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KEYSTONE
FAMILY OF FUNDS
[DIAMOND]
Balanced Fund (K-1)
Diversified Bond Fund (B-2)
Growth and Income Fund (S-1)
High Income Bond Fund (B-4)
International Fund Inc.
Liquid Trust
Mid-Cap Growth Fund (S-3)
Precious Metals Holdings, Inc.
Quality Bond Fund (B-1)
Small Company Growth Fund (S-4)
Strategic Growth Fund (K-2)
Tax Free Fund
- ------------------------------------------------------------------------------
This report was prepared primarily for the information of the Fund's
shareholders. It is authorized for distribution if preceded or accompanied by
the Fund's current prospectus. The prospectus contains important information
about the Fund including fees and expenses. Read it carefully before you invest
or send money. For a free prospectus on other Keystone funds, contact your
financial adviser or call Keystone.
[KEYSTONE INVESTMENTS LOGO]
P.O. Box 2121
Boston, Massachusetts 02106-2121
B1-R-12/96
15.7M
<PAGE>
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KEYSTONE
[PHOTO OF COUPLE ON BEACH]
QUALITY
BOND FUND (B-1)
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[KEYSTONE LOGO]
ANNUAL REPORT
OCTOBER 31, 1996
<PAGE>
PAGE 1
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Keystone Quality Bond Fund (B-1)
Seeks generous income and capital preservation from high quality bonds.
Dear Shareholder:
We are pleased to report on the activities of Keystone Quality Bond Fund
(B-1) for the twelve-month period which ended October 31, 1996. Following our
letter we have included a discussion with your Fund's manager and complete
financial information.
Performance
Your Fund returned 5.08% for the six-month period and 3.99% for the
twelve-month period which ended October 31, 1996. For the same periods, the
Lehman Aggregate Bond Index--a widely recognized index of corporate,
government and mortgage securities--returned 5.29% for the six-month period
and 5.83% for the twelve-month period.
Keystone Quality Bond Fund (B-1) provided satisfactory performance during a
period of sharp price fluctuations as interest rates rose and then fell in
reaction to changing economic conditions. Fund performance improved
particularly during the last six months of the period.
While interest rates were relatively unchanged from their levels of one year
ago, the credit markets endured considerable short-term price volatility
during the twelve-month period. In November and December 1995, interest rates
trended down as economic growth slowed from moderate levels, inflation
remained under control and the government appeared to be making progress
toward reducing the federal budget deficit. Most investors expected these
trends to continue into 1996. On October 31, 1996 the benchmark 30-year U.S.
Treasury bond yielded 6.35%. By January 1996 Treasuries had reached a low of
5.97% on this favorable news.
During the first quarter of 1996 economic reports showed
stronger-than-expected economic growth and employment gains, which increased
fears of higher inflation rates. Because inflation reduces returns to bond
holders, interest rates generally rose with each economic report that
indicated strong growth. By early July rates had peaked at 7.19%. As rates
rose, prices generally declined for nearly all fixed income investments.
Expectations of stronger growth moderated during the third quarter of 1996
as it appeared that the strong growth of the first half of the year was
slowing. Still watchful for signs of future inflation, investors gained
confidence that this favorable environment could be sustained and interest
rates began to move within a narrow range. On October 31, 1996 the 30-year
Treasury stood at 6.82%, not far from where it was at the beginning of the
fiscal period.
Portfolio strategy
Over the past six months, we restructured Keystone Quality Bond Fund (B-1) to
improve stability and enhance long-term potential total returns. We invested
a portion of the Fund in government bonds of Canada, Germany and Spain. With
their attractive yields, high quality and solid economic fundamentals, we
believed these investments offered good relative values. All transactions
were currency-hedged into U.S. dollars to protect the portfolio from foreign
currency fluctuations.
We also increased your Fund's investments in collateralized mortgage
obligations (CMOs), asset-backed securities, and bonds in the bank and
finance sectors. We believe these securities contributed favorably to your
Fund's income and total return. In its entirety, we believe the portfolio's
new structure increased diversification while maintaining a high degree of
quality and liquidity.
(continued on next page)
<PAGE>
PAGE 2
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Keystone Quality Bond Fund (B-1)
Keystone Quality Bond Fund (B-1) is designed for conservative,
income-oriented investors. We invest in a selection of high quality fixed
income securities, which include among others, U.S. government obligations,
mortgage-backed and asset-backed securities, and high-quality corporate
bonds. We apply careful credit analysis in selecting high quality securities
for the portfolio. We attempt to identify securities that we believe will
perform well given our expectations for the market environment. We believe
that your Fund's ability to diversify and be flexible are key elements in
navigating the changing conditions of the fixed income markets.
Looking ahead, we anticipate a stable-to-positive environment for high
quality bonds. We expect moderate economic growth and low inflation to
provide a positive background for interest rates to move within a narrow
range through early 1997.
New portfolio manager
After 20 years of distinguished service with Keystone, your Fund's manager
Barbara McCue has retired effective September 30, 1996. The leader of
Keystone's high grade bond team, Christopher P. Conkey, has assumed
responsibilities as your Fund's portfolio manager. Mr. Conkey is a Chartered
Financial Analyst and has over 13 years of investment experience. He
currently manages several other Keystone funds that invest in high grade
bonds. We look forward to his contribution to your Fund's management.
Keystone acquired by First Union Corporation
On another note, we are pleased to inform you that Keystone has been acquired
by First Union Corporation. First Union is a financial services firm based in
Charlotte, North Carolina. It is the nation's sixth largest bank holding
company with assets of approximately $130 billion. First Union, through its
wholly-owned subsidiary Evergreen Asset Management Corp., together with
Keystone mutual funds, manages more than $30 billion in 70 mutual funds.
While Keystone will remain a separate entity and will continue to provide
investment advisory and management services to the Fund, services will be
provided under the "Evergreen Keystone Funds" name. We believe First Union's
acquisition of Keystone strengthens the investment management services we
provide you.
We appreciate your continued support of Keystone Quality Bond Fund (B-1). If
you have any questions or comments about your investment, we encourage you to
write to us.
Sincerely,
/s/ Albert H. Elfner, III
- -------------------------
Albert H. Elfner, III
Chairman and President
Keystone Investments, Inc.
/s/ George S. Bissell
- -------------------------
George S. Bissell
Chairman of the Board
Keystone Funds
December 1996
<PAGE>
PAGE 3
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A Discussion With
Your Fund Manager
[PHOTO OF CHRISTOPHER P. CONKEY]
Christopher P. Conkey is portfolio manager of your Fund and
heads Keystone's high grade bond team. A Chartered
Financial Analyst, Mr. Conkey has 13 years of experience
managing fixed-income investments. He holds a BA in
economics from Clark University and an MBA in finance from
Boston University. Together with analysts David J. Bowers
and Gary E. Pzegeo, he evaluates interest rate and credit risk
in selecting high quality bonds for Keystone fixed income funds.
Q What was the investment climate like for high quality bonds over the past
year?
A The climate for high quality bonds changed several times over the past
year. There was a high degree of price volatility throughout much of the
period, as investors revised their interest rate and economic forecasts.
Despite these fluctuations, however, interest rates were relatively unchanged
at the end of this reporting period from one year ago.
Q What changed the outlooks for interest rates and the economy?
A Stronger-than-expected growth in employment and consumer spending in the
first quarter of 1996 caused investors to revise their economic and interest
rate forecasts. Interest rates had fallen to near historic lows during much
of 1995 on the outlook for a slow economy and low inflation. The reports of
strength in employment and consumer activity stimulated concerns
that the economy might be more robust than expected.
Interest rates rose and bond prices fell during that time.
By mid-year, signs of moderating economic growth appeared, relieving
inflation fears. While watchful of preliminary signs of future inflation,
investors became more confident that this trend of moderate growth and low
inflation could be sustained.
Q What strategies did you employ during these changing market climates?
A We restructured the portfolio's assets and adjusted its average maturity.
We believe the combination reduced the Fund's risk to U.S. interest rate
fluctuations, increased yield and improved diversification.
First, we reduced the Fund's holdings in U.S. government securities from 48%
to 5% of net assets. Since U.S. government securities carry no credit risk,
their prices are primarily influenced by the movement in interest rates. We
believe reducing the portfolio's exposure to interest rate risk increased
stability, particularly in light of the price volatility over the past year.
We reinvested the proceeds from these sales in non-dollar foreign government
bonds, collateralized mortgage obligations (CMOs), asset-backed securities,
and bonds in the bank and finance sectors. These bonds improved
diversification, increased income, and provided price appreciation to the
Fund's portfolio.
Fund Profile
Objective: Seeks the highest possible income consistent with preservation of
principal.
Commencement of investment operations: September 11, 1935
Average quality: AA+
Average maturity: 11 years
Net assets: $229 million
Newspaper symbol: "QultyB1"
<PAGE>
PAGE 4
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Keystone Quality Bond Fund (B-1)
Asset Allocation
as of October 31, 1996
[TABULAR REPRESENTATION OF PIE CHART]
Corporates (31.7%)
Collateralized mortgage obligations (CMOs) (22.3%)
Foreign (15.6%)
Mortgage-backed (13.6%)
Asset-backed (10.6%)
U.S. government & agency (5.1%)
Other(1) (1.1%)
(as a percent of net assets)
We adjusted average maturity, ultimately shortening it when interest rates
rose last spring. As of October 31, 1996, the Fund's average maturity stood
at 11 years. The average quality of Keystone Quality Bond Fund (B-1) was AA+,
the second highest rating available from Standard and Poor's Corporation.
Q Why did you invest in the foreign sector?
A The foreign sector offered higher yields and greater potential for capital
appreciation than many domestic alternatives. We did not increase credit risk
in the foreign sector, preferring to emphasize securities with high quality
ratings. Further, all of the investments were currency-hedged, to protect our
holdings from foreign currency exchange rate changes.
We invested in the government bonds of Canada, Germany and Spain; countries
that we believed offered attractive values based on solid economic
fundamentals, stable political environments and large, liquid securities
markets. In fact, interest rates in these countries have fallen over the past
year resulting in price appreciation. In addition, our foreign investments
avoided the price declines experienced in the U.S. credit markets.
Q How about other sectors?
A Collateralized mortgage obligations and asset-backed securities also
offered investors higher yields than U.S. government bonds, while enabling
the Fund to maintain credit quality. We invested in well structured,
AAA-rated securities. We concentrated on commercial loans and securities that
were collateralized by home equity loans and credit card receivables. We
chose these sectors because of their link to the consumer. Consumer
confidence ran high throughout the period, due to strength in employment,
income growth, and improving net wealth which was caused by a rising stock
market and generally higher housing prices. We believed that the strength of
the consumer sector would have a favorable effect on these securities versus
alternative investments.
We also increased the Fund's investments in the bank and finance sector as
interest rates rose. We believed that higher U.S. rates would eventually slow
economic growth. Slower growth historically has resulted in falling interest
rates. Typically, banks and finance companies have benefitted from this type
of environment. Towards the end of the reporting period this scenario of
lower rates appeared to be unfolding.
Q What is your outlook for the next six months?
A We believe the next six months should be a neutral environment for high
quality bonds with interest rates fluctuating in a narrow range. We
anticipate moderate economic growth accompanied by low inflation. On an
annual basis, we think the economy will grow at a pace of 2-2-1/2% and that
inflation, as measured by the consumer price index (CPI), will stay in the
area of 3%.
Q With interest rates at relatively low levels, do you believe that bonds
offer good long term value?
A We believe they do. While nominal interest rates have been relatively low,
"real" interest rates, or the rate received by investors after subtracting
inflation, continues to be attractive. For example, the 30-year U.S. Treasury
bond had a yield of 6.82% as of October 31, 1996.
- ---------------
(1) Includes repurchase agreement, and other assets and liabilities.
<PAGE>
PAGE 5
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Portfolio Quality Summary
as of October 31, 1996
[TABULAR REPRESENTATION OF PIE CHART]
AAA (36.3%)
U.S. government and agency(3) (26.6%)
A (15.2%)
AA (11.0%)
BBB (10.9%)
(as a percentage of portfolio assets)
Inflation was recently about 3%. Thus, the real return after subtracting
inflation was approximately 3.82% at the end of the period, a historically
attractive level.
Like most investments, high quality bonds can experience periods of
short-term price volatility. Over the long-run, however, high-quality bonds
have demonstrated relative stability and attractive income. We believe high
quality bonds will continue to produce solid total returns in the future. In
our opinion, the Fund serves an important role in a well-rounded investment
portfolio.
- ------------
(2) Where Standard & Poor's ratings were not available, we have used ratings
from Moody's Investor Service, Inc., Fitch Investors' Service, Inc., or
ratings assigned by another nationally recognized statistical rating
organization.
(3) Includes all U.S. government and agency securities including CMOs, asset-
backed and mortgage pass-through securities issued by the U.S. government
or its agencies.
Ratings are very important to evaluating bonds. What do they mean?
Bond ratings provide an indication of the relative investment quality of an
issuer. Each rating agency uses its own criteria for assigning ratings. In
general, each agency examines the ability of an issuer to maintain debt
protection levels in periods of recession as well as recovery. Bonds with
identical ratings are not necessarily equal. Different industries have
different business risks. However, most bonds within a certain rating
category tend to have similar characteristics. The following table briefly
defines investment grade bond ratings.
Investment Grade Bond Ratings
Moody's Investors Service S&P
Aaa AAA Highest Quality,
lowest likelihood of default
Aa AA High Quality
A A Upper Medium Grade
Baa BBB Medium Grade
We use bond ratings as one component of our credit research. For Keystone
Quality Bond Fund (B-1), we consider only investment-grade securities. That
is, bonds rated AAA, AA, A, and BBB. Lower rated bonds are considered
speculative grade.
[DIAMOND]
This column is intended to answer questions about your Fund.
If you have a question you would like answered, please write to:
Evergreen Keystone Investment Services, Inc.
Attn: Shareholder Communications, 22nd Floor
200 Berkeley Street, Boston, Massachusetts 02116-5034.
<PAGE>
PAGE 6
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Keystone Quality Bond Fund (B-1)
Your Fund's Performance
Growth of an investment in
Keystone Quality Bond Fund (B-1)
[MOUNTAIN CHART]
In Thousands
Initial Reinvested
Investment Distributions
10/86 10000 10000
8937 9756
10/88 9045 10740
9125 11794
10/90 8708 12259
9160 13986
10/92 9160 15065
9377 16647
10/94 8256 15603
8816 17739
10/96 8685 18447
A $10,000 investment in Keystone Quality Bond Fund (B-1) made
on October 31, 1986 with all distributions reinvested as worth $18,447
on October 31, 1996. Past performance is no guarantee of future results.
Twelve-Month Performance as of October 31, 1996
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Total return* 3.99%
Net asset value 10/31/95 $15.42
10/31/96 $15.19
Distributions $ 0.82
Capital gains None
* Before deduction of contingent deferred sales charge (CDSC).
Historical Record as of October 31, 1996
- -------------------------------------------------------
If you If you did
Cumulative total return redeemed not redeem
1-year 1.03% 3.99%
5-year 31.89% 31.89%
10-year 84.47% 84.47%
Average annual total return
1-year 1.03% 3.99%
5-year 5.69% 5.69%
10-year 6.31% 6.31%
The "if you redeemed" returns reflect the deduction of the 3% CDSC for those
investors who sold Fund shares after one calendar year. Investors who
retained their fund investment earned the returns reported in the second
column of the table.
The investment return and principal value will fluctuate so that your
shares, when redeemed, may be worth more or less than the original cost. Past
performance is no guarantee of future results.
Shareholders may exchange shares for another Keystone fund by calling or
writing to Keystone directly, or through Keystone's Automated Response Line
(KARL). The Fund reserves the right to change or terminate the exchange
offer.
<PAGE>
PAGE 7
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Growth of an Investment
Comparison of change in value of a $10,000 investment
in Keystone Quality Bond Fund (B-1), the Lehman
Aggregate Bond Index and the Consumer Price Index.
In Thousands October 1986 through October 1996
Fund Average
Annual Total Return
- -------------------------------------
1 Year 5 Year 10 Year
1.03% 5.69% 6.31%
[LINE CHART]
Fund LABI CPI
10/86 10000 10000 10000
9756 10205 10453
10/88 10740 11374 10898
11794 12726 11387
10/90 12259 13528 12103
13986 15663 12457
10/92 15065 17204 12856
16647 19247 13209
10/94 15603 18539 13554
17739 21441 13935
10/96 18447 22692 14306
Past performance is no guarantee of future results. The one-year return
reflects the deduction of the Fund's 3% contingent sales charge for shares
held for at least one year. The Consumer Price Index is through September
30, 1996.
This chart graphically compares your Fund's performance to certain investment
indexes. It is the result of fund performance guidelines issued by the
Securities and Exchange Commission. The intent is to provide investors with
more information about their investment.
Components of the chart
The chart is composed of several lines that represent the accumulated value
of an initial $10,000 investment for the period indicated. The lines
illustrate a hypothetical investment in:
1. Keystone Quality Bond Fund (B-1)
Your Fund seeks the highest possible income consistent with preservation of
principal. The return is quoted after deducting sales charges (if
applicable), fund expenses, and transaction costs and assumes reinvestment of
all distributions.
2. Lehman Aggregate Bond Index (LABI)
The LABI is a broad-based, unmanaged fixed income index of U.S. government,
corporate and mortgage-backed securities. It represents the price change and
coupon income of several thousand securities of various credit qualities and
maturities. Securities are selected and compiled by Lehman Brothers, Inc.
according to criteria that may be unrelated to your Fund's investment
objective. It would be difficult for most individual investors to duplicate
this index.
3. Consumer Price Index (CPI)
This index is a widely recognized measure of the cost of goods and services
produced in the U.S. The index contains factors such as prices of services,
housing, food, transportation and electricity which are compiled by the U.S.
Bureau of Labor Statistics. The CPI is generally considered a valuable
benchmark for investors who seek to outperform increases in the cost of
living.
These indexes do not include transaction costs associated with buying and
selling securities, and do not hold cash to meet redemptions. It would be
difficult for most individual investors to duplicate these indexes.
Understanding what the chart means
The chart demonstrates your Fund's performance in relation to a well known
investment index and to increases in the cost of living. It is important to
understand what the chart shows and does not show.
This illustration is useful because it charts Fund and index performance
over the same time frame and over a long period. Long-term performance is a
more reliable and useful measure of performance than measurements of
short-term returns or temporary swings in the market. Your financial adviser
can help you
<PAGE>
PAGE 8
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Keystone Quality Bond Fund (B-1)
evaluate fund performance in conjunction with the other important financial
considerations such as safety, stability and consistency.
Limitations of the chart
The chart, however, limits the evaluation of Fund performance in several
ways. Because the measurement is based on total returns over an extended
period of time, the comparison often favors those funds which emphasize
capital appreciation when the market is rising. Likewise, when the market is
declining, the comparison usually favors those funds which take less risk.
Performance can be distorted
Funds which are more conservative in their orientation and which place an
emphasis on capital preservation will tend to compare less favorably when the
market is rising. In addition, funds which have income as one of their
objectives also will tend to compare less favorably to relevant indexes.
Indexes may also reflect the performance of some securities which a fund may
be prohibited from buying. A bond fund, for example, may be limited to
investments in only high quality bonds, or a stock fund may only be able to
buy stocks that have been traded on a stock exchange for a minimum number of
years or stocks that have a certain market capitalization. Indexes usually do
not have the same investment restrictions as your Fund.
Indexes do not include costs of investing
The comparison is further limited in its utility because the indexes do not
take into account any deductions for sales charges, transaction costs or
other fund expenses. Your Fund's performance figures do reflect such
deductions. Sales charges--whether up-front or deferred--pay for the cost of
the investment advice of your financial adviser. Transaction costs pay for
the costs of buying and selling securities for your Fund's portfolio. Fund
expenses pay for the costs of investment management and various shareholder
services. None of these costs are reflected in index total returns. The
comparison is not completely realistic because an index cannot be duplicated
by an investor--even an unmanaged index--without incurring some charges and
expenses.
One of several measures
The chart is one of several tools you can use to understand your investment.
It should be read in conjunction with the Fund's prospectus, and annual and
semiannual reports. Also, your financial adviser, who understands your
personal financial situation, can best explain the features of your Keystone
fund and how it applies to your financial needs.
Future returns may be different
Shareholders also should be mindful that the long-run performance of either
the Fund or the indexes is not representative of what shareholders should
expect to receive from their Fund investment in the future; it is presented
to illustrate only past performance and is not a guarantee of future returns.
<PAGE>
PAGE 9
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Glossary of
Mutual Fund Terms
MUTUAL FUND--A company which combines the investment money of many people
whose financial goals are similar, and invests that money in a variety of
securities. A mutual fund allows the smaller investor the benefits of
diversification, professional management and constant supervision usually
available only to large investors.
PORTFOLIO MANAGER--An investment professional who is responsible for
managing a portfolio's assets prudently and making appropriate investment
decisions, such as which securities to buy, hold and sell, based on the
investment objectives of the portfolio.
STOCK--Equity or ownership interest in a corporation, which represents a
claim on the corporation's assets and earnings.
BOND--Security issued by a government or corporation to those from whom it
has borrowed money. A bond usually promises to pay interest income to the
bondholder at regular intervals and to repay the entire amount borrowed at
maturity date.
CONVERTIBLE SECURITY--A corporate security (usually preferred stock or
bonds) that is exchangeable for a set number of another security type
(usually common stocks) at a pre-stated price.
MONEY MARKET FUND--A mutual fund whose assets are invested in a diversified
portfolio of short- term securities, including commercial paper, bankers'
acceptances, certificates of deposit and other short-term instruments. The
fund pays income which can fluctuate daily. Liquidity and safety of principal
are primary objectives.
NET ASSET VALUE (NAV) PER SHARE--The value of one share of a mutual fund.
The NAV per share is determined by subtracting a fund's total liabilities
from its total assets, and dividing that amount by the number of fund shares
outstanding.
DIVIDEND--A per share distribution of the income earned from the fund's
portfolio holdings. When a dividend distribution is made, the fund's net
asset value drops by the amount of the distribution because the distribution
is no longer considered part of the fund's assets.
CAPITAL GAIN--The profit from the sale of securities, less any losses.
Capital gains are paid to fund shareholders on a per share basis. When a
capital gain distribution is made, the fund's net asset value drops by the
amount of the distribution because the distribution is no longer considered
part of the fund's assets.
YIELD--The annualized rate of income as measured against the current net
asset value of fund shares.
TOTAL RETURN--The change in value of a fund investment over a specified
period of time, taking into account the change in a fund's market price and
the reinvestment of all fund distributions.
SHORT-TERM--An investment with a maturity of one year or less.
LONG-TERM--An investment with a maturity of greater than one year.
AVERAGE MATURITY--The average number of days until the notes, drafts,
acceptances, bonds or other debt instruments in a portfolio become due and
payable.
OFFERING PRICE--The offering price of a share of a mutual fund is the price
at which the share is sold to the public.
<PAGE>
PAGE 10
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Keystone Quality Bond Fund (B-1)
SCHEDULE OF INVESTMENTS--October 31, 1996
<TABLE>
<CAPTION>
Interest Maturity Par Market
Rate Date Value Value
================================================================================================================
<S> <C> <C> <C> <C> <C>
FIXED INCOME (98.9%)
CORPORATE BONDS & NOTES (31.7%)
AIRCRAFT (0.9%)
Boeing Co. 7.875% 2043 $2,000,000 $ 2,146,420
- ----------------------------------------------------------------------------------------------------------------
BANK & FINANCE (13.0%)
AmSouth Bancorp. Subord. Deb. 6.750 2025 3,500,000 3,461,920
Associates Corp. North America Sr. Notes 7.625 2000 1,500,000 1,560,375
International Bank for
Reconstruction & Development
(World Bank) Deb. 8.250 2016 5,000,000 5,629,550
International Lease Finance
Corp. Notes 6.250 2000 2,235,000 2,219,377
Mellon Bank Corp. Subord. Notes 7.625 2007 3,500,000 3,665,340
NationsBank Corp. Subord. Notes 7.500 2006 4,500,000 4,656,555
Paine Webber Group, Inc. Sr. Notes 7.490 2004 3,500,000 3,545,500
Smith Barney Holdings, Inc. Notes 7.125 2006 3,000,000 3,016,770
Wachovia Corp. Subord. Notes 6.605 2025 2,000,000 1,974,840
- ----------------------------------------------------------------------------------------------------------------
29,730,227
- ----------------------------------------------------------------------------------------------------------------
CAPITAL GOODS (1.9%)
John Deere Capital Corp. Deb. 8.625 2019 4,000,000 4,280,000
- ----------------------------------------------------------------------------------------------------------------
CONSUMER GOODS (2.9%)
ConAgra, Inc. Sr. Notes 7.125 2026 3,000,000 3,070,440
Mattel, Inc. Notes 6.750 2000 3,500,000 3,455,760
- ----------------------------------------------------------------------------------------------------------------
6,526,200
- ----------------------------------------------------------------------------------------------------------------
DIVERSIFIED COMPANIES (0.5%)
Grand Metro Investment Corp.
(Eff. Yield 8.13%) (e) Co. Gtd. 0.000 2004 2,000,000 1,225,100
- ----------------------------------------------------------------------------------------------------------------
DRUGS (0.8%)
Lilly (Eli) & Co. Notes 6.570 2016 2,000,000 1,871,560
- ----------------------------------------------------------------------------------------------------------------
INSURANCE (4.6%)
AMBAC, Inc. Deb. 9.375 2011 2,000,000 2,414,500
Lumbermans Mutual Co. (d) Subord. Notes 9.150 2026 2,000,000 2,175,400
MBIA, Inc. Deb. 7.000 2025 4,000,000 3,816,280
Vesta Insurance Group, Inc. Deb. 8.750 2025 2,000,000 2,182,980
- ----------------------------------------------------------------------------------------------------------------
10,589,160
- ----------------------------------------------------------------------------------------------------------------
OIL (4.4%)
Atlantic Richfield Co. Deb. 9.875 2016 3,000,000 3,770,790
Occidental Petroleum Corp. Deb. 10.125 2009 3,000,000 3,716,970
Oslo Seismic Services, Inc. (d) 1st Pfd. Mtg. Notes 8.280 2011 2,500,000 2,577,375
- ----------------------------------------------------------------------------------------------------------------
10,065,135
- ----------------------------------------------------------------------------------------------------------------
<PAGE>
PAGE 11
- --------------------------------
SCHEDULE OF INVESTMENTS--October 31, 1996
Interest Maturity Par Market
Rate Date Value Value
================================================================================================================
RETAIL (1.1%)
Kohl's Corp. Notes 7.375% 2011 $ 2,500,000 $ 2,524,800
- ----------------------------------------------------------------------------------------------------------------
TELECOMMUNICATIONS (1.6%)
Sprint Corp. Deb. 9.250 2022 3,000,000 3,619,688
- ----------------------------------------------------------------------------------------------------------------
TOTAL CORPORATE BONDS & NOTES (COST--$70,823,953) 72,578,290
================================================================================================================
COLLATERALIZED MORTGAGE OBLIGATIONS (22.3%)
American Southwest Financial
Securities (Est. Mat. 1998) (b) Series 1994-C2 Class A3 8.000 2010 4,400,000 4,500,375
Asset Securitization Corp. (Est.
Mat. 2010) (b) Series 1996-D3 Class A3 7.526 2026 1,416,414 1,457,357
Criimi Mae Financial Corp. (Est.
Mat. 2004) (b) Series 1 Class A 7.000 2033 956,632 925,542
DeBartolo Limited Capital
Partnership (Est. Mat. 2001)
(b) (d) Series 1 Class B1 7.610 2004 1,550,000 1,598,437
FNMA REMIC Trust (Est. Mat.
2001) (b) Series 1996-17 Class A 6.000 2004 3,500,000 3,409,219
FNMA REMIC Trust (Est. Mat.
2004) (b) Series 1993-156 Class B 6.500 2018 2,800,000 2,697,604
FNMA REMIC Trust (Est. Mat.
2002) (b) Series 1996-28 Class PE 6.500 2020 5,000,000 4,957,031
FNMA REMIC Trust (Est. Mat.
2005) (b) Series 1992-181 Class PK 6.500 2021 4,000,000 3,862,480
FNMA REMIC Trust (Est. Mat.
2007) (b) Series 1993-38 Class L 5.000 2022 2,500,000 2,116,400
GS Mortgage Security Corp. (Est.
Mat. 2005) (b) Series 1996-PL Class A2 7.410 2027 1,850,000 1,851,156
KS Mortgage Capital LP (Est.
Mat. 1999) (b) (d) Series 1995-1 Class A1 7.041 2002 2,890,543 2,911,319
Merrill Lynch Trust (Est. Mat.
2005) (b) Series 35 Class G 8.450 2018 2,700,000 2,874,636
Morgan Stanley Capital I (Est.
Mat. 2004) (b) (d) Series 1996-WF Class 1B 6.586 2028 1,000,000 965,938
Paine Webber Mortgage Acceptance
Corp. IV (Est. Mat. 1997) (b) Series 1993-5 Class A3 6.875 2008 1,457,376 1,459,198
RASTA (Est. Mat. 1999) (b) Series 1996-AS Class A3 7.750 2026 3,000,000 3,034,453
Residential Accredit Loans, Inc. Series 1996-QS4 Class
(Est. Mat. 2005) (b) Series 1996-QS4 Class AI10 7.900 2026 3,500,000 3,582,031
Residential Funding Corp. (Est.
Mat. 1997) (b) Series 1994-S15 Class A1 7.750 2024 2,958,697 2,990,119
Ryland Acceptance Corp. (Est.
Mat. 2004) (b) Series 1988-E, 2 PAC 7.950 2019 2,794,173 2,828,206
Structured Asset Securities
Corp. (Est. Mat. 2000) (b) Series 1996-CFL Class B 6.303 2028 2,963,625 2,886,756
- ----------------------------------------------------------------------------------------------------------------
TOTAL COLLATERALIZED MORTGAGE OBLIGATIONS (COST--$50,578,120) 50,908,257
================================================================================================================
FOREIGN BONDS (NON U.S. DOLLARS) (14.3%)
Canadian Government Deb. 7.500 2003 11,000,000 8,879,114
Canadian Dollars
Canadian Government Deb. 8.750 2005 14,300,000 12,423,138
Canadian Dollars
Germany (Republic of) Deb. 6.500 2003 6,652,000 4,609,488
German Marks
Germany (Republic of) Deb. 6.875 2005 9,750,000 6,826,416
German Marks
- ----------------------------------------------------------------------------------------------------------------
TOTAL FOREIGN BONDS (NON U.S. DOLLARS) (COST--$30,889,476) 32,738,156
================================================================================================================
<PAGE>
PAGE 12
- --------------------------------
Keystone Quality Bond Fund (B-1)
SCHEDULE OF INVESTMENTS--October 31, 1996
Interest Maturity Par Market
Rate Date Value Value
================================================================================================================
MORTGAGE-BACKED SECURITIES (13.6%)
FHLMC Pool #303865 8.500% 1997 $ 23,337 $ 24,100
FHLMC Pool #607352 7.680 2022 820,651 856,046
FHLMC Pool #846298 7.191 2022 2,201,840 2,266,519
FNMA Pool #303664 6.500 2008 6,248,506 6,188,895
FNMA Pool #338867 6.500 2011 4,978,113 4,895,626
FNMA Pool #124945 7.617 2031 1,226,907 1,279,824
GNMA Pool #410254 7.000 2025 4,337,207 4,253,152
GNMA Pool #411526 7.000 2025 3,161,961 3,100,683
GNMA Pool #423413 7.000 2025 3,427,252 3,360,832
GNMA Pool #405576 6.500 2026 5,015,631 4,794,592
- ----------------------------------------------------------------------------------------------------------------
TOTAL MORTGAGE-BACKED SECURITIES (COST--$30,936,080) 31,020,269
================================================================================================================
ASSET-BACKED SECURITIES (10.6%)
CoreStates Home Equity Trust Series 1996-1 Class A4 7.000 2012 3,000,000 2,949,375
Ford Credit Auto Owner Trust Series 1996-B Class A4 6.300 2001 3,614,000 3,629,811
Merrill Lynch Mortgage
Investors, Inc. Series 1991-D Class A 9.000 2011 491 501
Merrill Lynch Mortgage
Investors, Inc. Series 1991-G Class B 9.150 2011 3,550,242 3,720,654
Merrill Lynch Mortgage
Investors, Inc. Series 1992-B Class B 8.500 2012 2,012,027 2,076,774
Merrill Lynch Mortgage
Investors, Inc. Series 1992-D Class B 8.500 2017 2,364,881 2,487,146
Olympic Auto Receivables Series 1996-C 6.800 2002 3,000,000 3,042,188
Southern Pacific Secured Assets
Corp. Series 1996-3 Class A4 7.600 2027 3,300,000 3,338,156
University Support Services,
Inc. Series 1992-D 9.074 2007 915,000 916,716
World Omni Automobile Lease
Trust Series 1996-B Class A3 6.250 2002 2,000,000 2,003,750
- ----------------------------------------------------------------------------------------------------------------
TOTAL ASSET-BACKED SECURITIES (COST--$23,560,144) 24,165,071
================================================================================================================
UNITED STATES GOVERNMENT (AND AGENCY) ISSUES (5.1%)
FHLB Deb. 8.700 2005 1,000,000 1,030,620
FHLMC Deb. 7.800 2016 2,000,000 2,065,000
U.S. Treasury Bonds 7.875 2021 4,200,000 4,756,500
U.S. Treasury Bonds 6.875 2025 1,250,000 1,277,925
U.S. Treasury Bonds 6.000 2026 2,900,000 2,645,351
- ----------------------------------------------------------------------------------------------------------------
TOTAL UNITED STATES GOVERNMENT (AND AGENCY) ISSUES (COST--$11,454,386) 11,775,396
================================================================================================================
FOREIGN BONDS (U.S. DOLLARS) (1.3%) (COST--$3,098,550)
Bayer Corp. (d) Notes 7.125 2015 3,000,000 2,940,870
- ----------------------------------------------------------------------------------------------------------------
TOTAL FIXED INCOME (COST--$221,340,709) 226,126,309
================================================================================================================
<PAGE>
PAGE 13
- --------------------------------
SCHEDULE OF INVESTMENTS--October 31, 1996
Interest Maturity Par Market
Rate Date Value Value
================================================================================================================
Keystone Joint Repurchase Agreement
(Investments in repurchase agreements, in a
joint trading account, purchased 10/31/96) (c) 5.565% 11/1/96 $307,047 $ 307,000
- ----------------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS (COST--$221,647,709) (A) 226,433,309
OTHER ASSETS AND LIABILITIES--NET (1.0%) 2,215,850
- ----------------------------------------------------------------------------------------------------------------
NET ASSETS (100%) $228,649,159
================================================================================================================
</TABLE>
(a) The cost of investments for federal income tax purposes is $222,327,705.
Gross unrealized appreciation and depreciation on investments, based on
identified tax cost at October 31, 1996, are as follows:
Gross unrealized appreciation $4,681,003
Gross unrealized depreciation (575,399)
----------
Net unrealized appreciation $4,105,604
==========
(b) The estimated maturity of a Collateralized Mortgage Obligation ("CMO") is
based on current and projected prepayment rates. Changes in interest
rates can cause the estimated maturity to differ from the listed dates.
(c) The repurchase agreements are fully collateralized by U.S. government
and/or agency obligations based on market prices at October 31, 1996.
(d) Securities that may be resold to "qualified institutional buyers" under
Rule 144A or securities offered pursuant to Section 4(2) of the Federal
Securities Act of 1933, as amended. These securities have been determined
to be liquid under guidelines established by the Board of Trustees.
(e) Effective yield (calculated at date of purchase) is the yield at which
the bond accretes on an annualized basis until maturity date.
Legend of Portfolio Abbreviations
FHLB--Federal Home Loan Bank
FHLMC--Federal Home Loan Mortgage Corporation
FNMA--Federal National Mortgage Association
GNMA--Government National Mortgage Association
RASTA--Residential Asset Securitization Trust Association
REMIC--Real Estate Mortgage Investment Conduit
PAC--Planned Amortization Class
FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS
<TABLE>
<CAPTION>
Unrealized
Exchange U.S. $ value at In Exchange Appreciation/
Date October 31, 1996 for U.S. $ (Depreciation)
==================================================================================================
<S> <C> <C> <C> <C>
Forward Foreign Currency Exchange Contracts to Buy:
Contracts to Receive
11/7/96 4,900,000 German Marks $ 3,237,007 $ 3,227,400 $ 9,607
11/29/96 8,569,000 Canadian Dollars 6,404,794 6,284,884 119,910
Forward Foreign Currency Exchange Contracts to Sell:
Contracts to Deliver
11/7/96 22,251,500 German Marks 14,699,645 15,104,211 404,566
11/29/96 36,579,000 Canadian Dollars 27,340,527 26,841,063 (499,464)
</TABLE>
See Notes to Financial Statements
<PAGE>
PAGE 14
- --------------------------------
Keystone Quality Bond Fund (B-1)
FINANCIAL HIGHLIGHTS
(For a share outstanding throughout each year)See Notes to Financial Statements.
<TABLE>
<CAPTION>
Year Ended October 31,
1996 1995 1994 1993 1992
==================================================================================================
<S> <C> <C> <C> <C> <C>
Net asset value beginning of year $ 15.42 $ 14.44 $ 16.40 $ 15.92 $ 15.92
- --------------------------------------------------------------------------------------------------
Income from investment operations:
Net investment income 0.75 0.87 0.76 0.96 1.04
Net realized and unrealized gain
(loss) on investments, closed
futures contracts and foreign
currency related transactions (0.16) 1.05 (1.76) 0.66 0.15
- --------------------------------------------------------------------------------------------------
Total from investment operations 0.59 1.92 (1.00) 1.62 1.19
- --------------------------------------------------------------------------------------------------
Less distributions from:
Net investment income (0.76) (0.87) (0.76) (0.96) (1.04)
In excess of net investment income 0 (0.05) (0.09) (0.18) (0.15)
Tax basis return of capital (0.06) (0.02) (0.11) 0 0
- --------------------------------------------------------------------------------------------------
Total distributions (0.82) (0.94) (0.96) (1.14) (1.19)
- --------------------------------------------------------------------------------------------------
Net asset value end of year $ 15.19 $ 15.42 $ 14.44 $ 16.40 $ 15.92
==================================================================================================
Total return (a) 3.99% 13.69% (6.27%) 10.50% 7.71%
Ratios/supplemental data
Ratios to average net assets:
Total expenses 1.95%(b) 1.96%(b) 1.86% 1.94% 2.01%
Net investment income 5.06% 5.86% 5.05% 5.85% 6.40%
Portfolio turnover rate 231% 244% 169% 190% 102%
- --------------------------------------------------------------------------------------------------
Net assets end of year (thousands) $228,649 $310,791 $327,276 $458,925 $456,912
==================================================================================================
</TABLE>
<TABLE>
<CAPTION>
1991 1990 1989 1988 1987
==================================================================================================
<S> <C> <C> <C> <C> <C>
Net asset value beginning of year $ 15.11 $ 15.85 $ 15.71 $ 15.52 $ 17.30
- --------------------------------------------------------------------------------------------------
Income from investment operations:
Net investment income 1.08 1.11 1.21 1.19 1.20
Net realized and unrealized gain
loss) on investments, closed
futures contracts and foreign
currency related transactions 0.99 (0.53) 0.25 0.32 (1.59)
- --------------------------------------------------------------------------------------------------
Total from investment operations 2.07 0.58 1.46 1.51 (0.39)
- --------------------------------------------------------------------------------------------------
Less distributions from:
Net investment income (1.08) (1.18) (1.32) (1.32) (1.39)
In excess of net investment income (0.18) (0.14) 0 0 0
Tax basis return of capital 0 0 0 0 0
- --------------------------------------------------------------------------------------------------
Total distributions (1.26) (1.32) (1.32) (1.32) (1.39)
- --------------------------------------------------------------------------------------------------
Net asset value end of year $ 15.92 $ 15.11 $ 15.85 $ 15.71 $ 15.52
==================================================================================================
Total return (a) 14.09% 3.93% 9.82% 10.09% (2.44%)
Ratios/supplemental data
Ratios to average net assets:
Total expenses 2.04% 1.95% 1.82% 1.64% 1.56%
Net investment income 6.95% 7.45% 7.61% 7.49% 7.32%
Portfolio turnover rate 158% 117% 116% 153% 127%
- --------------------------------------------------------------------------------------------------
Net assets end of year (thousands) $453,528 $408,330 $462,425 $447,454 $440,836
==================================================================================================
</TABLE>
(a) Excluding applicable sales charges.
(b) The ratio of total expenses to average net assets includes indirectly
paid expenses. Excluding indirectly paid expenses, the expense ratios
would have been 1.93% and 1.94% for the years ended October 31, 1996 and
1995, respectively.
See Notes to Financial Statements.
<PAGE>
PAGE 15
- --------------------------------
STATEMENT OF ASSETS AND LIABILITIES
October 31, 1996
=======================================================================
Assets (Note 2)
Investments at market value (identified cost--
$221,647,709) $226,433,309
Cash 492
Receivable for:
Investments sold 36,889
Interest 2,873,463
Fund shares sold 10,499
Unrealized appreciation on forward foreign currency
exchange contracts 534,083
Prepaid expenses and other assets 52,276
- -----------------------------------------------------------------------
Total assets 229,941,011
- -----------------------------------------------------------------------
Liabilities (Notes 2 and 5)
Payable for:
Fund shares redeemed 366,406
Distributions to shareholders 365,366
Unrealized depreciation on forward foreign currency
exchange contracts 499,464
Due to related parties 6,219
Other accrued expenses 54,397
- -----------------------------------------------------------------------
Total liabilities 1,291,852
- -----------------------------------------------------------------------
Net assets $228,649,159
=======================================================================
Net assets represented by
Paid-in capital $255,530,019
Accumulated distributions in excess of net
investment income (399,985)
Accumulated net realized loss on investments and
foreign currency related transactions (31,308,109)
Net unrealized appreciation on investments and
foreign currency related transactions 4,827,234
- -----------------------------------------------------------------------
Total net assets $228,649,159
- -----------------------------------------------------------------------
Net asset value per share (Note 2)
Net assets of $228,649,159 / 15,055,747 shares
outstanding $ 15.19
=======================================================================
STATEMENT OF OPERATIONS
Year Ended October 31, 1996
=======================================================================
Investment income
Interest $18,504,392
- -----------------------------------------------------------------------
Expenses (Notes 4, 5 and 6)
Management fee $ 1,578,211
Transfer agent fees 627,068
Accounting, auditing and legal fees 53,738
Custodian fees 142,613
Trustees' fees and expenses 31,867
Distribution Plan expenses 2,645,899
Other 65,509
- -----------------------------------------------------------------------
Total expenses 5,144,905
Less: Expenses paid indirectly (30,574)
- -----------------------------------------------------------------------
Net expenses 5,114,331
- -----------------------------------------------------------------------
Net investment income 13,390,061
- -----------------------------------------------------------------------
Net realized and unrealized loss on
investments and foreign currency
related transactions (Notes 1 and 3)
Net realized loss on:
Investments (1,910,620)
Foreign currency related
transactions (273,044)
- -----------------------------------------------------------------------
Net realized loss on investments
and foreign currency
related transactions (2,183,664)
- -----------------------------------------------------------------------
Net change in unrealized appreciation
(depreciation) on:
Investments (1,978,287)
Foreign currency related
transactions 41,634
- -----------------------------------------------------------------------
Net change in unrealized appreciation
(depreciation) on investments and
foreign currency
related transactions (1,936,653)
- -----------------------------------------------------------------------
Net realized and unrealized loss on
investments and foreign currency
related transactions (4,120,317)
- -----------------------------------------------------------------------
Net increase in net assets resulting
from operations $ 9,269,744
=======================================================================
See Notes to Financial Statements.
<PAGE>
PAGE 16
- --------------------------------
Keystone Quality Bond Fund (B-1)
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
Year Ended October 31,
1996 1995
===================================================================================================
<S> <C> <C>
Operations
Net investment income $ 13,390,061 $ 18,237,187
Net realized loss on investments, closed futures contracts and
foreign currency related transactions (2,183,664) (6,749,977)
Net change in unrealized appreciation (depreciation) on
investments and foreign currency related transactions (1,936,653) 28,285,126
- ---------------------------------------------------------------------------------------------------
Net increase in net assets resulting from operations 9,269,744 39,772,336
- ---------------------------------------------------------------------------------------------------
Distributions to shareholders from (Note 1)
Net investment income (13,289,851) (18,237,187)
In excess of net investment income 0 (763,245)
Tax basis return of capital (950,184) (472,154)
- ---------------------------------------------------------------------------------------------------
Total distributions to shareholders (14,240,035) (19,472,586)
- ---------------------------------------------------------------------------------------------------
Capital share transactions (Note 2)
Proceeds from shares sold 44,210,094 78,243,761
Payments for shares redeemed (130,171,813) (126,927,895)
Net asset value of shares issued in reinvestment of dividends
and distributions 8,789,681 11,900,336
- ---------------------------------------------------------------------------------------------------
Net decrease in net assets resulting from capital share
transactions (77,172,038) (36,783,798)
- ---------------------------------------------------------------------------------------------------
Total decrease in net assets (82,142,329) (16,484,048)
Net assets
Beginning of year 310,791,488 327,275,536
- ---------------------------------------------------------------------------------------------------
End of year [including accumulated distributions in excess of
net investment income as follows: 1996--($399,985) and
1995--($575,212)] (Note 1) $ 228,649,159 $ 310,791,488
===================================================================================================
</TABLE>
See Notes to Financial Statements.
<PAGE>
PAGE 17
- --------------------------------
NOTES TO FINANCIAL STATEMENTS
1. Significant Accounting Policies
Keystone Quality Bond Fund (B-1) (the "Fund") is a Pennsylvania common law
trust for which Keystone Management, Inc. ("KMI") is the Investment Manager
and Keystone Investment Management Company ("Keystone") is the Investment
Adviser. Keystone is a wholly-owned subsidiary of Keystone Investments, Inc.
("KII") and KMI is, in turn, a wholly-owned subsidiary of Keystone. The Fund
is registered under the Investment Company Act of 1940, as amended (the "1940
Act"), as a diversified, open-end investment company. The Fund seeks the
highest possible income consistent with preservation of principal. The Fund
invests primarily in high and investment grade corporate bonds, which possess
a high degree of dependability of interest and principal payments.
The following is a summary of significant accounting policies consistently
followed by the Fund in the preparation of its financial statements. The
policies are in conformity with generally accepted accounting principles,
which require management to make estimates and assumptions that affect
amounts reported herein. Although actual results could differ from these
estimates, any such differences are expected to be immaterial to the net
assets of the Fund.
A. Valuation of Securities
U.S. Government obligations held by the Fund are valued at the mean between
the over-the-counter bid and asked prices, as furnished by an independent
pricing service. Listed corporate bonds, other fixed income securities,
mortgage and other asset-backed securities, and other related securities are
valued at prices provided by an independent pricing service. In determining
value for normal institutional-size transactions, the pricing service uses
methods based on market transactions for comparable securities and various
relationships between securities that are generally recognized by
institutional traders. Securities for which valuations are not available from
an independent pricing service (including restricted securities) are valued
at fair value as determined in good faith according to procedures established
by the Board of Trustees.
Short-term investments with remaining maturities of 60 days or less are
carried at amortized cost, which approximates market value. Short-term
securities with greater than 60 days to maturity are valued at market value.
B. Repurchase Agreements
Pursuant to an exemptive order issued by the Securities
and Exchange Commission, the Fund, along with certain other Keystone funds,
may transfer uninvested cash balances into a joint trading account. These
balances are invested in one or more repurchase agreements that are fully
collateralized by U.S. Treasury and/or Federal Agency obligations.
Securities pledged as collateral for repurchase agreements are held by the
custodian on the Fund's behalf. The Fund monitors the adequacy of the
collateral daily and will require the seller to provide additional collateral
in the event the market value of the securities pledged falls below the
carrying value of the repurchase agreement.
C. Reverse Repurchase Agreements
The Fund enters into reverse repurchase agreements with qualified third-party
broker-dealers. Interest on the value of reverse repurchase agreements is
based upon competitive market rates at the time of issuance. At the time the
Fund enters into a reverse repurchase agreement, it will establish and
maintain a segregated account with its custodian containing liquid assets
having a value not less than the repurchase price (including accrued
interest). If the counterparty to the transaction is rendered insolvent, the
ultimate realiza-
<PAGE>
PAGE 18
- --------------------------------
Keystone Quality Bond Fund (B-1)
tion of the securities to be repurchased by the Fund may be delayed or
limited.
D. Foreign Currency
The books and records of the Fund are maintained in United States (U.S.)
dollars. Foreign currency amounts are translated into United States dollars
as follows: market value of investments, assets and liabilities at the daily
rate of exchange; purchases and sales of investments, income and expenses at
the rate of exchange prevailing on the respective dates of such transactions.
Net unrealized foreign exchange gain (loss) resulting from changes in foreign
currency exchange rates is a component of net unrealized appreciation
(depreciation) on investments and foreign currency transactions. Net realized
foreign currency gains and losses resulting from changes in exchange rates
include foreign currency gains and losses between trade date and settlement
date on investment securities transactions, foreign currency transactions and
the difference between the amounts of interest and dividends recorded on the
books of the Fund and the amount actually received. The portion of foreign
currency gains and losses related to fluctuations in exchange rates between
the initial purchase trade date and subsequent sale trade date is included in
realized gain (loss) on foreign currency transactions.
E. Futures Contracts
In order to gain exposure to or protect against changes in security values,
the Fund may buy and sell futures contracts.
The initial margin deposited with a broker when entering into a futures
transaction is subsequently adjusted by daily payments or receipts as the
value of the contract changes. Such changes are recorded as unrealized gains
or losses. Realized gains or losses are recognized upon closing the contract.
Risks of entering into futures contracts include (i) the possibility of an
illiquid market for the contract, (ii) the possibility that a change in value of
the contract may not correlate with changes in the value of the underlying
instrument or index, and (iii) the credit risk that the other party will not
fulfill their obligations under the contract. Futures contracts also involve
elements of market risk in excess of the amount reflected in the statement of
assets and liabilities.
F. Forward Foreign Currency Exchange Contracts
The Fund may enter into forward foreign currency exchange contracts ("forward
contracts") to settle portfolio
purchases and sales of securities denominated in a foreign currency and to
hedge certain foreign currency assets or liabilities. Forward contracts are
recorded at the forward rate and are marked-to-market daily. Realized gains
and losses arising from such transactions are included in net realized gain
(loss) on foreign currency related transactions. The Fund bears the risk of
an unfavorable change in the foreign currency exchange rate underlying the
forward contract and is subject to the credit risk that the other party will
not fulfill their obligations under the contract. Forward contracts involve
elements of market risk in excess of the amount reflected in the statement of
assets and liabilities.
G. Security Transactions and Investment Income
Securities transactions are accounted for no later than one business day
after the trade date. Realized gains and losses are computed on the
identified cost basis. Interest income is recorded on the accrual basis and
includes amortization of discounts.
H. Federal Income Taxes
The Fund has qualified and intends to qualify in the future as a regulated
investment company under the Internal Revenue Code of 1986, as amended (the
"Code"). Thus, the Fund is relieved of any federal income tax liability by
distributing all of its net tax-
<PAGE>
PAGE 19
- --------------------------------
able investment income and net taxable capital gains, if any, to its
shareholders. The Fund also intends to avoid excise tax liability by making
the required distributions under the Code. Accordingly, no provision for
federal income tax is required.
I. Distributions
The Fund distributes net investment income monthly and net capital gains, if
any, at least annually. Distributions to shareholders are recorded at the
close of business on the ex-dividend date.
Income and capital gains distributions to shareholders are determined in
accordance with income tax regulations which may differ from generally
accepted accounting principles. These differences are primarily due to
differing treatment for paydown gains (losses) and foreign currency
transactions.
2. Capital Share Transactions
The Fund's Trust Agreement, as amended and restored, authorizes the issuance
of an unlimited number of shares of beneficial interest with a par value of
$1.00. Transactions in shares of the Fund were as follows:
Year ended October 31,
1996 1995
- -------------------------------------------------------------
Shares sold 2,902,677 5,215,666
Shares redeemed (8,577,419) (8,523,861)
Shares issued in reinvestment
of dividends and
distributions 581,588 799,017
- -------------------------------------------------------------
Net decrease (5,093,154) (2,509,178)
=============================================================
3. Securities Transactions
Cost of purchases and proceeds from sales of investment securities (excluding
short-term securities) for the year ended October 31, 1996 were as follows:
Cost of Proceeds
Purchases from Sales
- ----------------------------------------------------
Non-U.S. Government $309,095,323 $255,751,880
U.S. Government 282,174,491 402,430,535
====================================================
The average daily balance of reverse repurchase agreements outstanding
during the year ended October 31, 1996 was approximately $7,133,000 at a
weighted average interest rate of 3.65%. The maximum amount of borrowing
during the year was $17,694,856 (including accrued interest).
As of October 31, 1996, the Fund has a capital loss carryover for federal
income tax purposes of approximately $30,627,000 which expires as follows:
$2,251,000--1998; $20,145,000--2002; $6,153,000--2003; and $2,078,000--2004.
4. Distribution Plan
The Fund bears some of the costs of selling its shares under a Distribution
Plan (the "Plan") adopted pursuant to Rule 12b-1 under the 1940 Act. Under
the Plan, the Fund pays its principal underwriter, Keystone Investment
Distributors Company ("KIDC"), a wholly-owned subsidiary of Keystone, amounts
which are calculated and paid daily.
Under the Plan, the Fund pays a distribution fee amount which may not exceed
1.00% of the Fund's average daily net assets. Of that amount, 0.75% is used
to pay distribution expenses and 0.25% may be used to pay service fees.
Contingent deferred sales charges paid by redeeming shareholders may be paid
to KIDC.
The Plan may be terminated at any time by vote of the Independent Trustees
or by vote of a majority of the outstanding voting shares of the Fund.
However,
<PAGE>
PAGE 20
- --------------------------------
Keystone Quality Bond Fund (B-1)
after the termination of the Plan, at the discretion of the Board of
Trustees, payments to KIDC may continue as compensation for its services
which had been earned while the Plan was in effect.
KIDC intends, but is not obligated, to continue to pay distribution costs
that exceed the current annual payments from the Fund. KIDC intends to seek
full payment of such distribution costs from the Fund at such time in the
future as, and to the extent that, payment thereof by the Fund would be
within permitted limits.
Total unpaid distribution costs at October 31, 1996 amounted to $9,151,321.
5. Investment Management Agreement and Other Affiliated Transactions
Under the terms of the Investment Management Agreement between KMI and the
Fund, KMI provides investment management and administrative services to the
Fund. In return, KMI is paid a management fee, computed and paid daily, at an
annual rate of 2.00% of the Fund's gross investment income plus an amount
determined by applying percentage rates starting at 0.50% and declining as
net assets increase to 0.25% per annum, to the average daily net asset value
of the Fund.
KMI has entered into an Investment Advisory Agreement with Keystone under
which Keystone provides investment advisory and management services to the
Fund. In return for its services, Keystone receives an annual fee equal to
85% of the management fee received by KMI.
During the year ended October 31, 1996, the Fund paid or accrued $23,191 to
Keystone for certain accounting services. The Fund paid or accrued $627,068
to Keystone Investor Resource Center, Inc., a wholly-owned subsidiary of
Keystone, for services rendered as the Fund's transfer and dividend
disbursing agent.
Certain officers and/or Directors of Keystone are also officers and/or
Trustees of the Fund. Officers of Keystone and affiliated Trustees receive no
compensation directly from the Fund.
6. Expense Offset Arrangement
The Fund has entered into an expense offset arrangement with its custodian.
For the year ended October 31, 1996, the Fund incurred total custody fees of
$142,613 and received a credit of $30,574 pursuant to this expense offset
arrangement, resulting in a net custody expense of $112,039. The assets
deposited with the custodian under this expense offset arrangement could have
been invested in income-producing assets.
7. Subsequent Distribution to Shareholders
A distribution from net investment income of $0.065 per share was declared
payable on December 5, 1996 to shareholders of record November 25, 1996. This
distribution is not reflected in the accompanying financial statements.
8. Agreement and Plan of Acquisition
On September 6, 1996, KII entered into an Agreement and Plan of Acquisition
and Merger with First Union Corporation ("First Union") and First Union
National Bank of North Carolina ("FUNB-NC") and certain other parties
pursuant to which KII will be merged with and into a wholly-owned subsidiary
of FUNB-NC. Subject to the receipt of required regulatory and shareholder
approvals, the proposed merger is expected to take place in December 1996.
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INDEPENDENT AUDITORS' REPORT
The Trustees and Shareholders
Keystone Quality Bond Fund (B-1)
We have audited the accompanying statement of assets and liabilities of
Keystone Quality Bond Fund (B-1), including the schedule of investments, as
of October 31, 1996, and the related statement of operations for the year
then ended, the statements of changes in net assets for each of the years in
the two-year period then ended, and the financial highlights for each of the
years in the ten-year period then ended. These financial statements and
financial highlights are the responsibility of the Fund's management. Our
responsibility is to express an opinion on these financial statements and
financial highlights based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements and
financial highlights are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. Our procedures included confirmation of
securities owned as of October 31, 1996 by correspondence with the custodian
and brokers. An audit includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred
to above present fairly, in all material respects, the financial position of
Keystone Quality Bond Fund (B-1) as of October 31, 1996, the results of its
operations for the year then ended, the changes in its net assets for each of
the years in the two-year period then ended, and the financial highlights for
each of the years in the ten-year period then ended in conformity with
generally accepted accounting principles.
KPMG Peat Marwick LLP
Boston, Massachusetts
November 29, 1996
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PAGE 22
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Keystone Quality Bond Fund (B-1)
Federal Tax Status--Fiscal 1996 Distributions (Unaudited)
During the fiscal year ended October 31, 1996, distributions of $0.82 per
share were paid in shares or cash. This total includes a nontaxable return of
capital equal to $0.06 per share. The remaining dividends are taxable to
shareholders as ordinary income in the year in which received by them or
credited to their accounts and are not eligible for the corporate dividend
received deduction.
In January 1997, we will send you complete information on the distributions
paid during the calendar year 1996 to help you in completing your federal tax
return.
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Keystone's Services
for Shareholders
KEYSTONE AUTOMATED RESPONSE LINE (KARL)--Receive up-to-date account
information on your balance, last transaction and recent Fund distribution.
You may also process transactions such as investments, redemptions and
exchanges using a touch-tone telephone as well as receive quotes on price,
yield, and total return of your Keystone Fund. Call toll-free,
1-800-346-3858.
EASY ACCESS TO INFORMATION ON YOUR ACCOUNT--Information about your Keystone
account is available 24 hours a day through KARL. To speak with a Shareholder
Services representative about your account, call toll-free 1-800-343-2898
between 8:00 A.M. and 6:00 P.M. Eastern time. Retirement Plan investors
should call 1-800-247-4075.
ADDITIONS TO YOUR ACCOUNT--You can buy additional shares for your account at
any time, with no minimum additional investment.
REINVESTMENT OF DISTRIBUTIONS--You can compound the return on your
investment by automatically reinvesting your Fund's distributions at net
asset value with no sales charge.
EXCHANGE PRIVILEGE--You may move your money among funds in the same Keystone
family quickly and easily for a nominal service fee. KARL gives you the added
ability to move your money any time of day, any day of the week. Keystone
offers a variety of funds with different investment objectives for your
changing investment needs.
ELECTRONIC FUNDS TRANSFER (EFT)-- Referred to as the "paper-less
transaction," EFT allows you to take advantage of a variety of preauthorized
account transactions, including automatic monthly investments and systematic
monthly or quarterly withdrawals. EFT is a quick, safe and accurate way to
move money between your bank account and your Keystone account.
CHECK WRITING--Shareholders of Keystone Liquid Trust may exercise the check
writing privilege to draw from their accounts.
EASY REDEMPTION--KARL makes redemption services available to you 24 hours a
day, every day of the year. The amount you receive may be more or less than
your original account value depending on the value of fund shares at time of
redemption.
RETIREMENT PLANS--Keystone offers a full range of retirement plans,
including IRA, SEP-IRA, profit sharing, money purchase, and defined
contribution plans. For more information, please call Retirement Plan
Services, toll-free at 1-800-247-4075.
Keystone is committed to providing you with quality, responsive account
service. We will do our best to assist you and your financial adviser in
carrying out your investment plans.
