock
As of December 31, 1997 there were 500,000,000 shares of $.01 par value
capital stock authorized. Transactions in capital stock were as follows:
<TABLE>
<CAPTION>
Year Ended Year Ended
December 31, 1997 December 31, 1996
-------------------------- --------------------------
Shares Amount Shares Amount
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Shares sold......................... 2,692,167,470 $2,280,916,160 3,704,110,578 $3,314,430,819
Shares issued on reinvestment
of dividends........................ 3,788,810 3,223,013 5,501,544 4,939,206
Shares redeemed .................... (2,765,077,644) (2,348,926,704) (3,714,943,217) (3,342,618,858)
-------------- -------------- -------------- --------------
Net (decrease) ..................... (69,121,364) $ (64,787,531) (5,331,095) $ (23,248,833)
============== ============== ============== ==============
</TABLE>
6.Line of Credit
The Fund has line of credit agreements with banks collateralized by cash
and portfolio securities. Borrowings under these agreements bear interest linked
to the banks' prime rate. Pursuant to these agreements $38,177,582 was
outstanding at December 31, 1997.
The maximum month end and the average borrowings outstanding during the year
ended December 31, 1997 were $82,500,000 and $20,630,505, respectively.
7. Agreement and Plan of Reorganization
On July 15, 1997 each of Fundamental's mutual funds (consisting of: New
York Muni Fund, The California Muni Fund, Fundamental Fixed Income Fund: Tax
Free Money Market Series, High Yield Municipal Bond Series, and Fundamental U.S.
Government Strategic Income Fund Series) have adopted, subject to shareholder
approval, an Agreement and Plan of Reorganization (the "Plan") under which each
fund (the "Fundamental Fund") will transfer all of its assets and liabilities to
a newly-created corresponding series of The Tocqueville Trust (the "Tocqueville
Fund") in exchange for shares of the Tocqueville Fund. Shareholders of each
Fundamental Fund will receive shares of the corresponding Tocqueville Fund equal
in value to their shares in the Fundamental Fund. Shareholders will not have to
pay a sales load upon receiving shares of the Tocqueville Fund.
The corresponding Tocqueville Fund will have investment objectives, polices
and restrictions substantially identical to those of the Fundamental Fund. The
Board of Trustees of the Tocqueville Funds is comprised of individuals other
than those who currently serve as Directors (Trustees) of the Fundamental Funds.
Tocqueville Asset Management L.P. is the investment adviser to the Tocqueville
Funds.
A majority of Fundamental's Board Members determined that the Plan would be
in the best interests of shareholders of the Fundamental Funds and recommended
that shareholders of each of the Fundamental Funds approve the Plan at a meeting
anticipated to be held in the Spring of 1998.
8. Subsequent Event
At its March 25, 1998 Board of Directors' meeting, the Board of the Fund
approved the continuation of the Management Agreement through May 30, 1998 in
contemplation of the consummation of the reorganization discussed in Note 7.
11
<PAGE>
NEW YORK MUNI FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
The Manager and FSC (on behalf of certain of their directors, officers,
shareholders, employees and control persons) (the "Indemnitees") received
payment during the fiscal year ended December 31, 1997 from the Fund in the
amount of approximately $50,230. Upon learning of the payments, the independent
Board Members of the Funds directed that the Indemnitees return all of the
payments to the Funds or place them in escrow pending their receipt of an
opinion of an inedpendent legal counsel to the effect that the Indemnitees are
entitled to receive them. The Declaration of Trust, Articles of Incorporation
and contracts that call for indemnification specify that no indemnification
shall be provided to a person who shall be found to have engaged in "disabling
conduct" as defined by applicable law. The Indemnities have undertaken to
reimburse the Fund for any indemnification expenses for which it is determined
that they were not entitled to as a result of "disabling conduct" net of any
reimbursements already made to the Fund in the form of fees forgone or other
similar payments.
FSC waived fees in the amount of $51,200 in 1998. The Manager and FSC have
asserted that they elected to forgo these fees because the Fund was paying legal
expenses pursuant to indemnification. The Fund has retained independent legal
counsel to determine whether the Indemnitees engaged in disabling conduct.
Pending clarification of the legal issues involved, the Independent Directors
have instructed the Manager to escrow the full amount incurred by the Fund of
approximately $50,230.
9. Selected Financial Information
<TABLE>
<CAPTION>
Years Ended December 31,
----------------------------------------------------
1997 1996 1995 1994 1993
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
PER SHARE OPERATING PERFORMANCE
(for a share outstanding throughout the year)
Net Asset Value, Beginning of Year ....................... $0.87 $0.98 $0.88 $1.18 $1.21
----- ----- ----- ----- -----
Income from investment operations:
Net investment income .................................... .021 .035 .035 .056 .065
Net realized and unrealized gains (losses)
on investments ........................................... (.009) (.110) .101 (.290) .082
---- ----- ----- ----- -----
Total from investment operations ......................... .012 (.075) .136 (.234) .147
----- ----- ----- ----- -----
Less Distributions:
Dividends from net investment income ..................... (.019) (.035) (.035) (.056) (.065)
Return of capital distributions........................... (.003) -- -- -- --
Dividends from net realized gains ........................ -- -- (.001) (.010) (.112)
----- ----- ----- ----- -----
Total distributions ...................................... (.022) (.035) (.036) (.066) (.177)
----- ----- ----- ----- -----
Net Asset Value, End of Year ............................. $0.86 $0.87 $0.98 $0.88 $1.18
===== ===== ===== ===== =====
Total Return ............................................. 1.46% (7.73%) 15.67% (20.47%) 12.58%
RATIOS/SUPPLEMENTAL DATA
Net Assets, End of Year (000) ............................ $134,595 $196,746 $226,692 $212,665 $275,552
Ratios to Average Net Assets:
Interest expense ......................................... 1.10% 2.11% 2.09% 1.59% .61%
Operating expenses ....................................... 2.64% 1.66% 1.55% 1.62% 1.44%
----- ----- ----- ----- -----
Total expenses ........................................... 3.74%+ 3.77% 3.64% 3.21% 2.05%
===== ===== ===== ===== =====
Net investment income .................................... 2.23%+ 3.89% 3.81% 5.34% 5.20%
Portfolio turnover rate .................................. 399.38% 347.44% 347.50% 289.69% 404.05%
</TABLE>
12
<PAGE>
<TABLE>
<CAPTION>
Years Ended December 31,
----------------------------------------------------
1997 1996 1995 1994 1993
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
BANK LOANS
Amount outstanding at end of year (000 omitted) .......... $38,178 $1,200 $64,575 $20,000 $20,873
Average amount of bank loans outstanding during the year
(000 omitted) ............................................ $20,631 $49,448 $49,603 $54,479 $24,100
Average number of shares outstanding during the year
(000 omitted) ............................................ 153,535 178,456 191,692 206,323 184,664
Average amount of debt per share during the year ......... $ .134 $ .277 $ .259 $ .264 $ .131
<FN>
+These ratios are after expense reimbursement of .03% for the year ended December 31, 1997.
</FN>
</TABLE>
13
<PAGE>
INDEPENDENT AUDITOR'S REPORT
- --------------------------------------------------------------------------------
The Board of Directors and Shareholders
New York Muni Fund
We have audited the accompanying statement of assets and liabilities, including
the statement of investments, of New York Muni Fund as of December 31, 1997, and
the related statements of operations and cash flows for the year then ended, the
statements of changes in net assets for each of the two years in the period then
ended, and selected financial information for each of the five years in the
period then ended. These financial statements and selected financial information
are the responsibility of the Fund's management. Our responsibility is to
express an opinion on these financial statements and selected financial
information based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements and selected
financial information are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. Our procedures included confirmation of securities
owned as of December 31, 1997 by correspondence with the custodian and brokers.
An audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements and selected financial information
referred to above present fairly, in all material respects, the financial
position of New York Muni Fund as of December 31, 1997 and the results of its
operations, cash flows, changes in net assets, and selected financial
information for the periods indicated, in conformity with generally accepted
accounting principles.
See Notes 2 and 8 for information regarding regulatory proceedings and
transactions with affiliates.
S I G N A T U R E
New York, New York
March 2, 1998, except for Note 8 as to which the date is April 30, 1998.
14
<PAGE>
THE CALIFORNIA MUNI FUND
(LEFT COLUMN)
STATEMENT OF ASSETS AND LIABILITIES
December 31, 1997
- --------------------------------------------------------------------------------
ASSETS
Investment in securities
at value (cost $8,917,684) ................. $ 9,183,831
Interest receivable .......................... 252,201
Receivable for fund shares sold .............. 4,962,106
-----------
Total assets ..................... 14,398,138
-----------
LIABILITIES
Loans (Note 6) ............................... 503,018
Dividend Payable ............................. 10,223
Accrued expenses ............................. 52,893
-----------
Total liabilities ................ 566,134
-----------
NET ASSETS consisting of:
Accumulated net realized gain ... $ 220,789
Unrealized appreciation of
securities .................... 266,147
Paid-in-capital applicable to
1,672,917 shares of beneficial
interest (Note 4) ............. 13,345,068
---------- -----------
$13,832,004
===========
NET ASSET VALUE PER SHARE $8.27
=====
(RIGHT COLUMN)
STATEMENT OF OPERATIONS
Year Ended December 31, 1997
- --------------------------------------------------------------------------------
INVESTMENT INCOME
Interest income .................. $1,009,193
EXPENSES (Notes 2 and 3)
Management fee ................... $63,726
Custodian and accounting fees .... 60,460
Transfer agent fees .............. 38,033
Professional fees ................ 144,918
Printing and postage ............. 16,886
Interest ......................... 53,011
Distribution expenses ............ 44,731
Trustees' fees ................... 10,471
-------
Total expenses ...... 432,236
Less: Expenses reim-
bursed by manager . (3,296)
Net expenses ........ ------- 428,940
----------
Net investment income 580,253
----------
REALIZED AND UNREALIZED GAIN ON
INVESTMENTS
Net realized gain on investments . 493,308
Unrealized appreciation of
investments for the year ....... 374,518
----------
Net gain on investments 867,826
----------
NET INCREASE IN NET ASSETS FROM
OPERATIONS ......................... $1,448,079
==========
(FULL COLUMN)
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
Year Ended Year Ended
December 31, December 31,
1997 1996
------------ ------------
<S> <C> <C>
INCREASE (DECREASE) IN NET ASSETS FROM:
OPERATIONS
Net investment income ................................................ $ 580,253 $ 694,929
Net realized gain on investments ..................................... 493,308 100,733
Unrealized appreciation (depreciation) of investments for the year ... 374,518 (876,013)
----------- -----------
Net increase (decrease) in net assets from operations ............ 1,448,079 (80,351)
DIVIDENDS PAID TO SHAREHOLDERS FROM
Net investment income ................................................ (580,253) (694,929)
CAPITAL SHARE TRANSACTIONS (Note 4) .................................... (3,287,401) 4,404,527
----------- -----------
Total increase (decrease) .................................... (2,419,575) 3,629,247
NET ASSETS:
Beginning of year .................................................... 16,251,579 12,622,332
----------- -----------
End of year .......................................................... $13,832,004 $16,251,579
=========== ===========
</TABLE>
See Notes to Financial Statements.
18
<PAGE>
THE CALIFORNIA MUNI FUND
STATEMENT OF CASH FLOWS
Year Ended December 31, 1997
- --------------------------------------------------------------------------------
Increase (Decrease) in Cash
Cash Flows From Operating Activities
Net increase to net assets from operations ................... $ 1,448,079
Adjustments to reconcile net increase in net assets from
operations to net cash provided by operating activities:
Purchase of investment securities .......................... (128,371,610)
Proceeds on sale of securities ............................. 136,362,253
Increase in interest receivable ............................ (5,768)
Decrease in accrued expenses ............................... (81,857)
Net accretion of discount on securities .................... (135,229)
Net realized gain:
Investments .............................................. (493,308)
Unrealized appreciation on securities ........................ (374,518)
------------
Net cash provided by operating activities ............. 8,348,042
------------
Cash Flows From Financing Activities:*
Increase in notes payable .................................. 503,018
Proceeds on shares sold .................................... 251,745,912
Payment on shares repurchased .............................. (260,415,184)
Cash dividends paid ........................................ (195,278)
------------
Net cash used in financing activities ................. (8,361,532)
------------
Net decrease in cash .................................. (13,490)
Cash at beginning of year ...................................... 13,490
------------
Cash at end of year ............................................ $ 0
============
- -----------
*Non-cash financing activities not included herein consist of reinvestment of
dividends of $419,765.
Cash payments for interest expense totaled $57,087.
See Notes to Financial Statements.
19
<PAGE>
THE CALIFORNIA MUNI FUND
<TABLE>
<CAPTION>
STATEMENT OF INVESTMENTS
December 31, 1997
- ---------------------------------------------------------------------------------------------------------------------
Principal
Amount Issue ooo Type Rating Value
------ ----- ---- ------ -----
<C> <S> <C> <C> <C>
$ 100,000(DD) Arvin, Development Corporation, COP, RB, 8.75%, 9/01/18 ............. FCLT NR $ 24,505
200,000 Beverly Hills, PFA, RB, IFRN*, MBIA Insured, 7.32%, 6/01/15 ......... LRIB AAA 209,428
100,000 CSAC Finance Corp, COP, Sutter County Health Facilities Project,
7.80%, 1/01/21 .................................................... FCLT Baa1 102,158
70,000 California, HFA, Home Mortgage, RB, Series A, MBIA Insured,
5.70%, 8/01/10 .................................................... FCSI Aaa 74,163
300,000+ California Statewide Communities Development Authority, Cedars
Sinai Medical Project, COP, RB, IFRN*, 6.97%, 11/01/15 ............ LRIB A1 290,166
300,000 East Bay, Wastewater System Project, RB, Refunding, AMBAC
Insured, IFRN*, 6.87%, 6/01/20 .................................... LRIB AAA 312,108
220,000 Hawthorne, CRA, TAR, 6.75%, 9/01/24 ................................. FCLT Baa 240,933
170,000 Lake Elsinore, USD, Refunding, COP, 6.90%, 2/01/20 .................. FCLT BBB 187,299
10,000 Los Angeles, Home Mortgage, RB, 9.00%, 6/15/18 ...................... FCLT A 10,200
1,505,192 Los Angeles, HFA, MFH Project C, CAB, RB, 12.00%, 12/01/29 .......... FCLT NR 1,112,291
35,000 Modesto, Valley Oak Project, RB, 10.60%, 5/01/09 .................... FCSI NR 35,792
250,000 Northern California Power Agency, Multiple Capital Facilities, RB,
MBIA Insured, IFRN*, 8.76%, 8/01/25 ............................... LRIB AAA 293,040
250,000 Northern California Transmission Agency, CA-ORE Transmission
Project, RB, MBIA Insured, IFRN*, 6.81%, 4/29/24 .................. LRIB AAA 254,042
500,000 Orange County Airport, RB, Refunding, MBIA Insured, 5.625%,
7/01/12 ........................................................... FCLT Aaa 526,415
250,000+ Orange County, LTA, RB, IFRN*, 8.01%, 2/14/11 ....................... LRIB AA 297,597
250,000 Orange County, LTA, RB, IFRN*, 7.81%, 2/14/11 ....................... LRIB AAA 289,027
185,000 Panoche, Water District, COP, 7.50%, 12/01/08 ....................... FCSI BBB 199,776
250,000 Rancho, Water District Financing Authority, RB, Prerefunded @
104, AMBAC Insured, IFRN*, 8.82%, 8/17/21 ......................... LRIB AAA 301,443
250,000 Redding, Electric System, COP, Series A, FGIC Insured, IFRN*,
7.20%, 6/01/19 .................................................... LRIB AAA 264,078
175,000 Riverside, HFA, Riverside Apartment Project, RB, 7.87%, 11/01/19 .... FCLT BB- 178,896
500,000 San Bernardino, COP, Series B. MBIA Insured, IFRN*, 6.38%,
7/01/16 ........................................................... INLT AAA 531,045
900,000 San Bernardino, COP, Series PA38, MBIA Insured, IFRN*,
11.92%, 7/01/16, Rule 144A Security (restricted as to resale
except to qualified institutions) ................................. LRIB NR 1,021,995
200,000 San Diego Water Authority, COP, FGIC Insured, IFRN*, 7.09%,
4/22/09 ........................................................... LRIB AAA 240,624
1,440,000x San Jose, CRA, Series PA-38, TAB, MBIA Insured, IFRN*, 5.83%,
8/01/16, Rule 144A Security (restricted as to resale except to
qualified institutions) ........................................... LRIB AAA 1,471,306
</TABLE>
20
<PAGE>
THE CALIFORNIA MUNI FUND
<TABLE>
<CAPTION>
STATEMENT OF INVESTMENTS (continued)
December 31, 1997
- ---------------------------------------------------------------------------------------------------------------------
Principal
Amount Issue ooo Type Rating Value
------ ----- ---- ------ -----
<C> <S> <C> <C> <C>
$ 250,000 Southern California Public Power Authority, FGIC Isured, IFRN*,
6.62%, 7/01/17 .................................................... LRIB AAA $ 248,070
55,000 Tri City, HFA, FNMA/GNMA Collateralized, AMT, 6.45%, 12/01/28 ....... FCLT AAA 59,388
30,000 Tri City, HFA, FNMA/GNMA Collateralized, AMT, Series B, 6.30%,
12/01/28 .......................................................... FCLT AAA 32,358
250,000 Tri City, HFA, FNMA/GNMA Collateralized, AMT, Series E, 6.40%,
12/01/28 .......................................................... FCLT AAA 271,518
100,000 Upland, HFA, RB, 7.85%, 7/01/20 ..................................... FCLT BBB 104,170
-----------
Total Investments (Cost $8,917,684#) ........................ $ 9,183,831
===========
<FN>
*Inverse Floating Rate Notes (IFRN) are instruments whose interest rates bear an inverse relationship to the interest
rate on another security or the value of an index. Rates shown are at December 31, 1997.
#Cost is the same for Federal income tax purposes.
xThe Fund owns 100% of the security and therefore there is no trading in the security.
(DD)Denotes non-income producing security: Security is in default.
+Segregated, in whole or part, a collateral securing a line of credit.
</FN>
</TABLE>
Legend
(LEFT COLUMN)
oType FCLT -Fixed Coupon Long Term
FCSI -Fixed Coupon Short or Intermediate Term
LRIB -Residual Interest Bond Long Term
INLT -Indexed Inverse Floating Rate Bond Long Term
ooRatings If a security has a split rating the highest applicable
rating is used, including published ratings on identicial
credits for individual securities not individually rated.
Ratings are unaudited.
NR -Not Rated
oooIssue AMBAC American Municipal Bond Assurance Corporation
AMT Alternative Minimum Tax
CAB Capital Appreciation Bond
CGIC Capital Guaranty Insurance Company
(RIGHT COLUMN)
COP Certificate of Participation
CRA California Redevelopment Agency
FGIC Financial Guaranty Insurance Corporation
FNMA Federal National Mortgage Association
FSA Financial Security Assurance, Inc.
GNMA Government National Mortgage Association
HFA Housing Finance Authority
LTA Local Transportation Authority
MBIA Municipal Bond Insurance Assurance Corporation
MFH Multi Family Housing
PFA Public Financing Authority
RB Revenue Bond
TAB Tax Allocation Bond
TAR Tax Allocation Refunding
USD Unified School District
See Notes to Financial Statements.
21
<PAGE>
THE CALIFORNIA MUNI FUND
NOTES TO FINANCIAL STATEMENTS
December 31, 1997
- --------------------------------------------------------------------------------
(LEFT COLUMN)
1. Significant Accounting Policies
The California Muni Fund (the Fund) was organized as a Massachusetts
business trust and is registered as an open end management investment company
under the Investment Company Act of 1940. The Fund's objective is to provide as
high a level of income that is excluded from gross income for Federal income tax
purposes and exempt from California personal income tax as is consistent with
the preservation of capital. The Fund employs leverage in attempting to achieve
its objective. The following is a summary of significant accounting policies
followed in the preparation of its financial statements:
Valuation of Securities-The Fund's portfolio securities are valued on the
basis of prices provided by an independent pricing service when, in the opinion
of persons designated by the Fund's trustees, such prices are believed to
reflect the fair market value of such securities. Prices of non-exchange traded
portfolio securities provided by independent pricing services are generally
determined without regard to bid or last sale prices but take into account
institutional size trading in similar groups of securities, yield, quality,
coupon rate, maturity, type of issue, trading characteristics and other market
data. Securities traded or dealt in upon a securities exchange and not subject
to restrictions against resale as well as options and futures contracts listed
for trading on a securities exchange or board of trade are valued at the last
quoted sales price, or, in the absence of a sale, at the mean of the last bid
and asked prices. Options not listed for trading on a securities exchange or
board of trade for which over-the-counter market quotations are readily
available are valued at the mean of the current bid and asked prices. Money
market and short-term debt instruments with a remaining maturity of 60 days or
less will be valued on an amortized cost basis. Securities not priced in a
manner described above and other assets are valued by persons designated by the
Fund's trustees using methods which the trustees believe accurately reflects
fair value.
Federal Income Taxes-It is the Fund's policy to comply with the requirements
of the Internal Revenue Code applicable to "regulated investment companies" and
to distribute all of its taxable and tax exempt income to its shareholders.
Therefore, no provision for federal income tax is required.
(RIGHT COLUMN)
Distributions-The Fund declares dividends daily from its net investment
income and pays such dividends on the last business day of each month.
Distributions of net capital gains, if any, realized on sales of investments are
made annually, as declared by the Fund's Board of Trustees. Dividends are
reinvested at the net asset value unless shareholders request payment in cash.
General-Securities transactions are accounted for on a trade date basis.
Interest income is accrued as earned. Premiums and original issue discount on
securities purchased are amortized over the life of the respective securities.
Realized gains and losses from the sale of securities are recorded on an
identified cost basis.
Accounting Estimates-The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of increases and decreases in
net assets from operations during the reporting period. Actual results could
differ from those estimates.
2. Investment Advisory Fees and Other Transactions With Affiliates
Management Agreement
Under a Management Agreement, the Fund pays an investment management fee to
Fundamental Portfolio Advisors, Inc. (the Manager) equal to 0.5% of the Fund's
average daily net asset value up to $100 million and decreasing by .02% of each
$100 million increase in net assets down to 0.4% of net assets in excess of $500
million. See Note 8.
SEC Administrative Action Against the Manager
On September 30, 1997, the Securities & Exchange Commission announced that
it instituted public administrative and cease-and desist proceedings against the
Manager, the former portfolio manager of the Fund, the president of the Manager
and Fundamental Service Corporation (FSC). The proceeding arises from the
alleged failure of an affiliated mutual fund to disclose the risks of the
affiliated Fund, and of the Manager's failure to disclose its soft dollar
arrangements to the Fund's Board of Trustees. A hearing has been sched-
22
<PAGE>
THE CALIFORNIA MUNI FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
(LEFT COLUMN)
uled with an administrative law judge to determine whether the allegations are
true, and, if so, what remedial action, if any, is appropriate.
Board's Termination of Portfolio Manager
Between April 17, 1997 and July 24, 1997, a representative of the Manager
engaged Tocqueville Securities L.P. ("Tocqueville Securities"), an affiliate of
Tocqueville (see note 7), as agent, to effect eight separate over-the-counter
purchase transactions of municipal obligations on behalf of an affiliated fund.
The affiliated fund's Board has concluded that the commissions paid to
Tocqueville Securities in connection with these transactions (a portion of which
was paid to the representative) were not justified and that the affiliated fund
bore unnecessary expenses as a result of the sale of its securities to another
party and the subsequent repurchase of them through Tocqueville Securities.
Based upon a report initiated by Tocqueville Securities and prepared by the
Fund's independent auditors, and upon the Board's own analysis, the Board
directed that the Manager terminate its representative's services as a portfolio
manager. At the Board's request and in order to reimburse the affiliated fund
for all of its losses, Tocqueville Securities, on September 15, 1997,
voluntarily paid $260,000 to the affiliated fund, an amount which significantly
exceeds the total commissions ($184,920.60) received by Tocqueville Securities
in connection with these transactions. The staff of the Securities and Exchange
Commission and the Department of NASD Regulation have been informed of these
events by Tocqueville Securities. See Note 7 regarding contemplated transaction
with the Tocqueville Trust.
Distribution Plan and Service Agreement
Pursuant to a Distribution Plan (the Plan) adopted pursuant to Rule 12b-1,
promulgated under the Investment Company Act of 1940, the Fund may pay certain
promotional and advertising expenses and may compensate certain registered
securities dealers and financial institutions for services provided in
connection with the processing of orders for purchase or redemption of the
Fund's shares and furnishing other shareholder services. Payments by the Fund
shall not in the aggregate, in any fiscal year, exceed 0.5% of the average daily
net assets of the Fund.
(RIGHT COLUMN)
Under a Service Agreement with FSC, an affiliate of the Manager, amounts are
paid under the Plan to compensate FSC for the services it provides and the
expenses it bears in distributing the Fund's shares to investors. Distribution
fees for the year ended December 31, 1997 are set forth in the Statement of
Operations of which approximately $39,200 was paid to FSC.
NASD Sanctions and Fines
On February 19, 1998, FSC and two of its executives, without admitting or
denying guilt, entered into an agreement with the National Association of
Securities Dealers Inc. ("NASD") whereby they accepted fines totaling $125,000
and other stipulated sanctions as a result of the NASD's finding that they had
distributed advertising materials of an affiliated mutual fund which violated
NASD rules governing advertisements.
Affiliated Transfer Agent
The Fund compensated Fundamental Shareholder Services, Inc. (FSSI), an
affiliate of the Manager, for the services it provided under a Transfer Agent
and Service Agreement which terminated on September 11, 1997. Transfer agent
fees paid to FSSI for the year ended December 31, 1997 aggregated $28,066.
3. Trustees' Fees
All of the Trustees of the Fund are also directors or trustees of two other
affiliated mutual funds for which the Manager acts as investment adviser. For
services and attendance at Board meetings and meetings of committees which are
common to each Fund, each Trustee who is not affiliated with the Manager is
compensated at the rate of $6,500 per quarter pro rated among the funds based on
their respective average net assets. The Trustees also received additional
compensation for special services as requested by the Board. Additional
compensation totaled $40,923 pro rated among the funds based on their respective
average net assets.
4. Shares of Beneficial Interest
As of December 31, 1997 there were an unlimited number of shares of
beneficial interest (no par value) authorized and capital paid in amounted to
$13,345,068. Transactions in shares were as follows:
23
<PAGE>
THE CALIFORNIA MUNI FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
(LEFT COLUMN)
Year Ended Year Ended
December 31, 1997 December 31, 1996
----------------- -----------------
Shares Amount Shares Amount
------ ------ ------ ------
Shares sold 32,632,214 $256,708,018 29,177,580 $234,552,576
Shares issued
on
reinvest-
ment of
dividends 51,101 419,765 58,802 472,727
Shares
redeemed (33,097,092) (260,415,184) (28,566,533) (230,620,776)
----------- ------------ ----------- ------------
Net increase
(decrease) (413,777) (3,287,401) 669,849 $ 4,404,527
======== ========== ======= ============
5. Complex Securities and Investment
Transactions
Inverse Floating Rate Notes:
The Fund invests in variable rate securities commonly called "inverse
floaters". The interest rates on these securities have an inverse relationship
to the interest rate of other securities or the value of an index. Changes in
interest rate on the other security or index inversely affect the rate paid on
the inverse floater, and the inverse floater's price will be more volatile than
that of a fixed rate bond. Certain interest rate movements and other market
factors can substantially affect the liquidity of IFRN's.
Investment Transactions:
During the year ended December 31, 1997, the cost of purchases and proceeds
from sales of investment securities, other than short-term obligations, were
$9,050,450 and $13,516,911, respectively.
As of December 31, 1997 the net unrealized appreciation of portfolio
securities amounted to $266,147 composed of unrealized appreciation of $744,806
and unrealized depreciation of $478,659.
(RIGHT COLUMN)
6. Line of Credit
The Fund has a line of credit agreement with its custodian bank
collateralized by portfolio securities. Borrowings under this agreement bear
interest linked to the bank's prime rate. The maximum month end and the average
borrowings outstanding during the year ended December 1997, were $2,000,000 and
$664,000, respectively.
7. Agreement and Plan of Reorganization
On July 16, 1997 each of Fundamental's mutual funds (consisting of: New York
Muni Fund, The California Muni Fund, Fundamental Fixed Income Fund: Tax Free
Money Market Series, High Yield Municipal Bond Series, and Fundamental U.S.
Government Strategic Income Fund Series) have adopted, subject to shareholder
approval, an Agreement and Plan of Reorganization (the "Plan") under which each
fund (the "Fundamental Fund") will transfer all of its assets and liabilities to
a newly-created corresponding series of The Tocqueville Trust (the "Tocqueville
Fund") in exchange for shares of the Tocqueville Fund. Shareholders of each
Fundamental Fund will receive shares of the corresponding Tocqueville Fund equal
in value to their shares in the Fundamental Fund. Shareholders will not have to
pay a sales load upon receiving shares of the Tocqueville Fund.
The corresponding Tocqueville Fund will have investment objectives, polices
and restrictions substantially identical to those of the Fundamental Fund. The
Board of Trustees of the Tocqueville Funds is comprised of individuals other
than those who currently serve as Directors (Trustees) of the Fundamental Funds.
Tocqueville Asset Management L.P. is the investment adviser to the Tocqueville
Funds.
A majority of Fundamental's Board Members determined that the Plan would be
in the best interests of shareholders of the Fundamental Funds and recommended
that shareholders of each of the Fundamental Funds approve the Plan at a meeting
anticipated to be held in the Spring of 1998.
24
<PAGE>
THE CALIFORNIA MUNI FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
8. Subsequent Event
At its March 25, 1998 Board of Trustees' meeting, the Board of the Fund
approved the continuation of the Management Agreement through May 30, 1998 in
contemplation of the consummation of the reorganization discussed in Note 7.
The Manager and FSC (on behalf of certain of their directors, officers,
shareholders, employees and control persons) (the "Indemnitees") received
payment during the fiscal year ended December 31, 1997 from the Fund in the
amount of approximately $4,000. Upon learning of the payments, the independent
Board Members of the Funds directed that the Indemnitees return all of the
payments to the Funds or place them in escrow pending their receipt of an
opinion of an independent legal counsel to the effect that the Indemnitees are
entitled to receive them. The Declaration of Trust, Articles of Incorporation
and contracts that call for indemnification specify that no indemnification
shall be provided to a person who shall be found to have engaged in "disabling
conduct" as defined by applicable law. The Indemnities have undertaken to
reimburse the Fund for any indemnification expenses for which it is determined
that they were not entitled to as a result of "disabling conduct" net of any
reimbursements already made to the Fund in the form of fees forgone or other
similar payments. Pending clarification of the legal issues involved, the
Indemnitees have placed into an escrow account $4,000 as of April 30, 1998.
9. Selected Financial Information
<TABLE>
<CAPTION>
Years Ended December 31,
-----------------------------------------------
1997 1996 1995 1994 1993
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
PER SHARE OPERATING PERFORMANCE
(for a share outstanding throughout the year)
Net Asset Value, Beginning of Year ......................... $ 7.79 $ 8.91 $ 7.10 $ 9.49 $ 8.81
------- ------- ------- ------- -------
Income from investment operations:
Net investment income ...................................... .376 .409 .419 .553 .563
Net realized and unrealized gains (losses)
on investments ........................................... .480 (1.120) 1.810 (2.390) .876
------- ------- ------- ------- -------
Total from investment operations .................... .856 (.711) 2.229 (1.837) 1.439
------- ------- ------- ------- -------
Less Distributions:
Dividends from net investment income ....................... (.376) (.409) (.419) (.553) (.563)
Dividends from net realized gains .......................... - - - - (.196)
------- ------- ------- ------- -------
Total distributions ........................................ (.376) (.409) (.419) (.553) (.759)
------- ------- ------- ------- -------
Net Asset Value, End of Year ............................... $ 8.27 $ 7.79 $ 8.91 $ 7.10 $ 9.49
======= ======= ======= ======= =======
Total Return ............................................... 11.33% (8.01%) 32.02% (19.89%) 16.80%
RATIOS/SUPPLEMENTAL DATA
Net Assets, End of Year (000) .............................. 13,832 16,252 12,622 10,558 16,280
Ratios to Average Net Assets:
Interest expense ......................................... .42 .45% .39% .98% .39%
Operating expenses ....................................... 2.95* 2.81% 2.81% 2.50% 1.77%*
------- ------- ------- ------- -------
Total expenses ...................................... 3.37* 3.26% 3.20% 3.48% 2.16%*
======= ======= ======= ======= =======
Net investment income ............................... 4.55%* 4.88% 5.02% 6.80% 6.04%*
Portfolio turnover rate .................................... 70.86% 89.83% 53.27% 15.88% 51.26%
BANK LOANS
Amount outstanding at end of year (000 omitted) ............ $ 503 $ 0 $ 0 $1,292 $3,714
Average amount of bank loans outstanding during the year
(000 omitted) ............................................ $ 664 $ 823 $ 642 $1,620 $ 958
Average number of shares outstanding during the year
(000 omitted) ............................................ 1,609 1,768 1,635 1,711 1,517
Average amount of debt per share during the year ........... $ .41 $ .47 $ .39 $ .95 $ .63
<FN>
*These ratios are after expense reimbursement of .03%, and .50% for the years ended December 31, 1997 and 1993.
</FN>
</TABLE>
25
<PAGE>
INDEPENDENT AUDITOR'S REPORT
The Board of Trustees and Shareholders
The California Muni Fund
We have audited the accompanying statement of assets and liabilities
including the statement of investments of The California Muni Fund as of
December 31, 1997 and the related statements of operations and cash flows for
the year then ended, statements of changes in net assets for each of the two
years in the period then ended, and the selected financial information for each
of the five years in the period then ended. These financial statements and
selected financial information are the responsibility of the Fund's management.
Our responsibility is to express an opinion on these financial statements and
selected financial information based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements and selected
financial information are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. Our procedures included confirmation of securities
owned as of December 31, 1997 by correspondence with the custodian and brokers.
An audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements and selected financial information
referred to above present fairly, in all material respects, the financial
position of The California Muni Fund as of December 31, 1997, the results of its
operations, cash flows, changes in its net assets, and selected financial
information for the periods indicated, in conformity with generally accepted
accounting principles.
See Notes 2 and 8 for information regarding regulatory proceedings and
transactions with affiliates.
S I G N A T U R E
New York, New York
March 2, 1998, except for Note 8 as to which the date is April 30, 1998.
26
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
TAX-FREE MONEY MARKET SERIES
(LEFT COLUMN)
STATEMENT OF ASSETS AND LIABILITIES
December 31, 1997
- --------------------------------------------------------------------------------
ASSETS
Cash ............................................ $ 1,776,944
Investment in securities at value
(cost $75,869,410) ............................ 75,869,410
Receivables:
Fund shares sold .............................. 135,853
Interest ...................................... 270,975
-----------
Total assets .......................... 78,053,182
-----------
LIABILITIES
Payables:
Investment securities purchased ............... 1,103,151
Fund shares redeemed .......................... 63,627,947
Dividends ..................................... 9,321
Due to advisor ................................ 10,866
Accrued expenses ................................ 38,729
-----------
Total liabilities ..................... 64,790,014
-----------
NET ASSETS equivalent to $1.00 per share on
13,270,069 shares of beneficial interest
outstanding (Note 4) ............................. $13,263,168
===========
(RIGHT COLUMN)
STATEMENT OF OPERATIONS
Year Ended December 31, 1997
- --------------------------------------------------------------------------------
INVESTMENT INCOME
Interest income ................... $1,729,572
EXPENSES (Notes 2 and 3)
Investment advisory fees ..........$245,844
Custodian and accounting fees ..... 41,002
Transfer agent fees ............... 84,687
Trustees' fees .................... 10,041
Professional fees ................. 88,996
Distribution fees ................. 245,844
Postage and printing .............. 22,506
Other ............................. 12,291
--------
Total expenses .......... 751,211
Less:
Expenses paid indirectly (Note 6) . (41,002)
Expenses reimbursed by Manager .... (5,982)
--------
Net expenses ............ 704,227
----------
NET INCREASE IN NET ASSETS FROM
OPERATIONS $1,025,345
----------
(FULL COLUMN)
STATEMENTS OF CHANGES IN NET ASSETS
- --------------------------------------------------------------------------------
Year Ended Year Ended
December 31, December 31,
1997 1996
------------ ------------
INCREASE (DECREASE) IN NET ASSETS FROM:
OPERATIONS
Net investment income .......................... $ 1,025,345 $ 1,161,235
----------- -----------
Net increase in net assets from operations. 1,025,345 1,161,235
DIVIDENDS PAID TO SHAREHOLDERS FROM
Investment income .............................. (1,025,345) (1,161,235)
CAPITAL SHARE TRANSACTIONS (Note 4) .............. 8,642,404 (6,629,783)
----------- -----------
Total (decrease) increase ................. 8,642,404 (6,629,783)
NET ASSETS
Beginning of year .............................. 4,620,764 11,250,547
----------- -----------
End of year .................................... $13,263,168 $ 4,620,764
=========== ===========
See Notes to Financial Statements.
27
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
TAX-FREE MONEY MARKET SERIES
<TABLE>
<CAPTION>
STATEMENT OF INVESTMENTS
December 31, 1997
- ------------------------------------------------------------------------------------------------------------
Principal
Amount Issue o Value
------ ----- -----
<C> <S> <C>
$2,700,000 Ascension Parish, LA, PCR, BASF Wyandote Corp, LOC Bank of Tokyo,
VRDN*, 5.10%, 12/01/15 ..................................................... $2,700,000
1,500,000 Burke County, GA, Development Authority, VRDN*, PCR, Georgia Power Co.
Vogtle Project 5th Series, 5.00%, 7/01/24 .................................. 1,500,000
4,000,000 Burke County, GA, Development Authority, VRDN*, PCR, Georgia Power Co.
Vogtle Project 4th Series, 5.00%, 9/01/25 .................................. 4,000,000
2,800,000 Columbia AL, IDB, PCR Alabama Power Co. Project, VRDN*, Series D, 5.00%,
10/01/22 ................................................................... 2,800,000
75,000 Cuyahoga County, OH, IDR, S & R Playhouse Realty, VRDN*, LOC Marine
Midland Bank, 3.85%, 12/01/09 .............................................. 75,000
200,000 Delaware County, PA, SWDF, Scott Paper Project, Kimberly-Clark Corp
Guaranty, VRDN*, 3.65%, 12/01/18 ............................................ 200,000
200,000 Fulton County, GA, PCR, General Motors Project, VRDN*, 3.90%, 4/01/10 ........ 200,000
200,000 Garfield County, OK, PCR, Oklahoma Gas & Electric Co. Project A, VRDN*,
3.75%, 1/01/25 ............................................................. 200,000
125,000 Genesee County, NY, IDR, Orcon Industries, AMT, LOC Fleet Bank, VRDN*,
4.50%,12/01/98 ............................................................. 125,000
300,000 Illinois Educational Facility Authority, RB, Art Institute of Chicago, Northern
Trust Liquidity, VRDN*, 3.85%, 3/01/27 ..................................... 300,000
300,000 Illinois HFAR, Franciscan Sisters Project, LOC Toronto Dominion Bank,
VRDN*, 3.65%, 9/01/15 ...................................................... 300,000
2,000,000 Illinois HFAR, Healthcorp Affiliates Project, LOC Raborbank Nederland,
VRDN*, 4.05%, 11/01/20 ..................................................... 2,000,000
2,855,000 Jackson County, Miss., PCR, Chevron Corp. Project, VRDN*, 5.00%,
12/01/16 ................................................................... 2,855,000
3,700,000 Los Angeles, CA, Regional Airports Improvement Corp, LOC Societe
Generale, VRDN*, 5.00%, 12/01/25 ........................................... 3,700,000
200,000 McIntosh, AL, PCR, Ciba Geigy Project, LOC Swiss Bank Corp. VRDN*,
3.65%, 12/01/03 ............................................................ 200,000
5,000,000 Midland County, MI, Economic Development Corp, Dow Chemical Project B,
AMT, VRDN*, 5.00%, 12/01/15 ................................................ 5,000,000
300,000 Missouri, PCR, Monsanto Project, VRDN*, 3.70%, 2/01/09 ....................... 300,000
200,000 Missouri, Third Street Building Project, SPA First Chicago, VRDN*, 3.90%,
8/01/99 .................................................................... 200,000
300,000 Montgomery, AL, Baptist Medical Center, Special Care Facilities Financing
Authority, Series H, AMBAC Insured, VRDN*, 3.70%, 12/01/30 ................. 300,000
200,000 Nebraska Higher Education Loan Program, SPA, SLMA, MBIA Insured,
VRDN*, 3.65%, 12/01/15 ..................................................... 200,000
</TABLE>
28
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
TAX-FREE MONEY MARKET SERIES
<TABLE>
<CAPTION>
STATEMENT OF INVESTMENTS (continued)
December 31, 1997
- ------------------------------------------------------------------------------------------------------------
Principal
Amount Issue o Value
------ ----- -----
<C> <S> <C>
$ 5,100,000 New York City, NY, GO, LOC Chase Manhattan Bank, VRDN*, 5.00%, 8/01/23 ...... $5,100,000
2,500,000 New York City, NY, GO, Landesbank Hessen Liquidity, VRDN*, 3.60%, 2/15/20 ... 2,500,000
4,000,000 New York City, NY, Municipal Water Finance Authority, Water & Sewer System
RB, TR Receipts Series 29, The Bank of New York Liquidity, VRDN*,
3.90%, 6/15/30 ............................................................ 4,000,000
40,000 New York City, NY, New PHA, 3.38%, 01/01/98 ................................. 39,740
10,700,000x New York State, DAR, TRS 27, 3.95%, 7/01/24, City University, Floating Rate
Trust Receipts 27, MBIA Insured, Liquidity The Bank of New York ........... 10,700,000
3,000,000 New York State Energy Research & Development Authority, PCR, New York,
State Electric & Gas Co., Series D, LOC Union Bank of Switzerland,
VRDN*, 5.00%, 10/01/29 .................................................... 3,000,000
2,100,000 New York State, Job Development Authority, St. Gtd., Special Purpose Series
A-1 thru A-25, LOC Sumitomo Bank, VRDN*, 5.25%, 3/01/07 ................... 2,100,000
5,200,000 Newport Beach CA, RB, Hoag Memorial Hospital Series B, SPA Bank of
America, 5.00%, 10/01/06 .................................................. 5,200,000
50,000 North Little Rock, AR, New PHA, FGIC Insured, 3.25%, 6/01/98 ................ 49,670
1,100,000 Orange County, CA, Water District Project B, COP, LOC National
Westminister VRDN*, 4.85%, 8/15/15 ........................................ 1,100,000
4,000,000 Princeton, IN, PCR, PSI Energy, Inc., Proj., LOC Morgan Guaranty, VRDN*,
5.10%, 4/01/22 ............................................................ 4,000,000
125,000 Scioto County, OH, HFR, VHA, Central Capital Project, AMBAC Insured,
VRDN*, 3.70%, 12/01/25 .................................................... 125,000
4,500,000 Sweetwater County, WY, PCR, Idaho Power Co. Project Series C, VRDN*,
5.10%, 7/15/26 ............................................................ 4,500,000
1,600,000 Uinta County, WY, PCR, Chevron Corp Project, VRDN*, 5.00%, 8/15/20 .......... 1,600,000
4,500,000 Valdez, AK, Marine Term Revenue, Exxon Pipeline Co. Project A, VRDN*,
5.00%, 12/01/33 ........................................................... 4,500,000
200,000 Wake County, NC, PCR, Carolina Power & Light Project, LOC Sumitomo
Bank, VRDN*, 4.15%, 10/01/15 .............................................. 200,000
-----------
Total Investments (Cost $75,869,410) ........................................ $75,869,410
===========
<FN>
*Variable Rate Demand Notes (VRDN) are instruments whose interest rate changes on a specific date and/or
whose interest rates vary with changes in a designated base rate.
**Cost is the same for Federal income tax purposes.
xThe Fund owns 100% of the security and therefore there is no trading in the security.
</FN>
</TABLE>
29
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
TAX-FREE MONEY MARKET SERIES
STATEMENT OF INVESTMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
Legend
Issue AMBAC American Municipal Bond Assurance Corporation
DAR Dormitory Authority Revenue
AMT Alternative Minimum Tax
GO General Obligation
ETM Escrowed to Maturity
HFAR Health Facilities Authority Revenue
HFR Hospital Facilities Revenue
IDB Industrial Development Board
IDR Industrial Development Revenue
LOC Letter of Credit
MBIA Municipal Bond Insurance Assurance Corporation
PCR Pollution Control Revenue
PHA Public Housing Authority
RB Revenue Bond
SLMA Student Loan Marketing Association
SPA Stand By Bond Purchase Agreement
SWDF Solid Waste Disposal Facility
TRANS Tax Revenue Anticipation Notes
TRS Trust Receipt Series
See Notes to Financial Statements.
30
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
TAX-FREE MONEY MARKET SERIES
NOTES TO FINANCIAL STATEMENTS
December 31, 1997
- --------------------------------------------------------------------------------
1. Significant Accounting Policies
Fundamental Fixed-Income Fund (the Fund) is an open-end management
investment company registered under the Investment Company Act of 1940. The Fund
acts as a series company currently issuing three classes of shares of beneficial
interest, the Tax-Free Money Market Series, the High-Yield Municipal Bond Series
and the Fundamental U.S. Government Strategic Income Fund Series. Each series is
considered a separate entity for financial reporting and tax purposes. The
Tax-Free Money Market Series (the Series) investment objective is to provide as
high a level of current income exempt from federal income tax as is consistent
with the preservaton of capital and liquidity. The following is a summary of
significant accounting policies followed in the preparation of the Series'
financial statements:
Valuation of Securities:
Investments are stated at amortized cost. Under this valuation method, a
portfolio instrument is valued at cost and any premium or discount is amortized
on a constant basis to the maturity of the instrument. Amortization of premium
is charged to income, and accretion of market discount is credited to unrealized
gains. The maturity of investments is deemed to be the longer of the period
required before the Fund is entitled to receive payment of the principal amount
or the period remaining until the next interest adjustment.
Federal Income Taxes:
It is the Series' policy to comply with the requirements of the Internal
Revenue Code applicable to "regulated investment companies" and to distribute
all of its taxable and tax exempt income to its shareholders. Therefore, no
provision for federal income tax is required.
Distributions:
The Series declares dividends daily from its net investment income and
pays such dividends on the last business day of each month. Distributions of net
capital gains are made annually, as declared by the Fund's Board of Trustees.
Dividends are reinvested at the net asset value unless shareholders request
payment in cash.
General:
Securities transactions are accounted for on a trade date basis. Interest
income is accrued as earned. Realized gains and losses from the sale of
securities are recorded on an identified cost basis.
Accounting Estimates:
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of increases and decreases in net assets
from operations during the reporting period. Actual results could differ from
those estimates.
31
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
TAX-FREE MONEY MARKET SERIES
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
2. Investment Advisory Fees and Other Transactions with Affiliates
Management Agreement
The Fund has a Management Agreement with Fundamental Portfolio Advisors,
Inc. (the Manager). Pursuant to the agreement, the Manager serves as investment
adviser to the Tax-Free Money Market Series and is responsible for the overall
management of the business affairs and assets of the Series subject to the
authority of the Fund's Board of Trustees. In consideration for the services
provided by the Manager, the Series will pay an annual management fee in an
amount equal to 0.5% of the Series' average daily net assets up to $100 million
and decreasing by .02% for each $100 million increase in net assets down to 0.4%
of net assets in excess of $500 million. See Note 8.
SEC Administrative Proceeding Against the Manager
On September 30, 1997, the Securities & Exchange Commission announced that
it instituted public administrative and cease-and desist proceedings against the
Manager, the former portfolio manager of the Fund, the president of the Manager
and Fundamental Service Corporation (FSC), the Fund's Distributor. The
proceeding arises from the alleged failure of an affiliated mutual fund to
disclose the risks of the affiliated series, and of the Manager's failure to
disclose its soft dollar arrangements to the Fund's Board of Trustees. A hearing
has been scheduled with an administrative law judge to determine whether the
allegations are true, and, if so, what remedial action, if any, is appropriate.
Board's Termination of Portfolio Manager
Between April 17, 1997 and July 24, 1997, a representative of the Manager
engaged Tocqueville Securities L.P. ("Tocqueville Securities") an affiliate of
Tocqueville, as agent, to effect eight separate over-the-counter purchase
transactions of municipal obligations on behalf of an affiliated fund. The
Fund's Board has concluded that the commissions paid to Tocqueville Securities
in connection with these transactions (a portion of which was paid to the
representative) were not justified and that the affiliated fund bore unnecessary
expenses as a result of the sale of its securities to another party and the
subsequent repurchase of them through Tocqueville Securities. Based upon a
report initiated by Tocqueville Securities and prepared by the Fund's
independent auditors, and upon the Board's own analysis, the Board directed that
the Manager terminate the representative's services as a portfolio manager. At
the Board's request and in order to reimburse the affiliated fund for all of its
losses, Tocqueville Securities, on September 15, 1997, voluntarily paid $260,000
to the affiliated fund, an amount which significantly exceeds the total
commissions ($184,920.60) received by Tocqueville Securities in connection with
these transactions. The staff of the Securities and Exchange Commission and the
Department of NASD Regulation have been informed of these events by Tocqueville
Securities. See Note 7 regarding contemplated transaction with the Tocqueville
Trust.
Plan of Distribution
The Fund has adopted a Plan of Distribution, pursuant to Rule 12b-1
promulgated under the Investment Company Act of 1940, under which the Series
pays to FSC, an affiliate of the Manager, a fee, which is accrued daily and paid
monthly, at an annual rate of 0.5% of the Series' average daily net assets. The
amounts paid under the plan compensate FSC for the services it provides and the
expenses it bears in distributing the Series' shares to investors. Distribution
fees for the year ended December 31, 1997 are set forth in the Statement of
Operations.
NASD Sanctions and Fines
On February 19, 1998, FSC and two of its executives, without admitting or
denying guilt, entered into an agreement with the National Association of
Securities Dealers Inc. ("NASD") whereby they accepted fines
32
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
TAX-FREE MONEY MARKET SERIES
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
totaling $125,000 and other stipulated sanctions as a result of the NASD's
finding that they had distributed advertising materials of an affiliated mutual
fund which violated NASD rules governing advertisements.
Affiliated Transfer Agent
The Fund compensated Fundamental Shareholder Services, Inc., (FSSI) an
affiliate of the Manager, for the services it provided under a Transfer Agent
and Service Agreement which was terminated on September 11, 1997. Transfer agent
fees paid by the Series to FSSI for the year ended December 31, 1997 amounted to
$17,745.
3. Trustees' Fees
All of the Trustees of the Fund are also directors or trustees of two other
affiliated mutual funds for which the Manager acts as investment adviser. For
services and attendance at Board meetings and meetings of committees which are
common to each Fund, each Trustee who is not affiliated with the Manager is
compensated at the rate of $6,500 per quarter pro rated among the funds based on
their respective average net assets. The Trustees also received additional
compensation for special services as requested by the Board. Additional
compensation totaled $40,923 pro rated among the funds based on their respective
average net assets.
4. Shares of Beneficial Interest
As of December 31, 1997 there were an unlimited number of shares of
beneficial interest (no par value) authorized and capital paid in amounted to
$13,270,069. Transactions in shares of beneficial interest, all at $1.00 per
share were as follows:
Year ended Year ended
December 31, December 31,
1997 1996
-------------- --------------
Shares sold ..............................$2,566,332,934 $3,547,580,681
Shares issued on reinvestment of dividends 1,048,578 1,042,865
Shares redeemed ..........................(2,558,739,108) (3,555,253,329)
-------------- ----------
Net (decrease) increase ..................$ 8,642,404 (6,629,783)
============== ==========
5. Line of Credit
The Fund has a line of credit agreement with its custodian bank
collateralized by cash and portfolio securities for $500,000. Borrowings under
this agreement bear interest linked to the bank's prime rate. The Series had no
borrowing under the line of credit agreement as of or during the year ended
December 31, 1997.
6. Expenses Paid Indirectly
The Fund has an arrangement with its custodian whereby credits earned on
cash balances maintained at the custodian are used to offset custody charges.
These credits amounted to approximately $41,000 for the year ended December 31,
1997.
7. Agreement and Plan of Reorganization
On July 16, 1997 each of Fundamental's mutual funds (consisting of: New York
Muni Fund, The California Muni Fund, Fundamental Fixed Income Fund: Tax Free
Money Market Series, High Yield Municipal Bond Series, and Fundamental U.S.
Government Strategic Income Fund Series) have adopted, subject to shareholder
approval, an Agreement and Plan of Reorganization (the "Plan") under which each
fund (the "Fundamental Fund") will transfer all of its assets and liabilities to
a newly-created corresponding series of The Tocqueville Trust (the "Tocqueville
Fund") in exchange for shares of the Tocqueville Fund. Shareholders of each
Fundamental Fund will receive shares of the corresponding Tocqueville Fund equal
in value to their shares in the Fundamental Fund. Shareholders will not have to
pay a sales load upon receiving shares of the Tocqueville Fund.
33
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
TAX-FREE MONEY MARKET SERIES
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
The corresponding Tocqueville Fund will have investment objectives, polices
and restrictions substantially identical to those of the Fundamental Fund. The
Board of Trustees of the Tocqueville Funds is comprised of individuals other
than those who currently serve as Directors (Trustees) of the Fundamental Funds.
Tocqueville Asset Management L.P. is the investment adviser to the Tocqueville
Funds.
A majority of Fundamentals' Board Members determined that the Plan would be
in the best interests of shareholders of the Fundamental Funds and recommended
that shareholders of each of the Fundamental Funds approve the Plan at a meeting
anticipated to be held in the Spring of 1998.
8. Subsequent Event
At its March 25, 1998 Board of Trustees' meeting, the Board of the Fund
approved the continuation of the Management Agreement and Distribution Agreement
through May 30, 1998 in contemplation of the consummation of the reorganization
discussed in Note 7.
9. Selected Financial Information
<TABLE>
<CAPTION>
Years Ended December 31,
--------------------------------------------------------------
1997 1996 1995 1994 1993
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
PER SHARE DATA AND RATIOS
(for a share outstanding throughout the period)
Net Asset Value, Beginning of Year ........................ $1.00 $1.00 $1.00 $1.00 $1.00
Income from investment operations:
Net investment income ..................................... 0.022 0.023 0.026 0.017 0.014
Less Distributions:
Dividends from net investment income ...................... (0.022) (0.023) (0.026) (0.017) (0.014)
Net Asset Value, End of Period ............................ $1.00 $1.00 $1.00 $1.00 $1.00
Total Return .............................................. 2.19% 2.28% 2.60% 1.69% 1.62%
RATIOS/SUPPLEMENTAL DATA
Net Assets, End of Year (000 omitted) ..................... 13,263 4,621 11,251 9,004 5,830
Ratios to Average Net Assets
Expenses .............................................. 1.52%(D)(D) (D) 1.54% 1.53%(D)(D) 0.91%(D) .95%(D)
Net investment income ................................. 2.10% 2.04% 2.43% 1.55% 1.25%
BANK LOANS
Amount outstanding at end of period
(000 omitted) ........................................... $ - $ 218 $ - $ 451 $ 290
Average amount of bank loans outstanding during the period
(000 omitted) ........................................... $ - $ - $ 41 $ 53 $ 111
Average number of shares outstanding during the period
(000 omitted) ........................................... 48,801 56,876 44,432 56,267 25,786
Average amount of debt per share during the period ........ $ - $ - $ .001 $ .001 $ .004
<FN>
(D)These ratios are after expense reimbursement of .02%, .44% and .67%, for each of the years ended December 31, 1997, 1994 and
1993, respectively.
(D)(D)These ratios would have been 1.44%, 1.40% and 1.35% net of expense offsets of .08%, .14% and .18% for the years ended December
31, 1997, 1996 and 1995, respectively.
</FN>
</TABLE>
34
<PAGE>
INDEPENDENT AUDITOR'S REPORT
The Board of Trustees and Shareholders
Tax-Free Money Market Series of
Fundamental Fixed-lncome Fund
We have audited the accompanying statement of assets and liabilities,
including the statement of investments, of the Tax-Free Money Market Series of
Fundamental Fixed-lncome Fund as of December 31, 1997 and the related statement
of operations for the year then ended, the statement of changes in net assets
for each of the two years in the period then ended, and the selected financial
information for each of the five years in the period then ended. These financial
statements and selected financial information are the responsibility of the
Fund's management. Our responsibility is to express an opinion on these
financial statements and selected financial information based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements and selected
financial information are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. Our procedures included confirmation of securities
owned as of December 31, 1997 by correspondence with the custodian and brokers.
An audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presenation. We believe that our audits provide a reasonable basis for
our opinion.
In our opinion, the financial statement and selected financial information
referred to above present fairly, in all material respects, the financial
position of the Tax-Free Money Market Series of Fundamental Fixed-Income Fund as
of December 31, 1997, and the results of its operations, changes in net assets,
and selected financial information for the periods indicated, in conformity with
generally accepted accounting principles.
See Note 2 for information regarding regulatory proceedings and transactions
with affiliates.
S I G N A T U R E
New York, New York
March 2, 1998, except for Note 8 as to which the date is March 25, 1998.
35
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
HIGH-YIELD MUNICIPAL BOND SERIES
(LEFT COLUMN)
STATEMENT OF ASSETS AND LIABILITIES
December 31, 1997
- --------------------------------------------------------------------------------
ASSETS
Investment in securities at value (Note 5)
(cost $2,739,553) ................................... $2,832,290
Interest receivable ................................... 40,346
Receivable for fund shares sold ....................... 463,520
----------
Total assets ............................. 3,336,156
----------
LIABILITIES
Payable for investments purchased ..................... 615,650
Accrued expenses ...................................... 11,735
Bank overdraft payable ................................ 452,313
Dividend payable ...................................... 1,233
Payable for fund shares redeemed ...................... 240
----------
Total liabilities ........................ 1,081,171
----------
NET ASSETS consisting of:
Accumulated net realized
loss .................................... $ (158,714)
Unrealized appreciation
of securities ........................... 92,737
Paid-in-capital applicable to
299,472 shares of
beneficial interest
(Note 4) ................................ 2,320,962
-----------
$2,254,985
==========
NET ASSET VALUE PER SHARE ............................... $ 7.53
==========
(RIGHT COLUMN)
STATEMENT OF OPERATIONS
Year Ended December 31, 1997
- --------------------------------------------------------------------------------
INVESTMENT INCOME
Interest income .................... $140,428
EXPENSES (Notes 2 and 3)
Investment advisory fees ........... $ 14,600
Custodian and accounting fees ...... 43,046
Transfer agent fees ................ 8,970
Trustee fees ....................... 2,413
Distribution fees .................. 9,125
Professional fees .................. 21,443
Postage and printing ............... 8,077
Other .............................. 3,583
--------
Total expenses .............. 111,257
Less: Expenses waived or reimbursed
by the manager and affiliates .... (64,243)
--------
Net expenses ................ 47,014
--------
Net investment income ....... 93,414
REALIZED AND UNREALIZED GAIN
(LOSS) ON INVESTMENTS
Net realized gain on investments ... 17,891
Change in unrealized appreciation of
investments for the year ........... 166,782
--------
Net gain on investments ..... 184,673
--------
NET INCREASE IN NET ASSETS FROM
OPERATIONS ......................... $278,087
========
(FULL COLUMN)
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
Years Ended December 31, 1997 and 1996
- --------------------------------------------------------------------------------------------------------
1997 1996
INCREASE (DECREASE) IN NET ASSETS FROM: ---- ----
<S> <C> <C>
OPERATIONS
Net investment income ................................................... $ 93,414 $ 108,670
Net realized gain on investments ........................................ 17,891 22,294
Unrealized (depreciation) appreciation of investments for the year ...... 166,782 (22,733)
--------- ---------
Net increase in net assets from operations ....................... 278,087 108,231
DIVIDENDS PAID TO SHAREHOLDERS FROM
Net investment income ................................................... (93,414) (108,670)
CAPITAL SHARE TRANSACTIONS (Note 4) ....................................... 212,100 401,216
--------- ---------
Total increase ................................................... 396,773 400,777
NET ASSETS:
Beginning of year ....................................................... 1,858,212 1,457,435
--------- ---------
End of year ............................................................. $2,254,985 $1,858,212
========== ==========
</TABLE>
See Notes to Financial Statements.
38
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
HIGH-YIELD MUNICIPAL BOND SERIES
<TABLE>
<CAPTION>
STATEMENT OF INVESTMENTS
December 31, 1997
- ------------------------------------------------------------------------------------------------------------
Principal
Amount Issue o Value
------ ----- -----
<C> <S> <C>
$ 40,000 Allegheny County, PA, IDA, AFR, USAir Inc., 8.88%, 3/01/21 ................................$ 40,782
40,000 Brookhaven, NY, IDA, CFR, Dowling College, 6.75%, 3/01/23 ................................. 42,730
250,000 Colorado Health Facilities Authority, RHR, Liberty Heights Project, ETM, CAB, 7/15/24 ..... 60,317
100,000 Corona, CA, COP, Vista Hospital Systems Inc. 8.38%, 7/01/11 ............................... 109,361
100,000 Escambia, FL, Housing Corporation, Royal Arms Project, Series B, 9.00%, 7/01/16 ........... 103,202
70,000 Florence County, SC, IDA, RB, Stone Container Corp., 7.38%, 2/01/07 ....................... 74,070
500,000 Foothill / Eastern TCA, Toll Road Revenue, CAB, 1/01/26 ................................... 106,500
25,000 Hildago County, TX, Health Services, Mission Hospital Inc Project, 6.88%, 8/15/26 ......... 26,567
50,000+ Illinois Development Financial Authority, Solid Waste Disposal, RB, Ford Heights Waste
Tire Project, 7.88%, 4/01/11 ............................................................ 10,582
45,000 Illinois Health Facilities Authority, Midwest Physician Group Ltd Project, RB, 8.13%,
11/15/19 ................................................................................ 48,833
35,000 Indianapolis, IN, RB, Robin Run Village Project, 7.63%, 10/01/22 .......................... 38,463
50,000 Joplin, MO, IDA, Hospital Facilities Revenue, Tri State Osteopathic, 8.25%, 12/15/14 ...... 53,674
50,000 Los Angeles, CA, Regional Airport, Continental Airlines, AMT, 9.25%, 8/01/24 .............. 59,104
630,000 Marengo County, AL, Port Authority Facilities, RB, CAB, Series A, 3/01/19 ................. 141,252
75,000 Maryland Economic Development Corporation, Nursing Facilities Mortgage RB,
Ravenwood Healthcare, Series A, 8.38%, 8/01/26 .......................................... 78,529
85,000 Montgomery County, TX, Health Facilities Development Corp., The Woodlands Medical
Center, 8.85%, 8/15/14 .................................................................. 93,171
100,000 New York City, NY, Municipal Water Finance Authority, Water & Sewer RB, TR Receipts
Series 29, 6.56%, 6/15/30 ............................................................... 96,974
100,000 New York State, DAR, City University System Residual Int Tr Recpts 27, MBIA Insured,
Liquidity The Bank of New York, 8.22%, 7/01/24 .......................................... 109,979
100,000 New York State, DAR, City University System Residual Int Tr Recpts 28, AMBAC Insured,
Liquidity The Bank of New York, 7.63%, 7/01/25 .......................................... 105,279
5,000,000 New York State, DAR, CAB, FHA Presbyterian Hospital Series A, AMBAC Insured,
8/15/36 ................................................................................. 643,400
100,000#x Niagara Falls, NY, URA, Old Falls Street Improvement Project, 11.00%, 5/01/09 ............. 35,795
50,000 Northeast, TX, Hospital Authority Revenue, Northeast Medical Center, 7.25%, 7/01/22 ....... 57,455
75,000 Perdido, FL, Housing Corporation, RB, Series B. 9.25%, 11/01/16 ........................... 75,787
30,000 Philadelphia, PA, HEHA, Graduate Health Systems Project, 7.25%, 7/01/18 ................... 31,468
60,000 Port Chester, NY, IDA, Nadal Industries Inc Project, 7.00%, 2/01/16 ....................... 61,876
75,000 San Antonio, TX, HFC, Multi Family Housing, RB, Agape Metro Housing Project, Series
A, 8.63%, 12/01/26 ...................................................................... 75,989
75,000 San Bernardino, CA, San Bernardino Community Hospital, RB, 7.88%, 12/01/19 ................ 77,531
100,000 San Bernardino County, CA, COP, Series PA-38, MBIA Insured, IFRN*, 11.92%, 7/01/16,
Rule 144A Security (restricted as to resale except to qualified institutions) ........... 113,555
</TABLE>
39
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
HIGH-YIELD MUNICIPAL BOND SERIES
<TABLE>
<CAPTION>
STATEMENT OF INVESTMENTS
December 31, 1997
- ------------------------------------------------------------------------------------------------------------
Principal
Amount Issue o Value
------ ----- -----
<C> <S> <C>
$ 35,000 San Joaquin Hills, CA, TCA, Toll Road Revenue, 7.00%, 1/01/30 ............................$ 40,033
60,000x San Jose, CA, Redevelopment Agency, Tax Allocation Bonds, IFRN*, MBIA Insured,
5.83%, 8/01/16, MBIA Insured, Rule 144A Security (restricted as to resale except to
qualified institutions) ................................................................ 61,304
150,000 Savannah, GA Economic Development Authority Revenue, ETM, CAB, 12/01/21 .................. 39,940
45,000 Schuylkill County, PA, IDA Resouce Recovery, Schuylkill Energy Res Inc. AMT, 6.50%,
1/01/10 ................................................................................ 46,040
15,000(D)# Troy, NY, IDA, Hudson River Project, 11.00%, 12/01/94 .................................... 6,150
75,000(D) (D)(D)Villages at Castle Rock, CO, Metropolitan District #4, 8.50%, 6/01/31 .................... 39,138
25,000 Wayne, MI, AFR, Northwest Airlines Inc. 6.75%, 12/01/15 .................................. 27,460
----------
Total Investments (Cost $2,739,553)** ....................................................$2,832,290
==========
<FN>
** Cost is approximately the same for income tax purposes.
* Inverse Floating Rate Notes (IFRN) are instruments whose interest rates bear an inverse relationship to the interest rate on
another security or the value of an index. Rates shown are at December 31, 1997.
# The value of this non-income producing security has been estimated by persons designated by the Fund's Board of
Trustees using methods the Trustees believe reflect fair value. See note 5 to the financial statements.
+ Non-income producing security.
(D)(D) Security in default. Interest paid on cash flow basis. Rate shown as of December 31, 1997.
x The Fund or its affiliates owns 100% of the security and therefore there is no trading in the security.
</FN>
</TABLE>
Legend
o Issue AFR Airport Facilities Revenue
AMBAC American Municipal Bond Assurance Corporation
AMT Subject to Alternative Minimum Tax
CAB Capital Appreciation Bond
COP Certificate of Participation
CFR Civic Facility Revenue
DAR Dorm Authority Revenue
ETM Escrowed to Maturity
FHA Federal Housing Authority
HEHA Higher Education and Health Authority
HFC Housing Finance Corporation
IDA Industrial Development Authority
MBIA Municipal Bond Insurance Assurance Corporation
RB Revenue Bond
RHR Retirement Housing Revenue
TCA Transportation Corridor Agency
URA Urban Renewal Agency
See Notes to Financial Statements.
40
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
HIGH-YIELD MUNICIPAL BOND SERIES
NOTES TO FINANCIAL STATEMENTS
December 31, 1997
- --------------------------------------------------------------------------------
1. Significant Accounting Policies
Fundamental Fixed-Income Fund (the Fund) is an open-end management
investment company registered under the Investment Company Act of 1940. The Fund
operates as a series company currently issuing three classes of shares of
beneficial interest, the Tax-Free Money Market Series, the High-Yield Municipal
Bond Series and the Fundamental U.S. Government Strategic Income Fund Series
(the Series). Each series is considered a separate entity for financial
reporting and tax purposes. The High-Yield Municipal Bond Series (the Series)
seeks to provide a high level of current income exempt from federal income tax
through investment in a portfolio of lower quality municipal bonds, generally
referred to as "junk bonds." These bonds are considered speculative because they
involve greater price volatility and risk than higher rated bonds. The following
is a summary of significant accounting policies followed in the preparation of
the Series' financial statements:
Valuation of Securities: The Fund's portfolio securities are valued on the basis
of prices provided by an independent pricing service when, in the opinion of
persons designated by the Fund's trustees, such prices are believed to reflect
the fair market value of such securities. Prices of non-exchange traded
portfolio securities provided by independent pricing services are generally
determined without regard to bid or last sale prices but take into account
institutional size trading in similar groups of securities, yield, quality,
coupon rate, maturity, type of issue, trading characteristics and other market
data. Securities traded or dealt in upon a securities exchange and not subject
to restrictions against resale as well as options and futures contracts listed
for trading on a securities exchange or board of trade are valued at the last
quoted sales price, or, in the absence of a sale, at the mean of the last bid
and asked prices. Options not listed for trading on a securities exchange or
board of trade for which over-the-counter market quotations are readily
available are valued at the mean of the current bid and asked prices. Money
market and short-term debt instruments with a remaining maturity of 60 days or
less will be valued on an amortized cost basis. Securities not priced in a
manner described above and other assets are valued by persons designated by the
Fund's trustees using methods which the trustees believe accurately reflects
fair value.
Federal Income Taxes: It is the Series' policy to comply with the requirements
of the Internal Revenue Code applicable to "regulated investment companies" and
to distribute all of its taxable and tax exempt income to its shareholders.
Therefore, no provision for federal income tax is required.
Distributions: The Series declares dividends daily from its net investment
income and pays such dividends on the last business day of each month.
Distributions of net capital gain, if any, realized on sales of investments are
anticipated to be made before the close of the Series' fiscal year, as declared
by the Board of Trustees. Dividends are reinvested at the net asset value unless
shareholders request payment in cash.
General: Securities transactions are accounted for on a trade date basis.
Interest income is accrued as earned. Realized gain and loss from the sale of
securities are recorded on an identified cost basis. Original issue discounts
and premiums are amortized over the life of the respective securities. Premiums
are amortized and charged against interest income and original issue discounts
are accreted to interest income.
41
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
HIGH-YIELD MUNICIPAL BOND SERIES
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
Accounting Estimates: The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of increases and decreases in net assets
from operations during the reporting period. Actual results could differ from
those estimates.
2. Investment Advisory Fees and Other Transactions with Affiliates
Management Agreement
The Fund has a Management Agreement with Fundamental Portfolio Advisors,
Inc. (the Manager). Pursuant to the agreement, the Manager serves as investment
adviser to the High-Yield Municipal Bond Series and is responsible for the
overall management of the business affairs and assets of the Series subject to
the authority of the Fund's Board of Trustees. In consideration for the services
provided by the Manager, the Series will pay an annual management fee in an
amount equal to 0.8% of the Series' average daily net assets up to $100 million
and decreasing by .02% for each $100 million increase in net assets down to 0.7%
of net assets in excess of $500 million. The Manager voluntarily waived fees and
reimbursed expenses of $49,643 for the year ended December 31, 1997. See Note 7.
SEC Administrative Action Against The Manager
On September 30, 1997, the Securities & Exchange Commission announced that
it instituted public administrative and cease-and desist proceedings against the
Manager, the former portfolio manager of the Fund, the president of the Manager
and Fundamental Service Corporation (FSC) the Funds distributor. The proceeding
arises from the alleged failure of an affiliated mutual fund to disclose the
risks of the Fund, and of the Manager's failure to disclose its soft dollar
arrangements to the Fund's Board of Trustees. A hearing has been scheduled to
determine whether the allegations are true, and, if so, what remedial action, if
any, is appropriate.
Board's Termination of Portfolio Manager
Between April 17, 1997 and July 24, 1997, a representative of the Manager
engaged Tocqueville Securities L.P. ("Tocqueville Securities") an affiliate of
Tocqueville, as agent, to effect eight separate over-the-counter purchase
transactions of municipal obligations on behalf of an affiliated fund. The
Fund's Board has concluded that the commissions paid to Tocqueville Securities
in connection with these transactions (a portion of which was paid to the
representative) were not justified and that the affiliated fund bore unnecessary
expenses as a result of the sale of its securities to another party and the
subsequent repurchase of them through Tocqueville Securities. Based upon a
report initiated by Tocqueville Securities and prepared by the Fund's
independent auditors, and upon the Board's own analysis, the Board directed that
the Manager terminate the representative's services as a portfolio manager. At
the Board's request and in order to reimburse the affiliated fund for all of its
losses, Tocqueville Securities, on September 15, 1997, voluntarily paid $260,000
to the affiliated fund, an amount which significantly exceeds the total
commissions ($184,920.60) received by Tocqueville Securities in connection with
these transactions. The staff of the Securities and Exchange Commission and the
Department of NASD Regulation have been informed of these events by Tocqueville
Securities. See note 7 regarding contemplated transaction with the Tocqueville
Trust.
42
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
HIGH-YIELD MUNICIPAL BOND SERIES
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
Plan of Distribution
The Fund has adopted a Plan of Distribution, pursuant to Rule 12b-1
promulgated under the Investment Company Act of 1940, under which the Series
pays to FSC, an affiliate of the Manager, a fee, which is accrued daily and paid
monthly, at an annual rate of 0.5% of the Series' average daily net assets.
Amounts paid under the plan are to compensate FSC for the services it provides
and the expenses it bears in distributing the Series' shares to investors. FSC
has waived all fees in the amount of $9,125 for the year ended December 31,
1997.
NASD Sanctions and Fines
On February 19, 1998, FSC and two of its executives, without admitting or
denying guilt, entered into an agreement with the National Association of
Securities Dealers, Inc. ("NASD") whereby they accepted fines totaling $125,000
and other stipulated sanctions as a result of the NASD's finding that they had
distributed advertising materials of an affiliated mutual fund which violated
NASD rules governing advertisements.
Affiliated Transfer Agent
The Fund compensated Fundamental Shareholder Services, Inc. (FSSI), an
affiliate of the Manager, for the services it provided under a Transfer Agent
and Service Agreement which was terminated on September 11, 1997. Transfer agent
fees paid by the Series to FSSI amounted to $5,012.
3. Trustees' Fees
All of the Trustees of the Fund are also directors or trustees of two other
affiliated mutual funds for which the Manager acts as investment adviser. For
services and attendance at Board meetings and meetings of committees which are
common to each fund, each Trustee who is not affiliated with the Manager is
compensated at the rate of $6,500 per quarter pro rated among the funds based on
their respective average net assets. The Trustees also received additional
compensation for special services as requested by the Board. Additional
compensation totaled $40,923 pro rated among the funds based on their respective
average net assets.
4. Shares of Beneficial Interest
As of December 31, 1997, there were an unlimited number of shares of
beneficial interest (no par value) authorized and capital paid in amounted to
$2,320,962. Transactions in shares of beneficial interest were as follows:
<TABLE>
<CAPTION>
Year Ended Year Ended
December 31, 1997 December 31, 1996
----------------------- --------------------------
Shares Amount Shares Amount
--------- ---------- --------- -----------
<S> <C> <C> <C> <C>
Shares sold .................................... 2,941,324 20,530,136 1,912,593 $12,834,095
Shares issued on reinvestment of dividends ..... 11,426 79,995 11,925 80,347
Shares redeemed ................................ (2,924,097) (20,398,031) (1,859,933) (12,513,226)
---------- ----------- ---------- -----------
Net increase ................................... 28,653 $ 212,100 64,585 $ 401,216
========== =========== ========== ===========
</TABLE>
5. Investment Transactions
The Fund invests in variable rate securities commonly called "inverse
floaters." The interest rates on these securities have an inverse relationship
to the interest rate of other securities or the value of an index. Changes in
43
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
HIGH-YIELD MUNICIPAL BOND SERIES
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
interest rate on the other security or index inversely affect the rate paid on
the inverse floater, and the inverse floater's price will be more volatile than
that of a fixed-rate bond. Certain interest rate movements and other market
factors can substantially affect the liquidity of IFRN's.
The Fund invests in lower rated or unrated ("junk") securities which are
more likely to react to developments affecting market risk and credit risk than
would higher rated securities which react primarily to interest rate
fluctuations. The Fund held securities in default with an aggregate value of
$91,665 at December 31, 1997 (4.1% of net assets). As indicated in the Statement
of Investments, the Troy, NY Industrial Revenue Bond, 11% due December 1, 2014
with a par value of $15,000 and a value of $6,150 at December 31, 1997 has been
estimated in good faith under methods determined by the Board of Trustees.
The Fund owns 1.7% of a Niagara Falls New York Urban Renewal Agency 11% Bond
("URA Bond") due to mature on May 1, 2009 which has missed interest and sinking
fund payments. An affiliated investment company owns 98.3% of this bond issue.
The Fund was party to an agreement whereby certain related bonds owned by an
affiliate were to be subject to repayment under a debt assumption agreement. The
agreement allowed the affiliate to allocate a portion of the debt services it
receives to the URA Bond. In exchange the Fund forfeited certain rights it had
as holder of the URA bond. The debt assumption was not completed and the timing
and amount of debt service payments is uncertain. The value of this bond is
$35,795, and is valued at 35.80% of face value at December 31, 1997 under
methods determined by the Board of Trustees.
During the year ended December 31, 1997, the cost of purchases and proceeds
from sales of investment securities, other than short-term obligations, were
$2,982,245 and $2,610,195, respectively.
As of December 31, 1997 net unrealized appreciation of portfolio securities
amounted to $92,737, composed of unrealized appreciation of $225,341 and
unrealized depreciation of $132,604.
The Fund has capital loss carryforwards to offset future capital gains as
follows:
Amount Expiration
------- ----------
$23,500 12/31/1998
22,200 12/31/1999
20,500 12/31/2000
54,300 12/31/2002
40,000 12/31/2003
--------
$160,500
========
6. Agreement and Plan of Reorganization
On July 16, 1997 each of Fundamental's mutual funds (consisting of: New York
Muni Fund, The California Muni Fund, Fundamental Fixed Income Fund: Tax Free
Money Market Series, High Yield Municipal Bond Series, and Fundamental U.S.
Government Strategic Income Fund Series) have adopted, subject to shareholder
approval, an Agreement and Plan of Reorganization (the "Plan") under which each
fund (the "Fundamental Fund") will transfer all of its assets and liabilities to
a newly-created corresponding series of The Tocqueville Trust (the "Tocqueville
Fund") in exchange for shares of the Tocqueville Fund. Shareholders of each
Fundamental Fund will receive shares of the corresponding Tocqueville Fund equal
in value to their shares in the Fundamental Fund. Shareholders will not have to
pay a sales load upon receiving shares of the Tocqueville Fund.
44
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
HIGH-YIELD MUNICIPAL BOND SERIES
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
The corresponding Tocqueville Fund will have investment objectives, polices
and restrictions substantially identical to those of the Fundamental Fund. The
Board of Trustees of the Tocqueville Funds is comprised of individuals other
than those who currently serve as Directors (Trustees) of the Fundamental Funds.
Tocqueville Asset Management L.P. is the investment adviser to the Tocqueville
Funds.
A majority of Fundamental's Board members determined that the Plan would be
in the best interests of shareholders of the Fundamental Funds and recommended
that shareholders of each of the Fundamental Funds approve the Plan at a meeting
anticipated to be held in the Spring of 1998.
7. Subsequent Event
At its March 25, 1998 Board of Trustees' meeting, the Board of the Fund
approved the continuation of the Management Agreement and Distribution Agreement
through May 30, 1998 in contemplation of the consummation of the reorganization
discussed in Note 6.
8. Selected Financial Information
<TABLE>
<CAPTION>
Years Ended December 31,
-----------------------------------------
1997 1996 1995 1994 1993
PER SHARE OPERATING PERFORMANCE ---- ---- ---- ---- ----
(for a share outstanding throughout the period)
<S> <C> <C> <C> <C> <C>
Net asset value, beginning of period $6.86 $7.07 $5.92 $7.27 $7.30
----- ----- ----- ----- -----
Income from investment operations:
Net investment income 0.37 0.47 0.34 0.43 0.39
Net realized and unrealized gains (losses) on investments 0.67 (0.21) 1.15 1.35) (0.03)
----- ----- ----- ----- -----
Total from investment operations 1.04 0.26 1.49 (0.92) 0.36
----- ----- ----- ----- -----
Less distributions:
Dividends from net investment income (0.37) (0.47) (0.34) (0.43) (0.39)
----- ----- ----- ----- -----
Net asset value, end of period $7.53 $6.86 $7.07 $5.92 $7.27
===== ===== ===== ===== =====
Total Return 15.71% 4.05% 25.70% (12.92%) 5.11%
RATIOS/SUPPLEMENTAL DATA
Net assets, end of period (000 omitted) 2,255 1,858 1,457 979 1,087
Ratios to average net assets:
Expenses* 2.58% 2.49% 2.50% 2.50% 2.50%
Net investment income* 5.12% 6.85% 5.15% 6.70% 5.40%
Portfolio turnover rate 3.79% 139.26% 43.51% 75.31% 84.89%
BANK LOANS
Amount outstanding at end of period (000 omitted) $ - 228 379 $ - $ -
Average amount of bank loans outstanding during the period
(000 omitted) $ - $ - 61 $ - $ -
Average number of shares outstanding during the period
(000 omitted) 260 237 183 156 145
Average amount of debt per share during the period $ - $ - $0.33 $ - $ -
<FN>
**These ratios are after expense reimbursements of 3.52%, 4.59%, 6.22%, 6.20% and 5.76%, for each of the
years ended December 31, 1997, 1996, 1995, 1994 and 1993, respectively.
</FN>
</TABLE>
45
<PAGE>
FUNDAMENTAL FIXED-INCOME FUND
HIGH-YIELD MUNICIPAL BOND SERIES
INDEPENDENT AUDITOR'S REPORT
- --------------------------------------------------------------------------------
To the Board of Trustees and Shareholders
Fundamental Fixed-Income Fund
High-Yield Municipal Bond Series
We have audited the accompanying statement of assets and liabilities, including
the statement of investments, of Fundamental Fixed-Income Fund High-Yield
Municipal Bond Series as of December 31, 1997, and the related statements of
operations for the year then ended, the statement of changes in net assets for
each of the two years then ended and the selected financial information for each
of the five years in the period then ended. These financial statements and
selected financial information are the responsibility of the Fund's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. Our procedures included
confirmation of securities owned as of December 31, 1997 by correspondence with
the custodian and brokers. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the financial statements and selected financial information
referred to above present fairly, in all material respects, the financial
position of Fundamental Fixed-Income Fund High-Yield Municipal Bond Series as of
December 31, 1997, and the results of its operations, changes in net assets, and
selected financial information for the periods indicated, in conformity with
generally accepted accounting principles.
See Note 2 for information regarding regulatory proceedings and transactions
with affiliates.
New York, New York
March 2, 1998, except for Note 7 as to which the date is March 25, 1998.
46
<PAGE>
FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND
(LEFT COLUMN)
STATEMENT OF ASSETS AND LIABILITIES
December 31, 1997
- --------------------------------------------------------------------------------
ASSETS
Investment in securities, at value
(cost $13,023,839) (Notes 5 and 6) $15,023,792
Receivables:
Interest 67,739
Fund shares sold ................ 4,001
-----------
Total assets ................ 15,095,532
-----------
LIABILITIES
Loans ............................. 225,907
Options written at value
(premiums received $18,801)
(Note 5) ........................ 10,625
Securities sold subject to
repurchase (Note 6) ............. 4,744,054
Payables:
Dividends declared .............. 11,104
Shares redeemed ................. 9,353
Variation margin ................ 41,563
Accrued expenses ................ 22,580
-----------
Total liabilities ........... 5,065,186
-----------
NET ASSETS consisting of:
Accumulated net realized loss ..... $(17,833,560)
Unrealized appreciation of
securities ...................... 1,999,953
Unrealized appreciation of
options written ................. 8,176
Unrealized depreciation of open
future contracts ................ (103,270)
Paid-in-capital applicable to
7,116,688 shares of beneficial
interest ........................ 25,959,047
-----------
$10,030,346
===========
NET ASSET VALUE PER SHARE $1.41
=====
(RIGHT COLUMN)
STATEMENT OF OPERATIONS
Year Ended December 31, 1997
- --------------------------------------------------------------------------------
INVESTMENT INCOME
Interest income, net of $315,574
of interest expense ...................... $1,812,306
EXPENSES (Notes 2, 3 and 6)
Investment advisory fees ................. $ 88,681
Custodian and accounting fees ............ 61,165
Transfer agent fees ...................... 71,081
Professional fees ........................ 563,154
Trustees' fees ........................... 5,458
Printing and postage ..................... 9,502
Interest on bank borrowing ............... 324,872
Distribution expenses .................... 29,560
Other .................................... 14,012
---------
Total expense ...................... 1,167,485
Less: Expenses waived or
reimbursed by the
manager and affiliates ........... (162,637)
---------
Net expenses ....................... 1,004,848
----------
Net investment income .............. 807,458
----------
REALIZED AND UNREALIZED GAIN
(LOSS) ON INVESTMENTS
Net realized gain (loss) on:
Investments ............................ 1,027,730
Future and options on futures .......... (956,715) 71,015
---------
Change in unrealized appreciation
(depreciation) of investments,
options and futures contracts
for the period:
Investments .......................... 66,558
Open option contracts
written ............................ (312)
Open futures contracts ............... (339,726) (273,480)
--------- ----------
Net loss on investments .................. (202,465)
----------
NET INCREASE IN NET ASSETS
FROM OPERATIONS .......................... $ 604,993
=========
<PAGE>
(FULL COLUMN)
<TABLE>
<CAPTION>
STATEMENTS OF CHANGES IN NET ASSETS
- ----------------------------------------------------------------------------------------------------------
Year Ended Year Ended
December December
31, 1997 31, 1996
-------- --------
INCREASE (DECREASE) IN NET ASSETS FROM:
OPERATIONS
<S> <C> <C>
Net investment income ...................................................... $ 807,458 $ 1,254,448
Net realized gain on investments ........................................... 71,015 433,173
Unrealized (depreciation) on investments, options and futures contracts .... (273,480) (1,070,217)
----------- -----------
Net increase in net assets from operations ........................ 604,993 617,404
DIVIDENDS PAID TO SHAREHOLDERS FROM
Investment income .......................................................... (807,458) (1,254,448)
CAPITAL SHARE TRANSACTIONS (Note 4) .......................................... (2,991,556) (1,332,818)
----------- -----------
Total decrease .................................................... (3,194,021) (1,969,862)
NET ASSETS
Beginning of year .......................................................... 13,224,367 15,194,229
----------- -----------
End of year ................................................................ $10,030,346 $13,224,367
=========== ===========
</TABLE>
See Notes to Financial Statements.
49
<PAGE>
FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND
STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
Year Ended December 31, 1997
- ---------------------------------------------------------------------------------------------
INCREASE (DECREASE) IN CASH
CASH FLOWS FROM OPERATING ACTIVITIES
<S> <C>
Net increase in net assets from operations ................................ $ 604,993
Adjustments to reconcile net increase in net assets from operations to
net cash provided by operating activities:
Purchase of investment securities ......................................... (2,228,044)
Proceeds on sale of securities ............................................ 8,312,593
Premiums received for options written ..................................... 633,904
Premiums paid to close options written .................................... (977,704)
Decrease in interest receivable ........................................... 28,925
Decrease in variation margin receivable ................................... 218,791
Decrease in accrued expenses .............................................. (93,909)
Net accretion of discount on securities ................................... (187,473)
Net realized (gain) loss:
Investments ............................................................. (1,027,730)
Options written ......................................................... 309,113
Unrealized appreciation on securities and options written for the period .. (66,246)
----------
Total adjustments ....................................................... 4,922,220
----------
Net cash provided by operating activities ............................... 5,527,213
----------
CASH FLOWS FROM FINANCING ACTIVITIES:*
Net repayments on sale of securities sold subject to repurchase ............. (1,617,934)
Net borrowings of note payable .............................................. (49,281)
Proceeds on shares sold ..................................................... 728,056
Payment on shares repurchased .............................................. (4,356,318)
Cash dividends paid ......................................................... (231,736)
----------
Net cash used in financing activities ................................... (5,527,213)
----------
Net increase in cash .................................................... 0
CASH AT BEGINNING OF YEAR .................................................. 0
----------
CASH AT END OF YEAR ......................................................... $ 0
==========
</TABLE>
*Non-cash financing activities not included herein consist of reinvestment of
dividends of $642,058. Cash payments for interest expense totaled $333,352 for
the period.
STATEMENT OF OPTIONS WRITTEN
<TABLE>
<CAPTION>
December 31, 1997
- ---------------------------------------------------------------------------------------------
Number of Expiration
Contracts++ Options Written Month Value
----------- --------------- ---------- -----
<C> <S> <C> <C>
40 U.S. Treasury Bonds, Call @ $123 ........... February 1998 $10,625
-------
$10,625
=======
</TABLE>
++Each contract represents $100,000 face value of U.S. Treasury Bond Futures.
See Notes to Financial Statements.
50
<PAGE>
FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND
STATEMENT OF INVESTMENTS
December 31, 1997
- --------------------------------------------------------------------------------
Principal Interest Maturity
Amount Rate o Date Value
------ ------ ---- -----
United States Treasury Securities-49.03%
United States Treasury Bonds
85,000(2) 0.00% ZCS 11/15/03 $ 60,395
4,300,000(2) 0.00% PS 11/15/06 2,574,333
3,500,000(5) 9.00% 11/15/18 4,731,566
----------
(Cost $6,403,170) 7,366,294
----------
United States Agency Backed Securities-50.97%
Federal Home Loan Mortgage Corporation
843,718(1) 9.25% 08/15/23 928,005
285,124(1) 6.50% Z-Bond 12/15/23 261,907
750,000 13.59% IFRN 05/15/24 858,060
209,406(2) 15.30% IFRN 05/25/24 251,287
180,000 12.00% TTIB 03/15/27 180,079
FNMA-Federal National Mortgage Assoc.
356,450(4)(1) 15.50% TTIB 03/25/23 381,224
3,671,204(4)(1) 15.30% TTIB 03/25/23 4,185,686
490,760(4) 14.49% TTIB 05/25/23 544,900
----------
7,591,148
----------
FICO-Financing Corporation (U.S. Government Agency)
100,000 0.00% ZCS 11/02/12 39,284
100,000 0.00% ZCS 08/03/18 27,066
----------
(Cost $6,620,669) 66,350
----------
Total investments (Cost $13,023,839)(3) $15,023,792
----------
(1) Segregated for securities sold subject to repurchase (Note 6)
(2) Segregated, in whole or part, as initial margin for futures contracts
(Note 5)
(3) Cost is the same for Federal income tax purposes
(4) The Fund owns 100% of the security or tranche. See Note 5 to the financial
statements.
(5) Securities sold subject to repurchase (Note 6).
o Legend-IFRN: Inverse Floating Rate Notes are instruments whose interest rates
bear an inverse relationship to the interest rate on another
security or the value of an index. Rates shown are at December
31, 1997.
TTIB: Two-Tiered Index Floating Rate Bonds are instruments with two
coupon levels. The "first tier" coupon is at a fixed rate,
effective as long as the underlying index is at or below the
strike level. At the strike level, the "second tier" coupon
resets the bond to an inverse floating rate note. See discussion
above. Coupons shown are at December 31, 1997.
ZCS: Zero Coupon Securities are instruments whose interest and
principal are paid at maturity.
Z Bond: A Z Bond is an instrument whose monthly interest coupon is paid
at a fixed rate in additional principal. Principal is paid at
maturity.
PS: Principal Stripped Bonds are instruments whose principle and
coupon have been separated and sold separately.
See Notes to Financial Statements.
51
<PAGE>
FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND
NOTES TO FINANCIAL STATEMENTS
December 31, 1997
- --------------------------------------------------------------------------------
1. Significant Accounting Policies
Fundamental Fixed-Income Fund (the Fund) is an open-end management
investment company registered under the Investment Company Act of 1940. The Fund
operates as a series company currently issuing three classes of shares of
beneficial interest, the Tax-Free Money Market Series, the High-Yield Municipal
Bond Series and the Fundamental U.S. Government Strategic Income Fund Series
(the Series). The objective of the Series is to provide high current income with
minimum risk of principal and relative stability of net asset value. The Series
seeks to achieve its objective by investing primarily in U.S. Government
Obligations. U.S. Government Obligations consist of marketable securities issued
or guaranteed by the U.S. Government, its agencies or instrumentalities
(hereunder collectively referred to as "Government Securities"). The Series also
uses leverage in seeking to achieve its investment objective. Each series is
considered a separate entity for financial reporting and tax purposes.
Valuation of Securities-The Series portfolio securities are valued on
the basis of prices provided by an independent pricing service when, in the
opinion of persons designated by the Fund's trustees, such prices are believed
to reflect the fair market value of such securities. Prices of non-exchange
traded portfolio securities provided by independent pricing services are
generally determined without regard to bid or last sale prices but take into
account institutional size trading in similar groups of securities, yield,
quality, coupon rate, maturity, type of issue, trading characteristics and other
market data. Securities traded or dealt in upon a securities exchange and not
subject to restrictions against resale as well as options and futures contracts
listed for trading on a securities exchange or board of trade are valued at the
last quoted sales price, or, in the absence of a sale, at the mean of the last
bid and asked prices. Options not listed for trading on a securities exchange or
board of trade for which over-the-counter market quotations are readily
available are valued at the mean of the the current bid and asked prices. Money
market and short-term debt instruments with a remaining maturity of 60 days or
less will be valued on an amortized cost basis. Securities not priced in a
manner described above and other assets are valued by persons designated by the
Fund's trustees using methods which the trustees believe reflect fair value.
Futures Contracts-Initial margin deposits with respect to these
contracts are maintained by the Fund's custodian in segregated asset accounts.
Subsequent changes in the daily valuation of open contracts are recognized as
unrealized gains or losses. Variation margin payments are made or received as
daily appreciation or depreciation in the value of these contracts occurs.
Realized gains or losses are recorded when a contract is closed.
Repurchase Agreements-The Series may invest in repurchase agreements, which
are agreements pursuant to which securities are acquired from a third party with
the commitment that they will be repurchased by the seller at a fixed price on
an agreed upon date. The Series may enter into repurchase agreements with banks
or lenders meeting the creditworthiness standards established by the Board of
Trustees. The resale price reflects the purchase price plus an agreed upon
market rate of interest which is unrelated to the coupon rate or date of
maturity of the purchased security. The Series' repurchase agreements will at
all times be fully collateralized in an amount equal to the purchase price
including accrued interest earned on the underlying security.
52
<PAGE>
FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
Reverse Repurchase Agreements-The Series may enter into reverse
repurchase agreements with the same parties with whom it may enter into
repurchase agreements. Under a reverse repurchase agreement, the Series sells
securities and agrees to repurchase them at a mutually agreed upon date and
price. Under the Investment Company Act of 1940 reverse repurchase agreements
are generally regarded as a form of borrowing. At the time the Series enters
into a reverse repurchase agreement it will establish and maintain a segregated
account with its custodian containing securities from its portfolio having a
value not less than the repurchase price including accrued interest.
Federal Income Taxes-It is the Series' policy to comply with the
requirements of the Internal Revenue Code applicable to "regulated investment
companies" and to distribute all of its taxable and tax exempt income to its
shareholders. Therefore, no provision for federal income tax is required.
Distributions-The Series declares dividends daily from its net
investment income and pays such dividends on the last business day of each
month. Distributions of net capital gain, if any, realized on sales of
investments are anticipated to be made before the close of the Series' fiscal
year, as declared by the Board of Trustees. Dividends are reinvested at the net
asset value unless shareholders request payment in cash.
General-Securities transactions are accounted for on a trade date basis.
Interest income is accrued as earned. Realized gain and loss from the sale of
securities are recorded on an identified cost basis. Discounts and premiums are
amortized over the life of the respective securities. Premiums are charged
against interest income and discounts are accreted to interest income.
Accounting Estimates-The preparation of financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of increases and decreases in
net assets from operations during the reporting period. Actual results could
differ from those estimates.
2. Investment Advisory Fees and Other Transactions With Affiliates
Management Agreement
The Series has a Management Agreement with Fundamental Portfolio Advisors,
Inc. (the Manager). Pursuant to the agreement the Manager serves as investment
adviser to the Series and is responsible for the overall management of the
business affairs and assets of the Series subject to the authority of the Fund's
Board of Trustees. In consideration for the services provided by the Manager,
the Series will pay an annual management fee in an amount equal to .75% of the
Series' average daily net assets up to $500 million, .725% on the next $500
million, and .70% per annum on assets over $1 billion. The Manager waived fees
and reimbursed expenses of $133,077 for the year ended December 31, 1997. See
Note 8.
SEC Administrative Proceeding Against the Manager
On September 30, 1997, the Securities & Exchange Commission announced that
it instituted public administrative and cease-and desist proceedings against the
Manager, the former portfolio manager of the Fund, the president of the Manager
and Fundamental Service Corporation (FSC). The proceeding arises from the
53
<PAGE>
FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
alleged failure of the Fund to disclose the risks of the Fund, and of the
Manager's failure to disclose its soft dollar arrangements to the Fund's Board
of Trustees. A hearing has been scheduled with an administrative law judge to
determine whether the allegations are true, and, if so, what remedial action, if
any, is appropriate.
Board's Termination of Portfolio Manager
Between April 17, 1997 and July 24, 1997, a representative of the Manager
engaged Tocqueville Securities L.P. ("Tocqueville Securities") an affiliate of
Tocqueville, as agent, to effect eight separate over-the-counter purchase
transactions of municipal obligations on behalf of an affiliated fund. The
Fund's Board has concluded that the commissions paid to Tocqueville Securities
in connection with these transactions (a portion of which was paid to the
representative) were not justified and that the affiliated fund bore unnecessary
expenses as a result of the sale of its securities to another party and the
subsequent repurchase of them through Tocqueville Securities. Based upon a
report initiated by Tocqueville Securities and prepared by the Fund's
independent auditors, and upon the Board's own analysis, the Board directed that
the Manager terminate its representative's services as a portfolio manager. At
the Board's request and in order to reimburse the affiliated fund for all of its
losses, Tocqueville Securities, on September 15, 1997, voluntarily paid $260,000
to the affiliated fund, an amount which significantly exceeds the total
commissions ($184,920.60) received by Tocqueville Securities in connection with
these transactions. The staff of the Securities and Exchange Commission and the
Department of NASD Regulation have been informed of these events by Tocqueville
Securities. See note 7 regarding contemplated transaction with the Tocqueville
Trust.
Plan of Distribution
The Series has adopted a Distribution and Marketing Plan, pursuant to Rule
12b-1, promulgated under the Investment Company Act of 1940, under which the
Series pays to FSC, an affiliate of the Manager, a fee which is accrued daily
and paid monthly at an annual rate of 0.25% of the Series' average daily net
assets. Amounts paid under the plan are to compensate FSC for the services it
provides and the expenses it bears in distributing the Series' shares to
investors. The amount incurred by the Series pursuant to the agreement for the
year ended December 31, 1997 is set forth in the Statement of Operations. FSC
has waived fees in the amount of $29,560.
NASD Sanctions and Fines
On February 19, 1998, FSC and two of its executives, without admitting or
denying guilt, entered into an agreement with the National Association of
Securities Dealers, Inc. ("NASD") whereby they accepted fines totaling $125,000
and other stipulated sanctions as a result of the NASD's finding that they had
distributed advertising materials relating to the Fund which violated NASD rules
governing advertisements.
Affiliated Transfer Agent
The Series compensated Fundamental Shareholders Services, Inc. (FSSI), an
affiliate of the Manager, for services it provided under a Transfer Agent and
Service Agreement which was terminated on September 11, 1997. The amount paid by
the Series to FSSI for the year ended December 31, 1997 amounted to $57,038.
Commissions Paid to Affiliate
The Series effects a significant portion of its futures and options
transactions through LAS Investments, Inc. (LAS), an affiliated broker-dealer.
Commissions paid to LAS amounted to approximately $14,591 for the year ended
December 31, 1997.
54
<PAGE>
FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
3. Trustees' Fees
All of the Trustees of the Fund are also directors or trustees of two other
affiliated mutual funds for which the Manager acts as investment adviser. For
services and attendance at Board meetings and meetings of committees which are
common to each fund, each Trustee who is not affiliated with the Manager is
compensated at the rate of $6,500 per quarter pro rated among the funds based on
their respective average net assets. The Trustees also received additional
compensation for special services as requested by the Board. Additional
compensation totaled $40,923 pro rated among the funds based on their respective
average net assets.
4. Shares of Beneficial Interest
As of December 31, 1997 there were an unlimited number of shares of
beneficial interest (no par value) authorized and capital paid-in amounted to
$25,959,047. Transactions in shares of beneficial interest were as follows:
<TABLE>
<CAPTION>
Year Ended Year Ended
December 31, 1997 December 31, 1996
----------------------- --------------------------
Shares Amount Shares Amount
--------- ---------- --------- -----------
<S> <C> <C> <C> <C>
Shares sold ................................... 521,491 $ 732,057 1,209,491 $1,721,466
Shares issued on reinvestment of dividends .... 457,380 642,058 605,897 860,888
Shares redeemed ............................... (3,119,211) (4,365,671) (2,749,791) (3,915,172)
---------- ----------- --------- -----------
Net decrease .................................. (2,140,340) ($2,991,556) (934,403) ($1,332,818)
========== =========== ========= ===========
</TABLE>
5. Complex Services, Off Balance Sheet Risks and Investment Transactions
Two-Tiered Index Floating Rate Bonds (TTIB):
The Fund invests in Two-Tiered Index Floating Rate Bonds. The term
two-tiered refers to the two coupon levels that the TTIB's coupon can reset to.
The "first tier" is the TTIB's fixed rate coupon, effective as long as the
underlying index is at or below the strike level. Above the strike, the TTIB
coupon resets to a formula similar to an inverse floating rate note. See
discussion of inverse floating rate notes below. Changes in interest rate on the
underlying security or index affect the rate paid on the TTIB, and the TTIB's
price will be more volatile than that of a fixed-rate bond.
Additionally the Fund owns 100% of several securities as indicated in the
Statement of Investments. As a result of its ownership position there is no
active market in these securities. Valuations of these securities are provided
by a pricing service and are believed by the Manager to reflect fair value. The
market value of securities owned 100% by the Fund was approximately $5,111,810
(or 50.96% of net assets) as of December 31, 1997.
Inverse Floating Rate Notes (IFRN):
The Fund invests in variable rate securities commonly called "inverse
floaters". The interest rates on these securities have an inverse relationship
to the interest rate of other securities or the value of an index. Changes in
interest rate on the other security or index inversely affect the rate paid on
the inverse floater, and the inverse floater's price will be more volatile than
that of a fixed-rate bond. Certain interest rate movements and other market
factors can substantially affect the liquidity of IFRN's.
55
<PAGE>
FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
Futures Contracts and Options on Futures Contracts:
The Fund invests in futures contracts consisting primarily of US Treasury
Bond Futures. A futures contract is an agreement between two parties to buy and
sell a security for a set price on a future date. Futures contracts are traded
on designated "contract markets" which through their clearing corporations,
guarantee performance of the contracts. In addition the fund invests in options
on US Treasury Bond Futures which gives the holder a right to buy or sell
futures contracts in the future. Unlike a futures contract which requires the
parties to the contract to buy and sell a security on a set date, an option on a
futures contract entitles its holder to decide before a future date whether to
enter into such a futures contract. Both types of contracts are marked to market
daily and changes in valuation will affect the net asset value of the Fund.
The Fund's principal objective in holding or issuing derivative financial
instruments is as a hedge against interest-rate fluctuations in its municipal
bond portfolio, and to enhance its total return. The Fund's principal objective
is to maximize the level of interest income while maintaining acceptable levels
of interest-rate and liquidity risk. To achieve this objective, the Fund uses a
combination of derivative financial instruments principally consisting of US
Treasury Bond Futures and Options on US Treasury Bond Futures. Typically the
Fund sells treasury bond futures contracts or writes treasury bond option
contracts. These activities create off balance sheet risk since the Fund may be
unable to enter into an offsetting position and under the terms of the contract
deliver the security at a specified time at a specified price. The cost to the
Fund of acquiring the security to deliver may be in excess of recorded amounts
and result in a loss to the Fund. For the year ended December 31, 1997, the Fund
had daily average notional amounts outstanding of approximately $15,136,000 and
$5,737,561 of short positions on US Treasury Bond Futures and Options Written on
US Treasury Bond Futures respectively. Realized gains and losses from these
transactions are stated separately in the Statement of Operations.
The Fund had the following open futures contracts at December 31, 1997.
Principal Expiration Unrealized
Type Amount Position Month Loss
---- ------ -------- ----- ----
U.S. Treasury Bond ............. $7,000,000 Short 3/98 ($103,270)
Portfolio securities with an aggregate value of approximately $1,389,306
have been segregated as initial margin as of December 31, 1997.
In addition, the following table summarizes option contracts written by the
Series for the year ended December 31, 1997:
Number of Premiums Realized
Contracts Received Cost Loss
--------- -------- ---- ----
Contracts outstanding
December 31, 1996 .............. 40 $53,488
Options written .................. 780 633,904
Contracts closed or expired ...... (780) (668,591) $977,704 ($309,113)
--- -------
Contracts outstanding
December 31, 1997 .............. 40 $ 18,801
=== ========
56
<PAGE>
FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
Other Investment Transactions
For the year ended December 31, 1997, the cost of purchases and proceeds
from sales of investment securities, other than short-term obligations, were
$2,228,044 and $7,702,650, respectively.
As of December 31, 1997, the Fund had no unrealized appreciation or
depreciation for tax purposes since it has elected to recognize market value
changes each day for tax purposes.
The Fund has capital loss carryforwards to offset future capital gains as
follows:
Amount Expiration
------ ----------
$15,000,500 12/31/2002
588,100 12/31/2004
202,500 12/31/2005
-----------
$15,791,100
===========
6. Borrowing
The Fund has a line of credit agreement with its custodian bank
collateralized by cash and portfolio securities to the extent of the amounts
borrowed. Borrowings under this agreement bear interest linked to the bank's
prime rate.
The Series enters into reverse repurchase agreements collateralized by
portfolio securities equal in value to the repurchase price. The reverse
repurchase agreement outstanding at December 31, 1997 bears an interest rate of
5.9%. Portfolio securities with an aggregate value of approximately $5,757,000
have been segregated for securities sold subject to repurchase as of December
31, 1997.
The maximum month-end and the average amount of borrowing outstanding under
these arrangements during the year ended December 31, 1997 were approximately
$6,329,000 and $5,967,000.
7. Agreement and Plan of Reorganization
On July 16, 1997 each of Fundamental's mutual funds (consisting of: New York
Muni Fund, The California Muni Fund, Fundamental Fixed Income Fund: Tax Free
Money Market Series, High Yield Municipal Bond Series, and Fundamental U.S.
Government Strategic Income Fund Series) have adopted, subject to shareholder
approval, an Agreement and Plan of Reorganization (the "Plan") under which each
fund (the "Fundamental Fund") will transfer all of its assets and liabilities to
a newly-created corresponding series of The Tocqueville Trust (the "Tocqueville
Fund") in exchange for shares of the Tocqueville Fund. Shareholders of each
Fundamental Fund will receive shares of the corresponding Tocqueville Fund equal
in value to their shares in the Fundamental Fund. Shareholders will not have to
pay a sales load upon receiving shares of the Tocqueville Fund.
The corresponding Tocqueville Fund will have investment objectives, polices
and restrictions substantially identical to those of the Fundamental Fund. The
Board of Trustees of the Tocqueville Funds is comprised of
57
<PAGE>
FUNDAMENTAL U.S. GOVERNMENT STRATEGIC INCOME FUND
NOTES TO FINANCIAL STATEMENTS (continued)
December 31, 1997
- --------------------------------------------------------------------------------
individuals other than those who currently serve as Directors (Trustees) of the
Fundamental Funds. Tocqueville Asset Management L.P. is the investment adviser
to the Tocqueville Funds.
A majority of Fundamental's Board members determined that the Plan would be
in the best interests of shareholders of the Fundamental Funds and recommended
that shareholders of each of the Fundamental Funds approve the Plan at a meeting
anticipated to be held in the Spring of 1998.
8. Subsequent Event
At its March 25, 1998 Board of Trustees' meeting, the Board of the Fund
approved the continuation of the Management Agreement and Distribution Agreement
through May 30, 1998 in contemplation of the consummation of the reorganization
discussed in Note 7.
The Manager and FSC (on behalf of certain of their directors, officers,
shareholders, employees and control persons) (the "Indemnitees") received
payment during the fiscal year ended December 31, 1997 from the Fund in the
amount of approximately $232,500. Upon learning of the payments, the independent
Board Members of the Funds directed that the Indemnitees return all of the
payments to the Funds or place them in escrow pending their receipt of an
opinion of an inedpendent legal counsel to the effect that the Indemnitees are
entitled to receive them. The Declaration of Trust, Articles of Incorporation
and contracts that call for indemnification specify that no indemnification
shall be provided to a person who shall be found to have engaged in "disabling
conduct" as defined by applicable law. The Indemnities have undertaken to
reimburse the Fund for any indemnification expenses for which it is determined
that they were not entitled to as a result of "disabling conduct" net of any
reimbursements already made to the Fund in the form of fees forgone or other
similar payments.
The Manager and FSC waived fees in the amount of $96,077 and $29,560,
respectively for the year ended December 31, 1997. The Manager and FSC have
asserted that they elected to forgo these fees because the Fund was paying legal
expenses pursuant to indemnification. The Fund has retained independent legal
counsel to determine whether the Indemnitees engaged in disabling conduct.
Pending clarification of the legal issues involved, the Indemnitees have placed
into an escrow account $102,863 as of April 30, 1998. The independent trustees
have instructed the Manager to escrow the full amount incurred by the Fund of
approximately $232,500.
58
<PAGE>
9. Selected Financial Information
<TABLE>
<CAPTION>
Year Year Year Year Year
Ended Ended Ended Ended Ended
December 31, December 31, December 31, December 31, December 31,
1997 1996 1995 1994 1993
---- ---- ---- ---- ----
Per share operating performance
(for a share outstanding throughout the period)
<S> <C> <C> <C> <C> <C>
Net asset value, beginning of period .............. $ 1.43 $ 1.49 $ 1.37 $ 2.01 $ 2.02
------ ------ ------ ------ ------
Income from investment operations
Net investment income ............................. 0.10 0.13 0.08 0.14 0.16
Net realized and unrealized gain/(loss) on
investments ..................................... (0.02) (0.06) 0.12 (0.64) -
------ ------ ------ ------ ------
Total from investment operations ............ 0.08 0.07 0.20 (0.50) 0.16
------ ------ ------ ------ ------
Less distributions
Dividends from net investment income .............. (0.10) (0.13) (0.08) (0.14) (0.16)
Dividends from net realized gains ................. - - - - (0.01)
------ ------ ------ ------ ------
Net asset value, end of period .................... $ 1.41 $ 1.43 $ 1.49 $ 1.37 $ 2.01
====== ====== ====== ====== ======
Total return ...................................... 5.51% 5.02% 15.43% (25.57%) 8.14%
Ratios/supplemental data:
Net assets, end of period (000 omitted) ........... $10,030 13,224 15,194 19,020 63,182
Ratios to average net assets
Interest expense (a) ............................ 2.75% 2.61% 3.00% 2.01% 1.54%
Operating expenses .............................. 5.75% 3.41% 3.05% 2.16% 1.39%
------ ------ ------ ------ ------
Total expenses+ (a) ......................... 8.50% 6.02% 6.05% 4.17% 2.93%
====== ====== ====== ====== ======
Net investment income+ .......................... 6.83% 9.01% 5.91% 8.94% 7.85%
Portfolio turnover rate ........................... 12.55% 12.65% 114.36% 60.66% 90.59%
Borrowings
Amount outstanding at end of period
(000 omitted) ................................... $4,969 $6,610 $ 7,481 $ 9,674 $31,072
Average amount of debt outstanding during the
period (000 omitted) ............................ $5,967 $6,577 $ 7,790 $16,592 $28,756
Average number of shares outstanding during the
period (000 omitted) ............................ 8,433 9,764 11,571 21,436 28,922
Average amount of debt per share during the
period .......................................... $ .71 $ .67 $ .67 $ .77 $ .99
<FN>
+These ratios are after expense reimbursement of 1.37%, 2.02%, 1.0% and .13% for the years ended December 31,
1997, 1996, 1995 and 1993, respectively.
(a)The ratios for each of the years in the four year period ending December 31, 1996 have been reclassified to
conform with the 1997 presentations.
</FN>
</TABLE>
59
<PAGE>
INDEPENDENT AUDITOR'S REPORT
The Board of Trustees and Shareholders
Fundamental Fixed-Income Fund
Fundamental U.S. Government Strategic Income Fund Series
We have audited the accompanying statement of assets and liabilities
including the statement of investments and statement of options written, of the
Fundamental U.S. Government Strategic Income Fund Series of Fundamental
Fixed-lncome Fund as of December 31, 1997 and the related statements of
operations and cash flows for the year then ended, and the statement of changes
in net assets for the two years then ended and selected financial information
for each of the five years in the period then ended. These financial statements
and selected financial information are the responsibility of the Fund's
management. Our responsibility is to express an opinion on these financial
statements and selected financial information based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements and selected
financial information are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. Our procedures included confirmation of securities
owned as of December 31, 1997 by correspondence with the custodian and brokers.
An audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements and selected financial information
referred to above present fairly, in all material respects, the financial
position of the Fundamental U.S. Government Strategic Income Fund Series of
Fundamental Fixed-lncome Fund as of December 31, 1997, the results of its
operations, changes in its net assets, cash flows, and selected financial
information for the periods indicated, in conformity with generally accepted
accounting principles.
See Notes 2 and 8 for information regarding regulatory proceedings and
transactions with affiliates.
S I G N A T U R E
New York, New York
March 2, 1998, except for Note 8 as to which the date is April 30, 1998.
60
<PAGE>
(LEFT COLUMN)
FUNDAMENTAL
FAMILY OF FUNDS
90 Washington Street
New York NY 10006
1-800-322-6864
Independent Auditors
McGladrey & Pullen, LLP
555 Fifth Avenue
New York, New York 10017
Legal Counsel
Kramer, Levin, Naftalis & Frankel
919 Third Avenue
New York, New York 10022
These reports and the financial statements contained
herein are submitted for the general information of
the shareholders of the Fund. These reports are not
authorized for distribution to prospective investors
in the Funds unless preceded or accompanied by an
effective prospectus.
(RIGHT COLUMN)
---------------------------
Annual Report
December 31, 1997
NEW YORK MUNI FUND
THE CALIFORNIA MUNI FUND
FUNDAMENTAL
FIXED-INCOME FUND
TAX-FREE
MONEY MARKET SERIES
HIGH-YIELD
MUNICIPAL MARKET SERIES
FUNDAMENTAL
U.S. GOVERNMENT
STRATEGIC INCOME FUND
F U N D A M E N T A L
Fundamental Family of Funds
---------------------------
<PAGE>
APPENDIX
RATINGS OF MUNICIPAL BONDS
MOODY'S INVESTORS SERVICE, INC.
A brief description of the applicable Moody's Investors
Services, Inc. rating symbols and their meanings is as follows:
Aaa-Bonds which are 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." Interest payments are protected by a large or by an
exceptionally stable margin and principal is secure. While the various
protective elements are likely to change, such changes as can be visualized are
most unlikely to impair the fundamentally strong position of such issues.
Aa-Bonds which are 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. They are rated lower than the best bonds because
margins of protection may not be as large as in the Aaa securities or
fluctuation of protective elements may be of a greater amplitude or there may be
other elements present which make the long-term risk appear somewhat larger than
Aaa securities.
A-Bonds which are rated A possess many favorable investment
attributes and are to be considered as upper-medium grade obligations. Factors
giving security to principal and interest are considered adequate but elements
may be present which suggest a susceptibility to impairment sometime in the
future.
Baa-Bonds which are 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 characteristically unreliable over any great
length of time. Such bonds lack outstanding investment characteristics and in
fact have speculative characteristics as well.
Ba-Bonds which are rated Ba are judged to have speculative
elements; their future 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 characterizes bonds in this class.
B-Bonds which are rated B generally lack characteristics of
the 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.
A-1
<PAGE>
Caa-Bonds which are 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 which are rated Ca represent obligations which are
speculative in a high degree. Such issues are often in default or have other
marked shortcomings.
C-Bonds which are rated C are the lowest rated class of bonds,
and issues so rated can be regarded as having extremely poor prospects of ever
attaining any real investment standing.
Moody's applies numerical modifiers 1, 2 and 3 to show
relative standing within the major rating categories, except in the Aaa
category. The modifier 1 indicates a ranking for the security in the higher end
of a rating category; the modifier 2 indicates a mid-range ranking; and the
modifier 3 indicates a ranking in the lower end of a rating category.
I. Con. (---)--Bonds for which the security depends upon the completion of some
act or the fulfillment of some condition are rated conditionally. These are
bonds secured by 1. earnings of projects under construction, 2. earnings of
projects unseasoned in operation experience, 3. rentals which begin when
facilities are completed, or 4. payments to which some other limiting condition
attaches. Parenthetical rating denotes probable credit stature upon completion
of construction or elimination of condition.
STANDARD & POOR'S CORPORATION
A brief description of the applicable S&P Corporation rating
symbols and their meanings is as follows:
AAA-This is the highest rating assigned by S&P 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 repay principal and interest is very strong, and in the
majority of instances they differ from AAA issues in only small degrees.
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
A-2
<PAGE>
capacity to pay principal and interest for bonds in this category than for bonds
in the A category.
BB, B, CCC, CC-Bonds rated BB, B, CCC and CC are regarded, on
balance, as predominantly speculative with respect to capacity to pay interest
and repay principal in accordance with the terms of the obligation. 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.
C-The rating C is reserved for income bonds on which no
interest is being paid.
D-Bonds rated D are in default, and payment of interest and/or
repayment of principal is in arrears.
Plus (+) or minus (-): The ratings from AA to BBB may be
modified by the addition of a plus or minus sign to show relative standing
within the major ratings categories.
Provisional Ratings: the letter "p" indicates that the rating
is provisional. A provisional rating assumes the successful completion of the
project being financed by the issuance of the bonds being rated and indicates
that payment of debt service requirements is largely or entirely dependent upon
the successful and timely completion of the project. This rating, however, while
addressing credit quality subsequent to completion of the project, makes no
comment on the likelihood of, or the risk of default upon failure of, such
completion. Accordingly, the investor should exercise his own judgment with
respect to such likelihood and risk.
FITCH
Ratings
A brief description of the applicable Fitch Investors Service,
Inc. rating symbols and their meanings is as follows:
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 the very high credit quality. The obligor's ability to pay
A-3
<PAGE>
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 rated 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, however, are more likely to have an 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
Bonds rated BB are considered speculative. The obligor's
ability to pay interest and repay principal may be affected over time by adverse
economic changes. However, business and financial alternatives can be identified
which could assist the obligor in satisfying its debt service requirements.
B
Bonds rated B are considered highly speculative. While bonds
in this class are currently meeting debt service requirements, the probability
of continued timely payment of principal and interest reflects the obligor's
limited margin of safety and the need for reasonable business and economic
activity throughout the life of the issue.
CCC
Bonds rated CCC have certain identifiable characteristics,
which, if not remedied, may lead to default. The ability to meet obligations
requires an advantageous business and economic environment.
A-4
<PAGE>
CC
Bonds rated CC are minimally protected. Default in payment of
interest and/or principal seems probable over time.
C
Bonds rated C are in imminent default in payment of interest
or principal.
DDD, DD AND D
Bonds rated DDD, DD and D are in actual or imminent default of
interest and/or principal payments. Such bonds are extremely speculative and
should be valued on the basis of their ultimate recovery value in liquidation or
reorganization of the obligor. DDD represents the highest potential for recovery
on these bonds and D represents the lowest potential for recovery.
Plus (+) and minus (-) signs are used with a rating symbol to
indicate the relative position of a credit within the rating category. Plus and
minus signs, however, are not used in the AAA Category covering 12-36 months or
the DDD, DD or D categories.
DUFF & PHELPS, INC.
RATING DEFINITION
SCALE
AAA Highest credit quality. The risk factors are negligible, being
only slightly more than for risk-free U.S.
Treasury debt.
AA+ High credit quality. Protection factors are strong.
AA- Risk is AA modest but may vary slightly from time to time
AA- because of economic conditions.
A+ Protection factors are average but adequate. However,
A risk factors are more variable and greater in periods of
A- economic stress.
BBB+ Below average protection factors but still considered BBB sufficient for
prudent investment. Considerable BBB- variability in risk during economic
cycles.
BB+ Below investment grade but deemed likely to meet
BB obligations when due. Present or prospective financial
BB- protection factors fluctuate according to industry
conditions or company fortunes. Overall quality may
move up or down frequently within this category.
A-5
<PAGE>
B+ Below investment grade and possessing risk that obliga-
B tions will not be met when due. Financial protection
B- factors will fluctuate widely according to economic
cycles, industry conditions and/or company fortunes.
Potential exists for frequent changes in the rating
within this category or into a higher or lower rating
grade.
CCC Well below investment grade securities. Considerable
uncertainty exists as to timely payment of principal, interest
or preferred dividends. Protection factors are narrow and risk
can be substantial with unfavorable economic/industry
conditions, and/or with unfavorable company developments.
DD Defaulted debt obligations. Issuer failed to meet scheduled
principal and/or interest payments.
DP Preferred stock with dividend arrearages.
RATING DEFINITION
SCALE
HIGH GRADE
Duff 1+ Highest certainty of timely payment. Short-term
liquidity, including internal operating factors and/or
access to alternative sources of funds, is outstanding,
and safety is just below risk-free U.S. Treasury
short-term obligations.
Duff 1 Very high certainty of timely payment. Liquidity factors
are excellent and supported by good fundamental
protection factors. Risk factors are minor.
Duff 1- High certainty of timely payment. Liquidity factors are
strong and supported by good fundamental protection factors.
Risk factors are very small.
GOOD GRADE
Duff 2 Good certainty of timely payment. Liquidity factors and
company fundamentals are sound. Although ongoing funding
needs may enlarge total financing requirements, access to
capital markets is good. Risk factors are small.
SATISFACTORY GRADE
Duff 3 Satisfactory liquidity and other protection factors
qualify issues as to investment grade. Risk factors are
larger and subject to more variation. Nevertheless,
timely payment is expected.
A-6
<PAGE>
NON-INVESTMENT GRADE
Duff 4 Speculative investment characteristics. Liquidity is not
sufficient to insure against disruption in debt service.
Operating factors and market access may be subject to a
high degree of variation.
DEFAULT
Issuer failed to meet scheduled principal and/or interest
payments.
RATINGS OF MUNICIPAL NOTES
MOODY'S INVESTORS SERVICE, INC.
A brief description of the applicable Moody's Investors
Service, Inc. rating symbols for municipal notes and their meanings is as
follows:
MIG-1 - This is the highest rating assigned by Moody's to
municipal notes and designates noted judged to be of the best quality.
MIG-2 - This rating designates notes of a high quality by all
standards. However, the margins of protection, although ample, are not as large
as in the preceding group.
MIG-3 - This rating designates notes which are of a favorable
quality, with all security elements accounted for. However, such notes are
lacking the undeniable strength of notes in the preceding two groups. Market
access for refinancing, in particular, is likely to be less well established.
SHORT-TERM RATINGS
FITCH
Fitch's short-term ratings apply to debt obligations that are
payable on demand or have original maturities of up to three years, including
commercial paper, certificates of deposit, medium-term notes, and municipal and
investment notes.
Although the credit analysis is similar to Fitch's bond rating
analysis, the short-term rating places greater emphasis than bond ratings on the
existence of liquidity necessary to meet the issuer's obligations in a timely
manner.
A-7
<PAGE>
F-1+
Exceptionally Strong Credit Quality. Issues assigned
this rating are regarded as having the strongest degree of
assurance for timely payment.
Very Strong Credit Quality. Issues assigned this rating
reflect an assurance of timely payment only slightly less in degree than issues
rated F-1+.
F-1
Very Strong Credit Quality. Issues assigned this rating
reflect an assurance of timely payment only slightly less in degree than issues
rated F-1+.
F-2
Good Credit Quality. Issues carrying this rating have a
satisfactory degree of assurance for timely payments, but the margin of safety
is not as great as the F-1+ and F-1 categories.
SHORT-TERM MUNICIPAL LOANS
Moody's highest rating for short-term municipal loans is
MIG-1/VMIG-1. Moody's states that short-term municipal securities rated
MIG-1/VMIG-1 are of the best quality, enjoying strong protection from
established cash flows of funds for their servicing or from established and
broad-based access to the market for refinancing, or both. Loans bearing the
MIG-2/VMIG-2 designation are of high quality, with margins of protection ample
although not so large as in the MIG-1/VMIG-1 group.
S&P's highest rating for short-term municipal loans is SP-1.
S&P states that short-term municipal securities bearing the SP-1 designation
have very strong or strong capacity to pay principal and interest. Those issues
rated SP-1 which are determined to possess overwhelming safety characteristics
will be given a plus (+) designation. Issues rated SP-2 have satisfactory
capacity to pay principal and interest.
OTHER MUNICIPAL SECURITIES AND COMMERCIAL PAPER
"Prime-1" is the highest rating assigned by Moody's for other
short-term municipal securities and commercial paper, and "A- 1+" and "A-1" are
the two highest ratings for commercial paper assigned by S&P (S&P does not rate
short-term tax-free obligations). Moody's uses the numbers 1, 2 and 3 to denote
relative strength within its highest classification of "Prime", while S&P uses
the number 1+, 1, 2 and 3 to denote relative strength within its highest
classification of "A". Issuers rated "Prime" by Moody's have the following
characteristics: their
A-8
<PAGE>
short-term debt obligations carry the smallest degree of investment risk,
margins of support for current indebtedness are large or stable with cash flow
and asset protection well assured, current liquidity provides ample coverage of
near-term liabilities and unused alternative financing arrangements are
generally available. While protective elements may change over the intermediate
or longer term, such changes are most unlikely to impair the fundamentally
strong position of short-term obligations. Commercial paper issuers rated "A" by
S&P have the following characteristics: liquidity ratios are better than
industry average, long-term debt rating is A or better, the issuer has access to
at least two additional channels of borrowing, and basic earnings and cash flow
are in an upward trend. Typically, the issuer is a strong company in a
well-established industry and has superior management.
A-9
