USAA NATIONAL
TAX-EXEMPT FUNDS
USAA LONG-TERM FUND
USAA INTERMEDIATE-TERM FUND
USAA SHORT-TERM FUND
USAA TAX EXEMPT MONEY MARKET FUND
PROSPECTUS
AUGUST 1, 1998
As with other mutual funds, the Securities and Exchange Commission has not
approved or disapproved of these Funds' shares or determined whether this
prospectus is accurate or complete. Anyone who tells you otherwise is
committing a crime.
TABLE OF CONTENTS
What Are Each Fund's Investment Objectives and Main Strategies?............ 2
Main Risks of Investing in These Funds..................................... 2
Are These Funds for You?................................................... 3
Could the Value of Your Investment in These Funds Fluctuate?............... 4
Fees and Expenses.......................................................... 9
Fund Investments........................................................... 10
Fund Management............................................................ 17
Using Mutual Funds in an Investment Program................................ 19
How to Invest.............................................................. 20
Important Information About Purchases and Redemptions...................... 23
Exchanges.................................................................. 24
Shareholder Information.................................................... 25
Financial Highlights....................................................... 28
Appendix A ................................................................ 32
Appendix B................................................................. 34
Appendix C................................................................. 35
<PAGE>
USAA Investment Management Company manages these Funds. For easier reading,
USAA Investment Management Company will be referred to as "we" or "us"
throughout the Prospectus.
WHAT ARE EACH FUND'S INVESTMENT OBJECTIVES AND MAIN STRATEGIES?
Each Fund has a common objective of providing investors with interest income
that is exempt from federal income tax. The Tax Exempt Money Market Fund has a
further objective of preserving capital and maintaining liquidity. Each Fund
has separate investment policies to achieve its objective.
The LONG-TERM,INTERMEDIATE-TERM, AND SHORT-TERM FUNDS invest primarily in
investment-grade, tax-exempt securities differentiated by maturity limitations.
The average dollar-weighted portfolio maturity for the Long-Term Fund is 10
years or more, the Intermediate-Term Fund is between 3 and 10 years, and the
Short-Term Fund is 3 years or less.
The TAX EXEMPT MONEY MARKET FUND invests in high-quality, tax-exempt securities
with maturities of 397 days or less.
In view of the risks inherent in all investments in securities, there is no
assurance that the Funds' objectives will be achieved. See FUND INVESTMENTS on
page 10 for more information.
MAIN RISKS OF INVESTING IN THESE FUNDS
The two main risks of investing in these Funds are credit risk and market risk.
As with other mutual funds, losing money is an additional risk associated with
investing in these Funds.
o CREDIT RISK involves the possibility that a borrower cannot make timely
interest and principal payments on its securities.
o MARKET RISK involves the possibility that the value of each Fund's
investments will decline due to an increase in interest rates, or to adverse
changes in supply and demand for municipal securities, or other market
factors.
IF INTEREST RATES INCREASE: the yield of each Fund may increase and the market
value of the Long-Term, Intermediate-Term, and Short-Term Funds' securities
will likely decline, adversely affecting the net asset value and total return.
IF INTEREST RATES DECREASE: the yield of each Fund may decrease and the market
value of the Long-Term, Intermediate-Term, and Short-Term Funds' securities may
increase, which would likely increase the Funds' net asset value and total
return. The Tax Exempt Money Market Fund's total return may decrease.
2
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As you consider an investment in any Fund, you should also take into account
your tolerance for the daily fluctuations of the financial markets and whether
you can afford to leave your money in this investment for long periods of time
to ride out down periods.
An investment in any of these Funds is not a deposit of USAA Federal Savings
Bank and is not insured or guaranteed by the Federal Deposit Insurance
Corporation or any other government agency. Although the Tax Exempt Money
Market Fund seeks to preserve the value of your investment at $1 per share, it
is possible to lose money by investing in that Fund.
[CAUTION LIGHT]
Look for this symbol throughout the Prospectus. We use it to mark more detailed
information about the main risks that you will face as a Fund shareholder.
ARE THESE FUNDS FOR YOU?
Any of these Funds might be appropriate as part of your investment portfolio if
. . .
|X| You are looking for current income that is exempt from federal income
taxes.
|X| You are looking for a fixed income investment in bonds to balance your
stock portfolio.
Any of these Funds MAY NOT be appropriate as part of your investment portfolio
if . . .
|X| You are seeking an appropriate investment for an IRA, through a 401(k) plan
or 403(b) plan, or other tax-sheltered account.
|X Your current tax situation does not allow you to benefit from tax-exempt
income.
Long-Term Fund
This Fund might be appropriate as part of your investment portfolio if . . .
|X| You are willing to accept moderate risk.
This Fund MAY NOT be appropriate as part of your investment portfolio if . . .
|X| You are unable or reluctant to invest for a period of four years or more.
|X| You are unwilling to take greater risk for long-term goals.
Intermediate-Term Fund
This Fund might be appropriate as part of your investment portfolio if . . .
|X| You are willing to accept low to moderate risk.
This Fund MAY NOT be appropriate as part of your investment portfolio if . . .
|X| You are unable or reluctant to invest for a period of three years or more.
|X| You are unwilling to take greater risk for intermediate-term goals.
3
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Short-Term Fund
This Fund might be appropriate as part of your investment portfolio if . . .
|X| You are looking for a short-term investment.
|X| You are looking for an investment that is low risk.
|X| You would like checkwriting privileges on the account.
This Fund MAY NOT be appropriate as part of your investment portfolio if . . .
|X| Your primary goal is to maximize long-term growth.
|X| You need a high total return to achieve your goals.
Tax Exempt Money Market Fund
This Fund might be appropriate as part of your investment portfolio if . . .
|X| You need to preserve principal.
|X| You want a low-risk investment.
|X| You need your money back within a short period.
|X| You would like checkwriting privileges on the account.
|X| You are looking for an investment in a money market fund to balance your
stock or long-term bond portfolio.
This Fund MAY NOT be appropriate as part of your investment portfolio if . . .
|X| You need a high total return to achieve your goals.
|X| Your primary goal is long-term growth.
COULD THE VALUE OF YOUR INVESTMENT IN THESE FUNDS FLUCTUATE?
Yes, it could. In fact, the value of your investment in the Long-Term,
Intermediate-Term, or Short-Term Funds likely will increase or decrease. We
manage the Tax Exempt Money Market Fund in accordance with strict Securities
and Exchange Commission (SEC) guidelines designed to preserve the Fund's value
at $1 per share, although, of course, we cannot guarantee that the value will
remain at $1 per share.
The value of the securities in which the Long-Term, Intermediate-Term, and
Short-Term Funds invest typically fluctuates inversely with changes in the
general level of interest rates. Changes in the creditworthiness of issuers and
changes in other market factors such as the relative supply of and demand for
tax-exempt bonds also create value fluctuations. The bar charts shown on the
next page illustrate the Funds' volatility and performance from year to year
for the past ten years.
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TOTAL RETURN
All mutual funds must use the same formulas to calculate total return.
TOTAL RETURN
MEASURES THE
PRICE CHANGE
IN A SHARE
ASSUMING THE
REINVESTMENT
OF ALL DIVIDEND
INCOME AND
CAPITAL GAIN
DISTRIBUTIONS.
Long-Term Fund
[BAR CHART]
CALENDAR TOTAL RETURN
YEAR PERCENTAGE
1988 12.49%
1989 10.62%
1990 6.55%
1991 12.38%
1992 8.62%
1993 12.51%
1994 -7.92%
1995 18.58%
1996 4.47%
1997 10.38%
During the periods shown in the bar chart, the highest total return for a
quarter was 7.77% (quarter ending March 31, 1995) and the lowest total return
for a quarter was -5.55% (quarter ending March 31, 1994).
Intermediate-Term Fund
[BAR CHART]
CALENDAR TOTAL RETURN
YEAR PERCENTAGE
1988 8.69%
1989 9.24%
1990 6.72%
1991 11.14%
1992 8.49%
1993 11.47%
1994 -4.03%
1995 15.07%
1996 4.49%
1997 9.39%
During the periods shown in the bar chart, the highest total return for a
quarter was 5.50% (quarter ending March 31, 1995) and the lowest total return
for a quarter was -4.63% (quarter ending March 31, 1994).
5
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Short-Term Fund
[BAR CHART]
CALENDAR TOTAL RETURN
YEAR PERCENTAGE
1988 6.06%
1989 7.40%
1990 5.87%
1991 7.70%
1992 5.96%
1993 5.52%
1994 .82%
1995 8.11%
1996 4.44%
1997 5.85%
During the periods shown in the bar chart, the highest total return for a
quarter was 3.19% (quarter ending June 30, 1989) and the lowest total return
for a quarter was -1.05% (quarter ending March 31, 1994).
THE TOTAL RETURN FOR THE SIX-MONTH PERIOD ENDED JUNE 30, 1998, WAS 2.93% FOR
THE LONG-TERM FUND, 2.76% FOR THE INTERMEDIATE-TERM FUND, AND 2.20% FOR THE
SHORT-TERM FUND.
Long-, Intermediate-, and Short-Term Funds
The table below shows how each Fund's average annual returns for the one-,
five-, and ten-year periods and the life of the Fund compared to those of a
broad-based securities market index. Remember, historical performance does not
necessarily indicate what will happen in the future.
===============================================================================
Average Annual Total Returns
(for the period ending Past Past Past Life of
December 31, 1997) 1 Year 5 Years 10 Years Fund
- -------------------------------------------------------------------------------
Long-Term Fund 10.38% 7.21% 8.65% 10.36%
- -------------------------------------------------------------------------------
Intermediate-Term Fund 9.39% 7.07% 7.95% 9.20%
- -------------------------------------------------------------------------------
Short-Term Fund 5.85% 4.92% 5.76% 6.37%
- -------------------------------------------------------------------------------
Lehman Bros. Municipal
Bond Index* 9.19% 7.36% 8.58% 10.89%
===============================================================================
* THE LEHMAN BROS. MUNICIPAL BOND INDEX IS AN UNMANAGED BENCHMARK OF TOTAL
RETURN PERFORMANCE FOR THE LONG-TERM, INVESTMENT-GRADE, TAX EXEMPT BOND MARKET.
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Tax Exempt Money Market Fund
[BAR CHART]
CALENDAR TOTAL RETURN
YEAR PERCENTAGE
1988 5.23%
1989 6.30%
1990 6.07%
1991 4.80%
1992 3.12%
1993 2.38%
1994 2.64%
1995 3.70%
1996 3.34%
1997 3.46%
During the periods shown in the bar chart, the highest total return for a
quarter was 1.59% (quarter ending June 30, 1989) and the lowest total return
for a quarter was .54% (quarter ending March 31, 1994).
THE TOTAL RETURN FOR THE SIX-MONTH PERIOD ENDED JUNE 30, 1998, WAS 1.70% FOR
THE TAX EXEMPT MONEY MARKET FUND.
YIELD
YIELD IS
ANNUALIZED NET
INCOME OF THE
FUND DURING A
SPECIFIED PERIOD
AS A PERCENTAGE
OF THE FUND'S
SHARE PRICE.
All mutual funds must use the same formulas to calculate yield and effective
yield.
Long-, Intermediate-, and Short-Term Funds
The Long-, Intermediate-, and Short-Term Funds may advertise performance in
terms of a 30-day yield quotation or a tax equivalent yield. The Funds' 30-day
yields for the period ended December 31, 1997, were as follows:
Long-Term Fund 4.79%
Intermediate-Term Fund 4.59%
Short-Term Fund 4.00%
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EFFECTIVE YIELD
IS CALCULATED
SIMILAR TO
THE YIELD,
HOWEVER, WHEN
ANNUALIZED,
THE INCOME
EARNED IS
ASSUMED TO BE
REINVESTED.
Tax Exempt Money Market Fund
The Tax Exempt Money Market Fund typically advertises performance in terms of a
7-day yield and effective yield or a tax equivalent yield and may advertise
total return. The 7-day yield quotation more closely reflects current earnings
of the Fund than the total return quotation. The effective yield will be
slightly higher than the yield because of the compounding effect of the assumed
reinvestment. Current yields and effective yields fluctuate daily and will vary
with factors such as interest rates and the quality, length of maturities, and
type of investments in the portfolio. The Fund's 7-day yield for the period
ended December 31, 1997, was 3.78%.
You may obtain the most current yield information for any of these Funds by
calling 1-800-531-8777.
TAX EQUIVALENT YIELD
Investors use tax equivalent yields to compare taxable and tax-exempt fixed
income investments using a common yield measure. The tax equivalent yield is
the yield that a fully taxable investment must generate to earn the same
"take-home" yield as a tax-exempt investment. The calculation depends upon your
federal marginal income tax rate and assumes that an investor can fully itemize
deductions on his or her federal tax return. The higher your marginal tax
bracket, the higher will be the tax equivalent yield and the more valuable is
the Fund's tax exemption.
For example, if you assume a federal marginal tax rate of 36%, the Funds' tax
equivalent yields for the period ending December 31, 1997, would be as follows:
===============================================================================
Tax Equivalent
Yield Yield
- -------------------------------------------------------------------------------
Long-Term Fund (30 day) 4.79% 7.48%
Intermediate-Term Fund (30 day) 4.59% 7.17%
Short-Term Fund (30 day) 4.00% 6.25%
Tax Exempt Money Market Fund (7 day) 3.78% 5.91%
===============================================================================
Using the example, to exceed the 30-day yield of the Long-Term Fund on an
after-tax basis, you must find a fully taxable investment that yields more than
7.48%. Likewise, to exceed the 7-day yield of the Tax Exempt Money Market Fund,
you must find a fully taxable investment that yields more than 5.91%.
For more information on calculating tax equivalent yields, see APPENDIX B on
page 34.
8
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[TELEPHONE GRAPHIC]
TouchLINE (R)
1-800-531-8777
PRESS
1
THEN
1
THEN
4 6 #
Please consider performance information in light of the Funds' investment
objectives and policies and market conditions during the reported time periods.
Again, you must remember that historical performance does not necessarily
indicate what will happen in the future. The value of your shares may go up or
down. For the most current price, yield, and return information for these
Funds, you may call TouchLine(R) at 1-800-531-8777. Press 1 for the Mutual Fund
Menu, press 1 again for prices, yields, and returns. Then, press 43# for the
Long-Term Fund, press 44# for the Intermediate-Term Fund, press 45# for the
Short-Term Fund, or press 46# for the Tax Exempt Money Market Fund when asked
for a Fund Code.
NEWSPAPER
SYMBOLS:
TxELT
TxElt
TxESh
TICKER
SYMBOLS:
USTEX
USATX
USSTX
USEXX
You can also find the most current price of your shares in the business section
of your newspaper in the mutual fund section under the heading "USAA Group" and
then the following symbols:
Long-Term Fund - "TxELT"
Intermediate-Term Fund - "TxEIt"
Short-Term Fund - "TxESh"
If you prefer to obtain this information from an on-line computer service, you
can do so by using the following ticker symbols:
Long-Term Fund - "USTEX"
Intermediate-Term Fund - "USATX"
Short-Term Fund - "USSTX"
Tax Exempt Money Market Fund - "USEXX"
FEES AND EXPENSES
This summary shows what it will cost you directly or indirectly to invest in
the Funds.
Shareholder Transaction Expenses -- Fees You Pay Directly
There are no fees or sales loads charged to your account when you buy or sell
Fund shares. However, if you sell shares and request your money by wire
transfer, there is a $10 fee. (Your bank may also charge a fee for receiving
wires.)
Annual Fund Operating Expenses -- Fees You Pay Indirectly
Fund expenses come out of the Funds' assets and are reflected in the Funds'
share prices and dividends. "Other Expenses" include expenses such as custodian
and transfer agent fees. The figures on the next page show actual expenses
during the past fiscal year ended March 31, 1998, and are calculated as a
percentage of average net assets.
9
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12B-1 FEES -
SOME MUTUAL
FUNDS CHARGE
THESE FEES
TO PAY FOR
ADVERTISING
AND OTHER
COSTS OF SELLING
FUND SHARES.
===============================================================================
Long-Term Intermediate-Term
Fund Fund
- -------------------------------------------------------------------------------
Management Fees .28% .28%
Distribution (12b-1) Fees None None
Other Expenses .08% .09%
---- ----
Total Annual Fund
Operating Expenses .36% .37%
==== ====
===============================================================================
Short-Term Tax Exempt
Fund Money Market Fund
- -------------------------------------------------------------------------------
Management Fees .28% .28%
Distribution (12b-1) Fees None None
Other Expenses .11% .10%
---- ----
Total Annual Fund
Operating Expenses .39% .38%
==== ====
===============================================================================
Example of Effect of the Funds' Operating Expenses
This example is intended to help you compare the cost of investing in one of
the Funds with the cost of investing in other mutual funds. Although your
actual costs may be higher or lower, you would pay the following expenses on a
$10,000 investment, assuming (1) 5% annual return, (2) the Fund's operating
expenses remain the same, and (3) you redeem all of your shares at the end of
those periods shown.
One Three Five Ten
Year Years Years Years
- -------------------------------------------------------------------------------
Long-Term Fund $37 $116 $202 $456
Intermediate-Term Fund $38 $119 $208 $468
Short-Term Fund $40 $125 $219 $493
Tax Exempt Money Market Fund $39 $122 $213 $480
FUND INVESTMENTS
Principal Investment Strategies and Risks
Q What is each Fund's principal investment strategy?
A Each Fund's principal investment strategy is to invest the Fund's assets
in securities, the interest from which, in the opinion of counsel, is
excluded from gross income for federal income tax purposes, but may be
subject to state and local taxes.
10
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These securities include municipal debt obligations that have been issued
by states and their political subdivisions, and duly constituted state
and local authorities and corporations as well as securities issued by
certain U.S. territories or possessions, such as Puerto Rico, the Virgin
Islands, and Guam. Tax-exempt securities are issued to fund public
infrastructure projects such as streets and highways, schools, water and
sewer systems, hospitals, and airports. Tax-exempt securities may also be
issued to refinance outstanding obligations as well as to obtain funds
for general operating expenses and for loans to other public institutions
and facilities.
Because the projects benefit the public, Congress has granted exemption
from federal income taxes for the interest income arising from these
securities.
Q What types of tax-exempt securities will be included in each Fund's
portfolio?
A Each Fund's assets may be invested in any of the following tax-exempt
securities:
o general obligation bonds which are secured by the issuer's pledge of its
full faith, credit, and taxing power for the payment of principal and
interest;
o revenue bonds which are payable from the revenue 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, but
not from the general taxing power;
o lease obligations backed by the municipality's covenant to budget for
the payments due under the lease obligation; and
o industrial development bonds issued by or on behalf of public
authorities to obtain funds for privately-operated facilities.
As a temporary defensive measure because of market, economic, political,
or other conditions, we may invest up to 100% of each Fund's assets in
short-term securities whether or not they are exempt from federal income
tax. To the extent that these temporary investments produce taxable
income, that income may result in that Fund not fully achieving its
investment objective during the time it is in this temporary defensive
posture.
Q What are the principal risks associated with investments in tax-exempt
securities?
A The two principal risks of investing in tax-exempt securities are credit
risk and market risk.
11
<PAGE>
[CAUTION LIGHT] CREDIT RISK. Credit risk is the possibility that an
issuer of a fixed income security will fail to make timely payments of
interest or principal. We attempt to minimize the Funds' credit risks by
investing in securities considered at least investment grade at the time
of purchase. Nevertheless, even investment-grade securities are subject
to some credit risk. In addition, the ratings of securities are estimates
by the rating agencies of the credit quality of the securities. The
ratings may not take into account every risk related to whether interest
or principal will be repaid on a timely basis.
When evaluating potential investments for the Funds, our analysts also
independently assess credit risk and its impact on the Funds' portfolios.
Securities in the lowest investment grade ratings category (BBB) have
speculative characteristics. Changes in economic conditions or other
circumstances are more likely to lead to a weakened capability to make
principal and interest payments on these securities than is the case for
higher-rated securities.
[CAUTION LIGHT]
MARKET RISK. As a mutual fund investing in bonds, the Funds are subject
to the risk that the market value of the bonds will decline because of
rising interest rates. Bond prices are linked to the prevailing market
interest rates. In general, when interest rates rise, the prices of bonds
fall and when interest rates fall, bond prices generally rise. The price
volatility of a bond also depends on its maturity. Generally, the longer
the maturity of a bond, the greater its sensitivity to interest rates. To
compensate investors for this higher market risk, bonds with longer
maturities generally offer higher yields than bonds with shorter
maturities.
Q What are the differences between the Long-Term, Intermediate-Term, and
Short-Term Funds?
A The differences in the Funds are in the average weighted maturities of
all the securities in the portfolios. Generally, the longer the maturity,
the higher the yield and the greater the price volatility.
Maturity Limits
Portfolio Weighted
Fund Average
------------------------------------------------
Long-Term 10 years or more
Intermediate-Term 3-10 years
Short-Term 3 years or less
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Within these limitations, a Fund may purchase individual securities with
stated maturities greater than the Fund's weighted average maturity
limits. In determining a security's maturity for purposes of calculating
a Fund's average maturity, estimates of the expected time for its
principal to be paid may be used. This can be substantially shorter than
its stated final maturity. For a discussion of the method of calculating
the average weighted maturities of these Funds' portfolios, see
INVESTMENT POLICIES in the Statement of Additional Information.
Q Are each Fund's investments diversified in many different issuers?
A Each Fund is considered diversified under the federal securities laws.
With respect to the Long-Term Fund, Intermediate-Term Fund, and the
Short-Term Fund, this means that we will not invest more than 5% in any
one issuer with respect to 75% of the Funds' assets. With respect to the
remaining 25% of the Funds' assets, we could invest more than 5% in any
one, or more, issuers.
With respect to the Tax Exempt Money Market Fund, we will not generally
invest more than 5% of the Fund's assets in any one or more issuers.
Also, strict SEC guidelines do not permit us to invest, with respect to
75% of the Fund's assets, greater than 10% of the Fund's assets in
securities issued by or subject to guarantees by the same institution.
Purchases of securities issued or guaranteed by the U.S. Government or
its agencies or instrumentalities are not counted toward these
limitations.
We also may not invest more than 25% of the Funds' assets in
securities issued in connection with the financing of projects with
similar characteristics, such as toll road revenue bonds, housing revenue
bonds, or electric power project revenue bonds, or in industrial revenue
bonds which are based, directly or indirectly, on the credit of private
entities of any one industry. However, we reserve the right to invest
more than 25% of the Funds' assets in tax-exempt industrial revenue
bonds.
Q Will any portion of the distributions from the Funds be subject to
federal income taxes?
A During normal market conditions, at least 80% of each Fund's annual
income will be excluded from gross income for federal income tax
purposes. This policy may only be changed by a shareholder vote. We
expect that any taxable interest income distributed will be minimal.
13
<PAGE>
However, gains and losses from trading securities that occur during the
normal course of managing a fund may create net capital gain
distributions. The Internal Revenue Code presently treats these
distributions differently than tax-exempt interest income in the
following ways:
o Distributions of net short-term capital gains are taxable as ordinary
income.
o Distributions of net long-term capital gains are taxable as long-term
capital gains, regardless of the length of time you have held the Fund
shares. These distributions may be taxable at different rates depending
on the length of time the Funds held the applicable investment.
o Both short-term and long-term capital gains are taxable whether received
in cash or reinvested in additional shares.
Q Will income from the Funds be subject to the federal alternative minimum
tax (AMT) for individuals?
A During normal market conditions, at least 80% of each Fund's annual
income will be excluded from the calculation of the federal alternative
minimum tax (AMT) for individuals. This policy may only be changed by a
shareholder vote. Since inception, the Funds have not distributed any
income that is subject to the federal AMT for individuals, and we do not
intend to invest in securities subject to the federal AMT. However, of
course, changes in federal tax laws or other unforeseen circumstances
could result in income subject to the federal AMT for individuals.
Long-, Intermediate-, and Short-Term Funds
Q What is the credit quality of the Fund's investments?
A Under normal market conditions, we will invest each Fund's assets so that
at least 50% of the total market value of the tax-exempt securities is
rated within the three highest long-term rating categories (A or higher)
by Moody's Investors Service, Inc. (Moody's), Standard & Poor's Ratings
Group (S&P), or Fitch IBCA, Inc. (Fitch), in the highest short-term
rating category by Moody's, S&P, or Fitch; or if a security is not rated
by these rating agencies, we must determine that the security is of
equivalent investment quality.
In no event will we purchase a security for a Fund unless it is rated at
least investment grade at the time of purchase. Investment-grade
securities are those securities rated within the four highest long-term
14
<PAGE>
rating categories by Moody's (Baa or higher), S&P, or Fitch (BBB or
higher), or in the two highest short-term rating categories by these
rating agencies; or if unrated by these agencies, we must determine that
the securities are of equivalent investment quality.
You will find a complete description of the above tax-exempt ratings in
the Funds' Statement of Additional Information.
Q What happens if the rating of a security is downgraded to below
investment grade?
A We will determine whether it is in the best interest of a Fund's
shareholders to continue to hold the security in the Fund's portfolio. If
downgrades result in more than 5% of the Fund's net assets being invested
in securities that are less than investment-grade quality, we will take
immediate action to reduce a Fund's holdings in such securities to 5% or
less of a Fund's net assets, unless otherwise directed by the Board of
Directors.
Q How does the portfolio manager decide which securities to buy and sell?
A He manages tax-exempt funds based on the common sense premise that our
investors value tax-exempt income over taxable capital gain
distributions. When weighing his decision to buy or sell a security, he
strives to balance the value of the tax-exempt income, the credit risk
of the issuer, and the price volatility of the bond.
Tax Exempt Money Market Fund
Q What is the credit quality of the Fund's investments?
A The Fund's investments consist of securities meeting the requirements to
qualify as "eligible securities" under the SEC rules applicable to money
market funds. In general, an eligible security is defined as a security
that is:
o issued or guaranteed by the U.S. Government or any agency or
instrumentality thereof, including "prerefunded" and "escrowed to
maturity" tax-exempt securities;
o rated or subject to a guarantee that is rated in one of the two highest
categories for short-term securities by at least two Nationally
Recognized Statistical Rating Organizations (NRSROs), or by one NRSRO
if the security is rated by only one NRSRO;
15
<PAGE>
o unrated but issued by an issuer or guaranteed by a guarantor that has
other comparable short-term debt obligations so rated; or
o unrated but determined by us to be of comparable quality.
In addition, we must consider whether a particular investment presents
minimal credit risk.
Q Who are the Nationally Recognized Statistical Rating Organizations?
A Current NRSROs include:
o Moody's Investors Service, Inc.;
o Standard & Poor's Ratings Group;
o Fitch IBCA, Inc.;
o Duff & Phelps Inc.; and
o Thompson BankWatch, Inc.
Q What happens if the rating of a security is downgraded?
A If the rating of a security is downgraded after purchase, we will
determine whether it is in the best interest of the Fund's shareholders
to continue to hold the security in the Fund's portfolio.
Q Will the Fund always maintain a net asset value of $1 per share?
A While we will endeavor to maintain a constant Fund net asset value of $1
per share, there is no assurance that we will be able to do so. Remember,
the shares are neither insured nor guaranteed by the U.S. Government. As
such, the Fund carries some risk.
For example, there is always a risk that the issuer of a security held by
the Fund will fail to pay interest or principal when due. We attempt to
minimize this credit risk by investing only in securities rated in one of
the two highest categories for short-term securities, or, if not rated,
of comparable quality, at the time of purchase. Additionally, we will not
purchase a security unless our analysts determine that the security
presents minimal credit risk.
There is also a risk that rising interest rates will cause the value of
the Fund's securities to decline. We attempt to minimize this interest
risk by limiting the maturity of each security to 397 days or less and
maintaining a dollar-weighted average portfolio maturity for the Fund of
90 days or less.
DOLLAR-
WEIGHTED
AVERAGE
PORTFOLIO
MATURITY IS
OBTAINED BY
MULTIPLYING
THE DOLLAR
VALUE OF EACH
INVESTMENT
BY THE NUMBER
OF DAYS LEFT TO
ITS MATURITY,
THEN ADDING
THOSE FIGURES TOGETHER
AND DIVIDING THE
TOTAL BY THE
DOLLAR VALUE
OF THE FUND'S
PORTFOLIO.
16
<PAGE>
Finally, there is the possibility that one or more investments in the
Fund cease to be "eligible securities" resulting in the net asset value
ceasing to be $1 per share. For example, a guarantor on a security may
fail to meet a contractual obligation.
Q How does the portfolio manager decide which securities to buy and sell?
A He balances factors such as credit quality and maturity to purchase the
best relative value available in the market at any given time. While
rare, sell decisions are usually based on a change in his credit analysis
or to take advantage of an opportunity to reinvest at a higher yield.
For additional information about other securities in which we may invest each
of the Fund's assets, see APPENDIX A on page 32.
FUND MANAGEMENT
The Company has retained us, USAA Investment Management Company, to serve as
the manager and distributor for the Company. We are an affiliate of United
Services Automobile Association (USAA), a large, diversified financial services
institution. As of the date of this Prospectus, we had approximately $39
billion in total assets under management. Our mailing address is 9800
Fredericksburg Road, San Antonio, TX 78288.
We provide management services to the Funds pursuant to an Advisory Agreement.
We are responsible for managing the Funds' portfolios (including placement of
brokerage orders) and their business affairs, subject to the authority of and
supervision by the Board of Directors. For our services, the Funds pay us an
annual fee. This fee, which is accrued daily and paid monthly, is computed as a
percentage of average net assets. The fee for each Fund was computed and paid
at twenty-eight one-hundredths of one percent (.28%) of average net assets, for
the fiscal year ended March 31, 1998. We also provide services related to
selling the Funds' shares and receive no compensation for those services.
Although our officers and employees, as well as those of the Company, may
engage in personal securities transactions, they are restricted by the
procedures in a Joint Code of Ethics adopted by the Company and us.
17
<PAGE>
Portfolio Managers
The following individuals are primarily responsible for managing the Funds:
LONG-TERM FUND
[PHOTOGRAPH OF
PORTFOLIO MANAGER]
Kenneth E. Willmann
Kenneth E. Willmann, Vice President of Fixed Income Investments since December
1986, has managed the Fund since its inception in March 1982. He has 24 years
investment management experience and has worked for us for 21 years. Mr.
Willmann earned the Chartered Financial Analyst (CFA) designation in 1978 and
is a member of the Association for Investment Management and Research (AIMR),
San Antonio Financial Analysts Society, Inc. (SAFAS), and the National
Federation of Municipal Analysts (NFMA). He holds an MBA and a BA from the
University of Texas.
INTERMEDIATE-TERM AND SHORT-TERM FUNDS
[PHOTOGRAPH OF
PORTFOLIO MANAGER]
Clifford A. Gladson
Clifford A. Gladson, Assistant Vice President of Fixed Income Investments since
November 1994, has managed the Funds since April 1993 and April 1994,
respectively. He has 11 years investment management experience and has worked
for us for eight years. Mr. Gladson earned the CFA designation in 1990 and is a
member of the AIMR, SAFAS, and NFMA. He holds an MS from the University of
Wisconsin, Milwaukee and a BS from Marquette University.
TAX EXEMPT MONEY MARKET FUND
[PHOTOGRAPH OF
PORTFOLIO MANAGER]
Thomas G. Ramos
Thomas G. Ramos, Vice President of Money Market Funds since September 1996, has
managed the Fund since August 1994. Mr. Ramos has 20 years investment
management experience and has worked for us for 16 years. Mr. Ramos earned the
CFA designation in 1983 and is a member of the AIMR, SAFAS, and NFMA. He holds
an MBA from the University of California, an MA from St. Mary's University, and
a BA from Yale University.
18
<PAGE>
USING MUTUAL FUNDS IN AN INVESTMENT PROGRAM
I. The Idea Behind Mutual Funds
Mutual funds provide small investors some of the advantages enjoyed by wealthy
investors. A relatively small investment can buy part of a diversified
portfolio. That portfolio is managed by investment professionals, relieving you
of the need to make individual stock or bond selections. You also enjoy
conveniences, such as daily pricing, liquidity, and in the case of the USAA
Family of Funds, no sales charge. The portfolio, because of its size, has lower
transaction costs on its trades than most individuals would have. As a result,
you own an investment that in earlier times would have been available only to
very wealthy people.
II. Using Funds in an Investment Program
In choosing a mutual fund as an investment vehicle, you are giving up some
investment decisions, but must still make others. The decisions you don't have
to make are those involved wit choosing individual securities. We will perform
that function. In addition, we will arrange for the safekeeping of securities,
auditing the annual financial statements, and daily valuation of the Fund, as
well as other functions.
You, however, retain at least part of the responsibility for an equally
important decision. This decision involves determining a portfolio of mutual
funds that balances your investment goals with your tolerance for risk. It is
likely that this decision may include the use of more than one fund of the USAA
Family of Funds.
For example, assume you wish to pursue the higher yields usually available in
the long-term bond market, but you are also concerned about the possible price
swings of the long-term bonds. You could divide your investments between the
Long-Term Fund and the Tax Exempt Money Market Fund. This would create a
portfolio with a higher yield than that of the money market and less volatility
than that of the long-term market. This is just one way you could combine funds
to fit your own risk and reward goals.
III. USAA's Family of Funds
We offer you another alternative with our asset strategy funds listed under
asset allocation on page 35. These unique mutual funds provide a professionally
managed diversified investment portfolio within a mutual fund. Designed for the
individual who prefers to delegate the asset allocation process to an
investment manager, their structure achieves diversification across a number of
investment categories.
19
<PAGE>
Whether you prefer to create your own mix of mutual funds or use a USAA Asset
Strategy Fund, the USAA Family of Funds provides a broad range of choices
covering just about any investor's investment objectives. Our sales
representatives stand ready to assist you with your choices and to help you
craft a portfolio to meet your needs. Refer to APPENDIX C on page 35 for a
complete list of the USAA Family of No-Load Mutual Funds.
HOW TO INVEST
Purchase of Shares
OPENING AN ACCOUNT
You may open an account and make an investment as described below by mail, in
person, bank wire, electronic funds transfer (EFT), or phone. A complete,
signed application is required for new accounts. However, after you open your
initial account with us, you will not need to fill out another application
unless the registration is different.
TAX ID NUMBER
Each shareholder named on the account must provide a social security number or
tax identification number to avoid possible withholding requirements.
EFFECTIVE DATE
When you make a purchase, your purchase price will be the net asset value (NAV)
per share next determined after we receive your request in proper form. Each
Fund's NAV is determined at the close of the regular trading session (generally
4:00 p.m. Eastern Time) of the New York Stock Exchange (NYSE) each day the NYSE
is open. If we receive your request and payment prior to that time, your
purchase price will be the NAV per share determined for that day. If we receive
your request or payment after the NAV per share is calculated, the purchase
will be effective on the next business day. If you plan to purchase Fund shares
with a foreign check, we suggest you convert your foreign check to U.S. dollars
prior to investment in a Fund to avoid a potential delay in the effective date
of your purchase of up to four to six weeks. Furthermore, a bank charge may be
assessed in the clearing process, which will be deducted from the amount of the
purchase.
MINIMUM INVESTMENTS
INITIAL PURCHASE
[MONEY GRAPHIC]
o $3,000. Employees of USAA and its affiliated companies may open an account
through payroll deduction for as little as $25 per pay period with no
initial investment.
ADDITIONAL PURCHASES
o $50 (Except transfers from brokerage accounts into the Tax Exempt Money
Market Fund, which are exempt from the minimum).
20
<PAGE>
HOW TO PURCHASE
MAIL
[ENVELOPE GRAPHIC]
o To open an account, send your application and check to:
USAA Investment Management Company
9800 Fredericksburg Road
San Antonio, TX 78288
o To add to your account, send your check and the "Invest by Mail" stub that
accompanies your Fund's transaction confirmation to the Transfer Agent:
USAA Shareholder Account Services
9800 Fredericksburg Road
San Antonio, TX 78288
IN PERSON
[HANDSHAKE GRAPHIC]
o To open an account, bring your application and check to:
USAA Investment Management Company
USAA Federal Savings Bank
10750 Robert F. McDermott Freeway
San Antonio, TX 78288
BANK WIRE
[WIRE GRAPHIC]
o Instruct your bank (which may charge a fee for the service) to wire the
specified amount to the Fund as follows:
State Street Bank and Trust Company
Boston, MA 02101
ABA#011000028
Attn: USAA Tax Exempt Fund Name
USAA Account Number: 69384998
Shareholder(s) Name(s)______________________________________
Shareholder(s) Mutual Fund Account Number___________________
ELECTRONIC FUNDS TRANSFER
[CALENDAR GRAPHIC]
o Additional purchases on a regular basis can be deducted from a bank
account, paycheck, income-producing investment, or USAA money market fund
account. Sign up for these services when opening an account or call
1-800-531-8448 to add these services.
PHONE 1-800-531-8448
[TELEPHONE GRAPHIC]
o If you have an existing USAA account and would like to open a new account
or exchange to another USAA fund, call for instructions. To open an account
by phone, the new account must have the same registration as your existing
account.
21
<PAGE>
Redemption of Shares
You may redeem Fund shares by any of the methods described below on any day the
NAV per share is calculated. Redemptions are effective on the day instructions
are received in a manner as described below. However, if instructions are
received after the NAV per share calculation (generally 4:00 p.m. Eastern
Time), redemption will be effective on the next business day.
We will send you your money within seven days after the effective date of
redemption, Payment for redemption of shares purchased by EFT or check is sent
after the EFT or check has cleared, which could take up to 15 days from the
purchase date. If you are considering redeeming shares soon after purchase, you
should purchase by bank wire or certified check to avoid delay. Redemptions are
subject to taxes based on the difference between the cost of shares when
purchased and the price received upon redemption.
In addition, the Company may elect to suspend the redemption of shares or
postpone the date of payment in limited circumstances.
HOW TO REDEEM
WRITTEN, FAX, TELEGRAPH, OR TELEPHONE
[FAX MACHINE GRAPHIC]
o Send your written instructions to:
USAA Shareholder Account Services
9800 Fredericksburg Road
San Antonio, TX 78288
o Send a signed fax to 1-800-292-8177, or send a telegram to USAA Shareholder
Account Services.
o Call toll free 1-800-531-8448, in San Antonio, 456-7202.
Telephone redemption privileges are automatically established when you complete
your application. The Fund will employ reasonable procedures to confirm that
instructions communicated by telephone are genuine; and if it does not, it may
be liable for any losses due to unauthorized or fraudulent instructions. Before
any discussion regarding your account, we obtain the following information: (1)
USAA number or account number, (2) the name(s) on the account registration, and
(3) social security number or tax identification number for the account
registration. In addition, we record all telephone communications with you and
send confirmations of account transactions to the address of record. If you
were issued stock certificates for your shares, redemption by telephone, fax,
or telegram is not available.
22
<PAGE>
CHECKWRITING
[CHECKBOOK GRAPHIC]
o Checks can be issued for the Short-Term Fund and Tax Exempt Money Market
Fund accounts. Return a signed signature card, which accompanies your
application, or request a signature card separately and return to:
USAA Shareholder Account Services
9800 Fredericksburg Road
San Antonio, TX 78288
You will not be charged for the use of checks or any subsequent reorders. Your
checkwriting privilege is subject to State Street Bank and Trust Company's
rules and regulations governing checking accounts. You may write checks in the
amount of $250 or more. Checks written for less than $250 will be returned
unpaid. Because the value of your account changes daily as dividends accrue,
you may not write a check to close your account.
IMPORTANT INFORMATION ABOUT PURCHASES AND REDEMPTIONS
Investor's Guide to USAA Mutual Fund Services
[INVESTOR'S GUIDE GRAPHIC]
Upon your initial investment with us, you will receive the INVESTOR'S GUIDE to
help you get the most out of your USAA mutual fund account and to help you in
your role as an investor. In the INVESTOR'S GUIDE, you will find additional
information on purchases, redemptions, and methods of payment. You will also
find in-depth information on automatic investment plans, shareholder statements
and reports, and other useful information.
Account Balance
USAA Shareholder Account Services (SAS), the Funds' transfer agent, may assess
annually a small balance account fee of $12 to each shareholder account with a
balance, at the time of assessment, of less than $2,000. The fee will reduce
total transfer agency fees paid by the Fund to SAS. Accounts exempt from the
fee include: (1) any account regularly purchasing additional shares each month
through an automatic investment plan; (2) any account registered under the
Uniform Gifts/Transfers to Minors Act (UGMA/UTMA); (3) all (non-IRA) money
market fund accounts; (4) any account whose registered owner has an aggregate
balance of $50,000 or more invested in USAA mutual funds; and (5) all IRA
accounts (for the first year the account is open).
23
<PAGE>
Company Rights
The Company reserves the right to:
o reject purchase or exchange orders when in the best interest of the Company;
o limit or discontinue the offering of shares of any portfolio of the Company
without notice to the shareholders;
o impose a redemption charge of up to 1% of the net asset value of shares
redeemed if circumstances indicate a charge is necessary for the protection
of remaining investors (for example, if excessive market-timing share
activity unfairly burdens long-term investors); however, this 1% charge will
not be imposed upon shareholders unless authorized by the Board of Directors
and the required notice has been given to shareholders;
o require a signature guarantee for transactions or changes in account
information in those instances where the appropriateness of a signature
authorization is in question. The Statement of Additional Information
contains information on acceptable guarantors;
o redeem an account with less than 50 full shares, with certain limitations.
EXCHANGES
Exchange Privilege
The exchange privilege is automatic when you complete your application. You may
exchange shares among Funds in the USAA Family of Funds, provided you do not
hold these shares in stock certificate form and the shares to be acquired are
offered in your state of residence. The Funds' transfer agent will
simultaneously process exchange redemptions and purchases at the share prices
next determined after the exchange order is received. The investment minimums
applicable to share purchases also apply to exchanges. For federal income tax
purposes, an exchange between Funds is a taxable event; and as such, you may
realize a capital gain or loss. Such capital gains or lossess are based on the
difference between the cost of shares when purchased and the price received
upon exchange.
The Funds have undertaken certain procedures regarding telephone transactions
as described on page 22.
Exchange Limitations, Excessive Trading
To minimize Fund costs and to protect the Funds and their shareholders from
unfair expense burdens, the Funds restrict excessive exchanges. The limit on
exchanges out of any Fund in the USAA Family of Funds for each account is six
per calendar year (except there is no limitation on exchanges out of the Tax
Exempt Short-Term Fund, Short-Term Bond Fund, or any of the money market funds
in the USAA Family of Funds).
24
<PAGE>
SHAREHOLDER INFORMATION
NAV
EQUALS
TOTAL ASSETS
MINUS
LIABILITIES
DIVIDED BY
# OF SHARES OUTSTANDING
Share Price Calculation
The price at which you purchase and redeem Fund shares is equal to the net
asset value (NAV) per share determined on the effective date of the purchase or
redemption. You may buy and sell Fund shares at the NAV per share without a
sales charge. Each Fund's NAV per share is calculated at the close of the
regular trading session of the NYSE, which is usually 4:00 p.m. Eastern Time.
Securities of the Long-Term, Intermediate-Term, and Short-Term Funds are valued
each business day at their current market value as determined by a pricing
service approved by the Company's Board of Directors. Securities which cannot
be valued by the pricing service, and all other assets, are valued in good
faith at fair value using methods we have determined under the general
supervision of the Board of Directors. In addition, securities purchased with
maturities of 60 days or less and all securities of the Tax Exempt Money Market
Fund are stated at amortized cost, which approximates market value.
For additional information on how securities are valued, see VALUATION OF
SECURITIES in the Funds' Statement of Additional Information.
Dividends and Distributions
Net investment income of each Fund is accrued daily and paid on the last
business day of the month. Dividends shall begin accruing on shares purchased
the day following the effective date and shall continue to accrue to the
effective date of redemption. Any net capital gain distribution usually occurs
within 45 days of the March 31 fiscal year end, which would be somewhere around
the middle of May. The Funds will make additional payments to shareholders, if
necessary, to avoid the imposition of any federal income or excise tax.
All income dividends and capital gain distributions are automatically
reinvested, unless we receive different instructions from you. The share price
will be the NAV of the Fund shares computed on the ex-dividend date. Any
capital gain distributions paid by the Tax Exempt Funds (except the Tax Exempt
Money Market Fund) will reduce the NAV per share by the amount of the dividend
or distribution. These dividends and distributions are subject to taxes. We
will mail a check for any capital gain distribution to you after the
distribution is paid.
We will invest any dividend or distribution payment returned to us in your
account at the then-current NAV per share. Dividend and distribution checks
become void six months from the date on the check. The amount of the voided
check will be invested in your account at the then-current NAV per share.
25
<PAGE>
Federal Taxes
This tax information is quite general and refers to the federal income tax
provisions in effect as of the date of this Prospectus. While we manage the
Funds so that at least 80% of each Fund's annual income will be exempt from
federal income taxes, we may invest up to 20% of the Funds' assets in
securities that generate income not exempt from federal or state income taxes.
Because interest income may be exempt for federal income tax purposes, it does
not necessarily mean that the interest income may be exempt under the income or
other tax laws of any state or local taxing authority. As discussed earlier on
page 14, capital gains distributed by a Fund may be taxable. Note that the
Taxpayer Relief Act of 1997 and regulations that will likely be adopted to
implement the Act may affect the status and treatment of certain distributions
shareholders receive from the Funds. We urge you to consult your own tax
adviser about the status of distributions from the Funds in your own state and
locality.
WITHHOLDING - Federal law requires each Fund to withhold and remit to the U.S.
Treasury a portion of the income dividends and capital gain distributions and
proceeds of redemptions paid to any non-corporate shareholder who:
o fails to furnish the Fund with a correct tax identification number,
o underreports dividend or interest income, or
o fails to certify that he or she is not subject to withholding.
To avoid this withholding requirement, you must certify on your application, or
on a separate Form W-9 supplied by the Funds' transfer agent, that your tax
identification number is correct and you are not currently subject to backup
withholding.
REPORTING - Each Fund will report information to you concerning the tax status
of dividends and distributions for federal income tax purposes annually,
including the portion of the dividends constituting interest on private
activity bonds and the percentage and source, on a state-by-state basis, of
interest income earned on tax-exempt securities held by the Fund during the
preceding year.
26
<PAGE>
Year 2000
Like other organizations around the world, the Funds could be adversely
affected if the computer systems used by them, their service providers, or
companies in which they invest do not properly process and calculate
information that relates to dates beginning January 1, 2000, and beyond. This
situation may occur because for many years computer programmers used only two
digits to describe years, such as 98 for 1998. A program written in this manner
may not work when it encounters the year 00. To confront this situation, USAA
companies have spent much effort and money; and we expect to have our systems
ready for the Year 2000 by mid-1999. In addition, we are actively assessing the
Year 2000 readiness of our service providers, partners, and companies in whose
securities we invest. It is not possible for us to say that you will experience
no effect from this situation, but we can say that we are making a large effort
to avoid any ill effects upon our shareholders.
We do believe you are entitled to know with certainty that we will stand behind
your share balance as of the close of business in 1999. When the market reopens
in 2000, should any computer problem cause a change in the number of shares in
your account, we will return your account to its proper share balance.
27
<PAGE>
FINANCIAL HIGHLIGHTS
The financial highlights tables are intended to help you understand the Funds'
financial performance for the past five years. Certain information reflects
financial results for a single Fund share. The total returns in the tables
represent the rate that an investor would have earned (or lost) on an
investment in the Fund (assuming reinvestment of all dividends and
distributions). This information has been audited by KPMG Peat Marwick LLP,
whose report, along with the Funds' financial statements, are included in the
Annual Report, which is available upon request.
Long-Term Fund:
Year Ended March 31,
-------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Net asset value at
beginning of period $ 13.22 $ 13.17 $ 12.96 $ 13.20 $ 14.21
Net investment income .78 .79 .79 .79 .81
Net realized and
unrealized gain (loss) .78 .05 .21 (.16) (.44)
Distributions from net
investment income (.78) (.79) (.79) (.78) (.82)
Distributions of
realized capital
gains - - - (.09) (.56)
---------- ---------- ---------- ---------- ----------
Net asset value at
end of period $ 14.00 $ 13.22 $ 13.17 $ 12.96 $ 13.20
========== ========== ========== ========== ==========
Total return (%)* 12.04 6.51 7.88 5.07 2.36
Net assets at end of
period (000) $2,042,525 $1,822,436 $1,804,116 $1,774,643 $1,831,693
Ratio of expenses to
average net assets (%) .36 .37 .37 .38 .38
Ratio of net investment
income to average
net assets (%) 5.65 5.95 5.99 6.23 5.69
Portfolio turnover (%) 35.20 40.78 53.25 64.72 109.28
- -----------------
* Assumes reinvestment of all dividend income and capital gains distributions
during the period.
28
<PAGE>
Financial Highlights (cont.)
Intermediate-Term Fund:
Year Ended March 31,
-------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Net asset value at
beginning of period $ 12.77 $ 12.77 $ 12.50 $ 12.48 $ 12.90
Net investment income .71 .72 .71 .69 .69
Net realized and
unrealized gain (loss) .61 - .27 .05 (.29)
Distributions from net
investment income (.71) (.72) (.71) (.69) (.69)
Distributions of realized
capital gains - - - (.03) (.13)
---------- ---------- ---------- ---------- ----------
Net asset value at
end of period $ 13.38 $ 12.77 $ 12.77 $ 12.50 $ 12.48
========== ========== ========== ========== ==========
Total return (%)* 10.59 5.80 7.97 6.16 3.06
Net assets at end of
period (000) $2,039,505 $1,725,684 $1,660,039 $1,529,750 $1,559,183
Ratio of expenses to
average net assets (%) .37 .37 .38 .40 .40
Ratio of net investment
income to average net
assets (%) 5.42 5.65 5.54 5.63 5.30
Portfolio turnover (%) 7.87 23.05 27.51 27.26 69.45
- ---------------------
* Assumes reinvestment of all dividend income and capital gains distributions
during the period.
29
<PAGE>
Financial Highlights (cont.)
Short-Term Fund:
Year Ended March 31,
-------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Net asset value at
beginning of period $ 10.57 $ 10.57 $ 10.47 $ 10.48 $ 10.63
Net investment income .49 .49 .50 .47 .45
Net realized and
unrealized gain (loss) .17 - .10 (.01) (.15)
Distributions from net
investment income (.49) (.49) (.50) (.47) (.45)
-------- -------- -------- -------- --------
Net asset value at
end of period $ 10.74 $ 10.57 $ 10.57 $ 10.47 $ 10.48
======== ======== ======== ======== ========
Total return (%)* 6.35 4.70 5.83 4.51 2.87
Net assets at end of
period (000) $970,805 $804,897 $774,020 $801,157 $995,624
Ratio of expenses to
average net assets (%) .39 .41 .42 .42 .43
Ratio of net investment
income to average net
assets (%) 4.57 4.60 4.73 4.50 4.25
Portfolio turnover (%) 7.91 27.67 35.99 32.61 101.67
- ---------------------
* Assumes reinvestment of all dividend income and capital gains distributions
during the period.
30
<PAGE>
Financial Highlights (cont.)
Tax Exempt Money Market Fund:
Year Ended March 31,
-------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Net asset value at
beginning of period $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
Net investment income .03 .03 .04 .03 .02
Distributions from net
investment income (.03) (.03) (.04) (.03) (.02)
---------- ---------- ---------- ---------- ----------
Net asset value at
end of period $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
========== ========== ========== ========== ==========
Total return (%)* 3.48 3.30 3.65 2.98 2.31
Net assets at end of
period (000) $1,631,785 $1,565,634 $1,529,176 $1,456,747 $1,569,760
Ratio of expenses to
average net assets (%) .38 .39 .40 .39 .40
Ratio of net investment
income to average net
assets (%) 3.42 3.25 3.59 2.93 2.29
- -----------------------
* Assumes reinvestment of all dividend income distributions during the period.
31
<PAGE>
APPENDIX A
THE FOLLOWING ARE DESCRIPTIONS OF CERTAIN TYPES OF SECURITIES IN WHICH WE MAY
INVEST EACH FUND'S ASSETS:
VARIABLE RATE SECURITIES
We may invest a Fund's assets in tax-exempt securities that bear interest at
rates which are adjusted periodically to market rates.
o These interest rate adjustments can both raise and lower the income
generated by such securities. These changes will have the same effect on the
income earned by the Fund depending on the proportion of such securities
held.
o The value of variable rate securities is less affected than fixed-coupon
securities by changes in prevailing interest rates because of the periodic
adjustment of their coupons to a market rate. The shorter the period between
adjustments, the smaller the impact of interest rate fluctuations on the
value of these securities.
o The market value of a variable rate security usually tends toward par (100%
of face value) at interest rate adjustment time.
In the case of the Tax Exempt Money Market Fund only, any variable rate
instrument with a demand feature will be deemed to have a maturity equal to
either the date on which the underlying principal amount may be recovered
through demand or the next rate adjustment date consistent with applicable
regulatory requirements.
PUT BONDS
We may invest a Fund's assets in tax-exempt securities (including securities
with variable interest rates) which may be redeemed or sold back (put) to the
issuer of the security or a third party prior to stated maturity (put bonds).
Such securities will normally trade as if maturity is the earlier put date,
even though stated maturity is longer. For the Long-Term, Intermediate-Term,
and Short-Term Bond Funds, maturity for put bonds is deemed to be the date on
which the put becomes exercisable. Generally, maturity for put bonds for the
Tax Exempt Money Market Fund is determined as stated under Variable Rate
Securities.
ZERO COUPON BONDS
We may invest a Fund's assets in zero coupon bonds. A zero coupon bond is a
security that is sold at a deep discount from its face value, makes no periodic
interest payments, and is redeemed at face value when it matures. The lump sum
payment at maturity increases the price volatility of the zero coupon bond to
changes in interest rates when compared to a bond that distributes a semiannual
coupon payment. In calculating its dividend, each Fund records as income the
daily amortization of the purchase discount.
32
<PAGE>
WHEN-ISSUED SECURITIES
We may invest a Fund's assets in new securities offered on a when-issued basis.
o Delivery and payment take place after the date of the commitment to
purchase, normally within 45 days. Both price and interest rate are fixed at
the time of commitment.
o The Funds do not earn interest on the securities until settlement, and the
market value of the securities may fluctuate between purchase and
settlement.
o Such securities can be sold before settlement date.
MUNICIPAL LEASE OBLIGATIONS
We may invest a Fund's assets in a variety of instruments commonly referred to
as municipal lease obligations, including:
o Leases,
o Installment purchase contracts, and
o Certificates of participation in such leases and contracts.
Certain lease obligations contain "non-appropriation" clauses which provide
that the municipality has no obligation to make lease obligation payments in
future years unless money is appropriated for such purpose on a yearly basis.
LIQUIDITY
We may invest up to 15% of the Long-Term, Intermediate-Term, and Short-Term
Funds' net assets and up to 10% of the Tax Exempt Money Market Fund's net
assets in securities which are illiquid. Illiquid securities are those
securities that cannot be disposed of in the ordinary course of business, seven
days or less, at approximately the value at which the Fund has valued the
securities.
Lease obligations and certain put bonds subject to restrictions on transfer may
be determined to be liquid in accordance with the guidelines established by the
Funds' Board of Directors.
In determining the liquidity of a lease obligation, we will consider: (1) the
frequency of trades and quotes for the lease obligation; (2) the number of
dealers willing to purchase or sell the lease obligation and the number of
other potential purchasers; (3) dealer undertakings to make a market in the
lease obligation; (4) the nature of the marketplace trades, including the time
needed to dispose of the lease obligation, the method of soliciting offers, and
the mechanics of transfer; (5) whether the lease obligation is of a size that
will be attractive to institutional investors; (6) whether the lease obligation
contains a non-appropriation clause and the likelihood that the obligor will
fail to make an appropriation therefor; and (7) such other factors as we may
determine to be relevant to such determination.
In determining the liquidity of put bonds with restrictions on transfer, we
will evaluate the credit quality of the party (the Put Provider) issuing (or
unconditionally guaranteeing performance on) the unconditional put or demand
feature of the put bond.
33
<PAGE>
APPENDIX B
Taxable Equivalent Yield Table
Assuming a Federal
Marginal Tax Rate of: 28% 31% 36% 39.6%
To Match a
Tax Free Yield of:
===============================================================================
2.00% 2.78% 2.90% 3.13% 3.31%
- -------------------------------------------------------------------------------
2.50% 3.47% 3.62% 3.91% 4.14%
- -------------------------------------------------------------------------------
3.00% 4.17% 4.35% 4.69% 4.97%
- -------------------------------------------------------------------------------
3.50% 4.86% 5.07% 5.47% 5.79%
- -------------------------------------------------------------------------------
4.00% 5.56% 5.80% 6.25% 6.62%
- -------------------------------------------------------------------------------
4.50% 6.25% 6.52% 7.03% 7.45%
- -------------------------------------------------------------------------------
5.00% 6.94% 7.25% 7.81% 8.28%
- -------------------------------------------------------------------------------
5.50% 7.64% 7.97% 8.59% 9.11%
- -------------------------------------------------------------------------------
6.00% 8.33% 8.70% 9.38% 9.93%
- -------------------------------------------------------------------------------
6.50% 9.03% 9.42% 10.16% 10.76%
- -------------------------------------------------------------------------------
7.00% 9.72% 10.14% 10.94% 11.59%
===============================================================================
THIS TABLE IS A HYPOTHETICAL ILLUSTRATION AND SHOULD NOT BE CONSIDERED AN
INDICATION OF FUND PERFORMANCE OF ANY OF THE USAA FAMILY OF FUNDS.
THESE RATES WERE SELECTED AS EXAMPLES THAT WOULD BE RELEVANT TO MOST TAXPAYERS.
FOR A FURTHER EXPLANATION ON CALCULATING TAX EQUIVALENT YIELDS, SEE THE FUNDS'
STATEMENT OF ADDITIONAL INFORMATION.
34
<PAGE>
APPENDIX C
USAA Family of No-Load Mutual Funds
The USAA Family of No-Load Mutual Funds includes a variety of Funds, each with
different objectives and policies. In combination, these Funds are designed to
provide you with the opportunity to formulate your own investment program. You
may exchange any shares you hold in any one USAA Fund for shares in any other
USAA Fund. For more complete information about other Funds in the USAA Family
of Funds, including charges and expenses, call us for a Prospectus. Read it
carefully before you invest or send money.
FUND
TYPE/NAME VOLATILITY
===============================================================
CAPITAL APPRECIATION
- ---------------------------------------------------------------
Aggressive Growth Very high
Emerging Markets (1) Very high
First Start Growth Moderate to high
Gold (1) Very high
Growth Moderate to high
Growth & Income Moderate
International (1) Moderate to high
S&P 500 Index (2) Moderate
Science & Technology Very high
World Growth (1) Moderate to high
- ---------------------------------------------------------------
ASSET ALLOCATION
- ---------------------------------------------------------------
Balanced Strategy (1) Moderate
Cornerstone Strategy (1) Moderate
Growth and Tax Strategy Moderate
Growth Strategy (1) Moderate to high
Income Strategy Low to moderate
- ---------------------------------------------------------------
INCOME - TAXABLE
- ---------------------------------------------------------------
GNMA Low to moderate
Income Moderate
Income Stock Moderate
Short-Term Bond Low
- ---------------------------------------------------------------
INCOME - TAX EXEMPT
- ---------------------------------------------------------------
Long-Term (3) Moderate
Intermediate-Term (3) Low to moderate
Short-Term (3) Low
State Bond/Income (3,4) Moderate
- ---------------------------------------------------------------
MONEY MARKET
- ---------------------------------------------------------------
Money Market (5) Very low
Tax Exempt Money Market (3,5) Very low
Treasury Money Market Trust (5) Very low
State Money Market (3,4,5) Very low
===============================================================
1 FOREIGN INVESTING IS SUBJECT TO ADDITIONAL RISKS, SUCH AS CURRENCY
FLUCTUATIONS, MARKET ILLIQUIDITY, AND POLITICAL INSTABILITY.
2 S&P(R) IS A TRADEMARK OF THE MCGRAW-HILL COMPANIES, INC., AND HAS BEEN
LICENSED FOR USE. THE PRODUCT IS NOT SPONSORED, SOLD OR PROMOTED BY STANDARD
& POOR'S, AND STANDARD & POOR'S MAKES NO REPRESENTATION REGARDING THE
ADVISABILITY OF INVESTING IN THE PRODUCT.
3 SOME INCOME MAY BE SUBJECT TO STATE OR LOCAL TAXES.
4 CALIFORNIA, FLORIDA, NEW YORK, TEXAS, AND VIRGINIA FUNDS ARE OFFERED ONLY TO
RESIDENTS OF THOSE STATES.
5 AN INVESTMENT IN A MONEY MARKET FUND IS NEITHER INSURED NOR GUARANTEED BY
THE U.S. GOVERNMENT AND THERE IS NO ASSURANCE THAT ANY OF THE FUNDS WILL BE
ABLE TO MAINTAIN A STABLE NET ASSET VALUE OF $1 PER SHARE.
35
<PAGE>
If you would like more information about the Funds, you may call 1-800-531-8181
to request a free copy of the Funds' Statement of Additional Information (SAI),
Annual or Semiannual Reports, or to ask other questions about the Funds. The
SAI has been filed with the Securities and Exchange Commission (SEC) and is
legally a part of the Prospectus. In each Fund's Annual Report, you will find a
discussion of the market conditions and investment strategies that
significantly affected the Fund's performance during the last fiscal year.
To view these documents, along with other related documents, you can visit the
SEC's Internet web site (http://www.sec.gov) or the Commission's Public
Reference Room in Washington, D.C. Information on the operation of the public
reference room can be obtained by calling 1-800-SEC-0330. Additionally, copies
of this information can be obtained, for a duplicating fee, by writing the
Public Reference Section of the Commission, Washington, D.C. 20549-6009.
Investment Adviser, Underwriter and Distributor
USAA Investment Management Company
9800 Fredericksburg Road
San Antonio, Texas 78288
-----------------------------------------------
Transfer Agent Custodian
USAA Shareholder Account Services State Street Bank and Trust Company
9800 Fredericksburg Road P.O. Box 1713
San Antonio, Texas 78288 Boston, Massachusetts 02105
-----------------------------------------------
Telephone Assistance Hours
Call toll free - Central Time
Monday - Friday 8:00 a.m. to 8:00 p.m.
Saturdays 8:30 a.m. to 5:00 p.m.
------------------------------------------------
For Additional Information on Mutual Funds
1-800-531-8181, (in San Antonio) 456-7211
For account servicing, exchanges or redemptions
1-800-531-8448, (in San Antonio) 456-7202
-----------------------------------------------
Recorded Mutual Fund Price Quotes
24-Hour Service (from any phone)
1-800-531-8066, (in San Antonio) 498-8066
-----------------------------------------------
Mutual Fund TouchLINE(R)
(from Touchtone phones only)
For account balance, last transaction or fund prices
1-800-531-8777, (in San Antonio) 498-8777
- -------------------------------------------------------------------------------
Investment Company Act File No. 811-3333
<PAGE>
USAA CALIFORNIA FUNDS
USAA CALIFORNIA BOND FUND
USAA CALIFORNIA MONEY MARKET FUND
PROSPECTUS
AUGUST 1, 1998
Shares of the California Funds are offered only to residents of the State of
California. The delivery of this Prospectus is not an offer in any state where
shares of the California Funds may not lawfully be made.
As with other mutual funds, the Securities and Exchange Commission has not
approved or disapproved of either of these Fund's shares or determined whether
this prospectus is accurate or complete. Anyone who tells you otherwise is
committing a crime.
TABLE OF CONTENTS
What Are Each Fund's Investment Objectives and Main Strategies?............ 2
Main Risks of Investing in These Funds..................................... 2
Are These Funds for You?................................................... 3
Could the Value of Your Investment in These Funds Fluctuate?............... 4
Fees and Expenses.......................................................... 7
Fund Investments........................................................... 8
Fund Management............................................................ 16
Using Mutual Funds in an Investment Program................................ 17
How to Invest.............................................................. 18
Important Information About Purchases and Redemptions...................... 22
Exchanges.................................................................. 23
Shareholder Information.................................................... 23
Financial Highlights....................................................... 27
Appendix A ................................................................ 29
Appendix B ................................................................ 31
Appendix C................................................................. 32
<PAGE>
USAA Investment Management Company manages these Funds. For easier reading,
USAA Investment Management Company will be referred to as "we" or "us"
throughout the Prospectus.
WHAT ARE EACH FUND'S INVESTMENT OBJECTIVES AND MAIN STRATEGIES?
Each Fund has a common objective of providing California investors with a high
level of current interest income that is exempt from federal and California
state income taxes. The California Money Market Fund has a further objective of
preserving capital and maintaining liquidity. Each Fund has separate investment
policies to achieve its objective.
The CALIFORNIA BOND FUND invests primarily in long-term, investment-grade
California tax-exempt securities. The Fund's average dollar-weighted portfolio
maturity is not restricted, but is expected to be greater than 10 years.
The CALIFORNIA MONEY MARKET FUND invests in high-quality, California tax-exempt
securities with maturities of 397 days or less.
In view of the risks inherent in all investments in securities, there is no
assurance that the Funds' objectives will be achieved. See FUND INVESTMENTS on
page 8 for more information.
MAIN RISKS OF INVESTING IN THESE FUNDS
The two primary risks of investing in these Funds are credit risk and market
risk. As with other mutual funds, losing money is an additional risk associated
with investing in these Funds.
o CREDIT RISK involves the possibility that a borrower cannot make timely
interest and principal payments on its securities.
o MARKET RISK involves the possibility that the value of each Fund's
investments will decline due to an increase in interest rates, or to
adverse changes in supply and demand for municipal securities, or other
market factors.
The credit and market risks may be magnified because each Fund concentrates in
California tax-exempt securities.
IF INTEREST RATES INCREASE: the yield of each fund may increase and the market
value of the California Bond Fund's securities will likely decline, adversely
affecting the net asset value and total return.
IF INTEREST RATES DECREASE: the yield of each Fund may decrease and the
market value of the California Bond Fund's securities may increase, which would
likely increase the Fund's net asset value and total return. The California
Money Market Fund's total return may decrease.
2
<PAGE>
As you consider an investment in any Fund, you should also take into account
your tolerance for the daily fluctuations of the financial markets and whether
you can afford to leave your money in this investment for long periods of time
to ride out down periods.
An investment in either Fund is not a deposit of USAA Federal Savings Bank and
is not insured or guaranteed by the Federal Deposit Insurance Corporation or
any other government agency. Although the California Money Market Fund seeks to
preserve the value of your investment at $1 per share, it is possible to lose
money by investing in that Fund.
[CAUTION LIGHT]
Look for this symbol throughout the Prospectus. We use it to mark more detailed
information about the main risks that you will face as a Fund shareholder.
ARE THESE FUNDS FOR YOU?
California Bond Fund
This Fund might be appropriate as part of your investment portfolio if . . .
|X| You are looking for current income that is exempt from California state
and federal income taxes.
|X| You are willing to accept moderate risk.
|X| You are looking for an investment in bonds to balance your stock
portfolio.
This Fund MAY NOT be appropriate as part of your investment portfolio if . . .
|X| You are unable or reluctant to invest for a period of four years or more.
|X| You are unwilling to take greater risk for intermediate-term goals.
|X| Your current tax situation does not allow you to benefit from tax-exempt
income.
|X| You are seeking an appropriate investment for an IRA, through a 401(k)
plan or 403(b) plan, or other tax-sheltered account.
California Money Market Fund
This Fund might be appropriate as part of your investment portfolio if . . .
|X| You are looking for current income that is exempt from California state
and federal income taxes.
|X| You need to preserve principal.
|X| You want a low-risk investment.
|X| You need your money back within a short period.
|X| You would like checkwriting privileges on the account.
|X| You are looking for an investment in a money market fund to balance your
stock or long-term bond portfolio.
3
<PAGE>
This Fund MAY NOT be appropriate as part of your investment portfolio if . . .
|X| You need a high total return to achieve your goals.
|X| Your primary goal is long-term growth.
|X| Your current tax situation does not allow you to benefit from tax-exempt
income.
COULD THE VALUE OF YOUR INVESTMENT IN THESE FUNDS FLUCTUATE?
Yes, it could. In fact, the value of your investment in the California Bond
Fund likely will increase or decrease. We manage the California Money Market
Fund in accordance with strict Securities and Exchange Commission (SEC)
guidelines designed to preserve the Fund's value at $1 per share, although, of
course, we cannot guarantee that the value will remain at $1 per share.
The value of the securities in which the California Bond Fund invests typically
fluctuates inversely with changes in the general level of interest rates.
Changes in the creditworthiness of issuers and changes in other market factors
such as the relative supply of and demand for tax-exempt bonds also create
value fluctuations. The bar charts shown below illustrate the Funds' volatility
and performance from year to year over the life of the Funds.
TOTAL RETURN
All mutual funds must use the same formulas to calculate total return.
TOTAL RETURN
MEASURES THE
PRICE CHANGE
IN A SHARE
ASSUMING THE
REINVESTMENT
OF ALL DIVIDEND
INCOME AND
CAPITAL GAIN
DISTRIBUTIONS.
California Bond Fund
[BAR CHART]
CALENDAR TOTAL RETURN
YEAR PERCENTAGE
1989* 1.39%
1990 8.17%
1991 10.90%
1992 8.29%
1993 12.74%
1994 -9.32%
1995 21.85%
1996 5.39%
1997 10.33%
*FUND BEGAN OPERATIONS ON AUGUST 1, 1989.
THE CALIFORNIA BOND FUND'S TOTAL RETURN FOR THE SIX-MONTH PERIOD ENDED
JUNE 30, 1998, WAS 2.88%.
4
<PAGE>
During the periods shown in the bar chart, the highest total return for a
quarter was 9.55% (quarter ending March 31, 1995) and the lowest return for a
quarter was -7.06% (quarter ending March 31, 1994).
The table below shows how the Fund's average annual returns for the one- and
five-year periods and the life of the Fund compared to those of a broad-based
securities market index. Remember, historical performance does not necessarily
indicate what will happen in the future.
===============================================================================
Average Annual Total Returns Since Fund's
(for the period ending Past Past Inception on
December 31, 1997) 1 Year 5 Years August 1, 1989
- -------------------------------------------------------------------------------
California Bond Fund 10.33% 7.69% 7.96%
- -------------------------------------------------------------------------------
Lehman Bros. Municipal
Bond Index* 9.19% 7.36% 8.02%
===============================================================================
* THE LEHMAN BROS. MUNICIPAL BOND INDEX IS AN UNMANAGED BENCHMARK OF TOTAL
RETURN PERFORMANCE FOR THE LONG-TERM, INVESTMENT-GRADE, TAX EXEMPT BOND
MARKET.
California Money Market Fund
[BAR CHART]
CALENDAR TOTAL RETURN
YEAR PERCENTAGE
1989* 2.38%
1990 5.60%
1991 4.39%
1992 2.91%
1993 2.26%
1994 2.58%
1995 3.64%
1996 3.27%
1997 3.35%
*FUND BEGAN OPERATIONS ON AUGUST 1, 1989.
THE CALIFORNIA MONEY MARKET FUND'S TOTAL RETURN FOR THE SIX-MONTH PERIOD
ENDED JUNE 30, 1998, WAS 1.64%.
During the periods shown in the bar chart, the highest total return for a
quarter was 1.47% (quarter ending December 31, 1989) and the lowest return for
a quarter was .51% (quarter ending March 31, 1994).
5
<PAGE>
YIELD
YIELD IS THE
ANNUALIZED NET
INCOME OF THE
FUND DURING A
SPECIFIED PERIOD
AS A PERCENTAGE
OF THE FUND'S
SHARE PRICE.
All mutual funds must use the same formulas to calculate yield and effective
yield.
California Bond Fund
The California Bond Fund may advertise performance in terms of a 30-day yield
quotation or a tax equivalent yield. The Fund's 30-day yield for the period
ended December 31, 1997, was 4.64%.
EFFECTIVE YIELD
IS CALCULATED
SIMILAR TO
THE YIELD,
HOWEVER, WHEN
ANNUALIZED,
THE INCOME
EARNED IS
ASSUMED TO BE
REINVESTED.
California Money Market Fund
The California Money Market Fund typically advertises performance in terms of a
7-day yield and effective yield or tax equivalent yield and may advertise total
return. The 7-day yield quotation more closely reflects current earnings of the
Fund than the total return quotation. The effective yield will be slightly
higher than the yield because of the compounding effect of the assumed
reinvestment. Current yields and effective yields fluctuate daily and will vary
with factors such as interest rates and the quality, length of maturities, and
type of investments in the portfolio. The Fund's 7-day yield for the period
ended December 31, 1998, was 3.66%.
You may obtain the most current yield information for either of the Funds by
calling 1-800-531-8777.
TAX EQUIVALENT YIELD
Investors use tax equivalent yields to compare taxable and tax-exempt fixed
income investments using a common yield measure. The tax equivalent yield is
the yield that a fully taxable investment must generate to earn the same
"take-home" yield as a tax-exempt investment. The calculation depends upon your
federal and California marginal income tax rates and assumes that an investor
can fully itemize deductions on his or her federal tax return. The higher your
marginal tax bracket, the higher will be the tax equivalent yield and the more
valuable is the Fund's tax exemption.
For example, if you assume a federal marginal tax rate of 36% and a state
marginal tax rate of 9.30%, the Effective Marginal Tax Rate would be 41.95%.
Using this tax rate, the Funds' tax equivalent yields for the period ending
December 31, 1997, would be as follows:
===============================================================================
Tax Equivalent
Yield Yield
- -------------------------------------------------------------------------------
California Bond Fund (30 day) 4.64% 7.99%
- -------------------------------------------------------------------------------
California Money Market Fund (7 day) 3.66% 6.31%
===============================================================================
6
<PAGE>
Using the example, to exceed the 30-day yield of the California Bond Fund on an
after-tax basis, you must find a fully taxable investment that yields more than
7.99%. Likewise, to exceed the 7-day yield of the California Money Market Fund,
you must find a fully taxable investment that yields more than 6.31%.
For more information on calculating tax equivalent yields, see APPENDIX B on
page 31.
[TELEPHONE GRAPHIC]
TouchLINE (R)
1-800-531-8777
PRESS
1
THEN
1
THEN
6 1 #
Please consider performance information in light of the Funds' investment
objectives and policies and market conditions during the reported time periods.
Again, you must remember that historical performance does not necessarily
indicate what will happen in the future. The value of your shares may go up or
down. For the most current price, yield, and return information for these
Funds, you may call TouchLine(R) at 1-800-531-8777. Press 1 for the Mutual Fund
Menu, press 1 again for prices, yields, and returns. Then, press 60# for the
California Bond Fund or press 61# for the California Money Market Fund when
asked for a Fund Code.
CALIFORNIA
BOND FUND
NEWSPAPER
SYMBOL
CA Bd
TICKER
SYMBOLS
USCBX
UCAXX
You can also find the most current price of your shares in the business section
of your newspaper in the mutual fund section under the heading "USAA Group" and
the symbol "CA Bd" for the California Bond Fund. If you prefer to obtain this
information from an on-line computer service, you can do so by using the ticker
symbol "USCBX" for the California Bond Fund or the ticker symbol "UCAXX" for
the California Money Market Fund.
FEES AND EXPENSES
This summary shows what it will cost you directly or indirectly to invest in
the Funds.
Shareholder Transaction Expenses -- Fees You Pay Directly
There are no fees or sales loads charged to your account when you buy or sell
Fund shares. However, if you sell shares and request your money by wire
transfer, there is a $10 fee. (Your bank may also charge a fee for receiving
wires.)
Annual Fund Operating Expenses -- Fees You Pay Indirectly
Fund expenses come out of the Funds' assets and are reflected in the Funds'
share prices and dividends. "Other Expenses" include expenses such as custodian
and transfer agent fees. The figures on the next page show actual expenses
during the past fiscal year ended March 31, 1998, and are calculated as a
percentage of average net assets.
7
<PAGE>
12B-1 FEES-
SOME MUTUAL
FUNDS CHARGE
THESE FEES
TO PAY FOR
ADVERTISING
AND OTHER
COSTS OF SELLING
FUND SHARES.
===============================================================================
California California
Bond Fund Money Market Fund
- -------------------------------------------------------------------------------
Management Fees .32% .32%
Distribution (12b-1) Fees None None
Other Expenses .08% .09%
---- ----
Total Annual Fund Operating Expenses .40% .41%
==== ====
===============================================================================
Example of Effect of the Funds' Operating Expenses
This example is intended to help you compare the cost of investing in one of
the Funds with the cost of investing in other mutual funds. Although your
actual costs may be higher or lower, you would pay the following expenses on a
$10,000 investment, assuming (1) 5% annual return, (2) the Fund's operating
expenses remain the same, and (3) you redeem all of your shares at the end of
those periods shown.
California California
Bond Fund Money Market Fund
- -------------------------------------------------------------------------------
1 year $ 41 $ 42
3 years 128 132
5 years 224 230
10 years 505 518
FUND INVESTMENTS
Principal Investment Strategies and Risks
Q What is each Fund's principal investment strategy?
A Each Fund's principal investment strategy is to invest the Fund's assets
in securities, the interest from which, in the opinion of counsel, is
excluded from gross income for federal income tax purposes and is exempt
from California state income taxes.
These securities include municipal debt obligations that have been
issued by California and its political subdivisions, and duly
constituted state and local authorities and corporations. We refer to
these securities as California tax-exempt securities. California
tax-exempt securities are issued to fund public infrastructure projects
such as streets and highways, schools, water and sewer systems,
hospitals, and airports. They may also be issued to refinance
outstanding obligations as well as to obtain funds for
8
<PAGE>
general operating expenses and for loans to other public institutions
and facilities.
Because the projects benefit the public, Congress has granted exemption
from federal income taxes for the interest income arising from these
securities. Likewise, the California Assembly has granted an exemption
from state personal income taxes for most California municipal
securities.
Q What types of tax-exempt securities will be included in each Fund's
portfolio?
A Each Fund's assets may be invested in any of the following tax-exempt
securities:
o general obligation bonds which are secured by the issuer's pledge of
its full faith, credit, and taxing power for the payment of
principal and interest;
o revenue bonds which are payable from the revenue 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, but not from the general taxing power;
o lease obligations backed by the municipality's covenant to budget
for the payments due under the lease obligation; and
o industrial development bonds issued by or on behalf of public
authorities to obtain funds for privately-operated facilities.
As a temporary defensive measure because of market, economic, political,
or other conditions, we may invest up to 100% of each Fund's assets in
short-term securities whether or not they are exempt from federal income
tax and California state taxes. To the extent that these temporary
investments produce taxable income, that income may result in that Fund
not fully achieving its investment objective during the time it is in
this temporary defensive posture.
Q What are the principal risks associated with investments in tax-exempt
securities?
A The two principal risks of investing in tax-exempt securities are credit
risk and market risk.
[CAUTION LIGHT]
CREDIT RISK. Credit risk is the possibility that an issuer of a fixed
income security will fail to make timely payments of interest or
principal. We attempt to minimize the Funds' credit risks by investing
in securities considered at least investment grade at the time of
purchase. Nevertheless, even investment-grade securities
9
<PAGE>
are subject to some credit risk. In addition, the ratings of securities
are estimates by the rating agencies of the credit quality of the
securities. The ratings may not take into account every risk related to
whether interest or principal will be repaid on a timely basis.
When evaluating potential investments for the Funds, our analysts also
independently assess credit risk and its impact on the Funds'
portfolios. Securities in the lowest investment grade ratings category
(BBB) have speculative characteristics. Changes in economic conditions
or other circumstances are more likely to lead to a weakened capability
to make principal and interest payments on these securities than is the
case for higher-rated securities.
[CAUTION LIGHT]
MARKET RISK. As a mutual fund investing in bonds, the Funds are subject
to the risk that the market value of the bonds will decline because of
rising interest rates. Bond prices are linked to the prevailing market
interest rates. In general, when interest rates rise, the prices of
bonds fall and when interest rates fall, bond prices generally rise. The
price volatility of a bond also depends on its maturity. Generally, the
longer the maturity of a bond, the greater its sensitivity to interest
rates. To compensate investors for this higher market risk, bonds with
longer maturities generally offer higher yields than bonds with shorter
maturities.
Q What percentage of each Fund's assets will be invested in California
tax-exempt securities?
A During normal market conditions, at least 80% of each Fund's net assets
will consist of California tax-exempt securities. This policy may only
be changed by a shareholder vote.
In addition to California tax-exempt securities, securities issued by
certain U.S. territories and possessions such as Puerto Rico, the Virgin
Islands, and Guam are exempt from federal and state personal income
taxes; and as such, we may consider investing up to 20% of each Fund's
assets in these securities.
Q Are each Fund's investments diversified in many different issuers?
A Each Fund is considered diversified under the federal securities laws.
This means that we will not invest more than 5% in any one issuer with
respect to 75% of each Fund's assets. With respect to the remaining 25%
of each Fund's assets, we could invest more than 5% in any one, or more,
issuers. Purchases of securities issued or guaranteed by the U.S.
Government or its agencies or instrumentalities are not counted toward
the 5%
10
<PAGE>
limitation. Each Fund, of course, is concentrated geographically through
the purchase of California tax-exempt securities.
With respect to the California Money Market Fund, strict SEC guidelines
do not permit us to invest, with respect to 75% of the Fund's assets,
greater than 10% of the Fund's assets in securities issued by or
subject to guarantees by the same institution.
We also may not invest more than 25% of the assets in securities issued
in connection with the financing of projects with similar
characteristics, such as toll road revenue bonds, housing revenue bonds,
or electric power project revenue bonds, or in industrial revenue bonds
which are based, directly or indirectly, on the credit of private
entities of any one industry. However, we reserve the right to invest
more than 25% of the Funds' assets in tax-exempt industrial revenue
bonds.
Q What are the potential risks associated with concentrating such a large
portion of each Fund's assets in one state?
[CAUTION LIGHT]
A The Funds are subject to credit and market risks, as described above,
which could be magnified by the Funds' concentration in California
issues. California tax-exempt securities may be affected by political,
economic, regulatory, or other developments that limit the ability of
California issuers to pay interest or repay principal in a timely
manner. Therefore, the Funds are affected by events within California to
a much greater degree than a more diversified national fund.
A particular development may not directly relate to the Funds'
investments but nevertheless might depress the entire market for the
state's tax-exempt securities and therefore adversely impact the Funds'
valuation.
An investment in the California Money Market Fund may be riskier than an
investment in other types of money market funds because of this
concentration.
The following are examples of just some of the events that may depress
valuations for California tax-exempt securities for an extended period
of time:
o Changes in state laws, including voter referendums, that restrict
revenues or raise costs for issuers.
o Court decisions that affect a category of municipal bonds, such as
municipal lease obligations or electric utilities.
11
<PAGE>
o Natural disasters such as floods, storms, hurricanes, droughts, fires,
or earthquakes.
o Bankruptcy or financial distress of a prominent municipal issuer
within the state.
o Economic issues that impact critical industries or large employers or
that weaken real estate prices.
o Reductions in federal or state financial aid.
o Imbalance in the supply and demand for the state's municipal
securities.
o Developments that may change the tax treatment of California municipal
securities.
In addition, because each Fund invests in securities backed by banks and
other financial institutions, changes in the credit quality of these
institutions could cause losses to a Fund and affect its share price.
Other considerations affecting the Funds' investments in California
tax-exempt securities are summarized in the Statement of Additional
Information under SPECIAL RISK CONSIDERATIONS.
Q Will any portion of the distributions from the Funds be subject to
federal income taxes?
A During normal market conditions, at least 80% of each Fund's annual
income will be excluded from gross income for federal income tax
purposes and will be exempt from California state income taxes. This
policy may only be changed by a shareholder vote. We expect that any
taxable interest income distributed will be minimal.
However, gains and losses from trading securities that occur during the
normal course of managing a fund may create net capital gain
distributions. The Internal Revenue Code presently treats these
distributions differently than tax-exempt interest income in the
following ways:
o Distributions of net short-term capital gains are taxable as ordinary
income.
o Distributions of net long-term capital gains are taxable as long-term
capital gains, regardless of the length of time you have held the Fund
shares. These distributions may be taxable at different rates
depending on the length of time the Funds held the applicable
investment.
12
<PAGE>
o Both short-term and long-term capital gains are taxable whether
received in cash or reinvested in additional shares.
Q Will income from the Funds be subject to the federal alternative minimum
tax (AMT) for individuals?
A During normal market conditions, at least 80% of each Fund's annual
income will be excluded from the calculation of the federal alternative
minimum tax (AMT) for individuals. This policy may only be changed by a
shareholder vote. Since inception, the Funds have not distributed any
income that is subject to the federal AMT for individuals, and we do not
intend to invest in securities subject to the federal AMT. However, of
course, changes in federal tax laws or other unforeseen circumstances
could result in income subject to the federal AMT for individuals.
California Bond Fund
Q What is the credit quality of the Fund's investments?
A Under normal market conditions, we will invest the Fund's assets so that
at least 50% of the total market value of the tax-exempt securities is
rated within the three highest long-term rating categories (A or higher)
by Moody's Investors Service, Inc. (Moody's), Standard & Poor's Ratings
Group (S&P), or Fitch IBCA, Inc. (Fitch) or in the highest short-term
rating category by Moody's, S&P, or Fitch; or if a security is not rated
by these rating agencies, we must determine that the security is of
equivalent investment quality.
In no event will we purchase a security for the Fund unless it is rated
at least investment grade at the time of purchase. Investment-grade
securities are those securities rated within the four highest long-term
rating categories by Moody's (Baa or higher), S&P, or Fitch (BBB or
higher), or in the two highest short-term rating categories by these
rating agencies; or if unrated by these agencies, we must determine that
the securities are of equivalent investment quality.
You will find a complete description of the above tax-exempt ratings in
the Fund's Statement of Additional Information.
Q What happens if the rating of a security is downgraded below investment
grade?
A We will determine whether it is in the best interest of the Fund's
shareholders to continue to hold the security in the Fund's portfolio.
If downgrades result in more than 5% of the Fund's net assets being
invested in securities that are less than investment-grade quality, we
13
<PAGE>
will take immediate action to reduce the Fund's holdings in such
securities to 5% or less of the Fund's net assets, unless otherwise
directed by the Board of Directors.
Q How does the portfolio manager decide which securities to buy and sell?
A He manages tax-exempt funds based on the common sense premise that our
investors value tax-exempt income over taxable capital gain
distributions. When weighing his decision to buy or sell a security, he
strives to balance the value of the tax-exempt income, the credit risk
of the issuer, and the price volatility of the bond.
Q What is the Fund's average portfolio maturity and how is it calculated?
A While the Fund's average portfolio maturity is not restricted, we expect
it to be greater than 10 years. To determine a security's maturity for
purposes of calculating the Fund's average portfolio maturity, we may
estimate the expected time in which the security's principal is to be
paid. This can be substantially shorter than its stated final maturity.
For more information on the method of calculating the Fund's average
weighted portfolio maturity, see INVESTMENT POLICIES in the Fund's
Statement of Additional Information.
California Money Market Fund
Q What is the credit quality of the Fund's investments?
A The Fund's investments consist of securities meeting the requirements to
qualify as "eligible securities" under the SEC rules applicable to money
market funds. In general, an eligible security is defined as a security
that is:
o issued or guaranteed by the U.S. Government or any agency or
instrumentality thereof, including "prerefunded" and "escrowed to
maturity" tax-exempt securities;
o rated or subject to a guarantee that is rated in one of the two
highest categories for short-term securities by at least two
Nationally Recognized Statistical Rating Organizations (NRSROs), or
by one NRSRO if the security is rated by only one NRSRO;
o unrated but issued by an issuer or guaranteed by a guarantor that has
other comparable short-term debt obligations so rated; or
14
<PAGE>
o unrated but determined by us to be of comparable quality.
In addition, we must consider whether a particular investment presents
minimal credit risk.
Q Who are the Nationally Recognized Statistical Rating Organizations?
A Current NRSROs include:
o Moody's Investors Service, Inc.;
o Standard & Poor's Ratings Group;
o Fitch IBCA, Inc.;
o Duff & Phelps Inc.; and
o Thompson BankWatch, Inc.
Q What happens if the rating of a security is downgraded?
A If the rating of a security is downgraded after purchase, we will
determine whether it is in the best interest of the Fund's shareholders
to continue to hold the security in the Fund's portfolio.
Q Will the Fund always maintain a net asset value of $1 per share?
A While we will endeavor to maintain a constant Fund net asset value of $1
per share, there is no assurance that we will be able to do so.
Remember, the shares are neither insured nor guaranteed by the U.S.
Government. As such, the Fund carries some risk.
For example, there is always a risk that the issuer of a security held
by the Fund will fail to pay interest or principal when due. We attempt
to minimize this credit risk by investing only in securities rated in
one of the two highest categories for short-term securities, or, if not
rated, of comparable quality, at the time of purchase. Additionally, we
will not purchase a security unless our analysts determine that the
security presents minimal credit risk.
There is also a risk that rising interest rates will cause the value of
the Fund's securities to decline. We attempt to minimize this interest
risk by limiting the maturity of each security to 397 days or less and
maintaining a dollar-weighted average portfolio maturity for the Fund of
90 days or less.
DOLLAR-
WEIGHTED
AVERAGE
PORTFOLIO
MATURITY IS
OBTAINED BY
MULTIPLYING
THE DOLLAR
VALUE OF EACH
INVESTMENT
BY THE NUMBER
OF DAYS LEFT TO
ITS MATURITY,
THEN ADDING
THOSE FIGURES TOGETHER
AND DIVIDING THE
TOTAL BY THE
DOLLAR VALUE
OF THE FUND'S
PORTFOLIO.
Finally, there is the possibility that one or more investments in the
Fund cease to be "eligible securities" resulting in the net asset value
ceasing to be $1 per share. For example, a guarantor on a security may
fail to meet a contractual obligation.
15
<PAGE>
Q How does the portfolio manager decide which securities to buy and sell?
A He balances factors such as credit quality and maturity to purchase the
best relative value available in the market at any given time. While
rare, sell decisions are usually based on a change in his credit
analysis or to take advantage of an opportunity to reinvest at a higher
yield.
For additional information about other securities in which we may invest each
Fund's assets, see APPENDIX A on page 29.
FUND MANAGEMENT
The Company has retained us, USAA Investment Management Company, to serve as
the manager and distributor for the Company. We are an affiliate of United
Services Automobile Association (USAA), a large, diversified financial services
institution. As of the date of this Prospectus, we had approximately $39
billion in total assets under management. Our mailing address is 9800
Fredericksburg Road, San Antonio, TX 78288.
We provide management services to the Funds pursuant to an Advisory Agreement.
We are responsible for managing the Funds' portfolios (including placement of
brokerage orders) and their business affairs, subject to the authority of and
supervision by the Board of Directors. For our services, the Funds pay us an
annual fee. This fee, which is accrued daily and paid monthly, is computed as a
percentage of the aggregate average net assets of both Funds combined. This fee
is allocated between the Funds based on the relative net assets of each. The
fee is computed at one-half of one percent (.50%) of the first $50 million of
average net assets, two-fifths of one percent (.40%) for that portion of
average net assets over $50 million but not over $100 million, and three-tenths
of one percent (.30%) for that portion of average net assets over $100 million.
The fees we received for the fiscal year ended March 31, 1998, were equal to
.32% of average net assets for the California Bond Fund and .32% of average net
assets for the California Money Market Fund. We also provide services related
to selling the Funds' shares and receive no compensation for those services.
Although our officers and employees, as well as those of the Company, may
engage in personal securities transactions, they are restricted by the
procedures in a Joint Code of Ethics adopted by the Company and us.
16
<PAGE>
PORTFOLIO MANAGERS
The following individuals are primarily responsible for managing the Funds:
CALIFORNIA BOND FUND
[PHOTOGRAPH OF
PORTFOLIO MANAGER]
Robert R. Pariseau
Robert R. Pariseau, Assistant Vice President of Fixed Income Investments since
June 1995, has managed the Fund since May 1995. He has 14 years investment
management experience working for us. Mr. Pariseau earned the Chartered
Financial Analyst (CFA) designation in 1987 and is a member of the Association
for Investment Management and Research (AIMR), San Antonio Financial Analysts
Society, Inc. (SAFAS), and the National Federation of Municipal Analysts
(NFMA). He holds an MBA from Lindenwood College and a BS from the U.S. Naval
Academy.
CALIFORNIA MONEY MARKET FUND
[PHOTOGRAPH OF
PORTFOLIO MANAGER]
John C. Bonnell
John C. Bonnell, Executive Director of Money Market Funds since May 1996, has
managed the Fund since May 1996. He has nine years investment management
experience working for us. Mr. Bonnell earned the CFA designation in 1994 and
is a member of AIMR, SAFAS, NFMA, and the Southern Municipal Finance Society.
He holds an MBA from St. Mary's University and a BBA from the University of
Texas at San Antonio.
USING MUTUAL FUNDS IN AN INVESTMENT PROGRAM
I. The Idea Behind Mutual Funds
Mutual funds provide small investors some of the advantages enjoyed by wealthy
investors. A relatively small investment can buy part of a diversified
portfolio. That portfolio is managed by investment professionals, relieving you
of the need to make individual stock or bond selections. You also enjoy
conveniences, such as daily pricing, liquidity, and in the case of the USAA
Family of Funds, no sales charge. The portfolio, because of its size, has lower
transaction costs on its trades than most individuals would have. As a result,
you own an investment that in earlier times would have been available only to
very wealthy people.
17
<PAGE>
II. Using Funds in an Investment Program
In choosing a mutual fund as an investment vehicle, you are giving up some
investment decisions, but must still make others. The decisions you don't have
to make are those involved with choosing individual securities. We will perform
that function. In addition, we will arrange for the safekeeping of securities,
auditing the annual financial statements, and daily valuation of the Fund, as
well as other functions.
You, however, retain at least part of the responsibility for an equally
important decision. This decision involves determining a portfolio of mutual
funds that balances your investment goals with your tolerance for risk. It is
likely that this decision may include the use of more than one fund of the USAA
Family of Funds.
For example, assume you wish to pursue the higher yields usually available in
the long-term bond market, but you are also concerned about the possible price
swings of the long-term bonds. You could divide your investments between the
California Bond Fund and the California Money Market Fund. This would create a
portfolio with a higher yield than that of the money market and less volatility
than that of the long-term market. This is just one way you could combine funds
to fit your own risk and reward goals.
III. USAA's Family of Funds
We offer you another alternative with our asset strategy funds listed under
asset allocation on page 32. These unique mutual funds provide a professionally
managed diversified investment portfolio within a mutual fund. Designed for the
individual who prefers to delegate the asset allocation process to an
investment manager, their structure achieves diversification across a number of
investment categories.
Whether you prefer to create your own mix of mutual funds or use a USAA Asset
Strategy Fund, the USAA Family of Funds provides a broad range of choices
covering just about any investor's investment objectives. Our sales
representatives stand ready to assist you with your choices and to help you
craft a portfolio to meet your needs. Refer to APPENDIX C on page 32 for a
complete list of the USAA Family of No-Load Mutual Funds.
HOW TO INVEST
Purchase of Shares
OPENING AN ACCOUNT
You may open an account and make an investment as described below by mail, in
person, bank wire, electronic funds transfer (EFT), or phone. A complete,
signed application is required for new accounts. However, after you open your
initial account with us, you will not need to fill out another application
unless the registration is different.
18
<PAGE>
TAX ID NUMBER
Each shareholder named on the account must provide a social security number or
tax identification number to avoid possible withholding requirements.
EFFECTIVE DATE
When you make a purchase, your purchase price will be the net asset value (NAV)
per share next determined after we receive your request in proper form. Each
Fund's NAV is determined at the close of the regular trading session (generally
4:00 p.m. Eastern Time) of the New York Stock Exchange (NYSE) each day the NYSE
is open. If we receive your request and payment prior to that time, your
purchase price will be the NAV per share determined for that day. If we receive
your request or payment after the NAV per share is calculated, the purchase
will be effective on the next business day. If you plan to purchase Fund shares
with a foreign check, we suggest you convert your foreign check to U.S. dollars
prior to investment in a Fund to avoid a potential delay in the effective date
of your purchase of up to four to six weeks. Furthermore, a ban k charge may be
assessed in the clearing process, which will be deducted from the amount of the
purchase.
MINIMUM INVESTMENTS
INITIAL PURCHASE
[MONEY GRAPHIC]
o $3,000. Employees of USAA and its affiliated companies may open an account
through payroll deduction for as little as $25 per pay period with no
initial investment.
ADDITIONAL PURCHASES
o $50 (Except transfers from brokerage accounts into the California Money
Market Fund, which are exempt from the minimum).
HOW TO PURCHASE
MAIL
[ENVELOPE GRAPHIC]
o To open an account, send your application and check to:
USAA Investment Management Company
9800 Fredericksburg Road
San Antonio, TX 78288
o To add to your account, send your check and the "Invest by Mail" stub that
accompanies your Fund's transaction confirmation to the Transfer Agent:
USAA Shareholder Account Services
9800 Fredericksburg Road
San Antonio, TX 78288
19
<PAGE>
IN PERSON
[HANDSHAKE GRAPHIC]
o To open an account, bring your application and check to:
USAA Investment Management Company
USAA Federal Savings Bank
10750 Robert F. McDermott Freeway
San Antonio, TX 78288
BANK WIRE
[WIRE GRAPHIC]
o Instruct your bank (which may charge a fee for the service) to wire the
specified amount to the Fund as follows:
State Street Bank and Trust Company
Boston, MA 02101
ABA#011000028
Attn: USAA California Fund Name
USAA Account Number: 69384998
Shareholder(s) Name(s)______________________________________
Shareholder(s) Mutual Fund Account Number___________________
ELECTRONIC FUNDS TRANSFER
[CALENDAR GRAPHIC]
o Additional purchases on a regular basis can be deducted from a bank
account, paycheck, income-producing investment, or USAA money market fund
account. Sign up for these services when opening an account or call
1-800-531-8448 to add these services.
PHONE 1-800-531-8448
[TELEPHONE GRAPHIC]
o If you have an existing USAA account and would like to open a new account
or exchange to another USAA fund, call for instructions. To open an account
by phone, the new account must have the same registration as your existing
account.
Redemption of Shares
You may redeem Fund shares by any of the methods described below on any day the
NAV per share is calculated. Redemptions are effective on the day instructions
are received in a manner as described below. However, if instructions are
received after the NAV per share calculation (generally 4:00 p.m. Eastern
Time), redemption will be effective on the next business day.
We will send you your money within seven days after the effective date of
redemption. Payment for redemption of shares purchased by EFT or check is sent
after the EFT or check has cleared, which could take up to 15 days from the
purchase date. If you are considering redeeming shares soon after purchase, you
should purchase by bank wire or certified check to avoid delay. Redemptions are
subject to taxes based on the difference between the cost of shares when
purchased and the price received upon redemption.
20
<PAGE>
In addition, the Company may elect to suspend the redemption of shares or
postpone the date of payment in limited circumstances.
HOW TO REDEEM
WRITTEN, FAX, TELEGRAPH, OR TELEPHONE
[FAX MACHINE GRAPHIC]
o Send your written instructions to:
USAA Shareholder Account Services
9800 Fredericksburg Road
San Antonio, TX 78288
o Send a signed fax to 1-800-292-8177, or send a telegram to USAA Shareholder
Account Services.
o Call toll free 1-800-531-8448, in San Antonio, 456-7202.
Telephone redemption privileges are automatically established when you complete
your application. The Fund will employ reasonable procedures to confirm that
instructions communicated by telephone are genuine; and if it does not, it may
be liable for any losses due to unauthorized or fraudulent instructions. Before
any discussion regarding your account, we obtain the following information: (1)
USAA number or account number, (2) the name(s) on the account registration, and
(3) social security number or tax identification number for the account
registration. In addition, we record all telephone communications with you and
send confirmations of account transactions to the address of record. If you
were issued stock certificates for your shares, redemption by telephone, fax,
or telegram is not available.
CHECKWRITING
[CHECKBOOK GRAPHIC]
o Checks can be issued for your California Money Market Fund account.
Return a signed signature card, which accompanies your application, or
request a signature card separately and return to:
USAA Shareholder Account Services
9800 Fredericksburg Road
San Antonio, TX 78288
You will not be charged for the use of checks or any subsequent reorders. Your
checkwriting privilege is subject to State Street Bank and Trust Company's
rules and regulations governing checking accounts. You may write checks in the
amount of $250 or more. Checks written for less than $250 will be returned
unpaid. Because the value of your account changes daily as dividends accrue,
you may not write a check to close your account.
21
<PAGE>
IMPORTANT INFORMATION ABOUT PURCHASES AND REDEMPTIONS
Investor's Guide to USAA Mutual Fund Services
[INVESTOR'S GUIDE GRAPHIC]
Upon your initial investment with us, you will receive the INVESTOR'S GUIDE to
help you get the most out of your USAA mutual fund account and to help you in
your role as an investor. In the INVESTOR'S GUIDE, you will find additional
information on purchases, redemptions, and methods of payment. You will also
find in-depth information on automatic investment plans, shareholder statements
and reports, and other useful information.
Account Balance
USAA Shareholder Account Services (SAS), the Funds' transfer agent, may assess
annually a small balance account fee of $12 to each shareholder account with a
balance, at the time of assessment, of less than $2,000. The fee will reduce
total transfer agency fees paid by the Fund to SAS. Accounts exempt from the
fee include: (1) any account regularly purchasing additional shares each month
through an automatic investment plan; (2) any account registered under the
Uniform Gifts/Transfers to Minors Act (UGMA/UTMA); (3) all (non-IRA) money
market fund accounts; (4) any account whose registered owner has an aggregate
balance of $50,000 or more invested in USAA mutual funds; and (5) all IRA
accounts (for the first year the account is open).
Company Rights
The Company reserves the right to:
o reject purchase or exchange orders when in the best interest of the
Company;
o limit or discontinue the offering of shares of any portfolio of the Company
without notice to the shareholders;
o impose a redemption charge of up to 1% of the net asset value of shares
redeemed if circumstances indicate a charge is necessary for the protection
of remaining investors (for example, if excessive market-timing share
activity unfairly burdens long-term investors); however, this 1% charge
will not be imposed upon shareholders unless authorized by the Board of
Directors and the required notice has been given to shareholders;
o require a signature guarantee for transactions or changes in account
information in those instances where the appropriateness of a
22
<PAGE>
signature authorization is in question. The Statement of Additional
Information contains information on acceptable guarantors;
o redeem an account with less than 50 full shares, with certain limitations.
EXCHANGES
Exchange Privilege
The exchange privilege is automatic when you complete your application. You may
exchange shares among Funds in the USAA Family of Funds, provided you do not
hold these shares in stock certificate form and the shares to be acquired are
offered in your state of residence. Only California residents may exchange into
a California Fund. The Funds' transfer agent will simultaneously process
exchange redemptions and purchases at the share prices next determined after
the exchange order is received. The investment minimums applicable to share
purchases also apply to exchanges. For federal income tax purposes, an exchange
between Funds is a taxable event; and as such, you may realize a capital gain
or loss. Such capital gains or losses are based on the difference between the
cost of shares when purchased and the price received upon exchange.
The Funds have undertaken certain procedures regarding telephone transactions
as described on page 21.
Exchange Limitations, Excessive Trading
To minimize Fund costs and to protect the Funds and their shareholders from
unfair expense burdens, the Funds restrict excessive exchanges. The limit on
exchanges out of any Fund in the USAA Family of Funds for each account is six
per calendar year (except there is no limitation on exchanges out of the Tax
Exempt Short-Term Fund, Short-Term Bond Fund, or any of the money market funds
in the USAA Family of Funds).
SHAREHOLDER INFORMATION
NAV
EQUALS
TOTAL ASSETS
MINUS
LIABILITIES
DIVIDED BY
# OF SHARES OUTSTANDING
Share Price Calculation
The price at which you purchase and redeem Fund shares is equal to the net
asset value (NAV) per share determined on the effective date of the purchase or
redemption. You may buy and sell Fund shares at the NAV per share without a
sales charge. Each Fund's NAV per share is calculated at the close of the
regular trading session of the NYSE, which is usually 4:00 p.m. Eastern Time.
Securities of the California Bond Fund are valued each business day at their
current market value as determined by a pricing service approved by the
Company's Board of Directors. Securities which cannot be valued by the
23
<PAGE>
pricing service, and all other assets, are valued in good faith at fair value
using methods we have determined under the general supervision of the Board of
Directors. In addition, securities with maturities of 60 days or less and all
securities of the California Money Market Fund are stated at amortized cost,
which approximates market value.
For additional information on how securities are valued, see VALUATION OF
SECURITIES in the Funds' Statement of Additional Information.
Dividends and Distributions
Net investment income of each Fund is accrued daily and paid on the last
business day of the month. Dividends shall begin accruing on shares purchased
the day following the effective date and shall continue to accrue to the
effective date of redemption. Any net capital gain distribution usually occurs
within 45 days of the March 31 fiscal year end, which would be somewhere around
the middle of May. The Funds will make additional payments to shareholders, if
necessary, to avoid the imposition of any federal income or excise tax.
All income dividends and capital gain distributions are automatically
reinvested, unless we receive different instructions from you. The share price
will be the NAV of the Fund shares computed on the ex-dividend date. Any
capital gain distributions paid by the California Bond Fund will reduce the NAV
per share by the amount of the dividend or distribution. These dividends and
distributions are subject to taxes. If you become a resident of a state other
than California, we will mail a check for proceeds of income dividends to you
monthly. We will mail a check for any capital gain distribution to you after
the distribution is paid.
We will invest any dividend or distribution payment returned to us in your
account at the then-current NAV per share. Dividend and distribution checks
become void six months from the date on the check. The amount of the voided
check will be invested in your account at the then-current NAV per share.
Federal Taxes
This tax information is quite general and refers to the federal income tax
provisions in effect as of the date of this Prospectus. While we manage the
Funds so that at least 80% of each Fund's annual income will be exempt from
federal or state income taxes, we may invest up to 20% of the Funds' assets in
securities that generate income not exempt from federal or state income taxes.
Because interest income may be exempt for federal income tax purposes, it does
not necessarily mean that the interest income may be exempt under the income or
other tax laws of any state or local taxing authority. As discussed earlier on
page 12, capital gains distributed by a Fund may be taxable. Note that
24
<PAGE>
the Taxpayer Relief Act of 1997 and regulations that will likely be adopted to
implement the Act may affect the status and treatment of certain distributions
shareholders receive from the Funds. We urge you to consult your own tax
adviser about the status of distributions from the Funds in your own state and
locality.
WITHHOLDING - Federal law requires each Fund to withhold and remit to the U.S.
Treasury a portion of the income dividends and capital gain distributions and
proceeds of redemptions paid to any non-corporate shareholder who:
o fails to furnish the Fund with a correct tax identification number,
o underreports dividend or interest income, or
o fails to certify that he or she is not subject to withholding.
To avoid this withholding requirement, you must certify on your application, or
on a separate Form W-9 supplied by the Funds' transfer agent, that your tax
identification number is correct and you are not currently subject to backup
withholding.
REPORTING - Each Fund will report information to you concerning the tax status
of dividends and distributions for federal income tax purposes annually,
including the portion of the dividends constituting interest on private
activity bonds and the percentage and source of interest income earned on
tax-exempt securities held by the Funds during the preceding year.
California Taxation
The following is only a summary of some of the important California personal
income tax considerations generally affecting the Funds and their shareholders.
This discussion is not intended as a substitute for careful planning. As a
potential investor in the Funds, you should consult your tax adviser with
specific reference to your own tax situations.
California law relating to the taxation of regulated investment companies was
generally conformed to federal law effective January 1, 1997. Any portion of
the dividends paid by the Funds and derived from interest on obligations that
pay interest (when such obligations are held by an individual) which is
excludable from California personal income under California law including
obligations of certain territories and possessions of the United States such as
Puerto Rico, the Virgin Islands, and Guam will be exempt from California
personal income tax (although not from the California franchise tax). To the
extent a portion of the dividends are derived from interest on debt obligations
other than those described directly above, such portion will be subject to the
California personal and corporate income tax even though it may be excludable
from gross income for federal income tax purposes. In addition, distributions
of short-term capital gains realized by the Funds will be taxable to the
shareholders as ordinary income. Distributions of long-term capital
25
<PAGE>
gains will be taxable as such to the shareholders regardless of how long they
have held their shares. If shares of the Funds that are sold at a loss have
been held six months or less, the loss will be disallowed to the extent of any
exempt-interest dividends received on such shares.
With respect to non-corporate shareholders, California does not treat tax-
exempt interest as a tax preference item for purposes of its alternative
minimum tax. To the extent a corporate shareholder receives dividends which are
exempt from California taxation, a portion of such dividends may be subject to
the alternative minimum tax. Interest on indebtedness incurred to purchase or
carry shares of an investment company paying exempt-interest dividends, such as
the Funds, will not be deductible by the shareholder for California personal
income tax purposes.
Year 2000
Like other organizations around the world, the Funds could be adversely
affected if the computer systems used by them, their service providers, or
companies in which they invest do not properly process and calculate
information that relates to dates beginning January 1, 2000, and beyond. This
situation may occur because for many years computer programmers used only two
digits to describe years, such as 98 for 1998. A program written in this manner
may not work when it encounters the year 00. To confront this situation, USAA
companies have spent much effort and money; and we expect to have our systems
ready for the Year 2000 by mid-1999. In addition, we are actively assessing the
Year 2000 readiness of our service providers, partners, and companies in whose
securities we invest. It is not possible for us to say that you will experience
no effect from this situation, but we can say that we are making a large effort
to avoid any ill effects upon our shareholders.
We do believe you are entitled to know with certainty that we will stand behind
your share balance as of the close of business in 1999. When the market reopens
in 2000, should any computer problem cause a change in the number of shares in
your account, we will return your account to its proper share balance.
26
<PAGE>
FINANCIAL HIGHLIGHTS
The financial highlights tables are intended to help you understand the Funds'
financial performance for the past five years. Certain information reflects
financial results for a single Fund share. The total returns in the tables
represent the rate that an investor would have earned (or lost) on an
investment in the Fund (assuming reinvestment of all dividends and
distributions). This information has been audited by KPMG Peat Marwick LLP,
whose report, along with the Funds' financial statements, are included in the
Annual Report, which is available upon request.
California Bond Fund:
Year Ended March 31,
-------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Net asset value at
beginning of period $ 10.50 $ 10.43 $ 10.10 $ 10.03 $10.75
Net investment income .60 .61 .60 .59 .59
Net realized and
unrealized gain (loss) .67 .07 .33 .07 (.52)
Distributions from
investment income (.60) (.61) (.60) (.59) (.59)
Distributions from net
realized capital gains -- -- -- -- (.20)
-------- ------- -------- -------- --------
Net asset value at
end of period $ 11.17 $ 10.50 $ 10.43 $ 10.10 $ 10.03
======== ======== ======== ======== ========
Total return (%)* 12.33 6.60 9.35 6.89 .31
Net assets at end of
period (000) $533,747 $440,231 $409,180 $372,877 $382,766
Ratio of expenses to
average net assets (%) .40 .41 .42 .44 .44
Ratio of net investment
income to average net
assets (%) 5.47 5.74 5.74 5.98 5.40
Portfolio turnover (%) 20.16 23.72 23.09 28.86 102.85
- -----------------
* Assumes reinvestment of all dividend income distributions during the
period.
27
<PAGE>
Financial Highlights (cont.)
California Money Market Fund:
Year Ended March 31,
-------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Net asset value at
beginning of period $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
Net investment income .03 .03 .04 .03 .02
Distributions from net
investment income (.03) (.03) (.04) (.03) (.02)
-------- -------- -------- -------- --------
Net asset value at
end of period $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
======== ======== ======== ======== ========
Total return (%)* 3.35 3.23 3.58 2.94 2.22
Net assets at end of
period (000) $431,754 $341,128 $296,349 $266,764 $247,303
Ratio of expenses to
average net assets (%) .41 .45 .47 .47 .49
Ratio of net investment
income to average net
assets (%) 3.30 3.19 3.52 2.91 2.19
- ---------------------
* Assumes reinvestment of all dividend income distributions during the period.
28
<PAGE>
APPENDIX A
THE FOLLOWING ARE DESCRIPTIONS OF CERTAIN TYPES OF SECURITIES IN WHICH WE MAY
INVEST EACH FUND'S ASSETS:
VARIABLE RATE SECURITIES
We may invest a Fund's assets in new securities that bear interest at rates
which are adjusted periodically to market rates.
o These interest rate adjustments can both raise and lower the income
generated by such securities. These changes will have the same effect on
the income earned by the Fund depending on the proportion of such
securities held.
o The value of variable rate securities is less affected than fixed-coupon
securities by changes in prevailing interest rates because of the periodic
adjustment of their coupons to a market rate. The shorter the period
between adjustments, the smaller the impact of interest rate fluctuations
on the value of these securities.
o The market value of a variable rate security usually tends toward par (100%
of face value) at interest rate adjustment time.
In the case of the California Money Market Fund only, any variable rate
instrument with a demand feature will be deemed to have a maturity equal to
either the date on which the underlying principal amount may be recovered
through demand or the next rate adjustment date consistent with applicable
regulatory requirements.
PUT BONDS
We may invest a Fund's assets in tax-exempt securities (including securities
with variable interest rates) which may be redeemed or sold back (put) to the
issuer of the security or a third party prior to stated maturity (put bonds).
Such securities will normally trade as if maturity is the earlier put date,
even though stated maturity is longer. For the California Bond Fund, maturity
for put bonds is deemed to be the date on which the put becomes exercisable.
Generally, maturity for put bonds for the California Money Market Fund is
determined as stated under Variable Rate Securities.
ZERO COUPON BONDS
We may invest a Fund's assets in zero coupon bonds. A zero coupon bond is a
security that is sold at a deep discount from its face value, makes no periodic
interest payments, and is redeemed at face value when it matures. The lump sum
payment at maturity increases the price volatility of the zero coupon bond to
changes in interest rates when compared to a bond that distributes a semiannual
coupon payment. In calculating its dividend, each Fund records as income the
daily amortization of the purchase discount.
29
<PAGE>
WHEN-ISSUED SECURITIES
We may invest a Fund's assets in new securities offered on a when-issued basis.
o Delivery and payment take place after the date of thecommitment to
purchase, normally within 45 days. Both price and interest rate are fixed
at the time of commitment.
o The Funds do not earn interest on the securities until settlement, and the
market value of the securities may fluctuate between purchase and
settlement.
o Such securities can be sold before settlement date.
MUNICIPAL LEASE OBLIGATIONS
We may invest a Fund's assets in a variety of instruments commonly referred to
as municipal lease obligations, including:
o Leases,
o Installment purchase contracts, and
o Certificates of participation in such leases and contracts.
Certain lease obligations contain "non-appropriation" clauses which provide
that the municipality has no obligation to make lease obligation payments in
future years unless money is appropriated for such purpose on a yearly basis.
LIQUIDITY
We may invest up to 15% of the California Bond Fund's net assets and up to 10%
of the California Money Market Fund's net assets in securities which are
illiquid. Illiquid securities are those securities that cannot be disposed of
in the ordinary course of business, seven days or less, at approximately the
value at which the Fund has valued the securities.
Lease obligations and certain put bonds subject to restrictions on transfer may
be determined to be liquid in accordance with the guidelines established by the
Funds' Board of Directors.
In determining the liquidity of a lease obligation, we will consider: (1) the
frequency of trades and quotes for the lease obligation; (2) the number of
dealers willing to purchase or sell the lease obligation and the number of
other potential purchasers; (3) dealer undertakings to make a market in the
lease obligation; (4) the nature of the marketplace trades, including the time
needed to dispose of the lease obligation, the method of soliciting offers, and
the mechanics of transfer; (5) whether the lease obligation is of a size that
will be attractive to institutional investors; (6) whether the lease obligation
contains a non-appropriation clause and the likelihood that the obligor will
fail to make an appropriation therefor; and (7) such other factors as we may
determine to be relevant to such determination.
In determining the liquidity of put bonds with restrictions on transfer, we
will evaluate the credit quality of the party (the Put Provider) issuing (or
unconditionally guaranteeing performance on) the unconditional put or demand
feature of the put bond.
30
<PAGE>
APPENDIX B
Taxable Equivalent Yield Table
COMBINED FEDERAL AND
CALIFORNIA STATE INCOME TAX RATES
Assuming a Federal
Marginal Tax Rate of: 28% 31% 36% 39.6%
and a State Rate of: 8.0% 9.3% 9.3% 9.3%
The Effective Marginal
Tax Rate would be: 33.760%(a) 37.417%(b) 41.952%(c) 45.217%(d)
To Match a Double
Tax Free Yield of: A Fully Taxable Investment Would Have to Pay You:
===============================================================================
2.00% 3.02% 3.20% 3.45% 3.65%
- -------------------------------------------------------------------------------
2.50% 3.77% 3.99% 4.31% 4.56%
- -------------------------------------------------------------------------------
3.00% 4.53% 4.79% 5.17% 5.48%
- -------------------------------------------------------------------------------
3.50% 5.28% 5.59% 6.03% 6.39%
- -------------------------------------------------------------------------------
4.00% 6.04% 6.39% 6.89% 7.30%
- -------------------------------------------------------------------------------
4.50% 6.79% 7.19% 7.75% 8.21%
- -------------------------------------------------------------------------------
5.00% 7.55% 7.99% 8.61% 9.13%
- -------------------------------------------------------------------------------
5.50% 8.30% 8.79% 9.47% 10.04%
- -------------------------------------------------------------------------------
6.00% 9.06% 9.59% 10.34% 10.95%
- -------------------------------------------------------------------------------
6.50% 9.81% 10.39% 11.20% 11.86%
- -------------------------------------------------------------------------------
7.00% 10.57% 11.19% 12.06% 12.78%
===============================================================================
- -------------
(a) Federal Rate of 28% + (California State Rate of 8.0% x (1-28%))
(b) Federal Rate of 31% + (California State Rate of 9.3% x (1-31%))
(c) Federal Rate of 36% + (California State Rate of 9.3% x (1-36%))
(d) Federal Rate of 39.6% + (California State Rate of 9.3% x (1-39.6%))
THIS TABLE IS A HYPOTHETICAL ILLUSTRATION AND SHOULD NOT BE CONSIDERED AN
INDICATION OF FUND PERFORMANCE OF ANY OF THE USAA FAMILY OF FUNDS.
THESE RATES WERE SELECTED AS EXAMPLES THAT WOULD BE RELEVANT TO MOST TAXPAYERS.
FOR A FURTHER EXPLANATION ON CALCULATING TAX EQUIVALENT YIELDS, SEE THE FUNDS'
STATEMENT OF ADDITIONAL INFORMATION.
31
<PAGE>
APPENDIX C
USAA Family of No-Load Mutual Funds
The USAA Family of No-Load Mutual Funds includes a variety of Funds, each with
different objectives and policies. In combination, these Funds are designed to
provide you with the opportunity to formulate your own investment program. You
may exchange any shares you hold in any one USAA Fund for shares in any other
USAA Fund. For more complete information about other Funds in the USAA Family
of Funds, including charges and expenses, call us for a Prospectus. Read it
carefully before you invest or send money.
FUND
TYPE/NAME VOLATILITY
===============================================================
CAPITAL APPRECIATION
- ---------------------------------------------------------------
Aggressive Growth Very high
Emerging Markets (1) Very high
First Start Growth Moderate to high
Gold (1) Very high
Growth Moderate to high
Growth & Income Moderate
International (1) Moderate to high
S&P 500 Index (2) Moderate
Science & Technology Very high
World Growth (1) Moderate to high
- ---------------------------------------------------------------
ASSET ALLOCATION
- ---------------------------------------------------------------
Balanced Strategy (1) Moderate
Cornerstone Strategy (1) Moderate
Growth and Tax Strategy Moderate
Growth Strategy (1) Moderate to high
Income Strategy Low to moderate
- ---------------------------------------------------------------
INCOME - TAXABLE
- ---------------------------------------------------------------
GNMA Low to moderate
Income Moderate
Income Stock Moderate
Short-Term Bond Low
- ---------------------------------------------------------------
INCOME - TAX EXEMPT
- ---------------------------------------------------------------
Long-Term (3) Moderate
Intermediate-Term (3) Low to moderate
Short-Term (3) Low
State Bond/Income (3,4) Moderate
- ---------------------------------------------------------------
MONEY MARKET
- ---------------------------------------------------------------
Money Market (5) Very low
Tax Exempt Money Market (3,5) Very low
Treasury Money Market Trust (5) Very low
State Money Market (3,4,5) Very low
===============================================================
1 FOREIGN INVESTING IS SUBJECT TO ADDITIONAL RISKS, SUCH AS CURRENCY
FLUCTUATIONS, MARKET ILLIQUIDITY, AND POLITICAL INSTABILITY.
2 S&P(R) IS A TRADEMARK OF THE MCGRAW-HILL COMPANIES, INC., AND HAS BEEN
LICENSED FOR USE. THE PRODUCT IS NOT SPONSORED, SOLD OR PROMOTED BY STANDARD
& POOR'S, AND STANDARD & POOR'S MAKES NO REPRESENTATION REGARDING THE
ADVISABILITY OF INVESTING IN THE PRODUCT.
3 SOME INCOME MAY BE SUBJECT TO STATE OR LOCAL TAXES.
4 CALIFORNIA, FLORIDA, NEW YORK, TEXAS, AND VIRGINIA FUNDS ARE OFFERED ONLY TO
RESIDENTS OF THOSE STATES.
5 AN INVESTMENT IN A MONEY MARKET FUND IS NEITHER INSURED NOR GUARANTEED BY
THE U.S. GOVERNMENT AND THERE IS NO ASSURANCE THAT ANY OF THE FUNDS WILL BE
ABLE TO MAINTAIN A STABLE NET ASSET VALUE OF $1 PER SHARE.
32
<PAGE>
If you would like more information about the Funds, you may call 1-800-531-8181
to request a free copy of the Funds' Statement of Additional Information (SAI),
Annual or Semiannual Reports, or to ask other questions about the Funds. The
SAI has been filed with the Securities and Exchange Commission (SEC) and is
legally a part of the Prospectus. In each Fund's Annual Report, you will find a
discussion of the market conditions and investment strategies that
significantly affected the Fund's performance during the last fiscal year.
To view these documents, along with other related documents, you can visit the
SEC's Internet web site (http://www.sec.gov) or the Commission's Public
Reference Room in Washington, D.C. Information on the operation of the public
reference room can be obtained by calling 1-800-SEC-0330. Additionally, copies
of this information can be obtained, for a duplicating fee, by writing the
Public Reference Section of the Commission, Washington, D.C. 20549-6009.
Investment Adviser, Underwriter and Distributor
USAA Investment Management Company
9800 Fredericksburg Road
San Antonio, Texas 78288
-----------------------------------------------
Transfer Agent Custodian
USAA Shareholder Account Services State Street Bank and Trust Company
9800 Fredericksburg Road P.O. Box 1713
San Antonio, Texas 78288 Boston, Massachusetts 02105
-----------------------------------------------
Telephone Assistance Hours
Call toll free - Central Time
Monday - Friday 8:00 a.m. to 8:00 p.m.
Saturdays 8:30 a.m. to 5:00 p.m.
------------------------------------------------
For Additional Information on Mutual Funds
1-800-531-8181, (in San Antonio) 456-7211
For account servicing, exchanges or redemptions
1-800-531-8448, (in San Antonio) 456-7202
-----------------------------------------------
Recorded Mutual Fund Price Quotes
24-Hour Service (from any phone)
1-800-531-8066, (in San Antonio) 498-8066
-----------------------------------------------
Mutual Fund TouchLINE(R)
(from Touchtone phones only)
For account balance, last transaction or fund prices
1-800-531-8777, (in San Antonio) 498-8777
- -------------------------------------------------------------------------------
Investment Company Act File No. 811-3333
<PAGE>
USAA NEW YORK FUNDS
USAA NEW YORK BOND FUND
USAA NEW YORK MONEY MARKET FUND
PROSPECTUS
AUGUST 1, 1998
Shares of the New York Funds are offered only to residents of the State of New
York. The delivery of this Prospectus is not an offer in any state where shares
of the New York Funds may not lawfully be made.
As with other mutual funds, the Securities and Exchange Commission has not
approved or disapproved of either of these Fund's shares or determined whether
this prospectus is accurate or complete. Anyone who tells you otherwise is
committing a crime.
TABLE OF CONTENTS
What Are Each Fund's Investment Objectives and Main Strategies?............ 2
Main Risks of Investing in These Funds..................................... 2
Are These Funds for You?................................................... 3
Could the Value of Your Investment in These Funds Fluctuate?............... 4
Fees and Expenses.......................................................... 7
Fund Investments........................................................... 9
Fund Management............................................................ 16
Using Mutual Funds in an Investment Program................................ 18
How to Invest.............................................................. 19
Important Information About Purchases and Redemptions...................... 22
Exchanges.................................................................. 23
Shareholder Information.................................................... 24
Financial Highlights....................................................... 28
Appendix A ................................................................ 30
Appendix B ................................................................ 32
Appendix C................................................................. 34
<PAGE>
USAA Investment Management Company manages these Funds. For easier reading,
USAA Investment Management Company will be referred to as "we" or "us"
throughout the Prospectus.
WHAT ARE EACH FUND'S INVESTMENT OBJECTIVES AND MAIN STRATEGIES?
Each Fund has a common objective of providing New York investors with a high
level of current interest income that is exempt from federal income tax and New
York State and New York City personal income taxes. The New York Money Market
Fund has a further objective of preserving capital and maintaining liquidity.
Each Fund has separate investment policies to achieve its objective.
The NEW YORK BOND FUND invests primarily in long-term, investment-grade New
York tax-exempt securities. The Fund's average dollar-weighted portfolio
maturity is not restricted, but is expected to be greater than 10 years.
The NEW YORK MONEY MARKET FUND invests in high-quality, New York tax-exempt
securities with maturities of 397 days or less.
In view of the risks inherent in all investments in securities, there is no
assurance that the Funds' objectives will be achieved. See FUND INVESTMENTS on
page 9 for more information.
MAIN RISKS OF INVESTING IN THESE FUNDS
The two primary risks of investing in these Funds are credit risk and market
risk. As with other mutual funds, losing money is an additional risk associated
with investing in these Funds.
o CREDIT RISK involves the possibility that a borrower cannot make timely
interest and principal payments on its securities.
o MARKET RISK involves the possibility that the value of each Fund's
investments will decline due to an increase in interest rates, or to adverse
changes in supply and demand for municipal securities, or other market
factors.
These credit and market risks may be magnified because each Fund concentrates
in New York tax-exempt securities.
IF INTEREST RATES INCREASE: the yield of each Fund may increase and the market
value of the New York Bond Fund's securities will likely decline, adversely
affecting the net asset value and total return.
IF INTEREST RATES DECREASE: the yield of each Fund may decrease and the market
value of the New York Bond Fund's securities may increase, which would likely
increase the Fund's net asset value and total return. The New York Money Market
Fund's total return may decrease.
2
<PAGE>
As you consider an investment in any Fund, you should also take into account
your tolerance for the daily fluctuations of the financial markets and whether
you can afford to leave your money in the investment for long periods of time
to ride out down periods.
An investment in either Fund is not a deposit of USAA Federal Savings Bank and
is not insured or guaranteed by the Federal Deposit Insurance Corporation or
any other government agency. Although the New York Money Market Fund seeks to
preserve the value of your investment at $1 per share, it is possible to lose
money by investing in that Fund.
[CAUTION LIGHT]
Look for this symbol throughout the Prospectus. We use it to mark more detailed
information about the main risks that you will face as a Fund shareholder.
ARE THESE FUNDS FOR YOU?
New York Bond Fund
This Fund might be appropriate as part of your investment portfolio if . . .
|X| You are looking for current income that is exempt from New York state and
city personal income taxes and federal income taxes.
|X| You are willing to accept moderate risk.
|X| You are looking for an investment in bonds to balance your stock portfolio.
This Fund MAY NOT be appropriate as part of your investment portfolio if . . .
|X| You are unable or reluctant to invest for a period of four years or more.
|X| You are unwilling to take greater risk for intermediate-term goals.
|X| Your current tax situation does not allow you to benefit from tax-exempt
income.
|X| You are seeking an appropriate investment for an IRA, through a 401(k) plan
or 403(b) plan, or other tax-sheltered account.
New York Money Market Fund
This Fund might be appropriate as part of your investment portfolio if . . .
|X| You are looking for current income that is exempt from New York state and
city personal income taxes and federal income taxes.
|X| You need to preserve principal.
|X| You want a low-risk investment.
|X| You need your money back within a short period.
|X| You would like checkwriting privileges on the account.
|X| You are looking for an investment in a money market fund to balance your
stock or long-term bond portfolio.
This Fund MAY NOT be appropriate as part of your investment portfolio if . . .
|X| You need a high total return to achieve your goals.
3
<PAGE>
|X| Your primary goal is long-term growth.
|X| Your current tax situation does not allow you to benefit from tax-exempt
income.
COULD THE VALUE OF YOUR INVESTMENT IN THESE FUNDS FLUCTUATE?
Yes, it could. In fact, the value of your investment in the New York Bond Fund
likely will increase or decrease. We manage the New York Money Market Fund in
accordance with strict Securities and Exchange Commission (SEC) guidelines
designed to preserve the Fund's value at $1 per share, although, of course, we
cannot guarantee that the value will remain at $1 per share.
The value of the securities in which the New York Bond Fund invests typically
fluctuates inversely with changes in the general level of interest rates.
Changes in the creditworthiness of issuers and changes in other market factors
such as the relative supply of and demand for tax-exempt bonds also create
value fluctuations. The bar charts shown below illustrate the Funds' volatility
and performance from year to year over the life of the Funds.
TOTAL RETURN
All mutual funds must use the same formulas to calculate total return.
New York Bond Fund
TOTAL RETURN
MEASURES THE
PRICE CHANGE
IN A SHARE
ASSUMING THE
REINVESTMENT
OF ALL DIVIDEND
INCOME AND
CAPITAL GAIN
DISTRIBUTIONS.
[BAR CHART]
CALENDAR TOTAL RETURN
YEAR PERCENTAGE
1990* 5.43%
1991 13.77%
1992 8.96%
1993 13.47%
1994 -9.04%
1995 18.07%
1996 3.73%
1997 10.64%
*FUND BEGAN OPERATIONS ON OCTOBER 15, 1990.
THE NEW YORK BOND FUND'S TOTAL RETURN FOR THE SIX-MONTH PERIOD ENDED
JUNE 30, 1998,WAS 3.41%.
4
<PAGE>
During the periods shown in the bar chart, the highest total return for a
quarter was 7.50% (quarter ending March 31, 1995) and the lowest total return
for a quarter was -7.25% (quarter ending March 31, 1994).
The table below shows how the Fund's average annual returns for the one- and
five-year periods and the life of the Fund compared to those of a broad-based
securities market index. Remember, historical performance does not necessarily
indicate what will happen in the future.
===============================================================================
Average Annual Total Returns Since Fund's
(for the period ending Past Past Inception on
December 31, 1997) 1 Year 5 Years October 15, 1990
- -------------------------------------------------------------------------------
New York Bond Fund 10.64% 6.94% 8.66%
- -------------------------------------------------------------------------------
Lehman Bros. Municipal
Bond Index* 9.19% 7.36% 8.44%
===============================================================================
* THE LEHMAN BROS. MUNICIPAL BOND INDEX IS AN UNMANAGED BENCHMARK OF TOTAL
RETURN PERFORMANCE FOR THE LONG-TERM, INVESTMENT-GRADE, TAX EXEMPT BOND
MARKET.
New York Money Market Fund
[BAR CHART]
CALENDAR TOTAL RETURN
YEAR PERCENTAGE
1990* 1.09%
1991 4.16%
1992 2.75%
1993 2.01%
1994 2.39%
1995 3.59%
1996 3.20%
1997 3.28%
* FUND BEGAN OPERATIONS ON OCTOBER 15, 1990.
THE NEW YORK MONEY MARKET FUND'S TOTAL RETURN FOR THE SIX-MONTH PERIOD
ENDED JUNE 30,1998, WAS 1.59%.
During the periods shown in the bar chart, the highest total return for a
quarter was 1.13% (quarter ending March 31, 1991) and the lowest total return
for a quarter was .46% (quarter ending March 31, 1994).
5
<PAGE>
YIELD
YIELD IS THE
ANNUALIZED NET
INCOME OF THE
FUND DURING A
SPECIFIED PERIOD
AS A PERCENTAGE
OF THE FUND'S
SHARE PRICE.
All mutual funds must use the same formulas to calculate yield and effective
yield.
New York Bond Fund
The New York Bond Fund may advertise performance in terms of a 30-day yield
quotation or a tax equivalent yield. The Fund's 30-day yield for the period
ended December 31, 1997, was 4.70%.
EFFECTIVE YIELD
IS CALCULATED
SIMILAR TO
THE YIELD,
HOWEVER, WHEN
ANNUALIZED,
THE INCOME
EARNED IS
ASSUMED TO BE
REINVESTED.
New York Money Market Fund
The New York Money Market Fund typically advertises performance in terms of a
7-day yield and effective yield or tax equivalent yield and may advertise total
return. The 7-day yield quotation more closely reflects current earnings of the
Fund than the total return quotation. The effective yield will be slightly
higher than the yield because of the compounding effect of the assumed
reinvestment. Current yields and effective yields fluctuate daily and will vary
with factors such as interest rates and the quality, length of maturities, and
type of investments in the portfolio. The Fund's 7-day yield for the period
ended December 31, 1997, was 3.60%.
You may obtain the most current yield information for either of the Funds by
calling 1-800-531-8777.
TAX EQUIVALENT YIELD
Investors use tax equivalent yields to compare taxable and tax-exempt fixed
income investments using a common yield measure. The tax equivalent yield is
the yield that a fully taxable investment must generate to earn the same
"take-home" yield as a tax-exempt investment. The calculation depends upon your
federal and New York marginal income tax rates and assumes that an investor can
fully itemize deductions on his or her federal tax return. The higher your
marginal tax bracket, the higher will be the tax equivalent yield and the more
valuable is the Fund's tax exemption.
For example, if you assume a federal marginal tax rate of 36% and a state and
city marginal tax rate of 11.31%, the Effective Marginal Tax Rate would be
43.24%. Using this tax rate, the Funds' tax equivalent yields for the period
ending December 31, 1998, would be as follows:
===============================================================================
Tax Equivalent
Yield Yield
- -------------------------------------------------------------------------------
New York Bond Fund (30 day) 4.70% 8.28%
- -------------------------------------------------------------------------------
New York Money Market Fund (7 day) 3.60% 6.34%
===============================================================================
6
<PAGE>
Using the example, to exceed the 30-day yield of the New York Bond Fund on an
after-tax basis, you must find a fully taxable investment that yields more than
8.28%. Likewise, to exceed the 7-day yield of the New York Money Market Fund,
you must find a fully taxable investment that yields more than 6.34%.
For more information on calculating tax equivalent yields, see APPENDIX B on
page 32.
[TELEPHONE GRAPHIC]
TouchLINE (R)
1-800-531-8777
PRESS
1
THEN
1
THEN
6 3 #
Please consider performance information in light of the Funds' investment
objectives and policies and market conditions during the reported time periods.
Again, you must remember that historical performance does not necessarily
indicate what will happen in the future. The value of your shares may go up or
down. For the most current price, yield, and return information for these
Funds, you may call TouchLINE(R) at 1-800-531-8777. Press 1 for the Mutual Fund
Menu, press 1 again for prices, yields, and returns. Then, press 62# for the
New York Bond Fund or press 63# for the New York Money Market Fund when asked
for a Fund Code.
NEW YORK
BOND FUND
NEWSPAPER
SYMBOL
NYBd
TICKER
SYMBOLS
USNYX
UNYXX
You can also find the most current price of your shares in the business section
of your newspaper in the mutual fund section under the heading "USAA Group" and
the symbol "NYBd" for the New York Bond Fund. If you prefer to obtain this
information from an on-line computer service, you can do so by using the ticker
symbol "USNYX" for the New York Bond Fund or the ticker symbol "UNYXX" for the
New York Money Market Fund.
FEES AND EXPENSES
This summary shows what it will cost you directly or indirectly to invest in
the Funds.
Shareholder Transaction Expenses -- Fees You Pay Directly
There are no fees or sales loads charged to your account when you buy or sell
Fund shares. However, if you sell shares and request your money by wire
transfer, there is a $10 fee. (Your bank may also charge a fee for receiving
wires.)
Annual Fund Operating Expenses -- Fees You Pay Indirectly
Fund expenses come out of the Funds' assets and are reflected in the Funds'
share prices and dividends. "Other Expenses" include expenses such as custodian
and transfer agent fees. The figures on the next page show actual expenses
before waivers, if any, during the past fiscal year ended March 31, 1998, and
are calculated as a percentage of average net assets (ANA).
7
<PAGE>
12B-1 FEES-
SOME MUTUAL
FUNDS CHARGE
THESE FEES
TO PAY FOR
ADVERTISING
AND OTHER
COSTS OF SELLING
FUND SHARES.
===============================================================================
New York New York
Bond Fund Money Market Fund
- -------------------------------------------------------------------------------
Management Fees .43% .42%
Distribution (12b-1) Fees None None
Other Expenses .18% .21%
---- ----
Total Annual Fund Operating Expenses .61% .63%
==== ====
===============================================================================
- -------------------
* During the year, we voluntarily limited each Fund's Total Annual Fund
Operating Expenses to .50% as follows:
========================================================================
New York New York
Bond Fund Money Market Fund
------------------------------------------------------------------------
Total Annual Fund Operating Expenses .61% .63%
Reimbursement from USAA Investment
Management Company (.11%) (.13%)
----- -----
Actual Fund Operating Expenses
After Reimbursement .50% .50%
===== =====
========================================================================
We have again voluntarily agreed to limit each Fund's annual expenses to
.50% of its ANA and will reimburse the Funds for all expenses in excess of
that amount until August 1, 1999.
Example of Effect of the Funds' Operating Expenses
This example is intended to help you compare the cost of investing in one of
the Funds with the cost of investing in other mutual funds. Although your
actual costs may be higher or lower, you would pay the following expenses on a
$10,000 investment, assuming (1) 5% annual return, (2) the Fund's operating
expenses (before any applicable reimbursement) remain the same, and (3) you
redeem all of your shares at the end of those periods shown.
New York New York
Bond Fund Money Market Fund
- ------------------------------------------------------------------------------
1 year $ 62 $ 64
3 years 195 202
5 years 340 351
10 years 762 786
8
<PAGE>
FUND INVESTMENTS
Principal Investment Strategies and Risks
Q What is each Fund's principal investment strategy?
A Each Fund's principal investment strategy is to invest the Fund's assets
in securities issued by New York State, its political subdivisions,
municipalities and public authorities, and by other governmental entities
if, in the opinion of counsel, the interest from such obligations is
excluded from gross income for federal income tax purposes and is exempt
from New York State and New York City personal income taxes.
These securities include municipal debt obligations that have been issued
by New York and its political subdivisions, and duly constituted state and
local authorities and corporations. We refer to these securities as New
York tax-exempt securities. New York tax-exempt securities are issued to
fund public infrastructure projects such as streets and highways, schools,
water and sewer systems, hospitals, and airports. They may also be issued
to refinance outstanding obligations as well as to obtain funds for
general operating expenses and for loans to other public institutions and
facilities.
Because the projects benefit the public, Congress has granted exemption
from federal income taxes for the interest income arising from these
securities. Likewise, the New York Legislature has granted an exemption
from state and city personal income taxes for most New York municipal
securities.
Q What types of tax-exempt securities will be included in each Fund's
portfolio?
A Each Fund's assets may be invested in any of the following tax-exempt
securities:
o general obligation bonds which are secured by the issuer's pledge of its
full faith, credit, and taxing power for the payment of principal and
interest;
o revenue bonds which are payable from the revenue 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, but
not from the general taxing power;
o lease obligations backed by the municipality's covenant to budget for
the payments due under the lease obligation; and
9
<PAGE>
o industrial development bonds issued by or on behalf of public
authorities to obtain funds for privately-operated facilities.
As a temporary defensive measure because of market, economic, political,
or other conditions, we may invest up to 100% of each Fund's assets in
short-term securities whether or not they are exempt from federal income
tax and New York State and New York City personal income taxes. To the
extent that these temporary investments produce taxable income, that
income may result in that Fund not fully achieving its investment
objective during the time it is in this defensive posture.
Q What are the principal risks associated with investments in tax-exempt
securities?
A The two principal risks of investing in tax-exempt securities are credit
risk and market risk.
[CAUTION LIGHT]
CREDIT RISK. Credit risk is the possibility that an issuer of a fixed
income security will fail to make timely payments of interest or
principal. We attempt to minimize the Funds' credit risks by investing in
securities considered at least investment grade at the time of purchase.
Nevertheless, even investment-grade securities are subject to some credit
risk. In addition, the ratings of securities are estimates by the rating
agencies of the credit quality of the securities. The ratings may not take
into account every risk related to whether interest or principal will be
repaid on a timely basis.
When evaluating potential investments for the Funds, our analysts also
independently assess credit risk and its impact on the Funds' portfolios.
Securities in the lowest investment grade ratings category (BBB) have
speculative characteristics. Changes in economic conditions or other
circumstances are more likely to lead to a weakened capability to make
principal and interest payments on these securities than is the case for
higher-rated securities.
[CAUTION LIGHT]
MARKET RISK. As a mutual fund investing in bonds, the Funds are subject to
the risk that the market value of the bonds will decline because of rising
interest rates. Bond prices are linked to the prevailing market interest
rates. In general, when interest rates rise, the prices of bonds fall and
when interest rates fall, bond prices generally rise. The price volatility
of a bond also depends on its maturity. Generally, the longer the maturity
of a bond, the greater its sensitivity to interest rates. To compensate
investors for this higher market risk, bonds with longer maturities
generally offer higher yields than bonds with shorter maturities.
10
<PAGE>
Q What percentage of each Fund's assets will be invested in New York
tax-exempt securities?
A During normal market conditions, at least 80% of each Fund's net assets
will consist of New York tax-exempt securities. This policy may only be
changed by a shareholder vote.
In addition to New York tax-exempt securities, securities issued by
certain U.S. territories and possessions such as Puerto Rico, the Virgin
Islands, and Guam are exempt from federal, state, and city personal income
taxes; and as such, we may consider investing up to 20% of each Fund's
assets in these securities.
Q Are each Fund's investments diversified in many different issuers?
A Each Fund is considered diversified under the federal securities laws.
This means that we will not invest more than 5% in any one issuer with
respect to 75% of each Fund's assets. With respect to the remaining 25% of
each Fund's assets, we could invest more than 5% in any one, or more,
issuers. Purchases of securities issued or guaranteed by the U.S.
Government or its agencies or instrumentalities are not counted toward the
5% limitation. Each Fund, of course, is concentrated geographically
through the purchase of New York tax-exempt securities.
With respect to the New York Money Market Fund, strict SEC guidelines do
not permit us to invest, with respect to 75% of the Fund's assets, greater
than 10% of the Fund's assets in securities issued by or subject to
guarantees by the same institution.
We also may not invest more than 25% of the Funds' assets in securities
issued in connection with the financing of projects with similar
characteristics, such as toll road revenue bonds, housing revenue bonds,
or electric power project revenue bonds, or in industrial revenue bonds
which are based, directly or indirectly, on the credit of private entitles
of any one industry. However, we reserve the right to invest more than 25%
of the Funds' assets in tax-exempt industrial revenue bonds.
Q What are the potential risks associated with concentrating such a large
portion of each Fund's assets in one state?
[CAUTION LIGHT]
A The Funds are subject to credit and market risks, as described above,
which could be magnified by the Funds' concentration in New York issues.
New York tax-exempt securities may be affected by political, economic,
regulatory, or other developments that limit the ability of New York
issuers to pay interest or repay
11
<PAGE>
principal in a timely manner. Therefore, the Funds are affected by events
within New York to a much greater degree than a more diversified national
fund.
A particular development may not directly relate to the Funds' investments
but nevertheless might depress the entire market for the state's
tax-exempt securities and therefore adversely impact the Funds' valuation.
An investment in the New York Money Market Fund may be riskier than an
investment in other types of money market funds because of this
concentration.
The following are examples of just some of the events that may depress
valuations for New York tax-exempt securities for an extended period of
time:
o Changes in state laws, including voter referendums, that restrict
revenues or raise costs for issuers.
o Court decisions that affect a category of municipal bonds, such as
municipal lease obligations or electric utilities.
o Natural or other disasters such as floods, storms, hurricanes, droughts,
fires, or earthquakes.
o Bankruptcy or financial distress of a prominent municipal issuer within
the state.
o Economic issues that impact critical industries or large employers or
that weaken real estate prices.
o Reductions in federal or state financial aid.
o Imbalance in the supply and demand for the state's municipal securities.
o Developments that may change the tax treatment of New York tax-exempt
securities.
In addition, because each Fund invests in securities backed by banks and
other financial institutions, changes in the credit quality of these
institutions could cause losses to a Fund and affect its share price.
Other considerations affecting the Funds' investments in New York
tax-exempt securities are summarized in the Statement of Additional
Information under SPECIAL RISK CONSIDERATIONS.
Q Will any portion of the distributions from the Funds be subject to federal
income taxes?
A During normal market conditions, at least 80% of each Fund's annual income
will be excluded from gross income for federal
12
<PAGE>
income tax purposes and will also be exempt from New York state and city
personal income taxes. This policy may only be changed by a shareholder
vote. We expect that any taxable interest income distributed will be
minimal.
However, gains and losses from trading securities that occur during the
normal course of managing a fund may create net capital gain
distributions. The Internal Revenue Code presently treats these
distributions differently than tax-exempt interest income in the following
ways:
o Distributions of net short-term capital gains are taxable as ordinary
income.
o Distributions of net long-term capital gains are taxable as long-term
capital gains, regardless of the length of time you have held the Fund
shares. These distributions may be taxable at different rates depending
on the length of time the Funds held the applicable investment.
o Both short-term and long-term capital gains are taxable whether received
in cash or reinvested in additional shares.
Q Will income from the Funds be subject to the federal alternative minimum
tax (AMT) for individuals?
A During normal market conditions, at least 80% of each Fund's annual income
will be excluded from the calculation of the federal alternative minimum
tax (AMT) for individuals. This policy may only be changed by a
shareholder vote. Since inception, the Funds have not distributed any
income that is subject to the federal AMT for individuals, and we do not
intend to invest in securities subject to the federal AMT. However, of
course, changes in federal tax laws or other unforeseen circumstances
could result in income subject to the federal AMT for individuals.
New York Bond Fund
Q What is the credit quality of the Fund's investments?
A Under normal market conditions, we will invest the Fund's assets so that
at least 50% of the total market value of the tax-exempt securities is
rated within the three highest long-term rating categories (A or higher)
by Moody's Investors Service, Inc. (Moody's), Standard & Poor's Ratings
Group (S&P), or Fitch IBCA, Inc. (Fitch) or in the highest short-term
rating category by Moody's, S&P, or Fitch; or if a security is not rated
by those rating agencies, we must determine that the security is of
equivalent investment quality.
13
<PAGE>
In no event will we purchase a security for the Fund unless it is rated at
least investment grade at the time of purchase. Investment-grade
securities are those securities rated within the four highest long-term
rating categories by Moody's (Baa or higher), S&P, or Fitch (BBB or
higher), or in the two highest short-term rating categories by these
rating agencies; or if unrated by these agencies, we must determine that
the securities are of equivalent investment quality.
You will find a complete description of the above tax-exempt ratings in
the Fund's Statement of Additional Information.
Q What happens if the rating of a security is downgraded to below investment
grade?
A We will determine whether it is in the best interest of the Fund's
shareholders to continue to hold the security in the Fund's portfolio. If
downgrades result in more than 5% of the Fund's net assets being invested
in securities that are less than investment-grade quality, we will take
immediate action to reduce the Fund's holdings in such securities to 5% or
less of the Fund's net assets, unless otherwise directed by the Board of
Directors.
Q How does the portfolio manager decide which securities to buy and sell?
A He manages tax-exempt funds based on the common sense premise that our
investors value tax-exempt income over taxable capital gain distributions.
When weighing his decision to buy or sell a security, he strives to
balance the value of the tax-exempt income, the credit risk of the issuer,
and the price volatility of the bond.
Q What is the Fund's average portfolio maturity and how is it calculated?
A While the Fund's average portfolio maturity is not restricted, we expect
it to be greater than 10 years. To determine a security's maturity for
purposes of calculating the Fund's average portfolio maturity, we may
estimate the expected time in which the security's principal is to be
paid. This can be substantially shorter than its stated final maturity.
For more information on the method of calculating the Fund's average
weighted portfolio maturity, see INVESTMENT POLICIES in the Fund's
Statement of Additional Information.
14
<PAGE>
New York Money Market Fund
Q What is the credit quality of the Fund's investments?
A The Fund's investments consist of securities meeting the requirements to
qualify as "eligible securities" under the SEC rules applicable to money
market funds. In general, an eligible security is defined as a security
that is:
o issued or guaranteed by the U.S. Government or any agency or
instrumentality thereof, including "prerefunded" and "escrowed to
maturity" tax-exempt securities;
o rated or subject to a guarantee that is rated in one of the two highest
categories for short-term securities by at least two Nationally
Recognized Statistical Rating Organizations (NRSROs), or by one NRSRO if
the security is rated by only one NRSRO;
o unrated but issued by an issuer or guaranteed by a guarantor that has
other comparable short-term debt obligations so rated; or
o unrated but determined by us to be of comparable quality.
In addition, we must consider whether a particular investment presents
minimal credit risk.
Q Who are the Nationally Recognized Statistical Rating Organizations?
A Current NRSROs include:
o Moody's Investors Service, Inc.;
o Standard & Poor's Ratings Group;
o Fitch IBCA, Inc.;
o Duff & Phelps Inc.; and
o Thompson BankWatch, Inc.
Q What happens if the rating of a security is downgraded?
A If the rating of a security is downgraded after purchase, we will
determine whether it is in the best interest of the Fund's shareholders to
continue to hold the security in the Fund's portfolio.
15
<PAGE>
Q Will the Fund always maintain a net asset value of $1 per share?
A While we will endeavor to maintain a constant Fund net asset value of $1
per share, there is no assurance that we will be able to do so. Remember,
the shares are neither insured nor guaranteed by the U.S. Government. As
such, the Fund carries some risk.
For example, there is always a risk that the issuer of a security held by
the Fund will fail to pay interest or principal when due. We attempt to
minimize this credit risk by investing only in securities rated in one of
the two highest categories for short-term securities, or, if not rated, of
comparable quality, at the time of purchase. Additionally, we will not
purchase a security unless our analysts determine that the security
presents minimal credit risk.
There is also a risk that rising interest rates will cause the value of
the Fund's securities to decline. We attempt to minimize this interest
risk by limiting the maturity of each security to 397 days or less and
maintaining a dollar-weighted average portfolio maturity for the Fund of
90 days or less.
DOLLAR-
WEIGHTED
AVERAGE
PORTFOLIO
MATURITY IS
OBTAINED BY
MULTIPLYING
THE DOLLAR
VALUE OF EACH
INVESTMENT
BY THE NUMBER
OF DAYS LEFT TO
ITS MATURITY,
THEN ADDING
THOSE FIGURES TOGETHER
AND DIVIDING THE
TOTAL BY THE
DOLLAR VALUE
OF THE FUND'S
PORTFOLIO.
Finally, there is the possibility that one or more investments in the Fund
cease to be "eligible securities" resulting in the net asset value ceasing
to be $1 per share. For example, a guarantor on a security may fail to
meet a contractual obligation.
Q How does the portfolio manager decide which securities to buy and sell?
A He balances factors such as credit quality and maturity to purchase the
best relative value available in the market at any given time. While rare,
sell decisions are usually based on a change in his credit analysis or to
take advantage of an opportunity to reinvest at a higher yield.
For additional information about other securities in which we may invest each
of the Fund's assets, see APPENDIX A on page 30.
FUND MANAGEMENT
The Company has retained us, USAA Investment Management Company, to serve as
the manager and distributor for the Company. We are an affiliate of United
Services Automobile Association (USAA), a large, diversified financial services
institution. As of the date of this Prospectus, we had approximately $39
billion in total assets under management. Our mailing address is 9800
Fredericksburg Road, San Antonio, TX 78288.
16
<PAGE>
We provide management services to the Funds pursuant to an Advisory Agreement.
We are responsible for managing the Funds' portfolios (including placement of
brokerage orders) and their business affairs, subject to the authority of and
supervision by the Board of Directors. For our services, the Funds pay us an
annual fee. This fee, which is accrued daily and paid monthly, is computed as a
percentage of the aggregate average net assets of both Funds combined. This fee
is allocated between the Funds based on the relative net assets of each. The
fee is computed at one-half of one percent (.50%) of the first $50 million of
average net assets, two-fifths of one percent (.40%) for that portion of
average net assets over $50 million but not over $100 million, and three-tenths
of one percent (.30%) for that portion of average net assets over $100
million. The fees we received for the fiscal year ended March 31, 1998, net of
reimbursements, were equal to .32% of average net assets for the New York Bond
Fund and .28% of average net assets for the New York Money Market Fund. We also
provide services related to selling the Funds' shares and receive no
compensation for those services.
Although our officers and employees, as well as those of the Company, may
engage in personal securities transactions, they are restricted by the
procedures in a Joint Code of Ethics adopted by the Company and us.
Portfolio Managers
The following individuals are primarily responsible for managing the Funds:
NEW YORK BOND FUND
[PHOTOGRAPH OF
PORTFOLIO MANAGER]
Kenneth E. Willmann
Kenneth E. Willmann, Vice President of Fixed Income Investments since December
1986, has managed the Fund since its inception in October 1990. He has 24 years
investment management experience and has worked for us for 21 years. Mr.
Willmann earned the Chartered Financial Analyst (CFA) designation in 1987 and
is a member of the Association for Investment Management and Research (AIMR),
San Antonio Financial Analysts Society, Inc. (SAFAS), and the National
Federation of Municipal Analysts (NFMA). He holds an MBA and a BA from the
University of Texas.
17
<PAGE>
NEW YORK MONEY MARKET FUND
[PHOTOGRAPH OF
PORTFOLIO MANAGER
John C. Bonnell
John C. Bonnell, Executive Director of Money Market Funds since May 1996, has
managed the Fund since May 1996. He has nine years investment management
experience working for us. Mr. Bonnell earned the CFA designation in 1994 and
is a member of AIMR, SAFAS, NFMA and the Southern Municipal Finance Society. He
holds an MBA from St. Mary's University and a BBA from the University of Texas
at San Antonio.
USING MUTUAL FUNDS IN AN INVESTMENT PROGRAM
I. The Idea Behind Mutual Funds
Mutual funds provide small investors some of the advantages enjoyed by wealthy
investors. A relatively small investment can buy part of a diversified
portfolio. That portfolio is managed by investment professionals, relieving you
of the need to make individual stock or bond selections. You also enjoy
conveniences, such as daily pricing, liquidity, and in the case of the USAA
Family of Funds, no sales charge. The portfolio, because of its size, has lower
transaction costs on its trades than most individuals would have. As a result,
you own an investment that in earlier times would have been available only to
very wealthy people.
II. Using Funds in an Investment Program
In choosing a mutual fund as an investment vehicle, you are giving up some
investment decisions, but must still make others. The decisions you don't have
to make are those involved with choosing individual securities. We will perform
that function. In addition, we will arrange for the safekeeping of securities,
auditing the annual financial statements, and daily valuation of the Fund, as
well as other functions.
You, however, retain at least part of the responsibility for an equally
important decision. This decision involves determining a portfolio of mutual
funds that balances your investment goals with your tolerance for risk. It is
likely that this decision may include the use of more than one fund of the USAA
Family of Funds.
For example, assume you wish to pursue the higher yields usually available in
the long-term bond market, but you are also concerned about the possible price
swings of the long-term bonds. You could divide your investments between the
New York Bond Fund and the New York Money Market Fund.
18
<PAGE>
This would create a portfolio with a higher yield than that of the money market
and less volatility than that of the long-term market. This is just one way you
could combine funds to fit your own risk and reward goals.
III. USAA's Family of Funds
We offer you another alternative with our asset strategy funds listed under
asset allocation on page 34. These unique mutual funds provide a professionally
managed diversified investment portfolio within a mutual fund. Designed for the
individual who prefers to delegate the asset allocation process to an
investment manager, their structure achieves diversification across a number of
investment categories.
Whether you prefer to create your own mix of mutual funds or use a USAA Asset
Strategy Fund, the USAA Family of Funds provides a broad range of choices
covering just about any investor's investment objectives. Our sales
representatives stand ready to assist you with your choices and to help you
craft a portfolio to meet your needs. Refer to APPENDIX C on page 34 for a
complete list of the USAA Family of No-Load Mutual Funds.
HOW TO INVEST
Purchase of Shares
OPENING AN ACCOUNT
You may open an account and make an investment as described below by mail, in
person, bank wire, electronic funds transfer (EFT), or phone. A complete,
signed application is required for each new account. However, after you open
your initial account with us, you will not need to fill out another application
unless the registration is different.
TAX ID NUMBER
Each shareholder named on the account must provide a social security number or
tax identification number to avoid possible withholding requirements.
EFFECTIVE DATE
When you make a purchase, your purchase price will be the net asset value (NAV)
per share next determined after we receive your request in proper form. Each
Fund's NAV is determined at the close of the regular trading session (generally
4:00 p.m. Eastern Time) of the New York Stock Exchange (NYSE) each day the NYSE
is open. If we receive your request and payment prior to that time, your
purchase price will be the NAV per share determined for that day. If we receive
your request or payment after the NAV per share is calculated, the purchase
will be effective on the next business day. If you plan to purchase Fund shares
with a foreign check, we suggest you convert your foreign check to U.S. dollars
prior to investment in a Fund to avoid a potential delay in the effective date
of your purchase of up to four to six weeks.
19
<PAGE>
Furthermore, a bank charge may be assessed in the clearing process, which will
be deducted from the amount of the purchase.
MINIMUM INVESTMENTS
Initial Purchase
[MONEY GRAPHIC]
o $3,000. Employees of USAA and its affiliated companies may open an account
through payroll deduction for as little as $25 per pay period with no
initial investment.
ADDITIONAL PURCHASES
o $50 (Except transfers from brokerage accounts into the New York Money
Market Fund, which are exempt from the minimum).
HOW TO PURCHASE
[ENVELOPE GRAPHIC]
MAIL
o To open an account, send your application and check to:
USAA Investment Management Company
9800 Fredericksburg Road
San Antonio, TX 78288
o To add to your account, send your check and the "Invest by Mail" stub that
accompanies your Fund's transaction confirmation to the Transfer Agent:
USAA Shareholder Account Services
9800 Fredericksburg Road
San Antonio, TX 78288
IN PERSON
[HANDSHAKE GRAPHIC]
o To open an account, bring your application and check to:
USAA Investment Management Company
USAA Federal Savings Bank
10750 Robert F. McDermott Freeway
San Antonio, TX 78288
BANK WIRE
[WIRE GRAPHIC]
o Instruct your bank (which may charge a fee for the service) to wire the
specified amount to the Fund as follows:
State Street Bank and Trust Company
Boston, MA 02101
ABA#011000028
Attn: USAA New York Fund Name
USAA Account Number: 69384998
Shareholder(s) Name(s)______________________________________
Shareholder(s) Mutual Fund Account Number___________________
20
<PAGE>
ELECTRONIC FUNDS TRANSFER
[CALENDAR GRAPHIC]
o Additional purchases on a regular basis can be deducted from a bank
account, paycheck, income-producing investment, or USAA money market fund
account. Sign up for these services when opening an account or call
1-800-531-8448 to add these services.
PHONE 1-800-531-8448
[TELEPHONE GRAPHIC]
o If you have an existing USAA account and would like to open a new account
or exchange to another USAA fund, call for instructions. To open an account
by phone, the new account must have the same registration as your existing
account.
Redemption of Shares
You may redeem Fund shares by any of the methods described below on any day the
NAV per share is calculated. Redemptions are effective on the day instructions
are received in a manner as described below. However, if instructions are
received after the NAV per share calculation (generally 4:00 p.m. Eastern
Time), redemption will be effective on the next business day.
We will send you your money within seven days after the effective date of
redemption. Payment for redemption of shares purchased by EFT or check is sent
after the EFT or check has cleared, which could take up to 15 days from the
purchase date. If you are considering redeeming shares soon after purchase, you
should purchase by bank wire or certified check to avoid delay. Redemptions are
subject to taxes based on the difference between the cost of shares when
purchased and the price received upon redemption.
In addition, the Company may elect to suspend the redemption of shares or
postpone the date of payment in limited circumstances.
HOW TO REDEEM
WRITTEN, FAX, TELEGRAPH, OR TELEPHONE
[FAX MACHINE GRAPHIC]
o Send your written instructions to:
USAA Shareholder Account Services
9800 Fredericksburg Road
San Antonio, TX 78288
o Send a signed fax to 1-800-292-8177, or send a telegram to USAA Shareholder
Account Services.
o Call toll free 1-800-531-8448, in San Antonio, 456-7202.
Telephone redemption privileges are automatically established when you complete
your application. The Fund will employ reasonable procedures to confirm that
instructions communicated by telephone are genuine; and if it does not, it may
be liable for any losses due to unauthorized or fraudulent
21
<PAGE>
instructions. Before any discussion regarding your account, we obtain the
following information: (1) USAA number or account number, (2) the name(s) on
the account registration, and (3) social security number or tax identification
number for the account registration. In addition, we record all telephone
communications with you and send confirmations of account transactions to the
address of record. If you were issued stock certificates for your shares,
redemption by telephone, fax, or telegram is not available.
CHECKWRITING
[CHECKBOOK GRAPHIC]
o Checks can be issued for your New York Money Market Fund account. Return a
signed signature card, which accompanies your application, or request a
signature card separately and return to:
USAA Shareholder Account Services
9800 Fredericksburg Road
San Antonio, TX 78288
You will not be charged for the use of checks or any subsequent reorders. Your
checkwriting privilege is subject to State Street Bank and Trust Company's
rules and regulations governing checking accounts. You may write checks in the
amount of $250 or more. Checks written for less than $250 will be returned
unpaid. Because the value of your account changes daily as dividends accrue,
you may not write a check to close your account.
IMPORTANT INFORMATION ABOUT PURCHASES AND REDEMPTIONS
Investor's Guide to USAA Mutual Fund Services
[INVESTOR'S GUIDE GRAPHIC]
Upon your initial investment with us, you will receive the INVESTOR'S GUIDE to
help you get the most out of your USAA mutual fund account and to help you in
your role as an investor. In the INVESTOR'S GUIDE, you will find additional
information on purchases, redemptions, and methods of payment. You will also
find in-depth information on automatic investment plans, shareholder statements
and reports, and other useful information.
Account Balance
USAA Shareholder Account Services (SAS), the Funds' transfer agent, may assess
annually a small balance account fee of $12 to each shareholder account with a
balance, at the time of assessment, of less than $2,000. The fee will reduce
total transfer agency fees paid by the Fund to SAS. Accounts exempt from the
fee include: (1) any account regularly purchasing additional shares each month
through an automatic investment plan; (2) any account registered under the
Uniform Gifts/Transfers to Minors Act (UGMA/UTMA); (3) all (non-IRA) money
market fund accounts; (4) any account whose
22
<PAGE>
registered owner has an aggregate balance of $50,000 or more invested in USAA
mutual funds; and (5) all IRA accounts (for the first year the account is
open).
Company Rights
The Company reserves the right to:
o reject purchase or exchange orders when in the best interest of the
Company;
o limit or discontinue the offering of shares of any portfolio of the
Company without notice to the shareholders;
o impose a redemption charge of up to 1% of the net asset value of shares
redeemed if circumstances indicate a charge is necessary for the
protection of remaining investors (for example, if excessive market-
timing share activity unfairly burdens long-term investors); however,
this 1% charge will not be imposed upon shareholders unless authorized
by the Board of Directors and the required notice has been given to
shareholders;
o require a signature guarantee for transactions or changes in account
information in those instances where the appropriateness of a signature
authorization is in question. The Statement of Additional Information
contains information on acceptable guarantors;
o redeem an account with less than 50 full shares, with certain
limitations.
EXCHANGES
Exchange Privilege
The exchange privilege is automatic when you complete your application. You may
exchange shares among Funds in the USAA Family of Funds, provided you do not
hold these shares in stock certificate form and the shares to be acquired are
offered in your state of residence. Only New York residents may exchange into a
New York Fund. The Funds' transfer agent will simultaneously process exchange
redemptions and purchases at the share prices next determined after the
exchange order is received. The investment minimums applicable to share
purchases also apply to exchanges. For federal income tax purposes, an exchange
between Funds is a taxable event; and as such, you may realize a capital gain
or loss. Such capital gains or losses are based on the difference between the
cost of shares when purchased and the price received upon exchange.
The Funds have undertaken certain procedures regarding telephone transactions
as described on page 21.
23
<PAGE>
Exchange Limitations, Excessive Trading
To minimize Fund costs and to protect the Funds and their shareholders from
unfair expense burdens, the Funds restrict excessive exchanges. The limit on
exchanges out of any Fund in the USAA Family of Funds for each account is six
per calendar year (except there is no limitation on exchanges out of the Tax
Exempt Short-Term Fund, Short-Term Bond Fund, or any of the money market funds
in the USAA Family of Funds).
SHAREHOLDER INFORMATION
NAV
EQUALS
TOTAL ASSETS
MINUS
LIABILITIES
DIVIDED BY
# OF SHARES OUTSTANDING
Share Price Calculation
The price at which you purchase and redeem Fund shares is equal to the net
asset value (NAV) per share determined on the effective date of the purchase or
redemption. You may buy and sell Fund shares at the NAV per share without a
sales charge. Each Fund's NAV per share is calculated at the close of the
regular trading session of the NYSE, which is usually 4:00 p.m. Eastern Time.
Securities of the New York Bond Fund are valued each business day at their
current market value as determined by a pricing service approved by the
Company's Board of Directors. Securities which cannot be valued by the pricing
service, and all other assets, are valued in good faith at fair value using
methods we have determined under the general supervision of the Board of
Directors. In addition, securities with maturities of 60 days or less and all
securities of the New York Money Market Fund are stated at amortized cost,
which approximates market value.
For additional information on how securities are valued, see VALUATION OF
SECURITIES in the Funds' Statement of Additional Information.
Dividends and Distributions
Net investment income of each Fund is accrued daily and paid on the last
business day of the month. Dividends shall begin accruing on shares purchased
the day following the effective date and shall continue to accrue to the
effective date of redemption. Any net capital gain distribution usually occurs
within 45 days of the March 31 fiscal year end, which would be somewhere around
the middle of May. The Funds will make additional payments to shareholders, if
necessary, to avoid the imposition of any federal income or excise tax.
All income dividends and capital gain distributions are automatically
reinvested, unless we receive different instructions from you. The share price
will be the NAV of the Fund shares computed on the ex-dividend date. Any
capital gain distributions paid by the New York Bond Fund will reduce the NAV
per share by the amount of the dividend or distribution. These dividends
24
<PAGE>
and distributions are subject to taxes. If you become a resident of a state
other than New York, we will mail a check for proceeds of income dividends to
you monthly. We will mail a check for any capital gain distribution to you
after the distribution is paid.
We will invest any dividend or distribution payment returned to us in your
account at the then-current NAV per share. Dividend and distribution checks
become void six months from the date on the check. The amount of the voided
check will be invested in your account at the then-current NAV per share.
Federal Taxes
This tax information is quite general and refers to the federal income tax
provisions in effect as of the date of this Prospectus. While we manage the
Funds so that at least 80% of each Fund's annual income will be exempt from
federal or state income taxes, we may invest up to 20% of the Funds' assets in
securities that generate income not exempt from federal or state income taxes.
Because interest income may be exempt for federal income tax purposes, it does
not necessarily mean that the interest income may be exempt under the income or
other tax laws of any state or local taxing authority. As discussed earlier on
page 13, capital gains distributed by a Fund may be taxable. Note that the
Taxpayer Relief Act of 1997 and regulations that will likely be adopted to
implement the Act may affect the status and treatment of certain distributions
shareholders receive from the Funds. We urge you to consult your own tax
adviser about the status of distributions from the Funds in your own state and
locality.
WITHHOLDING - Federal law requires each Fund to withhold and remit to the U.S.
Treasury a portion of the income dividends and capital gain distributions and
proceeds of redemptions paid to any non-corporate shareholder who:
o fails to furnish the Fund with a correct tax identification number,
o underreports dividend or interest income, or
o fails to certify that he or she is not subject to withholding.
To avoid this withholding requirement, you must certify on your application, or
on a separate Form W-9 supplied by the Funds' transfer agent, that your tax
identification number is correct and you are not currently subject to backup
withholding.
REPORTING - Each Fund will report information to you concerning the tax status
of dividends and distributions for federal income tax purposes annually,
including the portion of the dividends constituting interest on private
activity bonds and the percentage and source of interest income earned on
tax-exempt securities held by the Fund during the preceding year.
25
<PAGE>
New York Taxation
The following is only a general summary of certain state and local tax
considerations generally affecting shareholders and is not intended as a
substitute for careful tax planning. As a potential investor in the Funds, you
should consult your tax adviser with specific reference to your own tax
situations.
Each Fund intends to satisfy such requirements of applicable New York law so as
to pay dividends, as described below, that are exempt from New York State and
New York City personal income taxes. Dividends derived from interest on
qualifying New York Municipal Obligations (including certain territories and
possessions of the United States such as Puerto Rico, the Virgin Islands, and
Guam) will be exempt from New York State and New York City personal income
taxes, but not New York State corporate franchise tax or New York City general
corporation tax. Investment in a Fund, however, may result in liability for
state and/or local taxes for individual shareholders subject to taxation by
states other than New York State or cities other than New York City because the
exemption from New York State and New York City personal income taxes does not
prevent such other jurisdictions from taxing individual shareholders on
dividends received from the Funds. For New York State and New York City
personal income tax purposes, distributions of net long-term capital gains will
be taxable at the same rates as ordinary income. Dividends and distributions
derived from income (including capital gains on all New York Municipal
Obligations) other than interest on qualifying New York Municipal Obligations
are not exempt from New York State and New York City taxes. Interest on
indebtedness incurred by a shareholder to purchase or carry shares of the Fund
is not deductible for New York State and New York City personal income tax
purposes. You will receive an annual notification stating your portion of each
Fund's tax-exempt income attributable to qualified New York Municipal
Obligations.
26
<PAGE>
Year 2000
Like other organizations around the world, the Funds could be adversely
affected if the computer systems used by them, their service providers, or
companies in which they invest do not properly process and calculate
information that relates to dates beginning January 1, 2000, and beyond. This
situation may occur because for many years computer programmers used only two
digits to describe years, such as 98 for 1998. A program written in this manner
may not work when it encounters the year 00. To confront this situation, USAA
companies have spent much effort and money; and we expect to have our systems
ready for the Year 2000 by mid-1999. In addition, we are actively assessing the
Year 2000 readiness of our service providers, partners, and companies in whose
securities we invest. It is not possible for us to say that you will experience
no effect from this situation, but we can say that we are making a large effort
to avoid any ill effects upon our shareholders.
We do believe you are entitled to know with certainty that we will stand behind
your share balance as of the close of business in 1999. When the market reopens
in 2000, should any computer problem cause a change in the number of shares in
your account, we will return your account to its proper share balance.
27
<PAGE>
FINANCIAL HIGHLIGHTS
The financial highlights tables are intended to help you understand the Funds'
financial performance for the past five years. Certain information reflects
financial results for a single Fund share. The total returns in the tables
represent the rate that an investor would have earned (or lost) on an
investment in the Fund (assuming reinvestment of all dividends and
distributions). This information has been audited by KPMG Peat Marwick LLP,
whose report, along with the Funds' financial statements, are included in the
Annual Report, which is available upon request.
New York Bond Fund:
Year Ended March 31,
-------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Net asset value at
beginning of period $ 10.94 $ 10.95 $ 10.77 $ 10.83 $11.62
Net investment income .63 .64 .63 .62 .62
Net realized and
unrealized gain (loss) .68 (.01) .18 (.06) (.50)
Distributions from net
investment income (.63) (.64) (.63) (.62) (.62)
Distributions of realized
capital gains - - - - (.29)
------- ------- ------- ------- ------
Net asset value at
end of period $ 11.62 $ 10.94 $ 10.95 $ 10.77 $10.83
======= ======= ======= ======= ======
Total return (%)* 12.24 5.89 7.67 5.42 .68
Net assets at end of
period (000) $70,611 $58,035 $53,987 $50,507 $56,912
Ratio of expenses to
average net assets (%) .50 .50 .50 .50 .50
Ratio of expenses
to average net
assets excluding
reimbursements (%) .61 .66 .69 .71 .69
Ratio of net investment
income to average net
assets (%) 5.54 5.83 5.75 5.83 5.24
Portfolio turnover (%) 49.49 41.42 74.80 74.74 124.40
- ------------------
* Assumes reinvestment of all dividend income and capital gains distributions
during the period.
28
<PAGE>
Financial Highlights (cont.)
New York Money Market Fund:
Year Ended March 31,
-------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Net asset value at
beginning of period $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
Net investment income .03 .03 .04 .03 .02
Distributions from net
investment income (.03) (.03) (.04) (.03) (.02)
------- ------- ------- ------- -------
Net asset value at
end of period $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
======= ======= ======= ======= =======
Total return (%)* 3.29 3.16 3.56 2.76 2.00
Net assets at end of
period (000) $62,226 $49,996 $45,554 $27,525 $24,513
Ratio of expenses to
average net assets (%) .50 .50 .50 .50 .50
Ratio of expenses to average
net assets excluding
reimbursements (%) .63 .69 .78 .85 .98
Ratio of net investment
income to average net
assets (%) 3.23 3.12 3.47 2.74 1.98
- -----------------
* Assumes reinvestment of all dividend income distributions during the period.
29
<PAGE>
APPENDIX A
THE FOLLOWING ARE DESCRIPTIONS OF CERTAIN TYPES OF SECURITIES IN WHICH WE MAY
INVEST EACH FUND'S ASSETS:
VARIABLE RATE SECURITIES
We may invest a Fund's assets in tax-exempt securities that bear interest at
rates which are adjusted periodically to market rates.
o These interest rate adjustments can both raise and lower the income
generated by such securities. These changes will have the same effect on
the income earned by the Fund depending on the proportion of such
securities held.
o The value of variable rate securities is less affected than fixed-coupon
securities by changes in prevailing interest rates because of the periodic
adjustment of their coupons to a market rate. The shorter the period
between adjustments, the smaller the impact of interest rate fluctuations
on the value of these securities.
o The market value of a variable rate security usually tends toward par
(100% of face value) at interest rate adjustment time.
In the case of the New York Money Market Fund only, any variable rate
instrument with a demand feature will be deemed to have a maturity equal to
either the date on which the underlying principal amount may be recovered
through demand or the next rate adjustment date consistent with applicable
regulatory requirements.
PUT BONDS
We may invest a Fund's assets in tax-exempt securities (including securities
with variable interest rates) which may be redeemed or sold back (put) to the
issuer of the security or a third party prior to stated maturity (put bonds).
Such securities will normally trade as if maturity is the earlier put date,
even though stated maturity is longer. For the New York Bond Fund, maturity for
put bonds is deemed to be the date on which the put becomes exercisable.
Generally, maturity for put bonds for the New York Money Market Fund is
determined as stated under Variable Rate Securities.
ZERO COUPON BONDS
We may invest a Fund's assets in zero coupon bonds. A zero coupon bond is a
security that is sold at a deep discount from its face value, makes no periodic
interest payments, and is redeemed at face value when it matures. The lump sum
payment at maturity increases the price volatility of the zero coupon bond to
changes in interest rates when compared to a bond that distributes a semiannual
coupon payment. In calculating its dividend, each Fund records as income the
daily amortization of the purchase discount.
30
<PAGE>
WHEN-ISSUED SECURITIES
We may invest a Fund's assets in new securities offered on a when-issued basis.
o Delivery and payment take place after the date of the commitment to
purchase, normally within 45 days. Both price and interest rate are fixed
at the time of commitment.
o The Funds do not earn interest on the securities until settlement, and the
market value of the securities may fluctuate between purchase and
settlement.
o Such securities can be sold before settlement date.
MUNICIPAL LEASE OBLIGATIONS
We may invest a Fund's assets in a variety of instruments commonly referred to
as municipal lease obligations, including:
o Leases,
o Installment purchase contracts, and
o Certificates of participation in such leases and contracts.
Certain lease obligations contain "non-appropriation" clauses which provide
that the municipality has no obligation to make lease obligation payments in
future years unless money is appropriated for such purpose on a yearly basis.
LIQUIDITY
We may invest up to 15% of the New York Bond Fund's net assets and up to 10% of
the New York Money Market Fund's net assets in securities which are illiquid.
Illiquid securities are those securities that cannot be disposed of in the
ordinary course of business, seven days or less, at approximately the value at
which the Fund has valued the securities.
Lease obligations and certain put bonds subject to restrictions on transfer may
be determined to be liquid in accordance with the guidelines established by the
Funds' Board of Directors.
In determining the liquidity of a lease obligation, we will consider: (1) the
frequency of trades and quotes for the lease obligation; (2) the number of
dealers willing to purchase or sell the lease obligation and the number of
other potential purchasers; (3) dealer undertakings to make a market in the
lease obligation; (4) the nature of the marketplace trades, including the time
needed to dispose of the lease obligation, the method of soliciting offers, and
the mechanics of transfer; (5) whether the lease obligation is of a size that
will be attractive to institutional investors; (6) whether the lease obligation
contains a non-appropriation clause and the likelihood that the obligor will
fail to make an appropriation therefor; and (7) such other factors as we may
determine to be relevant to such determination.
In determining the liquidity of put bonds with restrictions on transfer, we
will evaluate the credit quality of the party (the Put Provider) issuing (or
unconditionally guaranteeing performance on) the unconditional put or demand
feature of the put bond.
31
<PAGE>
APPENDIX B
Taxable Equivalent Yield Table
COMBINED 1998 FEDERAL INCOME TAX AND
NEW YORK STATE PERSONAL INCOME TAX RATES
Assuming a Federal
Marginal Tax Rate of: 28% 31% 36% 39.6%
and a State rate of: 6.85% 6.85% 6.85% 6.85%
The Effective Marginal
Tax Rate would be: 32.9320(a) 35.7265%(b) 40.3840%(c) 43.7374(d)
To Match a Double
Tax Free Yield of: A Fully Taxable Investment Would Have to Pay You:
===============================================================================
2.00% 2.98% 3.11% 3.35% 3.55%
- -------------------------------------------------------------------------------
2.50% 3.73% 3.89% 4.19% 4.44%
- -------------------------------------------------------------------------------
3.00% 4.47% 4.67% 5.03% 5.33%
- -------------------------------------------------------------------------------
3.50% 5.22% 5.45% 5.87% 6.22%
- -------------------------------------------------------------------------------
4.00% 5.96% 6.22% 6.71% 7.11%
- -------------------------------------------------------------------------------
4.50% 6.71% 7.00% 7.55% 8.00%
- -------------------------------------------------------------------------------
5.00% 7.46% 7.78% 8.39% 8.89%
- -------------------------------------------------------------------------------
5.50% 8.20% 8.56% 9.23% 9.78%
- -------------------------------------------------------------------------------
6.00% 8.95% 9.34% 10.06% 10.66%
- -------------------------------------------------------------------------------
6.50% 9.69% 10.11% 10.90% 11.55%
- -------------------------------------------------------------------------------
7.00% 10.44% 10.89% 11.74% 12.44%
===============================================================================
- ----------------
(a) Federal Rate of 28% + (New York State Rate of 6.85% x (1-28%))
(b) Federal Rate of 31% + (New York State Rate of 6.85% x (1-31%))
(c) Federal Rate of 36% + (New York State Rate of 6.85% x (1-36%))
(d) Federal Rate of 39.6% + (New York State Rate of 6.85% x (1-39.6%))
THIS TABLE IS A HYPOTHETICAL ILLUSTRATION AND SHOULD NOT BE CONSIDERED AN
INDICATION OF FUND PERFORMANCE OF ANY OF THE USAA FAMILY OF FUNDS.
THESE RATES WERE SELECTED AS EXAMPLES THAT WOULD BE RELEVANT TO MOST TAXPAYERS.
FOR A FURTHER EXPLANATION ON CALCULATING TAX EQUIVALENT YIELDS, SEE THE FUNDS'
STATEMENT OF ADDITIONAL INFORMATION.
32
<PAGE>
Taxable Equivalent Yield Table
COMBINED 1998 FEDERAL INCOME TAX
AND NEW YORK STATE AND NEW YORK CITY
PERSONAL INCOME TAX RATES
Assuming a Federal
Marginal Tax Rate of: 28% 31% 36% 39.6%
and a Combined State
and City Rate of: 11.25% 11.31% 11.31% 11.31%
The Effective Marginal
Tax Rate would be: 36.1000%(e) 38.8039%(f) 43.2384%(g) 46.4312%(h)
To Match a Double
Tax Free Yield of: A Fully Taxable Investment Would Have to Pay You:
===============================================================================
2.00% 3.13% 3.27% 3.52% 3.73%
- -------------------------------------------------------------------------------
2.50% 3.91% 4.09% 4.40% 4.67%
- -------------------------------------------------------------------------------
3.00% 4.69% 4.90% 5.29% 5.60%
- -------------------------------------------------------------------------------
3.50% 5.48% 5.72% 6.17% 6.53%
- -------------------------------------------------------------------------------
4.00% 6.26% 6.54% 7.05% 7.47%
- -------------------------------------------------------------------------------
4.50% 7.04% 7.35% 7.93% 8.40%
- -------------------------------------------------------------------------------
5.00% 7.82% 8.17% 8.81% 9.33%
- -------------------------------------------------------------------------------
5.50% 8.61% 8.99% 9.69% 10.27%
- -------------------------------------------------------------------------------
6.00% 9.39% 9.80% 10.57% 11.20%
- -------------------------------------------------------------------------------
6.50% 10.17% 10.62% 11.45% 12.13%
- -------------------------------------------------------------------------------
7.00% 10.95% 11.44% 12.33% 13.07%
===============================================================================
(e) Federal Rate of 28% + (New York State Rate of 6.85% + City Rate of 4.40 x
(1-28%))
(f) Federal Rate of 31% + (New York State Rate of 6.85% + City Rate of 4.46 x
(1-31%))
(g) Federal Rate of 36% + (New York State Rate of 6.85% + City Rate of 4.46 x
(1-36%))
(h) Federal Rate of 39.6% + (New York State Rate of 6.85% + City Rate of 4.46
x (1-39.6%))
AN INVESTOR'S TAX RATES MAY EXCEED THE RATES SHOWN IN THE ABOVE TABLES IF SUCH
INVESTOR DOES NOT ITEMIZE DEDUCTIONS FOR FEDERAL INCOME TAX PURPOSES OR DUE TO
THE REDUCTION OR POSSIBLE ELIMINATION OF THE PERSONAL EXEMPTION DEDUCTION FOR
HIGH-INCOME TAXPAYERS AND AN OVERALL LIMIT ON ITEMIZED DEDUCTIONS. FOR
TAXPAYERS WHO PAY ALTERNATIVE MINIMUM TAX, TAX-FREE YIELDS MAY BE EQUIVALENT TO
LOWER TAXABLE YIELDS THAN THOSE SHOWN ABOVE. LIKEWISE, FOR SHAREHOLDERS WHO ARE
SUBJECT TO INCOME TAXATION BY STATES OTHER THAN NEW YORK, TAX-FREE YIELDS MAY
BE EQUIVALENT TO LOWER TAXABLE YIELDS THAN THOSE SHOWN ABOVE. THE ABOVE TABLES
DO NOT APPLY TO CORPORATE INVESTORS.
33
<PAGE>
USAA Family of No-Load Mutual Funds
The USAA Family of No-Load Mutual Funds includes a variety of Funds, each with
different objectives and policies. In combination, these Funds are designed to
provide you with the opportunity to formulate your own investment program. You
may exchange any shares you hold in any one USAA Fund for shares in any other
USAA Fund. For more complete information about other Funds in the USAA Family
of Funds, including charges and expenses, call us for a Prospectus. Read it
carefully before you invest or send money.
FUND
TYPE/NAME VOLATILITY
===============================================================
CAPITAL APPRECIATION
- ---------------------------------------------------------------
Aggressive Growth Very high
Emerging Markets (1) Very high
First Start Growth Moderate to high
Gold (1) Very high
Growth Moderate to high
Growth & Income Moderate
International (1) Moderate to high
S&P 500 Index (2) Moderate
Science & Technology Very high
World Growth (1) Moderate to high
- ---------------------------------------------------------------
ASSET ALLOCATION
- ---------------------------------------------------------------
Balanced Strategy (1) Moderate
Cornerstone Strategy (1) Moderate
Growth and Tax Strategy Moderate
Growth Strategy (1) Moderate to high
Income Strategy Low to moderate
- ---------------------------------------------------------------
INCOME - TAXABLE
- ---------------------------------------------------------------
GNMA Low to moderate
Income Moderate
Income Stock Moderate
Short-Term Bond Low
- ---------------------------------------------------------------
INCOME - TAX EXEMPT
- ---------------------------------------------------------------
Long-Term (3) Moderate
Intermediate-Term (3) Low to moderate
Short-Term (3) Low
State Bond/Income (3,4) Moderate
- ---------------------------------------------------------------
MONEY MARKET
- ---------------------------------------------------------------
Money Market (5) Very low
Tax Exempt Money Market (3,5) Very low
Treasury Money Market Trust (5) Very low
State Money Market (3,4,5) Very low
===============================================================
1 FOREIGN INVESTING IS SUBJECT TO ADDITIONAL RISKS, SUCH AS CURRENCY
FLUCTUATIONS, MARKET ILLIQUIDITY, AND POLITICAL INSTABILITY.
2 S&P(R) IS A TRADEMARK OF THE MCGRAW-HILL COMPANIES, INC., AND HAS BEEN
LICENSED FOR USE. THE PRODUCT IS NOT SPONSORED, SOLD OR PROMOTED BY STANDARD
& POOR'S, AND STANDARD & POOR'S MAKES NO REPRESENTATION REGARDING THE
ADVISABILITY OF INVESTING IN THE PRODUCT.
3 SOME INCOME MAY BE SUBJECT TO STATE OR LOCAL TAXES.
4 CALIFORNIA, FLORIDA, NEW YORK, TEXAS, AND VIRGINIA FUNDS ARE OFFERED ONLY TO
RESIDENTS OF THOSE STATES.
5 AN INVESTMENT IN A MONEY MARKET FUND IS NEITHER INSURED NOR GUARANTEED BY
THE U.S. GOVERNMENT AND THERE IS NO ASSURANCE THAT ANY OF THE FUNDS WILL BE
ABLE TO MAINTAIN A STABLE NET ASSET VALUE OF $1 PER SHARE.
34
<PAGE>
NOTES
<PAGE>
If you would like more information about the Funds, you may call 1-800-531-8181
to request a free copy of the Funds' Statement of Additional Information (SAI),
Annual or Semiannual Reports, or to ask other questions about the Funds. The
SAI has been filed with the Securities and Exchange Commission (SEC) and is
legally a part of the Prospectus. In each Fund's Annual Report, you will find a
discussion of the market conditions and investment strategies that
significantly affected the Fund's performance during the last fiscal year.
To view these documents, along with other related documents, you can visit the
SEC's Internet web site (http://www.sec.gov) or the Commission's Public
Reference Room in Washington, D.C. Information on the operation of the public
reference room can be obtained by calling 1-800-SEC-0330. Additionally, copies
of this information can be obtained, for a duplicating fee, by writing the
Public Reference Section of the Commission, Washington, D.C. 20549-6009.
Investment Adviser, Underwriter and Distributor
USAA Investment Management Company
9800 Fredericksburg Road
San Antonio, Texas 78288
-----------------------------------------------
Transfer Agent Custodian
USAA Shareholder Account Services State Street Bank and Trust Company
9800 Fredericksburg Road P.O. Box 1713
San Antonio, Texas 78288 Boston, Massachusetts 02105
-----------------------------------------------
Telephone Assistance Hours
Call toll free - Central Time
Monday - Friday 8:00 a.m. to 8:00 p.m.
Saturdays 8:30 a.m. to 5:00 p.m.
------------------------------------------------
For Additional Information on Mutual Funds
1-800-531-8181, (in San Antonio) 456-7211
For account servicing, exchanges or redemptions
1-800-531-8448, (in San Antonio) 456-7202
-----------------------------------------------
Recorded Mutual Fund Price Quotes
24-Hour Service (from any phone)
1-800-531-8066, (in San Antonio) 498-8066
-----------------------------------------------
Mutual Fund TouchLINE(R)
(from Touchtone phones only)
For account balance, last transaction or fund prices
1-800-531-8777, (in San Antonio) 498-8777
- -------------------------------------------------------------------------------
Investment Company Act File No. 811-3333
<PAGE>
USAA VIRGINIA FUNDS
USAA VIRGINIA BOND FUND
USAA VIRGINIA MONEY MARKET FUND
Prospectus
August 1, 1998
Shares of the Virginia Funds are offered only to residents of the Commonwealth
of Virginia. The delivery of this Prospectus is not an offer in any state where
shares of the Virginia Funds may not lawfully be made.
As with other mutual funds, the Securities and Exchange Commission has not
approved or disapproved of either of these Fund's shares or determined whether
this prospectus is accurate or complete. Anyone who tells you otherwise is
committing a crime.
TABLE OF CONTENTS
What Are Each Fund's Investment Objectives and Main Strategies?............ 2
Main Risks of Investing in These Funds..................................... 2
Are These Funds for You?................................................... 3
Could the Value of Your Investment in These Funds Fluctuate?............... 4
Fees and Expenses.......................................................... 7
Fund Investments........................................................... 9
Fund Management............................................................ 16
Using Mutual Funds in an Investment Program................................ 18
How to Invest.............................................................. 19
Important Information About Purchases and Redemptions...................... 22
Exchanges.................................................................. 23
Shareholder Information.................................................... 24
Financial Highlights....................................................... 27
Appendix A ................................................................ 29
Appendix B ................................................................ 31
Appendix C................................................................. 32
<PAGE>
USAA Investment Management Company manages these Funds. For easier reading,
USAA Investment Management Company will be referred to as "we" or "us"
throughout the Prospectus.
WHAT ARE EACH FUND'S INVESTMENT OBJECTIVES AND MAIN STRATEGIES?
Each Fund has a common objective of providing Virginia investors with a high
level of current interest income that is exempt from federal and Virginia state
income taxes. The Virginia Money Market Fund has a further objective of
preserving capital and maintaining liquidity. Each Fund has separate investment
policies to achieve its objective.
The VIRGINIA BOND FUND invests primarily in long-term, investment-grade
Virginia tax-exempt securities. The Fund's average dollar-weighted portfolio
maturity is not restricted, but is expected to be greater than 10 years.
The VIRGINIA MONEY MARKET FUND invests in high-quality, Virginia tax-exempt
securities with maturities of 397 days or less.
In view of the risks inherent in all investments in securities, there is no
assurance that the Funds' objectives will be achieved. See FUND INVESTMENTS on
page 9 for more information.
MAIN RISKS OF INVESTING IN THESE FUNDS
The two primary risks of investing in these Funds are credit risk and market
risk. As with other mutual funds, losing money is an additional risk associated
with investing in these Funds.
o CREDIT RISK involves the possibility that a borrower cannot make timely
interest and principal payments on its securities.
o MARKET RISK involves the possibility that the value of each Fund's
investments will decline due to an increase in interest rates, or to
adverse changes in supply and demand for municipal securities, or other
market factors.
These credit and market risks may be magnified because each Fund concentrates
in Virginia tax-exempt securities.
IF INTEREST RATES INCREASE: the yield of each Fund may increase and the market
value of the Virginia Bond Fund's securities will likely decline, adversely
affecting the net asset value and total return.
IF INTEREST RATES DECREASE: the yield of each Fund may decrease and the market
value of the Virginia Bond Fund's securities may increase, which would likely
increase the Fund's net asset value and total return. The Virginia Market
Fund's total return may decrease.
2
<PAGE>
As you consider an investment in any Fund, you should also take into account
your tolerance for the daily fluctuations of the financial markets and whether
you can afford to leave your money in the investment for long periods of time
to ride out down periods.
An investment in either Fund is not a deposit of USAA Federal Savings Bank and
is not insured or guaranteed by the Federal Deposit Insurance Corporation or
any other government agency. Although the Virginia Money Market Fund seeks to
preserve the value of your investment at $1 per share, it is possible to lose
money by investing in that Fund.
[CAUTION LIGHT]
Look for this symbol throughout the Prospectus. We use it to mark more detailed
information about the main risks that you will face as a Fund shareholder.
ARE THESE FUNDS FOR YOU?
Virginia Bond Fund
This Fund might be appropriate as part of your investment portfolio if . . .
|X| You are looking for current income that is exempt from Virginia state and
federal income taxes.
|X| You are willing to accept moderate risk.
|X| You are looking for an investment in bonds to balance your stock portfolio.
This Fund MAY NOT be appropriate as part of your investment portfolio if . . .
|X| You are unable or reluctant to invest for a period of four years or more.
|X| You are unwilling to take greater risk for intermediate-term goals.
|X| Your current tax situation does not allow you to benefit from tax-exempt
income.
|X| You are seeking an appropriate investment for an IRA, through a 401(k) plan
or 403(b) plan, or other tax-sheltered account.
Virginia Money Market Fund
This Fund might be appropriate as part of your investment portfolio if ...
|X| You are looking for current income that is exempt from Virginia state and
federal income taxes.
|X| You need to preserve principal.
|X| You want a low-risk investment.
|X| You need your money back within a short period.
|X| You would like checkwriting privileges on the account.
|X| You are looking for an investment in a money market fund to balance your
stock or long-term bond portfolio.
This Fund MAY NOT be appropriate as part of your investment portfolio if . . .
|X| You need a high total return to achieve your goals.
3
<PAGE>
|X| Your primary goal is long-term growth.
|X| Your current tax situation does not allow you to benefit from tax-exempt
income.
COULD THE VALUE OF YOUR INVESTMENT IN THESE FUNDS FLUCTUATE?
Yes, it could. In fact, the value of your investment in the Virginia Bond Fund
likely will increase or decrease. We manage the Virginia Money Market Fund in
accordance with strict Securities and Exchange Commission (SEC) guidelines
designed to preserve the Fund's value at $1 per share, although, of course, we
cannot guarantee that the value will remain at $1 per share.
The value of the securities in which the Virginia Bond Fund invests typically
fluctuates inversely with changes in the general level of interest rates.
Changes in the creditworthiness of issuers and changes in other market factors
such as the relative supply of and demand for tax-exempt bonds also create
value fluctuations. The bar charts shown below illustrate the Funds' volatility
and performance from year to year over the life of the Funds.
TOTAL RETURN
All mutual funds must use the same formulas to calculate total return.
Virginia Bond Fund
TOTAL RETURN
TOTAL RETURN
MEASURES THE
PRICE CHANGE
IN A SHARE
ASSUMING THE
REINVESTMENT
OF ALL DIVIDEND
INCOME AND
CAPITAL GAIN
DISTRIBUTIONS.
[BAR CHART]
CALENDAR TOTAL RETURN
YEAR PERCENTAGE
1990* 3.95%
1991 11.72%
1992 8.49%
1993 12.67%
1994 -6.32%
1995 17.08%
1996 5.06%
1997 9.50%
*FUND BEGAN OPERATIONS ON OCTOBER 15, 1990.
THE VIRGINIA BOND FUND'S TOTAL RETURN FOR THE SIX-MONTH PERIOD ENDED
JUNE 30, 1998, WAS 2.70%.
4
<PAGE>
During the periods shown in the bar chart, the highest total return for a
quarter was 7.72% (quarter ending March 31, 1995) and the lowest total return
for a quarter was -5.34% (quarter ending March 31, 1994).
The table below shows how the Fund's average annual returns for the one- and
five-year periods and the life of the Fund compared to those of a broad-based
securities market index. Remember, historical performance does not necessarily
indicate what will happen in the future.
===============================================================================
Average Annual Total Returns Since Fund's
(for the period ending Past Past Inception on
December 31, 1997) 1 Year 5 Years October 15, 1990
- -------------------------------------------------------------------------------
Virginia Bond Fund 9.50% 7.29% 8.36%
- -------------------------------------------------------------------------------
Lehman Bros. Municipal
Bond Index* 9.19% 7.36% 8.44%
===============================================================================
* THE LEHMAN BROS. MUNICIPAL BOND INDEX IS AN UNMANAGED BENCHMARK OF TOTAL
RETURN PERFORMANCE FOR THE LONG-TERM, INVESTMENT-GRADE, TAX EXEMPT BOND
MARKET.
Virginia Money Market Fund
[BAR CHART]
CALENDAR TOTAL RETURN
YEAR PERCENTAGE
1990* 1.17%
1991 4.50%
1992 2.91%
1993 2.20%
1994 2.54%
1995 3.52%
1996 3.17%
1997 3.31%
*FUND BEGAN OPERATIONS ON OCTOBER 15, 1990.
THE VIRGINIA MONEY MARKET FUND'S TOTAL RETURN FOR THE SIX-MONTH PERIOD
ENDED JUNE 30, 1998, WAS 1.61%.
During the periods shown in the bar chart, the highest total return for a
quarter was 1.20% (quarter ending March 31, 1991) and the lowest total return
for a quarter was .49% (quarter ending March 31, 1994).
5
<PAGE>
YIELD
YIELD IS THE
ANNUALIZED NET
INCOME OF THE
FUND DURING A
SPECIFIED PERIOD
AS A PERCENTAGE
OF THE FUND'S
SHARE PRICE.
All mutual funds must use the same formulas to calculate yield and effective
yield.
VIRGINIA BOND FUND
The Virginia Bond Fund may advertise performance in terms of a 30-day yield
quotation or a tax equivalent yield. The Fund's 30-day yield for the period
ended December 31, 1997, was 4.86%.
EFFECTIVE YIELD
IS CALCULATED
SIMILAR TO
THE YIELD,
HOWEVER, WHEN
ANNUALIZED,
THE INCOME
EARNED IS
ASSUMED TO BE
REINVESTED.
VIRGINIA MONEY MARKET FUND
The Virginia Money Market Fund typically advertises performance in terms of a
7-day yield and effective yield or tax equivalent yield and may advertise total
return. The 7-day yield quotation more closely reflects current earnings of the
Fund than the total return quotation. The effective yield will be slightly
higher than the yield because of the compounding effect of the assumed
reinvestment. Current yields and effective yields fluctuate daily and will vary
with factors such as interest rates and the quality, length of maturities, and
type of investments in the portfolio. The Fund's 7-day yield for the period
ended December 31, 1997, was 3.61%.
You may obtain the most current yield information for either of the Funds by
calling 1-800-531-8777.
TAX EQUIVALENT YIELD
Investors use tax equivalent yields to compare taxable and tax-exempt fixed
income investments using a common yield measure. The tax equivalent yield is
the yield that a fully taxable investment must generate to earn the same
"take-home" yield as a tax-exempt investment. The calculation depends upon your
federal and Virginia marginal income tax rates and assumes that an investor can
fully itemize deductions on his or her federal tax return. The higher your
marginal tax bracket, the higher will be the tax equivalent yield and the more
valuable is the Fund's tax exemption.
For example, if you assume a federal marginal tax rate of 36% and a state
marginal tax rate of 5.75%, the Effective Marginal Tax Rate would be 39.68%.
Using this tax rate, the Funds' tax equivalent yields for the period ending
December 31, 1997, would be as follows:
===============================================================================
Tax Equivalent
Yield Yield
- -------------------------------------------------------------------------------
Virginia Bond Fund (30 day) 4.86% 8.06%
- -------------------------------------------------------------------------------
Virginia Money Market Fund (7 day) 3.61% 5.98%
===============================================================================
6
<PAGE>
Using the example, to exceed the 30-day yield of the Virginia Bond Fund on an
after-tax basis, you must find a fully taxable investment that yields more than
8.06%. Likewise, to exceed the 7-day yield of the Virginia Money Market Fund,
you must find a fully taxable investment that yields more than 5.98%.
For more information on calculating tax equivalent yields, see APPENDIX B on
page 31.
[TELEPHONE GRAPHIC]
TouchLINE (R)
1-800-531-8777
PRESS
1
THEN
1
THEN
6 5 #
Please consider performance information in light of the Funds' investment
objectives and policies and market conditions during the reported time periods.
Again, you must remember that historical performance does not necessarily
indicate what will happen in the future. The value of your shares may go up or
down. For the most current price, yield, and return information for these
Funds, you may call TouchLine(R) at 1-800-531-8777. Press 1 for the Mutual Fund
Menu, press 1 again for prices, yields, and returns. Then, press 64# for the
Virginia Bond Fund or press 65# for the Virginia Money Market Fund when asked
for a Fund Code.
VIRGINIA
BOND FUND
NEWSPAPER
SYMBOL
VA Bd
TICKER
SYMBOLS
USVAX
UVAXX
You can also find the most current price of your shares in the business section
of your newspaper in the mutual fund section under the heading "USAA Group" and
the symbol "VA Bd" for the Virginia Bond Fund. If you prefer to obtain this
information from an on-line computer service, you can do so by using the ticker
symbol "USVAX" for the Virginia Bond Fund or the ticker symbol "UVAXX" for the
Virginia Money Market Fund.
FEES AND EXPENSES
This summary shows what it will cost you directly or indirectly to invest in
the Funds.
Shareholder Transaction Expenses -- Fees You Pay Directly
There are no fees or sales loads charged to your account when you buy or sell
Fund shares. However, if you sell shares and request your money by wire
transfer, there is a $10 fee. (Your bank may also charge a fee for receiving
wires.)
Annual Fund Operating Expenses -- Fees You Pay Indirectly
Fund expenses come out of the Funds' assets and are reflected in the Funds'
share prices and dividends. "Other Expenses" include expenses such as custodian
and transfer agent fees. The figures on the next page show actual expenses
before waivers, if any, during the past fiscal year ended March 31, 1998, and
are calculated as a percentage of average net assets (ANA).
7
<PAGE>
12B-1 FEES -
SOME MUTUAL
FUNDS CHARGE
THESE FEES
TO PAY FOR
ADVERTISING
AND OTHER
COSTS OF SELLING
FUND SHARES.
===============================================================================
Virginia Virginia
Bond Fund Money Market Fund
- -------------------------------------------------------------------------------
Management Fees .33% .33%
Distribution (12b-1) Fees None None
Other Expenses .11% .18%
---- ----
Total Annual Fund Operating Expenses .44% .51%
==== ====
===============================================================================
* During the year, we voluntarily limited each Fund's Total Annual Fund
Operating Expenses to .50% of its ANA. However, the Total Fund Operating
Expenses for the Virginia Bond Fund did not exceed the limitation,
therefore, no reimbursements were required. With respect to the Virginia
Money Market Fund, these reimbursements were as follows:
==============================================================
Virginia
Money Market Fund
--------------------------------------------------------------
Total Annual Fund Operating Expenses .51%
Reimbursement from USAA Investment
Management Company (.01%)
-----
Actual Fund Operation Expenses
After Reimbursement .50%
====
==============================================================
We have again voluntarily agreed to limit each Fund's annual expenses to
.50% of its ANA and will reimburse the Funds for all expenses in excess of
that amount until August 1, 1999.
Example of Effect of the Funds' Operating Expenses
This example is intended to help you compare the cost of investing in one of
the Funds with the cost of investing in other mutual funds. Although your
actual costs may be higher or lower, you would pay the following expenses on a
$10,000 investment, assuming (1) 5% annual return, (2) the Fund's operating
expenses (before any applicable reimbursement) remain the same, and (3) you
redeem all of your shares at the end of those periods shown.
Virginia Virgina
Bond Fund Money Market Fund
- -------------------------------------------------------------------------------
1 year $ 45 $ 52
3 years 141 164
5 years 246 285
10 years 555 640
8
<PAGE>
FUND INVESTMENTS
Principal Investment Strategies and Risks
Q What is each Fund's principal investment strategy?
A Each Fund's principal investment strategy is to invest the Fund's assets
in securities issued by the Commonwealth of Virginia, its political
subdivisions and instrumentalities, and by other governmental entities if,
in the opinion of counsel, the interest from such obligations is excluded
from gross income for federal income tax purposes and is exempt from
Virginia state income taxes.
These securities include municipal debt obligations that have been issued
by Virginia and its political subdivisions, and duly constituted state and
local authorities and corporations. We refer to these securities as
Virginia tax-exempt securities. Virginia tax-exempt securities are issued
to fund public infrastructure projects such as streets and highways,
schools, water and sewer systems, hospitals, and airports. They may also
be issued to refinance outstanding obligations as well as to obtain funds
for general operating expenses and for loans to other public institutions
and facilities.
Because the projects benefit the public, Congress has granted exemption
from federal income taxes for the interest income arising from these
securities. Likewise, the Virginia Legislature has granted an exemption
from state personal income taxes for most Virginia municipal securities.
Q What types of tax-exempt securities will be included in each Fund's
portfolio?
A Each Fund's assets may be invested in any of the following tax-exempt
securities:
o general obligation bonds which are secured by the issuer's pledge of its
full faith, credit, and taxing power for the payment of principal and
interest;
o revenue bonds which are payable from the revenue derived from a
particular facility or class of facilities or, in some cases, from
annual appropriations made by the state legislature for the repayment of
interest and principal or other specific revenue source, but not from
the general taxing power;
9
<PAGE>
o lease obligations backed by the municipality's covenant to budget for
the payments due under the lease obligation; and
o industrial development bonds issued by or on behalf of public
authorities to obtain funds for privately-operated facilities.
As a temporary defensive measure because of market, economic, political,
or other conditions, we may invest up to 100% of each Fund's assets in
short-term securities whether or not they are exempt from federal income
tax and Virginia state income taxes. To the extent that these temporary
investments produce taxable income, that income may result in that Fund
not fully achieving its investment objective during the time it is in
this temporary defensive posture.
Q What are the principal risks associated with investments in tax-exempt
securities?
A The two principal risks of investing in tax-exempt securities are credit
risk and market risk.
[CAUTION LIGHT]
CREDIT RISK. Credit risk is the possibility that an issuer of a fixed
income security will fail to make timely payments of interest or
principal. We attempt to minimize the Funds' credit risks by investing in
securities considered at least investment grade at the time of purchase.
Nevertheless, even investment-grade securities are subject to some credit
risk. In addition, the ratings of securities are estimates by the rating
agencies of the credit quality of the securities. The ratings may not take
into account every risk related to whether interest or principal will be
repaid on a timely basis.
When evaluating potential investments for the Funds, our analysts also
independently assess credit risk and its impact on the Funds'portfolios.
Securities in the lowest investment grade ratings category (BBB) have
speculative characteristics. Changes in economic conditions or other
circumstances are more likely to lead to a weakened capability to make
principal and interest payments on these securities than is the case for
higher-rated securities.
[CAUTION LIGHT]
MARKET RISK. As a mutual fund investing in bonds, the Funds are subject to
the risk that the market value of the bonds will decline because of rising
interest rates. Bond prices are linked to the prevailing market interest
rates. In general, when interest rates rise, the prices of bonds fall and
when interest rates fall, bond prices generally rise. The price volatility
of a bond also depends on its maturity. Generally, the longer the maturity
of a bond, the greater its sensitivity to interest rates. To compensate
investors for
10
<PAGE>
this higher market risk, bonds with longer maturities generally offer
higher yields than bonds with shorter maturities.
Q What percentage of each Fund's assets will be invested in Virginia
tax-exempt securities?
A During normal market conditions, at least 80% of each Fund's net assets
will consist of Virginia tax-exempt securities. This policy may only be
changed by a shareholder vote.
In addition to Virginia tax-exempt securities, securities issued by
certain U.S. territories and possessions such as Puerto Rico, the Virgin
Islands, and Guam are exempt from federal and state personal income taxes;
and as such, we may consider investing up to 20% of each Fund's assets in
these securities.
Q Are each Fund's investments diversified in many different issuers?
A Each Fund is considered diversified under the federal securities laws.
This means that we will not invest more than 5% in any one issuer with
respect to 75% of each Fund's assets. With respect to the remaining 25% of
each Fund's assets, we could invest more than 5% in any one, or more,
issuers. Purchases of securities issued or guaranteed by the U.S.
Government or its agencies or instrumentalities are not counted toward the
5% limitation. Each Fund, of course, is concentrated geographically
through the purchase of Virginia tax-exempt securities.
With respect to the Virginia Money Market Fund, strict SEC guidelines do
not permit us to invest, with respect to 75% of the Fund's assets, greater
than 10% of the Fund's assets in securities issued by or subject to
guarantees by the same institution.
We also may not invest more than 25% of the Fund's assets in securities
issued in connection with the financing of projects with similar
characteristics, such as toll road revenue bonds, housing revenue bonds,
or electric power project revenue bonds, or in industrial revenue bonds
which are based, directly or indirectly, on the credit of private entitles
of any one industry. However, we reserve the right to invest more than 25%
of the Fund's assets in tax-exempt industrial revenue bonds.
Q What are the potential risks associated with concentrating such a large
portion of each Fund's assets in one state?
[CAUTION LIGHT]
A The Funds are subject to credit and market risks, as described above,
which could be magnified by the Funds' concentration in
11
<PAGE>
Virginia issues. Virginia tax-exempt securities may be affected by
political, economic, regulatory, or other developments that limit the
ability of Virginia issuers to pay interest or repay principal in a timely
manner. Therefore, the Funds are affected by events within Virginia to a
much greater degree than a more diversified national fund.
A particular development may not directly relate to the Funds' investments
but nevertheless might depress the entire market for the state's
tax-exempt securities and therefore adversely impact the Funds' valuation.
An investment in the Virginia Money Market Fund may be riskier than an
investment in other types of money market funds because of this
concentration.
The following are examples of just some of the events that may depress
valuations for Virginia tax-exempt securities for an extended period of
time:
o Changes in state laws, including voter referendums, that restrict
revenues or raise costs for issuers.
o Court decisions that affect a category of municipal bonds, such as
municipal lease obligations or electric utilities.
o Natural disasters such as floods, storms, hurricanes, droughts, fires,
or earthquakes.
o Bankruptcy or financial distress of a prominent municipal issuer within
the state.
o Economic issues that impact critical industries, or large employers, or
that weaken real estate prices.
o Reductions in federal or state financial aid.
o Imbalance in the supply and demand for the state's municipal securities.
o Developments that may change the tax treatment of Virginia tax-exempt
securities.
In addition, because each Fund invests in securities backed by banks and
other financial institutions, changes in the credit quality of these
institutions could cause losses to a Fund and affect its share price.
Other considerations affecting the Funds' investments in Virginia
obligations are summarized in the Statement of Additional Information
under SPECIAL RISK CONSIDERATIONS.
12
<PAGE>
Q Will any portion of the distributions from the Funds be subject to federal
income taxes?
A During normal market conditions, at least 80% of each Fund's annual income
will be excluded from gross income for federal income tax purposes and
will be exempt from Virginia state income taxes. This policy may only be
changed by a shareholder vote. We expect that any taxable interest income
distributed will be minimal.
However, gains and losses from trading securities that occur during the
normal course of managing a fund may create net capital gain
distributions. The Internal Revenue Code presently treats these
distributions differently than tax-exempt interest income in the following
ways:
o Distributions of net short-term capital gains are taxable as ordinary
income.
o Distributions of net long-term capital gains are taxable as long-term
capital gains, regardless of the length of time you have held the Fund
shares. These distributions may be taxable at different rates depending
on the length of time the Funds held the applicable investment.
o Both short-term and long-term capital gains are taxable whether received
in cash or reinvested in additional shares.
Q Will income from the Funds be subject to the federal alternative minimum
tax (AMT) for individuals?
A During normal market conditions, at least 80% of each Fund's annual income
will be excluded from the calculation of the federal alternative minimum
tax (AMT) for individuals. This policy may only be changed by a
shareholder vote. Since inception, the Funds have not distributed any
income that is subject to the federal AMT for individuals, and we do not
intend to invest in securities subject to the federal AMT. However, of
course, changes in federal tax laws or other unforeseen circumstances
could result in income subject to the federal AMT for individuals.
Virginia Bond Fund
Q What is the credit quality of the Fund's investments?
A Under normal market conditions, we will invest the Fund's assets so that
at least 50% of the total market value of the tax-exempt securities is
rated within the three highest long-term rating categories (A or
13
<PAGE>
higher) by Moody's Investors Service, Inc. (Moody's), Standard & Poor's
Ratings Group (S&P), or Fitch IBCA, Inc. (Fitch) or in the highest
short-term rating category by Moody's, S&P, or Fitch; or if a security is
not rated by those rating agencies, we must determine that the security is
of equivalent investment quality.
In no event will we purchase a security for the Fund unless it is rated at
least investment grade at the time of purchase. Investment-grade
securities are those securities rated within the four highest long-term
rating categories by Moody's (Baa or higher), S&P, or Fitch (BBB or
higher), or in the two highest short-term rating categories by these
rating agencies; or if unrated by these agencies, we must determine that
the securities are of equivalent investment quality.
You will find a complete description of the above tax-exempt ratings in
the Fund's Statement of Additional Information.
Q What happens if the rating of a security is downgraded to below investment
grade?
A We will determine whether it is in the best interest of the Fund's
shareholders to continue to hold the security in the Fund's portfolio.
If downgrades result in more than 5% of the Fund's net assets being
invested in securities that are less than investment-grade quality, we
will take immediate action to reduce the Fund's holdings in such
securities to 5% or less of the Fund's net assets, unless otherwise
directed by the Board of Directors.
Q How does the portfolio manager decide which securities to buy and sell?
A He manages tax-exempt funds based on the common sense premise that our
investors value tax-exempt income over taxable capital gain
distributions. When weighing his decision to buy or sell a security he
strives to balance the value of the tax-exempt income, the credit risk of
the issuer, and the price volatility of the bond.
Q What is the Fund's average portfolio maturity and how is it calculated?
A While the Fund's average portfolio maturity is not restricted, we expect
it to be greater than 10 years. To determine a security's maturity for
purposes of calculating the Fund's average portfolio maturity, we may
estimate the expected time in which the security's principal is to be
paid. This can be substantially shorter than its stated final maturity.
For more information on the method of calculating the Fund's average
weighted portfolio
14
<PAGE>
maturity, see INVESTMENT POLICIES in the Fund's Statement of Additional
Information.
Virginia Money Market Fund
Q What is the credit quality of the Fund's investments?
A The Fund's investments consist of securities meeting the requirements to
qualify as "eligible securities" under the SEC rules applicable to money
market funds. In general, an eligible security is defined as a security
that is:
o issued or guaranteed by the U.S. Government or any agency or
instrumentality thereof, including "prerefunded" and "escrowed to
maturity" tax-exempt securities;
o rated or subject to a guarantee that is rated in one of the two highest
categories for short-term securities by at least two Nationally
Recognized Statistical Rating Organizations (NRSROs), or by one NRSRO if
the security is rated by only one NRSRO;
o unrated but issued by an issuer or guaranteed by a guarantor that has
other comparable short-term debt obligations so rated; or
o unrated but determined by us to be of comparable quality.
In addition, we must consider whether a particular investment presents
minimal credit risk.
Q Who are the Nationally Recognized Statistical Rating Organizations?
A Current NRSROs include:
o Moody's Investors Service, Inc.;
o Standard & Poor's Ratings Group;
o Fitch IBCA, Inc.;
o Duff & Phelps Inc.; and
o Thompson BankWatch, Inc.
Q What happens if the rating of a security is downgraded?
A If the rating of a security is downgraded after purchase, we will
determine whether it is in the best interest of the Fund's shareholders to
continue to hold the security in the Fund's portfolio.
15
<PAGE>
Q Will the Fund always maintain a net asset value of $1 per share?
A While we will endeavor to maintain a constant Fund net asset value of $1
per share, there is no assurance that we will be able to do so. Remember,
the shares are neither insured nor guaranteed by the U.S. Government. As
such, the Fund carries some risk.
For example, there is always a risk that the issuer of a security held by
the Fund will fail to pay interest or principal when due. We attempt to
minimize this credit risk by investing only in securities rated in one of
the two highest categories for short-term securities, or, if not rated, of
comparable quality, at the time of purchase. Additionally, we will not
purchase a security unless our analysts determine that the security
presents minimal credit risk.
There is also a risk that rising interest rates will cause the value of
the Fund's securities to decline. We attempt to minimize this interest
risk by limiting the maturity of each security to 397 days or less and
maintaining a dollar-weighted average portfolio maturity for the Fund of
90 days or less.
DOLLAR-
WEIGHTED
AVERAGE
PORTFOLIO
MATURITY IS
OBTAINED BY
MULTIPLYING
THE DOLLAR
VALUE OF EACH
INVESTMENT
BY THE NUMBER
OF DAYS LEFT TO
ITS MATURITY,
THEN ADDING
THOSE FIGURES TOGETHER
AND DIVIDING THE
TOTAL BY THE
DOLLAR VALUE
OF THE FUND'S
PORTFOLIO.
15
<PAGE>
Finally, there is the possibility that one or more investments in the Fund
cease to be "eligible securities" resulting in the net asset value ceasing
to be $1 per share. For example, a guarantor on a security may fail to
meet a contractual obligation.
Q How does the portfolio manager decide which securities to buy and sell?
A He balances factors such as credit quality and maturity to purchase the
best relative value available in the market at any given time. While rare,
sell decisions are usually based on a change in his credit analysis or to
take advantage of an opportunity to reinvest at a higher yield.
For additional information about other securities in which we may invest each
Fund's assets, see APPENDIX A on page 29.
FUND MANAGEMENT
The Company has retained us, USAA Investment Management Company, to serve as
the manager and distributor for the Company. We are an affiliate of United
Services Automobile Association (USAA), a large, diversified financial services
institution. As of the date of this Prospectus, we had approximately $39
billion in total assets under management. Our mailing address is 9800
Fredericksburg Road, San Antonio, TX 78288.
16
<PAGE>
We provide management services to the Funds pursuant to an Advisory Agreement.
We are responsible for managing the Funds' portfolios (including placement of
brokerage orders) and their business affairs, subject to the authority of and
supervision by the Board of Directors. For our services, the Funds pay us an
annual fee. This fee, which is accrued daily and paid monthly, is computed as a
percentage of the aggregate average net assets of both Funds combined. This fee
is allocated between the Funds based on the relative net assets of each. The
fee is computed at one-half of one percent (.50%) of the first $50 million of
average net assets, two-fifths of one percent (.40%) for that portion of
average net assets over $50 million but not over $100 million, and three-tenths
of one percent (.30%) for that portion of average net assets over $100 million.
The fees we received for the fiscal year ended March 31, 1998, were equal to
.33% of average net assets for the Virginia Bond Fund and, net of
reimbursements, .32% of average net assets for the Virginia Money Market Fund.
We also provide services related to selling the Funds' shares and receive no
compensation for those services.
Although our officers and employees, as well as those of the Company, may
engage in personal securities transactions, they are restricted by the
procedures in a Joint Code of Ethics adopted by the Company and us.
Portfolio Managers
The following individuals are primarily responsible for managing the Funds:
Virginia Bond Fund
[PHOTOGRAPH OF
PORTFOLIO MANAGER]
Robert R. Pariseau
Robert R. Pariseau, Assistant Vice President of Fixed Income Investments since
June 1995, has managed the Fund since May 1995. He has 14 years investment
management experience working for us. Mr. Pariseau earned the Chartered
Financial Analyst (CFA) designation in 1987 and is a member of the Association
for investment Management and Research (AIMR), San Antonio Financial Analysts
Society, Inc. (SAFAS), and the National Federation of Municipal Analysts
(NFMA). He holds an MBA from Lindenwood College and a BS from the U.S. Naval
Academy.
Virginia Money Market Fund
[PHOTOGRAPH OF
PORTFOLIO MANAGER]
John C. Bonnell
John C. Bonnell, Executive Director of Money Market Funds since May 1996, has
managed the Fund since May 1996. He has nine years investment management
experience working for us. Mr. Bonnell earned the CFA designation in 1994 and
is a member of AIMR, SAFAS, NFMA, and the Southern Municipal Finance Society.
He holds an MBA from St. Mary's University and a BBA from the University of
Texas at San Antonio.
17
<PAGE>
USING MUTUAL FUNDS IN AN INVESTMENT PROGRAM
I. The Idea Behind Mutual Funds
Mutual funds provide small investors some of the advantages enjoyed by wealthy
investors. A relatively small investment can buy part of a diversified
portfolio. That portfolio is managed by investment professionals, relieving you
of the need to make individual stock or bond selections. You also enjoy
conveniences, such as daily pricing, liquidity, and in the case of the USAA
Family of Funds, no sales charge. The portfolio, because of its size, has lower
transaction costs on its trades than most individuals would have. As a result,
you own an investment that in earlier times would have been available only to
very wealthy people.
II. Using Funds in an Investment Program
In choosing a mutual fund as an investment vehicle, you are giving up some
investment decisions, but must still make others. The decisions you don't have
to make are those involved with choosing individual securities. We will perform
that function. In addition, we will arrange for the safekeeping of securities,
auditing the annual financial statements, and daily valuation of the Fund, as
well as other functions.
You, however, retain at least part of the responsibility for an equally
important decision. This decision involves determining a portfolio of mutual
funds that balances your investment goals with your tolerance for risk. It is
likely that this decision may include the use of more than one fund of the USAA
Family of Funds.
For example, assume you wish to pursue the higher yields usually available in
the long-term bond market, but you are also concerned about the possible price
swings of the long-term bonds. You could divide your investments between the
Virginia Bond Fund and the Virginia Money Market Fund. This would create a
portfolio with a higher yield than that of the money market and less volatility
than that of the long-term market. This is just one way you could combine funds
to fit your own risk and reward goals.
III. USAA's Family of Funds
We offer you another alternative with our asset strategy funds listed under
asset allocation on page 32. These unique mutual funds provide a professionally
managed diversified investment portfolio within a mutual fund. Designed for the
individual who prefers to delegate the asset allocation process to an
investment manager, their structure achieves diversification across a number of
investment categories.
18
<PAGE>
Whether you prefer to create your own mix of mutual funds or use a USAA Asset
Strategy Fund, the USAA Family of Funds provides a broad range of choices
covering just about any investor's investment objectives. Our sales
representatives stand ready to assist you with your choices and to help you
craft a portfolio to meet your needs. Refer to APPENDIX C on page 32 for a
complete list of the USAA Family of No-Load Mutual Funds.
HOW TO INVEST
Purchase of Shares
OPENING AN ACCOUNT
You may open an account and make an investment as described below by mail, in
person, bank wire, electronic funds transfer (EFT), or phone. A complete,
signed application is required for each new account. However, after you open
your initial account with us, you will not need to fill out another application
unless the registration is different.
TAX ID NUMBER
Each shareholder named on the account must provide a social security number or
tax identification number to avoid possible withholding requirements.
EFFECTIVE DATE
When you make a purchase, your purchase price will be the net asset value (NAV)
per share next determined after we receive your request in proper form. Each
Fund's NAV is determined at the close of the regular trading session (generally
4:00 p.m. Eastern Time) of the New York Stock Exchange (NYSE) each day the NYSE
is open. If we receive your request and payment prior to that time, your
purchase price will be the NAV per share determined for that day. If we receive
your request or payment after the NAV per share is calculated, the purchase
will be effective on the next business day. If you plan to purchase Fund shares
with a foreign check, we suggest you convert your foreign check to U.S. dollars
prior to investment in a Fund to avoid a potential delay in the effective date
of your purchase of up to four to six weeks. Furthermore, a bank charge may be
assessed in the clearing process, which will be deducted from the amount of the
purchase.
MINIMUM INVESTMENTS
INITIAL PURCHASE
[MONEY GRAPHIC]
o $3,000. Employees of USAA and its affiliated companies may open an account
through payroll deduction for as little as $25 per pay period with no
initial investment.
ADDITIONAL PURCHASES
o $50 (Except transfers from brokerage accounts into the Virginia Money
Market Fund, which are exempt from the minimum).
19
<PAGE>
HOW TO PURCHASE
[ENVELOPE GRAPHIC]
MAIL
o To open an account, send your application and check to:
USAA Investment Management Company
9800 Fredericksburg Road
San Antonio, TX 78288
o To add to your account, send your check and the "Invest by Mail" stub that
accompanies your Fund's transaction confirmation to the Transfer Agent:
USAA Shareholder Account Services
9800 Fredericksburg Road
San Antonio, TX 78288
IN PERSON
[HANDSHAKE GRAPHIC]
o To open an account, bring your application and check to:
USAA Investment Management Company
USAA Federal Savings Bank
10750 Robert F. McDermott Freeway
San Antonio, TX 78288
BANK WIRE
[WIRE GRAPHIC]
o Instruct your bank (which may charge a fee for the service) to wire the
specified amount to the Fund as follows:
State Street Bank and Trust Company
Boston, MA 02101
ABA#011000028
Attn: USAA Virginia Fund Name
USAA Account Number: 69384998
Shareholder(s) Name(s)______________________________________
Shareholder(s) Mutual Fund Account Number___________________
ELECTRONIC FUNDS TRANSFER
[CALENDAR GRAPHIC]
o Additional purchases on a regular basis can be deducted from a bank
account, paycheck, income-producing investment, or USAA money market fund
account. Sign up for these services when opening an account or call
1-800-531-8448 to add these services.
PHONE 1-800-531-8448
[TELEPHONE GRAPHIC]
o If you have an existing USAA account and would like to open a new account
or exchange to another USAA fund, call for instructions. To open an account
by phone, the new account must have the same registration as your existing
account.
20
<PAGE>
Redemption of Shares
You may redeem Fund shares by any of the methods described below on any day the
NAV per share is calculated. Redemptions are effective on the day instructions
are received in a manner as described below. However, if instructions are
received after the NAV per share calculation (generally 4:00 p.m. Eastern
Time), redemption will be effective on the next business day.
We will send you your money within seven days after the effective date of
redemption. Payment for redemption of shares purchased by EFT or check is sent
after the EFT or check has cleared, which could take up to 15 days from the
purchase date. If you are considering redeeming shares soon after purchase, you
should purchase by bank wire or certified check to avoid delay.
Redemptions are subject to taxes based on the difference between the cost of
shares when purchased and the price received upon redemption.
In addition, the Company may elect to suspend the redemption of shares or
postpone the date of payment in limited circumstances.
HOW TO REDEEM
WRITTEN, FAX, TELEGRAPH, OR TELEPHONE
[FAX MACHINE GRAPHIC]
o Send your written instructions to:
USAA Shareholder Account Services
9800 Fredericksburg Road
San Antonio, TX 78288
o Send a signed fax to 1-800-292-8177, or send a telegram to USAA Shareholder
Account Services.
o Call toll free 1-800-531-8448, in San Antonio, 456-7202.
Telephone redemption privileges are automatically established when you complete
your application. The Fund will employ reasonable procedures to confirm that
instructions communicated by telephone are genuine; and if it does not, it may
be liable for any losses due to unauthorized or fraudulent instructions. Before
any discussion regarding your account, we obtain the following information: (1)
USAA number or account number, (2) the name(s) on the account registration, and
(3) social security number or tax identification number for the account
registration. In addition, we record all telephone communications with you and
send confirmations of account transactions to the address of record. If you
were issued stock certificates for your shares, redemption by telephone, fax,
or telegram is not available.
21
<PAGE>
CHECKWRITING
[CHECKBOOK GRAPHIC]
o Checks can be issued for your Virgina Money Market Fund account. Return a
signed signature card, which accompanies your application, or request a
signature card separately and return to:
USAA Shareholder Account Services
9800 Fredericksburg Road
San Antonio, TX 78288
You will not be charged for the use of checks or any subsequent reorders. Your
checkwriting privilege is subject to State Street Bank and Trust Company's
rules and regulations governing checking accounts. You may write checks in the
amount of $250 or more. Checks written for less than $250 will be returned
unpaid. Because the value of your account changes daily as dividends accrue,
you may not write a check to close your account.
IMPORTANT INFORMATION ABOUT PURCHASES AND REDEMPTIONS
Investor's Guide to USAA Mutual Fund Services
[INVESTOR'S GUIDE GRAPHIC]
Upon your initial investment with us, you will receive the INVESTOR'S GUIDE to
help you get the most out of your USAA mutual fund account and to help you in
your role as an investor. In the INVESTOR'S GUIDE, you will find additional
information on purchases, redemptions, and methods of payment. You will also
find in-depth information on automatic investment plans, shareholder statements
and reports, and other useful information.
Account Balance
USAA Shareholder Account Services (SAS), the Funds' transfer agent, may assess
annually a small balance account fee of $12 to each shareholder account with a
balance, at the time of assessment, of less than $2,000. The fee will reduce
total transfer agency fees paid by the Fund to SAS. Accounts exempt from the
fee include: (1) any account regularly purchasing additional shares each month
through an automatic investment plan; (2) any account registered under the
Uniform Gifts/Transfers to Minors Act (UGMA/UTMA); (3) all (non-IRA) money
market fund accounts; (4) any account whose registered owner has an aggregate
balance of $50,000 or more invested in USAA mutual funds; and (5) all IRA
accounts (for the first year the account is open).
Company Rights
The Company reserves the right to:
o reject purchase or exchange orders when in the best interest of the
Company;
22
<PAGE>
o limit or discontinue the offering of shares of any portfolio of the Company
without notice to the shareholders;
o impose a redemption charge of up to 1% of the net asset value of shares
redeemed if circumstances indicate a charge is necessary for the protection
of remaining investors (for example, if excessive market-timing share
activity unfairly burdens long-term investors); however, this 1% charge
will not be imposed upon shareholders unless authorized by the Board of
Directors and the required notice has been given to shareholders;
o require a signature guarantee for transactions or changes in account
information in those instances where the appropriateness of a signature
authorization is in question. The Statement of Additional Information
contains information on acceptable guarantors;
o redeem an account with less than 50 full shares, with certain limitations.
EXCHANGES
Exchange Privilege
The exchange privilege is automatic when you complete your application. You may
exchange shares among Funds in the USAA Family of Funds, provided you do not
hold these shares in stock certificate form and the shares to be acquired are
offered in your state of residence. Only Virginia residents may exchange into a
Virginia Fund. The Funds' transfer agent will simultaneously process exchange
redemptions and purchases at the share prices next determined after the
exchange order is received. The investment minimums applicable to share
purchases also apply to exchanges. For federal income tax purposes, an exchange
between Funds is a taxable event; and as such, you may realize a capital gain
or loss. Such capital gains or losses are based on the difference between the
cost of shares when purchased and the price received upon exchange.
The Funds have undertaken certain procedures regarding telephone transactions
as described on page 21.
Exchange Limitations, Excessive Trading
To minimize Fund costs and to protect the Funds and their shareholders from
unfair expense burdens, the Funds restrict excessive exchanges. The limit on
exchanges out of any Fund in the USAA Family of Funds for each account is six
per calendar year (except there is no limitation on exchanges out of the Tax
Exempt Short-Term Fund, Short-Term Bond Fund, or any of the money market funds
in the USAA Family of Funds).
23
<PAGE>
SHAREHOLDER INFORMATION
NAV
EQUALS
TOTAL ASSETS
MINUS
LIABILITIES
DIVIDED BY
# OF SHARES OUTSTANDING
Share Price Calculation
The price at which you purchase and redeem Fund shares is equal to the net
asset value (NAV) per share determined on the effective date of the purchase or
redemption. You may buy and sell Fund shares at the NAV per share without a
sales charge. Each Fund's NAV per share is calculated at the close of the
regular trading session of the NYSE, which is usually 4:00 p.m. Eastern Time.
Securities of the Virgina Bond Fund are valued each business day at their
current market value as determined by a pricing service approved by the
Company's Board of Directors. Securities which cannot be valued by the pricing
service, and all other assets, are valued in good faith at fair value using
methods we have determined under the general supervision of the Board of
Directors. In addition, securities with maturities of 60 days or less and all
securities of the Virginia Money Market Fund are stated at amortized cost,
which approximates market value.
For additional information on how securities are valued, see VALUATION OF
SECURITIES in the Funds' Statement of Additional Information.
Dividends and Distributions
Net investment income of each Fund is accrued daily and paid on the last
business day of the month. Dividends shall begin accruing on shares purchased
the day following the effective date and shall continue to accrue to the
effective date of redemption. Any net capital gain distribution usually occurs
within 45 days of the March 31 fiscal year end, which would be somewhere around
the middle of May. The Funds will make additional payments to shareholders, if
necessary, to avoid the imposition of any federal income or excise tax.
All income dividends and capital gain distributions are automatically
reinvested, unless we receive different instructions from you. The share price
will be the NAV of the Fund shares computed on the ex-dividend date. Any
capital gain distributions paid by the Virginia Bond Fund will reduce the NAV
per share by the amount of the dividend or distribution. These dividends and
distributions are subject to taxes. If you become a resident of a state other
than Virginia, we will mail a check for proceeds of income dividends to you
monthly. We will mail a check for any capital gain distribution to you after
the distribution is paid.
We will invest any dividend or distribution payment returned to us in your
account at the then-current NAV per share. Dividend and distribution checks
become void six months from the date on the check. The amount of the voided
check will be invested in your account at the then-current NAV per share.
24
<PAGE>
Federal Taxes
This tax information is quite general and refers to the federal income tax
provisions in effect as of the date of this Prospectus. While we manage the
Funds so that at least 80% of each Fund's annual income will be exempt from
federal or state income taxes, we may invest up to 20% of the Funds' assets in
securities that generate income not exempt from federal or state income taxes.
Because interest income may be exempt for federal income tax purposes, it does
not necessarily mean that the interest income may be exempt under the income or
other tax laws of any state or local taxing authority. As discussed earlier on
page 13, capital gains distributed by a Fund may be taxable. Note that the
Taxpayer Relief Act of 1997 and regulations that will likely be adopted to
implement the Act may affect the status and treatment of certain distributions
shareholders receive from the Funds. We urge you to consult your own tax
adviser about the status of distributions from the Funds in your own state and
locality.
WITHHOLDING - Federal law requires each Fund to withhold and remit to the U.S.
Treasury a portion of the income dividends and capital gain distributions and
proceeds of redemptions paid to any non-corporate shareholder who:
o fails to furnish the Fund with a correct tax identification number,
o underreports dividend or interest income, or
o fails to certify that he or she is not subject to withholding.
To avoid this withholding requirement, you must certify on your application, or
on a separate Form W-9 supplied by the Funds' transfer agent, that your tax
identification number is correct and you are not currently subject to backup
withholding.
REPORTING - Each Fund will report information to you concerning the tax status
of dividends and distributions for federal income tax purposes annually,
including the portion of the dividends constituting interest on private
activity bonds and the percentage and source of interest income earned on
tax-exempt securities held by the Fund during the preceding year.
Virginia Taxation
The following is only a summary of some of the important Virginia personal
income tax considerations generally affecting the Funds and their shareholders.
This discussion is not intended as a substitute for careful planning. As a
potential investor in the Funds, you should consult your tax adviser with
specific reference to your own tax situations.
Dividends paid by the Funds and derived from interest on obligations of the
Commonwealth of Virginia or of any political subdivision or instrumentality of
the Commonwealth, which pay interest excludable from federal gross income, or
derived from obligations of the United States, which pay interest or
25
<PAGE>
dividends excludable from Virginia taxable income under the laws of the United
States, will be exempt from the Virginia income tax. Dividends (1) paid by the
Funds, (2) excluded from gross income for federal income tax purposes, and (3)
derived from interest on obligations of certain territories and possessions of
the United States (those issued by Puerto Rico, the Virgin Islands and Guam)
will be exempt from the Virginia income tax. To the extent a portion of the
dividends is derived from interest on obligations other than those described
above, such portion will be subject to the Virginia income tax even though it
may be excludable from gross income for federal income tax purposes.
As a general rule, distribution of short-term capital gains realized by the
Funds will be taxable to you as ordinary income. Distributions of long-term
capital gains generally will be taxable to you regardless of how long you have
held the shares.
Year 2000
Like other organizations around the world, the Funds could be adversely
affected if the computer systems used by them, their service providers, or
companies in which they invest do not properly process and calculate
information that relates to dates beginning January 1, 2000, and beyond. This
situation may occur because for many years computer programmers used only two
digits to describe years, such as 98 for 1998. A program written in this manner
may not work when it encounters the year 00. To confront this situation, USAA
companies have spent much effort and money; and we expect to have our systems
ready for the Year 2000 by mid-1999. In addition, we are actively assessing the
Year 2000 readiness of our service providers, partners, and companies in whose
securities we invest. It is not possible for us to say that you will experience
no effect from this situation, but we can say that we are making a large effort
to avoid any ill effects upon our shareholders.
We do believe you are entitled to know with certainty that we will stand behind
your share balance as of the close of business in 1999. When the market reopens
in 2000, should any computer problem cause a change in the number of shares in
your account, we will return your account to its proper share balance.
26
<PAGE>
FINANCIAL HIGHLIGHTS
The financial highlights tables are intended to help you understand the Funds'
financial performance for the past five years. Certain information reflects
financial results for a single Fund share. The total returns in the tables
represent the rate that an investor would have earned (or lost) on an
investment in the Fund (assuming reinvestment of all dividends and
distributions). This information has been audited by KPMG Peat Marwick LLP,
whose report, along with the Funds' financial statements, are included in the
Annual Report, which is available upon request.
Virginia Bond Fund:
Year Ended March 31,
--------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Net asset value at
beginning of period $ 10.92 $ 10.93 $ 10.76 $ 10.71 $ 11.16
Net investment income .62 .63 .63 .62 .62
Net realized and
unrealized gain (loss) .57 (.01) .17 .05 (.30)
Distributions from net
investment income (.62) (.63) (.63) (.62) (.62)
Distributions of realized
capital gains - - - - (.15)
-------- -------- -------- -------- --------
Net asset value at
end of period $ 11.49 $ 10.92 $ 10.93 $ 10.76 $ 10.71
======== ======== ======== ======== ========
Total return (%)* 11.13 5.82 7.57 6.61 2.69
Net assets at end of
period (000) $346,246 $292,914 $267,111 $238,920 $235,901
Ratio of expenses to
average net assets (%) .44 .46 .48 .50 .49
Ratio of net investment
income to average net
assets (%) 5.48 5.76 5.74 5.95 5.44
Portfolio turnover (%) 14.24 26.84 27.20 27.77 92.17
- -----------------
* Assumes reinvestment of all dividend income and capital gains distributions
during the period.
27
<PAGE>
Virginia Money Market Fund:
Year Ended March 31,
--------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
Net asset value at
beginning of period $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
Net investment income .03 .03 .03 .03 .02
Distributions from net
investment income (.03) (.03) (.03) (.03) (.02)
-------- -------- -------- ------- -------
Net asset value at
end of period $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00
======== ======== ======== ======= =======
Total return (%)* 3.34 3.14 3.42 2.91 2.14
Net assets at end of
period (000) $122,509 $113,330 $110,308 $98,049 $92,570
Ratio of expenses to
average net assets (%) .50 .50 .50 .50 .50
Ratio of expenses to
average net assets
excluding
reimbursements (%) .51 .53 .55 .56 .61
Ratio of net investment
income to average net
assets (%) 3.29 3.10 3.36 2.88 2.12
- ---------------------
* Assumes reinvestment of all dividend income distributions during the period.
28
<PAGE>
APPENDIX A
THE FOLLOWING ARE DESCRIPTIONS OF CERTAIN TYPES OF SECURITIES IN WHICH WE MAY
INVEST EACH FUND'S ASSETS:
VARIABLE RATE SECURITIES
We may invest a Fund's assets in tax-exempt securities that bear interest at
rates which are adjusted periodically to market rates.
o These interest rate adjustments can both raise and lower the income
generated by such securities. These changes will have the same effect on
the income earned by the Fund depending on the proportion of such
securities held.
o The value of variable rate securities is less affected than fixed-coupon
securities by changes in prevailing interest rates because of the periodic
adjustment of their coupons to a market rate. The shorter the period
between adjustments, the smaller the impact of interest rate fluctuations
on the value of these securities.
o The market value of a variable rate security usually tends toward par (100%
of face value) at interest rate adjustment time.
In the case of the Virginia Money Market Fund only, any variable rate
instrument with a demand feature will be deemed to have a maturity equal to
either the date on which the underlying principal amount may be recovered
through demand or the next rate adjustment date consistent with applicable
regulatory requirements.
PUT BONDS
We may invest a Fund's assets in tax-exempt securities (including securities
with variable interest rates) which may be redeemed or sold back (put) to the
issuer of the security or a third party prior to stated maturity (put bonds).
Such securities will normally trade as if maturity is the earlier put date,
even though stated maturity is longer. For the Virginia Bond Fund, maturity for
put bonds is deemed to be the date on which the put becomes exercisable.
Generally, maturity for put bonds for the Virginia Money Market Fund is
determined as stated under Variable Rate Securities.
ZERO COUPON BONDS
We may invest a Fund's assets in zero coupon bonds. A zero coupon bond is a
security that is sold at a deep discount from its face value, makes no periodic
interest payments, and is redeemed at face value when it matures. The lump sum
payment at maturity increases the price volatility of the zero coupon bond to
changes in interest rates when compared to a bond that distributes a semiannual
coupon payment. In calculating its dividend, each Fund records as income the
daily amortization of the purchase discount.
29
<PAGE>
WHEN-ISSUED SECURITIES
We may invest a Fund's assets in new securities offered on a when-issued basis.
o Delivery and payment take place after the date of the commitment to
purchase, normally within 45 days. Both price and interest rate are fixed
at the time of commitment.
o The Funds do not earn interest on the securities until settlement, and the
market value of the securities may fluctuate between purchase and
settlement.
o Such securities can be sold before settlement date.
MUNICIPAL LEASE OBLIGATIONS
We may invest a Fund's assets in a variety of instruments commonly referred to
as municipal lease obligations, including:
o Leases,
o Installment purchase contracts, and
o Certificates of participation in such leases and contracts.
Certain lease obligations contain "non-appropriation" clauses which provide
that the municipality has no obligation to make lease obligation payments in
future years unless money is appropriated for such purpose on a yearly basis.
LIQUIDITY
We may invest up to 15% of the Virginia Bond Fund's net assets and up to 10% of
the Virginia Money Market Fund's net assets in securities which are illiquid.
Illiquid securities are those securities that cannot be disposed of in the
ordinary course of business, seven days or less, at approximately the value at
which the Fund has valued the securities.
Lease obligations and certain put bonds subject to restrictions on transfer may
be determined to be liquid in accordance with the guidelines established by the
Funds' Board of Directors.
In determining the liquidity of a lease obligation, we will consider: (1) the
frequency of trades and quotes for the lease obligation; (2) the number of
dealers willing to purchase or sell the lease obligation and the number of
other potential purchasers; (3) dealer undertakings to make a market in the
lease obligation; (4) the nature of the marketplace trades, including the time
needed to dispose of the lease obligation, the method of soliciting offers, and
the mechanics of transfer; (5) whether the lease obligation is of a size that
will be attractive to institutional investors; (6) whether the lease obligation
contains a non-appropriation clause and the likelihood that the obligor will
fail to make an appropriation therefor; and (7) such other factors as we may
determine to be relevant to such determination.
In determining the liquidity of put bonds with restrictions on transfer, we
will evaluate the credit quality of the party (the Put Provider) issuing (or
unconditionally guaranteeing performance on) the unconditional put or demand
feature of the put bond.
30
<PAGE>
APPENDIX B
Taxable Equivalent Yield Table
COMBINED FEDERAL AND
VIRGINIA STATE INCOME TAX
Assuming a Federal
Marginal Tax Rate of: 28% 31% 36% 39.6%
and a State Rate of: 5.75% 5.75% 5.75% 5.75%
The Effective Marginal
Tax Rate would be: 32.140%(a) 34.968%(b) 39.680%(c) 43.073%(d)
To Match a Double
Tax Free Yield of: A Fully Taxable Investment Would Have to Pay You:
===============================================================================
2.00% 2.95% 3.08% 3.32% 3.51%
- -------------------------------------------------------------------------------
2.50% 3.68% 3.84% 4.14% 4.39%
- -------------------------------------------------------------------------------
3.00% 4.42% 4.61% 4.97% 5.27%
- -------------------------------------------------------------------------------
3.50% 5.16% 5.38% 5.80% 6.15%
- -------------------------------------------------------------------------------
4.00% 5.89% 6.15% 6.63% 7.03%
- -------------------------------------------------------------------------------
4.50% 6.63% 6.92% 7.46% 7.90%
- -------------------------------------------------------------------------------
5.00% 7.37% 7.69% 8.29% 8.78%
- -------------------------------------------------------------------------------
5.50% 8.10% 8.46% 9.12% 9.66%
- -------------------------------------------------------------------------------
6.00% 8.84% 9.23% 9.95% 10.54%
- -------------------------------------------------------------------------------
6.50% 9.58% 10.00% 10.78% 11.42%
- -------------------------------------------------------------------------------
7.00% 10.32% 10.76% 11.60% 12.30%
===============================================================================
- -------------
(a) Federal Rate of 28% + (Virginia State Rate of 5.75% x (1-28%))
(b) Federal Rate of 31% + (Virginia State Rate of 5.75% x (1-31%))
(c) Federal Rate of 36% + (Virginia State Rate of 5.75% x (1-36%))
(d) Federal Rate of 39.6% + (Virginia State Rate of 5.75% x (1-39.6%))
THIS TABLE IS A HYPOTHETICAL ILLUSTRATION AND SHOULD NOT BE CONSIDERED AN
INDICATION OF FUND PERFORMANCE OF ANY OF THE USAA FAMILY OF FUNDS.
THESE RATES WERE SELECTED AS EXAMPLES THAT WOULD BE RELEVANT TO MOST TAXPAYERS.
FOR A FURTHER EXPLANATION ON CALCULATING TAX EQUIVALENT YIELDS, SEE THE FUNDS'
STATEMENT OF ADDITIONAL INFORMATION.
31
<PAGE>
APPENDIX C
USAA Family of No-Load Mutual Funds
The USAA Family of No-Load Mutual Funds includes a variety of Funds, each with
different objectives and policies. In combination, these Funds are designed to
provide you with the opportunity to formulate your own investment program. You
may exchange any shares you hold in any one USAA Fund for shares in any other
USAA Fund. For more complete information about other Funds in the USAA Family
of Funds, including charges and expenses, call us for a Prospectus. Read it
carefully before you invest or send money.
FUND
TYPE/NAME VOLATILITY
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CAPITAL APPRECIATION
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Aggressive Growth Very high
Emerging Markets (1) Very high
First Start Growth Moderate to high
Gold (1) Very high
Growth Moderate to high
Growth & Income Moderate
International (1) Moderate to high
S&P 500 Index (2) Moderate
Science & Technology Very high
World Growth (1) Moderate to high
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ASSET ALLOCATION
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Balanced Strategy (1) Moderate
Cornerstone Strategy (1) Moderate
Growth and Tax Strategy Moderate
Growth Strategy (1) Moderate to high
Income Strategy Low to moderate
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INCOME - TAXABLE
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GNMA Low to moderate
Income Moderate
Income Stock Moderate
Short-Term Bond Low
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INCOME - TAX EXEMPT
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Long-Term (3) Moderate
Intermediate-Term (3) Low to moderate
Short-Term (3) Low
State Bond/Income (3,4) Moderate
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MONEY MARKET
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Money Market (5) Very low
Tax Exempt Money Market (3,5) Very low
Treasury Money Market Trust (5) Very low
State Money Market (3,4,5) Very low
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1 FOREIGN INVESTING IS SUBJECT TO ADDITIONAL RISKS, SUCH AS CURRENCY
FLUCTUATIONS, MARKET ILLIQUIDITY, AND POLITICAL INSTABILITY.
2 S&P(R) IS A TRADEMARK OF THE MCGRAW-HILL COMPANIES, INC., AND HAS BEEN
LICENSED FOR USE. THE PRODUCT IS NOT SPONSORED, SOLD OR PROMOTED BY STANDARD
& POOR'S, AND STANDARD & POOR'S MAKES NO REPRESENTATION REGARDING THE
ADVISABILITY OF INVESTING IN THE PRODUCT.
3 SOME INCOME MAY BE SUBJECT TO STATE OR LOCAL TAXES.
4 CALIFORNIA, FLORIDA, NEW YORK, TEXAS, AND VIRGINIA FUNDS ARE OFFERED ONLY TO
RESIDENTS OF THOSE STATES.
5 AN INVESTMENT IN A MONEY MARKET FUND IS NEITHER INSURED NOR GUARANTEED BY
THE U.S. GOVERNMENT AND THERE IS NO ASSURANCE THAT ANY OF THE FUNDS WILL BE
ABLE TO MAINTAIN A STABLE NET ASSET VALUE OF $1 PER SHARE.
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If you would like more information about the Funds, you may call 1-800-531-8181
to request a free copy of the Funds' Statement of Additional Information (SAI),
Annual or Semiannual Reports, or to ask other questions about the Funds. The
SAI has been filed with the Securities and Exchange Commission (SEC) and is
legally a part of the Prospectus. In each Fund's Annual Report, you will find a
discussion of the market conditions and investment strategies that
significantly affected the Fund's performance during the last fiscal year.
To view these documents, along with other related documents, you can visit the
SEC's Internet web site (http://www.sec.gov) or the Commission's Public
Reference Room in Washington, D.C. Information on the operation of the public
reference room can be obtained by calling 1-800-SEC-0330. Additionally, copies
of this information can be obtained, for a duplicating fee, by writing the
Public Reference Section of the Commission, Washington, D.C. 20549-6009.
Investment Adviser, Underwriter and Distributor
USAA Investment Management Company
9800 Fredericksburg Road
San Antonio, Texas 78288
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Transfer Agent Custodian
USAA Shareholder Account Services State Street Bank and Trust Company
9800 Fredericksburg Road P.O. Box 1713
San Antonio, Texas 78288 Boston, Massachusetts 02105
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Telephone Assistance Hours
Call toll free - Central Time
Monday - Friday 8:00 a.m. to 8:00 p.m.
Saturdays 8:30 a.m. to 5:00 p.m.
------------------------------------------------
For Additional Information on Mutual Funds
1-800-531-8181, (in San Antonio) 456-7211
For account servicing, exchanges or redemptions
1-800-531-8448, (in San Antonio) 456-7202
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Recorded Mutual Fund Price Quotes
24-Hour Service (from any phone)
1-800-531-8066, (in San Antonio) 498-8066
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Mutual Fund TouchLINE(R)
(from Touchtone phones only)
For account balance, last transaction or fund prices
1-800-531-8777, (in San Antonio) 498-8777
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Investment Company Act File No. 811-3333
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USAA USAA TAX STATEMENT OF
EAGLE EXEMPT ADDITIONAL INFORMATION
LOGO FUND, INC. August 1, 1998
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USAA TAX EXEMPT FUND, INC.
(Long-Term Fund, Intermediate-Term Fund,
Short-Term Fund, and Tax Exempt Money Market Fund)
USAA TAX EXEMPT FUND, INC. (the Company) is a registered investment company
offering shares of ten no-load mutual funds, four of which are described in
this Statement of Additional Information (SAI): the Long-Term Fund,
Intermediate-Term Fund, Short-Term Fund, and Tax Exempt Money Market Fund
(collectively, the Funds). Each Fund is classified as diversified and has a
common investment objective of providing investors with interest income that is
exempt from federal income tax. The Tax Exempt Money Market Fund has a further
objective of preserving capital and maintaining liquidity.
You may obtain a free copy of a Prospectus dated August 1, 1998, for the Funds
by writing to USAA Tax Exempt Fund, Inc., 9800 Fredericksburg Road, San
Antonio, TX 78288, or by calling toll free 1-800-531-8181. The Prospectus
provides the basic information you should know before investing in the Funds.
This SAI is not a Prospectus and contains information in addition to and more
detailed than that set forth in the Prospectus. It is intended to provide you
with additional information regarding the activities and operations of the
Company and the Funds, and should be read in conjunction with the Prospectus.
The financial statements of the Funds and the Independent Auditors' Report
thereon for the fiscal year ended March 31, 1998, are included in the
accompanying Annual Report to Shareholders of that date and are incorporated by
reference.
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TABLE OF CONTENTS
PAGE
2 Valuation of Securities
2 Conditions of Purchase and Redemption
3 Additional Information Regarding Redemption of Shares
4 Investment Plans
4 Investment Policies
6 Investment Restrictions
7 Portfolio Transactions
8 Description of Shares
8 Tax Considerations
10 Directors and Officers of the Company
13 The Company's Manager
14 General Information
14 Calculation of Performance Data
16 Appendix A - Tax-Exempt Securities and Their Ratings
18 Appendix B - Comparison of Fund Performance
21 Appendix C - Dollar-Cost Averaging
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VALUATION OF SECURITIES
Shares of each Fund are offered on a continuing best efforts basis through USAA
Investment Management Company (IMCO or the Manager). The offering price for
shares of each Fund is equal to the current net asset value (NAV) per share.
The NAV per share of each Fund is calculated by adding the value of all its
portfolio securities and other assets, deducting its liabilities, and dividing
by the number of shares outstanding.
A Fund's NAV per share is calculated each day, Monday through Friday,
except days on which the New York Stock Exchange (NYSE) is closed. The NYSE is
currently scheduled to be closed on New Year's Day, Martin Luther King, Jr.
Day, Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day,
Thanksgiving, and Christmas, and on the preceding Friday or subsequent Monday
when one of these holidays falls on a Saturday or Sunday, respectively.
The investments of the LONG-TERM, INTERMEDIATE-TERM, AND SHORT-TERM FUNDS
are valued each business day by a pricing service (the Service) approved by the
Company's Board of Directors. The Service uses the mean between quoted bid and
asked prices or the last sale price to price securities when, in the Service's
judgment, these prices are readily available and are representative of the
securities' market values. For many securities, such prices are not readily
available. The Service generally prices these securities based on methods which
include consideration of yields or prices of tax-exempt securities of
comparable quality, coupon, maturity, and type, indications as to values from
dealers in securities, and general market conditions. Securities purchased with
maturities of 60 days or less are stated at amortized cost which approximates
market value. Repurchase agreements are valued at cost. Securities which cannot
be valued by the Service, and all other assets, are valued in good faith at
fair value using methods determined by the Manager under the general
supervision of the Board of Directors.
The value of the TAX EXEMPT MONEY MARKET FUND'S securities is stated at
amortized cost which approximates market value. This involves valuing a
security at its cost and thereafter assuming a constant amortization to
maturity of any discount or premium, regardless of the impact of fluctuating
interest rates. While this method provides certainty in valuation, it may
result in periods during which the value of an instrument, as determined by
amortized cost, is higher or lower than the price the Fund would receive upon
the sale of the instrument.
The valuation of the Tax Exempt Money Market Fund's portfolio instruments
based upon their amortized cost is subject to the Fund's adherence to certain
procedures and conditions. Consistent with regulatory requirements, the Manager
will only purchase securities with remaining maturities of 397 days or less and
will maintain a dollar-weighted average portfolio maturity of no more than 90
days. The Manager will invest only in securities that have been determined to
present minimal credit risk and that satisfy the quality and diversification
requirements of applicable rules and regulations of the Securities and Exchange
Commission (SEC).
The Board of Directors has established procedures designed to stabilize
the Tax Exempt Money Market Fund's price per share, as computed for the purpose
of sales and redemptions, at $1. There can be no assurance, however, that the
Fund will at all times be able to maintain a constant $1 NAV per share. Such
procedures include review of the Fund's holdings at such intervals as is deemed
appropriate to determine whether the Fund's NAV calculated by using available
market quotations deviates from $1 per share and, if so, whether such deviation
may result in material dilution or is otherwise unfair to existing
shareholders. In the event that it is determined that such a deviation exists,
the Board of Directors will take such corrective action as it regards as
necessary and appropriate. Such action may include selling portfolio
instruments prior to maturity to realize capital gains or losses or to shorten
average portfolio maturity, withholding dividends, or establishing a NAV per
share by using available market quotations.
CONDITIONS OF PURCHASE AND REDEMPTION
NONPAYMENT
If any order to purchase shares is canceled due to nonpayment or if the Company
does not receive good funds either by check or electronic funds transfer, USAA
Shareholder Account Services (Transfer Agent) will treat the cancellation as a
redemption of shares purchased, and you will be responsible for any resulting
loss incurred by the Fund or the Manager. If you are a shareholder, the
Transfer Agent can redeem shares from your account(s) as reimbursement for all
losses. In addition, you may be prohibited or restricted from making future
purchases in any of the USAA Family of Funds. A $15 fee is charged for all
returned items, including checks and electronic funds transfers.
TRANSFER OF SHARES
You may transfer Fund shares to another person by sending written instructions
to the Transfer Agent. The account must be clearly identified, and you must
include the number of shares to be transferred, the signatures of all
registered owners, and all stock certificates, if any, which are the subject of
transfer. You
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also need to send written instructions signed by all registered owners and
supporting documents to change an account registration due to events such as
divorce, marriage, or death. If a new account needs to be established, you must
complete and return an application to the Transfer Agent.
ADDITIONAL INFORMATION REGARDING REDEMPTION OF SHARES
The value of your investment at the time of redemption may be more or less than
the cost at purchase, depending on the value of the securities held in each
Fund's portfolio. Requests for redemption which are subject to any special
conditions, or which specify an effective date other than as provided herein,
cannot be accepted. A gain or loss for tax purposes may be realized on the sale
of shares, depending upon the price when redeemed.
The Board of Directors may cause the redemption of an account with a
balance of less than 50 shares provided (1) the value of the account has been
reduced, for reasons other than market action, below the minimum initial
investment in such Fund at the time of the establishment of the account, (2)
the account has remained below the minimum level for six months, and (3) 60
days' prior written notice of the proposed redemption has been sent to you.
Shares will be redeemed at the NAV on the date fixed for redemption by the
Board of Directors. Prompt payment will be made by mail to your last known
address.
The Company reserves the right to suspend the right of redemption or
postpone the date of payment (1) for any periods during which the NYSE is
closed, (2) when trading in the markets the Company normally utilizes is
restricted, or an emergency exists as determined by the SEC so that disposal of
the Company's investments or determination of its NAV is not reasonably
practicable, or (3) for such other periods as the SEC by order may permit for
protection of the Company's shareholders.
For the mutual protection of the investor and the Funds, the Company may
require a signature guarantee. If required, EACH signature on the account
registration must be guaranteed. Signature guarantees are acceptable from FDIC
member banks, brokers, dealers, municipal securities dealers, municipal
securities brokers, government securities dealers, government securities
brokers, credit unions, national securities exchanges, registered securities
associations, clearing agencies, and savings associations. A signature
guarantee for active duty military personnel stationed abroad may be provided
by an officer of the United States Embassy or Consulate, a staff officer of the
Judge Advocate General, or an individual's commanding officer.
REDEMPTION BY CHECK
Shareholders in the Short-Term Fund or Tax Exempt Money Market Fund may request
that checks be issued for their accounts. Checks must be written in amounts of
at least $250.
Checks issued to shareholders of either Fund will be sent only to the
person in whose name the account is registered and only to the address of
record. The checks must be manually signed by the registered owner(s) exactly
as the account is registered. For joint accounts the signature of either or
both joint owners will be required on the check, according to the election made
on the signature card. You will continue to earn dividends until the shares are
redeemed by the presentation of a check.
When a check is presented to the Transfer Agent for payment, a sufficient
number of full and fractional shares from your account will be redeemed to
cover the amount of the check. If the account's balance is not adequate to
cover the amount of a check, the check will be returned unpaid. A check drawn
on an account in the Short-Term Fund may be returned for insufficient funds if
the NAV per share of that Fund declines over the time between the date the
check was written and the date it was presented for payment. Because the value
of an account in either the Short-Term Fund or Tax Exempt Money Market Fund
changes as dividends are accrued on a daily basis, checks may not be used to
close an account.
The checkwriting privilege is subject to the customary rules and
regulations of State Street Bank and Trust Company (State Street Bank or the
Custodian) governing checking accounts. There is no charge to you for the use
of the checks or for subsequent reorders of checks.
The Company reserves the right to assess a processing fee against your
account for any redemption check not honored by a clearing or paying agent.
Currently, this fee is $15 and is subject to change at any time. Some examples
of such dishonor are improper endorsement, checks written for an amount less
than the minimum check amount, and insufficient or uncollectible funds.
The Company, the Transfer Agent, and State Street Bank each reserve the
right to change or suspend the checkwriting privilege upon 30 days' written
notice to participating shareholders.
You may request that the Transfer Agent stop payment on a check. The
Transfer Agent will use its best efforts to execute stop payment instructions,
but does not guarantee that such efforts will be effective. The Transfer Agent
will charge you $10 for each stop payment you request.
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INVESTMENT PLANS
The Company makes available the following investment plans to shareholders of
all the Funds. At the time you sign up for any of the following investment
plans that utilize the electronic funds transfer service, you will choose the
day of the month (the effective date) on which you would like to regularly
purchase shares. When this day falls on a weekend or holiday, the electronic
transfer will take place on the last business day before the effective date.
You may terminate your participation in a plan at any time. Please call the
Manager for details and necessary forms or applications.
AUTOMATIC PURCHASE OF SHARES
INVESTRONIC(R) - The regular purchase of additional shares through electronic
funds transfers from a checking or savings account. You may invest as little as
$50 per month.
DIRECT PURCHASE SERVICE - The periodic purchase of shares through electronic
funds transfer from an employer (including government allotments and social
security), an income-producing investment, or an account with a participating
financial institution.
AUTOMATIC PURCHASE PLAN - The periodic transfer of funds from a USAA money
market fund to purchase shares in another non-money market USAA mutual fund.
There is a minimum investment required for this program of $5,000 in the money
market fund, with a monthly transaction minimum of $50.
BUY/SELL SERVICE - The intermittent purchase or redemption of shares through
electronic funds transfer to or from a checking or savings account. You may
initiate a "buy" or "sell" whenever you choose.
DIRECTED DIVIDENDS - If you own shares in more than one of the Funds in the
USAA Family of Funds, you may direct that dividends and/or capital gain
distributions earned in one fund be used to purchase shares automatically in
another fund.
Participation in these systematic purchase plans allows you to engage in
dollar-cost averaging. For additional information concerning the benefits of
dollar-cost averaging, see APPENDIX C.
SYSTEMATIC WITHDRAWAL PLAN
If you own shares having a NAV of $5,000 or more in a single investment account
(accounts in different Funds cannot be aggregated for this purpose), you may
request that enough shares to produce a fixed amount of money be liquidated
from the account monthly or quarterly. The amount of each withdrawal must be at
least $50. Using the electronic funds transfer service, you may choose to have
withdrawals electronically deposited at your bank or other financial
institution. You may also elect to have checks mailed to a designated address.
This plan may be initiated by depositing shares worth at least $5,000 with
the Transfer Agent and by completing a Systematic Withdrawal Plan application,
which may be requested from the Manager. You may terminate participation in the
plan at any time. You are not charged for withdrawals under the Systematic
Withdrawal Plan. The Company will not bear any expenses in administering the
plan beyond the regular transfer agent and custodian costs of issuing and
redeeming shares. The Manager will bear any additional expenses of
administering the plan.
Withdrawals will be made by redeeming full and fractional shares on the
date you select at the time the plan is established. Withdrawal payments made
under this plan may exceed dividends and distributions and, to this extent,
will involve the use of principal and could reduce the dollar value of your
investment and eventually exhaust the account. Reinvesting dividends and
distributions helps replenish the account. Because share values and net
investment income can fluctuate, you should not expect withdrawals to be offset
by rising income or share value gains.
Each redemption of shares may result in a gain or loss, which must be
reported on your income tax return. Therefore, you should keep an accurate
record of any gain or loss on each withdrawal.
INVESTMENT POLICIES
The sections captioned WHAT ARE EACH FUND'S INVESTMENT OBJECTIVE AND MAIN
STRATEGIES? and FUND INVESTMENTS in the Prospectus describe the fundamental
investment objectives and the investment policies applicable to each Fund. Each
Fund's objective cannot be changed without shareholder approval. The following
is provided as additional information.
CALCULATION OF PORTFOLIO WEIGHTED AVERAGE MATURITIES
Weighted average maturity is derived by multiplying the value of each
investment by the number of days remaining to its maturity, adding the results
of these calculations, and then dividing the total by the value of a Fund's
portfolio. An obligation's maturity is typically determined on a stated final
maturity basis, although there are some exceptions to this rule.
With respect to obligations held by the Long-Term Fund, the
Intermediate-Term Fund, and the Short-Term Fund, if it is probable that the
issuer of an instrument will take advantage of a maturity-shortening
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device, such as a call, refunding, or redemption provision, the date on which
the instrument will probably be called, refunded, or redeemed may be considered
to be its maturity date. Also, the maturities of securities subject to sinking
fund arrangements are determined on a weighted average life basis, which is the
average time for principal to be repaid. The weighted average life of these
securities is likely to be substantially shorter than their stated final
maturity. In addition, for purposes of these Funds' investment policies, an
instrument will be treated as having a maturity earlier than its stated
maturity date if the instrument has technical features such as puts or demand
features which, in the judgment of the Manager, will result in the instrument
being valued in the market as though it has the earlier maturity.
The Tax Exempt Money Market Fund will determine the maturity of an
obligation in its portfolio in accordance with Rule 2a-7 under the Investment
Company Act of 1940, as amended (1940 Act).
LENDING OF SECURITIES
Each Fund may lend its securities. A lending policy may be authorized by the
Company's Directors and implemented by the Manager, but securities may be
loaned only to qualified broker-dealers or institutional investors that agree
to maintain cash collateral with the Company equal at all times to at least
100% of the value of the loaned securities. The Directors will establish
procedures and monitor the creditworthiness of any institution or broker-dealer
during such time as any loan is outstanding. The Company will continue to
receive interest on the loaned securities and will invest the cash collateral
in readily marketable short-term obligations of high quality, thereby earning
additional interest. Interest on loaned tax-exempt securities received by the
borrower and paid to the Company will not be exempt from federal income taxes
in the hands of the Company.
No loan of securities will be made if, as a result, the aggregate of such
loans would exceed 33 1/3% of the value of a Fund's total assets. The Company
may terminate such loans at any time.
REPURCHASE AGREEMENTS
Each Fund may invest up to 5% of its total assets in repurchase agreements. A
repurchase agreement is a transaction in which a security is purchased with a
simultaneous commitment to sell the security back to the seller (a commercial
bank or recognized securities dealer) at an agreed upon price on an agreed upon
date, usually not more than seven days from the date of purchase. The resale
price reflects the purchase price plus an agreed upon market rate of interest
which is unrelated to the coupon rate or maturity of the purchased security. A
repurchase agreement involves the obligation of the seller to pay the agreed
upon price, which obligation is in effect secured by the value of the
underlying security. In these transactions, the securities purchased by a Fund
will have a total value equal to or in excess of the amount of the repurchase
obligation and will be held by the Funds' custodian until repurchased. If the
seller defaults and the value of the underlying security declines, a Fund may
incur a loss and may incur expenses in selling the collateral. If the seller
seeks relief under the bankruptcy laws, the disposition of the collateral may
be delayed or limited. Any investments in repurchase agreements will give rise
to income which will not qualify as tax-exempt income when distributed by a
Fund.
WHEN-ISSUED SECURITIES
Each Fund may invest in new issues of tax-exempt securities offered on a
when-issued basis; that is, delivery and payment take place after the date of
the commitment to purchase, normally within 45 days. Both price and interest
rate are fixed at the time of commitment. The Funds do not earn interest on the
securities until settlement, and the market value of the securities may
fluctuate between purchase and settlement. Such securities can be sold before
settlement date.
Cash or high quality liquid debt securities equal to the amount of the
when-issued commitments are segregated at the Fund's custodian bank. The
segregated securities are valued at market, and daily adjustments are made to
keep the value of the cash and segregated securities at least equal to the
amount of such commitments by the Fund. On the settlement date, the Fund will
meet its obligations from then available cash, sale of segregated securities,
sale of other securities, or sale of the when-issued securities themselves.
MUNICIPAL LEASE OBLIGATIONS
Each Fund may invest in municipal lease obligations and certificates of
participation in such obligations (collectively, lease obligations). A lease
obligation does not constitute a general obligation of the municipality for
which the municipality's taxing power is pledged, although the lease obligation
is ordinarily backed by the municipality's covenant to budget for the payments
due under the lease obligation.
Certain lease obligations contain "non-appropriation" clauses which
provide that the municipality has no obligation to make lease obligation
payments in future years unless money is appropriated for such purpose on a
yearly basis. Although "non-appropriation" lease obligations are secured by the
leased property, disposition of the property in the event of foreclosure might
prove difficult. In evaluating a potential investment in such a lease
obligation, the Manager will consider: (1) the credit quality of the obligor,
(2) whether the underlying property is essential to a governmental function,
and (3) whether the lease obligation contains covenants prohibiting the obligor
from substituting similar property if the obligor fails to make appropriations
for the lease obligation.
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TEMPORARY DEFENSIVE POLICY
Each Fund may on a temporary basis because of market, economic, political, or
other conditions invest up to 100% of its assets in short-term securities
whether or not they are exempt from federal income taxes. Such taxable
securities may consist of obligations of the U.S. Government, its agencies or
instrumentalities, and repurchase agreements secured by such instruments;
certificates of deposit of domestic banks having capital, surplus, and
undivided profits in excess of $100 million; banker's acceptances of similar
banks; commercial paper; and other corporate debt obligations.
INVESTMENT RESTRICTIONS
The following investment restrictions have been adopted by the Company for each
Fund. These restrictions may not be changed for any given Fund without approval
by the lesser of (1) 67% or more of the voting securities present at a meeting
of the Fund if more than 50% of the outstanding voting securities of the Fund
are present or represented by proxy or (2) more than 50% of the Fund's
outstanding voting securities. The investment restrictions of one Fund may be
changed without affecting those of any other Fund.
Under the restrictions, each Fund may not:
(1) with respect to 75% of its total assets, purchase the securities of any
issuer (except Government Securities, as such term is defined in the 1940
Act) if, as a result, the Fund would have more than 5% of the value of
its total assets invested in the securities of such issuer;
(2) purchase more than 10% of the outstanding voting securities of any issuer;
(3) borrow money, except for temporary or emergency purposes in an amount not
exceeding 33 1/3% of its total assets (including the amount borrowed)
less liabilities (other than borrowings);
(4) pledge, mortgage, or hypothecate its assets to any extent greater than
10% of the value of its total assets;
(5) purchase or retain securities of any issuer if any officer or Director of
the Company or its Manager owns individually more than one-half of one
percent (1/2%) of the securities of that issuer, and collectively the
officers and Directors of the Company and Manager together own more than
5% of the securities of that issuer;
(6) purchase any securities which would cause more than 25% of the value of
that Fund's total assets at the time of such purchase to be invested in
either (i) the securities of issuers conducting their principal
activities in the same state, or (ii) the securities the interest upon
which is derived from revenues or projects with similar characteristics,
such as toll road revenue bonds, housing revenue bonds, electric power
project revenue bonds, etc.; provided that the foregoing limitation does
not apply with respect to investments in U.S. Treasury Bills, other
obligations issued or guaranteed by the U.S. Government, its agencies and
instrumentalities, and, in the case of the Tax Exempt Money Market Fund,
certificates of deposit and banker's acceptances of domestic banks;
(7) invest in issuers for the purpose of exercising control of management;
(8) issue senior securities as defined in the 1940 Act, except that it may
purchase tax-exempt securities on a "when-issued" basis as permitted by
Section 18(f)(2);
(9) underwrite securities of other issuers, except to the extent that it may
be deemed to act as a statutory underwriter in the distribution of any
restricted securities or not readily marketable securities;
(10) purchase or sell real estate, but this shall not prevent investments in
tax-exempt securities secured by real estate or interests therein;
(11) lend any securities or make any loan if, as a result, more than 33 1/3%
of its total assets would be lent to other parties, except that this
limitation does not apply to purchases of debt securities or to
repurchase agreements;
(12) purchase on margin or sell short;
(13) purchase or sell commodities or commodities contracts;
(14) invest its assets in securities of other investment companies except by
purchases in the open market involving only customary brokers'
commissions or as part of a merger, consolidation, reorganization, or
purchase of assets approved by the shareholders; or
(15) invest in put, call, straddle, or spread options or interests in oil,
gas, or other mineral exploration or development programs.
ADDITIONAL RESTRICTIONS
The following restrictions are not considered to be fundamental policies of the
Funds. The Board of Directors may change these additional restrictions without
notice to or approval by the shareholders.
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Each Fund may not:
(1) invest more than 15% (10% with respect to the Tax Exempt Money Market
Fund) of the value of its net assets in illiquid securities, including
repurchase agreements maturing in more than seven days; or
(2) purchase any security while borrowings representing more than 5% of the
Fund's total assets are outstanding.
PORTFOLIO TRANSACTIONS
The Manager, pursuant to the Advisory Agreement dated July 20, 1990, and
subject to the general control of the Company's Board of Directors, places all
orders for the purchase and sale of Fund securities. Purchases of Fund
securities are made either directly from the issuer or from dealers who deal in
tax-exempt securities. The Manager may sell Fund securities prior to maturity
if circumstances warrant and if it believes such disposition is advisable. In
connection with portfolio transactions for the Company, the Manager seeks to
obtain the best available net price and most favorable execution for its
orders. The Manager has no agreement or commitment to place transactions with
any broker-dealer and no regular formula is used to allocate orders to any
broker-dealer. However, the Manager may place security orders with brokers or
dealers who furnish research or other services to the Manager as long as there
is no sacrifice in obtaining the best overall terms available. Payment for such
services would be generated only through purchase of new issue fixed income
securities.
Such research and other services may include, for example: advice
concerning the value of securities, the advisability of investing in,
purchasing, or selling securities, and the availability of securities or the
purchasers or sellers of securities; analyses and reports concerning issuers,
industries, securities, economic factors and trends, portfolio strategy, and
performance of accounts; and various functions incidental to effecting
securities transactions, such as clearance and settlement. The Manager
continuously reviews the performance of the broker-dealers with whom it places
orders for transactions. The receipt of research from broker-dealers that
execute transactions on behalf of the Company may be useful to the Manager in
rendering investment management services to other clients (including affiliates
of the Manager), and conversely, such research provided by broker-dealers who
have executed transaction orders on behalf of other clients may be useful to
the Manager in carrying out its obligations to the Company. While such research
is available to and may be used by the Manager in providing investment advice
to all its clients (including affiliates of the Manager), not all of such
research may be used by the Manager for the benefit of the Company. Such
research and services will be in addition to and not in lieu of research and
services provided by the Manager, and the expenses of the Manager will not
necessarily be reduced by the receipt of such supplemental research. See THE
COMPANY'S MANAGER.
On occasions when the Manager deems the purchase or sale of a security to
be in the best interest of the Company, as well as the Manager's other clients,
the Manager, to the extent permitted by applicable laws and regulations, may
aggregate such securities to be sold or purchased for the Company with those to
be sold or purchased for other customers in order to obtain best execution and
lower brokerage commissions, if any. In such event, allocation of the
securities so purchased or sold, as well as the expenses incurred in the
transaction, will be made by the Manager in the manner it considers to be most
equitable and consistent with its fiduciary obligations to all such customers,
including the Company. In some instances, this procedure may impact the price
and size of the position obtainable for the Company.
The tax-exempt security market is typically a "dealer" market in which
investment dealers buy and sell bonds for their own accounts, rather than for
customers, and although the price may reflect a dealer's mark-up or mark-down,
the Company pays no brokerage commissions as such. In addition, some securities
may be purchased directly from issuers.
PORTFOLIO TURNOVER RATES
The portfolio turnover rate is computed by dividing the dollar amount of
securities purchased or sold (whichever is smaller) by the average value of
securities owned during the year.
The rate of portfolio turnover will not be a limiting factor when the
Manager deems changes in the Long-Term, Intermediate-Term, and Short-Term
Funds' portfolios appropriate in view of each Fund's investment objective. For
example, securities may be sold in anticipation of a rise in interest rates
(market decline) or purchased in anticipation of a decline in interest rates
(market rise) and later sold. In addition, a security may be sold and another
security of comparable quality may be purchased at approximately the same time
in order to take advantage of what the Fund believes to be a temporary
disparity in the normal yield relationship between the two securities. These
yield disparities may occur for reasons not directly related to the investment
quality of particular issues or the general movement of interest rates, such as
changes in the overall demand for or supply of various types of tax-exempt
securities.
7
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For the last two fiscal years the Funds' portfolio turnover rates were as
follows:
FUND 1997 1998
---- ---- ----
Long-Term 40.78% 35.20%
Intermediate-Term 23.05% 7.87%
Short-Term 27.67% 7.91%
Portfolio turnover rates have been calculated excluding short-term
variable rate securities, which are those with put date intervals of less than
one year.
DESCRIPTION OF SHARES
The Funds are series of USAA Tax Exempt Fund, Inc. (the Company) and are
diversified. The Company is an open-end management investment company
incorporated under the laws of the State of Maryland on November 16, 1981. The
Company is authorized to issue shares of common stock in separate portfolios.
Ten such portfolios have been established, four of which are described in this
SAI. Under the Articles of Incorporation, the Board of Directors is authorized
to create new portfolios in addition to those already existing without
shareholder approval. The Company began offering shares of the Long-Term,
Intermediate-Term and Short-Term Funds in March 1982 and began offering shares
of the Tax Exempt Money Market Fund in February 1984.
Each Fund's assets and all income, earnings, profits, and proceeds
thereof, subject only to the rights of creditors, are specifically allocated to
such Fund. They constitute the underlying assets of each Fund, are required to
be segregated on the books of account, and are to be charged with the expenses
of such Fund. Any general expenses of the Company not readily identifiable as
belonging to a particular Fund are allocated on the basis of the Funds'
relative net assets during the fiscal year or in such other manner as the Board
determines to be fair and equitable. Each share of each Fund represents an
equal proportionate interest in that Fund with every other share and is
entitled to dividends and distributions out of the net income and capital gains
belonging to that Fund when declared by the Board.
Under the provisions of the Bylaws of the Company, no annual meeting of
shareholders is required. Thus, there will ordinarily be no shareholder meeting
unless required by the 1940 Act. Under certain circumstances, however,
shareholders may apply to the Directors for shareholder information to obtain
signatures to request a special shareholder meeting. The Company may fill
vacancies on the Board or appoint new Directors if the result is that at least
two-thirds of the Directors have still been elected by shareholders. Moreover,
pursuant to the Bylaws of the Company, any Director may be removed by the
affirmative vote of a majority of the outstanding Company shares; and holders
of 10% or more of the outstanding shares of the Company can require Directors
to call a meeting of shareholders for the purpose of voting on the removal of
one or more Directors. The Company will assist in communicating to other
shareholders about the meeting. On any matter submitted to the shareholders,
the holder of each Fund share is entitled to one vote per share (with
proportionate voting for fractional shares) regardless of the relative net
asset values of the Funds' shares. However, on matters affecting an individual
Fund, a separate vote of the shareholders of that Fund is required.
Shareholders of a Fund are not entitled to vote on any matter which does not
affect that Fund but which requires a separate vote of another Fund. Shares do
not have cumulative voting rights, which means that holders of more than 50% of
the shares voting for the election of Directors can elect 100% of the Company's
Board of Directors, and the holders of less than 50% of the shares voting for
the election of Directors will not be able to elect any person as a Director.
Shareholders of a particular Fund might have the power to elect all of the
Directors of the Company because that Fund has a majority of the total
outstanding shares of the Company. When issued, each Fund's shares are fully
paid and nonassessable, have no pre-emptive or subscription rights, and are
fully transferable. There are no conversion rights.
TAX CONSIDERATIONS
TAXATION OF THE FUNDS
Each Fund intends to qualify as a regulated investment company under Subchapter
M of the Internal Revenue Code of 1986, as amended (the Code). Accordingly,
each Fund will not be liable for federal income taxes on its taxable net
investment income and net capital gains (capital gains in excess of capital
losses) that are distributed to shareholders, provided that each Fund
distributes at least 90% of its net investment income and net short-term
capital gain for the taxable year.
To qualify as a regulated investment company, a Fund must, among other
things, (1) derive in each taxable year at least 90% of its gross income from
dividends, interest, payments with respect to securities loans, gains from the
sale or other disposition of stock, securities or foreign currencies, or other
income
8
<PAGE>
derived with respect to its business of investing in such stock, securities, or
currencies (the 90% test) and (2) satisfy certain diversification requirements
at the close of each quarter of the Fund's taxable year. Furthermore, to pay
tax-exempt interest income dividends, at least 50% of the value of each Fund's
total assets at the close of each quarter of its taxable year must consist of
obligations the interest of which is exempt from federal income tax. Each Fund
intends to satisfy this requirement.
The Code imposes a nondeductible 4% excise tax on a regulated investment
company that fails to distribute during each calendar year an amount at least
equal to the sum of (1) 98% of its taxable net investment income for the
calendar year, (2) 98% of its capital gain net income for the twelve-month
period ending on October 31, and (3) any prior amounts not distributed. Each
Fund intends to make such distributions as are necessary to avoid imposition of
this excise tax.
For federal income tax purposes, debt securities purchased by the Funds
may be treated as having original issue discount. Original issue discount
represents interest income for federal income tax purposes and can generally be
defined as the excess of the stated redemption price at maturity of a debt
obligation over the issue price. Original issue discount is treated for federal
income tax purposes as earned by the Funds, whether or not any income is
actually received, and therefore is subject to the distribution requirements of
the Code. However, original issue discount with respect to tax-exempt
obligations generally will be excluded from the Funds' taxable income, although
such discount will be included in gross income for purposes of the 90% test
described previously. Original issue discount with respect to tax-exempt
securities is accrued and added to the adjusted tax basis of such securities
for purposes of determining gain or loss upon sale or at maturity. Generally,
the amount of original issue discount is determined on the basis of a constant
yield to maturity which takes into account the compounding of accrued interest.
An investment in a stripped bond or stripped coupon will result in original
issue discount.
Debt securities may be purchased by the Funds at a market discount. Market
discount occurs when a security is purchased at a price less than the original
issue price adjusted for accrued original issue discount, if any. The Funds
intend to defer recognition of accrued market discount until maturity or other
disposition of the bond. For securities purchased at a market discount, the
gain realized on disposition will be treated as taxable ordinary income to the
extent it does not exceed accrued market discount on the bond.
The Funds may also purchase debt securities at a premium, i.e., at a
purchase price in excess of face amount. With respect to tax-exempt securities,
the premium must be amortized to the maturity date but no deduction is allowed
for the premium amortization. The amortized bond premium will reduce the Funds'
adjusted tax basis in the securities. For taxable securities, the premium may
be amortized if the Funds so elect. The amortized premium on taxable securities
is first offset against interest received on the securities and then allowed as
a deduction, and, for securities issued after September 27, 1985, must be
amortized under an economic accrual method.
TAXATION OF THE SHAREHOLDERS
Taxable distributions are generally included in a shareholder's gross income
for the taxable year in which they are received. Dividends declared in October,
November, or December and made payable to shareholders of record in such a
month will be deemed to have been received on December 31, if a Fund pays the
dividend during the following January. It is expected that none of the Funds'
distributions will qualify for the corporate dividends-received deduction.
To the extent that a Fund's dividends distributed to shareholders are
derived from interest income exempt from federal income tax and are designated
as "exempt-interest dividends" by a Fund, they will be excludable from a
shareholder's gross income for federal income tax purposes. Shareholders who
are recipients of Social Security benefits should be aware that exempt-interest
dividends received from a Fund are includible in their "modified adjusted gross
income" for purposes of determining the amount of such Social Security
benefits, if any, that are required to be included in their gross income.
All distributions of investment income during the year will have the same
percentage designated as tax-exempt. This method is called the "average annual
method." Since the Funds invest primarily in tax-exempt securities, the
percentage will be substantially the same as the amount actually earned during
any particular distribution period.
A shareholder of the Long-Term, Intermediate-Term, or Short-Term Funds
should be aware that a redemption of shares (including any exchange into
another USAA Fund) is a taxable event and, accordingly, a capital gain or loss
may be recognized. If a shareholder receives an exempt-interest dividend with
respect to any share and such share has been held for six months or less, any
loss on the redemption or exchange will be disallowed to the extent of such
exempt-interest dividend. Similarly, if a shareholder of a Fund receives a
distribution taxable as long-term capital gain with respect to shares of a Fund
and redeems or exchanges shares before he has held them for more than six
months, any loss on the redemption or exchange (not otherwise disallowed as
attributable to an exempt-interest dividend) will be treated as long-term
capital loss.
The Funds may invest in private activity bonds. Interest on certain
private activity bonds issued after August 7, 1986, is an item of tax
preference for purposes of the Federal Alternative Minimum Tax (AMT),
9
<PAGE>
although the interest continues to be excludable from gross income for other
purposes. AMT is a supplemental tax designed to ensure that taxpayers pay at
least a minimum amount of tax on their income, even if they make substantial
use of certain tax deductions and exclusions (referred to as tax preference
items). Interest from private activity bonds is one of the tax preference items
that is added to income from other sources for the purposes of determining
whether a taxpayer is subject to the AMT and the amount of any tax to be paid.
For corporate investors, alternative minimum taxable income is increased by 75%
of the amount by which adjusted current earnings (ACE) exceeds alternative
minimum taxable income before the ACE adjustment. For corporate taxpayers, all
tax-exempt interest is considered in calculating the AMT as part of the ACE.
Prospective investors should consult their own tax advisers with respect to the
possible application of the AMT to their tax situation.
Opinions relating to the validity of tax-exempt securities and the
exemption of interest thereon from federal income tax are rendered by
recognized bond counsel to the issuers. Neither the Manager's nor the Funds'
counsel makes any review of the basis of such opinions.
STATE AND LOCAL TAXES
The exemption of interest income for federal income tax purposes does not
necessarily result in exemption under the income or other tax laws of any state
or local taxing authority. Shareholders of a Fund may be exempt from state and
local taxes on distributions of tax-exempt interest income derived from
obligations of the state and/or municipalities of the state in which they are
resident, but generally are subject to tax on income derived from obligations
of other jurisdictions. Shareholders should consult their tax advisers about
the status of distributions from a Fund in their own states and localities.
DIRECTORS AND OFFICERS OF THE COMPANY
The Board of Directors of the Company consists of seven Directors who supervise
the business affairs of the Company. Set forth below are the Directors and
officers of the Company, and their respective offices and principal occupations
during the last five years. Unless otherwise indicated, the business address of
each is 9800 Fredericksburg Road, San Antonio, TX 78288.
Robert G. Davis 1, 2
Director and Chairman of the Board of Directors
Age: 51
Deputy Chief Executive Officer for Capital Management of USAA (6/98-present);
President, Chief Executive Officer, Director, and Vice Chairman of the Board of
Directors of USAA Capital Corporation and several of its subsidiaries and
affiliates (1/97-present); President, Chief Executive Officer, Director, and
Chairman of the Board of Directors of USAA Financial Planning Network, Inc.
(1/97-present); Executive Vice President, Chief Operating Officer, Director,
and Vice Chairman of the Board of Directors of USAA Financial Planning Network,
Inc. (9/96-1/97); Special Assistant to Chairman, United Services Automobile
Association (USAA) (6/96-12/96); President and Chief Executive Officer, Banc
One Credit Corporation (12/95-6/96); and President and Chief Executive Officer,
Banc One Columbus, (8/91-12/95). Mr. Davis serves as a Director/Trustee and
Chairman of the Boards of Directors/Trustees of each of the remaining funds
within the USAA Family of Funds; Director and Chairman of the Boards of
Directors of USAA Investment Management Company (IMCO), USAA Shareholder
Account Services, USAA Federal Savings Bank, and USAA Real Estate Company.
Michael J.C. Roth 1, 2
Director, President, and Vice Chairman of the Board of Directors
Age: 56
Chief Executive Officer, IMCO (10/93-present); President, Director, and Vice
Chairman of the Board of Directors, IMCO (1/90-present). Mr. Roth serves as
President, Director/Trustee, and Vice Chairman of the Boards of
Directors/Trustees of each of the remaining funds within the USAA Family of
Funds and USAA Shareholder Account Services; Director of USAA Life Insurance
Company; and Trustee and Vice Chairman of USAA Life Investment Trust.
John W. Saunders, Jr. 1, 2, 4
Director and Vice President
Age: 63
Senior Vice President, Fixed Income Investments, IMCO (10/85-present). Mr.
Saunders serves as a Director/Trustee of each of the remaining funds within the
USAA Family of Funds; Director of IMCO; Senior Vice President of USAA
Shareholder Account Services, and Vice President of USAA Life Investment Trust.
10
<PAGE>
Barbara B. Dreeben 3, 4, 5
200 Patterson #1008
San Antonio, TX 78209
Director
Age: 53
President, Postal Addvantage (7/92-present); Consultant, Nancy Harkins
Stationer (8/91-12/95). Mrs. Dreeben serves as a Director/Trustee of each of
the remaining funds within the USAA Family of Funds.
Howard L. Freeman, Jr. 2, 3, 4, 5
2710 Hopeton
San Antonio, TX 78230
Director
Age: 63
Retired. Assistant General Manager for Finance, San Antonio City Public Service
Board (1976-1996). Mr. Freeman serves as a Director/Trustee of each of the
remaining funds within the USAA Family of Funds.
Robert L. Mason, Ph.D. 3, 4, 5
12823 Queens Forest
San Antonio, TX 78230
Director
Age: 52
Manager, Statistical Analysis Section, Southwest Research Institute
(8/75-present). Dr. Mason serves as a Director/Trustee of the remaining funds
within each of the USAA Family of Funds.
Richard A. Zucker 3, 4, 5
407 Arch Bluff
San Antonio, TX 78216
Director
Age: 55
Vice President, Beldon Roofing and Remodeling (1985-present). Mr. Zucker serves
as a Director/Trustee of each of the remaining funds within the USAA Family of
Funds.
Michael D. Wagner 1
Secretary
Age: 50
Vice President, Corporate Counsel, USAA (1982-present). Mr. Wagner has held
various positions in the legal department of USAA since 1970 and serves as Vice
President, Secretary, and Counsel, IMCO and USAA Shareholder Account Services;
Secretary of each of the remaining funds within the USAA Family of Funds; and
Vice President, Corporate Counsel, for various other USAA subsidiaries and
affiliates.
Alex M. Ciccone 1
Assistant Secretary
Age: 48
Vice President, Compliance, IMCO (12/94-present); Vice President and Chief
Operating Officer, Commonwealth Shareholder Services (6/94-11/94); and Vice
President, Compliance, IMCO (12/91-5/94). Mr. Ciccone serves as Assistant
Secretary of each of the remaining funds within the USAA Family of Funds.
Mark S. Howard 1
Assistant Secretary
Age: 34
Assistant Vice President, Securities Counsel, USAA (2/98-present); Executive
Director, Securities Counsel, USAA (9/96-2/98); Senior Associate Counsel,
Securities Counsel, USAA (5/95-8/96); Attorney, Kirkpatrick & Lockhart LLP
(9/90-4/95). Mr. Howard serves as Assistant Vice President and Assistant
Secretary IMCO and USAA Shareholder Account Services; Assistant Secretary of
each of the remaining funds within the USAA Family of Funds; and Assistant Vice
President, Securities Counsel for various other USAA subsidiaries and
affiliates.
11
<PAGE>
Sherron A. Kirk 1
Treasurer
Age: 53
Vice President, Controller, IMCO (10/92-present). Mrs. Kirk serves as Treasurer
of each of the remaining funds within the USAA Family of Funds; and Vice
President, Controller of USAA Shareholder Account Services.
Caryl Swann 1
Assistant Treasurer
Age: 50
Director, Mutual Fund Portfolio Analysis & Support, IMCO (2/98-present);
Manager, Mutual Fund Accounting, IMCO (7/92-2/98). Ms. Swann serves as
Assistant Treasurer for each of the remaining funds within the USAA Family of
Funds.
- ---------------------
1 Indicates those Directors and officers who are employees of the Manager or
affiliated companies and are considered "interested persons" under the 1940
Act.
2 Member of Executive Committee
3 Member of Audit Committee
4 Member of Pricing and Investment Committee
5 Member of Corporate Governance Committee
Between the meetings of the Board of Directors and while the Board is not
in session, the Executive Committee of the Board of Directors has all the
powers and may exercise all the duties of the Board of Directors in the
management of the business of the Company which may be delegated to it by the
Board. The Pricing and Investment Committee of the Board of Directors acts upon
various investment-related issues and other matters which have been delegated
to it by the Board. The Audit Committee of the Board of Directors reviews the
financial statements and the auditor's reports and undertakes certain studies
and analyses as directed by the Board. The Corporate Governance Committee of
the Board of Directors maintains oversight of the organization, performance,
and effectiveness of the Board and Independent Directors.
In addition to the previously listed Directors and/or officers of the
Company who also serve as Directors and/or officers of the Manager, the
following individuals are Directors and/or executive officers of the Manager:
Harry W. Miller, Senior Vice President, Investments (Equity); Carl W. Shirley,
Senior Vice President, Insurance Company Portfolios; and John J. Dallahan,
Senior Vice President, Investment Services. There are no family relationships
among the Directors, officers and managerial level employees of the Company, or
its Manager.
The following table sets forth information describing the compensation of
the current Directors of the Company for their services as Directors for the
fiscal year ended March 31, 1998.
NAME AGGREGATE TOTAL COMPENSATION
OF COMPENSATION FROM THE USAA
DIRECTOR FROM THE COMPANY FAMILY OF FUNDS (b)
-------- ---------------- -------------------
Robert G. Davis None (a) None (a)
Barbara B. Dreeben $7,968 $29,500
Howard L. Freeman, Jr. $7,968 $29,500
Robert L. Mason $7,968 $29,500
Michael J.C. Roth None (a) None (a)
John W. Saunders, Jr. None (a) None (a)
Richard A. Zucker $7,968 $29,500
- ---------------------
(a) Robert G. Davis, Michael J.C. Roth, and John W. Saunders, Jr. are
affiliated with the Company's investment adviser, IMCO, and, accordingly,
receive no remuneration from the Company or any other Fund of the USAA
Family of Funds.
(b) At March 31, 1998, the USAA Family of Funds consisted of four registered
investment companies offering 35 individual funds. Each Director presently
serves as a Trustee or Director of each investment company in the USAA
Family of Funds. In addition, Michael J.C. Roth presently serves as a
Trustee of USAA Life Investment Trust, a registered investment company
advised by IMCO, consisting of seven funds offered to investors in a fixed
and variable annuity contract with USAA Life Insurance Company. Mr. Roth
receives no compensation as Trustee of USAA Life Investment Trust.
All of the above Directors are also Trustees/Directors of the other funds
within the USAA Family of Funds. No compensation is paid by any fund to any
Trustee/Director who is a director, officer, or employee
12
<PAGE>
of IMCO or its affiliates. No pension or retirement benefits are accrued as
part of fund expenses. The Company reimburses certain expenses of the Directors
who are not affiliated with the investment adviser. As of April 30, 1998, the
officers and Directors of the Company and their families as a group owned
beneficially or of record less than 1% of the outstanding shares of the
Company.
As of April 30, 1998, USAA and its affiliates (including related employee
benefit plans) owned 4,904,675 shares (3.2%) of the Intermediate-Term Fund, and
no shares of the Long-Term, Short-Term and Tax Exempt Money Market Funds.
The following table identifies all persons, who as of April 30, 1998, held
of record or owned beneficially 5% or more of any of the Funds' shares.
NAME AND ADDRESS
TITLE OF CLASS OF BENEFICIAL OWNER PERCENT OF CLASS
-------------- ------------------- ----------------
Short-Term Robert M Kommerstad 8.4%
Fund Lila M Kommerstad
Trst Kommerstad Family Trust
218 Deodar Ln
Bradbury, CA 9101-1011
THE COMPANY'S MANAGER
As described in the Prospectus, USAA Investment Management Company is the
Manager and investment adviser, providing services under the Advisory
Agreement. The Manager, an affiliate of United Services Automobile Association
(USAA), a large, diversified financial services institution, was organized in
May 1970 and has served as investment adviser and underwriter for USAA Tax
Exempt Fund, Inc. from its inception.
In addition to managing the Company's assets, the Manager advises and
manages the investments for USAA and its affiliated companies as well as those
of USAA Mutual Fund, Inc., USAA Investment Trust, USAA State Tax-Free Trust,
and USAA Life Investment Trust. As of the date of this SAI, total assets under
management by the Manager were approximately $39 billion, of which
approximately $24 billion were in mutual fund portfolios.
ADVISORY AGREEMENT
Under the Advisory Agreement, the Manager provides an investment program,
carries out the investment policy, and manages the portfolio assets for each
Fund. The Manager is authorized, subject to the control of the Board of
Directors of the Company, to determine the selection, amount, and time to buy
or sell securities for each Fund. In addition to providing investment services,
the Manager pays for office space, facilities, business equipment, and
accounting services (in addition to those provided by the Custodian) for the
Company. The Manager compensates all personnel, officers, and Directors of the
Company if such persons are also employees of the Manager or its affiliates.
For these services under the Advisory Agreement, the Company has agreed to pay
the Manager a fee computed as described under FUND MANAGEMENT in the
Prospectus. Management fees are computed and accrued daily and payable monthly.
Except for the services and facilities provided by the Manager, the Funds
pay all other expenses incurred in their operations. Expenses for which the
Funds are responsible include taxes (if any); brokerage commissions on
portfolio transactions (if any); expenses of issuance and redemption of shares;
charges of transfer agents, custodians, and dividend disbursing agents; costs
of preparing and distributing proxy material; costs of printing and engraving
stock certificates; auditing and legal expenses; certain expenses of
registering and qualifying shares for sale; fees of Directors who are not
interested persons (not affiliated) of the Manager; costs of printing and
mailing the Prospectus, SAI, and periodic reports to existing shareholders; and
any other charges or fees not specifically enumerated. The Manager pays the
cost of printing and mailing copies of the Prospectus, the SAI, and reports to
prospective shareholders.
The Advisory Agreement will remain in effect until June 30, 1999, for each
Fund and will continue in effect from year to year thereafter for each Fund as
long as it is approved at least annually by a vote of the outstanding voting
securities of such Fund (as defined by the 1940 Act) or by the Board of
Directors (on behalf of such Fund) including a majority of the Directors who
are not interested persons of the Manager or (otherwise than as Directors) of
the Company, at a meeting called for the purpose of voting on such approval.
The Advisory Agreement may be terminated at any time by either the Company or
the Manager on 60 days' written notice. It will automatically terminate in the
event of its assignment (as defined in the 1940 Act).
From time to time the Manager may, without prior notice to shareholders,
waive all or any portion of fees or agree to reimburse expenses incurred by a
Fund. Any such waiver or reimbursement may be terminated by the Manager at any
time without prior notice to shareholders.
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For the last three fiscal years, the Company paid the Manager the
following fees:
FUND 1996 1997 1998
---- ---- ---- ----
Long-Term $5,119,811 $5,167,507 $5,497,968
Intermediate-Term $4,532,471 $4,723,990 $5,238,815
Short-Term $2,188,350 $2,188,649 $2,442,108
Tax Exempt Money Market $4,067,473 $4,208,391 $4,292,183
UNDERWRITER
The Company has an agreement with the Manager for exclusive underwriting and
distribution of the Funds' shares on a continuing best efforts basis. This
agreement provides that the Manager will receive no fee or other compensation
for such distribution services.
TRANSFER AGENT
The Transfer Agent performs transfer agent services for the Company under a
Transfer Agency Agreement. Services include maintenance of shareholder account
records, handling of communications with shareholders, distribution of Fund
dividends, and production of reports with respect to account activity for
shareholders and the Company. For its services under the Transfer Agency
Agreement, each Fund pays the Transfer Agent an annual fixed fee of $26 per
account. This fee is subject to change at any time.
The fee to the Transfer Agent includes processing of all transactions and
correspondence. Fees are billed on a monthly basis at the rate of one-twelfth
of the annual fee. In addition, the Funds pay all out-of-pocket expenses of the
Transfer Agent and other expenses which are incurred at the specific direction
of the Company.
GENERAL INFORMATION
CUSTODIAN
State Street Bank and Trust Company, P.O. Box 1713, Boston, MA 02105, is the
Company's Custodian. The Custodian is responsible for, among other things,
safeguarding and controlling the Company's cash and securities, handling the
receipt and delivery of securities, and collecting interest on the company's
investments.
COUNSEL
Goodwin, Procter & Hoar LLP, Exchange Place, Boston, MA 02109, will review
certain legal matters for the Company in connection with the shares offered by
the Prospectus.
INDEPENDENT AUDITORS
KPMG Peat Marwick LLP, 112 East Pecan, Suite 2400, San Antonio, TX 78205, is
the Company's independent auditor. In this capacity, the firm is responsible
for auditing the annual financial statements of the Funds and reporting
thereon.
CALCULATION OF PERFORMANCE DATA
Information regarding total return and yield of each Fund is provided under
COULD THE VALUE OF YOUR INVESTMENT IN THESE FUNDS FLUCTUATE? in the Prospectus.
See VALUATION OF SECURITIES herein for a discussion of the manner in which each
Fund's price per share is calculated.
TOTAL RETURN
The Funds, other than the Tax Exempt Money Market Fund, may each advertise
performance in terms of average annual total return for 1-, 5-, and 10-year
periods. Average annual total return is computed by finding the average annual
compounded rates of return over the periods that would equate the initial
amount invested to the ending redeemable value, according to the following
formula:
P(1 + T)n = ERV
Where: P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $1,000
payment made at the beginning of the 1-, 5-, or
10-year periods at the end of the year or period
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The calculation assumes all charges are deducted from the initial $1,000
payment and assumes all dividends and distributions by such Fund are reinvested
at the price stated in the Prospectus on the reinvestment dates during the
period, and includes all recurring fees that are charged to all shareholder
accounts.
AVERAGE ANNUAL TOTAL RETURNS
FOR PERIODS ENDED 3/31/98
1 5 10
FUND YEAR YEARS YEARS
---- ---- ----- -----
Long-Term 12.04% 6.72% 8.49%
Intermediate-Term 10.59% 6.69% 7.75%
Short-Term 6.35% 4.84% 5.66%
YIELD
The Funds, other than the Tax Exempt Money Market Fund, each may advertise
performance in terms of a 30-day yield quotation. The 30-day yield quotation is
computed by dividing the net investment income per share earned during the
period by the maximum offering price per share on the last day of the period,
according to the following formula:
YIELD = 2[((a-b)/(cd)+1)^6 -1]
Where: a = dividends and interest earned during the period
b = expenses accrued for the period (net of reimbursement)
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 the yield calculation, interest income is computed based
on the yield to maturity of each debt obligation in a Fund's portfolio and all
recurring charges are recognized.
The 30-day yields for the Funds for the period ended March 31, 1998, were
as follows:
Long-Term Fund . . . . . 4.73%
Intermediate-Term Fund . . . . 4.52%
Short-Term Fund . . . . 3.85%
YIELD - TAX EXEMPT MONEY MARKET FUND
When the Tax Exempt Money Market Fund quotes a current annualized yield, it is
based on a specified recent seven-calendar-day period. It is computed by (1)
determining the net change, exclusive of capital changes and income other than
investment income, in the value of a hypothetical preexisting account having a
balance of one share at the beginning of the period, (2) dividing the net
change in account value by the value of the account at the beginning of the
base period to obtain the base return, then (3) multiplying the base period
return by 52.14 (365/7). The resulting yield figure is carried to the nearest
hundredth of one percent.
The calculation includes (1) the value of additional shares purchased with
dividends on the original share, and dividends declared on both the original
share and any such additional shares and (2) any fees charged to all
shareholder accounts, in proportion to the length of the base period and the
Fund's average account size.
The capital changes excluded from the calculation are realized capital
gains and losses from the sale of securities and unrealized appreciation and
depreciation. The Fund's effective (compounded) yield will be computed by
dividing the seven-day annualized yield as defined above by 365, adding 1 to
the quotient, raising the sum to the 365th power, and subtracting 1 from the
result.
Current and effective yields fluctuate daily and will vary with factors
such as interest rates and the quality, length of maturities, and type of
investments in the portfolio.
Yield For 7-day Period Ended March 31, 1998, was 3.43%.
Effective Yield For 7-day Period Ended March 31, 1998, was 3.49%.
TAX EQUIVALENT YIELD
A tax-exempt mutual fund may provide more "take-home" income than a fully
taxable mutual fund after paying taxes. Calculating a "tax equivalent yield"
means converting a tax-exempt yield to a pretax equivalent so that a meaningful
comparison can be made between a tax-exempt municipal fund and a fully taxable
fund. The Tax Exempt Money Market Fund may advertise performance in terms of a
tax equivalent yield based on the 7-day yield or effective yield and the other
Funds may advertise performance in terms of a 30-day tax equivalent yield.
To calculate a tax equivalent yield, an investor must know his federal
marginal income tax rate. The tax equivalent yield is then computed by dividing
the tax-exempt yield of a fund by the complement of the federal marginal tax
rate. The complement, for example, of a federal marginal tax rate of 36.0% is
64.0%, that is (1.00-0.36= 0.64).
15
<PAGE>
Tax Equivalent Yield = Tax Exempt Yield / (1- Federal Marginal Tax Rate)
Based on a federal marginal tax rate of 36.0%, the tax equivalent yields
for the Long-Term, Intermediate-Term, Short-Term, and Tax Exempt Money Market
Funds for the period ended March 31, 1998 were 7.39%, 7.06%, 6.02%, and 5.36%,
respectively.
APPENDIX A - TAX-EXEMPT SECURITIES AND THEIR RATINGS
TAX-EXEMPT SECURITIES
Tax-exempt securities generally include debt obligations issued by states and
their political subdivisions, and duly constituted authorities and
corporations, to obtain funds to construct, repair or improve various public
facilities such as airports, bridges, highways, hospitals, housing, schools,
streets, and water and sewer works. Tax-exempt securities may also be issued to
refinance outstanding obligations as well as to obtain funds for general
operating expenses and for loans to other public institutions and facilities.
The two principal classifications of tax-exempt securities are "general
obligations" and "revenue" or "special tax" 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 or special tax bonds are payable
only from the revenues derived from a particular facility or class of
facilities or, in some cases, from the proceeds of a special excise or other
tax, but not from general tax revenues. The Funds may also invest in tax-exempt
private activity bonds, which in most cases are revenue bonds and generally do
not have the pledge of the credit of the issuer. The payment of the principal
and interest on such industrial revenue bonds is dependent 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. There are, of course, many variations in
the terms of, and the security underlying, tax-exempt securities. Short-term
obligations issued by states, cities, municipalities or municipal agencies,
include Tax Anticipation Notes, Revenue Anticipation Notes, Bond Anticipation
Notes, Construction Loan Notes, and Short-Term Notes.
The yields of tax-exempt securities depend on, among other things, general
money market conditions, conditions of the tax-exempt bond market, the size of
a particular offering, the maturity of the obligation, and the rating of the
issue. The ratings of Moody's Investors Service, Inc. (Moody's), Standard &
Poor's Ratings Group (S&P), Fitch IBCA, Inc. (Fitch), Duff & Phelps Inc., and
Thompson BankWatch, Inc. represent their opinions of the quality of the
securities rated by them. It should be emphasized that such ratings are general
and are not absolute standards of quality. Consequently, securities with the
same maturity, coupon, and rating may have different yields, while securities
of the same maturity and coupon but with different ratings may have the same
yield. It will be the responsibility of the Manager to appraise independently
the fundamental quality of the tax-exempt securities included in a Fund's
portfolio.
I. LONG-TERM DEBT RATINGS:
MOODY'S INVESTOR SERVICES, INC.
Aaa Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally
referred to as "gilt edged." 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 Aaa
securities or fluctuation of protective elements may be of greater
amplitude or there may be other elements present which make the
long-term risk appear somewhat larger than in 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 lacking or may be
characteristically unreliable over any great length of time. Such
bonds lack outstanding investment characteristics and in fact have
speculative characteristics as well.
NOTE: MOODY'S APPLIES NUMERICAL MODIFIERS 1, 2, AND 3 IN EACH GENERIC RATING
CLASSIFICATION. THE MODIFIER 1 INDICATES THAT THE OBLIGATION RANKS IN THE
HIGHER END OF ITS GENERIC RATING CATEGORY, THE MODIFIER 2 INDICATES A MID-RANGE
RANKING, AND THE MODIFIER 3 INDICATES A RANKING IN THE LOWER END OF THAT
GENERIC RATING CATEGORY.
16
<PAGE>
STANDARD & POOR'S RATINGS GROUP
AAA An obligation rated AAA has the highest rating assigned by Standard &
Poor's. The obligor's capacity to meet its financial commitment on the
obligation is EXTREMELY STRONG.
AA An obligation rated AA differs from the highest rated issues only in
small degree. The obligor's capacity to meet its financial commitment
on the obligation is VERY STRONG.
A An obligation rated A is somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than
obligations in higher rated categories. However, the obligor's
capacity to meet its financial commitment on the obligation is still
STRONG.
BBB An obligation rated BBB exhibits ADEQUATE capacity to pay interest and
repay principal. However, adverse economic conditions or changing
circumstances are more likely to lead to a weakened capacity of the
obligor to meet its financial commitment on the obligation.
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
RATING CATEGORIES.
FITCH IBCA, INC.
AAA Highest credit quality. "AAA" ratings denote the lowest expectation of
credit risk. They are assigned only in case of exceptionally strong
capacity for timely payment of financial commitments. This capacity is
highly unlikely to be adversely affected by foreseeable events.
AA Very high credit quality. "AA" ratings denote a very low expectation
of credit risk. They indicate very strong capacity for timely payment
of financial commitments. This capacity is not significantly
vulnerable to foreseeable events.
A High credit quality. "A" ratings denote a low expectation of credit
risk. The capacity for timely payment of financial commitments is
considered strong. This capacity may, nevertheless, be more vulnerable
to changes in circumstances or in economic conditions than is the case
for higher ratings.
BBB Good credit quality. "BBB" ratings indicate that there is currently a
low expectation of credit risk. The capacity for timely payment of
financial commitments is considered adequate, but adverse changes in
circumstances and in economic conditions are more likely to impair
this capacity. This is the lowest investment-grade category.
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.
DUFF & PHELPS, INC.
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. Risk is modest but
may vary slightly from time to time because of economic conditions.
A Protection factors are average but adequate. However, risk factors are
more variable and greater in periods of economic stress.
BBB Below average protection factors but still considered sufficient for
prudent investment. Considerable variability in risk during economic
cycles.
2. SHORT-TERM DEBT RATINGS:
MOODY'S STATE AND TAX-EXEMPT NOTES
MIG-1/VMIG1 This designation denotes best quality. There is present
strong protection by established cash flows, superior
liquidity support or demonstrated broad-based access to the
market for refinancing.
MIG-2/VMIG2 This designation denotes high quality. Margins of protection
are ample although not so large as in the preceding group.
MOODY'S COMMERCIAL PAPER
Prime-1 Issuers rated Prime-1 (or supporting institutions) have a superior
ability for repayment of senior short-term promissory obligations.
Prime-1 repayment capacity will normally be evidenced by the
following characteristics:
o Leading market positions in well-established industries.
o High rates of return on funds employed.
o Conservative capitalization structures with moderate reliance on
debt and ample asset protection.
o Broad margins in earning coverage of fixed financial charges and
high internal cash generation.
o Well-established access to a range of financial markets and
assured sources of alternate liquidity.
17
<PAGE>
Prime-2 Issuers rated Prime-2 (or supporting institutions) have a strong
ability for repayment of senior short-term promissory obligations.
This will normally be evidenced by many of the characteristics cited
above but to a lesser degree. Earnings trends and coverage ratios,
while sound, may be more subject to variation. Capitalization
characteristics, while still appropriate, may be more affected by
external conditions. Ample alternate liquidity is maintained.
S&P TAX-EXEMPT NOTES
SP-1 Strong capacity to pay principal and interest. Issues determined to
possess very strong characteristics are given a plus (+) designation.
SP-2 Satisfactory capacity to pay principal and interest, with some
vulnerability to adverse financial and economic changes over the term
of the notes.
S&P COMMERCIAL PAPER
A-1 This highest category indicates that the degree of safety regarding
timely payment is strong. Those issues determined to possess extremely
strong safety characteristics are denoted with a plus (+) sign
designation.
A-2 Capacity for timely payment on issues with this designation is
satisfactory. However, the relative degree of safety is not as high as
for issues designated A-1.
FITCH'S COMMERCIAL PAPER, CERTIFICATES OF DEPOSIT, AND TAX-EXEMPT NOTES
F1 Highest credit quality. Indicates the strongest capacity for timely
payment of financial commitments; may have an added "+" to denote any
exceptionally strong credit features.
F2 Good credit quality. A satisfactory capacity for timely payment of
financial commitments, but the margin of safety is not as great as in
the case of the higher ratings.
F3 Fair credit quality. The capacity for timely payment of financial
commitments is adequate; however, near-term adverse changes could
result in a reduction to non-investment grade.
DUFF & PHELPS COMMERCIAL PAPER
D-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.
D-1 Very high certainty of timely payment. Liquidity factors are excellent
and supported by good fundamental protection factors. Risk factors are
minor.
D-1- High certainty of timely payment. Liquidity factors are strong and
supported by good fundamental protection factors. Risk factors are
very small.
D-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.
THOMPSON BANKWATCH, INC.
TBW-1 The highest category; indicates a very high likelihood that principal
and interest will be paid on a timely basis.
TBW-2 The second highest category; while the degree of safety regarding
timely repayment of principal and interest is strong, the relative
degree of safety is not as high as for issues rated TBW-1.
TBW-3 The lowest investment-grade category; indicates that while the
obligation is more susceptible to adverse developments (both internal
and external) than those with higher ratings, the capacity to service
principal and interest in a timely fashion is considered adequate.
APPENDIX B -- COMPARISON OF PORTFOLIO PERFORMANCE
Occasionally, we may make comparisons in advertising and sales literature
between the Funds contained in this SAI and other Funds in the USAA Family of
Funds. These comparisons may include such topics as risk and reward, investment
objectives, investment strategies, and performance.
Fund performance also may be compared to the performance of broad groups
of mutual funds with similar investment goals or unmanaged indexes of
comparable securities. Evaluations of Fund performance made by independent
sources may be used in advertisements concerning the Fund, including reprints
of, or selections from, editorials or articles about the Fund. The Fund or its
performance may also be compared to products and services not constituting
securities subject to registration under the Securities Act of 1933 such as,
but not limited to, certificates of deposit and money market accounts. Sources
for performance information and articles about the Fund may include but are not
restricted to the following:
18
<PAGE>
AAII JOURNAL, a monthly association magazine for members of the American
Association of Individual Investors.
ARIZONA REPUBLIC, a newspaper which may cover financial and investment news.
AUSTIN AMERICAN-STATESMAN, a newspaper which may cover financial news.
BARRON'S, a Dow Jones and Company, Inc. business and financial weekly that
periodically reviews mutual fund performance data.
THE BOND BUYER, a daily newspaper which covers bond market news.
BUSINESS WEEK, a national business weekly that periodically reports the
performance rankings and ratings of a variety of mutual funds.
CHICAGO TRIBUNE, a newspaper which may cover financial news.
CONSUMER REPORTS, a monthly magazine which from time to time reports on
companies in the mutual fund industry.
DALLAS MORNING NEWS, a newspaper which may cover financial news.
DENVER POST, a newspaper which may quote financial news.
FINANCIAL PLANNING, a monthly magazine that periodically features companies in
the mutual fund industry.
FINANCIAL SERVICES WEEK, a weekly newspaper which covers financial news.
FINANCIAL WORLD, a monthly magazine which may periodically review mutual fund
companies.
FORBES, a national business publication that periodically reports the
performance of companies in the mutual fund industry.
FORTUNE, a national business publication that periodically rates the
performance of a variety of mutual funds.
FUND ACTION, a mutual fund news report.
HOUSTON CHRONICLE, a newspaper which may cover financial news.
HOUSTON POST, a newspaper which may cover financial news.
IBC'S MONEYLETTER, a biweekly newsletter which covers financial news and from
time to time rates specific mutual funds.
IBC'S MONEY FUND REPORT, a weekly publication of IBC Financial Data, Inc.,
reporting on the performance of the nation's money market funds, summarizing
money market fund activity, and including certain averages as performance
benchmarks, specifically: (1) Taxable Money Fund Averages: "100% U.S. Treasury"
and "First Tier" and (2) Tax-Free Money Fund Averages: "Stockbroker and General
Purpose" and "State Specific Stockbroker and General Purpose."
IBC'S MONEY MARKET INSIGHT, a monthly money market industry analysis prepared
by IBC Financial Data, Inc.
INCOME AND SAFETY, a monthly newsletter that rates mutual funds.
INVESTECH, a bimonthly investment newsletter.
INVESTMENT ADVISOR, a monthly publication directed primarily to the advisor
community; includes ranking of mutual funds using a proprietary methodology.
INVESTMENT COMPANY INSTITUTE, a national association of the American Investment
Company industry.
INVESTOR'S BUSINESS DAILY, a newspaper which covers financial news.
KIPLINGER'S PERSONAL FINANCE MAGAZINE, a monthly investment advisory
publication that periodically features the performance of a variety of
securities.
LIPPER ANALYTICAL SERVICES, INC.'S EQUITY FUND PERFORMANCE ANALYSIS, a weekly
and monthly publication of industry-wide mutual fund performance averages by
type of fund.
LIPPER ANALYTICAL SERVICES, INC.'S FIXED INCOME FUND PERFORMANCE ANALYSIS, a
monthly publication of industry-wide mutual fund performance averages by type
of fund.
LOS ANGELES TIMES, a newspaper which may cover financial news.
LOUIS RUKEYSER'S WALL STREET, a publication for investors.
MEDICAL ECONOMICS, a monthly magazine providing information to the medical
profession.
MONEY, a monthly magazine that features the performance of both specific funds
and the mutual fund industry as a whole.
MORNINGSTAR 5 STAR INVESTOR, a monthly newsletter which covers financial news
and rates mutual funds produced by Morningstar, Inc. (a data service which
tracks open-end mutual funds).
19
<PAGE>
MUNI BOND FUND REPORT, a monthly newsletter which covers news on the municipal
bond market and features performance data for municipal bond mutual funds.
MUNIWEEK, a weekly newspaper which covers news on the municipal bond market.
MUTUAL FUND FORECASTER, a monthly newsletter that ranks mutual funds.
MUTUAL FUND INVESTING, a newsletter covering mutual funds.
MUTUAL FUND PERFORMANCE REPORT, a monthly publication of industry-wide mutual
fund averages produced by Morningstar, Inc.
MUTUAL FUNDS MAGAZINE, a monthly publication reporting on mutual fund
investing.
MUTUAL FUND SOURCE BOOK, an annual publication produced by Morningstar, Inc.
which describes and rates mutual funds.
MUTUAL FUND VALUES, a biweekly guidebook to mutual funds produced by
Morningstar, Inc.
NEWSWEEK, a national business weekly.
NEW YORK TIMES, a newspaper which may cover financial news.
NO LOAD FUND INVESTOR, a newsletter covering companies in the mutual fund
industry.
ORLANDO SENTINEL, a newspaper which may cover financial news.
PERSONAL INVESTOR, a monthly magazine which from time to time features mutual
fund companies and the mutual fund industry.
SAN ANTONIO BUSINESS JOURNAL, a weekly newspaper that periodically covers
mutual fund companies as well as financial news.
SAN ANTONIO EXPRESS-NEWS, a newspaper which may cover financial news.
SAN FRANCISCO CHRONICLE, a newspaper which may cover financial news.
SMART MONEY, a monthly magazine featuring news and articles on investing and
mutual funds.
USA TODAY, a newspaper which may cover financial news.
U.S. NEWS AND WORLD REPORT, a national business weekly that periodically
reports mutual fund performance data.
WALL STREET JOURNAL, a Dow Jones and Company, Inc. newspaper which covers
financial news.
WASHINGTON POST, a newspaper which may cover financial news.
WEISENBERGER MUTUAL FUNDS INVESTMENT REPORT, a monthly newsletter that reports
on both specific mutual fund companies and the mutual fund industry as a whole.
WORTH, a magazine which covers financial and investment subjects including
mutual funds.
YOUR MONEY, a monthly magazine directed towards the novice investor.
In addition to the sources above, performance of our Funds may also be tracked
by Lipper Analytical Services, Inc. Each Fund will be compared to Lipper's
appropriate fund category according to objective and portfolio holdings. The
Long-Term Fund will be compared to funds in Lipper's General Municipal Debt
Funds category, Intermediate-Term Fund to funds in Lipper's Intermediate
Municipal Debt Funds category, Short-Term Fund to Lipper's Short Municipal Debt
Funds category, and Tax Exempt Money Market Fund to Lipper's Tax-Exempt Money
Market Funds category. Footnotes in advertisements and other sales literature
will include the time period applicable for any rankings used.
For comparative purposes, unmanaged indices of comparable securities or
economic data may be cited. Examples include the following:
--Shearson Lehman Hutton Bond Indices, indices of fixed-rate debt issues
rated investment grade or higher which can be found in the BOND MARKET REPORT.
--Bond Buyer Indices, indices of debt of varying maturities including
revenue bonds, general obligation bonds, and U.S. Treasury bonds which can be
found in MUNIWEEK and THE BOND BUYER.
Other sources for total return and other performance data which may be
used by the Funds or by those publications listed previously are Morningstar,
Inc., Schabaker Investment Management, and Investment Company Data, Inc. These
are services that collect and compile data on mutual fund companies.
20
<PAGE>
APPENDIX C - DOLLAR-COST AVERAGING
Dollar-cost averaging is a systematic investing method which can be used by
investors as a disciplined technique for investing. A fixed amount of money is
invested in a security (such as a stock or mutual fund) on a regular basis over
a period of time, regardless of whether securities markets are moving up or
down.
This practice reduces average share costs to the investor who acquires
more shares in periods of lower securities prices and fewer shares in periods
of higher prices.
While dollar-cost averaging does not assure a profit or protect against
loss in declining markets, this investment strategy is an effective way to help
calm the effect of fluctuations in the financial markets. Systematic investing
involves continuous investment in securities regardless of fluctuating price
levels of such securities. Investors should consider their financial ability to
continue purchases through periods of low and high price levels.
As the following chart illustrates, dollar-cost averaging tends to keep
the overall cost of shares lower. This example is for illustration only, and
different trends would result in different average costs.
HOW DOLLAR-COST AVERAGING WORKS
$100 Invested Regularly for 5 Periods
Market Trend
--------------------------------------------------------------------
Down Up Mixed
------------------- --------------------- -----------------------
Share Shares Share Shares Share Shares
Investment Price Purchased Price Purchased Price Purchased
------------------- --------------------- -----------------------
$100 10 10 6 16.67 10 10
100 9 11.1 7 14.29 9 11.1
100 8 12.5 7 14.29 8 12.5
100 8 12.5 9 11.1 9 11.1
100 6 16.67 10 10 10 10
- ---- -- ----- -- ----- -- -----
$500 ***41 62.77 ***39 66.35 ***46 54.7
*Avg. Cost: $7.97 *Avg. Cost: $7.54 *Avg. Cost: $9.14
----- ----- -----
**Avg. Price: $8.20 *Avg. Price: $7.80 **Avg. Price: $9.20
----- ----- -----
* Average Cost is the total amount invested divided by number of
shares purchased.
** Average Price is the sum of the prices paid divided by number
of purchases.
*** Cumulative total of share prices used to compute average prices.
21
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22
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23
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06052-0898
<PAGE>
USAA USAA TAX STATEMENT OF
EAGLE EXEMPT ADDITIONAL INFORMATION
LOGO FUND, INC. August 1, 1998
- -------------------------------------------------------------------------------
USAA TAX EXEMPT FUND, INC.
CALIFORNIA FUNDS
USAA TAX EXEMPT FUND, INC. (the Company) is a registered investment company
offering shares of ten no-load mutual funds, two of which are described in this
Statement of Additional Information (SAI): the California Bond Fund and
California Money Market Fund (collectively, the Funds or the California Funds).
Each Fund is classified as diversified and has a common investment objective of
providing California investors with a high level of current interest income
that is exempt from federal and California state income taxes. The California
Money Market Fund has a further objective of preserving capital and maintaining
liquidity.
You may obtain a free copy of a Prospectus dated August 1, 1998, for the
California Funds by writing to USAA Tax Exempt Fund, Inc., 9800 Fredericksburg
Road, San Antonio, TX 78288, or by calling toll free 1-800-531-8181. The
Prospectus provides the basic information you should know before investing in
the Funds. This SAI is not a Prospectus and contains information in addition to
and more detailed than that set forth in the Prospectus. It is intended to
provide you with additional information regarding the activities and operations
of the Company and the Funds, and should be read in conjunction with the
Prospectus.
The financial statements of the Funds and the Independent Auditors' Report
thereon for the fiscal year ended March 31, 1998, are included in the
accompanying Annual Report to Shareholders of that date and are incorporated
herein by reference.
- -------------------------------------------------------------------------------
TABLE OF CONTENTS
PAGE
2 Valuation of Securities
2 Conditions of Purchase and Redemption
3 Additional Information Regarding Redemption of Shares
3 Investment Plans
4 Investment Policies
6 Investment Restrictions
7 Special Risk Considerations
11 Portfolio Transactions
12 Description of Shares
12 Certain Federal Income Tax Considerations
14 California Taxation
15 Directors and Officers of the Company
17 The Company's Manager
18 General Information
19 Calculation of Performance Data
20 Appendix A - Tax-Exempt Securities and Their Ratings
23 Appendix B - Comparison of Portfolio Performance
25 Appendix C - Dollar-Cost Averaging
<PAGE>
VALUATION OF SECURITIES
Shares of each Fund are offered on a continuing best efforts basis through USAA
Investment Management Company (IMCO or the Manager). The offering price for
shares of each Fund is equal to the current net asset value (NAV) per share.
The NAV per share of each Fund is calculated by adding the value of all its
portfolio securities and other assets, deducting its liabilities, and dividing
by the number of shares outstanding.
A Fund's NAV per share is calculated each day, Monday through Friday,
except days on which the New York Stock Exchange (NYSE) is closed. The NYSE is
currently scheduled to be closed on New Year's Day, Martin Luther King, Jr.
Day, Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day,
Thanksgiving, and Christmas, and on the preceding Friday or subsequent Monday
when one of these holidays falls on a Saturday or Sunday, respectively.
The investments of the CALIFORNIA BOND FUND are valued each business day
by a pricing service (the Service) approved by the Company's Board of
Directors. The Service uses the mean between quoted bid and asked prices or the
last sale price to price securities when, in the Service's judgment, these
prices are readily available and are representative of the securities' market
values. For many securities, such prices are not readily available. The Service
generally prices these securities based on methods which include consideration
of yields or prices of tax-exempt securities of comparable quality, coupon,
maturity and type, indications as to values from dealers in securities, and
general market conditions. Securities purchased with maturities of 60 days or
less are stated at amortized cost which approximates market value. Repurchase
agreements are valued at cost. Securities which cannot be valued by the
Service, and all other assets, are valued in good faith at fair value using
methods determined by the Manager under the general supervision of the Board of
Directors.
The value of the CALIFORNIA MONEY MARKET FUND'S securities is stated at
amortized cost which approximates market value. This involves valuing a
security at its cost and thereafter assuming a constant amortization to
maturity of any discount or premium, regardless of the impact of fluctuating
interest rates. While this method provides certainty in valuation, it may
result in periods during which the value of an instrument, as determined by
amortized cost, is higher or lower than the price the Fund would receive upon
the sale of the instrument.
The valuation of the California Money Market Fund's portfolio instruments
based upon their amortized cost is subject to the Fund's adherence to certain
procedures and conditions. Consistent with regulatory requirements, the Manager
will only purchase securities with remaining maturities of 397 days or less and
will maintain a dollar-weighted average portfolio maturity of no more than 90
days. The Manager will invest only in securities that have been determined to
present minimal credit risk and that satisfy the quality and diversification
requirements of applicable rules and regulations of the Securities and Exchange
Commission (SEC).
The Board of Directors has established procedures designed to stabilize
the California Money Market Fund's price per share, as computed for the purpose
of sales and redemptions, at $1. There can be no assurance, however, that the
Fund will at all times be able to maintain a constant $1 NAV per share. Such
procedures include review of the Fund's holdings at such intervals as is deemed
appropriate to determine whether the Fund's NAV calculated by using available
market quotations deviates from $1 per share and, if so, whether such deviation
may result in material dilution or is otherwise unfair to existing
shareholders. In the event that it is determined that such a deviation exists,
the Board of Directors will take such corrective action as it regards as
necessary and appropriate. Such action may include selling portfolio
instruments prior to maturity to realize capital gains or losses or to shorten
average portfolio maturity, withholding dividends, or establishing a NAV per
share by using available market quotations.
CONDITIONS OF PURCHASE AND REDEMPTION
NONPAYMENT
If any order to purchase shares is canceled due to nonpayment or if the Company
does not receive good funds either by check or electronic funds transfer, USAA
Shareholder Account Services (Transfer Agent) will treat the cancellation as a
redemption of shares purchased, and you will be responsible for any resulting
loss incurred by the Fund or the Manager. If you are a shareholder, the
Transfer Agent can redeem shares from your account(s) as reimbursement for all
losses. In addition, you may be prohibited or restricted from making future
purchases in any of the USAA Family of Funds. A $15 fee is charged for all
returned items, including checks and electronic funds transfers.
TRANSFER OF SHARES
You may transfer Fund shares to another person by sending written instructions
to the Transfer Agent. The account must be clearly identified, and you must
include the number of shares to be transferred, the signatures of all
registered owners, and all stock certificates, if any, which are the subject of
transfer. You also need to send written instructions signed by all registered
owners and supporting documents to change an account registration due to events
such as divorce, marriage, or death. If a new account needs to be established,
you must complete and return an application to the Transfer Agent.
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ADDITIONAL INFORMATION REGARDING REDEMPTION OF SHARES
The value of your investment at the time of redemption may be more or less than
the cost at purchase, depending on the value of the securities held in each
Fund's portfolio. Requests for redemption which are subject to any special
conditions, or which specify an effective date other than as provided herein,
cannot be accepted. A gain or loss for tax purposes may be realized on the sale
of shares, depending upon the price when redeemed.
The Board of Directors may cause the redemption of an account with a
balance of less than 50 shares provided (1) the value of the account has been
reduced, for reasons other than market action, below the minimum initial
investment in such Fund at the time of the establishment of the account, (2)
the account has remained below the minimum level for six months, and (3) 60
days' prior written notice of the proposed redemption has been sent to you.
Shares will be redeemed at the NAV on the date fixed for redemption by the
Board of Directors. Prompt payment will be made by mail to your last known
address.
The Company reserves the right to suspend the right of redemption or
postpone the date of payment (1) for any periods during which the NYSE is
closed, (2) when trading in the markets the Company normally utilizes is
restricted, or an emergency exists as determined by the SEC so that disposal of
the Company's investments or determination of its NAV is not reasonably
practicable, or (3) for such other periods as the SEC by order may permit for
protection of the Company's shareholders.
For the mutual protection of the investor and the Funds, the Company may
require a signature guarantee. If required, EACH signature on the account
registration must be guaranteed. Signature guarantees are acceptable from FDIC
member banks, brokers, dealers, municipal securities dealers, municipal
securities brokers, government securities dealers, government securities
brokers, credit unions, national securities exchanges, registered securities
associations, clearing agencies, and savings associations. A signature
guarantee for active duty military personnel stationed abroad may be provided
by an officer of the United States Embassy or Consulate, a staff officer of the
Judge Advocate General, or an individual's commanding officer.
REDEMPTION BY CHECK
Shareholders in the California Money Market Fund may request that checks be
issued for their account. Checks must be written in amounts of at least $250.
Checks issued to shareholders of the Fund will be sent only to the person
in whose name the account is registered and only to the address of record. The
checks must be manually signed by the registered owner(s) exactly as the
account is registered. For joint accounts the signature of either or both joint
owners will be required on the check, according to the election made on the
signature card. You will continue to earn dividends until the shares are
redeemed by the presentation of a check.
When a check is presented to the Transfer Agent for payment, a sufficient
number of full and fractional shares from your account will be redeemed to
cover the amount of the check. If the account's balance is not adequate to
cover the amount of a check, the check will be returned unpaid. Because the
value of each account changes as dividends are accrued on a daily basis, checks
may not be used to close an account.
The checkwriting privilege is subject to the customary rules and
regulations of State Street Bank and Trust Company (State Street Bank or the
Custodian) governing checking accounts. There is no charge to you for the use
of the checks or for subsequent reorders of checks.
The Company reserves the right to assess a processing fee against your
account for any redemption check not honored by a clearing or paying agent.
Currently, this fee is $15 and is subject to change at any time. Some examples
of such dishonor are improper endorsement, checks written for an amount less
than the minimum check amount, and insufficient or uncollectible funds.
The Company, the Transfer Agent, and State Street Bank each reserve the
right to change or suspend the checkwriting privilege upon 30 days' written
notice to participating shareholders.
You may request that the Transfer Agent stop payment on a check. The
Transfer Agent will use its best efforts to execute stop payment instructions,
but does not guarantee that such efforts will be effective. The Transfer Agent
will charge you $10 for each stop payment you request.
INVESTMENT PLANS
The Company makes available the following investment plans to shareholders of
the Funds. At the time you sign up for any of the following investment plans
that utilize the electronic funds transfer service, you will choose the day of
the month (the effective date) on which you would like to regularly purchase
shares. When this day falls on a weekend or holiday, the electronic transfer
will take place on the last business day before the effective date. You may
terminate your participation in a plan at any time. Please call the Manager for
details and necessary forms or applications.
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AUTOMATIC PURCHASE OF SHARES
INVESTRONIC(R) - The regular purchase of additional shares through electronic
funds transfer from a checking or savings account. You may invest as little as
$50 per month.
DIRECT PURCHASE SERVICE - The periodic purchase of shares through electronic
funds transfer from an employer (including government allotments and social
security), an income-producing investment, or an account with a participating
financial institution.
AUTOMATIC PURCHASE PLAN - The periodic transfer of funds from a USAA money
market fund to purchase shares in another non-money market USAA mutual fund.
There is a minimum investment required for this program of $5,000 in the money
market fund, with a monthly transaction minimum of $50.
BUY/SELL SERVICE - The intermittent purchase or redemption of shares through
electronic funds transfer to or from a checking or savings account. You may
initiate a "buy" or "sell" whenever you choose.
DIRECTED DIVIDENDS - If you own shares in more than one of the Funds in the
USAA Family of Funds, you may direct that dividends and/or capital gain
distributions earned in one fund be used to purchase shares automatically in
another fund.
Participation in these systematic purchase plans allows you to engage in
dollar-cost averaging. For additional information concerning the benefits of
dollar-cost averaging, see APPENDIX C.
SYSTEMATIC WITHDRAWAL PLAN
If you own shares having a NAV of $5,000 or more in a single investment account
(accounts in different Funds cannot be aggregated for this purpose), you may
request that enough shares to produce a fixed amount of money be liquidated
from the account monthly or quarterly. The amount of each withdrawal must be at
least $50. Using the electronic funds transfer service, you may choose to have
withdrawals electronically deposited at your bank or other financial
institution. You may also elect to have checks mailed to a designated address.
This plan may be initiated by depositing shares worth at least $5,000 with
the Transfer Agent and by completing a Systematic Withdrawal Plan application,
which may be requested from the Manager. You may terminate participation in the
plan at any time. You are not charged for withdrawals under the Systematic
Withdrawal Plan. The Company will not bear any expenses in administering the
plan beyond the regular transfer agent and custodian costs of issuing and
redeeming shares. The Manager will bear any additional expenses of
administering the plan.
Withdrawals will be made by redeeming full and fractional shares on the
date you select at the time the plan is established. Withdrawal payments made
under this plan may exceed dividends and distributions and, to this extent,
will involve the use of principal and could reduce the dollar value of your
investment and eventually exhaust the account. Reinvesting dividends and
distributions helps replenish the account. Because share values and net
investment income can fluctuate, you should not expect withdrawals to be offset
by rising income or share value gains.
Each redemption of shares may result in a gain or loss, which must be
reported on your income tax return. Therefore, you should keep an accurate
record of any gain or loss on each withdrawal.
INVESTMENT POLICIES
The sections captioned WHAT ARE EACH FUND'S INVESTMENT OBJECTIVE AND MAIN
STRATEGIES? and FUND INVESTMENTS in the Prospectus describe the fundamental
investment objectives and the investment policies applicable to each Fund. Each
Fund's objective cannot be changed without shareholder approval. The following
is provided as additional information.
CALCULATION OF PORTFOLIO WEIGHTED AVERAGE MATURITIES
Weighted average maturity is derived by multiplying the value of each
investment by the number of days remaining to its maturity, adding the results
of these calculations, and then dividing the total by the value of the Fund's
portfolio. An obligation's maturity is typically determined on a stated final
maturity basis, although there are some exceptions to this rule.
With respect to obligations held by the California Bond Fund, if it is
probable that the issuer of an instrument will take advantage of a
maturity-shortening device, such as a call, refunding, or redemption provision,
the date on which the instrument will probably be called, refunded, or redeemed
may be considered to be its maturity date. Also, the maturities of securities
subject to sinking fund arrangements are determined on a weighted average life
basis, which is the average time for principal to be repaid. The weighted
average life of these securities is likely to be substantially shorter than
their stated final maturity. In addition, for purposes of the Fund's investment
policies, an instrument will be treated as having a maturity earlier than its
stated maturity date if the instrument has technical features such as puts or
demand features which, in the judgment of the Manager, will result in the
instrument being valued in the market as though it has the earlier maturity.
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The California Money Market Fund will determine the maturity of an
obligation in its portfolio in accordance with Rule 2a-7 under the Investment
Company Act of 1940, as amended (1940 Act).
LENDING OF SECURITIES
Each Fund may lend its securities. A lending policy may be authorized by the
Company's Directors and implemented by the Manager, but securities may be
loaned only to qualified broker-dealers or institutional investors that agree
to maintain cash collateral with the Company equal at all times to at least
100% of the value of the loaned securities. The Directors will establish
procedures and monitor the creditworthiness of any institution or broker-dealer
during such time as any loan is outstanding. The Company will continue to
receive interest on the loaned securities and will invest the cash collateral
in readily marketable short-term obligations of high quality, thereby earning
additional interest. Interest on loaned tax-exempt securities received by the
borrower and paid to the Company will not be exempt from federal income taxes
in the hands of the Company.
No loan of securities will be made if, as a result, the aggregate of such
loans would exceed 33 1/3% of the value of a Fund's total assets. The Company
may terminate such loans at any time.
REPURCHASE AGREEMENTS
Each Fund may invest up to 5% of its total assets in repurchase agreements. A
repurchase agreement is a transaction in which a security is purchased with a
simultaneous commitment to sell the security back to the seller (a commercial
bank or recognized securities dealer) at an agreed upon price on an agreed upon
date, usually not more than seven days from the date of purchase. The resale
price reflects the purchase price plus an agreed upon market rate of interest
which is unrelated to the coupon rate or maturity of the purchased security. A
repurchase agreement involves the obligation of the seller to pay the agreed
upon price, which obligation is in effect secured by the value of the
underlying security. In these transactions, the securities purchased by a Fund
will have a total value equal to or in excess of the amount of the repurchase
obligation and will be held by the Funds' custodian until repurchased. If the
seller defaults and the value of the underlying security declines, a Fund may
incur a loss and may incur expenses in selling the collateral. If the seller
seeks relief under the bankruptcy laws, the disposition of the collateral may
be delayed or limited. Any investments in repurchase agreements will give rise
to income which will not qualify as tax-exempt income when distributed by a
Fund.
WHEN-ISSUED SECURITIES
Each Fund may invest in new issues of tax-exempt securities offered on a
when-issued basis; that is, delivery and payment take place after the date of
the commitment to purchase, normally within 45 days. Both price and interest
rate are fixed at the time of commitment. The Funds do not earn interest on the
securities until settlement, and the market value of the securities may
fluctuate between purchase and settlement. Such securities can be sold before
settlement date.
Cash or high quality liquid debt securities equal to the amount of the
when-issued commitments are segregated at the Fund's custodian bank. The
segregated securities are valued at market, and daily adjustments are made to
keep the value of the cash and segregated securities at least equal to the
amount of such commitments by the Fund. On the settlement date, the Fund will
meet its obligations from then available cash, sale of segregated securities,
sale of other securities, or sale of the when-issued securities themselves.
MUNICIPAL LEASE OBLIGATIONS
Each Fund may invest in municipal lease obligations and certificates of
participation in such obligations (collectively, lease obligations). A lease
obligation does not constitute a general obligation of the municipality for
which the municipality's taxing power is pledged, although the lease obligation
is ordinarily backed by the municipality's covenant to budget for the payments
due under the lease obligation.
Certain lease obligations contain "non-appropriation" clauses which
provide that the municipality has no obligation to make lease obligation
payments in future years unless money is appropriated for such purpose on a
yearly basis. Although "non-appropriation" lease obligations are secured by the
leased property, disposition of the property in the event of foreclosure might
prove difficult. In evaluating a potential investment in such a lease
obligation, the Manager will consider: (1) the credit quality of the obligor,
(2) whether the underlying property is essential to a governmental function,
and (3) whether the lease obligation contains covenants prohibiting the obligor
from substituting similar property if the obligor fails to make appropriations
for the lease obligation.
TEMPORARY DEFENSIVE POLICY
Each Fund may on a temporary basis because of market, economic, political, or
other conditions invest up to 100% of its assets in short-term securities
whether or not they are exempt from federal and California state income taxes.
Such taxable securities may consist of obligations of the U.S. Government, its
agencies or instrumentalities, and repurchase agreements secured by such
instruments; certificates of deposit of domestic banks having capital, surplus,
and undivided profits in excess of $100 million; banker's acceptances of
similar banks; commercial paper; and other corporate debt obligations.
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OTHER POLICIES
Although the California Bond Fund is permitted to invest in options, financial
futures contracts, and options on financial futures contracts, the Fund has no
current intention of doing so and will not invest in such securities without
first notifying shareholders and supplying further information in the
Prospectus.
INVESTMENT RESTRICTIONS
The following investment restrictions have been adopted by the Company for each
Fund. These restrictions may not be changed for any given Fund without approval
by the lesser of (1) 67% or more of the voting securities present at a meeting
of the Fund if more than 50% of the outstanding voting securities of the Fund
are present or represented by proxy or (2) more than 50% of the Fund's
outstanding voting securities. The investment restrictions of one Fund may be
changed without affecting those of the other Fund.
Under the restrictions, neither Fund will:
(1) with respect to 75% of its total assets, purchase securities of any
issuer (except the U.S. Government, its agencies and instrumentalities
and any tax-exempt security guaranteed by the U.S. Government) if as a
result more than 5% of the total assets of that Fund would be invested in
securities of such issuer; for purposes of this limitation,
identification of the "issuer" will be based on a determination of the
source of assets and revenues committed to meeting interest and principal
payments of each security; for purposes of this limitation the State of
California or other jurisdictions and each of its separate political
subdivisions, agencies, authorities, and instrumentalities shall be
treated as a separate issuer;
(2) purchase more than 10% of the outstanding voting securities of any issuer;
(3) borrow money, except for temporary or emergency purposes in an amount not
exceeding 33 1/3% of its total assets (including the amount borrowed)
less liabilities (other than borrowings);
(4) pledge, mortgage, or hypothecate its assets to any extent greater than
10% of the value of its total assets;
(5) purchase or retain securities of any issuer if any officer or Director of
the Company or its Manager owns individually more than one-half of one
percent (1/2%) of the securities of that issuer, and collectively the
officers and Directors of the Company and Manager together own more than
5% of the securities of that issuer;
(6) purchase any securities which would cause more than 25% of the value of
that Fund's total assets at the time of such purchase to be invested in
securities the interest upon which is derived from revenues or projects
with similar characteristics, such as toll road revenue bonds, housing
revenue bonds, electric power project revenue bonds, or in industrial
revenue bonds which are based, directly or indirectly, on the credit of
private entities of any one industry; provided that the foregoing
limitation does not apply with respect to investments in U.S. Treasury
Bills, other obligations issued or guaranteed by the U.S. Government, its
agencies and instrumentalities, and, in the case of the California Money
Market Fund, certificates of deposit and banker's acceptances of domestic
banks;
(7) invest in issuers for the purpose of exercising control or management;
(8) issue senior securities as defined in the 1940 Act, except that it may
purchase tax-exempt securities on a "when-issued" basis or in financial
futures contracts as permitted by Section 18(f)(2);
(9) underwrite securities of other issuers, except to the extent that it may
be deemed to act as a statutory underwriter in the distribution of any
restricted securities or not readily marketable securities;
(10) purchase or sell real estate, but this shall not prevent investments in
tax-exempt securities secured by real estate or interests therein;
(11) lend any securities or make any loan if, as a result, more than 33 1/3%
of its total assets would be lent to other parties, except that this
limitation does not apply to purchases of debt securities or to
repurchase agreements;
(12) purchase on margin or sell short; for purposes of this restriction the
deposit or payment of initial or variation margin in connection with
financial futures contracts or related options will not be deemed to be a
purchase of securities on margin by a Fund;
(13) purchase or sell commodities or commodities contracts, except that the
Fund may invest in financial futures contracts and options thereon;
(14) invest its assets in securities of other investment companies except by
purchases in the open market involving only customary brokers'
commissions or as part of a merger, consolidation, reorganization or
purchase of assets approved by the shareholders; or
(15) invest in put, call, straddle, or spread options or interests in oil,
gas, or other mineral exploration or development programs, except that a
Fund may write covered call options and purchase put options.
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ADDITIONAL RESTRICTIONS
The following restrictions are not considered to be fundamental policies of the
Funds. The Board of Directors may change these additional restrictions without
notice to or approval by the shareholders.
Neither Fund will:
(1) invest more than 15% (10% with respect to the California Money Market
Fund) of the value of its net assets in illiquid securities, including
repurchase agreements maturing in more than seven days; or
(2) purchase any security while borrowings representing more than 5% of the
Fund's total assets are outstanding.
SPECIAL RISK CONSIDERATIONS
Certain California constitutional amendments, legislative measures, executive
orders, administrative regulations and voter initiatives could result in the
adverse effects described below. The following information constitutes only a
brief summary, does not purport to be a complete description, and is based on
information drawn from official statements and prospectuses relating to
securities offerings of the State of California (the "State") and various local
agencies in California and from other relevant sources. While the Funds have
not independently verified such information, they have no reason to believe
that such information is not correct in all material respects.
Certain of the tax-exempt securities in which the Funds may invest may be
obligations of issuers which rely in whole or in part on California State
revenues for payment of these obligations. Property tax revenues and a portion
of the State's General Fund surplus are distributed to counties, cities and
their various taxing entities, and the State assumes certain obligations
theretofore paid out of local funds. Whether and to what extent a portion of
the State's General Fund will be distributed in the future to counties, cities
and their various entities, is unclear.
Certain of the tax-exempt securities may be obligations of issuers who
rely in whole or in part on ad valorem real property taxes as a source of
revenue. On June 6, 1978, California voters approved an amendment to the
California Constitution known as Proposition 13, which added Article XIIIA to
the California Constitution. The effect of Article XIIIA is to limit ad valorem
taxes on real property, and to restrict the ability of taxing entities to
increase real property tax revenues. On November 7, 1978, California voters
approved Proposition 8, and on June 3, 1986, California voters approved
Proposition 46, both of which amended Article XIIIA.
Section 1 of Article XIIIA limits the maximum ad valorem property tax on
real property to 1% of full cash value (as defined in Section 2), to be
collected by the counties and apportioned according to law; provided that the
1% limitation does not apply to ad valorem taxes or special assessments to pay
the interest and redemption charges or (1) any indebtedness approved by the
voters prior to July 1, 1978, or (2) any bonded indebtedness for the
acquisition or improvement of real property approved on or after July 1, 1978,
by two-thirds of the votes cast by the voters voting on the proposition.
Section 2 of Article XIIIA defines "full cash value" to mean "the County
Assessor's valuation of real property as shown on the 1975-76 tax bill under
full cash value or, thereafter, the appraised value of real property when
purchased, newly constructed, or a change in ownership has occurred after the
1975 assessment." The "full cash value" may be adjusted annually to reflect
inflation at a rate not to exceed 2% per year, or a reduction in the Consumer
Price Index or comparable local data, or reduced in the event of declining
property value caused by damage, destruction or other factors. The California
State Board of Equalization has adopted regulations, binding on county
assessors, interpreting the meaning of "change in ownership" and "new
construction" for purposes of determining full cash value of property under
Article XIIIA.
Legislation enacted by the California Legislature to implement Article
XIIIA (statutes of 1978, Chapter 292, as amended) provides, that
notwithstanding any other law, local agencies may not levy any ad valorem
property tax except to pay debt service on indebtedness approved by the voters
prior to July 1, 1978, and that each county will levy the maximum tax permitted
by Article XIIIA of $4.00 per $100 assessed valuation (based on the former
practice of using 25%, instead of 100%, of full cash value as the assessed
value for tax purposes). The legislation further provided that, for the 1978-79
fiscal year only, the tax levied by each county was to be apportioned among all
taxing agencies within the county in proportion to their average share of taxes
levied in certain previous years. The apportionment of property taxes for
fiscal years after 1978-79 has been revised pursuant to Statutes of 1979,
Chapter 282, which provides relief funds from state revenues beginning in
fiscal year 1979-80 and is designed to provide a permanent system for sharing
state taxes and budget funds with local agencies. Under Chapter 282, cities and
counties receive more of the remaining property tax revenues collected under
Proposition 13 instead of direct State aid. School districts receive a
correspondingly reduced amount of property taxes, but receive compensation
directly from the State and are given additional relief. Chapter 282 does not
affect the derivation of the base levy ($4 per $100 of assessed valuation) and
the bonded debt tax rate. However, there can be no assurance that any
particular level of State aid to local governments will be maintained in future
years.
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On November 6, 1979, another initiative known as "Proposition 4" or the
"Gann Initiative" was approved by the California voters, which added Article
XIIIB to the California Constitution. Under Article XIIIB, state and local
governmental entities have an annual "appropriations limit" and are not able to
spend certain moneys called "appropriations subject to limitation" in an amount
higher than the "appropriations limit." Article XIIIB does not affect the
appropriation of moneys which are excluded from the definition of
"appropriations subject to limitation," including debt service on indebtedness
existing or authorized as of January 1, 1979, or bonded indebtedness
subsequently approved by the voters. In general terms, the "appropriations
limit" is to be based on certain 1978-79 expenditures, and is to be adjusted
annually to reflect changes in consumer prices, population and certain services
provided by these entities. Article XIIIB also provides that if these entities'
revenues in any year exceed the amount permitted to be spent, the excess would
have to be returned by revising tax rates or fee schedules over the subsequent
two years.
In June 1982, the voters of California passed two initiative measures to
repeal the California gift and inheritance tax laws and to enact, in lieu
thereof, a California death tax. California voters also passed an initiative
measure to increase, for taxable years commencing on or after January 1, 1982,
the amount by which personal income tax brackets will be adjusted annually in
an effort to index such tax brackets to account for the effects of inflation.
Decreases in State and local revenues in future fiscal years as a consequence
of these initiatives may result in reductions in allocations of state revenues
to California issuers or in the ability of California issuers to pay their
obligations.
At the November 8, 1988 general election, California voters approved an
initiative known as Proposition 98. This initiative amends Article XIIIB to
require that (1) the California Legislature establish a prudent state reserve
fund in an amount as shall be reasonable and necessary and (2) revenues in
excess of amounts permitted to be spent and which would otherwise be returned
pursuant to Article XIIIB by revision of tax rates or fees schedules, be
transferred and allocated (up to a maximum of 40%) to the State School Fund and
be expended solely for purposes of instructional improvement and
accountability. No such transfer or allocation of funds will be required if
certain designated state officials determine that annual student expenditures
and class size meet certain criteria as set forth in Proposition 98. Any funds
allocated to the State School Fund shall cause the appropriation limits
established in Article XIIIB to be annually increased for any such allocation
made in the prior year.
Proposition 98 also amends Article XVI to require that the State of
California provide a minimum level of funding for public schools and community
colleges. Commencing with the 1988-89 fiscal year, moneys to be applied by the
State for the support of school districts and community college districts shall
not be less than the greater of: (1) the amount which, as a percentage of the
State General Fund revenues which may be appropriated pursuant to Article
XIIIB, equals the percentage of such State General Fund revenues appropriated
for school districts and community college districts, respectively, in fiscal
year 1986-87, or (2) the amount required to ensure that the total allocations
to school districts and community college districts from the State general fund
proceeds of taxes appropriated pursuant to Article XIIIB and allocated local
proceeds of taxes shall not be less than the total amount from the sources in
the prior year, adjusted for increases in enrollment and adjusted for changes
in the cost of living pursuant to the provisions of Article XIIIB. The
initiative permits the enactment of legislation, by a two-thirds vote, to
suspend the minimum funding requirements for one year.
In June 1989, the California Legislature enacted Senate Constitutional
amendment number one ("SCA 1"), a proposed modification of the California
Constitution to alter the spending limit in the educational funding provisions
of Proposition 98. SCA 1 was approved by the voters on the June 1990 ballot and
took effect on July 1, 1990. SCA 1 permits annual adjustments to the spending
limit to be more closely linked to the rate of economic growth in the State.
Instead of being tied to the consumer price index, the change in "cost of
living" is measured by the change in California per capita personal income. In
addition, if certain kinds of emergencies are declared by the Governor, an
appropriation enacted by a two-thirds vote of the Legislature will be excluded
from the State's appropriations limit.
SCA 1 also provides two new exceptions to the calculation of
appropriations which are subject to the spending limit. First, there will be
excluded all appropriations for "qualified capital outlay projects" as defined
by the Legislature. Second, there will be excluded any increase in gasoline
taxes above their current 9% per gallon level. In addition, SCA 1 recalculates
the appropriation limits for each unit in government, beginning in the 1990-91
fiscal year, based upon a two-year cycle. The Proposition 98 provision
regarding excess taxes will also be modified. After a two-year period if there
are any excess state tax revenues, 50% (instead of 100%) of the excess will be
transferred to schools with the balance returned to taxpayers. SCA 1 also
modifies in certain respects the complex adjustment in the Proposition 98
formula which guarantees schools a certain amount of the General Fund revenues.
In September 1980, the legislature enacted a measure (Chapter 1342,
Statutes of 1980) declaring that tax increment revenues are not "proceeds of
taxes" within the meaning of Article XIIIB and that the allocation and
expenditure of such moneys are not appropriations subject to the limitations
under Article XIIIB, if used for repayment of indebtedness incurred for
redevelopment activity. While the California
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Supreme Court expressly declined to rule on the validity of Chapter 1342 and
the applicability of Article XIIIB to redevelopment agencies in HUNTINGTON PARK
REDEVELOPMENT AGENCY V. MARTIN, two subsequent decisions of the California
Court of Appeal have upheld the validity of Chapter 1342 and have concluded
that redevelopment agencies are not subject to the appropriations limit of
Article XIIIB. Proposition 87 was approved by the California voters on November
8, 1988. Proposition 87 amends Article XVI, Section 16, of the California
Constitution by authorizing the California Legislature to prohibit
redevelopment agencies from receiving any of the property tax revenue raised by
increased property tax rates levied to repay bonded indebtedness of local
governments which is approved by voters on or after January 1, 1989. It is not
possible to predict whether the California Legislature will enact such a
prohibition, nor is it possible to predict the impact of Proposition 87 on
redevelopment agencies and their ability to make payments on outstanding debt
obligations.
On November 4, 1986, California voters approved an initiative statute
known as Proposition 62. This initiative (1) requires that any tax for general
governmental purposes imposed by local governments be approved by resolution or
ordinance adopted by a two-thirds vote of the governmental entity's legislative
body and by a majority vote of the electorate of the governmental entity, (2)
requires that any special tax (defined as taxes levied for other than general
governmental purposes) imposed by a local governmental entity be approved by a
two-thirds vote of the voters within the jurisdiction, (3) restricts the use of
revenues from a special tax to the purposes or for the service for which the
special tax was imposed, (4) prohibits the imposition of ad valorem taxes on
real property by local governmental entities except as permitted by Article
XIIIA, (5) prohibits the imposition of transaction taxes and sales taxes on the
sale of real property by local governments, (6) requires that any tax imposed
by a local government on or after August 1, 1985 be ratified by a majority vote
of the electorate within two years of the adoption of the initiative or be
terminated by November 15, 1988, (7) requires that, in the event a local
government fails to comply with the provisions of this measure, a reduction in
the amount of property tax revenue allocated to such local government occurs in
an amount equal to the revenues received by such entity attributable to the tax
levied in violation of the initiative, and (8) permits these provisions to be
amended exclusively by the voters of the State of California. In September
1995, the California Supreme Court upheld the constitutionality of Proposition
62, creating uncertainty as to the legality of certain local taxes enacted by
non-charter cities in California without voter approval. It is not possible to
predict the impact of the decision.
In November 1996, California voters approved Proposition 218. The
initiative applied the provisions of Proposition 62 to all entities, including
charter cities. It requires that all taxes for general purposes obtain a simple
majority popular vote and that taxes for special purposes obtain a two-thirds
majority vote. Prior to the effectiveness of Proposition 218, charter cities
could levy certain taxes such as transient occupancy taxes and utility user's
taxes without a popular vote. Proposition 218 will also limit the authority of
local governments to impose property-related assessments, fees and charges,
requiring that such assessments be limited to the special benefit conferred and
prohibiting their use for general governmental services. Proposition 218 also
allows voters to use their initiative power to reduce or repeal
previously-authorized taxes, assessments, fees and charges.
California is the most populous state in the nation with a total
population at the 1990 Census of 29,976,000. Growth has been incessant since
World War II, with population gains in each decade since 1950 of between 18%
and 49%. During the last decade, population rose 20%. The State now comprises
12.3% of the nation's population and 12.5% of its total personal income. Its
economy is broad and diversified with major concentrations in high technology
research and manufacturing, aerospace and defense-related manufacturing, trade,
real estate, entertainment, and financial services. After experiencing strong
growth throughout much of the 1980s, from 1990-1993, California suffered
through a severe recession, the worst since the 1930s, heavily influenced by
large cutbacks in defense/aerospace industries and military base closures and a
major drop in real estate construction. California's economy has been
recovering and growing steadily stronger since the start of 1994, to the point
where the State's economic growth is outpacing the rest of the nation. The
unemployment rate, while still higher than the national average, fell to the
low 6% range in mid-1997, compared to over 10% at the worst of the recession.
Recent economic reports indicate that, while the rate of economic growth is
expected to moderate over the next three years, the increases in employment and
income may exceed those of the nation as a whole. The unsettled financial
situation occurring in certain Asian economies may adversely affect the State's
export-related industries and, therefore, the State's rate of economic growth.
California's economic difficulties exacerbated a structural budget
imbalance which had been evident since fiscal year 1985-86. Many of the State's
budget problems were attributed to a great population increase which increased
demand for educational and social services at a pace far greater than growth in
revenues. To combat its budget problems, the State has cut non-mandatory
spending and aggressively sought assistance from the federal government.
On August 18, 1997, the Governor signed the 1997-98 Budget Act which
provides for General Fund and Special Fund expenditures of approximately $67.2
billion and projects a 97-98 fiscal year end reserve of $112 million. For the
second year in a row, the State budget contains a large increase in funding for
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education, reflecting strong revenues which have exceeded initial budgeted
amounts. The Budget Act reflects a $1.235 billion pension case judgment
payment, and returns funding of the State's pension contribution to the
quarterly basis existing prior to the deferral actions invalidated by the
courts. Because of the effect of the pension payment, most other State programs
were continued at 1996-97 levels. Health and welfare costs are contained,
continuing generally the grant levels from prior years, as part of the initial
implementation of the new CalWORKs welfare reform program. Unlike prior years,
this Budget Act does not depend on uncertain federal budget actions. About $300
million in federal funds, already included in the federal FY 1997 and 1998
budgets, are included in the Budget Act to offset incarceration costs for
illegal immigrants. The Budget Act contains no tax increases and no tax
reductions. The Renters Tax Credit was suspended for another year, saving
approximately $500 million. After enactment of the Budget Act, and prior to the
end of the Legislative Session, the Legislature and the Governor reached
certain agreements related to State expenditures and taxes. Legislation signed
by the Governor includes a variety of phased-in tax cuts, conformity with
certain provisions of the federal tax reform law passed earlier in the year,
and reform of funding for county trial courts, with the State to assume greater
financial responsibility.
The Governor's proposed budget for fiscal year 1998-1999 proposes total
State spending of $70.6 billion (excluding the expenditure of federal funds and
selected bond funds), which is up 4.7% from the current year's budget. This
total includes $55.4 billion in General Fund spending (a 4.5% increase from the
current year) and $15.2 billion in special funds spending (a 5.3% increase).
The Governor's proposed budget anticipates a $296 million reserve for economic
uncertainties. The new budget reflects agreements reached in the prior year in
the areas of welfare reform, education, state tax relief, and the financial
restructuring of the State's trial court system. The budget contains no tax
changes and relatively few major programmatic changes.
With the recovery in California's economy, revenue growth over the next
few years could recommence at levels that would enable California to restore
fiscal stability. The political environment, however, combined with pressures
on the State's financial flexibility, may frustrate its ability to reach this
goal. Strong interests in long-established state programs ranging from low-cost
public higher education access to welfare and health benefits join with the
more recently emerging pressures for expanded prison construction and
heightened awareness and concern over the State's business climate.
Because of the State of California's continuing budget problems, the
State's General Obligation bonds were downgraded in July 1994 to A1 from Aa by
Moody's, to A from A+ by Standard & Poor's, and to A from AA by Fitch. All
three rating agencies expressed uncertainty in the State's ability to balance
the budget by 1996. However, in 1996, citing California's improving economy and
budget situation, both Fitch and Standard & Poor's raised their ratings from A
to A+. In October, 1997, Fitch raised its rating from A+ to AA- referring to
the State's fundamental strengths, the extent of its economic recovery and the
return of financial stability.
On December 6, 1994, Orange County became the largest municipality in the
United States to file for protection under the federal bankruptcy laws. The
filing stemmed from approximately $1.7 billion in losses suffered by the
County's investment pool due to investments in high risk "derivative"
securities. In September 1995, the state legislature approved legislation
permitting Orange County to use for bankruptcy recovery $820 million over 20
years in sales taxes previously earmarked for highways, transit and
development. In June 1996 the County completed a $880 million bond offering
secured by real property owned by the County. On June 12, 1996, the County
emerged from bankruptcy protection. On January 7, 1997, Orange County returned
to the municipal bond market with a $136 million bond issue maturing in 13
years at an insured yield of 7.23%. In December, 1997, Moody's raised its
ratings on $325 million of Orange County pension obligation bonds to Baa3 from
Ba.
Los Angeles County, the nation's largest county, is also experiencing
financial difficulty. In August 1995, the credit rating of the county's
long-term bonds was downgraded for the third time since 1992 as a result of,
among other things, severe operating deficits for the county's health care
system. Also, the county has not yet recovered from the ongoing loss of revenue
caused by state property tax shift initiatives in 1993 through 1995. In April
1997, the Los Angeles County Board of Supervisors gave preliminary approval to
an approximately $12 billion 1997-98 proposed budget containing measures to
eliminate a $157 million deficit. In April, 1998, the Los Angeles County Chief
Administrative Officer proposed an approximately $13.2 billion 1998-99 budget,
which would be 5.3% larger than the 1997-98 budget, and which would not require
cuts in services and jobs to close any deficit.
Certain tax-exempt securities in which the Funds may invest may be
obligations payable solely from the revenues of specific institutions, or may
be secured by specific properties, which are subject to provisions of
California law that could adversely affect the holders of such obligations. For
example, the revenues of California health care institutions may be subject to
state laws, and California laws limit the remedies of a creditor secured by a
mortgage or deed of trust on real property.
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PORTFOLIO TRANSACTIONS
The Manager, pursuant to the Advisory Agreement dated July 20, 1990, and
subject to the general control of the Company's Board of Directors, places all
orders for the purchase and sale of Fund securities. Purchases of Fund
securities are made either directly from the issuer or from dealers who deal in
tax-exempt securities. The Manager may sell Fund securities prior to maturity
if circumstances warrant and if it believes such disposition is advisable. In
connection with portfolio transactions for the Company, the Manager seeks to
obtain the best available net price and most favorable execution for its
orders. The Manager has no agreement or commitment to place transactions with
any broker-dealer and no regular formula is used to allocate orders to any
broker-dealer. However, the Manager may place security orders with brokers or
dealers who furnish research or other services to the Manager as long as there
is no sacrifice in obtaining the best overall terms available. Payment for such
services would be generated only through purchase of new issue fixed income
securities.
Such research and other services may include, for example: advice
concerning the value of securities, the advisability of investing in,
purchasing, or selling securities, and the availability of securities or the
purchasers or sellers of securities; analyses and reports concerning issuers,
industries, securities, economic factors and trends, portfolio strategy, and
performance of accounts; and various functions incidental to effecting
securities transactions, such as clearance and settlement. The Manager
continuously reviews the performance of the broker-dealers with whom it places
orders for transactions. The receipt of research from broker-dealers that
execute transactions on behalf of the Company may be useful to the Manager in
rendering investment management services to other clients (including affiliates
of the Manager), and conversely, such research provided by broker-dealers who
have executed transaction orders on behalf of other clients may be useful to
the Manager in carrying out its obligations to the Company. While such research
is available to and may be used by the Manager in providing investment advice
to all its clients (including affiliates of the Manager), not all of such
research may be used by the Manager for the benefit of the Company. Such
research and services will be in addition to and not in lieu of research and
services provided by the Manager, and the expenses of the Manager will not
necessarily be reduced by the receipt of such supplemental research. See THE
COMPANY'S MANAGER.
On occasions when the Manager deems the purchase or sale of a security to
be in the best interest of the Company, as well as the Manager's other clients,
the Manager, to the extent permitted by applicable laws and regulations, may
aggregate such securities to be sold or purchased for the Company with those to
be sold or purchased for other customers in order to obtain best execution and
lower brokerage commissions, if any. In such event, allocation of the
securities so purchased or sold, as well as the expenses incurred in the
transaction, will be made by the Manager in the manner it considers to be most
equitable and consistent with its fiduciary obligations to all such customers,
including the Company. In some instances, this procedure may impact the price
and size of the position obtainable for the Company.
The tax-exempt security market is typically a "dealer" market in which
investment dealers buy and sell bonds for their own accounts, rather than for
customers, and although the price may reflect a dealer's mark-up or mark-down,
the Company pays no brokerage commissions as such. In addition, some securities
may be purchased directly from issuers.
PORTFOLIO TURNOVER RATES
The portfolio turnover rate is computed by dividing the dollar amount of
securities purchased or sold (whichever is smaller) by the average value of
securities owned during the year.
The rate of portfolio turnover will not be a limiting factor when the
Manager deems changes in the California Bond Fund's portfolio appropriate in
view of its investment objective. For example, securities may be sold in
anticipation of a rise in interest rates (market decline) or purchased in
anticipation of a decline in interest rates (market rise) and later sold. In
addition, a security may be sold and another security of comparable quality may
be purchased at approximately the same time in order to take advantage of what
the Fund believes to be a temporary disparity in the normal yield relationship
between the two securities. These yield disparities may occur for reasons not
directly related to the investment quality of particular issues or the general
movement of interest rates, such as changes in the overall demand for or supply
of various types of tax-exempt securities.
For the last two fiscal years the California Bond Fund's portfolio
turnover rates were as follows:
1997. . . . . 23.72% 1998. . . . 20.16%
Portfolio turnover rates have been calculated excluding short-term
variable rate securities, which are those with put date intervals of less than
one year.
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DESCRIPTION OF SHARES
The Funds are series of USAA Tax Exempt Fund, Inc. (the Company) and are
diversified. The Company is an open-end management investment company
incorporated under the laws of the State of Maryland on November 16, 1981. The
Company is authorized to issue shares of common stock in separate portfolios.
Ten such portfolios have been established, two of which are described in this
SAI. Under the Articles of Incorporation, the Board of Directors is authorized
to create new portfolios in addition to those already existing without
shareholder approval. The Company began offering shares of the California Bond
and the California Money Market Funds in August 1989.
Each Fund's assets and all income, earnings, profits, and proceeds
thereof, subject only to the rights of creditors, are specifically allocated to
such Fund. They constitute the underlying assets of each Fund, are required to
be segregated on the books of account, and are to be charged with the expenses
of such Fund. Any general expenses of the Company not readily identifiable as
belonging to a particular Fund are allocated on the basis of the Funds'
relative net assets during the fiscal year or in such other manner as the Board
determines to be fair and equitable. Each share of each Fund represents an
equal proportionate interest in that Fund with every other share and is
entitled to dividends and distributions out of the net income and capital gains
belonging to that Fund when declared by the Board.
Under the provisions of the Bylaws of the Company, no annual meeting of
shareholders is required. Thus, there will ordinarily be no shareholder meeting
unless required by the 1940 Act. Under certain circumstances, however,
shareholders may apply to the Directors for shareholder information to obtain
signatures to request a special shareholder meeting. The Company may fill
vacancies on the Board or appoint new Directors if the result is that at least
two-thirds of the Directors have still been elected by shareholders. Moreover,
pursuant to the Bylaws of the Company, any Director may be removed by the
affirmative vote of a majority of the outstanding Company shares; and holders
of 10% or more of the outstanding shares of the Company can require Directors
to call a meeting of shareholders for the purpose of voting on the removal of
one or more Directors. The Company will assist in communicating to other
shareholders about the meeting. On any matter submitted to the shareholders,
the holder of each Fund share is entitled to one vote per share (with
proportionate voting for fractional shares) regardless of the relative net
asset values of the Funds' shares. However, on matters affecting an individual
Fund a separate vote of the shareholders of that Fund is required. Shareholders
of a Fund are not entitled to vote on any matter which does not affect that
Fund but which requires a separate vote of another Fund. Shares do not have
cumulative voting rights, which means that holders of more than 50% of the
shares voting for the election of Directors can elect 100% of the Company's
Board of Directors, and the holders of less than 50% of the shares voting for
the election of Directors will not be able to elect any person as a Director.
Shareholders of a particular Fund might have the power to elect all of the
Directors of the Company because that Fund has a majority of the total
outstanding shares of the Company. When issued, each Fund's shares are fully
paid and nonassessable, have no pre-emptive or subscription rights, and are
fully transferable. There are no conversion rights.
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
TAXATION OF THE FUNDS
Each Fund intends to qualify as a regulated investment company under Subchapter
M of the Internal Revenue Code of 1986, as amended (the Code). Accordingly,
each Fund will not be liable for federal income taxes on its taxable net
investment income and net capital gains (capital gains in excess of capital
losses) that are distributed to shareholders, provided that each Fund
distributes at least 90% of its net investment income and net short-term
capital gain for the taxable year.
To qualify as a regulated investment company, a Fund must, among other
things, (1) derive in each taxable year at least 90% of its gross income from
dividends, interest, payments with respect to securities loans, gains from the
sale or other disposition of stock, securities, or foreign currencies, or other
income derived with respect to its business of investing in such stock,
securities or currencies (the 90% test) and (2) satisfy certain diversification
requirements at the close of each quarter of the Fund's taxable year.
Furthermore, to pay tax-exempt interest income dividends, at least 50% of the
value of each Fund's total assets at the close of each quarter of its taxable
year must consist of obligations the interest of which is exempt from federal
income tax. Each Fund intends to satisfy this requirement.
The Code imposes a nondeductible 4% excise tax on a regulated investment
company that fails to distribute during each calendar year an amount at least
equal to the sum of (1) 98% of its taxable net investment income for the
calendar year, (2) 98% of its capital gain net income for the twelve-month
period ending on October 31, and (3) any prior amounts not distributed. Each
Fund intends to make such distributions as are necessary to avoid imposition of
this excise tax.
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For federal income tax purposes, debt securities purchased by the Funds
may be treated as having original issue discount. Original issue discount
represents interest income for federal income tax purposes and can generally be
defined as the excess of the stated redemption price at maturity of a debt
obligation over the issue price. Original issue discount is treated for federal
income tax purposes as earned by the Funds, whether or not any income is
actually received, and therefore is subject to the distribution requirements of
the Code. However, original issue discount with respect to tax-exempt
obligations generally will be excluded from the Funds' taxable income, although
such discount will be included in gross income for purposes of the 90% test
described previously. Original issue discount with respect to tax-exempt
securities is accrued and added to the adjusted tax basis of such securities
for purposes of determining gain or loss upon sale or at maturity. Generally,
the amount of original issue discount is determined on the basis of a constant
yield to maturity which takes into account the compounding of accrued interest.
An investment in a stripped bond or stripped coupon will result in original
issue discount.
Debt securities may be purchased by the Funds at a market discount. Market
discount occurs when a security is purchased at a price less than the original
issue price adjusted for accrued original issue discount, if any. The Funds
intend to defer recognition of accrued market discount until maturity or other
disposition of the bond. For securities purchased at a market discount, the
gain realized on disposition will be treated as taxable ordinary income to the
extent it does not exceed accrued market discount on the bond.
The Funds may also purchase debt securities at a premium, i.e., at a
purchase price in excess of face amount. With respect to tax-exempt securities,
the premium must be amortized to the maturity date but no deduction is allowed
for the premium amortization. The amortized bond premium will reduce the Funds'
adjusted tax basis in the securities. For taxable securities, the premium may
be amortized if the Funds so elect. The amortized premium on taxable securities
is first offset against interest received on the securities and then allowed as
a deduction, and, for securities issued after September 27, 1985, must be
amortized under an economic accrual method.
TAXATION OF THE SHAREHOLDERS
Taxable distributions are generally included in a shareholder's gross income
for the taxable year in which they are received. Dividends declared in October,
November, or December and made payable to shareholders of record in such a
month will be deemed to have been received on December 31, if a Fund pays the
dividend during the following January. It is expected that none of the Funds'
distributions will qualify for the corporate dividends-received deduction.
To the extent that a Fund's dividends distributed to shareholders are
derived from interest income exempt from federal income tax and are designated
as "exempt-interest dividends" by a Fund, they will be excludable from a
shareholder's gross income for federal income tax purposes. Shareholders who
are recipients of Social Security benefits should be aware that exempt-interest
dividends received from a Fund are includible in their "modified adjusted gross
income" for purposes of determining the amount of such Social Security
benefits, if any, that are required to be included in their gross income.
All distributions of investment income during the year will have the same
percentage designated as tax-exempt. This method is called the "average annual
method." Since the Funds invest primarily in tax-exempt securities, the
percentage will be substantially the same as the amount actually earned during
any particular distribution period.
A shareholder of the California Bond Fund should be aware that a
redemption of shares (including any exchange into another USAA Fund) is a
taxable event and, accordingly, a capital gain or loss may be recognized. If a
shareholder receives an exempt-interest dividend with respect to any share and
such share has been held for six months or less, any loss on the redemption or
exchange will be disallowed to the extent of such exempt-interest dividend.
Similarly, if a shareholder of the Fund receives a distribution taxable as
long-term capital gain with respect to shares of the Fund and redeems or
exchanges shares before he has held them for more than six months, any loss on
the redemption or exchange (not otherwise disallowed as attributable to an
exempt-interest dividend) will be treated as long-term capital loss.
The Funds may invest in private activity bonds. Interest on certain
private activity bonds issued after August 7, 1986, is an item of tax
preference for purposes of the Federal Alternative Minimum Tax (AMT), although
the interest continues to be excludable from gross income for other purposes.
AMT is a supplemental tax designed to ensure that taxpayers pay at least a
minimum amount of tax on their income, even if they make substantial use of
certain tax deductions and exclusions (referred to as tax preference items).
Interest from private activity bonds is one of the tax preference items that is
added to income from other sources for the purposes of determining whether a
taxpayer is subject to the AMT and the amount of any tax to be paid. For
corporate investors, alternative minimum taxable income is increased by 75% of
the amount by which adjusted current earnings (ACE) exceeds alternative minimum
taxable income before the ACE adjustment. For corporate taxpayers, all
tax-exempt interest is considered in calculating the AMT as part of the ACE.
Prospective investors should consult their own tax advisers with respect to the
possible application of the AMT to their tax situation.
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Opinions relating to the validity of tax-exempt securities and the
exemption of interest thereon from federal income tax are rendered by
recognized bond counsel to the issuers. Neither the Manager's nor the Funds'
counsel makes any review of the basis of such opinions.
CALIFORNIA TAXATION
The State of California has adopted legislation incorporating the federal
provisions relating to regulated investment companies. Thus, to the extent the
Funds distribute their income, they will be exempt from the California
franchise and corporate income taxes as regulated investment companies under
Section 24870 of the California Revenue and Taxation Code.
In the year in which a Fund qualifies as a regulated investment company
under the Code and is exempt from federal income tax, (1) the Fund will also be
exempt from the California corporate income and franchise taxes to the extent
it distributes its income and (2), provided 50% or more of the value of the
total assets of the Fund at the close of each quarter of its taxable year
consists of obligations, the interest on which (when held by an individual) is
exempt from personal income taxation under California law, the Fund will be
qualified under California law to distribute dividends ("California
exempt-interest dividends") which will be exempt from the California personal
income tax. The Funds intend to qualify under the above requirement so that
they can distribute California exempt-interest dividends. If the Funds fail to
so qualify, no part of their dividends will be exempt from the California
personal income tax.
The portion of dividends constituting California exempt-interest dividends
is that portion derived from interest on obligations issued by California and
its municipalities and localities, (as well as certain territories and
possessions of the United States such as Puerto Rico, the Virgin Islands, and
Guam), the interest on which (when held by an individual) is excludable from
California personal income under California law. Distributions from the Funds
that are attributable to sources other than those described in the preceding
sentence generally will be taxable to such shareholders as ordinary income. In
addition, distributions other than exempt-interest dividends to such
shareholders are includable in income that may be subject to the California
alternative minimum tax. The total amount of California exempt-interest
dividends paid by each Fund to all of its shareholders with respect to any
taxable year cannot exceed the amount of interest received by each Fund during
such year on California municipal obligations less any expenses and
expenditures. California exempt-interest dividends are excludable from income
for California personal income tax purposes only. Any dividends paid to
shareholders subject to the California franchise tax will be taxed as ordinary
dividends to such shareholders notwithstanding that all or a portion of such
dividends are exempt from the California personal income tax.
To the extent any portion of the dividends distributed to the shareholders
by the Funds are derived from taxable interest for California purposes or net
short-term capital gains, such portion will be taxable to the shareholders as
ordinary income. The character of long-term capital gains realized and
distributed by the California Bond Fund will flow through to its shareholders
regardless of how long the shareholders have held their shares. If a
shareholder of the Funds received any California exempt-interest dividends on
shares thereafter sold within six months of acquisition, then any realized
loss, to the extent of the amount of exempt-interest dividends received prior
to such sale, will be disallowed. Interest on indebtedness incurred by
shareholders to purchase or carry shares of the Funds' will not be deductible
for California personal income tax purposes. Any loss realized upon the
redemption of shares within 30 days before or after the acquisition of other
shares of the same series may be disallowed under the "wash sale" rules.
The foregoing is only a summary of some of the important California
personal income tax considerations generally affecting the Funds and their
shareholders. No attempt is made to present a detailed explanation of the
California personal income tax treatment of the Funds or their shareholders,
and this discussion is not intended as a substitute for careful planning.
Accordingly, potential investors in the Funds should consult their tax advisers
with respect to the application of California taxes to the receipt of the
Funds' dividends and as to their own California tax situation.
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DIRECTORS AND OFFICERS OF THE COMPANY
The Board of Directors of the Company consists of seven Directors who supervise
the business affairs of the Company. Set forth below are the Directors and
officers of the Company, and their respective offices and principal occupations
during the last five years. Unless otherwise indicated, the business address of
each is 9800 Fredericksburg Road, San Antonio, TX 78288.
Robert G. Davis 1, 2
Director and Chairman of the Board of Directors
Age: 51
Deputy Chief Executive Officer for Capital Management of USAA (6/98-present);
President, Chief Executive Officer, Director, and Vice Chairman of the Board of
Directors of USAA Capital Corporation and several of its subsidiaries and
affiliates (1/97-present); President, Chief Executive Officer, Director, and
Chairman of the Board of Directors of USAA Financial Planning Network, Inc.
(1/97-present); Executive Vice President, Chief Operating Officer, Director,
and Vice Chairman of the Board of Directors of USAA Financial Planning Network,
Inc. (9/96-1/97); Special Assistant to Chairman, United Services Automobile
Association (USAA) (6/96-12/96); President and Chief Executive Officer, Banc
One Credit Corporation (12/95-6/96); and President and Chief Executive Officer,
Banc One Columbus, (8/91-12/95). Mr. Davis serves as a Director/Trustee and
Chairman of the Boards of Directors/Trustees of each of the remaining funds
within the USAA Family of Funds; Director and Chairman of the Boards of
Directors of USAA Investment Management Company (IMCO), USAA Shareholder
Account Services, USAA Federal Savings Bank, and USAA Real Estate Company.
Michael J.C. Roth 1, 2
Director, President, and Vice Chairman of the Board of Directors
Age: 56
Chief Executive Officer, IMCO (10/93-present); President, Director, and Vice
Chairman of the Board of Directors, IMCO (1/90-present). Mr. Roth serves as
President, Director/Trustee, and Vice Chairman of the Boards of
Directors/Trustees of each of the remaining funds within the USAA Family of
Funds and USAA Shareholder Account Services; Director of USAA Life Insurance
Company; and Trustee and Vice Chairman of USAA Life Investment Trust.
John W. Saunders, Jr. 1, 2, 4
Director and Vice President
Age: 63
Senior Vice President, Fixed Income Investments, IMCO (10/85-present). Mr.
Saunders serves as a Director/Trustee of each of the remaining funds within the
USAA Family of Funds; Director of IMCO; Senior Vice President of USAA
Shareholder Account Services, and Vice President of USAA Life Investment Trust.
Barbara B. Dreeben 3, 4, 5
200 Patterson #1008
San Antonio, TX 78209
Director
Age: 53
President, Postal Addvantage (7/92-present); Consultant, Nancy Harkins
Stationer (8/91-12/95). Mrs. Dreeben serves as a Director/Trustee of each of
the remaining funds within the USAA Family of Funds.
Howard L. Freeman, Jr. 2, 3, 4, 5
2710 Hopeton
San Antonio, TX 78230
Director
Age: 63
Retired. Assistant General Manager for Finance, San Antonio City Public Service
Board (1976-1996). Mr. Freeman serves as a Director/Trustee of each of the
remaining funds within the USAA Family of Funds.
Robert L. Mason, Ph.D. 3, 4, 5
12823 Queens Forest
San Antonio, TX 78230
Director
Age: 52
Manager, Statistical Analysis Section, Southwest Research Institute
(8/75-present). Dr. Mason serves as a Director/Trustee of the remaining funds
within each of the USAA Family of Funds.
15
<PAGE>
Richard A. Zucker 3, 4, 5
407 Arch Bluff
San Antonio, TX 78216
Director
Age: 55
Vice President, Beldon Roofing and Remodeling (1985-present). Mr. Zucker serves
as a Director/Trustee of each of the remaining funds within the USAA Family of
Funds.
Michael D. Wagner 1
Secretary
Age: 50
Vice President, Corporate Counsel, USAA (1982-present). Mr. Wagner has held
various positions in the legal department of USAA since 1970 and serves as Vice
President, Secretary, and Counsel, IMCO and USAA Shareholder Account Services;
Secretary of each of the remaining funds within the USAA Family of Funds; and
Vice President, Corporate Counsel, for various other USAA subsidiaries and
affiliates.
Alex M. Ciccone 1
Assistant Secretary
Age: 48
Vice President, Compliance, IMCO (12/94-present); Vice President and Chief
Operating Officer, Commonwealth Shareholder Services (6/94-11/94); and Vice
President, Compliance, IMCO (12/91-5/94). Mr. Ciccone serves as Assistant
Secretary of each of the remaining funds within the USAA Family of Funds.
Mark S. Howard 1
Assistant Secretary
Age: 34
Assistant Vice President, Securities Counsel, USAA (2/98-present); Executive
Director, Securities Counsel, USAA (9/96-2/98); Senior Associate Counsel,
Securities Counsel, USAA (5/95-8/96); Attorney, Kirkpatrick & Lockhart LLP
(9/90-4/95). Mr. Howard serves as Assistant Vice President and Assistant
Secretary IMCO and USAA Shareholder Account Services; Assistant Secretary of
each of the remaining funds within the USAA Family of Funds; and Assistant Vice
President, Securities Counsel for various other USAA subsidiaries and
affiliates.
Sherron A. Kirk 1
Treasurer
Age: 53
Vice President, Controller, IMCO (10/92-present). Mrs. Kirk serves as Treasurer
of each of the remaining funds within the USAA Family of Funds; and Vice
President, Controller of USAA Shareholder Account Services.
Caryl Swann 1
Assistant Treasurer
Age: 50
Director, Mutual Fund Portfolio Analysis & Support, IMCO (2/98-present);
Manager, Mutual Fund Accounting, IMCO (7/92-2/98). Ms. Swann serves as
Assistant Treasurer for each of the remaining funds within the USAA Family of
Funds.
- --------------------
1 Indicates those Directors and officers who are employees of the Manager or
affiliated companies and are considered "interested persons" under the 1940
Act.
2 Member of Executive Committee
3 Member of Audit Committee
4 Member of Pricing and Investment Committee
5 Member of Corporate Governance Committee
Between the meetings of the Board of Directors and while the Board is not
in session, the Executive Committee of the Board of Directors has all the
powers and may exercise all the duties of the Board of Directors in the
management of the business of the Company which may be delegated to it by the
Board. The Pricing and Investment Committee of the Board of Directors acts upon
various investment-related issues and other matters which have been delegated
to it by the Board. The Audit Committee of the Board of Directors reviews the
financial statements and the auditor's reports and undertakes certain studies
and analyses as directed by the Board. The Corporate Governance Committee of
the Board of Directors maintains oversight of the organization, performance,
and effectiveness of the Board and Independent Directors.
16
<PAGE>
In addition to the previously listed Directors and/or officers of the
Company who also serve as Directors and/or officers of the Manager, the
following individuals are Directors and/or executive officers of the Manager:
Harry W. Miller, Senior Vice President, Investments (Equity); Carl W. Shirley,
Senior Vice President, Insurance Company Portfolios; and John J. Dallahan,
Senior Vice President, Investment Services. There are no family relationships
among the Directors, officers and managerial level employees of the Company, or
its Manager.
The following table sets forth information describing the compensation of
the current Directors of the Company for their services as Directors for the
fiscal year ended March 31, 1998.
NAME AGGREGATE TOTAL COMPENSATION
OF COMPENSATION FROM THE USAA
TRUSTEE FROM THE COMPANY FAMILY OF FUNDS (b)
------- ---------------- -------------------
Robert G. Davis None (a) None (a)
Barbara B. Dreeben $7,968 $29,500
Howard L. Freeman, Jr. $7,968 $29,500
Robert L. Mason $7,968 $29,500
Michael J.C. Roth None (a) None (a)
John W. Saunders, Jr. None (a) None (a)
Richard A. Zucker $7,968 $29,500
- --------------------
(a) Robert G. Davis, Michael J.C. Roth, and John W. Saunders, Jr. are
affiliated with the Company's investment adviser, IMCO, and, accordingly,
receive no remuneration from the Company or any other Fund of the USAA
Family of Funds.
(b) At March 31, 1998, the USAA Family of Funds consisted of four registered
investment companies offering 35 individual funds. Each Director presently
serves as a Trustee or Director of each investment company in the USAA
Family of Funds. In addition, Michael J.C. Roth presently serves as a
Trustee of USAA Life Investment Trust, a registered investment company
advised by IMCO, consisting of seven funds offered to investors in a fixed
and variable annuity contract with USAA Life Insurance Company. Mr. Roth
receives no compensation as Trustee of USAA Life Investment Trust.
All of the above Directors are also Trustees/Directors of the other funds
within the USAA Family of Funds. No compensation is paid by any fund to any
Trustee/Director who is a director, officer, or employee of IMCO or its
affiliates. No pension or retirement benefits are accrued as part of fund
expenses. The Company reimburses certain expenses of the Directors who are not
affiliated with the investment adviser. As of April 30, 1998, the officers and
Directors of the Company and their families as a group owned beneficially or of
record less than 1% of the outstanding shares of the Company.
The following table identifies all persons, who as of April 30, 1998, held
of record or owned beneficially 5% or more of either Fund's shares.
NAME AND ADDRESS
TITLE OF CLASS OF BENEFICIAL OWNER PERCENT OF CLASS
-------------- ------------------- ----------------
California Money Idanta Partners Ltd. 12.2%
Market Fund 4660 La Jolla Village Dr.
San Diego, CA 92122-4606
California Money David J Dunn 5.5%
Market Fund Trst Dunn Family Trust
Ste 850
San Diego, CA 92122-4606
THE COMPANY'S MANAGER
As described in the Prospectus, USAA Investment Management Company is the
Manager and investment adviser, providing services under the Advisory
Agreement. The Manager, an affiliate of United Services Automobile Association
(USAA), a large, diversified financial services institution, was organized in
May 1970 and has served as investment adviser and underwriter for USAA Tax
Exempt Fund, Inc. from its inception.
In addition to managing the Company's assets, the Manager advises and
manages the investments for USAA and its affiliated companies as well as those
of USAA Mutual Fund, Inc.; USAA Investment Trust, USAA State Tax-Free Trust,
and USAA Life Investment Trust. As of the date of this SAI, total assets under
management by the Manager were approximately $39 billion, of which
approximately $24 billion were in mutual fund portfolios.
17
<PAGE>
ADVISORY AGREEMENT
Under the Advisory Agreement, the Manager provides an investment program,
carries out the investment policy, and manages the portfolio assets for each
Fund. The Manager is authorized, subject to the control of the Board of
Directors of the Company, to determine the selection, amount, and time to buy
or sell securities for each Fund. In addition to providing investment services,
the Manager pays for office space, facilities, business equipment, and
accounting services (in addition to those provided by the Custodian) for the
Company. The Manager compensates all personnel, officers, and Directors of the
Company if such persons are also employees of the Manager or its affiliates.
For these services under the Advisory Agreement, the Company has agreed to pay
the Manager a fee computed as described under FUND MANAGEMENT in the
Prospectus. Management fees are computed and accrued daily and payable monthly.
Except for the services and facilities provided by the Manager, the Funds
pay all other expenses incurred in their operations. Expenses for which the
Funds are responsible include taxes (if any); brokerage commissions on
portfolio transactions (if any); expenses of issuance and redemption of shares;
charges of transfer agents, custodians, and dividend disbursing agents; costs
of preparing and distributing proxy material; costs of printing and engraving
stock certificates; auditing and legal expenses; certain expenses of
registering and qualifying shares for sale; fees of Directors who are not
interested persons (not affiliated) of the Manager; costs of printing and
mailing the Prospectus, SAI, and periodic reports to existing shareholders; and
any other charges or fees not specifically enumerated. The Manager pays the
cost of printing and mailing copies of the Prospectus, the SAI, and reports to
prospective shareholders.
The Advisory Agreement will remain in effect until June 30, 1999, for each
Fund and will continue in effect from year to year thereafter for each Fund as
long as it is approved at least annually by a vote of the outstanding voting
securities of such Fund (as defined by the 1940 Act) or by the Board of
Directors (on behalf of such Fund) including a majority of the Directors who
are not interested persons of the Manager or (otherwise than as Directors) of
the Company, at a meeting called for the purpose of voting on such approval.
The Advisory Agreement may be terminated at any time by either the Company or
the Manager on 60 days' written notice. It will automatically terminate in the
event of its assignment (as defined in the 1940 Act).
From time to time the Manager may, without prior notice to shareholders,
waive all or any portion of fees or agree to reimburse expenses incurred by a
Fund. Any such waiver or reimbursement may be terminated by the Manager at any
time without prior notice to shareholders.
For the last three fiscal years, the Company paid the Manager the
following fees:
1996 1997 1998
---- ---- ----
California Bond Fund $1,281,538 $1,366,876 $1,547,374
California Money Market Fund $890,228 $1,004,583 $1,212,332
UNDERWRITER
The Company has an agreement with the Manager for exclusive underwriting and
distribution of the Funds' shares on a continuing best efforts basis. This
agreement provides that the Manager will receive no fee or other compensation
for such distribution services.
TRANSFER AGENT
The Transfer Agent performs transfer agent services for the Company under a
Transfer Agency Agreement. Services include maintenance of shareholder account
records, handling of communications with shareholders, distribution of Fund
dividends, and production of reports with respect to account activity for
shareholders and the Company. For its services under the Transfer Agency
Agreement, each Fund pays the Transfer Agent an annual fixed fee of $26 per
account. This fee is subject to change at any time.
The fee to the Transfer Agent includes processing of all transactions and
correspondence. Fees are billed on a monthly basis at the rate of one-twelfth
of the annual fee. In addition, the Funds pay all out-of-pocket expenses of the
Transfer Agent and other expenses which are incurred at the specific direction
of the Company.
GENERAL INFORMATION
CUSTODIAN
State Street Bank and Trust Company, P.O. Box 1713, Boston, MA 02105, is the
Company's Custodian. The Custodian is responsible for, among other things,
safeguarding and controlling the Company's cash and securities, handling the
receipt and delivery of securities, and collecting interest on the Company's
investments.
COUNSEL
Goodwin, Procter & Hoar LLP, Exchange Place, Boston, MA 02109, will review
certain legal matters for the Company in connection with the shares offered by
the Prospectus.
18
<PAGE>
INDEPENDENT AUDITORS
KPMG Peat Marwick LLP, 112 East Pecan, Suite 2400, San Antonio, TX 78205, is
the Company's independent auditor. In this capacity, the firm is responsible
for auditing the annual financial statements of the Funds and reporting
thereon.
CALCULATION OF PERFORMANCE DATA
Information regarding total return and yield of each Fund is provided under
COULD THE VALUE OF YOUR INVESTMENT IN THESE FUNDS FLUCTUATE? in the Prospectus.
See VALUATION OF SECURITIES herein for a discussion of the manner in which each
Fund's price per share is calculated.
TOTAL RETURN
The California Bond Fund may advertise performance in terms of average annual
total return for 1-, 5-, and 10-year periods, or for such lesser period as the
Fund has been in existence. Average annual total return is computed by finding
the average annual compounded rates of return over the periods that would
equate the initial amount invested to the ending redeemable value, according to
the following formula:
P(1 + T)n = ERV
Where: P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $1,000 payment
made at the beginning of the 1-, 5-, or 10-year periods at
the end of the year or period
The calculation assumes all charges are deducted from the initial $1,000
payment and assumes all dividends and distributions by such Fund are reinvested
at the price stated in the Prospectus on the reinvestment dates during the
period, and includes all recurring fees that are charged to all shareholder
accounts.
The date of commencement of operations for the California Bond Fund was
August 1, 1989. The Fund's average annual total returns for the periods ended
March 31, 1998 were:
1 year.... 12.33% 5 years.... 7.02% Since inception .... 7.88%
YIELD
The California Bond Fund may advertise performance in terms of a 30-day yield
quotation. The 30-day yield quotation is computed by dividing the net
investment income per share earned during the period by the maximum offering
price per share on the last day of the period, according to the following
formula:
YIELD = 2[((a-b)/(cd)+1)^6 -1]
Where: a = dividends and interest earned during the period
b = expenses accrued for the period (net of reimbursement)
c = the average daily number of shares outstanding during the
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 the yield calculation, interest income is computed based
on the yield to maturity of each debt obligation in the Fund's portfolio and
all recurring charges are recognized.
The Fund's 30-day yield for the period ended March 31, 1998 was 4.53%.
YIELD - CALIFORNIA MONEY MARKET FUND
When the California Money Market Fund quotes a current annualized yield, it is
based on a specified recent seven-calendar-day period. It is computed by (1)
determining the net change, exclusive of capital changes and income other than
investment income, in the value of a hypothetical preexisting account having a
balance of one share at the beginning of the period, (2) dividing the net
change in account value by the value of the account at the beginning of the
base period to obtain the base return, then (3) multiplying the base period
return by 52.14 (365/7). The resulting yield figure is carried to the nearest
hundredth of one percent.
The calculation includes (1) the value of additional shares purchased with
dividends on the original share, and dividends declared on both the original
share and any such additional shares and (2) any fees charged to all
shareholder accounts, in proportion to the length of the base period and the
Fund's average account size.
The capital changes excluded from the calculation are realized capital
gains and losses from the sale of securities and unrealized appreciation and
depreciation. The Fund's effective (compounded) yield will be computed by
dividing the seven-day annualized yield as defined above by 365, adding 1 to
the quotient, raising the sum to the 365th power, and subtracting 1 from the
result.
19
<PAGE>
Current and effective yields fluctuate daily and will vary with factors
such as interest rates and the quality, length of maturities, and type of
investments in the portfolio.
Yield for 7-day Period Ended March 31, 1998, was 3.31%.
Effective Yield for 7-day Period Ended March 31, 1998, was 3.37%.
TAX EQUIVALENT YIELD
A tax-exempt mutual fund may provide more "take-home" income than a fully
taxable mutual fund after paying taxes. Calculating a "tax equivalent yield"
means converting a tax-exempt yield to a pretax equivalent so that a meaningful
comparison can be made between a tax-exempt municipal fund and a fully taxable
fund. The California Money Market Fund may advertise performance in terms of a
tax equivalent yield based on the 7-day yield or effective yield and the
California Bond Fund may advertise performance in terms of a 30-day tax
equivalent yield.
To calculate a tax equivalent yield, the California investor must know his
Effective Marginal Tax Rate or EMTR. Assuming an investor can fully itemize
deductions on his or her federal tax return, the EMTR is the sum of the federal
marginal tax rate and the state marginal tax rate adjusted to reflect the
deductibility of state taxes from federal taxable income. The formula for
computing the EMTR to compare with fully taxable securities subject to both
federal and state taxes is:
EMTR = Federal Marginal Tax Rate +
[State Marginal Tax Rate x (1-Federal Marginal Tax Rate)]
The tax equivalent yield is then computed by dividing the tax-exempt yield
of a fund by the complement of the EMTR. The complement, for example, of an
EMTR of 41.9% is 58.1%, that is (1.00-0.419=0.581).
Tax Equivalent Yield = Tax Exempt Yield / (1-Effective Marginal Tax Rate)
Using a federal marginal tax rate of 36% and state marginal tax rate of
9.30%, resulting in an EMTR of 41.95%, the tax equivalent yields for the
California Bond and California Money Market Funds for the period ended March
31, 1998 were 7.80% and 5.70%, respectively.
APPENDIX A - TAX-EXEMPT SECURITIES AND THEIR RATINGS
TAX-EXEMPT SECURITIES
Tax-exempt securities generally include debt obligations issued by states and
their political subdivisions, and duly constituted authorities and
corporations, to obtain funds to construct, repair or improve various public
facilities such as airports, bridges, highways, hospitals, housing, schools,
streets, and water and sewer works. Tax-exempt securities may also be issued to
refinance outstanding obligations as well as to obtain funds for general
operating expenses and for loans to other public institutions and facilities.
The two principal classifications of tax-exempt securities are "general
obligations" and "revenue" or "special tax" 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 or special tax bonds are payable
only from the revenues derived from a particular facility or class of
facilities or, in some cases, from the proceeds of a special excise or other
tax, but not from general tax revenues. The Funds may also invest in tax-exempt
private activity bonds, which in most cases are revenue bonds and generally do
not have the pledge of the credit of the issuer. The payment of the principal
and interest on such industrial revenue bonds is dependent 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. There are, of course, many variations in
the terms of, and the security underlying, tax-exempt securities. Short-term
obligations issued by states, cities, municipalities or municipal agencies,
include Tax Anticipation Notes, Revenue Anticipation Notes, Bond Anticipation
Notes, Construction Loan Notes, and Short-Term Notes.
The yields of tax-exempt securities depend on, among other things, general
money market conditions, conditions of the tax-exempt bond market, the size of
a particular offering, the maturity of the obligation, and the rating of the
issue. The ratings of Moody's Investors Service, Inc. (Moody's), Standard &
Poor's Ratings Group (S&P), Fitch IBCA, Inc. (Fitch), Duff & Phelps Inc., and
Thompson BankWatch, Inc. represent their opinions of the quality of the
securities rated by them. It should be emphasized that such ratings are general
and are not absolute standards of quality. Consequently, securities with the
same maturity, coupon, and rating may have different yields, while securities
of the same maturity and coupon but with different ratings may have the same
yield. It will be the responsibility of the Manager to appraise independently
the fundamental quality of the tax-exempt securities included in a Fund's
portfolio.
1. LONG-TERM DEBT RATINGS:
MOODY'S INVESTOR SERVICES, INC.
Aaa Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally
referred to as "gilt edged." 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 Aaa
securities or fluctuation of protective elements may be of greater
amplitude or there may be other elements present which make the
long-term risk appear somewhat larger than in 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
some time 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 lacking or may be
characteristically unreliable over any great length of time. Such
bonds lack outstanding investment characteristics and in fact have
speculative characteristics as well.
NOTE: MOODY'S APPLIES NUMERICAL MODIFIERS 1, 2, AND 3 IN EACH GENERIC RATING
CLASSIFICATION. THE MODIFIER 1 INDICATES THAT THE OBLIGATION RANKS IN THE
HIGHER END OF ITS GENERIC RATING CATEGORY, THE MODIFIER 2 INDICATES A MID-RANGE
RANKING, AND THE MODIFIER 3 INDICATES A RANKING IN THE LOWER END OF THAT
GENERIC RATING CATEGORY.
STANDARD & POOR'S RATINGS GROUP (S&P)
AAA An obligation rated AAA has the highest rating assigned by Standard &
Poor's. The obligor's capacity to meet its financial commitment on the
obligation is EXTREMELY STRONG.
AA An obligation rated AA differs from the highest rated issues only in
small degree. The obligor's capacity to meet its financial commitment
on the obligation is VERY STRONG.
A An obligation rated A is somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than
obligations in higher rated categories. However, the obligor's
capacity to meet its financial commitment on the obligation is still
STRONG.
BBB An obligation rated BBB exhibits ADEQUATE capacity to pay interest and
repay principal. However, adverse economic conditions or changing
circumstances are more likely to lead to a weakened capacity of the
obligor to meet its financial commitment on the obligation.
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
RATING CATEGORIES.
FITCH IBCA, INC.
AAA Highest credit quality. "AAA" ratings denote the lowest expectation of
credit risk. They are assigned only in case of exceptionally strong
capacity for timely payment of financial commitments. This capacity is
highly unlikely to be adversely affected by foreseeable events.
AA Very high credit quality. "AA" ratings denote a very low expectation
of credit risk. They indicate very strong capacity for timely payment
of financial commitments. This capacity is not significantly
vulnerable to foreseeable events.
A High credit quality. "A" ratings denote a low expectation of credit
risk. The capacity for timely payment of financial commitments is
considered strong. This capacity may, nevertheless, be more vulnerable
to changes in circumstances or in economic conditions than is the case
for higher ratings.
BBB Good credit quality. "BBB" ratings indicate that there is currently a
low expectation of credit risk. The capacity for timely payment of
financial commitments is considered adequate, but adverse changes in
circumstances and in economic conditions are more likely to impair
this capacity. This is the lowest investment-grade category.
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.
DUFF & PHELPS, INC.
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. Risk is modest but
may vary slightly from time to time because of economic conditions.
A Protection factors are average but adequate. However, risk factors are
more variable and greater in periods of economic stress.
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<PAGE>
BBB Below average protection factors but still considered sufficient for
prudent investment. Considerable variability in risk during economic
cycles.
2. SHORT-TERM DEBT RATINGS:
MOODY'S STATE AND TAX-EXEMPT NOTES
MIG-1/VMIG1 This designation denotes best quality. There is present
strong protection by established cash flows, superior
liquidity support or demonstrated broad-based access to the
market for refinancing.
MIG-2/VMIG2 This designation denotes high quality. Margins of protection
are ample although not so large as in the preceding group.
MOODY'S COMMERCIAL PAPER
Prime-1 Issuers rated Prime-1 (or supporting institutions) have a superior
ability for repayment of senior short-term debt obligations. Prime-1
repayment ability will often be evidenced by many of the following
characteristics:
o Leading market positions in well-established industries.
o High rates of return on funds employed.
o Conservative capitalization structures with moderate reliance on
debt and ample asset protection.
o Broad margins in earning coverage of fixed financial charges and
high internal cash generation.
o Well-established access to a range of financial markets and
assured sources of alternate liquidity.
Prime-2 Issuers rated Prime-2 (or supporting institutions) have a strong
ability for repayment of senior short-term debt obligations. This
will normally be evidenced by many of the characteristics cited
above but to a lesser degree. Earnings trends and coverage ratios,
while sound, may be more subject to variation. Capitalization
characteristics, while still appropriate, may be more affected by
external conditions. Ample alternate liquidity is maintained.
S&P TAX-EXEMPT NOTES
SP-1 Strong capacity to pay principal and interest. Issues determined to
possess very strong characteristics are given a plus (+) designation.
SP-2 Satisfactory capacity to pay principal and interest, with some
vulnerability to adverse financial and economic changes over the term
of the notes.
S&P COMMERCIAL PAPER
A-1 This highest category indicates that the degree of safety regarding
timely payment is strong. Those issues determined to possess extremely
strong safety characteristics are denoted with a plus (+) sign
designation.
A-2 Capacity for timely payment on issues with this designation is
satisfactory. However, the relative degree of safety is not as high as
for issues designated A-1.
FITCH'S COMMERCIAL PAPER, CERTIFICATES OF DEPOSIT, AND TAX-EXEMPT NOTES
F-1+ Exceptionally strong credit quality. Issues assigned this rating are
regarded as having the strongest degree of assurance for timely
payment.
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 assigned this rating have a satisfactory
degree of assurance for timely payment, but the margin of safety is
not as great as for issues assigned F-1+ and F-1 ratings.
DUFF & PHELPS COMMERCIAL PAPER
D-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.
D-1 Very high certainty of timely payment. Liquidity factors are excellent
and supported by good fundamental protection factors. Risk factors are
minor.
D-1- High certainty of timely payment. Liquidity factors are strong and
supported by good fundamental protection factors. Risk factors are
very small.
D-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.
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THOMPSON BANKWATCH, INC.
TBW-1 The highest category; indicates a very high likelihood that principal
and interest will be paid on a timely basis.
TBW-2 The second highest category; while the degree of safety regarding
timely repayment of principal and interest is strong, the relative
degree of safety is not as high as for issues rated TBW-1.
TBW-3 The lowest investment-grade category; indicates that while the
obligation is more susceptible to adverse developments (both internal
and external) than those with higher ratings, the capacity to service
principal and interest in a timely fashion is considered adequate.
APPENDIX B - COMPARISON OF PORTFOLIO PERFORMANCE
Occasionally, we may make comparisons in advertising and sales literature
between the Funds contained in this SAI and other Funds in the USAA Family of
Funds. These comparisons may include such topics as risk and reward, investment
objectives, investment strategies, and performance.
Fund performance also may be compared to the performance of broad groups
of mutual funds with similar investment goals or unmanaged indexes of
comparable securities. Evaluations of Fund performance made by independent
sources may be used in advertisements concerning the Fund, including reprints
of, or selections from, editorials or articles about the Fund. The Fund or its
performance may also be compared to products and services not constituting
securities subject to registration under the Securities Act of 1933 such as,
but not limited to, certificates of deposit and money market accounts. Sources
for performance information and articles about the Fund may include but are not
restricted to the following:
AAII JOURNAL, a monthly association magazine for members of the American
Association of Individual Investors.
ARIZONA REPUBLIC, a newspaper which may cover financial and investment news.
AUSTIN AMERICAN-STATESMAN, a newspaper which may cover financial news.
BARRON'S, a Dow Jones and Company, Inc. business and financial weekly that
periodically reviews mutual fund performance data.
THE BOND BUYER, a daily newspaper which covers bond market news.
BUSINESS WEEK, a national business weekly that periodically reports the
performance rankings and ratings of a variety of mutual funds.
CHICAGO TRIBUNE, a newspaper which may cover financial news.
CONSUMER REPORTS, a monthly magazine which from time to time reports on
companies in the mutual fund industry.
DALLAS MORNING NEWS, a newspaper which may cover financial news.
DENVER POST, a newspaper which may quote financial news.
FINANCIAL PLANNING, a monthly magazine that periodically features companies in
the mutual fund industry.
FINANCIAL SERVICES WEEK, a weekly newspaper which covers financial news.
FINANCIAL WORLD, a monthly magazine which may periodically review mutual fund
companies.
FORBES, a national business publication that periodically reports the
performance of companies in the mutual fund industry.
FORTUNE, a national business publication that periodically rates the
performance of a variety of mutual funds.
FUND ACTION, a mutual fund news report.
HOUSTON CHRONICLE, a newspaper which may cover financial news.
HOUSTON POST, a newspaper which may cover financial news.
IBC'S MONEYLETTER, a biweekly newsletter which covers financial news and from
time to time rates specific mutual funds.
IBC'S MONEY FUND REPORT, a weekly publication of IBC Financial Data, Inc.,
reporting on the performance of the nation's money market funds, summarizing
money market fund activity, and including certain averages as performance
benchmarks, specifically: (1) Taxable Money Fund Averages: "100% U.S. Treasury"
and "First Tier" and (2) Tax-Free Money Fund Averages: "Stockbroker and General
Purpose" and "State Specific Stockbroker and General Purpose."
IBC'S MONEY MARKET INSIGHT, a monthly money market industry analysis prepared
by IBC Financial Data, Inc.
INCOME AND SAFETY, a monthly newsletter that rates mutual funds.
23
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INVESTECH, a bimonthly investment newsletter.
INVESTMENT ADVISOR, a monthly publication directed primarily to the advisor
community; includes ranking of mutual funds using a proprietary methodology.
INVESTMENT COMPANY INSTITUTE, a national association of the American Investment
Company industry.
INVESTOR'S BUSINESS DAILY, a newspaper which covers financial news.
KIPLINGER'S PERSONAL FINANCE MAGAZINE, a monthly investment advisory
publication that periodically features the performance of a variety of
securities.
LIPPER ANALYTICAL SERVICES, INC.'S EQUITY FUND PERFORMANCE ANALYSIS, a weekly
and monthly publication of industry-wide mutual fund performance averages by
type of fund.
LIPPER ANALYTICAL SERVICES, INC.'S FIXED INCOME FUND PERFORMANCE ANALYSIS, a
monthly publication of industry-wide mutual fund performance averages by type
of fund.
LOS ANGELES TIMES, a newspaper which may cover financial news.
LOUIS RUKEYSER'S WALL STREET, a publication for investors.
MEDICAL ECONOMICS, a monthly magazine providing information to the medical
profession.
MONEY, a monthly magazine that features the performance of both specific funds
and the mutual fund industry as a whole.
MORNINGSTAR 5 STAR INVESTOR, a monthly newsletter which covers financial news
and rates mutual funds produced by Morningstar, Inc. (a data service which
tracks open-end mutual funds).
MUNI BOND FUND REPORT, a monthly newsletter which covers news on the municipal
bond market and features performance data for municipal bond mutual funds.
MUNIWEEK, a weekly newspaper which covers news on the municipal bond market.
MUTUAL FUND FORECASTER, a monthly newsletter that ranks mutual funds.
MUTUAL FUND INVESTING, a newsletter covering mutual funds.
MUTUAL FUND PERFORMANCE REPORT, a monthly publication of industry-wide mutual
fund averages produced by Morningstar, Inc.
MUTUAL FUNDS MAGAZINE, a monthly publication reporting on mutual fund
investing.
MUTUAL FUND SOURCE BOOK, an annual publication produced by Morningstar, Inc.
which describes and rates mutual funds.
MUTUAL FUND VALUES, a biweekly guidebook to mutual funds produced by
Morningstar, Inc.
NEWSWEEK, a national business weekly.
NEW YORK TIMES, a newspaper which may cover financial news.
NO LOAD FUND INVESTOR, a newsletter covering companies in the mutual fund
industry.
ORLANDO SENTINEL, a newspaper which may cover financial news.
PERSONAL INVESTOR, a monthly magazine which from time to time features mutual
fund companies and the mutual fund industry.
SAN ANTONIO BUSINESS JOURNAL, a weekly newspaper that periodically covers
mutual fund companies as well as financial news.
SAN ANTONIO EXPRESS-NEWS, a newspaper which may cover financial news.
SAN FRANCISCO CHRONICLE, a newspaper which may cover financial news.
SMART MONEY, a monthly magazine featuring news and articles on investing and
mutual funds.
USA TODAY, a newspaper which may cover financial news.
U.S. NEWS AND WORLD REPORT, a national business weekly that periodically
reports mutual fund performance data.
WALL STREET JOURNAL, a Dow Jones and Company, Inc. newspaper which covers
financial news.
WASHINGTON POST, a newspaper which may cover financial news.
WEISENBERGER MUTUAL FUNDS INVESTMENT REPORT, a monthly newsletter that reports
on both specific mutual fund companies and the mutual fund industry as a whole.
WORTH, a magazine which covers financial and investment subjects including
mutual funds.
YOUR MONEY, a monthly magazine directed towards the novice investor.
In addition to the sources above, performance of our Funds may also be
tracked by Lipper Analytical Services, Inc. Each Fund will be compared to
Lipper's appropriate fund category according to objective and portfolio
holdings. The California Bond Fund will be compared to funds in Lipper's
California Municipal
24
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Debt Funds category, and the California Money Market Fund to funds in Lipper's
California Tax-Exempt Money Market Funds category. Footnotes in advertisements
and other sales literature will include the time period applicable for any
rankings used.
For comparative purposes, unmanaged indices of comparable securities or
economic data may be cited. Examples include the following:
--Shearson Lehman Hutton Bond Indices, indices of fixed-rate debt issues
rated investment grade or higher which can be found in the BOND MARKET REPORT.
--Bond Buyer Indices, indices of debt of varying maturities including
revenue bonds, general obligation bonds, and U.S. Treasury bonds which can be
found in MUNIWEEK and THE BOND BUYER.
Other sources for total return and other performance data which may be
used by the Funds or by those publications listed previously are Morningstar,
Inc., Schabaker Investment Management, and Investment Company Data, Inc. These
are services that collect and compile data on mutual fund companies.
APPENDIX C -- DOLLAR-COST AVERAGING
Dollar-cost averaging is a systematic investing method which can be used by
investors as a disciplined technique for investing. A fixed amount of money is
invested in a security (such as a stock or mutual fund) on a regular basis over
a period of time, regardless of whether securities markets are moving up or
down.
This practice reduces average share costs to the investor who acquires
more shares in periods of lower securities prices and fewer shares in periods
of higher prices.
While dollar-cost averaging does not assure a profit or protect against
loss in declining markets, this investment strategy is an effective way to help
calm the effect of fluctuations in the financial markets. Systematic investing
involves continuous investment in securities regardless of fluctuating price
levels of such securities. Investors should consider their financial ability to
continue purchases through periods of low and high price levels.
As the following chart illustrates, dollar-cost averaging tends to keep
the overall cost of shares lower. This example is for illustration only, and
different trends would result in different average costs.
HOW DOLLAR-COST AVERAGING WORKS
$100 Invested Regularly for 5 Periods
Market Trend
--------------------------------------------------------------------
Down Up Mixed
------------------- --------------------- -----------------------
Share Shares Share Shares Share Shares
Investment Price Purchased Price Purchased Price Purchased
------------------- --------------------- -----------------------
$100 10 10 6 16.67 10 10
100 9 11.1 7 14.29 9 11.1
100 8 12.5 7 14.29 8 12.5
100 8 12.5 9 11.1 9 11.1
100 6 16.67 10 10 10 10
- ---- -- ----- -- ----- -- -----
$500 ***41 62.77 ***39 66.35 ***46 54.7
*Avg. Cost: $7.97 *Avg. Cost: $7.54 *Avg. Cost: $9.14
----- ----- -----
**Avg. Price: $8.20 **Avg. Price: $7.80 **Avg. Price: $9.20
----- ----- -----
* Average Cost is the total amount invested divided by number of
shares purchased.
** Average Price is the sum of the prices paid divided by number
of purchases.
*** Cumulative total of share prices used to compute average prices.
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27
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14356-0898
<PAGE>
USAA USAA TAX STATEMENT OF
EAGLE EXEMPT ADDITIONAL INFORMATION
LOGO FUND, INC. August 1, 1998
- -------------------------------------------------------------------------------
USAA TAX EXEMPT FUND, INC.
NEW YORK FUNDS
USAA TAX EXEMPT FUND, INC. (the Company) is a registered investment company
offering shares of ten no-load mutual funds, two of which are described in this
Statement of Additional Information (SAI): the New York Bond Fund and New York
Money Market Fund (collectively, the Funds or the New York Funds). Each Fund is
classified as diversified and has a common investment objective of providing
New York investors with a high level of current interest income that is exempt
from federal income taxes and New York State and New York City personal income
taxes. The New York Money Market Fund has a further objective of preserving
capital and maintaining liquidity.
You may obtain a free copy of a Prospectus dated August 1, 1998, for the New
York Funds by writing to USAA Tax Exempt Fund, Inc., 9800 Fredericksburg Road,
San Antonio, TX 78288, or by calling toll free 1-800-531-8181. The Prospectus
provides the basic information you should know before investing in the Funds.
This SAI is not a Prospectus and contains information in addition to and more
detailed than that set forth in the Prospectus. It is intended to provide you
with additional information regarding the activities and operations of the
Company and the Funds, and should be read in conjunction with the Prospectus.
The financial statements of the Funds and the Independent Auditors' Report
thereon for the fiscal year ended March 31, 1998, are included in the
accompanying Annual Report to Shareholders of that date and are incorporated
herein by reference.
- -------------------------------------------------------------------------------
TABLE OF CONTENTS
PAGE
2 Valuation of Securities
2 Conditions of Purchase and Redemption
3 Additional Information Regarding Redemption of Shares
3 Investment Plans
4 Investment Policies
6 Investment Restrictions
7 Special Risk Considerations
15 Portfolio Transactions
16 Description of Shares
16 Certain Federal Income Tax Considerations
18 Directors and Officers of the Company
20 The Company's Manager
21 General Information
22 Calculation of Performance Data
23 Appendix A - Tax-Exempt Securities and Their Ratings
26 Appendix B - Comparison of Portfolio Performance
28 Appendix C - Dollar-Cost Averaging
<PAGE>
VALUATION OF SECURITIES
Shares of each Fund are offered on a continuing best efforts basis through USAA
Investment Management Company (IMCO or the Manager). The offering price for
shares of each Fund is equal to the current net asset value (NAV) per share.
The NAV per share of each Fund is calculated by adding the value of all its
portfolio securities and other assets, deducting its liabilities, and dividing
by the number of shares outstanding.
A Fund's NAV per share is calculated each day, Monday through Friday,
except days on which the New York Stock Exchange (NYSE) is closed. The NYSE is
currently scheduled to be closed on New Year's Day, Martin Luther King, Jr.
Day, Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day,
Thanksgiving, and Christmas, and on the preceding Friday or subsequent Monday
when one of these holidays falls on a Saturday or Sunday, respectively.
The investments of the NEW YORK BOND FUND are valued each business day by
a pricing service (the Service) approved by the Company's Board of Directors.
The Service uses the mean between quoted bid and asked prices or the last sale
price to price securities when, in the Service's judgment, these prices are
readily available and are representative of the securities' market values. For
many securities, such prices are not readily available. The Service generally
prices these securities based on methods which include consideration of yields
or prices of tax-exempt securities of comparable quality, coupon, maturity and
type, indications as to values from dealers in securities, and general market
conditions. Securities purchased with maturities of 60 days or less are stated
at amortized cost which approximates market value. Repurchase agreements are
valued at cost. Securities which cannot be valued by the Service, and all other
assets, are valued in good faith at fair value using methods determined by the
Manager under the general supervision of the Board of Directors.
The value of the NEW YORK MONEY MARKET FUND'S securities is stated at
amortized cost which approximates market value. This involves valuing a
security at its cost and thereafter assuming a constant amortization to
maturity of any discount or premium, regardless of the impact of fluctuating
interest rates. While this method provides certainty in valuation, it may
result in periods during which the value of an instrument, as determined by
amortized cost, is higher or lower than the price the Fund would receive upon
the sale of the instrument.
The valuation of the New York Money Market Fund's portfolio instruments
based upon their amortized cost is subject to the Fund's adherence to certain
procedures and conditions. Consistent with regulatory requirements, the Manager
will only purchase securities with remaining maturities of 397 days or less and
will maintain a dollar-weighted average portfolio maturity of no more than 90
days. The Manager will invest only in securities that have been determined to
present minimal credit risk and that satisfy the quality and diversification
requirements of applicable rules and regulations of the Securities and Exchange
Commission (SEC).
The Board of Directors has established procedures designed to stabilize
the New York Money Market Fund's price per share, as computed for the purpose
of sales and redemptions, at $1. There can be no assurance, however, that the
Fund will at all times be able to maintain a constant $1 NAV per share. Such
procedures include review of the Fund's holdings at such intervals as is deemed
appropriate to determine whether the Fund's NAV calculated by using available
market quotations deviates from $1 per share and, if so, whether such deviation
may result in material dilution or is otherwise unfair to existing
shareholders. In the event that it is determined that such a deviation exists,
the Board of Directors will take such corrective action as it regards as
necessary and appropriate. Such action may include selling portfolio
instruments prior to maturity to realize capital gains or losses or to shorten
average portfolio maturity, withholding dividends, or establishing a NAV per
share by using available market quotations.
CONDITIONS OF PURCHASE AND REDEMPTION
NONPAYMENT
If any order to purchase shares is canceled due to nonpayment or if the Trust
does not receive good funds either by check or electronic funds transfer, USAA
Shareholder Account Services (Transfer Agent) will treat the cancellation as a
redemption of shares purchased, and you will be responsible for any resulting
loss incurred by the Fund or the Manager. If you are a shareholder, the
Transfer Agent can redeem shares from your account(s) as reimbursement for all
losses. In addition, you may be prohibited or restricted from making future
purchases in any of the USAA Family of Funds. A $15 fee is charged for all
returned items, including checks and electronic funds transfers.
TRANSFER OF SHARES
You may transfer Fund shares to another person by sending written instructions
to the Transfer Agent. The account must be clearly identified, and you must
include the number of shares to be transferred, the signatures of all
registered owners, and all stock certificates, if any, which are the subject of
transfer. You also need to send written instructions signed by all registered
owners and supporting documents to change
2
<PAGE>
an account registration due to events such as divorce, marriage, or death. If a
new account needs to be established, you must complete and return an
application to the Transfer Agent.
ADDITIONAL INFORMATION REGARDING REDEMPTION OF SHARES
The value of your investment at the time of redemption may be more or less than
the cost at purchase, depending on the value of the securities held in each
Fund's portfolio. Requests for redemption which are subject to any special
conditions, or which specify an effective date other than as provided herein,
cannot be accepted. A gain or loss for tax purposes may be realized on the sale
of shares, depending upon the price when redeemed.
The Board of Directors may cause the redemption of an account with a
balance of less than 50 shares provided (1) the value of the account has been
reduced, for reasons other than market action, below the minimum initial
investment in such Fund at the time of the establishment of the account, (2)
the account has remained below the minimum level for six months, and (3) 60
days' prior written notice of the proposed redemption has been sent to you.
Shares will be redeemed at the NAV on the date fixed for redemption by the
Board of Directors. Prompt payment will be made by mail to your last known
address.
The Company reserves the right to suspend the right of redemption or
postpone the date of payment (1) for any periods during which the NYSE is
closed, (2) when trading in the markets the Company normally utilizes is
restricted, or an emergency exists as determined by the SEC so that disposal of
the Company's investments or determination of its NAV is not reasonably
practicable, or (3) for such other periods as the SEC by order may permit for
protection of the Company's shareholders.
For the mutual protection of the investor and the Funds, the Company may
require a signature guarantee. If required, EACH signature on the account
registration must be guaranteed. Signature guarantees are acceptable from FDIC
member banks, brokers, dealers, municipal securities dealers, municipal
securities brokers, government securities dealers, government securities
brokers, credit unions, national securities exchanges, registered securities
associations, clearing agencies, and savings associations. A signature
guarantee for active duty military personnel stationed abroad may be provided
by an officer of the United States Embassy or Consulate, a staff officer of the
Judge Advocate General, or an individual's commanding officer.
REDEMPTION BY CHECK
Shareholders in the New York Money Market Fund may request that checks be
issued for their account. Checks must be written in amounts of at least $250.
Checks issued to shareholders of the Fund will be sent only to the person
in whose name the account is registered and only to the address of record. The
checks must be manually signed by the registered owner(s) exactly as the
account is registered. For joint accounts the signature of either or both joint
owners will be required on the check, according to the election made on the
signature card. You will continue to earn dividends until the shares are
redeemed by the presentation of a check.
When a check is presented to the Transfer Agent for payment, a sufficient
number of full and fractional shares from your account will be redeemed to
cover the amount of the check. If the account's balance is not adequate to
cover the amount of a check, the check will be returned unpaid. Because the
value of each account changes as dividends are accrued on a daily basis, checks
may not be used to close an account.
The checkwriting privilege is subject to the customary rules and
regulations of State Street Bank and Trust Company (State Street Bank or the
Custodian) governing checking accounts. There is no charge to you for the use
of the checks or for subsequent reorders of checks.
The Company reserves the right to assess a processing fee against your
account for any redemption check not honored by a clearing or paying agent.
Currently, this fee is $15 and is subject to change at any time. Some examples
of such dishonor are improper endorsement, checks written for an amount less
than the minimum check amount, and insufficient or uncollectible funds.
The Company, the Transfer Agent, and State Street Bank each reserve the
right to change or suspend the checkwriting privilege upon 30 days' written
notice to participating shareholders.
You may request that the Transfer Agent stop payment on a check. The
Transfer Agent will use its best efforts to execute stop payment instructions,
but does not guarantee that such efforts will be effective. The Transfer Agent
will charge you $10 for each stop payment you request.
INVESTMENT PLANS
The Company makes available the following investment plans to shareholders of
the Funds. At the time you sign up for any of the following investment plans
that utilize the electronic funds transfer service, you will choose the day of
the month (the effective date) on which you would like to regularly purchase
shares. When
3
<PAGE>
this day falls on a weekend or holiday, the electronic transfer will take place
on the last business day before the effective date. You may terminate your
participation in a plan at any time. Please call the Manager for details and
necessary forms or applications.
AUTOMATIC PURCHASE OF SHARES
INVESTRONIC(R) - The regular purchase of additional shares through electronic
funds transfer from a checking or savings account. You may invest as little as
$50 per month.
DIRECT PURCHASE SERVICE - The periodic purchase of shares through electronic
funds transfer from an employer (including government allotments and social
security), an income-producing investment, or an account with a participating
financial institution.
AUTOMATIC PURCHASE PLAN - The periodic transfer of funds from a USAA money
market fund to purchase shares in another non-money market USAA mutual fund.
There is a minimum investment required for this program of $5,000 in the money
market fund, with a monthly transaction minimum of $50.
BUY/SELL SERVICE - The intermittent purchase or redemption of shares through
electronic funds transfer to or from a checking or savings account. You may
initiate a "buy" or "sell" whenever you choose.
DIRECTED DIVIDENDS - If you own shares in more than one of the Funds in the
USAA Family of Funds, you may direct that dividends and/or capital gain
distributions earned in one fund be used to purchase shares automatically in
another fund.
Participation in these systematic purchase plans allows you to engage in
dollar-cost averaging. For additional information concerning the benefits of
dollar-cost averaging, see APPENDIX C.
SYSTEMATIC WITHDRAWAL PLAN
If you own shares having a NAV of $5,000 or more in a single investment account
(accounts in different Funds cannot be aggregated for this purpose), you may
request that enough shares to produce a fixed amount of money be liquidated
from the account monthly or quarterly. The amount of each withdrawal must be at
least $50. Using the electronic funds transfer service, you may choose to have
withdrawals electronically deposited at your bank or other financial
institution. You may also elect to have checks mailed to a designated address.
This plan may be initiated by depositing shares worth at least $5,000 with
the Transfer Agent and by completing the Systematic Withdrawal Plan
application, which may be requested from the Manager. You may terminate
participation in the plan at any time. You are not charged for withdrawals
under the Systematic Withdrawal Plan. The Company will not bear any expenses in
administering the plan beyond the regular transfer agent and custodian costs of
issuing and redeeming shares. The Manager will bear any additional expenses of
administering the plan.
Withdrawals will be made by redeeming full and fractional shares on the
date you select at the time the plan is established. Withdrawal payments made
under this plan may exceed dividends and distributions and, to this extent,
will involve the use of principal and could reduce the dollar value of your
investment and eventually exhaust the account. Reinvesting dividends and
distributions helps replenish the account. Because share values and net
investment income can fluctuate, you should not expect withdrawals to be offset
by rising income or share value gains.
Each redemption of shares may result in a gain or loss, which must be
reported on your income tax return. Therefore, you should keep an accurate
record of any gain or loss on each withdrawal.
INVESTMENT POLICIES
The sections captioned WHAT ARE EACH FUND'S INVESTMENT OBJECTIVE AND MAIN
STRATEGIES? and FUND INVESTMENTS in the Prospectus describe the fundamental
investment objectives and the investment policies applicable to each Fund. Each
Fund's objective cannot be changed without shareholder approval. The following
is provided as additional information.
CALCULATION OF PORTFOLIO WEIGHTED AVERAGE MATURITIES
Weighted average maturity is derived by multiplying the value of each
investment by the number of days remaining to its maturity, adding the results
of these calculations, and then dividing the total by the value of the Fund's
portfolio. An obligation's maturity is typically determined on a stated final
maturity basis, although there are some exceptions to this rule.
With respect to obligations held by the New York Bond Fund, if it is
probable that the issuer of an instrument will take advantage of a
maturity-shortening device, such as a call, refunding, or redemption provision,
the date on which the instrument will probably be called, refunded, or redeemed
may be considered to be its maturity date. Also, the maturities of securities
subject to sinking fund arrangements are determined on a weighted average life
basis, which is the average time for principal to be repaid. The weighted
average life of these securities is likely to be substantially shorter than
their stated final maturity. In addition, for purposes of the Fund's investment
policies, an instrument will be treated as having a
4
<PAGE>
maturity earlier than its stated maturity date if the instrument has technical
features such as puts or demand features which, in the judgment of the Manager,
will result in the instrument being valued in the market as though it has the
earlier maturity.
The New York Money Market Fund will determine the maturity of an
obligation in its portfolio in accordance with Rule 2a-7 under the Investment
Company Act of 1940, as amended (1940 Act).
LENDING OF SECURITIES
Each Fund may lend its securities. A lending policy may be authorized by the
Company's Directors and implemented by the Manager, but securities may be
loaned only to qualified broker-dealers or institutional investors that agree
to maintain cash collateral with the Company equal at all times to at least
100% of the value of the loaned securities. The Directors will establish
procedures and monitor the creditworthiness of any institution or broker-dealer
during such time as any loan is outstanding. The Company will continue to
receive interest on the loaned securities and will invest the cash collateral
in readily marketable short-term obligations of high quality, thereby earning
additional interest. Interest on loaned tax-exempt securities received by the
borrower and paid to the Company will not be exempt from federal income taxes
in the hands of the Company.
No loan of securities will be made if, as a result, the aggregate of such
loans would exceed 33 1/3% of the value of a Fund's total assets. The Company
may terminate such loans at any time.
REPURCHASE AGREEMENTS
Each Fund may invest up to 5% of its total assets in repurchase agreements. A
repurchase agreement is a transaction in which a security is purchased with a
simultaneous commitment to sell the security back to the seller (a commercial
bank or recognized securities dealer) at an agreed upon price on an agreed upon
date, usually not more than seven days from the date of purchase. The resale
price reflects the purchase price plus an agreed upon market rate of interest
which is unrelated to the coupon rate or maturity of the purchased security. A
repurchase agreement involves the obligation of the seller to pay the agreed
upon price, which obligation is in effect secured by the value of the
underlying security. In these transactions, the securities purchased by a Fund
will have a total value equal to or in excess of the amount of the repurchase
obligation and will be held by the Funds' custodian until repurchased. If the
seller defaults and the value of the underlying security declines, a Fund may
incur a loss and may incur expenses in selling the collateral. If the seller
seeks relief under the bankruptcy laws, the disposition of the collateral may
be delayed or limited. Any investments in repurchase agreements will give rise
to income which will not qualify as tax-exempt income when distributed by a
Fund.
WHEN-ISSUED SECURITIES
Each Fund may invest in new issues of tax-exempt securities offered on a
when-issued basis; that is, delivery and payment take place after the date of
the commitment to purchase, normally within 45 days. Both price and interest
rate are fixed at the time of commitment. The Funds do not earn interest on the
securities until settlement, and the market value of the securities may
fluctuate between purchase and settlement. Such securities can be sold before
settlement date.
Cash or high quality liquid debt securities equal to the amount of the
when-issued commitments are segregated at the Fund's custodian bank. The
segregated securities are valued at market, and daily adjustments are made to
keep the value of the cash and segregated securities at least equal to the
amount of such commitments by the Fund. On the settlement date, the Fund will
meet its obligations from then available cash, sale of segregated securities,
sale of other securities, or sale of the when-issued securities themselves.
MUNICIPAL LEASE OBLIGATIONS
Each Fund may invest in municipal lease obligations and certificates of
participation in such obligations (collectively, lease obligations). A lease
obligation does not constitute a general obligation of the municipality for
which the municipality's taxing power is pledged, although the lease obligation
is ordinarily backed by the municipality's covenant to budget for the payments
due under the lease obligation.
Certain lease obligations contain "non-appropriation" clauses which
provide that the municipality has no obligation to make lease obligation
payments in future years unless money is appropriated for such purpose on a
yearly basis. Although "non-appropriation" lease obligations are secured by the
leased property, disposition of the property in the event of foreclosure might
prove difficult. In evaluating a potential investment in such a lease
obligation, the Manager will consider: (1) the credit quality of the obligor,
(2) whether the underlying property is essential to a governmental function,
and (3) whether the lease obligation contains covenants prohibiting the obligor
from substituting similar property if the obligor fails to make appropriations
for the lease obligation.
TEMPORARY DEFENSIVE POLICY
Each Fund may on a temporary basis because of market, economic, political, or
other conditions invest up to 100% of its assets in short-term securities
whether or not they are exempt from federal and New York State and New York
City income taxes. Such taxable securities may consist of obligations of the
U.S.
5
<PAGE>
Government, its agencies or instrumentalities, and repurchase agreements
secured by such instruments; certificates of deposit of domestic banks having
capital, surplus, and undivided profits in excess of $100 million; banker's
acceptances of similar banks; commercial paper; and other corporate debt
obligations.
OTHER POLICIES
Although the New York Bond Fund is permitted to invest in options, financial
futures contracts, and options on financial futures contracts, the Fund has no
current intention of doing so and will not invest in such securities without
first notifying shareholders and supplying further information in the
Prospectus.
INVESTMENT RESTRICTIONS
The following investment restrictions have been adopted by the Company for each
Fund. These restrictions may not be changed for any given Fund without approval
by the lesser of (1) 67% or more of the voting securities present at a meeting
of the Fund if more than 50% of the outstanding voting securities of the Fund
are present or represented by proxy or (2) more than 50% of the Fund's
outstanding voting securities. The investment restrictions of one Fund may be
changed without affecting those of the other Fund.
Under the restrictions, neither Fund will:
(1) with respect to 75% of its total assets, purchase securities of any
issuer (other than a security issued or guaranteed as to principal or
interest by the United States, or by a person controlled or supervised by
and acting as an instrumentality of the Government of the United States;
or any certificate of deposit for any of the foregoing) if as a result
more than 5% of the total assets of that Fund would be invested in
securities of such issuer; for purposes of this limitation,
identification of the "issuer" will be based on a determination of the
source of assets and revenues committed to meeting interest and principal
payments of each security; for purposes of this limitation the State of
New York or other jurisdictions and each of its separate political
subdivisions, agencies, authorities, and instrumentalities shall be
treated as a separate issuer;
(2) purchase more than 10% of the outstanding voting securities of any issuer;
(3) borrow money, except for temporary or emergency purposes in an amount not
exceeding 33 1/3% of its total assets (including the amount borrowed)
less liabilities (other than borrowings);
(4) pledge, mortgage, or hypothecate its assets to any extent greater than
10% of the value of its total assets;
(5) purchase or retain securities of any issuer if any officer or Director of
the Company or its Manager owns individually more than one-half of one
percent (1/2%) of the securities of that issuer, and collectively the
officers and Directors of the Company and Manager together own more than
5% of the securities of that issuer;
(6) purchase any securities which would cause 25% or more of the value of
that Fund's total assets at the time of such purchase to be invested in
securities the interest upon which is derived from revenues or projects
with similar characteristics, such as toll road revenue bonds, housing
revenue bonds, electric power project revenue bonds, or in industrial
revenue bonds which are based, directly or indirectly, on the credit of
private entities of any one industry; provided that the foregoing
limitation does not apply with respect to investments in U.S. Treasury
Bills, other obligations issued or guaranteed by the U.S. Government, its
agencies and instrumentalities, and, in the case of the New York Money
Market Fund, certificates of deposit and banker's acceptances of domestic
banks;
(7) invest in issuers for the purpose of exercising control or management;
(8) issue senior securities as defined in the 1940 Act, except that it may
purchase tax-exempt securities on a "when-issued" basis and may purchase
and sell financial futures contracts and options as permitted by Section
18(f)(2);
(9) underwrite securities of other issuers, except to the extent that it may
be deemed to act as a statutory underwriter in the distribution of any
restricted securities or not readily marketable securities;
(10) purchase or sell real estate, but this shall not prevent investments in
tax-exempt securities secured by real estate or interests therein;
(11) lend any securities or make any loan if, as a result, more than 33 1/3%
of its total assets would be lent to other parties, except that this
limitation does not apply to purchases of debt securities or to
repurchase agreements;
(12) purchase on margin or sell short; for purposes of this restriction the
deposit or payment of initial or variation margin in connection with
financial futures contracts or related options will not be deemed to be a
purchase of securities on margin by a Fund;
(13) purchase or sell commodities or commodities contracts, except that the
Fund may invest in financial futures and contracts and options thereon;
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(14) invest its assets in securities of other investment companies except by
purchases in the open market involving only customary brokers'
commissions or as part of a merger, consolidation, reorganization or
purchase of assets approved by the shareholders; or
(15) invest in put, call, straddle, or spread options or interests in oil,
gas, or other mineral exploration or development programs, except that a
Fund may write covered call options and purchase put options.
ADDITIONAL RESTRICTIONS
The following restrictions are not considered to be fundamental policies of the
Funds. The Board of Directors may change these additional restrictions without
notice to or approval by the shareholders.
Neither Fund will:
(1) invest more than 15% (10% with respect to the New York Money Market Fund)
of the value of its net assets in illiquid securities, including
repurchase agreements maturing in more than seven days; or
(2) purchase any security while borrowings representing more than 5% of the
Fund's total assets are outstanding.
SPECIAL RISK CONSIDERATIONS
SPECIAL CONSIDERATIONS RELATING TO NEW YORK MUNICIPAL OBLIGATIONS
Some of the significant financial considerations relating to the Fund's
investments in New York Municipal Obligations are summarized below. This
summary information is not intended to be a complete description and is
principally derived from official statements relating to issues of New York
Municipal Obligations that were available prior to the date of this SAI. The
accuracy and completeness of the information contained in those official
statements have not been independently verified.
STATE 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 has a declining proportion of its
workforce engaged in manufacturing, and an increasing proportion engaged in
service industries. New York City (the City), which is the most populous city
in the State and nation and is the center of the nation's largest metropolitan
area, accounts for a large portion of the State's population and personal
income.
The State has historically been one of the wealthiest states in the
nation. For decades, however, the State has grown more slowly than the nation
as a whole, gradually eroding its relative economic position.
There can be no assurance that the State economy will not experience
worse-than-predicted results in the 1998-99 fiscal year (April 1, 1998 through
March 31, 1999), with corresponding material and adverse effects on the State's
projections of receipts and disbursements.
State per capita personal income has historically been significantly
higher than the national average, although the ratio has varied substantially.
Between 1975 and 1990, total employment grew by 21.3% while the labor force
grew only by 15.7%, unemployment fell from 9.5% to 5.2% of the labor force. In
1991 and 1992, however, total employment in the State fell by 5.5%. As a
result, the unemployment rate rose to 8.5% reflecting a recession that has had
a particularly strong impact on the entire Northeast. Calendar years 1993 and
1994 saw only a partial recovery, with the unemployment rate decreasing to 7.8%
and 6.9%, respectively. The unemployment rate for both 1995 and 1996 was 6.3%
and was projected by the State Division of Budget to be 6.3% for 1997.
STATE BUDGET. The State Constitution requires the governor (the Governor) to
submit to the State legislature (the Legislature) a balanced executive budget
which contains a complete plan of expenditures for the ensuing fiscal year and
all moneys and revenues estimated to be available therefor, accompanied by
bills containing all proposed appropriations or reappropriations and any new or
modified revenue measures to be enacted in connection with the executive
budget. The entire plan constitutes the proposed State financial plan for that
fiscal year. The Governor is required to submit to the Legislature quarterly
budget updates which include a revised cash-basis state financial plan, and an
explanation of any changes from the previous state financial plan.
The Governor presented his 1998-99 Executive Budget and the draft 1998-99
State Financial Plan to the Legislature on January 20, 1998. As of April 27,
1998 the Legislature has passed the State's budget for the 1998-99 fiscal year.
Certain appropriation items added to the State budget by the Legislature are
subject to line item veto by the Governor. If two-thirds of the Members of each
House of the Legislature were to approve such appropriation items after a veto
the items would become law notwithstanding a veto. There can be no assurance
that the State's adopted budget projections will not differ materially and
adversely from the projections set forth in the Executive Budget. The State,
however, has enacted legislation making appropriations for the legal
requirements of State debt service, lease purchase payments and other special
contractual obligations for the current fiscal year. Furthermore, such
legislation also provides for the payment of the State's certificates of
participation for the current fiscal year.
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The draft 1998-99 State Financial Plan projects a balanced General Fund,
on a cash basis, with a General Fund closing balance of $500 million for the
1998-99 fiscal year. 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. Total General Fund receipts, including transfers from
other funds, are projected to be $36.22 billion, an increase of $1.02 billion
from total receipts projected in the 1997-98 fiscal year. Total General Fund
disbursements and transfers to other funds are projected to be $36.18 billion,
an increase of $1.02 billion over the projected expenditures (including
prepayments) for the 1997-98 fiscal year. As compared to the 1997-98 State
Financial Plan, the draft 1998-99 State Financial Plan proposes year-to-year
growth in General Fund spending of 2.89%. State funds spending (i.e., General
Fund plus other dedicated funds, with the exception of federal aid) is
projected to grow by 8.5%. Spending from all governmental funds (excluding
transfers) is proposed to increase by 7.6% from the prior fiscal year.
RECEIPTS
Recurring growth in the State General Fund tax base is projected to be
approximately 6% during 1998-99, after adjusting for tax law and administrative
changes. This growth rate is lower than the rates for 1996-97 or estimated for
1997-98, but roughly equivalent to the rate for 1995-96.
The forecast of General Fund receipts in 1998-99 incorporates several
Executive Budget tax proposals that would further reduce receipts otherwise
available to the General Fund by approximately $700 million during 1998-99. The
Executive Budget proposes accelerating school tax relief for senior citizens
under the School Tax Assistance Program ("STAR"), which is projected to reduce
General Fund receipts by $537 million in 1998-99. The proposed reduction
supplements STAR tax reductions already scheduled in law, which are projected
at $187 million in 1998-99. The Executive Budget also proposes several new
tax-cut initiatives and other funding changes that are projected to further
reduce receipts available to the General Fund by over $200 million. These
initiatives include reducing the fee to register passenger motor vehicles and
earmarking a larger portion of such fees to dedicated funds and other purposes;
extending the number of weeks in which certain clothing purchases are exempt
from sales taxes; more fully conforming State law to reflect recent Federal
changes in estate taxes; continuing lower pari-mutuel tax rates; and
accelerating scheduled property tax relief for farmers from 1999 to 1998. In
addition to the specific tax and fee reductions discussed above, the Executive
Budget also proposes establishing a reserve of $100 million to permit the
acceleration into 1998-99 of other tax reductions that are otherwise scheduled
in law for implementation in future fiscal years.
General Fund receipts in 1998-99 will also be affected by the loss of
certain one-time receipts recorded in 1997-98, the largest of which include
approximately $200 million in retroactive federal reimbursements for prior-year
social service spending recorded as a transfer from other funds and about $55
million in retroactive assessments on Office of Mental Retardation and
Developmental Disabilities facilities that were received in 1997-98 as
miscellaneous receipts. Estimates for 1998-99 also reflect the loss of one-time
receipts from a tax amnesty program.
Personal income tax collections in the General Fund are projected to
increase by $1.32 billion over 1997-98, from $18.50 billion to $19.82 billion.
The increase reflects growth in constant New York law liability of over 6% in
1998, down from an estimated 12% growth in 1997. Growth in personal income tax
liability in 1997 benefited from a temporary surge in capital-gains income in
response to 1997 reductions in the federal tax rate on such income. In addition
to the General Fund receipts, approximately $724 million in personal income tax
collections will be deposited in special revenue funds to finance STAR.
User tax collections and fee receipts are projected to reach $7.2 billion
in 1998-99, an increase of $144 million over the 1997-98 fiscal year. The
largest source of receipts in this category is the sales and use tax, which
accounts for nearly 80% of projected receipts. Sales tax receipts are the most
responsive to economic trends such as nominal growth in income, prices,
employment, and consumer confidence. The strong growth in income produced
growth in the base of the sales and use tax of 5.2% in 1997-98. The sales tax
growth rate projected for the 1998-99 fiscal year is expected to be marginally
higher.
The 1998-99 forecast for user taxes and fees also reflects the impact of
scheduled tax reductions that will lower receipts by $38 million, as well as
the impact of two Executive Budget proposals that are projected to lower
receipts by an additional $79 million. The first proposal would divert $30
million in motor vehicle registration fees from the General Fund to the
Dedicated Highway and Bridge Trust Fund; the second would reduce fees for motor
vehicle registrations, which would further lower receipts by $49 million. The
underlying growth of receipts in this category is projected at 4%, after
adjusting for these scheduled and recommended changes.
In comparison to the 1997-98 fiscal year, business tax receipts are
projected to decline slightly in 1998-99, falling from $4.98 billion to $4.96
billion. The decline in this category is largely attributable to scheduled tax
reductions. In total, collections for corporation and utility taxes and the
petroleum business tax are projected to fall by $107 million from 1997-98. The
decline in receipts in these categories is partially offset by growth in the
corporation franchise, insurance and bank taxes, which are projected to grow by
$88 million over the 1997-98 fiscal year.
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Receipts from other taxes, which include taxes on estate and gifts, real
property gains, and pari-mutuel wagering, are projected to total $1.01 billion
in 1998-99, a decline of $78 million from the 1997-98 fiscal year. The main
reason for the decline is an expected fall in the number and value of large
estate tax payments from the extraordinary level achieved in 1997-98. The
decline also reflects the first full-year impact of the repeal of the gains
tax.
Miscellaneous receipts, which include license revenues, fee and fine
income, investment income and abandoned property proceeds, as well as the yield
of the largest share of the State's medical provider assessments, are projected
to fall from $1.57 billion in the 1997-98 year to $1.4 billion in 1998-99, a
decline of $170 million. The decline is largely a result of the loss of over
$90 million in one-time transactions and $56 million in statutory reductions in
medical provider assessments.
DISBURSEMENTS
Disbursements from the category of Grants to Local Governments constitute
approximately 67.9% of all General Fund spending, and include payments to local
governments, non-profit providers and individuals. Disbursements in this
category are projected to increase by $931 million to $24.55 billion in
1998-99, or 3.9% above 1997-98. The largest increases are for school aid and
Medicaid.
School aid is projected at $9.47 billion in 1998-99, an increase of $607
million on a State fiscal year basis. This increase funds both the balance of
aid payable for the 1997-98 school year and a proposed 1998-99 school year
increase of $518 million. Medicaid costs are estimated to increase $212 million
to $5.68 billion, about the same spending level as in 1994-95. After adjusting
1997-98 spending for the one-time acceleration of a 53rd weekly Medicaid
payment scheduled for 1998-99, Medicaid spending is projected to increase by
$348 million or 6.5%. The adjustment eliminates this extraordinary payment in
1997-98 for purposes of comparison with 1998-99. Spending in local assistance
programs for higher education, handicapped education, mental hygiene, local
public health and revenue sharing are also proposed to increase.
Transfers in support of debt service are projected to grow at 5.8% in
1998-99, from $2.03 billion to $2.15 billion. Transfers in support of capital
projects for 1998-99 are estimated to total $190 million, a decrease of $453
million from 1997-98, reflecting the absence of one-time transfers for the
Hudson River Park and CEFAP in 1997-98.
NON-RECURRING RESOURCES
The Division of the Budget estimates that the draft 1998-99 Financial Plan
includes approximately $62 million in non-recurring resources, comprising less
than two-tenths of one percent of General Fund disbursements.
FUTURE STATE FISCAL YEAR PROJECTIONS
The 1998-99 Executive Budget projects General Fund receipts of $36.14 billion
and $35.75 billion for the 1999-2000 and 2000-2001 fiscal years, respectively.
The receipts projections were prepared on the basis of an economic forecast of
a steadily growing national economy, in an environment of low inflation and
slow employment growth. The forecast for the State's economic performance
likewise was for slow but steady economic growth. Statutory changes affecting
General Fund receipts are dominated by the dedication of a portion of the
income tax to fund school tax reductions under STAR. Personal income receipts
dedicated to STAR are estimated at $1.39 billion in 1999-2000 and at $2.04
billion in 2000-2001. The General Fund tax relief provided by the estate and
gift tax reduction program, sales tax reductions and other 1997 enactments
further reduce taxes and fees by roughly $1 billion by the last year of the
forecast period. Other 1998-1999 budget proposals that lower General Fund taxes
and fees will annualize to approximately $110 million in 1999-2000 and $100
million in 2000-2001.
Disbursements from the General Fund are projected at $37.84 billion in
1999-2000 and $39.45 billion in 2000-2001, after assuming implementation of
spending proposals contained in the Executive Budget, the value of which is
annualized and assumed to continue. The projections include additional school
aid increases of roughly 7% annually to finance present law and implement
proposals enacted under the STAR/School Aid program. Additional funding to
implement welfare reform is also included, as well as funding for mental health
community reinvestment, prison expansion, and other previous multi-year
spending commitments. Growth in General Fund Medicaid spending is projected at
just over 6% annually. Other spending growth is projected to follow recent
trends. Consistent with past practice, funding is not included for any costs
associated with new collective bargaining agreements after the expiration of
the current round of contracts at the end of the 1998-1999 fiscal year.
The Executive Budget contained projections of a potential imbalance in the
1999-2000 fiscal year of $1.75 billion and in the 2000-2001 fiscal year of
$3.75 billion, assuming implementation of $600 million and $800 million of
unspecified efficiency initiatives and other savings actions in the 1999-2000
and 2000-2001 fiscal years, respectively.
The Division of the Budget believed that the economic assumptions and
projections of receipts and disbursements accompanying the 1998-99 Executive
Budget were reasonable. However, the economic and financial condition of the
State may be affected by various financial, social, economic and political
factors.
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Those factors can be very complex, can vary from fiscal year to fiscal year,
and are frequently the result of actions taken not only by the State but also
by entities, such as the federal government, that are outside the State's
control. Because of the uncertainty and unpredictability of changes in these
factors, their impact cannot be fully included in the assumptions underlying
the State's projections. There can be no assurance that the State's actions
will be sufficient to preserve budgetary balance or to align recurring receipts
and disbursements in either 1998-1999 or in future fiscal years.
Uncertainties with regard to both the economy and potential decisions at
the Federal level add further pressure on future efforts to balance budgets in
New York State. Risks to the financial plan include either a financial market
or broader economic "correction" during the period, a risk heightened by the
relatively lengthy expansions currently underway. In addition, a normal
"forecast error" of one percentage point in the expected growth rate could
raise or lower receipts by $1 billion during the last year of the 1998 through
the 2001 projection period.
RECENT STATE FISCAL YEARS
The State's budget for the 1997-98 fiscal year was enacted by the
Legislature on August 4, 1997, more than four months after the start of that
fiscal year. The State Financial Plan for the 1997-98 fiscal year was
formulated on August 11, 1997, and was based upon the State's budget as enacted
by the Legislature and signed into law by the Governor as well as actual
results through the third quarter of the 1997-1998 fiscal year (the 1997-98
State Financial Plan).
The 1997-1998 State Financial Plan projects a balanced General Fund (the
major operating fund of the State), on a cash basis, with a projected cash
surplus of $1.83 billion. The State has planned to accelerate $1.18 billion in
income tax refund payments into the 1997-1998 fiscal year, or provide reserves
for such payments, in order to make the cash surplus available to help finance
requirements of the 1998-1999 fiscal year. General Fund receipts are projected
to be $35.197 billion while General Fund disbursements are projected at $35.165
billion. The State projects it has closed a budget gap of approximately $2.3
billion for the 1997-1998 fiscal year. Gap-closing actions included cost
containment in State Medicaid, the use of the $1.4 billion 1996-1997 fiscal
year budget surplus to finance 1997-1998 fiscal year spending, control on State
agency spending and other actions.
Certain actions taken in the 1997-1998 adopted budget add further pressure
on future efforts to balance budgets in New York State. For example, the fiscal
effects of tax reductions adopted in the 1997-1998 budget are projected to grow
more substantially beyond the 1998-1999 fiscal year. In addition, the 1997-1998
budget included multi-year commitments for school aid and pre-kindergarten
early learning programs which could add as much as $1.4 billion in costs when
fully annualized in fiscal year 2001-2002. These spending commitments are
subject to annual appropriation.
The State ended its 1996-97 fiscal year in balance on a cash basis, with a
reported 1996-97 cash surplus of $1.4 billion. Prior to adoption of the State's
1996-97 fiscal year budget, the State had projected a potential budget gap of
approximately $3.9 billion.
The State ended the 1995-1996 fiscal year in balance on a cash basis, with
a reported 1995-96 General Fund cash surplus of $445 million. Prior to adoption
of the State's 1995-96 fiscal year budget, the State had projected a potential
budget gap of approximately $5 billion.
DEBT LIMITS, RATINGS AND OUTSTANDING DEBT. There are a number of methods by
which the State of New York may incur debt. 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.
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, 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. The State may also, pursuant to specific
constitutional authorization, directly guarantee certain obligations of the
State of New York's authorities and public benefit corporations (Authorities).
Payments of debt service on New York State general obligation and New York
State-guaranteed bonds and notes are legally enforceable obligations of the
State of New York.
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 are 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
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making the payments. The State has also entered into a contractual-obligation
financing arrangement with the Local Government Assistance Corporation (LGAC)
to restructure the way the State makes certain local aid payments.
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 traditionally funded
through New York State's annual seasonal borrowing. As of June 1995, LGAC had
issued bonds 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 projected 1998-1999 General Fund cash flow will not depend on
either short-term spring borrowing or the issuance of LGAC bonds.
As of March 3, 1998 Moody's rated New York State general obligations bonds
A2, and Standard & Poor's rated such bonds A. Standard & Poor's revised its
rating upwards from A- to A on August 28, 1997. Ratings reflect only the
respective views of such organizations, and an explanation of the significance
of such ratings may be obtained from the rating agency furnishing the same.
There is no assurance that a particular rating will continue for any given
period of time or that any such rating will not be revised downward or
withdrawn entirely, if in the judgment of the agency originally establishing
the rating, circumstances so warrant.
As of March 31, 1997, the State had approximately $5.03 billion
outstanding in general obligation debt, including $294 million in bond
anticipation notes outstanding. The total amount of moral obligation debt was
approximately $4.07 billion, and $22.50 billion of bonds issued primarily in
connection with lease-purchase and contractual-obligation financing of State
capital programs were outstanding.
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 obligations 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, 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.
Total outstanding State-related debt increased from $24.45 billion at the
end of the 1987-88 fiscal year to $37.11 billion at the end of the 1996-97
fiscal year, an average annual increase of 4.7%. State-supported debt increased
from $11.61 billion at the end of the 1987-88 fiscal year to $32.77 billion at
the end of the 1996-97 fiscal year, an average annual increase of 12.2%. During
the prior ten year period, annual personal income in the State rose from $329.6
billion to $526.5 billion, an average annual increase of 5.3%. Thus,
State-supported debt grew at a faster rate than personal income while
State-related obligations grew at a slower rate.
Principal and interest payments on general obligation bonds and interest
payments on bond anticipation notes were $749.6 million for the 1996-97 fiscal
year and were estimated to be $720.9 million for the 1997-98 fiscal year.
LITIGATION. Certain litigation pending against New York State or its officers
or employees could have a substantial or long-term adverse effect on New York
State taxes. An adverse decision in any of these proceedings could exceed the
amount of the reserve established in the State's financial plan for the payment
of judgments and, therefore, could affect the ability of the State to maintain
a balanced financial plan. In its audited financial statements for the fiscal
year ended March 31, 1997, the State reported its estimated liability for
awarded and anticipated unfavorable judgments to be $364 million.
AUTHORITIES. The fiscal stability of New York State is related, in part, to the
fiscal stability of its Authorities, which generally have responsibility for
financing, constructing and operating revenue-producing public benefit
facilities. Authorities are not subject to the constitutional restrictions on
the incurrence of debt which apply to the State itself, and may issue bonds and
notes within the amounts of, and as otherwise restricted by, their legislative
authorization. The State's access to the public credit markets could be
impaired, and the market price of its outstanding debt may be materially and
adversely affected, if any of the Authorities were to default on their
respective obligations, particularly with respect to debt that is
State-supported or State-related. As of September 30, 1996, there were 17
Authorities that had outstanding debt of $100 million or more. The aggregate
outstanding debt, including refunding bonds, of these 17 Authorities was $75.4
billion.
Public authority operating expenses and debt service costs are generally
paid by revenues generated by the projects financed or operated, such as user
fees on bridges or tunnels, highway tolls and rentals for dormitory rooms and
housing units and charges for occupancy at medical care facilities. In recent
years, however, New York State has provided financial assistance through
appropriations, in some cases of a recurring nature, to certain of the
Authorities for operating and other expenses and, in fulfillment of its
commitments on moral obligation indebtedness or otherwise, for debt service.
This operating assistance is
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expected to continue to be required in future years. In addition, certain
statutory arrangements provide for State local assistance payments otherwise
payable to localities to be made under certain circumstances to certain
Authorities. The State has no obligation to provide additional assistance to
localities whose local assistance payments have been paid to Authorities under
these arrangements. However, in the event that such local assistance payments
are so diverted, the affected localities could seek additional State funds.
NEW YORK CITY AND OTHER LOCALITIES. The fiscal health of the State of New York
may also be impacted by the fiscal health of its localities, particularly the
City of New York, which has required and continues to require significant
financial assistance from New York State. The City depends on State aid both to
enable the City to balance its budget and to meet its cash requirements. There
can be no assurance that there will not be reductions in State aid to the City
from amounts currently projected or that State budgets in any given fiscal year
will be adopted by the April 1 statutory deadline or that any such reductions
or delays will not have adverse effects on the City's cash flow or
expenditures.
For each of the 1981 through 1997 fiscal years, the City had an operating
surplus, before discretionary transfers, and achieved balanced operating
results as reported in accordance with generally accepted accounting principles
("GAAP"), after discretionary transfers and revenues and expenditures for the
City's 1998 and 1999 fiscal years are projected to be balanced in accordance
with GAAP. The City has been required to close substantial budget gaps in
recent years in order to maintain balanced operating results. A pattern of
current year surplus operating results and projected subsequent year budget
gaps has been consistent through the entire period since 1982, during which the
City has achieved surplus operating results, before discretionary transfers for
each fiscal year. There can be no assurance that the City will continue to
maintain a balanced budget as required by State law, or that it can maintain a
balanced budget without tax or other revenue increases or reductions in City
services or entitlement programs, which could adversely affect the City's
economic base.
In 1975, New York City suffered a fiscal crisis that impaired the
borrowing ability of both the City and New York State. In that year, the City
lost access to the public credit markets. The City was not able to sell
short-term notes to the public again until 1979.
As of May 19, 1998, Moody's rated the City's general obligation bonds A3
and Standard & Poor's rated the bonds BBB+. On July 10, 1995, Standard & Poor's
downgraded its rating on the City's outstanding general obligation bonds to
BBB+ from A-, citing to the City's chronic structural budget problems and weak
economic outlook. Standard & Poor's stated that New York City's reliance on
one-time revenue measures to close annual budget gaps, a dependence on
unrealized labor savings, overly optimistic estimates of revenues and state and
federal aid and the City's continued high debt levels also contributed to its
decision to lower the rating. On February 3, 1998, Standard & Poor's placed its
BBB+ rating of City bonds on Credit Watch with positive implication. In
February 1998, Moody's revised its rating of City bonds upwards to A3 from
Baa1.
New York City is heavily dependent on New York State and federal
assistance to cover insufficiencies in its revenues. There can be no assurance
that in the future federal and State assistance will enable the City to make up
its budget deficits. To help alleviate the City's financial difficulties, the
Legislature created the Municipal Assistance Corporation (MAC) in 1975. Since
its creation, MAC has provided, among other things, financing assistance to the
City by refunding maturing City short-term debt and transferring to the City
funds received from sales of MAC bonds and notes. MAC is authorized to issue
bonds and notes payable from certain stock transfer tax revenues, from the
City's portion of the State sales tax derived in the City and, subject to
certain prior claims, from State per capita aid otherwise payable by the State
to the City. Failure by the State to continue the imposition of such taxes, the
reduction of the rate of such taxes to rates less than those in effect on July
2, 1975, failure by the State to pay such aid revenues and the reduction of
such aid revenues below a specified level are included among the events of
default in the resolutions authorizing MAC's long-term debt. The occurrence of
an event of default may result in the acceleration of the maturity of all or a
portion of MAC's debt. MAC bonds and notes constitute general obligations of
MAC and do not constitute an enforceable obligation or debt of either the State
or the City. As of March 31, 1998, MAC had outstanding an aggregate of
approximately $4.242 billion of its bonds. MAC is authorized to issue bonds and
notes to refund its outstanding bonds and notes and to fund certain reserves.
Since 1975, the City's financial condition has been subject to oversight
and review by the New York State Financial Control Board (the Control Board)
and since 1978 the City's financial statements have been audited by independent
accounting firms. To be eligible for guarantees and assistance, the City is
required during a "control period" to submit annually for Control Board
approval, and when a control period is not in effect for Control Board review,
a financial plan for the next four fiscal years covering the City and certain
agencies showing balanced budgets determined in accordance with GAAP. New York
State also established the Office of the State Deputy Comptroller for New York
City (OSDC) to assist the Control Board in exercising its powers and
responsibilities. On June 30, 1986, the City satisfied the statutory
requirements for termination of the control period. This means that the Control
Board's powers of approval are suspended, but the Control Board continues to
have oversight responsibilities.
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The most recent quarterly modification to the City's financial plan for
the 1998 fiscal year, submitted to the Control Board on April 30, 1998 (the
"1998 Modification"), projects a balanced budget in accordance with GAAP for
the 1998 fiscal year.
The Mayor is responsible for preparing the City's financial plan,
including the City's current financial plan for the 1999 through 2002 fiscal
years (the "1999-2002 Financial Plan", "Financial Plan" or "City Plan"). On
April 24, 1998, the City released the Financial Plan for the 1999 through 2002
fiscal years, which relates to the City and certain entities which receive
funds from the City, and which is based on the Executive Budget and Budget
Message for the City's 1999 fiscal year (the "Executive Budget"). The Executive
Budget and Financial Plan project revenues for the 1999 fiscal year balanced in
accordance with GAAP, and project gaps of $1.5 billion, $2.1 billion and $1.6
billion for the 2000, 2001 and 2002 fiscal years, respectively.
In connection with the Financial Plan, the City has outlined a gap-closing
program for fiscal years 2000, 2001 and 2002 to eliminate the respective
projected budget gaps for such fiscal years. This program, which is not
specified in detail, assumes for the 2000, 2001 and 2002 fiscal years,
respectively, additional agency programs to reduce expenditures or increase
revenues; savings from privatization initiatives and asset sales; additional
Federal and State aid; additional entitlement cost containment initiatives; and
the availability of moneys of the City's General Reserve.
The 1998 Modification and the 1999-2002 Financial Plan include a proposed
discretionary transfer in the 1998 fiscal year of approximately $2.0 billion to
pay debt service due in the 1999 fiscal year, and a proposed discretionary
transfer in the 1999 fiscal year of $416 million to pay debt service due in
fiscal year 2000. In addition the financial Plan reflects proposed tax
reduction programs totaling $237 million, $537 million, $657 million and $666
million in fiscal years 1999 through 2002, respectively. These programs include
the elimination of the City sales tax on all clothing as of December 1, 1999, a
personal income tax credit for child care and for resident holders of
Subchapter S corporations, which are subject to State legislative approval, and
reduction of the commercial rent tax commencing in fiscal year 2000.
The 1998 Modification and the 1999-2002 Financial Plan are based on
numerous assumptions, including the condition of the City's and the region's
economy and a modest employment recovery and the concomitant receipt of
economically sensitive tax revenues in the amounts projected. The 1998
Modification and the 1999-2002 Financial Plan are subject to various other
uncertainties and contingencies relating to, among other factors, the extent,
if any, to which wage increases for City employees exceed the annual wage costs
assumed for the 1998 through 2002 fiscal years; continuation of projected
interest earnings assumptions for pension fund assets and current assumptions
with respect to wages for City employees affecting the City's required pension
fund contributions; the willingness and ability of the State to provide the
aid contemplated by the Financial Plan and to take various other actions to
assist the City; the ability of New York City Health and Hospitals Corporation
("HHC"), the BOE and other such agencies to maintain balanced budgets; the
willingness of the Federal government to provide the amount of Federal aid
contemplated in the Financial Plan; the impact on City revenues and
expenditures of Federal and State welfare reform, and any future legislation
affecting Medicare or other entitlement programs; adoptions of the City's
budgets by the City Council in substantially the forms submitted by the Mayor;
the ability of the City to implement cost reduction initiatives, and the
success with which the City controls expenditures; the impact on the City of
conditions in the real estate market on real estate revenues; and unanticipated
expenditures that may be incurred as a result of the need to maintain the
City's infrastructure.
Implementation of the City Plan is also dependent upon the City's ability
to market its securities successfully in the public credit markets. The City's
financing program for fiscal years 1999 through 2002 contemplates the issuance
of $5.2 billion of general obligation bonds and $5.4 billion of bonds to be
issued by the New York City Transitional Finance Authority (the "Finance
Authority"). The Finance Authority was created as part of the City's effort to
assist in keeping the City's indebtedness within the forecast level of the
constitutional restrictions on the amount of debt the City is authorized to
incur. In a challenge to the New York City Transitional Finance Authority Act
(the "Finance Authority Act"), the state trial court, by summary judgment on
November 25, 1997, held the Finance Authority Act to be constitutional. On
March 10, 1998, plaintiffs asked the State appellate court for a preliminary
injunction pending an appeal enjoining the Finance Authority from issuing
bonds. On March 25, 1998, the State appellate court denied plaintiff's request
for a preliminary injunction. In addition, the City issues revenue and tax
anticipation notes to finance its seasonal working capital requirements. The
success of projected public sales of City bonds and notes, New York City
Municipal Water Finance Authority ("Water Authority") bonds and Finance
Authority bonds will be subject to prevailing market conditions, and no
assurance can be given that such sales will be completed. The City's planned
capital and operating expenditures are dependent upon the sale of its general
obligation bonds and notes, and the Water Authority and Finance Authority
bonds. Future developments concerning the City and public discussion of such
developments, as well as prevailing market conditions, may affect the market
for outstanding City general obligation bonds and notes.
The Financial Plan assumes (i) approval by the Governor and the State
Legislature of the extension of the 14% personal income tax surcharge, which is
scheduled to expire on December 31, 1999, and of the extension of the 12.5%
personal income tax surcharge which is scheduled to expire on December 31,
1998;
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(ii) collection of the projected rent payments for the City's airports in the
1999 through 2002 fiscal years, which may depend on the successful completion
of negotiations with the Port Authority of New York and New Jersey or the
enforcement of the City's rights under the existing leases thereto through
pending legal actions; and (iii) State approval of the repeal of the Wicks Law
relating to contracting requirements for City construction projects and the
additional State funding assumed in the Financial Plan, and State and Federal
approval of the State and Federal gap-closing actions proposed by the City in
the Financial Plan. In addition, the economic and financial condition of the
City may be affected by various financial, social, economic and political
factors which could have a material effect on the City.
From time to time, the Control Board staff, the staff of the Office of the
State Deputy Comptroller of New York, the City Comptroller, the City's
Independent Budget Office and others issue reports and make public statements
regarding the City's financial condition, commenting on, among other matters,
the City's financial plans, projected revenues and expenditures and actions by
the City to eliminate projected operating deficits. Some of these reports and
statements have warned that the City may have underestimated certain
expenditures and overestimated certain revenues and have suggested that the
City may not have adequately provided for future contingencies. Certain of
these reports have analyzed the City's future economic and social conditions
and have questioned whether the City has the capacity to generate sufficient
revenues in the future to meet the costs of its expenditure increases and to
provide necessary services. It is reasonable to expect that reports and
statements will continue to be issued and to engender public comment.
The City since 1981 has fully satisfied its seasonal financing needs in
the public credit markets, repaying all short-term obligations within their
fiscal year of issuance. The City has issued $1.075 billion of short-term
obligations in fiscal year 1998 to finance the City's current estimate of its
seasonal cash flow needs for the 1998 fiscal year. The City issued $2.4 billion
of short-term obligations in fiscal year 1997. Seasonal financing requirements
for the 1996 fiscal year increased to $2.4 billion from $2.2 billion and $1.75
billion in the 1995 and 1994 fiscal years, respectively. The delay in the
adoption of the State's budget in certain past fiscal years has required the
City to issue short-term notes in amounts exceeding those expected early in
such fiscal year.
Certain localities, in addition to the City, could have financial problems
leading to requests for additional New York State assistance. The potential
impact on the State of such requests by localities was not included in the
State's projections of its receipts and disbursements.
Fiscal difficulties experienced by the City of Yonkers (Yonkers) resulted
in the creation of the Financial Control Board for the City of Yonkers (the
Yonkers Board) by New York State in 1984. The Yonkers Board is charged with
oversight of the fiscal affairs of Yonkers. Future actions taken by the State
to assist Yonkers could result in increased State expenditures for
extraordinary local assistance.
Beginning in 1990, the City of Troy experienced a series of budgetary
deficits that resulted in the establishment of a Supervisory Board for the City
of Troy in 1994. The Supervisory Board's powers were increased in 1995, when
Troy MAC was created to help Troy avoid default on certain obligations. The
legislation creating Troy MAC prohibits the City of Troy from seeking federal
bankruptcy protection while Troy MAC bonds are outstanding. Troy MAC has issued
bonds to effect a restructuring of the City of Troy's obligations.
Eighteen municipalities received extraordinary assistance during the 1996
legislative session through $50 million in special appropriations targeted for
distressed cities.
Municipalities and school districts have engaged in substantial short-term
and long-term borrowings. In 1995, the total indebtedness of all localities in
New York State other than New York City was approximately $19.0 billion. A
small portion (approximately $102.3 million) of that indebtedness represented
borrowing to finance budgetary deficits and was issued pursuant to enabling New
York State legislation. State law requires the Comptroller to review and make
recommendations concerning the budgets of those local government units other
than New York City authorized by State law to issue debt to finance deficits
during the period that such deficit financing is outstanding. Eighteen
localities had outstanding indebtedness for deficit financing at the close of
their fiscal year ending in 1995.
From time to time, federal expenditure reductions could reduce, or in some
cases eliminate, federal funding of some local programs and accordingly might
impose substantial increased expenditure requirements on affected localities.
If New York State, New York City or any of the Authorities were to suffer
serious financial difficulties jeopardizing their respective access to the
public credit markets, the marketability of notes and bonds issued by
localities within New York State could be adversely affected. Localities also
face anticipated and potential problems resulting from certain pending
litigation, judicial decisions and long-range economic trends. Long-range
potential problems of declining urban population, increasing expenditures and
other economic trends could adversely affect localities and require increasing
New York State assistance in the future.
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PORTFOLIO TRANSACTIONS
The Manager, pursuant to the Advisory Agreement dated July 20, 1990,
supplemented by letter agreement dated July 26, 1990, and subject to the
general control of the Company's Board of Directors, places all orders for the
purchase and sale of Fund securities. Purchases of Fund securities are made
either directly from the issuer or from dealers who deal in tax-exempt
securities. The Manager may sell Fund securities prior to maturity if
circumstances warrant and if it believes such disposition is advisable. In
connection with portfolio transactions for the Company, the Manager seeks
to obtain the best available net price and most favorable execution for its
orders. The Manager has no agreement or commitment to place transactions with
any broker-dealer and no regular formula is used to allocate orders to any
broker-dealer. However, the Manager may place security orders with brokers or
dealers who furnish research or other services to the Manager as long as there
is no sacrifice in obtaining the best overall terms available. Payment for such
services would be generated only through purchase of new issue fixed income
securities.
Such research and other services may include, for example: advice
concerning the value of securities, the advisability of investing in,
purchasing, or selling securities, and the availability of securities or the
purchasers or sellers of securities; analyses and reports concerning issuers,
industries, securities, economic factors and trends, portfolio strategy, and
performance of accounts; and various functions incidental to effecting
securities transactions, such as clearance and settlement. The Manager
continuously reviews the performance of the broker-dealers with whom it places
orders for transactions. The receipt of research from broker-dealers that
execute transactions on behalf of the Company may be useful to the Manager in
rendering investment management services to other clients (including affiliates
of the Manager), and conversely, such research provided by broker-dealers who
have executed transaction orders on behalf of other clients may be useful to
the Manager in carrying out its obligations to the Company. While such research
is available to and may be used by the Manager in providing investment advice
to all its clients (including affiliates of the Manager), not all of such
research may be used by the Manager for the benefit of the Company. Such
research and services will be in addition to and not in lieu of research and
services provided by the Manager, and the expenses of the Manager will not
necessarily be reduced by the receipt of such supplemental research. See THE
COMPANY'S MANAGER.
On occasions when the Manager deems the purchase or sale of a security to
be in the best interest of the Company, as well as the Manager's other clients,
the Manager, to the extent permitted by applicable laws and regulations, may
aggregate such securities to be sold or purchased for the Company with those to
be sold or purchased for other customers in order to obtain best execution and
lower brokerage commissions, if any. In such event, allocation of the
securities so purchased or sold, as well as the expenses incurred in the
transaction, will be made by the Manager in the manner it considers to be most
equitable and consistent with its fiduciary obligations to all such customers,
including the Company. In some instances, this procedure may impact the price
and size of the position obtainable for the Company.
The tax-exempt security market is typically a "dealer" market in which
investment dealers buy and sell bonds for their own accounts, rather than for
customers, and although the price may reflect a dealer's mark-up or mark-down,
the Company pays no brokerage commissions as such. In addition, some securities
may be purchased directly from issuers.
PORTFOLIO TURNOVER RATES
The portfolio turnover rate is computed by dividing the dollar amount of
securities purchased or sold (whichever is smaller) by the average value of
securities owned during the year.
The rate of portfolio turnover will not be a limiting factor when the
Manager deems changes in the New York Bond Fund's portfolio appropriate in view
of its investment objective. For example, securities may be sold in
anticipation of a rise in interest rates (market decline) or purchased in
anticipation of a decline in interest rates (market rise) and later sold. In
addition, a security may be sold and another security of comparable quality may
be purchased at approximately the same time in order to take advantage of what
the Fund believes to be a temporary disparity in the normal yield relationship
between the two securities. These yield disparities may occur for reasons not
directly related to the investment quality of particular issues or the general
movement of interest rates, such as changes in the overall demand for or supply
of various types of tax-exempt securities.
For the last two fiscal years the New York Bond Fund's portfolio turnover
rates were as follows:
1997. . . . . 41.42% 1998. . . . . 49.49%
Portfolio turnover rates have been calculated excluding short-term
variable rate securities, which are those with put date intervals of less than
one year.
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DESCRIPTION OF SHARES
The Funds are series of USAA Tax Exempt Fund, Inc. (the Company) and are
diversified. The Company is an open-end management investment company
incorporated under the laws of the State of Maryland on November 16, 1981. The
Company is authorized to issue shares of common stock in separate portfolios.
Ten such portfolios have been established, two of which are described in this
SAI. Under the Articles of Incorporation, the Board of Directors is authorized
to create new portfolios in addition to those already existing without
shareholder approval. The Company began offering shares of the New York Bond
and New York Money Market Funds in October 1990.
Each Fund's assets and all income, earnings, profits, and proceeds
thereof, subject only to the rights of creditors, are specifically allocated to
such Fund. They constitute the underlying assets of each Fund, are required to
be segregated on the books of account, and are to be charged with the expenses
of such Fund. Any general expenses of the Company not readily identifiable as
belonging to a particular Fund are allocated on the basis of the Funds'
relative net assets during the fiscal year or in such other manner as the Board
determines to be fair and equitable. Each share or each Fund represents an
equal proportionate interest in that Fund with every other share and is
entitled to dividends and distributions out of the net income and capital gains
belonging to that Fund when declared by the Board.
Under the provisions of the Bylaws of the Company, no annual meeting of
shareholders is required. Thus, there will ordinarily be no shareholder meeting
unless required by the 1940 Act. Under certain circumstances, however,
shareholders may apply to the Directors for shareholder information to obtain
signatures to request a special shareholder meeting. The Company may fill
vacancies on the Board or appoint new Directors if the result is that at least
two-thirds of the Directors have still been elected by shareholders. Moreover,
pursuant to the Bylaws of the Company, any Director may be removed by the
affirmative vote of a majority of the outstanding Company shares; and holders
of 10% or more of the outstanding shares of the Company can require Directors
to call a meeting of shareholders for the purpose of voting on the removal of
one or more Directors. The Company will assist in communicating to other
shareholders about the meeting. On any matter submitted to the shareholders,
the holder of each Fund share is entitled to one vote per share (with
proportionate voting for fractional shares) regardless of the relative net
asset values of the Funds' shares. However, on matters affecting an individual
Fund, a separate vote of the shareholders of that Fund is required.
Shareholders of a Fund are not entitled to vote on any matter which does not
affect that Fund but which requires a separate vote of another Fund. Shares do
not have cumulative voting rights, which means that holders of more than 50% of
the shares voting for the election of Directors can elect 100% of the Company's
Board of Directors, and the holders of less than 50% of the shares voting for
the election of Directors will not be able to elect any person as a Director.
Shareholders of a particular Fund might have the power to elect all of the
Directors of the Company because that Fund has a majority of the total
outstanding shares of the Company. When issued, each Fund's shares are fully
paid and nonassessable, have no pre-emptive or subscription rights, and are
fully transferable. There are no conversion rights.
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
TAXATION OF THE FUNDS
Each Fund intends to qualify as a regulated investment company under Subchapter
M of the Internal Revenue Code of 1986, as amended (the Code). Accordingly,
each Fund will not be liable for federal income taxes on its taxable net
investment income and net capital gains (capital gains in excess of capital
losses) that are distributed to shareholders, provided that each Fund
distributes at least 90% of its net investment income and net short-term
capital gain for the taxable year.
To qualify as a regulated investment company, a Fund must, among other
things, (1) derive in each taxable year at least 90% of its gross income from
dividends, interest, payments with respect to securities loans, gains from the
sale or other disposition of stock, securities, or foreign currencies, or other
income derived with respect to its business of investing in such stock,
securities or currencies (the 90% test) and (2) satisfy certain diversification
requirements at the close of each quarter of the Fund's taxable year.
Furthermore, to pay tax-exempt interest income dividends, at least 50% of the
value of each Fund's total assets at the close of each quarter of its taxable
year must consist of obligations the interest of which is exempt from federal
income tax. Each Fund intends to satisfy this requirement.
The Code imposes a nondeductible 4% excise tax on a regulated investment
company that fails to distribute during each calendar year an amount at least
equal to the sum of (1) 98% of its taxable net investment income for the
calendar year, (2) 98% of its capital gain net income for the twelve-month
period ending on October 31, and (3) any prior amounts not distributed. Each
Fund intends to make such distributions as are necessary to avoid imposition of
this excise tax.
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For federal income tax purposes, debt securities purchased by the Funds
may be treated as having original issue discount. Original issue discount
represents interest income for federal income tax purposes and can generally be
defined as the excess of the stated redemption price at maturity of a debt
obligation over the issue price. Original issue discount is treated for federal
income tax purposes as earned by the Funds, whether or not any income is
actually received, and therefore is subject to the distribution requirements of
the Code. However, original issue discount with respect to tax-exempt
obligations generally will be excluded from the Funds' taxable income, although
such discount will be included in gross income for purposes of the 90% test
described previously. Original issue discount with respect to tax-exempt
securities is accrued and added to the adjusted tax basis of such securities
for purposes of determining gain or loss upon sale or at maturity. Generally,
the amount of original issue discount is determined on the basis of a constant
yield to maturity which takes into account the compounding of accrued interest.
An investment in a stripped bond or stripped coupon will result in original
issue discount.
Debt securities may be purchased by the Funds at a market discount. Market
discount occurs when a security is purchased at a price less than the original
issue price adjusted for accrued original issue discount, if any. The Funds
intend to defer recognition of accrued market discount until maturity or other
disposition of the bond. For securities purchased at a market discount, the
gain realized on disposition will be treated as taxable ordinary income to the
extent it does not exceed accrued market discount on the bond.
The Funds may also purchase debt securities at a premium, I.E., at a
purchase price in excess of face amount. With respect to tax-exempt securities,
the premium must be amortized to the maturity date but no deduction is allowed
for the premium amortization. The amortized bond premium will reduce the Funds'
adjusted tax basis in the securities. For taxable securities, the premium may
be amortized if the Funds so elect. The amortized premium on taxable securities
is first offset against interest received on the securities and then allowed as
a deduction, and, for securities issued after September 27, 1985, must be
amortized under an economic accrual method.
TAXATION OF THE SHAREHOLDERS
Taxable distributions are generally included in a shareholder's gross income
for the taxable year in which they are received. Dividends declared in October,
November, or December and made payable to shareholders of record in such a
month will be deemed to have been received on December 31, if a Fund pays the
dividend during the following January. It is expected that none of the Funds'
distributions will qualify for the corporate dividends-received deduction.
To the extent that a Fund's dividends distributed to shareholders are
derived from interest income exempt from federal income tax and are designated
as "exempt-interest dividends" by a Fund, they will be excludable from a
shareholder's gross income for federal income tax purposes. Shareholders who
are recipients of Social Security benefits should be aware that exempt-interest
dividends received from a Fund are includible in their "modified adjusted gross
income" for purposes of determining the amount of such Social Security
benefits, if any, that are required to be included in their gross income.
All distributions of investment income during the year will have the same
percentage designated as tax-exempt. This method is called the "average annual
method." Since the Funds invest primarily in tax-exempt securities, the
percentage will be substantially the same as the amount actually earned during
any particular distribution period.
A shareholder of the New York Bond Fund should be aware that a redemption
of shares (including any exchange into another USAA Fund) is a taxable event
and, accordingly, a capital gain or loss may be recognized. If a shareholder
receives an exempt-interest dividend with respect to any share and such share
has been held for six months or less, any loss on the redemption or exchange
will be disallowed to the extent of such exempt-interest dividend. Similarly,
if a shareholder of the Fund receives a distribution taxable as long-term
capital gain with respect to shares of the Fund and redeems or exchanges shares
before he has held them for more than six months, any loss on the redemption or
exchange (not otherwise disallowed as attributable to an exempt-interest
dividend) will be treated as long-term capital loss.
The Funds may invest in private activity bonds. Interest on certain
private activity bonds issued after August 7, 1986, is an item of tax
preference for purposes of the Federal Alternative Minimum Tax (AMT), although
the interest continues to be excludable from gross income for other purposes.
AMT is a supplemental tax designed to ensure that taxpayers pay at least a
minimum amount of tax on their income, even if they make substantial use of
certain tax deductions and exclusions (referred to as tax preference items).
Interest from private activity bonds is one of the tax preference items that is
added to income from other sources for the purposes of determining whether a
taxpayer is subject to the AMT and the amount of any tax to be paid. For
corporate investors, alternative minimum taxable income is increased by 75% of
the amount by which adjusted current earnings (ACE) exceeds alternative minimum
taxable income before the ACE adjustment. For corporate taxpayers, all
tax-exempt interest is considered in calculating the AMT as part of the ACE.
Prospective investors should consult their own tax advisers with respect to the
possible application of the AMT to their tax situation.
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Opinions relating to the validity of tax-exempt securities and the
exemption of interest thereon from federal income tax are rendered by
recognized bond counsel to the issuers. Neither the Manager's nor the Funds'
counsel makes any review of the basis of such opinions.
DIRECTORS AND OFFICERS OF THE COMPANY
The Board of Directors of the Company consists of seven Directors who supervise
the business affairs of the Company. Set forth below are the Directors and
officers of the Company, and their respective offices and principal occupations
during the last five years. Unless otherwise indicated, the business address of
each is 9800 Fredericksburg Road, San Antonio, TX 78288.
Robert G. Davis 1, 2
Director and Chairman of the Board of Directors
Age: 51
Deputy Chief Executive Officer for Capital Management of USAA (6/98-present);
President, Chief Executive Officer, Director, and Vice Chairman of the Board of
Directors of USAA Capital Corporation and several of its subsidiaries and
affiliates (1/97-present); President, Chief Executive Officer, Director, and
Chairman of the Board of Directors of USAA Financial Planning Network, Inc.
(1/97-present); Executive Vice President, Chief Operating Officer, Director,
and Vice Chairman of the Board of Directors of USAA Financial Planning Network,
Inc. (9/96-1/97); Special Assistant to Chairman, United Services Automobile
Association (USAA) (6/96-12/96); President and Chief Executive Officer, Banc
One Credit Corporation (12/95-6/96); and President and Chief Executive Officer,
Banc One Columbus, (8/91-12/95). Mr. Davis serves as a Director/Trustee and
Chairman of the Boards of Directors/Trustees of each of the remaining funds
within the USAA Family of Funds; Director and Chairman of the Boards of
Directors of USAA Investment Management Company (IMCO), USAA Shareholder
Account Services, USAA Federal Savings Bank, and USAA Real Estate Company.
Michael J.C. Roth 1, 2
Director, President, and Vice Chairman of the Board of Directors
Age: 56
Chief Executive Officer, IMCO (10/93-present); President, Director, and Vice
Chairman of the Board of Directors, IMCO (1/90-present). Mr. Roth serves as
President, Director/Trustee, and Vice Chairman of the Boards of
Directors/Trustees of each of the remaining funds within the USAA Family of
Funds and USAA Shareholder Account Services; Director of USAA Life Insurance
Company; and Trustee and Vice Chairman of USAA Life Investment Trust.
John W. Saunders, Jr. 1, 2, 4
Director and Vice President
Age: 63
Senior Vice President, Fixed Income Investments, IMCO (10/85-present). Mr.
Saunders serves as a Director/Trustee of each of the remaining funds within the
USAA Family of Funds; Director of IMCO; Senior Vice President of USAA
Shareholder Account Services, and Vice President of USAA Life Investment Trust.
Barbara B. Dreeben 3, 4, 5
200 Patterson #1008
San Antonio, TX 78209
Director
Age: 53
President, Postal Addvantage (7/92-present); Consultant, Nancy Harkins
Stationer (8/91-12/95). Mrs. Dreeben serves as a Director/Trustee of each of
the remaining funds within the USAA Family of Funds.
Howard L. Freeman, Jr. 2, 3, 4, 5
2710 Hopeton
San Antonio, TX 78230
Director
Age: 63
Retired. Assistant General Manager for Finance, San Antonio City Public Service
Board (1976-1996). Mr. Freeman serves as a Director/Trustee of each of the
remaining funds within the USAA Family of Funds.
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Robert L. Mason, Ph.D. 3, 4, 5
12823 Queens Forest
San Antonio, TX 78230
Director
Age: 52
Manager, Statistical Analysis Section, Southwest Research Institute
(8/75-present). Dr. Mason serves as a Director/Trustee of the remaining funds
within each of the USAA Family of Funds.
Richard A. Zucker 3, 4, 5
407 Arch Bluff
San Antonio, TX 78216
Director
Age: 55
Vice President, Beldon Roofing and Remodeling (1985-present). Mr. Zucker serves
as a Director/Trustee of each of the remaining funds within the USAA Family of
Funds.
Michael D. Wagner 1
Secretary
Age: 50
Vice President, Corporate Counsel, USAA (1982-present). Mr. Wagner has held
various positions in the legal department of USAA since 1970 and serves as Vice
President, Secretary, and Counsel, IMCO and USAA Shareholder Account Services;
Secretary of each of the remaining funds within the USAA Family of Funds; and
Vice President, Corporate Counsel, for various other USAA subsidiaries and
affiliates.
Alex M. Ciccone 1
Assistant Secretary
Age: 48
Vice President, Compliance, IMCO (12/94-present); Vice President and Chief
Operating Officer, Commonwealth Shareholder Services (6/94-11/94); and Vice
President, Compliance, IMCO (12/91-5/94). Mr. Ciccone serves as Assistant
Secretary of each of the remaining funds within the USAA Family of Funds.
Mark S. Howard 1
Assistant Secretary
Age: 34
Assistant Vice President, Securities Counsel, USAA (2/98-present); Executive
Director, Securities Counsel, USAA (9/96-2/98); Senior Associate Counsel,
Securities Counsel, USAA (5/95-8/96); Attorney, Kirkpatrick & Lockhart LLP
(9/90-4/95). Mr. Howard serves as Assistant Vice President and Assistant
Secretary IMCO and USAA Shareholder Account Services; Assistant Secretary of
each of the remaining funds within the USAA Family of Funds; and Assistant Vice
President, Securities Counsel for various other USAA subsidiaries and
affiliates.
Sherron A. Kirk 1
Treasurer
Age: 53
Vice President, Controller, IMCO (10/92-present). Mrs. Kirk serves as Treasurer
of each of the remaining funds within the USAA Family of Funds; and Vice
President, Controller of USAA Shareholder Account Services.
Caryl Swann 1
Assistant Treasurer
Age: 50
Director, Mutual Fund Portfolio Analysis & Support, IMCO (2/98-present);
Manager, Mutual Fund Accounting, IMCO (7/92-2/98). Ms. Swann serves as
Assistant Treasurer for each of the remaining funds within the USAA Family of
Funds.
- --------------------
1 Indicates those Directors and officers who are employees of the Manager or
affiliated companies and are considered "interested persons" under the 1940
Act.
2 Member of Executive Committee
3 Member of Audit Committee
4 Member of Pricing and Investment Committee
5 Member of Corporate Governance Committee
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Between the meetings of the Board of Directors and while the Board is not
in session, the Executive Committee of the Board of Directors has all the
powers and may exercise all the duties of the Board of Directors in the
management of the business of the Company which may be delegated to it by the
Board. The Pricing and Investment Committee of the Board of Directors acts upon
various investment-related issues and other matters which have been delegated
to it by the Board. The Audit Committee of the Board of Directors reviews the
financial statements and the auditor's reports and undertakes certain studies
and analyses as directed by the Board. The Corporate Governance Committee of
the Board of Directors maintains oversight of the organization, performance,
and effectiveness of the Board and Independent Directors.
In addition to the previously listed Directors and/or officers of the
Company who also serve as Directors and/or officers of the Manager, the
following individuals are Directors and/or executive officers of the Manager:
Harry W. Miller, Senior Vice President, Investments (Equity); Carl W. Shirley,
Senior Vice President, Insurance Company Portfolios; and John J. Dallahan,
Senior Vice President, Investment Services. There are no family relationships
among the Directors, officers and managerial level employees of the Company, or
its Manager.
The following table sets forth information describing the compensation of
the current Directors of the Company for their services as Directors for the
fiscal year ended March 31, 1998.
NAME AGGREGATE TOTAL COMPENSATION
OF COMPENSATION FROM THE USAA
TRUSTEE FROM THE COMPANY FAMILY OF FUNDS (b)
------- ---------------- -------------------
Robert G. Davis None (a) None (a)
Barbara B. Dreeben $7,968 $29,500
Howard L. Freeman, Jr. $7,968 $29,500
Robert L. Mason $7,968 $29,500
Michael J.C. Roth None (a) None (a)
John W. Saunders, Jr. None (a) None (a)
Richard A. Zucker $7,968 $29,500
- -----------------
(a) Robert G. Davis, Michael J.C. Roth, and John W. Saunders, Jr. are
affiliated with the Company's investment adviser, IMCO, and, accordingly,
receive no remuneration from the Company or any other Fund of the USAA
Family of Funds.
(b) At March 31, 1998, the USAA Family of Funds consisted of four registered
investment companies offering 35 individual funds. Each Director presently
serves as a Trustee or Director of each investment company in the USAA
Family of Funds. In addition, Michael J.C. Roth presently serves as a
Trustee of USAA Life Investment Trust, a registered investment company
advised by IMCO, consisting of seven funds offered to investors in a fixed
and variable annuity contract with USAA Life Insurance Company. Mr. Roth
receives no compensation as Trustee of USAA Life Investment Trust.
All of the above Directors are also Trustees/Directors of the other funds
within the USAA Family of Funds. No compensation is paid by any fund to any
Trustee/Director who is a director, officer, or employee of IMCO or its
affiliates. No pension or retirement benefits are accrued as part of fund
expenses. The Company reimburses certain expenses of the Directors who are not
affiliated with the investment adviser. As of April 30, 1998, the officers and
Directors of the Company and their families as a group owned beneficially or of
record less than 1% of the outstanding shares of the Company.
The Company knows of no one person who, as of April 30, 1998, held of
record or owned beneficially 5% or more of either Fund's shares.
THE COMPANY'S MANAGER
As described in the Prospectus, USAA Investment Management Company is the
Manager and investment adviser, providing services under the Advisory
Agreement. The Manager, an affiliate of United Services Automobile Association
(USAA), a large, diversified financial services institution, was organized in
May 1970 and has served as investment adviser and underwriter for USAA Tax
Exempt Fund, Inc. from its inception.
In addition to managing the Company's assets, the Manager advises and
manages the investments for USAA and its affiliated companies as well as those
of USAA Mutual Fund, Inc., USAA Investment Trust, USAA State Tax-Free Trust,
and USAA Life Investment Trust. As of the date of this SAI, total assets under
management by the Manager were approximately $39 billion, of which
approximately $24 billion were in mutual fund portfolios.
ADVISORY AGREEMENT
Under the Advisory Agreement, the Manager provides an investment program,
carries out the investment policy, and manages the portfolio assets for each
Fund. The Manager is authorized, subject to the control of
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the Board of Directors of the Company, to determine the selection, amount, and
time to buy or sell securities for each Fund. In addition to providing
investment services, the Manager pays for office space, facilities, business
equipment, and accounting services (in addition to those provided by the
Custodian) for the Company. The Manager compensates all personnel, officers,
and Directors of the Company if such persons are also employees of the Manager
or its affiliates. For these services under the Advisory Agreement, the Company
has agreed to pay the Manager a fee computed as described under FUND
MANAGEMENT in the Prospectus. Management fees are computed and accrued daily
and payable monthly.
Except for the services and facilities provided by the Manager, the Funds
pay all other expenses incurred in their operations. Expenses for which the
Funds are responsible include taxes (if any); brokerage commissions on
portfolio transactions (if any); expenses of issuance and redemption of shares;
charges of transfer agents, custodians, and dividend disbursing agents; cost of
preparing and distributing proxy material; costs of printing and engraving
stock certificates; auditing and legal expenses; certain expenses of
registering and qualifying shares for sale; fees of Directors who are not
interested persons (not affiliated) of the Manager; costs of printing and
mailing the Prospectus, SAI, and periodic reports to existing shareholders; and
any other charges or fees not specifically enumerated. The Manager pays the
cost of printing and mailing copies of the Prospectus, the SAI, and reports to
prospective shareholders.
The Advisory Agreement will remain in effect until June 30, 1999, for each
Fund and will continue in effect from year to year thereafter for each Fund as
long as it is approved at least annually by a vote of the outstanding voting
securities of such Fund (as defined by the 1940 Act) or by the Board of
Directors (on behalf of such Fund) including a majority of the Directors who
are not interested persons of the Manager or (otherwise than as Directors) of
the Company, at a meeting called for the purpose of voting on such approval.
The Advisory Agreement may be terminated at any time by either the Company or
the Manager on 60 days' written notice. It will automatically terminate in the
event of its assignment (as defined in the 1940 Act).
From time to time the Manager may, without prior notice to shareholders,
waive all or any portion of fees or agree to reimburse expenses incurred by a
Fund. Any such waiver or reimbursement may be terminated by the Manager at any
time without prior notice to shareholders. The Manager has voluntarily agreed
to limit each Fund's annual expenses to .50% of its ANA until August 1, 1999,
and will reimburse the Funds for all expenses in excess of the limitations.
For the last three fiscal years, management fees were as follows:
1996 1997 1998
---- ---- ----
New York Bond Fund $242,866 $248,023 $272,778
New York Money Market Fund $154,397 $208,986 $217,662
Because the Funds' expenses exceeded the Manager's voluntary expense
limitation, the Manager did not receive management fees to which it would have
been entitled as follows:
1996 1997 1998
---- ---- ----
New York Bond Fund $102,918 $85,840 $71,681
New York Money Market Fund $ 97,382 $86,217 $71,994
UNDERWRITER
The Company has an agreement with the Manager for exclusive underwriting and
distribution of the Funds' shares on a continuing best efforts basis. This
agreement provides that the Manager will receive no fee or other compensation
for such distribution services.
TRANSFER AGENT
The Transfer Agent performs transfer agent services for the Company under a
Transfer Agency Agreement. Services include maintenance of shareholder account
records, handling of communications with shareholders, distribution of Fund
dividends, and production of reports with respect to account activity for
shareholders and the Company. For its services under the Transfer Agency
Agreement, each Fund pays the Transfer Agent an annual fixed fee of $26 per
account. This fee is subject to change at any time.
The fee to the Transfer Agent includes processing of all transactions and
correspondence. Fees are billed on a monthly basis at the rate of one-twelfth
of the annual fee. In addition, the Funds pay all out-of-pocket expenses of the
Transfer Agent and other expenses which are incurred at the specific direction
of the Company.
GENERAL INFORMATION
CUSTODIAN
State Street Bank and Trust Company, P.O. Box 1713, Boston, MA 02105, is the
Company's Custodian. The Custodian is responsible for, among other things,
safeguarding and controlling the Company's cash and securities, handling the
receipt and delivery of securities, and collecting interest on the Company's
investments.
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COUNSEL
Goodwin, Procter & Hoar LLP, Exchange Place, Boston, MA 02109, will review
certain legal matters for the Company in connection with the shares offered by
the Prospectus.
INDEPENDENT AUDITORS
KPMG Peat Marwick LLP, 112 East Pecan Suite 2400, San Antonio, TX 78205, is the
Company's independent auditor. In this capacity, the firm is responsible for
auditing the annual financial statements of the Funds and reporting thereon.
CALCULATION OF PERFORMANCE DATA
Information regarding total return and yield of each Fund is provided under
COULD THE VALUE OF YOUR INVESTMENT IN THESE FUNDS FLUCTUATE? in the Prospectus.
See VALUATION OF SECURITIES herein for a discussion of the manner in which each
Fund's price per share is calculated.
TOTAL RETURN
The New York Bond Fund may advertise performance in terms of average annual
total return for 1-, 5-, and 10-year periods, or for such lesser period as the
Fund has been in existence. Average annual total return is computed by finding
the average annual compounded rates of return over the periods that would
equate the initial amount invested to the ending redeemable value, according to
the following formula:
P(1 + T)n = ERV
Where: P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $1,000
payment made at the beginning of the 1-, 5-, or
10-year periods at the end of the year or period
The calculation assumes all charges are deducted from the initial $1,000
payment and assumes all dividends and distributions by such Fund are reinvested
at the price stated in the Prospectus on the reinvestment dates during the
period, and includes all recurring fees that are charged to all shareholder
accounts.
The date of commencement of operations for the New York Bond Fund was
October 15, 1990. The Fund's average annual total returns for the periods ended
March 31, 1998 were:
1 year..... 12.24% 5 years..... 6.31% Since inception..... 8.58%
YIELD
The New York Bond Fund may advertise performance in terms of a 30-day yield
quotation. The 30-day yield quotation is computed by dividing the net
investment income per share earned during the period by the maximum offering
price per share on the last day of the period, according to the following
formula:
YIELD = 2[((a-b)/(cd)+1)^6 -1]
Where: a = dividends and interest earned during the period
b = expenses accrued for the period (net of reimbursement)
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 the yield calculation, interest income is computed based
on the yield to maturity of each debt obligation in the Fund's portfolio and
all recurring charges are recognized.
The Fund's 30-day yield for the period ended March 31, 1998 was 4.54%.
YIELD - NEW YORK MONEY MARKET FUND
When the New York Money Market Fund quotes a current annualized yield, it is
based on a specified recent seven-calendar-day period. It is computed by (1)
determining the net change, exclusive of capital changes and income other than
investment income, in the value of a hypothetical preexisting account having a
balance of one share at the beginning of the period, (2) dividing the net
change in account value by the value of the account at the beginning of the
base period to obtain the base return, then (3) multiplying the base period
return by 52.14 (365/7). The resulting yield figure is carried to the nearest
hundredth of one percent.
The calculation includes (1) the value of additional shares purchased with
dividends on the original share, and dividends declared on both the original
share and any such additional shares and (2) any fees charged to all
shareholder accounts, in proportion to the length of the base period and the
Fund's average account size.
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<PAGE>
The capital changes excluded from the calculation are realized capital
gains and losses from the sale of securities and unrealized appreciation and
depreciation. The Fund's effective (compounded) yield will be computed by
dividing the seven-day annualized yield as defined above by 365, adding 1 to
the quotient, raising the sum to the 365th power, and subtracting 1 from the
result.
Current and effective yields fluctuate daily and will vary with factors
such as interest rates and the quality, length of maturities, and type of
investments in the portfolio.
Yield For 7-day Period Ended March 31, 1998, was 3.20%.
Effective Yield For 7-day Period Ended March 31, 1998, was 3.25%.
TAX EQUIVALENT YIELD
A tax-exempt mutual fund may provide more "take-home" income than a fully
taxable mutual fund after paying taxes. Calculating a "tax equivalent yield"
means converting a tax-exempt yield to a pretax equivalent so that a meaningful
comparison can be made between a tax-exempt municipal fund and a fully taxable
fund. The New York Money Market Fund may advertise performance in terms of a
tax equivalent yield based on the 7-day yield or effective yield and the New
York Bond Fund may advertise performance in terms of a 30-day tax equivalent
yield.
To calculate a tax equivalent yield, the New York investor must know his
Effective Marginal Tax Rate or EMTR. Assuming an investor can fully itemize
deductions on his or her federal tax return, the EMTR is the sum of the Federal
marginal tax rate and the state (and city if applicable) marginal tax rate
adjusted to reflect the deductibility of state (and city if applicable) taxes
from federal taxable income. The formula for computing the EMTR to compare with
fully taxable securities subject to federal, state, and city taxes is:
EMTR = Federal Marginal Tax Rate +
[State Marginal Tax Rate x (1-Federal Marginal Tax Rate)]
The tax equivalent yield is then computed by dividing the tax-exempt yield
of a fund by the complement of the EMTR. The complement, for example, of an
EMTR of 43.24% is 56.76%, that is (1.00-0.4324= 0.5676).
Tax Equivalent Yield = Tax Exempt Yield / (1-Effective Marginal Tax Rate)
Using a federal marginal tax rate of 36% and state and city marginal tax
rate of 11.31%, resulting in an EMTR of 43.24%, the tax equivalent yields for
the New York Bond and New York Money Market Funds for the period ended March
31, 1998 were 8.00% and 5.64%, respectively.
APPENDIX A - TAX-EXEMPT SECURITIES AND THEIR RATINGS
TAX-EXEMPT SECURITIES
Tax-exempt securities generally include debt obligations issued by states and
their political subdivisions, and duly constituted authorities and
corporations, to obtain funds to construct, repair or improve various public
facilities such as airports, bridges, highways, hospitals, housing, schools,
streets, and water and sewer works. Tax-exempt securities may also be issued to
refinance outstanding obligations as well as to obtain funds for general
operating expenses and for loans to other public institutions and facilities.
The two principal classifications of tax-exempt securities are "general
obligations" and "revenue" or "special tax" 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 or special tax bonds are payable
only from the revenues derived from a particular facility or class of
facilities or, in some cases, from the proceeds of a special excise or other
tax, but not from general tax revenues. The Funds may also invest in tax-exempt
private activity bonds, which in most cases are revenue bonds and generally do
not have the pledge of the credit of the issuer. The payment of the principal
and interest on such industrial revenue bonds is dependent 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. There are, of course, many variations in
the terms of, and the security underlying, tax-exempt securities. Short-term
obligations issued by states, cities, municipalities or municipal agencies,
include Tax Anticipation Notes, Revenue Anticipation Notes, Bond Anticipation
Notes, Construction Loan Notes, and Short-Term Notes.
The yields of tax-exempt securities depend on, among other things, general
money market conditions, conditions of the tax-exempt bond market, the size of
a particular offering, the maturity of the obligation, and the rating of the
issue. The ratings of Moody's Investors Service, Inc. (Moody's), Standard &
Poor's Ratings Group (S&P), Fitch IBCA, Inc. (Fitch), Duff & Phelps Inc., and
Thompson BankWatch, Inc. represent their opinions of the quality of the
securities rated by them. It should be emphasized that such ratings are general
and are not absolute standards of quality. Consequently, securities with the
same maturity, coupon, and rating may have different yields, while securities
of the same maturity and coupon but with different ratings may have the same
yield. It will be the responsibility of the Manager to appraise independently
the fundamental quality of the tax-exempt securities included in a Fund's
portfolio.
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1. LONG-TERM DEBT RATINGS:
MOODY'S INVESTOR SERVICES, INC.
Aaa Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally
referred to as "gilt edged." 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 Aaa
securities or fluctuation of protective elements may be of greater
amplitude or there may be other elements present which make the
long-term risk appear somewhat larger than in 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 lacking or may be
characteristically unreliable over any great length of time. Such
bonds lack outstanding investment characteristics and in fact have
speculative characteristics as well.
NOTE: MOODY'S APPLIES NUMERICAL MODIFIERS 1, 2, AND 3 IN EACH GENERIC RATING
CLASSIFICATION. THE MODIFIER 1 INDICATES THAT THE OBLIGATION RANKS IN THE
HIGHER END OF ITS GENERIC RATING CATEGORY, THE MODIFIER 2 INDICATES A MID-RANGE
RANKING, AND THE MODIFIER 3 INDICATES A RANKING IN THE LOWER END OF THAT
GENERIC RATING CATEGORY.
STANDARD & POOR'S RATINGS GROUP
AAA An obligation rated AAA has the highest rating assigned by Standard
& Poor's. The obligor's capacity to meet its financial commitment on
the obligation is EXTREMELY STRONG.
AA An obligation rated AA differs from the highest rated issues only in
small degree. The obligor's capacity to meet its financial commitment
on the obligation is VERY STRONG.
A An obligation rated A is somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than
obligations in higher rated categories. However, the obligor's
capacity to meet its financial commitment on the obligation is still
STRONG.
BBB An obligation rated BBB exhibits ADEQUATE capacity to pay interest and
repay principal. However, adverse economic conditions or changing
circumstances are more likely to lead to a weakened capacity of the
obligor to meet its financial commitment on the obligation.
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
RATING CATEGORIES.
FITCH IBCA, INC.
AAA Highest credit quality. "AAA" ratings denote the lowest expectation of
credit risk. They are assigned only in case of exceptionally strong
capacity for timely payment of financial commitments. This capacity is
highly unlikely to be adversely affected by foreseeable events.
AA Very high credit quality. "AA" ratings denote a very low expectation
of credit risk. They indicate very strong capacity for timely payment
of financial commitments. This capacity is not significantly
vulnerable to foreseeable events.
A High credit quality. "A" ratings denote a low expectation of credit
risk. The capacity for timely payment of financial commitments is
considered strong. This capacity may, nevertheless, be more vulnerable
to changes in circumstances or in economic conditions than is the case
for higher ratings.
BBB Good credit quality. "BBB" ratings indicate that there is currently a
low expectation of credit risk. The capacity for timely payment of
financial commitments is considered adequate, but adverse changes in
circumstances and in economic conditions are more likely to impair
this capacity. This is the lowest investment-grade category.
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.
DUFF & PHELPS, INC.
AAA Highest credit quality. The risk factors are negligible, being only
slightly more than for risk-free U.S. Treasury debt.
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AA High credit quality. Protection factors are strong. Risk is modest but
may vary slightly from time to time because of economic conditions.
A Protection factors are average but adequate. However, risk factors are
more variable and greater in periods of economic stress.
BBB Below average protection factors but still considered sufficient for
prudent investment. Considerable variability in risk during economic
cycles.
2. SHORT-TERM DEBT RATINGS:
MOODY'S STATE AND TAX-EXEMPT NOTES
MIG-1/VMIG1 This designation denotes best quality. There is present
strong protection by established cash flows, superior
liquidity support or demonstrated broad-based access to the
market for refinancing.
MIG-2/VMIG2 This designation denotes high quality. Margins of protection
are ample although not so large as in the preceding group.
MOODY'S COMMERCIAL PAPER
Prime-1 Issuers rated Prime-1 (or supporting institutions) have a superior
ability for repayment of senior short-term promissory obligations.
Prime-1 repayment capacity will normally be evidenced by the
following characteristics:
o Leading market positions in well-established industries.
o High rates of return on funds employed.
o Conservative capitalization structures with moderate reliance on
debt and ample asset protection.
o Broad margins in earning coverage of fixed financial charges and
high internal cash generation.
o Well-established access to a range of financial markets and
assured sources of alternate liquidity.
Prime-2 Issuers rated Prime-2 (or supporting institutions) have a strong
ability for repayment of senior short-term promissory obligations.
This will normally be evidenced by many of the characteristics cited
above but to a lesser degree. Earnings trends and coverage ratios,
while sound, may be more subject to variation. Capitalization
characteristics, while still appropriate, may be more affected by
external conditions. Ample alternate liquidity is maintained.
S&P TAX-EXEMPT NOTES
SP-1 Strong capacity to pay principal and interest. Issues determined to
possess very strong characteristics are given a plus (+) designation.
SP-2 Satisfactory capacity to pay principal and interest, with some
vulnerability to adverse financial and economic changes over the term
of the notes.
S&P COMMERCIAL PAPER
A-1 This highest category indicates that the degree of safety regarding
timely payment is strong. Those issues determined to possess extremely
strong safety characteristics are denoted with a plus (+) sign
designation.
A-2 Capacity for timely payment on issues with this designation is
satisfactory. However, the relative degree of safety is not as high as
for issues designated A-1.
FITCH'S COMMERCIAL PAPER, CERTIFICATES OF DEPOSIT, AND TAX-EXEMPT NOTES
F1 Highest credit quality. Indicates the strongest capacity for timely
payment of financial commitments; may have an added "+" to denote any
exceptionally strong credit features.
F2 Good credit quality. A satisfactory capacity for timely payment of
financial commitments, but the margin of safety is not as great as in
the case of the higher ratings.
F3 Fair credit quality. The capacity for timely payment of financial
commitments is adequate; however, near-term adverse changes could
result in a reduction to non-investment grade.
DUFF & PHELPS COMMERCIAL PAPER
D-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.
D-1 Very high certainty of timely payment. Liquidity factors are excellent
and supported by good fundamental protection factors. Risk factors are
minor.
D-1- High certainty of timely payment. Liquidity factors are strong and
supported by good fundamental protection factors. Risk factors are
very small.
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D-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.
THOMPSON BANKWATCH, INC.
TBW-1 The highest category; indicates a very high likelihood that principal
and interest will be paid on a timely basis.
TBW-2 The second highest category; while the degree of safety regarding
timely repayment of principal and interest is strong, the relative
degree of safety is not as high as for issues rated TBW-1.
TBW-3 The lowest investment-grade category; indicates that while the
obligation is more susceptible to adverse developments (both internal
and external) than those with higher ratings, the capacity to service
principal and interest in a timely fashion is considered adequate.
APPENDIX B - COMPARISON OF PORTFOLIO PERFORMANCE
Occasionally, we may make comparisons in advertising and sales literature
between the Funds contained in this SAI and other Funds in the USAA Family of
Funds. These comparisons may include such topics as risk and reward, investment
objectives, investment strategies, and performance.
Fund performance also may be compared to the performance of broad groups
of mutual funds with similar investment goals or unmanaged indexes of
comparable securities. Evaluations of Fund performance made by independent
sources may be used in advertisements concerning the Fund, including reprints
of, or selections from, editorials or articles about the Fund. The Fund or its
performance may also be compared to products and services not constituting
securities subject to registration under the Securities Act of 1933 such as,
but not limited to, certificates of deposit and money market accounts. Sources
for performance information and articles about the Fund may include but are not
restricted to the following:
AAII JOURNAL, a monthly association magazine for members of the American
Association of Individual Investors.
ARIZONA REPUBLIC, a newspaper which may cover financial and investment news.
AUSTIN AMERICAN-STATESMAN, a newspaper which may cover financial news.
BARRON'S, a Dow Jones and Company, Inc. business and financial weekly that
periodically reviews mutual fund performance data.
THE BOND BUYER, a daily newspaper which covers bond market news.
BUSINESS WEEK, a national business weekly that periodically reports the
performance rankings and ratings of a variety of mutual funds.
CHICAGO TRIBUNE, a newspaper which may cover financial news.
CONSUMER REPORTS, a monthly magazine which from time to time reports on
companies in the mutual fund industry.
DALLAS MORNING NEWS, a newspaper which may cover financial news.
DENVER POST, a newspaper which may quote financial news.
FINANCIAL PLANNING, a monthly magazine that periodically features companies in
the mutual fund industry.
FINANCIAL SERVICES WEEK, a weekly newspaper which covers financial news.
FINANCIAL WORLD, a monthly magazine which may periodically review mutual fund
companies.
FORBES, a national business publication that periodically reports the
performance of companies in the mutual fund industry.
FORTUNE, a national business publication that periodically rates the
performance of a variety of mutual funds.
FUND ACTION, a mutual fund news report.
HOUSTON CHRONICLE, a newspaper which may cover financial news.
HOUSTON POST, a newspaper which may cover financial news.
IBC'S MONEYLETTER, a biweekly newsletter which covers financial news and from
time to time rates specific mutual funds.
IBC'S MONEY FUND REPORT, a weekly publication of IBC Financial Data, Inc.,
reporting on the performance of the nation's money market funds, summarizing
money market fund activity, and including certain averages as performance
benchmarks, specifically: (1) Taxable Money Fund Averages: "100% U.S. Treasury"
and "First Tier" and (2) Tax-Free Money Fund Averages: "Stockbroker and General
Purpose" and "State Specific Stockbroker and General Purpose."
26
<PAGE>
IBC'S MONEY MARKET INSIGHT, a monthly money market industry analysis prepared
by IBC Financial Data, Inc.
INCOME AND SAFETY, a monthly newsletter that rates mutual funds.
INVESTECH, a bimonthly investment newsletter.
INVESTMENT ADVISOR, a monthly publication directed primarily to the advisor
community; includes ranking of mutual funds using a proprietary methodology.
INVESTMENT COMPANY INSTITUTE, a national association of the American Investment
Company industry.
INVESTOR'S BUSINESS DAILY, a newspaper which covers financial news.
KIPLINGER'S PERSONAL FINANCE MAGAZINE, a monthly investment advisory
publication that periodically features the performance of a variety of
securities.
LIPPER ANALYTICAL SERVICES, INC.'S EQUITY FUND PERFORMANCE ANALYSIS, a weekly
and monthly publication of industry-wide mutual fund performance averages by
type of fund.
LIPPER ANALYTICAL SERVICES, INC.'S FIXED INCOME FUND PERFORMANCE ANALYSIS, a
monthly publication of industry-wide mutual fund performance averages by type
of fund.
LOS ANGELES TIMES, a newspaper which may cover financial news.
LOUIS RUKEYSER'S WALL STREET, a publication for investors.
MEDICAL ECONOMICS, a monthly magazine providing information to the medical
profession.
MONEY, a monthly magazine that features the performance of both specific funds
and the mutual fund industry as a whole.
MORNINGSTAR 5 STAR INVESTOR, a monthly newsletter which covers financial news
and rates mutual funds produced by Morningstar, Inc. (a data service which
tracks open-end mutual funds).
MUNI BOND FUND REPORT, a monthly newsletter which covers news on the municipal
bond market and features performance data for municipal bond mutual funds.
MUNIWEEK, a weekly newspaper which covers news on the municipal bond market.
MUTUAL FUND FORECASTER, a monthly newsletter that ranks mutual funds.
MUTUAL FUND INVESTING, a newsletter covering mutual funds.
MUTUAL FUND PERFORMANCE REPORT, a monthly publication of industry-wide mutual
fund averages produced by Morningstar, Inc.
MUTUAL FUNDS MAGAZINE, a monthly publication reporting on mutual fund
investing.
MUTUAL FUND SOURCE BOOK, an annual publication produced by Morningstar, Inc.
which describes and rates mutual funds.
MUTUAL FUND VALUES, a biweekly guidebook to mutual funds produced by
Morningstar, Inc.
NEWSWEEK, a national business weekly.
NEW YORK TIMES, a newspaper which may cover financial news.
NO LOAD FUND INVESTOR, a newsletter covering companies in the mutual fund
industry.
ORLANDO SENTINEL, a newspaper which may cover financial news.
PERSONAL INVESTOR, a monthly magazine which from time to time features mutual
fund companies and the mutual fund industry.
SAN ANTONIO BUSINESS JOURNAL, a weekly newspaper that periodically covers
mutual fund companies as well as financial news.
SAN ANTONIO EXPRESS-NEWS, a newspaper which may cover financial news.
SAN FRANCISCO CHRONICLE, a newspaper which may cover financial news.
SMART MONEY, a monthly magazine featuring news and articles on investing and
mutual funds.
USA TODAY, a newspaper which may cover financial news.
U.S. NEWS AND WORLD REPORT, a national business weekly that periodically
reports mutual fund performance data.
WALL STREET JOURNAL, a Dow Jones and Company, Inc. newspaper which covers
financial news.
WASHINGTON POST, a newspaper which may cover financial news.
WEISENBERGER MUTUAL FUNDS INVESTMENT REPORT, a monthly newsletter that reports
on both specific mutual fund companies and the mutual fund industry as a whole.
WORTH, a magazine which covers financial and investment subjects including
mutual funds.
YOUR MONEY, a monthly magazine directed towards the novice investor.
27
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In addition to the sources above, performance of our Funds may also be
tracked by Lipper Analytical Services, Inc. Each Fund will be compared to
Lipper's appropriate fund category according to objective and portfolio
holdings. The New York Bond Fund will be compared to funds in Lipper's New York
Municipal Debt Funds category, and the New York Money Market Fund to funds in
Lipper's New York Tax-Exempt Money Market Funds category. Footnotes in
advertisements and other sales literature will include the time period
applicable for any rankings used.
For comparative purposes, unmanaged indices of comparable securities or
economic data may be cited. Examples include the following:
--Shearson Lehman Hutton Bond Indices, indices of fixed-rate debt issues
rated investment grade or higher which can be found in the BOND MARKET REPORT.
--Bond Buyer Indices, indices of debt of varying maturities including
revenue bonds, general obligation bonds, and U.S. Treasury bonds which can be
found in MUNIWEEK and THE BOND BUYER.
Other sources for total return and other performance data which may be
used by the Funds or by those publications listed previously are Morningstar,
Inc., Schabaker Investment Management, and Investment Company Data, Inc. These
are services that collect and compile data on mutual fund companies.
APPENDIX C - DOLLAR-COST AVERAGING
Dollar-cost averaging is a systematic investing method which can be used by
investors as a disciplined technique for investing. A fixed amount of money is
invested in a security (such as a stock or mutual fund) on a regular basis over
a period of time, regardless of whether securities markets are moving up or
down.
This practice reduces average share costs to the investor who acquires
more shares in periods of lower securities prices and fewer shares in periods
of higher prices.
While dollar-cost averaging does not assure a profit or protect against
loss in declining markets, this investment strategy is an effective way to help
calm the effect of fluctuations in the financial markets. Systematic investing
involves continuous investment in securities regardless of fluctuating price
levels of such securities. Investors should consider their financial ability to
continue purchases through periods of low and high price levels.
As the following chart illustrates, dollar-cost averaging tends to keep
the overall cost of shares lower. This example is for illustration only, and
different trends would result in different average costs.
HOW DOLLAR-COST AVERAGING WORKS
$100 Invested Regularly for 5 Periods
Market Trend
--------------------------------------------------------------------
Down Up Mixed
------------------- --------------------- -----------------------
Share Shares Share Shares Share Shares
Investment Price Purchased Price Purchased Price Purchased
------------------- --------------------- -----------------------
$100 10 10 6 16.67 10 10
100 9 11.1 7 14.29 9 11.1
100 8 12.5 7 14.29 8 12.5
100 8 12.5 9 11.1 9 11.1
100 6 16.67 10 10 10 10
- ---- -- ----- -- ----- -- -----
$500 ***41 62.77 ***39 66.35 ***46 54.7
*Avg. Cost: $7.97 *Avg. Cost: $7.54 *Avg. Cost: $9.14
----- ----- -----
**Avg. Price: $8.20 **Avg. Price: $7.80 **Avg. Price: $9.20
----- ----- -----
* Average Cost is the total amount invested divided by number of
shares purchased.
** Average Price is the sum of the prices paid divided by number
of purchases.
*** Cumulative total of share prices used to compute average prices.
17005-0898
28
<PAGE>
USAA USAA TAX STATEMENT OF
EAGLE EXEMPT ADDITIONAL INFORMATION
LOGO FUND, INC. August 1, 1998
- -------------------------------------------------------------------------------
USAA TAX EXEMPT FUND, INC.
VIRGINIA FUNDS
USAA TAX EXEMPT FUND, INC. (the Company) is a registered investment company
offering shares of ten no-load mutual funds, two of which are described in this
Statement of Additional Information (SAI): the Virginia Bond Fund and Virginia
Money Market Fund (collectively, the Funds or the Virginia Funds). Each Fund is
classified as diversified and has a common investment objective of providing
Virginia investors with a high level of current interest income that is exempt
from federal and Virginia state income taxes. The Virginia Money Market Fund
has a further objective of preserving capital and maintaining liquidity.
You may obtain a free copy of a Prospectus dated August 1, 1998, for the
Virginia Funds by writing to USAA Tax Exempt Fund, Inc., 9800 Fredericksburg
Road, San Antonio, TX 78288, or by calling toll free 1-800-531-8181. The
Prospectus provides the basic information you should know before investing in
the Funds. This SAI is not a Prospectus and contains information in addition to
and more detailed than that set forth in the Prospectus. It is intended to
provide you with additional information regarding the activities and operations
of the Company and the Funds, and should be read in conjunction with the
Prospectus.
The financial statements of the Funds and the Independent Auditors' Report
thereon for the fiscal year ended March 31, 1998, are included in the Annual
Report to Shareholders of that date and are incorporated herein by reference.
- -------------------------------------------------------------------------------
TABLE OF CONTENTS
PAGE
2 Valuation of Securities
2 Conditions of Purchase and Redemption
3 Additional Information Regarding Redemption of Shares
4 Investment Plans
4 Investment Policies
6 Investment Restrictions
7 Special Risk Considerations
9 Portfolio Transactions
10 Description of Shares
10 Certain Federal Income Tax Considerations
12 Virginia Taxation
12 Directors and Officers of the Company
15 The Company's Manager
16 General Information
16 Calculation of Performance Data
18 Appendix A - Tax-Exempt Securities and Their Ratings
21 Appendix B - Comparison of Portfolio Performance
23 Appendix C - Dollar-Cost Averaging
<PAGE>
VALUATION OF SECURITIES
Shares of each Fund are offered on a continuing best efforts basis through USAA
Investment Management Company (IMCO or the Manager). The offering price for
shares of each Fund is equal to the current net asset value (NAV) per share.
The NAV value per share of each Fund is calculated by adding the value of all
its portfolio securities and other assets, deducting its liabilities, and
dividing by the number of shares outstanding.
A Fund's NAV per share is calculated each day, Monday through Friday,
except days on which the New York Stock Exchange (NYSE) is closed. The NYSE is
currently scheduled to be closed on New Year's Day, Martin Luther King, Jr.
Day, Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day,
Thanksgiving, and Christmas, and on the preceding Friday or subsequent Monday
when one of these holidays falls on a Saturday or Sunday, respectively.
The investments of the VIRGINIA BOND FUND are valued each business day by
a pricing service (the Service) approved by the Company's Board of Directors.
The Service uses the mean between quoted bid and asked prices or the last sale
price to price securities when, in the Service's judgment, these prices are
readily available and are representative of the securities' market values. For
many securities, such prices are not readily available. The Service generally
prices these securities based on methods which include consideration of yields
or prices of tax-exempt securities of comparable quality, coupon, maturity and
type, indications as to values from dealers in securities, and general market
conditions. Securities purchased with maturities of 60 days or less are stated
at amortized cost which approximates market value. Repurchase agreements are
valued at cost. Securities which cannot be valued by the Service, and all other
assets, are valued in good faith at fair value using methods determined by the
Manager under the general supervision of the Board of Directors.
The value of the VIRGINIA MONEY MARKET FUND'S securities is stated at
amortized cost which approximates market value. This involves valuing a
security at its cost and thereafter assuming a constant amortization to
maturity of any discount or premium, regardless of the impact of fluctuating
interest rates. While this method provides certainty in valuation, it may
result in periods during which the value of an instrument, as determined by
amortized cost, is higher or lower than the price the Fund would receive upon
the sale of the instrument.
The valuation of the Virginia Money Market Fund's portfolio instruments
based upon their amortized cost is subject to the Fund's adherence to certain
procedures and conditions. Consistent with regulatory requirements, the Manager
will only purchase securities with remaining maturities of 397 days or less and
will maintain a dollar-weighted average portfolio maturity of no more than 90
days. The Manager will invest only in securities that have been determined to
present minimal credit risk and that satisfy the quality and diversification
requirements of applicable rules and regulations of the Securities and Exchange
Commission (SEC).
The Board of Directors has established procedures designed to stabilize
the Virginia Money Market Fund's price per share, as computed for the purpose
of sales and redemptions, at $1. There can be no assurance, however, that the
Fund will at all times be able to maintain a constant $1 NAV per share. Such
procedures include review of the Fund's holdings at such intervals as is deemed
appropriate to determine whether the Fund's NAV calculated by using available
market quotations deviates from $1 per share and, if so, whether such deviation
may result in material dilution or is otherwise unfair to existing
shareholders. In the event that it is determined that such a deviation exists,
the Board of Directors will take such corrective action as it regards necessary
and appropriate. Such action may include selling portfolio instruments prior to
maturity to realize capital gains or losses or to shorten average portfolio
maturity, withholding dividends, or establishing a NAV per share by using
available market quotations.
CONDITIONS OF PURCHASE AND REDEMPTION
NONPAYMENT
If any order to purchase shares is canceled due to nonpayment or if the Company
does not receive good funds either by check or electronic funds transfer, USAA
Shareholder Account Services (Transfer Agent) will treat the cancellation as a
redemption of shares purchased, and you will be responsible for any resulting
loss incurred by the Fund or the Manager. If you are a shareholder, the
Transfer Agent can redeem shares from your account(s) as reimbursement for all
losses. In addition, you may be prohibited or restricted from making future
purchases in any of the USAA Family of Funds. A $15 fee is charged for all
returned items, including checks and electronic funds transfers.
TRANSFER OF SHARES
You may transfer Fund shares to another person by sending written instructions
to the Transfer Agent. The account must be clearly identified, and you must
include the number of shares to be transferred, the
2
<PAGE>
signatures of all registered owners, and all stock certificates, if any, which
are the subject of transfer. You also need to send written instructions signed
by all registered owners and supporting documents to change an account
registration due to events such as divorce, marriage, or death. If a new
account needs to be established, you must complete and return an application to
the Transfer Agent.
ADDITIONAL INFORMATION REGARDING REDEMPTION OF SHARES
The value of your investment at the time of redemption may be more or less than
the cost at purchase, depending on the value of the securities held in each
Fund's portfolio. Requests for redemption which are subject to any special
conditions, or which specify an effective date other than as provided herein,
cannot be accepted. A gain or loss for tax purposes may be realized on the sale
of shares, depending upon the price when redeemed.
The Board of Directors may cause the redemption of an account with a
balance of less than 50 shares provided (1) the value of the account has been
reduced, for reasons other than market action, below the minimum initial
investment in such Fund at the time of the establishment of the account, (2)
the account has remained below the minimum level for six months, and (3) 60
days' prior written notice of the proposed redemption has been sent to you.
Shares will be redeemed at the NAV on the date fixed for redemption by the
Board of Directors. Prompt payment will be made by mail to your last known
address.
The Company reserves the right to suspend the right of redemption or
postpone the date of payment (1) for any periods during which the NYSE is
closed, (2) when trading in the markets the Company normally utilizes is
restricted, or an emergency exists as determined by the SEC so that disposal of
the Company's investments or determination of its NAV is not reasonably
practicable, or (3) for such other periods as the SEC by order may permit for
protection of the Company's shareholders.
For the mutual protection of the investor and the Funds, the Company may
require a signature guarantee. If required, EACH signature on the account
registration must be guaranteed. Signature guarantees are acceptable from FDIC
member banks, brokers, dealers, municipal securities dealers, municipal
securities brokers, government securities dealers, government securities
brokers, credit unions, national securities exchanges, registered securities
associations, clearing agencies, and savings associations. A signature
guarantee for active duty military personnel stationed abroad may be provided
by an officer of the United States Embassy or Consulate, a staff officer of the
Judge Advocate General, or an individual's commanding officer.
REDEMPTION BY CHECK
Shareholders in the Virginia Money Market Fund may request that checks be
issued for their account. Checks must be written in amounts of at least $250.
Checks issued to shareholders of the Fund will be sent only to the person
in whose name the account is registered and only to the address of record. The
checks must be manually signed by the registered owner(s) exactly as the
account is registered. For joint accounts the signature of either or both joint
owners will be required on the check, according to the election made on the
signature card. You will continue to earn dividends until the shares are
redeemed by the presentation of a check.
When a check is presented to the Transfer Agent for payment, a sufficient
number of full and fractional shares from your account will be redeemed to
cover the amount of the check. If the account's balance is not adequate to
cover the amount of a check, the check will be returned unpaid. Because the
value of each account changes as dividends are accrued on a daily basis, checks
may not be used to close an account.
The checkwriting privilege is subject to the customary rules and
regulations of State Street Bank and Trust Company (State Street Bank or the
Custodian) governing checking accounts. There is no charge to you for the use
of the checks or for subsequent reorders of checks.
The Company reserves the right to assess a processing fee against your
account for any redemption check not honored by a clearing or paying agent.
Currently, this fee is $15 and is subject to change at any time. Some examples
of such dishonor are improper endorsement, checks written for an amount less
than the minimum check amount, and insufficient or uncollectible funds.
The Company, the Transfer Agent, and State Street Bank each reserve the
right to change or suspend the checkwriting privilege upon 30 days' written
notice to participating shareholders.
You may request that the Transfer Agent stop payment on a check. The
Transfer Agent will use its best efforts to execute stop payment instructions,
but does not guarantee that such efforts will be effective. The Transfer Agent
will charge you $10 for each stop payment you request.
3
<PAGE>
INVESTMENT PLANS
The Company makes available the following investment plans to shareholders of
the Funds. At the time you sign up for any of the following investment plans
that utilize the electronic funds transfer service, you will choose the day of
the month (the effective date) on which you would like to regularly purchase
shares. When this day falls on a weekend or holiday, the electronic transfer
will take place on the last business day before the effective date. You may
terminate your participation in a plan at any time. Please call the Manager for
details and necessary forms or applications.
AUTOMATIC PURCHASE OF SHARES
INVESTRONIC(R) - The regular purchase of additional shares through electronic
funds transfer from a checking or savings account. You may invest as little as
$50 per month.
DIRECT PURCHASE SERVICE - The periodic purchase of shares through electronic
funds transfer from an employer (including government allotments and social
security), an income-producing investment, or an account with a participating
financial institution.
AUTOMATIC PURCHASE PLAN - The periodic transfer of funds from a USAA money
market fund to purchase shares in another non-money market USAA mutual fund.
There is a minimum investment required for this program of $5,000 in the money
market fund, with a monthly transaction minimum of $50.
BUY/SELL SERVICE - The intermittent purchase or redemption of shares through
electronic funds transfer to or from a checking or savings account. You may
initiate a "buy" or "sell" whenever you choose.
DIRECTED DIVIDENDS - If you own shares in more than one of the Funds in the
USAA Family of Funds, you may direct that dividends and/or capital gain
distributions earned in one fund be used to purchase shares automatically in
another fund.
Participation in these systematic purchase plans allows you to engage in
dollar-cost averaging. For additional information concerning the benefits of
dollar-cost averaging, see APPENDIX C.
SYSTEMATIC WITHDRAWAL PLAN
If you own shares having a NAV of $5,000 or more in a single investment account
(accounts in different Funds cannot be aggregated for this purpose), you may
request that enough shares to produce a fixed amount of money be liquidated
from the account monthly or quarterly. The amount of each withdrawal must be at
least $50. Using the electronic funds transfer service, you may choose to have
withdrawals electronically deposited at your bank or other financial
institution. You may also elect to have checks mailed to a designated address.
This plan may be initiated by depositing shares worth at least $5,000 with
the Transfer Agent and by completing the Systematic Withdrawal Plan
application, which may be requested from the Manager. You may terminate
participation in the plan at any time. You are not charged for withdrawals
under the Systematic Withdrawal Plan. The Company will not bear any expenses in
administering the plan beyond the regular transfer agent and custodian costs of
issuing and redeeming shares. The Manager will bear any additional expenses of
administering the plan.
Withdrawals will be made by redeeming full and fractional shares on the
date you select at the time the plan is established. Withdrawal payments made
under this plan may exceed dividends and distributions and, to this extent,
will involve the use of principal and could reduce the dollar value of your
investment and eventually exhaust the account. Reinvesting dividends and
distributions helps replenish the account. Because share values and net
investment income can fluctuate, you should not expect withdrawals to be offset
by rising income or share value gains.
Each redemption of shares may result in a gain or loss, which must be
reported on your income tax return. Therefore, you should keep an accurate
record of any gain or loss on each withdrawal.
INVESTMENT POLICIES
The sections captioned WHAT ARE EACH FUND'S INVESTMENT OBJECTIVE AND MAIN
STRATEGIES? and FUND INVESTMENTS in the Prospectus describe the fundamental
investment objectives and the investment policies applicable to each Fund. Each
Fund's objective cannot be changed without shareholder approval. The following
is provided as additional information.
CALCULATION OF PORTFOLIO WEIGHTED AVERAGE MATURITIES
Weighted average maturity is derived by multiplying the value of each
investment by the number of days remaining to its maturity, adding the results
of these calculations, and then dividing the total by the value of the Fund's
portfolio. An obligation's maturity is typically determined on a stated final
maturity basis, although there are some exceptions to this rule.
With respect to obligations held by the Virginia Bond Fund, if it is probable
that the issuer of an instrument will take advantage of a maturity-shortening
device, such as a call, refunding, or redemption
4
<PAGE>
provision, the date on which the instrument will probably be called, refunded,
or redeemed may be considered to be its maturity date. Also, the maturities of
securities subject to sinking fund arrangements are determined on a weighted
average life basis, which is the average time for principal to be repaid. The
weighted average life of these securities is likely to be substantially shorter
than their stated final maturity. In addition, for purposes of the Fund's
investment policies, an instrument will be treated as having a maturity earlier
than its stated maturity date if the instrument has technical features such as
puts or demand features which, in the judgment of the Manager, will result in
the instrument being valued in the market as though it has the earlier
maturity.
The Virginia Money Market Fund will determine the maturity of an
obligation in its portfolio in accordance with Rule 2a-7 under the Investment
Company Act of 1940, as amended (1940 Act).
LENDING OF SECURITIES
Each Fund may lend its securities. A lending policy may be authorized by the
Company's Directors and implemented by the Manager, but securities may be
loaned only to qualified broker-dealers or institutional investors that agree
to maintain cash collateral with the Company equal at all time to at least 100%
of the value of the loaned securities. The Directors will establish procedures
and monitor the creditworthiness of any institution or broker-dealer during
such time as any loan is outstanding. The Company will continue to receive
interest on the loaned securities and will invest the cash collateral in
readily marketable short-term obligations of high quality, thereby earning
additional interest. Interest on loaned tax-exempt securities received by the
borrower and paid to the Company will not be exempt from federal income taxes
in the hands of the Company.
No loan of securities will be made if, as a result, the aggregate of such
loans would exceed 33 1/3% of the value of a Fund's total assets. The Company
may terminate such loans at any time.
REPURCHASE AGREEMENTS
Each Fund may invest up to 5% of its total assets in repurchase agreements. A
repurchase agreement is a transaction in which a security is purchased with a
simultaneous commitment to sell the security back to the seller (a commercial
bank or recognized securities dealer) at an agreed upon price on an agreed upon
date, usually not more than seven days from the date of purchase. The resale
price reflects the purchase price plus an agreed upon market rate of interest
which is unrelated to the coupon rate or maturity of the purchased security. A
repurchase agreement involves the obligation of the seller to pay the agreed
upon price, which obligation is in effect secured by the value of the
underlying security. In these transactions, the securities purchased by a Fund
will have a total value equal to or in excess of the amount of the repurchase
obligation and will be held by the Funds' custodian until repurchased. If the
seller defaults and the value of the underlying security declines, a Fund may
incur a loss and may incur expenses in selling the collateral. If the seller
seeks relief under the bankruptcy laws, the disposition of the collateral may
be delayed or limited. Any investments in repurchase agreements will give rise
to income which will not qualify as tax-exempt income when distributed by a
Fund.
WHEN-ISSUED SECURITIES
Each Fund may invest in new issues of tax-exempt securities offered on a
when-issued basis; that is, delivery and payment take place after the date of
the commitment to purchase, normally within 45 days. Both price and interest
rate are fixed at the time of commitment. The Funds do not earn interest on the
securities until settlement, and the market value of the securities may
fluctuate between purchase and settlement. Such securities can be sold before
settlement date.
Cash or high quality liquid debt securities equal to the amount of the
when-issued commitments are segregated at the Fund's custodian bank. The
segregated securities are valued at market, and daily adjustments are made to
keep the value of the cash and segregated securities at least equal to the
amount of such commitments by the Fund. On the settlement date, the Fund will
meet its obligations from then available cash, sale of segregated securities,
sale of other securities, or sale of the when-issued securities themselves.
MUNICIPAL LEASE OBLIGATIONS
Each Fund may invest in municipal lease obligations and certificates of
participation in such obligations (collectively, lease obligations). A lease
obligation does not constitute a general obligation of the municipality for
which the municipality's taxing power is pledged, although the lease obligation
is ordinarily backed by the municipality's covenant to budget for the payments
due under the lease obligation.
Certain lease obligations contain "non-appropriation" clauses which
provide that the municipality has no obligation to make lease obligation
payments in future years unless money is appropriated for such purpose on a
yearly basis. Although "non-appropriation" lease obligations are secured by the
leased property, disposition of the property in the event of foreclosure might
prove difficult. In evaluating a potential investment in such a lease
obligation, the Manager will consider: (1) the credit quality of the obligor,
(2) whether the underlying property is essential to a governmental function,
and (3) whether the lease obligation contains covenants prohibiting the obligor
from substituting similar property if the obligor fails to make appropriations
for the lease obligation.
5
<PAGE>
TEMPORARY DEFENSIVE POLICY
Each Fund may on a temporary basis because of market, economic, political, or
other conditions invest up to 100% of its assets in short-term securities
whether or not they are exempt from federal and Virginia state income taxes.
Such taxable securities may consist of obligations of the U.S. Government, its
agencies or instrumentalities, and repurchase agreements secured by such
instruments.
OTHER POLICIES
Although the Virginia Bond Fund is permitted to invest in options, financial
futures contracts, and options on financial futures contracts, the Fund has no
current intention of doing so and will not invest in such securities without
first notifying shareholders and supplying further information in the
Prospectus.
INVESTMENT RESTRICTIONS
The following investment restrictions have been adopted by the Company for each
Fund. These restrictions may not be changed for any given Fund without approval
by the lesser of (1) 67% or more of the voting securities present at a meeting
of the Fund if more than 50% of the outstanding voting securities of the Fund
are present or represented by proxy or (2) more than 50% of the Fund's
outstanding voting securities. The investment restrictions of one Fund may be
changed without affecting those of the other Fund.
Under the restrictions, neither Fund will:
(1) with respect to 75% of its total assets, purchase securities of any
issuer (other than a security issued or guaranteed as to principal or
interest by the United States, or by a person controlled or supervised by
and acting as an instrumentality of the Government of the United States;
or any certificate of deposit for any of the foregoing) if as a result
more than 5% of the total assets of that Fund would be invested in
securities of such issuer; for purposes of this limitation,
identification of the "issuer" will be based on a determination of the
source of assets and revenues committed to meeting interest and principal
payments of each security; for purposes of this limitation the
Commonwealth of Virginia or other jurisdictions and each of its separate
political subdivisions, agencies, authorities, and instrumentalities
shall be treated as a separate issuer;
(2) purchase more than 10% of the outstanding voting securities of any issuer;
(3) borrow money, except for temporary or emergency purposes in an amount not
exceeding 33 1/3% of its total assets (including the amount borrowed)
less liabilities (other than borrowings);
(4) pledge, mortgage, or hypothecate its assets to any extent greater than
10% of the value of its total assets;
(5) purchase or retain securities of any issuer if any officer or Director of
the Company or its Manager owns individually more than one-half of one
percent (1/2%) of the securities of that issuer, and collectively the
officers and Directors of the Company and Manager together own more than
5% of the securities of that issuer;
(6) purchase any securities which would cause 25% or more of the value of
that Fund's total assets at the time of such purchase to be invested in
securities the interest upon which is derived from revenues or projects
with similar characteristics, such as toll road revenue bonds, housing
revenue bonds, electric power project revenue bonds, or in industrial
revenue bonds which are based, directly or indirectly, on the credit of
private entities of any one industry; provided that the foregoing
limitation does not apply with respect to investments in U.S. Treasury
Bills, other obligations issued or guaranteed by the U.S. Government, its
agencies and instrumentalities, and, in the case of the Virginia Money
Market Fund, certificates of deposit and banker's acceptances of domestic
banks;
(7) invest in issuers for the purpose of exercising control or management;
(8) issue senior securities as defined in the 1940 Act, except that it may
purchase tax-exempt securities on a "when-issued" basis and may purchase
and sell financial futures contracts and options as permitted by Section
18(f)(2);
(9) underwrite securities of other issuers, except to the extent that it may
be deemed to act as a statutory underwriter in the distribution of any
restricted securities or not readily marketable securities;
(10) purchase or sell real estate, but this shall not prevent investments in
tax-exempt securities secured by real estate or interests therein;
(11) lend any securities or make any loan if, as a result, more than 33 1/3%
of its total assets would be lent to other parties, except that this
limitation does not apply to purchases of debt securities or to
repurchase agreements;
(12) purchase on margin or sell short; for purposes of this restriction the
deposit or payment of initial or variation margin in connection with
financial futures contracts or related options will not be deemed to be a
purchase of securities on margin by a Fund;
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(13) purchase or sell commodities or commodities contracts, except that the
Fund may invest in financial futures contracts and options thereon;
(14) invest its assets in securities of other investment companies except by
purchases in the open market involving only customary brokers'
commissions or as part of a merger, consolidation, reorganization or
purchase of assets approved by the shareholders; or
(15) invest in put, call, straddle, or spread options or interests in oil,
gas, or other mineral exploration or development programs, except that a
Fund may write covered call options and purchase put options.
ADDITIONAL RESTRICTIONS
The following restrictions are not considered to be fundamental policies of the
Funds. The Board of Directors may change these additional restrictions without
notice to or approval by the shareholders.
Neither Fund will:
(1) invest more than 15% (10% with respect to the Virginia Money Market Fund)
of the value of its net assets in illiquid securities, including
repurchase agreements maturing in more than seven days; or
(2) purchase any security while borrowings representing more than 5% of the
Fund's total assets are outstanding.
SPECIAL RISK CONSIDERATIONS
A substantial portion of the Funds' investments will consist of debt
obligations issued to obtain funds for bonds issued by or on behalf of Virginia
state and local governments and other public authorities (Virginia Issues). For
this reason, the Funds are affected by political, economic, regulatory or other
developments which constrain the taxing, revenue collecting and spending
authority of Virginia issuers or otherwise affect the ability of Virginia
issuers to pay interest, repay principal, or any premium. The following
information constitutes only a brief summary of some of such developments and
does not purport to be a complete description.
Investors should be aware of certain factors that might affect the
financial condition of issuers of Virginia municipal securities.
Virginia Issues may include primarily debt obligations of the subdivisions
of the Commonwealth of Virginia issued to obtain funds for various public
purposes, including the construction of a wide range of public facilities such
as airports, bridges, highways, schools, streets and water and sewer works.
Other purposes for which bonds may be issued include the obtaining of funds to
lend to public or private institutions for the construction of facilities such
as educational, hospital, housing, and solid waste disposal facilities. The
latter are generally payable from private sources which, in varying degrees,
may depend on local economic conditions, but are not necessarily affected by
the ability of the Commonwealth of Virginia and its political subdivisions to
pay their debts. Therefore, the general risk factors as to the credit of the
State or its political subdivision discussed herein may not be relevant to the
Virginia Issues.
(a) THE COMMONWEALTH AS AN ISSUER. To the extent bonds of the Commonwealth
of Virginia are included in the Virginia Issues, information on the financial
condition of the Commonwealth is noted. The Constitution of Virginia limits the
ability of the Commonwealth to create debt. The Constitution requires a
balanced budget. The Commonwealth has maintained a high level of fiscal
stability for many years due in large part to conservative financial operations
and diverse sources of revenue. The Commonwealth ended the fiscal year on June
30, 1997, with general fund revenues exceeding budget projections by $205
million. The economy of the Commonwealth is based primarily on manufacturing,
the government sector (including defense), agriculture, mining and tourism.
Defense spending is a major component. Defense installations are concentrated
in Northern Virginia, the location of the Pentagon, and the Hampton Roads area,
including the Cities of Newport News, Hampton, Norfolk, and Virginia Beach, the
locations of, among other installations, the Army Transportation Center (Ft.
Eustis), the Langley Air Force Base, Norfolk Naval Base, and the Oceana Naval
Air Station, respectively. Any substantial reductions in defense spending
generally or in particular areas, including base closings, could adversely
affect the state and local economies.
The Commonwealth currently has a Standard & Poor's rating of AAA and a
Moody's rating of Aaa on its general obligation bonds. There can be no
assurance that the economic conditions on which these ratings are based will
continue or that particular bond issues may not be adversely affected by
changes in economic or political conditions. Further, the credit of the
Commonwealth is not material to the ability of political subdivisions and
private entities to make payments on the obligations described below.
(b) BONDS OF OTHER ENTITIES. General obligations of cities, towns and
counties in Virginia are payable from the general revenues of the entity,
including ad valorem tax revenues on property within the jurisdiction. The
obligation to levy taxes could be enforced by mandamus, but such a remedy may
be impracticable and difficult to enforce. Under section 15.1-227.61 of the
Code of Virginia of 1950, as
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amended, a holder of any general obligation bond in default may file an
affidavit setting forth such default with the Governor. If, after
investigating, the Governor determines that such default exists, he is directed
to order the State Comptroller to withhold State funds appropriated and payable
to the entity and apply the amount so withheld to unpaid principal and
interest. The Commonwealth, however, has no obligation to provide any
additional funds necessary to pay such principal and interest.
Revenue bonds issued by Virginia political subdivisions include (1)
revenue bonds payable exclusively from revenue producing governmental
enterprises and (2) industrial revenue bonds, college and hospital revenue
bonds and other "private activity bonds" which are essentially non-governmental
debt issues and which are payable exclusively by private entities such as
non-profit organizations and business concerns of all sizes. State and local
governments have no obligation to provide for payment of such private activity
bonds and in many cases would be legally prohibited from doing so. The value of
such private activity bonds may be affected by a wide variety of factors
relevant to particular localities or industries, including economic
developments outside of Virginia.
Virginia municipal securities that are lease obligations are customarily
subject to "non-appropriation" clauses which allow the municipality, or other
public entity, to terminate its lease obligations if moneys to make the lease
payments are not appropriated for that purpose. Legal principles may restrict
the enforcement of provisions in lease financing limiting the municipal
issuer's ability to utilize property similar to that leased in the event that
debt service is not appropriated.
Recent amendments to Chapter 9 of the United States Bankruptcy Code, which
applies to bankruptcies by political subdivisions, limit the filing under that
chapter to political subdivisions that have been specifically authorized to do
so under applicable state law. The Company is not aware of any statute in
Virginia that gives any such authorization to political subdivisions in
Virginia. Bonds payable exclusively by private entities may be subject to the
provisions of the United States Bankruptcy Code other than Chapter 9.
(c) OTHER FACTORS. Virginia municipal issuers have generally not been
required to provide ongoing information about their finances and operations to
holders of their debt obligations, although a number of cities, counties and
other issuers prepare annual reports. Virginia political subdivisions that sell
bonds after July 3, 1995, will be subject to Rule 15c2-12 of the SEC that
requires continuing disclosure, including annual audited financial statements,
with respect to those obligations, unless exempted by the Rule.
Although revenue obligations of the Commonwealth or its political
subdivisions may be payable from a specific project or source, including lease
rentals, there can be no assurance that future economic difficulties and the
resulting impact on Commonwealth and local government finances will not
adversely affect the market value of the portfolio of the Fund or the ability
of the respective obligors to make timely payments of principal and interest on
such obligations.
With respect to Virginia Issues that are backed by a letter of credit
issued by a foreign or domestic bank, the ultimate source of payment is the
bank. Investment in foreign banks may involve risks not present in domestic
investments. These include the fact that the foreign bank may be subject to
different, and in some cases less comprehensive, regulatory, accounting,
financial reporting and disclosure standards than are domestic banks.
When Virginia Issues are insured by a municipal bond insurer, there are
certain risks which the bond insurance policy typically does not cover. For
example, some insurance policies do not insure against loss resulting from: (1)
a pre-payment premium; (2) an optional or mandatory redemption (other than
sinking fund redemptions); (3) an accelerated payment; (4) a payment of the
purchase price of Virginia Issues upon tender thereof; and (5) a preference.
Certain municipal bond insurers may not insure against nonpayment of principal
of or interest on Virginia Issues resulting from the insolvency, negligence or
any other act or omission of a paying agent for Virginia Issues. Also, the
capitalization of the various municipal bond insurers is not uniform. If an
insurer of Virginia Issues must make payments pursuant to its bond insurance
policy, such payments could be limited by, among other things, such companies'
capitalization and insurance regulatory authorities.
The rights of the holders of the Virginia Issues and the enforceability of
the Virginia Issues and the financing documents may be subject to (1)
bankruptcy, insolvency, reorganization, moratorium and other similar laws
relating to or affecting creditors' rights, in effect now or after the date of
the issuance of Virginia Issues, to the extent constitutionally applicable, (2)
principles of equity, and (3) the exercise of judicial discretion.
There are risks in any investment program, and there is no assurance that
either Fund will achieve its investment objective. Virginia Issues are subject
to relative degrees of risk, including credit risk, market volatility, tax law
change and fluctuation of the return of the investment of the Virginia Issues
proceeds. Credit risk relates to the issuer's, pledgor's, contributor's,
grantor's, credit enhancer's and/or guarantor's ability to make timely payments
of principal and interest and any premium. Furthermore, in revenue bond
financings, the bonds may be payable exclusively from moneys derived from the
fees, rents and other
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charges collected from the bond-financed project. Payment of principal,
interest and any premium on the bonds by the issuer of Virginia Issues which
are revenue bonds may be adversely affected if the collection of fees, rents
and charges from the project is diminished. Market volatility relates to the
changes in market price that occur as a result of variations in the level of
prevailing interest rates and yield relationships between sectors in the
tax-exempt securities market and other market factors. Also, each Fund will be
affected by general changes in interest rates nationally which will result in
increases or decreases in the value of the securities held by such Fund.
The ability of each Fund to achieve its investment objectives is dependent
on the continuing ability of the issuers of Virginia Issues in which the Fund
invests to meet their obligations for the payment of principal, interest and
premium when due.
PORTFOLIO TRANSACTIONS
The Manager, pursuant to the Advisory Agreement dated July 20, 1990,
supplemented by letter agreement dated July 26, 1990, and subject to the
general control of the Company's Board of Directors, places all orders for the
purchase and sale of Fund securities. Purchases of Fund securities are made
either directly from the issuer or from dealers who deal in tax-exempt
securities. The Manager may sell Fund securities prior to maturity if
circumstances warrant and if it believes such disposition is advisable. In
connection with portfolio transactions for the Company, the Manager seeks to
obtain the best available net price and most favorable execution for its
orders. The Manager has no agreement or commitment to place transaction with
any broker-dealer and no regular formula is used to allocate orders to any
broker-dealer. However, the Manager may place security orders with brokers or
dealers who furnish research or other services to the Manager as long as there
is no sacrifice in obtaining the best overall terms available. Payment for such
services would be generated only through purchase of new issue fixed income
securities.
Such research and other services may include, for example: advice
concerning the value of securities, the advisability of investing in,
purchasing, or selling securities, and the availability of securities or the
purchasers or sellers of securities; analyses and reports concerning issuers,
industries, securities, economic factors and trends, portfolio strategy, and
performance of accounts; and various functions incidental to effecting
securities transactions, such as clearance and settlement. The Manager
continuously reviews the performance of the broker-dealers with whom it places
orders for transactions. The receipt of research from broker-dealers that
execute transactions on behalf of the Company may be useful to the Manager in
rendering investment management services to other clients (including affiliates
of the Manager), and conversely, such research provided by broker-dealers who
have executed transaction orders on behalf of other clients may be useful to
the Manager in carrying out its obligations to the Company. While such research
is available to and may be used by the Manager in providing investment advice
to all its clients (including affiliates of the Manager), not all of such
research may be used by the Manager for the benefit of the Company. Such
research and services will be in addition to and not in lieu of research and
services provided by the Manager, and the expenses of the Manager will not
necessarily be reduced by the receipt of such supplemental research. See THE
COMPANY'S MANAGER.
On occasions when the Manager deems the purchase or sale of a security to
be in the best interest of the Company, as well as the Manager's other clients,
the Manager, to the extent permitted by applicable laws and regulations, may
aggregate such securities to be sold or purchased for the Company with those to
be sold or purchased for other customers in order to obtain best execution and
lower brokerage commissions, if any. In such event, allocation of the
securities so purchased or sold, as well as the expenses incurred in the
transaction, will be made by the Manager in the manner it considers to be most
equitable and consistent with its fiduciary obligations to all such customers,
including the Company. In some instances, this procedure may impact the price
and size of the position obtainable for the Company.
The tax-exempt security market is typically a "dealer" market in which
investment dealers buy and sell bonds for their own accounts, rather than for
customers, and although the price may reflect a dealer's mark-up or mark-down,
the Company pays no brokerage commissions as such. In addition, some securities
may be purchased directly from issuers.
PORTFOLIO TURNOVER RATES
The portfolio turnover rate is computed by dividing the dollar amount of
securities purchased or sold (whichever is smaller) by the average value of
securities owned during the year.
The rate of portfolio turnover will not be a limiting factor when the
Manager deems changes in the Virginia Bond Fund's portfolio appropriate in view
of its investment objective. For example, securities may be sold in
anticipation of a rise in interest rates (market decline) or purchased in
anticipation of a decline in interest rates (market rise) and later sold. In
addition, a security may be sold and another security of comparable quality may
be purchased at approximately the same time in order to take advantage of what
the Fund believes to be a temporary disparity in the normal yield relationship
between the two securities.
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These yield disparities may occur for reasons not directly related to the
investment quality of particular issues or the general movement of interest
rates, such as changes in the overall demand for or supply of various types of
tax-exempt securities.
For the last two fiscal years the Virginia Bond Fund's portfolio turnover
rates were as follows:
1997. . . . . 26.84% 1998. . . . . 14.24%
Portfolio turnover rates have been calculated excluding short-term
variable rate securities, which are those with put date intervals of less than
one year.
DESCRIPTION OF SHARES
The Funds are series of USAA Tax Exempt Fund, Inc. (the Company) and are
diversified. The Company is an open-end management investment company
incorporated under the laws of the State of Maryland on November 16, 1981. The
Company is authorized to issue shares of common stock in separate portfolios.
Ten such portfolios have been established, two of which are described in this
SAI. Under the Articles of Incorporation, the Board of Directors is authorized
to create new portfolios in addition to those already existing without
shareholder approval. The Company began offering shares of the Virginia Bond
and Virginia Money Market Funds in October 1990.
Each Fund's assets and all income, earnings, profits, and proceeds
thereof, subject only to the rights of creditors, are specifically allocated to
such Fund. They constitute the underlying assets of each Fund, are required to
be segregated on the books of account, and are to be charged with the expenses
of such Fund. Any general expenses of the Company not readily identifiable as
belonging to a particular Fund are allocated on the basis of the Funds'
relative net assets during the fiscal year or in such other manner as the Board
determines to be fair and equitable. Each share of each Fund represents an
equal proportionate interest in that Fund with every other share and is
entitled to dividends and distributions out of the net income and capital gains
belonging to that Fund when declared by the Board.
Under the provisions of the Bylaws of the Company, no annual meeting of
shareholders is required. Thus, there will ordinarily be no shareholder meeting
unless required by the 1940 Act. Under certain circumstances, however,
shareholders may apply to the Directors for shareholder information to obtain
signatures to request a special shareholder meeting. The Company may fill
vacancies on the Board or appoint new Directors if the result is that at least
two-thirds of the Directors have still been elected by shareholders. Moreover,
pursuant to the Bylaws of the Company, any Director may be removed by the
affirmative vote of a majority of the outstanding Company shares; and holders
of 10% or more of the outstanding shares of the Company can require Directors
to call a meeting of shareholders for the purpose of voting on the removal of
one or more Directors. The Company will assist in communicating to other
shareholders about the meeting. On any matter submitted to the shareholders,
the holder of each Fund share is entitled to one vote per share (with
proportionate voting for fractional shares) regardless of the relative net
asset values of the Funds' shares. However, on matters affecting an individual
Fund a separate vote of the shareholders of that Fund is required. Shareholders
of a Fund are not entitled to vote on any matter which does not affect that
Fund but which requires a separate vote of another Fund. Shares do not have
cumulative voting rights, which means that holders of more than 50% of the
shares voting for the election of Directors can elect 100% of the Company's
Board of Directors, and the holders of less than 50% of the shares voting for
the election of Directors will not be able to elect any person as a Director.
Shareholders of a particular Fund might have the power to elect all of the
Directors of the Company because that Fund has a majority of the total
outstanding shares of the Company. When issued, each Fund's shares are fully
paid and nonassessable, have no pre-emptive or subscription rights, and are
fully transferable. There are no conversion rights.
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
TAXATION OF THE FUNDS
Each Fund intends to qualify as a regulated investment company under Subchapter
M of the Internal Revenue Code of 1986, as amended (the Code). Accordingly,
each Fund will not be liable for federal income taxes on its taxable net
investment income and net capital gains (capital gains in excess of capital
losses) that are distributed to shareholders, provided that each Fund
distributes at least 90% of its net investment income and net short-term
capital gain for the taxable year.
To qualify as a regulated investment company, a Fund must, among other
things, (1) derive in each taxable year at least 90% of its gross income from
dividends, interest, payments with respect to securities loans, gains from the
sale or other disposition of stock, securities or foreign currencies, or other
income derived with respect to its business of investing in such stock,
securities, or currencies (the 90% test) and (2) satisfy certain
diversification requirements at the close of each quarter of the Fund's taxable
year. Furthermore, to pay tax-exempt interest income dividends, at least 50% of
the value of each Fund's total
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assets at the close of each quarter of its taxable year must consist of
obligations the interest of which is exempt from federal income tax. Each Fund
intends to satisfy this requirement.
The Code imposes a nondeductible 4% excise tax on a regulated investment
company that fails to distribute during each calendar year an amount at least
equal to the sum of (1) 98% of its taxable net investment income for the
calendar year, (2) 98% of its capital gain net income for the twelve-month
period ending on October 31, and (3) any prior amounts not distributed. Each
Fund intends to make such distributions as are necessary to avoid imposition of
this excise tax.
For federal income tax purposes, debt securities purchased by the Funds
may be treated as having original issue discount. Original issue discount
represents interest income for federal income tax purposes and can generally be
defined as the excess of the stated redemption price at maturity of a debt
obligation over the issue price. Original issue discount is treated for federal
income tax purposes as earned by the Funds, whether or not any income is
actually received, and therefore is subject to the distribution requirements of
the Code. However, original issue discount with respect to tax-exempt
obligations generally will be excluded from the Funds' taxable income, although
such discount will be included in gross income for purposes of the 90% test
described previously. Original issue discount with respect to tax-exempt
securities is accrued and added to the adjusted tax basis of such securities
for purposes of determining gain or loss upon sale or at maturity. Generally,
the amount of original issue discount is determined on the basis of a constant
yield to maturity which takes into account the compounding of accrued interest.
An investment in a stripped bond or stripped coupon will result in original
issue discount.
Debt securities may be purchased by the Funds at a market discount. Market
discount occurs when a security is purchased at a price less than the original
issue price adjusted for accrued original issue discount, if any. The Funds
intend to defer recognition of accrued market discount until maturity or other
disposition of the bond. For securities purchased at a market discount, the
gain realized on disposition will be treated as taxable ordinary income to the
extent it does not exceed accrued market discount on the bond.
The Funds may also purchase debt securities at a premium, i.e., at a
purchase price in excess of face amount. With respect to tax-exempt securities,
the premium must be amortized to the maturity date but no deduction is allowed
for the premium amortization. The amortized bond premium will reduce the Funds'
adjusted tax basis in the securities. For taxable securities, the premium may
be amortized if the Funds so elect. The amortized premium on taxable securities
is first offset against interest received on the securities and then allowed as
a deduction, and, for securities issued after September 27, 1985, must be
amortized under an economic accrual method.
TAXATION OF THE SHAREHOLDERS
Taxable distributions are generally included in a shareholder's gross income
for the taxable year in which they are received. Dividends declared in October,
November, or December and made payable to shareholders of record in such a
month will be deemed to have been received on December 31, if a Fund pays the
dividend during the following January. It is expected that none of the Funds'
distributions will qualify for the corporate dividends-received deduction.
To the extent that a Fund's dividends distributed to shareholders are
derived from interest income exempt from federal income tax and are designated
as "exempt-interest dividends" by a Fund, they will be excludable from a
shareholder's gross income for federal income tax purposes. Shareholders who
are recipients of Social Security benefits should be aware that exempt-interest
dividends received from a Fund are includible in their "modified adjusted gross
income" for purposes of determining the amount of such Social Security
benefits, if any, that are required to be included in their gross income.
A shareholder of the Virginia Bond Fund should be aware that a redemption
of shares (including any exchange into another USAA Fund) is a taxable event
and, accordingly, a capital gain or loss may be recognized. If a shareholder
receives an exempt-interest dividend with respect to any share and such share
has been held for six months or less, any loss on the redemption or exchange
will be disallowed to the extent of such exempt-interest dividend. Similarly,
if a shareholder of the Fund receives a distribution taxable as long-term
capital gain with respect to shares of the Fund and redeems or exchanges shares
before he has held them for more than six months, any loss on the redemption or
exchange (not otherwise disallowed as attributable to an exempt-interest
dividend) will be treated as long-term capital loss.
The Funds may invest in private activity bonds. Interest on certain
private activity bonds issued after August 7, 1986, is an item of tax
preference for purposes of the Federal Alternative Minimum Tax (AMT), although
the interest continues to be excludable from gross income for other purposes.
AMT is a supplemental tax designed to ensure that taxpayers pay at least a
minimum amount of tax on their income, even if they make substantial use of
certain tax deductions and exclusions (referred to as tax preference items).
Interest from private activity bonds is one of the tax preference items that is
added to income from other sources for the purposes of determining whether a
taxpayer is subject to the AMT and the amount of any tax to be paid. For
corporate investors, alternative minimum taxable income is increased by 75% of
the amount by which adjusted current earnings (ACE) exceeds alternative minimum
taxable income before the ACE adjustment. For corporate taxpayers, all
tax-exempt interest is considered in calculating the AMT as
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part of the ACE. Prospective investors should consult their own tax advisers
with respect to the possible application of the AMT to their tax situation.
Opinions relating to the validity of tax-exempt securities and the
exemption of interest thereon from federal income tax are rendered by
recognized bond counsel to the issuers. Neither the Manager's nor the Funds'
counsel makes any review of the basis of such opinions.
VIRGINIA TAXATION
As a regulated investment company, each Fund may distribute dividends (Virginia
exempt-interest dividends) that are exempt from the Virginia income tax to its
shareholders if (1) at the close of each quarter of its taxable year, at least
50% of the value of its total assets consists of obligations, the interest on
which is excluded from gross income for federal income tax purposes and (2) the
Fund satisfies certain Virginia reporting requirements. The Funds intend to
qualify and report under the above requirement so that they can distribute
Virginia exempt-interest dividends. If a Fund fails to so qualify or report, no
part of its dividends will be exempt from the Virginia income tax.
The portion of dividends constituting Virginia exempt-interest dividends
is that portion derived from obligations of Virginia or its political
subdivisions or instrumentalities which pay interest excludable from federal
gross income or derived from obligations of the United States which pay
interest excludable from Virginia taxable income under the laws of the United
States. Dividends (1) paid by the Funds, (2) excluded from gross income for
federal income tax purposes, and (3) derived from interest on obligations of
certain territories and possessions of the United States (those issued by
Puerto Rico, the Virgin Islands and Guam) will be exempt from the Virginia
income tax.
To the extent any portion of the dividends distributed to the shareholders
by the Funds is derived from taxable interest for Virginia purposes or, as a
general rule, net short-term gains, such portion will be taxable to the
shareholders as ordinary income. Distributions of long-term capital gains
realized and distributed by the Funds generally will be taxable to their
shareholders regardless of how long the shareholders have held their shares.
Generally, interest on indebtedness incurred by shareholders to purchase or
carry shares of the Funds will not be deductible for Virginia income tax
purposes.
The foregoing is only a summary of some of the important Virginia income
tax considerations generally affecting the Funds and their shareholders, and
does not address any Virginia taxes other than income taxes. No attempt is made
to present a detailed explanation of the Virginia income tax treatment of the
Funds or their shareholders, and this discussion is not intended as a
substitute for careful planning. Accordingly, potential investors in the Funds
should consult their tax advisers with respect to the application of Virginia
taxes to the receipt of the Funds' dividends and as to their own Virginia tax
situation.
DIRECTORS AND OFFICERS OF THE COMPANY
The Board of Directors of the Company consists of seven Directors who supervise
the business affairs of the Company. Set forth below are the Directors and
officers of the Company, and their respective offices and principal occupations
during the last five years. Unless otherwise indicated, the business address of
each is 9800 Fredericksburg Road, San Antonio, TX 78288.
Robert G. Davis 1, 2
Director and Chairman of the Board of Directors
Age: 51
Deputy Chief Executive Officer for Capital Management of USAA (6/98-present);
President, Chief Executive Officer, Director, and Vice Chairman of the Board of
Directors of USAA Capital Corporation and several of its subsidiaries and
affiliates (1/97-present); President, Chief Executive Officer, Director, and
Chairman of the Board of Directors of USAA Financial Planning Network, Inc.
(1/97-present); Executive Vice President, Chief Operating Officer, Director,
and Vice Chairman of the Board of Directors of USAA Financial Planning Network,
Inc. (9/96-1/97); Special Assistant to Chairman, United Services Automobile
Association (USAA) (6/96-12/96); President and Chief Executive Officer, Banc
One Credit Corporation (12/95-6/96); and President and Chief Executive Officer,
Banc One Columbus, (8/91-12/95). Mr. Davis serves as a Director/Trustee and
Chairman of the Boards of Directors/Trustees of each of the remaining funds
within the USAA Family of Funds; Director and Chairman of the Boards of
Directors of USAA Investment Management Company (IMCO), USAA Shareholder
Account Services, USAA Federal Savings Bank, and USAA Real Estate Company.
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Michael J.C. Roth 1, 2
Director, President, and Vice Chairman of the Board of Directors
Age: 56
Chief Executive Officer, IMCO (10/93-present); President, Director, and Vice
Chairman of the Board of Directors, IMCO (1/90-present). Mr. Roth serves as
President, Director/Trustee, and Vice Chairman of the Boards of
Directors/Trustees of each of the remaining funds within the USAA Family of
Funds and USAA Shareholder Account Services; Director of USAA Life Insurance
Company; and Trustee and Vice Chairman of USAA Life Investment Trust.
John W. Saunders, Jr. 1, 2, 4
Director and Vice President
Age: 63
Senior Vice President, Fixed Income Investments, IMCO (10/85-present). Mr.
Saunders serves as a Director/Trustee of each of the remaining funds within the
USAA Family of Funds; Director of IMCO; Senior Vice President of USAA
Shareholder Account Services, and Vice President of USAA Life Investment Trust.
Barbara B. Dreeben 3, 4, 5
200 Patterson #1008
San Antonio, TX 78209
Director
Age: 53
President, Postal Addvantage (7/92-present); Consultant, Nancy Harkins
Stationer (8/91-12/95). Mrs. Dreeben serves as a Director/Trustee of each of
the remaining funds within the USAA Family of Funds.
Howard L. Freeman, Jr. 2, 3, 4, 5
2710 Hopeton
San Antonio, TX 78230
Director
Age: 63
Retired. Assistant General Manager for Finance, San Antonio City Public Service
Board (1976-1996). Mr. Freeman serves as a Director/Trustee of each of the
remaining funds within the USAA Family of Funds.
Robert L. Mason, Ph.D. 3, 4, 5
12823 Queens Forest
San Antonio, TX 78230
Director
Age: 52
Manager, Statistical Analysis Section, Southwest Research Institute
(8/75-present). Dr. Mason serves as a Director/Trustee of the remaining funds
within each of the USAA Family of Funds.
Richard A. Zucker 3, 4, 5
407 Arch Bluff
San Antonio, TX 78216
Director
Age: 55
Vice President, Beldon Roofing and Remodeling (1985-present). Mr. Zucker serves
as a Director/Trustee of each of the remaining funds within the USAA Family of
Funds.
Michael D. Wagner 1
Secretary
Age: 50
Vice President, Corporate Counsel, USAA (1982-present). Mr. Wagner has held
various positions in the legal department of USAA since 1970 and serves as Vice
President, Secretary, and Counsel, IMCO and USAA Shareholder Account Services;
Secretary of each of the remaining funds within the USAA Family of Funds; and
Vice President, Corporate Counsel, for various other USAA subsidiaries and
affiliates.
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Alex M. Ciccone 1
Assistant Secretary
Age: 48
Vice President, Compliance, IMCO (12/94-present); Vice President and Chief
Operating Officer, Commonwealth Shareholder Services (6/94-11/94); and Vice
President, Compliance, IMCO (12/91-5/94). Mr. Ciccone serves as Assistant
Secretary of each of the remaining funds within the USAA Family of Funds.
Mark S. Howard 1
Assistant Secretary
Age: 34
Assistant Vice President, Securities Counsel, USAA (2/98-present); Executive
Director, Securities Counsel, USAA (9/96-2/98); Senior Associate Counsel,
Securities Counsel, USAA (5/95-8/96); Attorney, Kirkpatrick & Lockhart LLP
(9/90-4/95). Mr. Howard serves as Assistant Vice President and Assistant
Secretary IMCO and USAA Shareholder Account Services; Assistant Secretary of
each of the remaining funds within the USAA Family of Funds; and Assistant Vice
President, Securities Counsel for various other USAA subsidiaries and
affiliates.
Sherron A. Kirk 1
Treasurer
Age: 53
Vice President, Controller, IMCO (10/92-present). Mrs. Kirk serves as Treasurer
of each of the remaining funds within the USAA Family of Funds; and Vice
President, Controller of USAA Shareholder Account Services.
Caryl Swann 1
Assistant Treasurer
Age: 50
Director, Mutual Fund Portfolio Analysis & Support, IMCO (2/98-present);
Manager, Mutual Fund Accounting, IMCO (7/92-2/98). Ms. Swann serves as
Assistant Treasurer for each of the remaining funds within the USAA Family of
Funds.
- ------------------------
1 Indicates those Directors and officers who are employees of the Manager or
affiliated companies and are considered "interested persons" under the 1940
Act.
2 Member of Executive Committee
3 Member of Audit Committee
4 Member of Pricing and Investment Committee
5 Member of Corporate Governance Committee
Between the meetings of the Board of Directors and while the Board is not
in session, the Executive Committee of the Board of Directors has all the
powers and may exercise all the duties of the Board of Directors in the
management of the business of the Company which may be delegated to it by the
Board. The Pricing and Investment Committee of the Board of Directors acts upon
various investment-related issues and other matters which have been delegated
to it by the Board. The Audit Committee of the Board of Directors reviews the
financial statements and the auditor's reports and undertakes certain studies
and analyses as directed by the Board. The Corporate Governance Committee of
the Board of Directors maintains oversight of the organization, performance,
and effectiveness of the Board and Independent Directors.
In addition to the previously listed Directors and/or officers of the
Company who also serve as Directors and/or officers of the Manager, the
following individuals are Directors and/or executive officers of the Manager:
Harry W. Miller, Senior Vice President, Investments (Equity); Carl W. Shirley,
Senior Vice President, Insurance Company Portfolios; and John J. Dallahan,
Senior Vice President, Investment Services. There are no family relationships
among the Directors, officers and managerial level employees of the Company, or
its Manager.
The following table sets forth information describing the compensation of
the current Directors of the Company for their services as Directors for the
fiscal year ended March 31, 1998.
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NAME AGGREGATE TOTAL COMPENSATION
OF COMPENSATION FROM THE USAA
TRUSTEE FROM THE COMPANY FAMILY OF FUNDS (b)
------- ---------------- -------------------
Robert G. Davis None (a) None (a)
Barbara B. Dreeben $7,968 $29,500
Howard L. Freeman, Jr. $7,968 $29,500
Robert L. Mason $7,968 $29,500
Michael J.C. Roth None (a) None (a)
John W. Saunders, Jr. None (a) None (a)
Richard A. Zucker $7,968 $29,500
- -------------------------
(a) Robert G. Davis, Michael J.C. Roth, and John W. Saunders, Jr. are
affiliated with the Company's investment adviser, IMCO, and, accordingly,
receive no remuneration from the Company or any other Fund of the USAA
Family of Funds.
(b) At March 31, 1998, the USAA Family of Funds consisted of four registered
investment companies offering 35 individual funds. Each Director presently
serves as a Trustee or Director of each investment company in the USAA
Family of Funds. In addition, Michael J.C. Roth presently serves as a
Trustee of USAA Life Investment Trust, a registered investment company
advised by IMCO, consisting of seven funds offered to investors in a fixed
and variable annuity contract with USAA Life Insurance Company. Mr. Roth
receives no compensation as Trustee of USAA Life Investment Trust.
All of the above Directors are also Trustees/Directors of the other funds
within the USAA Family of Funds. No compensation is paid by any fund to any
Trustee/Director who is a director, officer, or employee of IMCO or its
affiliates. No pension or retirement benefits are accrued as part of fund
expenses. The Company reimburses certain expenses of the Directors who are not
affiliated with the investment adviser. As of April 30, 1998, the officers and
Directors of the Company and their families as a group owned beneficially or of
record less than 1% of the outstanding shares of the Company.
The Company knows of no one person who, as of April 30, 1998, held of
record or owned beneficially 5% or more of either Fund's shares.
THE COMPANY'S MANAGER
As described in the Prospectus, USAA Investment Management Company is the
Manager and investment adviser, providing services under the Advisory
Agreement. The Manager, an affiliate of United Services Automobile Association
(USAA), a large, diversified financial services institution, was organized in
May 1970 and has served as investment adviser and underwriter for USAA Tax
Exempt Fund, Inc. from its inception.
In addition to managing the Company's assets, the Manager advises and
manages the investments for USAA and its affiliated companies as well as those
of USAA Mutual Fund, Inc., USAA Investment Trust, USAA State Tax-Free Trust,
and USAA Life Investment Trust. As of the date of this SAI, total assets under
management by the Manager were approximately $39 billion, of which
approximately $24 billion were in mutual fund portfolios.
ADVISORY AGREEMENT
Under the Advisory Agreement, the Manager provides an investment program,
carries out the investment policy, and manages the portfolio assets for each
Fund. The Manager is authorized, subject to the control of the Board of
Directors of the Company, to determine the selection, amount, and time to buy
or sell securities for each Fund. In addition to providing investment services,
the Manager pays for office space, facilities, business equipment, and
accounting services (in addition to those provided by the Custodian) for the
Company. The Manager compensates all personnel, officers, and Directors of the
Company if such persons are also employees of the Manager or its affiliates.
For these services under the Advisory Agreement, the Company has agreed to pay
the Manager a fee computed as described under FUND MANAGEMENT in the
Prospectus. Management fees are computed and accrued daily and payable monthly.
Except for the services and facilities provided by the Manager, the Funds
pay all other expenses incurred in their operations. Expenses for which the
Funds are responsible include taxes (if any); brokerage commissions on
portfolio transactions (if any); expenses of issuance and redemption of shares;
charges of transfer agents, custodians, and dividend disbursing agents; cost of
preparing and distributing proxy material; costs of printing and engraving
stock certificates; auditing and legal expenses; certain expenses of
registering and qualifying shares for sale; fees of Directors who are not
interested persons (not affiliated) of the Manager; costs of printing and
mailing the Prospectus, SAI, and periodic reports to existing shareholders; and
any other charges or fees not specifically enumerated. The Manager pays the
cost of printing and mailing copies of the Prospectus, the SAI, and reports to
prospective shareholders.
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The Advisory Agreement will remain in effect until June 30, 1999, for each
Fund and will continue in effect from year to year thereafter for each Fund as
long as it is approved at least annually by a vote of the outstanding voting
securities of such Fund (as defined by the 1940 Act) or by the Board of
Directors (on behalf of such Fund) including a majority of the Directors who
are not interested persons of the Manager or (otherwise than as Directors) of
the Company, at a meeting called for the purpose of voting on such approval.
The Advisory Agreement may be terminated at any time by either the Company or
the Manager on 60 days' written notice. It will automatically terminate in the
event of its assignment (as defined in the 1940 Act).
From time to time the Manager may, without prior notice to shareholders,
waive all or any portion of fees or agree to reimburse expenses incurred by a
Fund. Any such waiver or reimbursement may be terminated by the Manager at any
time without prior notice to shareholders. The Manager has voluntarily agreed
to limit each Fund's annual expenses to .50% of its ANA until August 1, 1999,
and will reimburse the Funds for all expenses in excess of the limitations.
For the last three fiscal years, management fees were as follows:
1996 1997 1998
---- ---- ----
Virginia Bond Fund $869,725 $940,252 $1,063,438
Virginia Money Market Fund $354,537 $371,358 $388,424
Because the expenses of the Virginia Money Market Fund exceeded the
Manager's voluntary expense limitation, in 1996, 1997, and 1998 the Manager did
not receive management fees of $58,627, $36,204, and $13,712 respectively, from
that Fund.
UNDERWRITER
The Company has an agreement with the Manager for exclusive underwriting and
distribution of the Funds' shares on a continuing best efforts basis. This
agreement provides that the Manager will receive no fee or other compensation
for such distribution services.
TRANSFER AGENT
The Transfer Agent performs transfer agent services for the Company under a
Transfer Agency Agreement. Services include maintenance of shareholder account
records, handling of communications with shareholders, distribution of Fund
dividends, and production of reports with respect to account activity for
shareholders and the Company. For its services under the Transfer Agency
Agreement, each Fund pays the Transfer Agent an annual fixed fee of $26 per
account. This fee is subject to change at any time.
The fee to the Transfer Agent includes processing of all transactions and
correspondence. Fees are billed on a monthly basis at the rate of one-twelfth
of the annual fee. In addition, the Funds pay all out-of-pocket expenses of the
Transfer Agent and other expenses which are incurred at the specific direction
of the Company.
GENERAL INFORMATION
CUSTODIAN
State Street Bank and Trust Company, P.O. Box 1713, Boston, MA 02105, is the
Company's Custodian. The Custodian is responsible for, among other things,
safeguarding and controlling the Company's cash and securities, handling the
receipt and delivery of securities, and collecting interest on the Company's
investments.
COUNSEL
Goodwin, Procter & Hoar LLP, Exchange Place, Boston, MA 02109, will review
certain legal matters for the Company in connection with the shares offered by
the Prospectus.
INDEPENDENT AUDITORS
KPMG Peat Marwick LLP, 112 East Pecan, Suite 2400, San Antonio, TX 78205, is
the Company's independent auditor. In this capacity, the firm is responsible
for auditing the annual financial statements of the Funds and reporting
thereon.
CALCULATION OF PERFORMANCE DATA
Information regarding total return and yield of each Fund is provided under
COULD THE VALUE OF YOUR INVESTMENT IN THESE FUNDS FLUCTUATE? in the Prospectus.
See VALUATION OF SECURITIES herein for a discussion of the manner in which each
Fund's price per share is calculated.
TOTAL RETURN
The Virginia Bond Fund may advertise performance in terms of average annual
total return for 1-, 5-, and 10-year periods, or for such lesser period as the
Fund has been in existence. Average annual total return is
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computed by finding the average annual compounded rates of return over the
periods that would equate the initial amount invested to the ending redeemable
value, according to the following formula:
P(1 + T)n = ERV
Where: P = a hypothetical initial payment of $1,000
T = average annual total return
n = number of years
ERV = ending redeemable value of a hypothetical $1,000
payment made at the beginning of the 1-, 5-, or
10-year periods at the end of the year or period
The calculation assumes all charges are deducted from the initial $1,000
payment and assumes all dividends and distributions by such Fund are reinvested
at the price stated in the Prospectus on the reinvestment dates during the
period, and includes all recurring fees that are charged to all shareholder
accounts.
The date of commencement of operations for the Virginia Bond Fund was
October 15, 1990. The Fund's average annual total returns for the periods ended
March 31, 1998, were:
1 year..... 11.13% 5 years..... 6.73% Since inception..... 8.24%
YIELD
The Virginia Bond Fund may advertise performance in terms of a 30-day yield
quotation. The 30-day yield quotation is computed by dividing the net
investment income per share earned during the period by the maximum offering
price per share on the last day of the period, according to the following
formula:
YIELD = 2[((a-b)/(cd)+1)^6 -1]
Where: a = dividends and interest earned during the period
b = expenses accrued for the period (net of reimbursement)
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 the yield calculation, interest income is computed based
on the yield to maturity of each debt obligation in the Fund's portfolio and
all recurring charges are recognized.
The Fund's 30-day yield for the period ended March 31, 1998, was 4.69%.
YIELD -- VIRGINIA MONEY MARKET FUND
When the Virginia Money Market Fund quotes a current annualized yield, it is
based on a specified recent seven-calendar-day period. It is computed by (1)
determining the net change, exclusive of capital changes and income other than
investment income, in the value of a hypothetical preexisting account having a
balance of one share at the beginning of the period, (2) dividing the net
change in account value by the value of the account at the beginning of the
base period to obtain the base return, then (3) multiplying the base period
return by 52.14 (365/7). The resulting yield figure is carried to the nearest
hundredth of one percent.
The calculation includes (1) the value of additional shares purchased with
dividends on the original share, and dividends declared on both the original
share and any such additional shares and (2) any fees charged to all
shareholder accounts, in proportion to the length of the base period and the
Fund's average account size.
The capital changes excluded from the calculation are realized capital
gains and losses from the sale of securities and unrealized appreciation and
depreciation. The Fund's effective (compounded) yield will be computed by
dividing the seven-day annualized yield as defined above by 365, adding 1 to
the quotient, raising the sum to the 365th power, and subtracting 1 from the
result.
Current and effective yields fluctuate daily and will vary with factors
such as interest rates and the quality, length of maturities, and type of
investments in the portfolio.
Yield For 7-day Period Ended March 31, 1998, was 3.35%.
Effective Yield For 7-day Period Ended March 31, 1998, was 3.41%.
TAX EQUIVALENT YIELD
A tax-exempt mutual fund may provide more "take-home" income than a fully
taxable mutual fund after paying taxes. Calculating a "tax equivalent yield"
means converting a tax-exempt yield to a pretax equivalent so that a meaningful
comparison can be made between a tax-exempt municipal fund and a fully taxable
fund. The Virginia Money Market Fund may advertise performance in terms of a
tax equivalent yield based on the 7-day yield or effective yield and the
Virginia Bond Fund may advertise performance in terms of a 30-day tax
equivalent yield.
To calculate a tax equivalent yield, the Virginia investor must know his
Effective Marginal Tax Rate or EMTR. Assuming an investor can fully itemize
deductions on his or her federal tax return, the EMTR is the
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sum of the federal marginal tax rate and the state marginal tax rate adjusted
to reflect the deductibility of state taxes from federal taxable income. The
formula for computing the EMTR to compare with fully taxable securities subject
to both federal and state taxes is:
EMTR = Federal Marginal Tax Rate +
[State Marginal Tax Rate x (1-Federal Marginal Tax Rate)]
The tax equivalent yield is then computed by dividing the tax-exempt yield
of a fund by the complement of the EMTR. The complement, for example, of an
EMTR of 39.68% is 60.32%, that is (1.00-0.3968= 0.6032).
Tax Equivalent Yield = Tax Exempt Yield / (1-Effective Marginal Tax Rate)
Using a federal marginal tax rate of 36% and state marginal tax rate of
5.75%, resulting in an EMTR of 39.68%, the tax equivalent yields for the
Virginia Bond and Virginia Money Market Funds for the period ended March 31,
1998 were 7.78% and 5.55%, respectively.
APPENDIX A -- TAX-EXEMPT SECURITIES AND THEIR RATINGS
TAX-EXEMPT SECURITIES
Tax-exempt securities generally include debt obligations issued by states and
their political subdivisions, and duly constituted authorities and
corporations, to obtain funds to construct, repair or improve various public
facilities such as airports, bridges, highways, hospitals, housing, schools,
streets, and water and sewer works. Tax-exempt securities may also be issued to
refinance outstanding obligations as well as to obtain funds for general
operating expenses and for loans to other public institutions and facilities.
The two principal classifications of tax-exempt securities are "general
obligations" and "revenue" or "special tax" 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 or special tax bonds are payable
only from the revenues derived from a particular facility or class of
facilities or, in some cases, from the proceeds of a special excise or other
tax, but not from general tax revenues. The Funds may also invest in tax-exempt
private activity bonds, which in most cases are revenue bonds and generally do
not have the pledge of the credit of the issuer. The payment of the principal
and interest on such industrial revenue bonds is dependent 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. There are, of course, many variations in
the terms of, and the security underlying, tax-exempt securities. Short-term
obligations issued by states, cities, municipalities or municipal agencies,
include Tax Anticipation Notes, Revenue Anticipation Notes, Bond Anticipation
Notes, Construction Loan Notes, and Short-Term Notes.
The yields of tax-exempt securities depend on, among other things, general
money market conditions, conditions of the tax-exempt bond market, the size of
a particular offering, the maturity of the obligation, and the rating of the
issue. The ratings of Moody's Investors Service, Inc. (Moody's), Standard &
Poor's Ratings Group (S&P), Fitch IBCA, Inc. (Fitch), Duff & Phelps Inc., and
Thompson BankWatch, Inc. represent their opinions of the quality of the
securities rated by them. It should be emphasized that such ratings are general
and are not absolute standards of quality. Consequently, securities with the
same maturity, coupon, and rating may have different yields, while securities
of the same maturity and coupon but with different ratings may have the same
yield. It will be the responsibility of the Manager to appraise independently
the fundamental quality of the tax-exempt securities included in a Fund's
portfolio.
1. LONG-TERM DEBT RATINGS:
MOODY'S INVESTOR SERVICES, INC.
Aaa Bonds which are rated Aaa are judged to be of the best quality. They
carry the smallest degree of investment risk and are generally
referred to as "gilt edged." 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 Aaa
securities or fluctuation of protective elements may be of greater
amplitude or there may be other elements present which make the
long-term risk appear somewhat larger than in 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.
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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 lacking or may be
characteristically unreliable over any great length of time. Such
bonds lack outstanding investment characteristics and in fact have
speculative characteristics as well.
NOTE: MOODY'S APPLIES NUMERICAL MODIFIERS 1, 2, AND 3 IN EACH GENERIC RATING
CLASSIFICATION. THE MODIFIER 1 INDICATES THAT THE OBLIGATION RANKS IN THE
HIGHER END OF ITS GENERIC RATING CATEGORY, THE MODIFIER 2 INDICATES A MID-RANGE
RANKING, AND THE MODIFIER 3 INDICATES A RANKING IN THE LOWER END OF THAT
GENERIC RATING CATEGORY.
STANDARD & POOR'S RATINGS GROUP
AAA An obligation rated AAA has the highest rating assigned by Standard &
Poor's. The obligor's capacity to meet its financial commitment on the
obligation is EXTREMELY STRONG.
AA An obligation rated AA differs from the highest rated issues only in
small degree. The obligor's capacity to meet its financial commitment
on the obligation is VERY STRONG.
A An obligation rated A is somewhat more susceptible to the adverse
effects of changes in circumstances and economic conditions than
obligations in higher rated categories. However, the obligor's
capacity to meet its financial commitment on the obligation is still
STRONG.
BBB An obligation rated BBB exhibits ADEQUATE capacity to pay interest and
repay principal. However, adverse economic conditions or changing
circumstances are more likely to lead to a weakened capacity of the
obligor to meet its financial commitment on the obligation.
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
RATING CATEGORIES.
FITCH IBCA, INC.
AAA Highest credit quality. "AAA" ratings denote the lowest expectation of
credit risk. They are assigned only in case of exceptionally strong
capacity for timely payment of financial commitments. This capacity is
highly unlikely to be adversely affected by foreseeable events.
AA Very high credit quality. "AA" ratings denote a very low expectation
of credit risk. They indicate very strong capacity for timely payment
of financial commitments. This capacity is not significantly
vulnerable to foreseeable events.
A High credit quality. "A" ratings denote a low expectation of credit
risk. The capacity for timely payment of financial commitments is
considered strong. This capacity may, nevertheless, be more vulnerable
to changes in circumstances or in economic conditions than is the case
for higher ratings.
BBB Good credit quality. "BBB" ratings indicate that there is currently a
low expectation of credit risk. The capacity for timely payment of
financial commitments is considered adequate, but adverse changes in
circumstances and in economic conditions are more likely to impair
this capacity. This is the lowest investment-grade category.
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.
DUFF & PHELPS, INC.
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. Risk is modest but
may vary slightly from time to time because of economic conditions.
A Protection factors are average but adequate. However, risk factors are
more variable and greater in periods of economic stress.
BBB Below average protection factors but still considered sufficient for
prudent investment. Considerable variability in risk during economic
cycles.
2. SHORT-TERM DEBT RATINGS:
MOODY'S STATE AND TAX-EXEMPT NOTES
MIG-1/VMIG1 This designation denotes best quality. There is present
strong protection by established cash flows, superior
liquidity support or demonstrated broad-based access to the
market for refinancing.
MIG-2/VMIG2 This designation denotes high quality. Margins of protection
are ample although not so large as in the preceding group.
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MOODY'S COMMERCIAL PAPER
Prime-1 Issuers rated Prime-1 (or supporting institutions) have a superior
ability for repayment of senior short-term promissory obligations.
Prime-1 repayment capacity will normally be evidenced by the
following characteristics:
o Leading market positions in well-established industries.
o High rates of return on funds employed.
o Conservative capitalization structures with moderate reliance on
debt and ample asset protection.
o Broad margins in earning coverage of fixed financial charges and
high internal cash generation.
o Well-established access to a range of financial markets and
assured sources of alternate liquidity.
Prime-2 Issuers rated Prime-2 (or supporting institutions) have a strong
ability for repayment of senior short-term promissory obligations.
This will normally be evidenced by many of the characteristics cited
above but to a lesser degree. Earnings trends and coverage ratios,
while sound, may be more subject to variation. Capitalization
characteristics, while still appropriate, may be more affected by
external conditions. Ample alternate liquidity is maintained.
S&P TAX-EXEMPT NOTES
SP-1 Strong capacity to pay principal and interest. Issues determined to
possess very strong characteristics are given a plus (+) designation.
SP-2 Satisfactory capacity to pay principal and interest, with some
vulnerability to adverse financial and economic changes over the term
of the notes.
S&P COMMERCIAL PAPER
A-1 This highest category indicates that the degree of safety regarding
timely payment is strong. Those issues determined to possess extremely
strong safety characteristics are denoted with a plus (+) sign
designation.
A-2 Capacity for timely payment on issues with this designation is
satisfactory. However, the relative degree of safety is not as high as
for issues designated A-1.
FITCH'S COMMERCIAL PAPER, CERTIFICATES OF DEPOSIT, AND TAX-EXEMPT NOTES
F1 Highest credit quality. Indicates the strongest capacity for timely
payment of financial commitments; may have an added "+" to denote any
exceptionally strong credit features.
F2 Good credit quality. A satisfactory capacity for timely payment of
financial commitments, but the margin of safety is not as great as in
the case of the higher ratings.
F3 Fair credit quality. The capacity for timely payment of financial
commitments is adequate; however, near-term adverse changes could
result in a reduction to non-investment grade.
DUFF & PHELPS COMMERCIAL PAPER
D-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.
D-1 Very high certainty of timely payment. Liquidity factors are excellent
and supported by good fundamental protection factors. Risk factors are
minor.
D-1- High certainty of timely payment. Liquidity factors are strong and
supported by good fundamental protection factors. Risk factors are
very small.
D-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.
THOMPSON BANKWATCH, INC.
TBW-1 The highest category; indicates a very high likelihood that principal
and interest will be paid on a timely basis.
TBW-2 The second highest category; while the degree of safety regarding
timely repayment of principal and interest is strong, the relative
degree of safety is not as high as for issues rated TBW-1.
TBW-3 The lowest investment-grade category; indicates that while the
obligation is more susceptible to adverse developments (both internal
and external) than those with higher ratings, the capacity to service
principal and interest in a timely fashion is considered adequate.
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APPENDIX B -- COMPARISON OF PORTFOLIO PERFORMANCE
Occasionally, we may make comparisons in advertising and sales literature
between the Funds contained in this SAI and other Funds in the USAA Family of
Funds. These comparisons may include such topics as risk and reward, investment
objectives, investment strategies, and performance.
Fund performance also may be compared to the performance of broad groups
of mutual funds with similar investment goals or unmanaged indexes of
comparable securities. Evaluations of Fund performance made by independent
sources may be used in advertisements concerning the Fund, including reprints
of, or selections from, editorials or articles about the Fund. The Fund or its
performance may also be compared to products and services not constituting
securities subject to registration under the Securities Act of 1933 such as,
but not limited to, certificates of deposit and money market accounts. Sources
for performance information and articles about the Fund may include but are not
restricted to the following:
AAII JOURNAL, a monthly association magazine for members of the American
Association of Individual Investors.
ARIZONA REPUBLIC, a newspaper which may cover financial and investment news.
AUSTIN AMERICAN-STATESMAN, a newspaper which may cover financial news.
BARRON'S, a Dow Jones and Company, Inc. business and financial weekly that
periodically reviews mutual fund performance data.
THE BOND BUYER, a daily newspaper which covers bond market news.
BUSINESS WEEK, a national business weekly that periodically reports the
performance rankings and ratings of a variety of mutual funds.
CHICAGO TRIBUNE, a newspaper which may cover financial news.
CONSUMER REPORTS, a monthly magazine which from time to time reports on
companies in the mutual fund industry.
DALLAS MORNING NEWS, a newspaper which may cover financial news.
DENVER POST, a newspaper which may quote financial news.
FINANCIAL PLANNING, a monthly magazine that periodically features companies in
the mutual fund industry.
FINANCIAL SERVICES WEEK, a weekly newspaper which covers financial news.
FINANCIAL WORLD, a monthly magazine which may periodically review mutual fund
companies.
FORBES, a national business publication that periodically reports the
performance of companies in the mutual fund industry.
FORTUNE, a national business publication that periodically rates the
performance of a variety of mutual funds.
FUND ACTION, a mutual fund news report.
HOUSTON CHRONICLE, a newspaper which may cover financial news.
HOUSTON POST, a newspaper which may cover financial news.
IBC'S MONEYLETTER, a biweekly newsletter which covers financial news and from
time to time rates specific mutual funds.
IBC'S MONEY FUND REPORT, a weekly publication of IBC Financial Data, Inc.,
reporting on the performance of the nation's money market funds, summarizing
money market fund activity, and including certain averages as performance
benchmarks, specifically: (1) Taxable Money Fund Averages: "100% U.S. Treasury"
and "First Tier" and (2) Tax-Free Money Fund Averages: "Stockbroker and General
Purpose" and "State Specific Stockbroker and General Purpose."
IBC'S MONEY MARKET INSIGHT, a monthly money market industry analysis prepared
by IBC Financial Data, Inc.
INCOME AND SAFETY, a monthly newsletter that rates mutual funds.
INVESTECH, a bimonthly investment newsletter.
INVESTMENT ADVISOR, a monthly publication directed primarily to the advisor
community; includes ranking of mutual funds using a proprietary methodology.
INVESTMENT COMPANY INSTITUTE, a national association of the American Investment
Company industry.
INVESTOR'S BUSINESS DAILY, a newspaper which covers financial news.
KIPLINGER'S PERSONAL FINANCE MAGAZINE, a monthly investment advisory
publication that periodically features the performance of a variety of
securities.
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LIPPER ANALYTICAL SERVICES, INC.'S EQUITY FUND PERFORMANCE ANALYSIS, a weekly
and monthly publication of industry-wide mutual fund performance averages by
type of fund.
LIPPER ANALYTICAL SERVICES, INC.'S FIXED INCOME FUND PERFORMANCE ANALYSIS, a
monthly publication of industry-wide mutual fund performance averages by type
of fund.
LOS ANGELES TIMES, a newspaper which may cover financial news.
LOUIS RUKEYSER'S WALL STREET, a publication for investors.
MEDICAL ECONOMICS, a monthly magazine providing information to the medical
profession.
MONEY, a monthly magazine that features the performance of both specific funds
and the mutual fund industry as a whole.
MORNINGSTAR 5 STAR INVESTOR, a monthly newsletter which covers financial news
and rates mutual funds produced by Morningstar, Inc. (a data service which
tracks open-end mutual funds).
MUNI BOND FUND REPORT, a monthly newsletter which covers news on the municipal
bond market and features performance data for municipal bond mutual funds.
MUNIWEEK, a weekly newspaper which covers news on the municipal bond market.
MUTUAL FUND FORECASTER, a monthly newsletter that ranks mutual funds.
MUTUAL FUND INVESTING, a newsletter covering mutual funds.
MUTUAL FUND PERFORMANCE REPORT, a monthly publication of industry-wide mutual
fund averages produced by Morningstar, Inc.
MUTUAL FUNDS MAGAZINE, a monthly publication reporting on mutual fund
investing.
MUTUAL FUND SOURCE BOOK, an annual publication produced by Morningstar, Inc.
which describes and rates mutual funds.
MUTUAL FUND VALUES, a biweekly guidebook to mutual funds produced by
Morningstar, Inc.
NEWSWEEK, a national business weekly.
NEW YORK TIMES, a newspaper which may cover financial news.
NO LOAD FUND INVESTOR, a newsletter covering companies in the mutual fund
industry.
ORLANDO SENTINEL, a newspaper which may cover financial news.
PERSONAL INVESTOR, a monthly magazine which from time to time features mutual
fund companies and the mutual fund industry.
SAN ANTONIO BUSINESS JOURNAL, a weekly newspaper that periodically covers
mutual fund companies as well as financial news.
SAN ANTONIO EXPRESS-NEWS, a newspaper which may cover financial news.
SAN FRANCISCO CHRONICLE, a newspaper which may cover financial news.
SMART MONEY, a monthly magazine featuring news and articles on investing and
mutual funds.
USA TODAY, a newspaper which may cover financial news.
U.S. NEWS AND WORLD REPORT, a national business weekly that periodically
reports mutual fund performance data.
WALL STREET JOURNAL, a Dow Jones and Company, Inc. newspaper which covers
financial news.
WASHINGTON POST, a newspaper which may cover financial news.
WEISENBERGER MUTUAL FUNDS INVESTMENT REPORT, a monthly newsletter that reports
on both specific mutual fund companies and the mutual fund industry as a whole.
WORTH, a magazine which covers financial and investment subjects including
mutual funds.
YOUR MONEY, a monthly magazine directed towards the novice investor.
In addition to the sources above, performance of our Funds may also be tracked
by Lipper Analytical Services, Inc. Each Fund will be compared to Lipper's
appropriate fund category according to objective and portfolio holdings. The
Virginia Bond Fund will be compared to funds in Lipper's Virginia Municipal
Debt Funds category, and the Virginia Money Market Fund to funds in Lipper's
States Tax-Exempt Money Market Funds category. Footnotes in advertisements and
other sales literature will include the time period applicable for any rankings
used.
For comparative purposes, unmanaged indices of comparable securities or
economic data may be cited. Examples include the following:
--Shearson Lehman Hutton Bond Indices, indices of fixed-rate debt issues
rated investment grade or higher which can be found in the BOND MARKET REPORT.
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--Bond Buyer Indices, indices of debt of varying maturities including
revenue bonds, general obligation bonds, and U.S. Treasury bonds which can be
found in MUNIWEEK and THE BOND BUYER.
Other sources for total return and other performance data which may be
used by the Funds or by those publications listed previously are Morningstar,
Inc., Schabaker Investment Management, and Investment Company Data, Inc. These
are services that collect and compile data on mutual fund companies.
APPENDIX C -- DOLLAR-COST AVERAGING
Dollar-cost averaging is a systematic investing method which can be used by
investors as a disciplined technique for investing. A fixed amount of money is
invested in a security (such as a stock or mutual fund) on a regular basis over
a period of time, regardless of whether securities markets are moving up or
down.
This practice reduces average share costs to the investor who acquires
more shares in periods of lower securities prices and fewer shares in periods
of higher prices.
While dollar-cost averaging does not assure a profit or protect against
loss in declining markets, this investment strategy is an effective way to help
calm the effect of fluctuations in the financial markets. Systematic investing
involves continuous investment in securities regardless of fluctuating price
levels of such securities. Investors should consider their financial ability to
continue purchases through periods of low and high price levels.
As the following chart illustrates, dollar-cost averaging tends to keep
the overall cost of shares lower. This example is for illustration only, and
different trends would result in different average costs.
HOW DOLLAR-COST AVERAGING WORKS
$100 Invested Regularly for 5 Periods
Market Trend
--------------------------------------------------------------------
Down Up Mixed
------------------- --------------------- -----------------------
Share Shares Share Shares Share Shares
Investment Price Purchased Price Purchased Price Purchased
------------------- --------------------- -----------------------
$100 10 10 6 16.67 10 10
100 9 11.1 7 14.29 9 11.1
100 8 12.5 7 14.29 8 12.5
100 8 12.5 9 11.1 9 11.1
100 6 16.67 10 10 10 10
- ---- -- ----- -- ----- -- -----
$500 ***41 62.77 ***39 66.35 ***46 54.7
*Avg. Cost: $7.97 *Avg. Cost: $7.54 *Avg. Cost: $9.14
----- ----- -----
**Avg. Price: $8.20 **Avg. Price: $7.80 **Avg. Price: $9.20
----- ----- -----
* Average Cost is the total amount invested divided by number of
shares purchased.
** Average Price is the sum of the prices paid divided by number
of purchases.
*** Cumulative total of share prices used to compute average prices.
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