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PROSPECTUS NOVEMBER 29, 1996
AS SUPPLEMENTED MAY 1, 1997
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KEYSTONE HIGH INCOME BOND FUND (B-4)
200 BERKELEY STREET, BOSTON, MASSACHUSETTS 02116-5034
CALL TOLL FREE 1-800-343-2898
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Keystone High Income Bond Fund (B-4) (the "Fund") is a mutual fund whose
investment objective is generous income. The generous income sought by the Fund
is ordinarily associated with high yield, high risk bonds and similar securities
in the lower rating categories of the recognized rating agencies or with
securities that are unrated.
Your purchase payment is fully invested. There is no sales charge when you
buy the Fund's shares. With certain exceptions, the Fund imposes a deferred
sales charge, which declines from 4.00% to 1.00%, if you redeem your shares
within four years of purchase.
The Fund has adopted a Distribution Plan pursuant to Rule 12b-1 under the
Investment Company Act of 1940 (the "1940 Act") under which it bears some of the
costs of selling its shares to the public.
This prospectus sets forth concisely the information about the Fund that
you should know before investing. Please read it and retain it for future
reference.
Additional information about the Fund is contained in a statement of
additional information dated November 29, 1996, as supplemented from time to
time, which has been filed with the Securities and Exchange Commission and is
incorporated by reference into this prospectus. For a free copy, or for other
information about the Fund, write to the address or call the telephone number
listed above.
SHARES OF THE FUND ARE NOT DEPOSITS OR OBLIGATIONS OF, OR GUARANTEED OR
ENDORSED BY, ANY BANK, AND SHARES ARE NOT INSURED OR OTHERWISE PROTECTED BY THE
U.S. GOVERNMENT, THE FEDERAL DEPOSIT INSURANCE CORPORATION, THE FEDERAL RESERVE
BOARD, OR ANY OTHER GOVERNMENT AGENCY AND INVOLVE RISK, INCLUDING THE POSSIBLE
LOSS OF PRINCIPAL.
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TABLE OF CONTENTS
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Page Page
Expense Information .............. 2 Distribution Plan ................ 12
Financial Highlights ............. 3 How to Buy Shares ................ 14
Fund Description ................. 4 How to Redeem Shares ............. 15
Investment Objective and Policies 4 Shareholder Services ............. 16
Investment Restrictions .......... 5 Performance Data ................. 18
Risk Factors ..................... 6 Fund Shares ...................... 18
Pricing Shares ................... 8 Additional Information ........... 18
Dividends and Taxes .............. 9 Additional Investment Information (i)
Fund Management and Expenses ..... 10
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THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS
A CRIMINAL OFFENSE.
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<PAGE>
EXPENSE INFORMATION
KEYSTONE HIGH INCOME BOND FUND (B-4)
The purpose of the fee table is to assist investors in understanding the
costs and expenses that an investor in the Fund will bear directly or
indirectly. For more complete descriptions of the various costs and expenses,
see the following sections of this prospectus: "Fund Management and Expenses";
"How to Buy Shares"; "Distribution Plan"; and "Shareholder Services."
SHAREHOLDER TRANSACTION EXPENSES
Maximum Deferred Sales Charge(1) ..................... 4.00%
(as a percentage of the lesser of original purchase
price or redemption proceeds, as applicable)
ANNUAL FUND OPERATING EXPENSES(2)
(as a percentage of average net assets)
Management Fees ...................................... 0.56%
12b-1 Fees(3) ........................................ 1.00%
Other Expenses ....................................... 0.38%
----
Total Fund Operating Expenses ........................ 1.94%
====
1 YEAR 3 YEARS 5 YEARS 10 YEARS
------ ------- ------- --------
EXAMPLE(4)
You would pay the following expenses
on a $1,000 investment, assuming (1)
a 5% annual return and (2)
redemption at the end of each
period: ............................ $60 $81 $105 $226
You would pay the following expenses
on the same investment, assuming no
redemption: ........................ $20 $61 $105 $226
AMOUNTS SHOWN IN THE EXAMPLE SHOULD NOT BE CONSIDERED A REPRESENTATION OF PAST
OR FUTURE EXPENSES; ACTUAL EXPENSES MAY BE GREATER OR LESS THAN THOSE SHOWN.
- ----------
(1) The deferred sales charge declines from 4.00% to 1.00% of amounts redeemed
within four calendar years after purchase. No deferred sales charge is
imposed thereafter.
(2) Expense ratios are for the Fund's fiscal year ended July 31, 1996. Total
Fund Operating Expenses include indirectly paid expenses.
(3) Long-term shareholders may pay more than the economic equivalent of the
maximum front-end sales charges permitted by rules adopted by the National
Association of Securities Dealers, Inc. (the "NASD").
(4) The Securities and Exchange Commission requires use of a 5% annual return
figure for purposes of this example. Actual return for the Fund may be
greater or less than 5%.
<PAGE>
FINANCIAL HIGHLIGHTS
KEYSTONE HIGH INCOME BOND FUND (B-4)
(For a share outstanding throughout each year)
The following table contains important financial information relating to the
Fund and has been audited by KPMG Peat Marwick LLP, the Fund's independent
auditors. The table appears in the Fund's Annual Report and should be read in
conjunction with the Fund's financial statements and related notes, which also
appear, together with the independent auditors' report, in the Fund's Annual
Report. The Fund's financial statements, related notes, and independent
auditors' report are incorporated by reference into the statement of additional
information. Additional information about the Fund's performance is contained in
its Annual Report, which will be made available upon request and without charge.
<TABLE>
<CAPTION>
YEAR ENDED JULY 31,
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1996 1995 1994 1993 1992 1991 1990 1989 1988 1987
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
NET ASSET VALUE
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
BEGINNING OF YEAR . $ 4.42 $ 4.68 $ 5.13 $ 4.74 $ 4.19 $ 5.02 $ 6.38 $ 6.91 $ 7.66 $ 8.08
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
INCOME FROM INVESTMENT OPERATIONS
Net investment
income ............ 0.32 0.38 0.38 0.45 0.49 0.61 0.68 0.83 0.80 0.81
Net realized and
unrealized gain
(loss) on
investments ....... (0.27) (0.15) (0.38) 0.44 0.58 (0.72) (1.18) (0.51) (0.71) (0.26)
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total from
investment
operations ........ 0.05 0.23 0 0.89 1.07 (0.11) (0.50) 0.32 0.09 0.55
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
LESS DISTRIBUTIONS FROM:
Net investment
income ............ (0.31) (0.37) (0.38) (0.45) (0.50) (0.72) (0.78) (0.85) (0.84) (0.90)
In excess of net
investment income . (0.06) (0.02) (0.07) (0.05) (0.02) 0 (0.08) 0 0 0
Tax basis return of
capital ........... 0 (0.10) 0 0 0 0 0 0 0 0
Net realized gain on
investments ....... 0 0 0 0 0 0 0 0 0 (0.07)
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total distributions (0.37) (0.49) (0.45) (0.50) (0.52) (0.72) (0.86) (0.85) (0.84) (0.97)
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
NET ASSET VALUE END
OF YEAR ........... $ 4.10 $ 4.42 $ 4.68 $ 5.13 $ 4.74 $ 4.19 $ 5.02 $ 6.38 $ 6.91 $ 7.66
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
TOTAL RETURN (a) ... 1.38% 5.66% (0.41%) 20.28% 27.25% 0.03% (7.84%) 4.95% 1.66% 7.15%
RATIOS/SUPPLEMENTAL DATA
RATIOS TO AVERAGE NET ASSETS:
Total expenses .... 1.94%(b) 2.03% 1.84% 2.06% 2.17% 2.34% 2.06% 1.97% 1.82% 1.65%
Net investment
income .......... 7.92% 8.64% 7.57% 9.30% 10.86% 14.64% 12.77% 12.36% 11.29% 10.26%
Portfolio turnover
rate .............. 116% 82% 110% 125% 94% 78% 45% 75% 81% 135%
NET ASSETS END OF
YEAR (THOUSANDS) .. $593,681 $764,965 $766,283 $972,164 $841,757 $710,590 $820,940 $1,188,660 $1,274,673 $1,464,891
(a) Excluding applicable sales charges.
(b) The expense ratio includes indirectly paid expenses for the year ended July 31, 1996. Excluding indirectly paid expenses, the
expense ratio would have been 1.93%.
</TABLE>
<PAGE>
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FUND DESCRIPTION
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The Fund is an open-end, diversified management investment company, commonly
known as a mutual fund. The Fund was created under Pennsylvania law as a common
law trust and has been offering its shares continuously since September 11,
1935. The Fund is one of more than thirty funds advised and managed by Keystone
Investment Management Company ("Keystone"), the Fund's investment
adviser.
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INVESTMENT OBJECTIVE AND POLICIES
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INVESTMENT OBJECTIVE
The Fund's investment objective is to provide shareholders with generous
income.
The Fund's investment objective is fundamental and cannot be changed without
the approval of a majority of the Fund's outstanding shares (as defined in the
1940 Act), which means the lesser of (1) 67% of the shares represented at a
meeting at which more than 50% of the outstanding shares are represented or (2)
more than 50% of the outstanding shares (a "1940 Act Majority").
Any investment involves risk, and there is no assurance that the Fund will
achieve its investment objective.
PRINCIPAL INVESTMENTS
Under normal circumstances, the Fund will invest at least 65% of its total
assets in bonds, debentures, and other income obligations. The Fund's portfolio
ordinarily includes a substantial number of bonds, debentures, and other income
obligations that are rated by Standard & Poor's Corporation ("S&P") or Moody's
Investors Service ("Moody's") as below investment grade, i.e., S&P rating below
BBB and Moody's rating below BAA.
While growth of capital is not a Fund objective, the Fund may purchase
securities that offer the possibility of capital appreciation in addition to
income, provided the acquisition of such securities does not conflict with the
Fund's objective of generous income.
The Fund may purchase securities with any rating or may purchase unrated
securities, which are not necessarily of lower quality than rated securities,
but may not be as attractive to as many buyers. While Keystone performs its own
credit analyses of the Fund's investments and does not rely on ratings assigned
by rating services, bonds rated below-investment grade generally involve greater
volatility of price and risk of principal and income than bonds in the higher
rating categories and are, on balance, considered predominantly speculative.
In addition to its other investment options, the Fund may invest in limited
partnerships, including master limited partnerships, and may invest up to 25% of
its assets in foreign securities. The Fund may also invest in participations in
bank loans.
OTHER ELIGIBLE INVESTMENTS
When market conditions warrant, the Fund may invest up to 100% of its assets
for temporary or defensive purposes in short-term investments. Such investments,
which must mature within one year of their purchase, consist of United States
("U.S.") government securities; instruments, including certificates of deposit,
demand and time deposits and bankers' acceptances, of banks that are members of
the Federal Deposit Insurance Corporation and have assets of at least $1
billion, including U.S. branches of foreign banks and foreign branches of U.S.
banks; prime commercial paper, including master demand notes; and repurchase
agreements secured by U.S. government securities. When the Fund invests for
defensive purposes, it seeks to limit the loss of principal and is not pursuing
its investment objective.
The Fund's investments may include fixed and adjustable rate or stripped
bonds, including zero coupon bonds and payment-in-kind securities ("PIKs"),
debentures, notes, equipment trust certificates, U.S. government securities, and
debt securities convertible into or exchangeable for preferred or common stock.
The Fund may continue to hold preferred or common stock received in connection
with convertible or exchangeable securities. The Fund may also invest in units
consisting of debt securities with stock or warrants to buy stock attached.
The Fund may also invest in preferred stock, including convertible preferred
stock and adjustable rate preferred stock; warrants, which may be used to create
other permissible investments; and common stock of issuers that are objects of
acquisition attempts, are undergoing reorganization through bankruptcy or
otherwise, or are in the process of refinancing. Investments in common stocks of
such issuers are expected to provide the Fund with the opportunity to receive
high-yielding, fixed-income securities. Investments in common stocks will be
limited to those stocks that Keystone believes will assist the Fund in achieving
its investment objective.
The Fund intends to follow policies of the Securities and Exchange Commission
as they are adopted from time to time with respect to illiquid securities,
including, at this time, (1) treating as illiquid, securities that may not be
sold or disposed of in the ordinary course of business within seven days at
approximately the value at which the Fund has valued the investment on its books
and (2) limiting its holdings of such securities to 15% of net assets.
The Fund may invest in restricted securities, including securities eligible
for resale pursuant to Rule 144A under the Securities Act of 1933 (the "1933
Act"). Generally, Rule 144A establishes a safe harbor from the registration
requirements of the 1933 Act for resale by large institutional investors of
securities not publicly traded in the U.S. The Fund may purchase Rule 144A
securities when such securities present an attractive investment opportunity and
otherwise meet the Fund's selection criteria. The Board of Trustees has adopted
guidelines and procedures pursuant to which the liquidity of the Fund's Rule
144A securities is determined by Keystone, and the Board of Trustees monitors
Keystone's implementation of such guidelines and procedures.
At the present time, the Fund cannot accurately predict exactly how the market
for Rule 144A securities will develop. A Rule 144A security that was readily
marketable upon purchase may subsequently become illiquid. In such an event, the
Board of Trustees will consider what action, if any, is appropriate.
The Fund may (i) write covered call and put options; (ii) purchase call and
put options, including call and put options to close out existing positions; and
(iii) employ new investment techniques with respect to such options. The Fund
currently does not intend to invest more than 5% of its assets in options
transactions.
The Fund may enter into reverse repurchase agreements and firm commitment and
when-issued transactions for securities and currencies. In addition, the Fund
may enter into currency and other financial futures contracts and related
options transactions for hedging purposes and not for speculation. The Fund may
also employ new investment techniques with respect to such futures contracts and
related options transactions. The Fund will supplement its prospectus if
appropriate in the event it employs any such new techniques.
In addition to the options, futures contracts, and forwards mentioned above,
the Fund may also invest in certain other types of derivative instruments,
including collateralized mortgage obligations, structured notes, interest rate
swaps, index swaps, currency swaps, and caps and floors. These basic vehicles
can also be combined to create more complex products called hybrid derivatives
or structured securities.
For further information about the types of investments and investment
techniques available to the Fund, including the associated risks, see the "Risk
Factors" and "Additional Investment Information" sections of this prospectus as
well as the statement of additional information.
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INVESTMENT RESTRICTIONS
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The Fund has adopted the fundamental restrictions summarized below, which may
not be changed without the approval of a 1940 Act Majority of the Fund's
outstanding shares. These restrictions and certain other fundamental and
nonfundamental restrictions are set forth in detail in the statement of
additional information.
The Fund may not do the following: (1) with respect to 75% of its total
assets, invest more than 5% of its total assets, computed at market value at the
time of purchase, in the securities of any one issuer, or invest in more than
10% of the outstanding voting securities of any one issuer; provided that these
limitations do not apply to investments in securities issued or guaranteed by
the U.S. government and (2) borrow money, except that the Fund may borrow money
from banks for temporary or emergency purposes in aggregate amounts up to 10% of
the value of the Fund's net assets (computed at cost), or enter into reverse
repurchase agreements (bank borrowings and reverse repurchase agreements, in the
aggregate, shall not exceed 10% of the value of the Fund's net assets).
In addition, the Fund may, notwithstanding any other investment policy or
restriction, invest all of its assets in the securities of a single open-end
management investment company with substantially the same fundamental investment
objective, policies, and restrictions as the Fund. The Fund does not currently
intend to implement this policy and would do so only if the Board of Trustees
were to determine such action to be in the best interest of the Fund and its
shareholders. In the event of such implementation, the Fund will comply with
such requirements as to written notice to shareholders as are then in effect.
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RISK FACTORS
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Like any investment, your investment in the Fund involves an element of risk.
Before you buy shares of the Fund, you should carefully evaluate your ability to
assume the risks your investment in the Fund poses. YOU CAN LOSE MONEY BY
INVESTING IN THE FUND. YOUR INVESTMENT IS NOT GUARANTEED. A DECREASE IN THE
VALUE OF THE FUND'S PORTFOLIO SECURITIES CAN RESULT IN A DECREASE IN THE VALUE
OF YOUR INVESTMENT.
Certain risks related to the Fund are discussed below. To the extent not
discussed in this section, specific risks attendant to individual securities or
investment practices are discussed in detail in "Additional Investment
Information" and the statement of additional information.
By itself, the Fund does not constitute a balanced investment plan. The Fund
seeks generous income ordinarily from high yield, high risk bonds, commonly
known as "junk bonds." This investment approach involves risks greater than a
more conservative approach. You should take into account your own investment
objectives as well as your other investments when considering an investment in
the Fund.
Should the Fund need to raise cash to meet a large number of redemptions, it
might have to sell portfolio securities at a time when it would be
disadvantageous to do so.
BELOW-INVESTMENT GRADE BONDS
Since 1935, the Fund has had continuous experience investing in bonds selling
at a substantial discount from par, convertible bonds, below- investment grade
bonds, and other securities that as a class may be considered high yield, high
risk securities.
Prior to the 1980's, corporate bonds were primarily issued to finance growth
and development. Below-investment grade bonds were predominantly bonds that
often traded at discounts from par because the company's credit ratings had been
downgraded. The rapid growth of the below-investment grade sector of the bond
market during the 1980's was largely attributable to the issuance of such bonds
to finance corporate reorganizations. An economic downturn could severely
disrupt the market for high yield, high risk bonds and adversely affect the
value of outstanding bonds and the ability of issuers to repay principal and
interest.
Although the change in the size and characteristics of the market may result
in higher risks associated with individual bonds, Keystone believes that an
effective program of broad diversification can, over time, enable the Fund to
successfully achieve its investment objective while reducing the risk of
investing in individual below-investment grade bonds.
The generous income sought by the Fund is ordinarily associated with
securities in the lower rating categories of the recognized rating agencies or
with securities that are unrated. Such securities are generally rated BB or
lower by S&P or Ba or lower by Moody's. The Fund may invest in securities that
are rated as low as D by S&P and C- by Moody's. It is possible for securities
rated D or C-, respectively, to have defaulted on payments of principal and/or
interest at the time of investment. The section of this prospectus entitled
"Additional Investment Information" describes these rating categories. The Fund
intends to invest in D rated debt only in cases when, in Keystone's judgment,
there is a distinct prospect of improvement in the issuer's financial position
as a result of the completion of reorganization or otherwise. The Fund may also
invest in unrated securities that, in Keystone's judgment, offer comparable
yields and risks to those of securities that are rated, as well as in
below-investment quality zero coupon bonds or PIKs.
Keystone considers the ratings of Moody's and S&P assigned to various
securities, but does not rely solely on those ratings because (1) Moody's and
S&P assigned ratings are based largely on historical financial data and may not
accurately reflect the current financial outlook of companies, and (2) there can
be large differences among the current financial conditions of issuers within
the same rating category.
While an investment in the Fund provides opportunities to maximize return over
time, investors should be aware of the following risks associated with
below-investment grade bonds:
(1) Securities rated BB or lower by S&P or Ba or lower by Moody's are
considered predominantly speculative with respect to the ability of the issuer
to meet principal and interest payments.
(2) The lower ratings of certain securities held by the Fund reflect a greater
possibility that adverse changes in the financial condition of the issuer or in
general economic conditions, or both, or an unanticipated rise in interest rates
may impair the ability of the issuer to make payments of interest and principal,
especially if the issuer is highly leveraged. Such issuer's ability to meet its
debt obligations may also be adversely affected by specific corporate
developments, the issuer's inability to meet specific projected business
forecasts, or the unavailability of additional financing. Also, an economic
downturn or an increase in interest rates may increase the potential for default
by the issuers of these securities.
(3) Their values are more sensitive to real or perceived adverse economic,
company or industry conditions and publicity than is the case for higher quality
securities.
(4) Their value, like those of other fixed income securities, fluctuates in
response to changes in interest rates; generally rising when interest rates
decline and falling when interest rates rise. For example, if interest rates
increase after a fixed-income security is purchased, the security, if sold prior
to maturity, may return less than its cost. The prices of below- investment
grade bonds, however, are generally less sensitive to interest rate changes than
the prices of higher-rated bonds.
(5) The secondary market for certain securities held by the Fund may be less
liquid at certain times than the secondary market for higher quality debt
securities, which may adversely effect (i) the market price of the security,
(ii) the Fund's ability to dispose of particular issues and (iii) the Fund's
ability to obtain accurate market quotations for purposes of valuing its assets.
(6) Zero coupon bonds and PIKs involve additional special considerations. Zero
coupon bonds do not require the periodic payment of interest. PIK bonds are debt
obligations that provide that the issuer may, at its option, pay interest on
such bonds in cash or in the form of additional debt obligations. Such
investments may experience greater fluctuation in value due to changes in
interest rates than debt obligations that pay interest currently. Even though
these investments do not pay current interest in cash, the Fund is nonetheless
required by tax laws to accrue interest income on such investments and to
distribute such amounts at least annually to shareholders. Thus, the Fund could
be required at times to liquidate investments in order to fulfill its intention
to distribute substantially all of its net income as dividends.
The following table shows the weighted average percentages of the Fund's
assets invested at the end of each month during the last fiscal year in
securities assigned to the various rating categories by S&P and in unrated
securities determined by Keystone to be of comparable quality. Since the
percentages in this table are based on month-end averages throughout the Fund's
fiscal year, they do not reflect the Fund's holdings at any one point in time.
The percentages in each category may be higher or lower on any day than those
shown in the table.
*UNRATED SECURITIES
OF COMPARABLE
RATED SECURITIES QUALITY AS
AS PERCENTAGE OF PERCENTAGE OF
RATING FUND'S ASSETS FUND'S ASSETS
- ---- ----------------- -------------------
AAA 0.00% 0.00%
AA 0.00% 0.00%
A 0.00% 0.00%
BBB 1.37% 0.00%
BB 29.33% 0.30%
B 46.49% 5.95%
CCC 1.51% 4.00%
CC 0.00% 0.00%
C 0.00% 0.00%
D 0.00% 0.19%
Unrated* 10.44%
U.S. governments, cash, equities
and others 10.86%
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TOTAL 100.00%
-------
Since the Fund takes an aggressive approach to investing, Keystone attempts to
maximize the return by controlling risk through diversification, credit
analysis, review of sector and industry trends, interest rate forecasts, and
economic analysis. Keystone's analysis of securities focuses on values based on
factors such as interest or dividend coverage, asset values, earnings prospects,
and the quality of management of the company. In making investment
recommendations, Keystone also considers current income, potential for capital
appreciation, maturity structure, quality guidelines, coupon structure, average
yield, percentage of zeros and PIKs, percentage of non-accruing items, and yield
to maturity.
Income and yields on high yield, high risk securities, as on all securities,
will fluctuate over time.
FOREIGN RISK
The Fund may invest up to 25% of its assets in securities that are principally
traded in securities markets outside the U.S. While investing in foreign
securities is intended to reduce risk by providing further diversification, such
investments do involve the following risks: publicly available information on
issuers and securities may be scarce; many foreign countries do not follow the
same accounting, auditing, and financial reporting standards as are used in the
U.S.; market trading volumes may be smaller, resulting in less liquidity and
more price volatility compared to U.S. securities of comparable quality; there
may be less regulation of securities trading and its participants; the
possibility may exist for expropriation, confiscatory taxation, nationalization,
establishment of exchange controls, political or social instability or negative
diplomatic developments; and dividend or interest withholding may be imposed at
the source.
Fluctuations in foreign exchange rates impose an additional level of risk,
possibly affecting the value of the Fund's foreign investments and earnings, as
well as gains and losses realized through trades, and the unrealized
appreciation or depreciation of investments. The Fund may also incur costs when
it shifts assets from one country to another.
DERIVATIVE SECURITIES
With respect to derivative or structured securities, the market value of such
securities may vary depending on the manner in which such securities have been
structured. As a result, the value of such investments may change at a more
rapid rate than that of traditional fixed income securities.
For more detailed information on derivatives, see "Additional Investment
Information" and the statement of additional information.
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PRICING SHARES
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The Fund computes its net asset value as of the close of trading (currently
4:00 p.m. eastern time) on each day that the New York Stock Exchange (the
"Exchange") is open. However, the Fund does not compute its net asset value on
days when changes in the value of the Fund's securities do not affect the
current net asset value of its shares. The Exchange currently is closed on
weekends, New Year's Day, Presidents' Day, Good Friday, Memorial Day,
Independence Day, Labor Day, Thanksgiving Day, and Christmas Day. The net asset
value per share is arrived at by determining the value of all of the Fund's
assets, subtracting all liabilities and dividing the result by the number of
shares outstanding.
Current values for the Fund's portfolio securities are determined as follows:
(1) short-term investments with remaining maturities of sixty days or less are
valued at amortized cost (original purchase cost as adjusted for amortization of
premium or accretion of discount), which, when combined with accrued interest,
approximates market;
(2) short-term investments with greater than sixty days to maturity are
valued at market value; and
(3) all other investments are valued at market value or, when market
quotations are not readily available, at fair value, as determined in good faith
by the Board of Trustees.
The Fund believes that reliable market quotations are generally not readily
available for purposes of valuing certain fixed income securities. As a result,
it is likely that most of the valuations for such securities will be based upon
their fair value determined under procedures that have been approved by the
Board of Trustees. The Board of Trustees has authorized the use of a pricing
service to determine the fair value of the Fund's fixed income securities and
certain other securities.
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DIVIDENDS AND TAXES
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The Fund has qualified and intends to continue to qualify as a regulated
investment company (a "RIC") under the Internal Revenue Code of 1986, as amended
(the "Code"). The Fund qualifies if, among other things, it distributes to its
shareholders at least 90% of its net investment income for its fiscal year. The
Fund also intends to make timely distributions, if necessary, sufficient in
amount to avoid the nondeductible 4% excise tax imposed on a RIC when it fails
to distribute, with respect to each calendar year, at least 98% of its ordinary
income for such calendar year and 98% of its net capital gains for the one-year
period ending on October 31 of such calendar year.
If the Fund qualifies as a RIC and if it distributes all of its net investment
income and net capital gains, if any, to shareholders, it will be relieved of
any federal income tax liability.
The Fund will declare dividends from its net investment income daily and will
pay such dividends monthly. The Fund will distribute its net capital gains, if
any, at least annually. Shareholders receive Fund distributions in the form of
additional shares of the Fund or, at the shareholder's election (which must be
made before the record date for the distribution), in cash. Fund distributions
in the form of additional shares are made at net asset value without the
imposition of a sales charge.
Dividends and distributions are taxable whether they are received in cash or
in shares. Income dividends and net short-term gains distributions are taxable
as ordinary income. Net long-term gains distributions are taxable as capital
gains regardless of how long the Fund's shares are held. If Fund shares held for
less than six months are sold at a loss, however, such loss will be treated for
tax purposes as a long-term capital loss to the extent of any long-term capital
gains dividends received. Any taxable dividend declared in October, November, or
December to shareholders of record in such month and paid by the following
January 31, will be includable in the taxable income of the shareholder as if
paid on December 31 of the year in which the dividend was declared.
The Fund advises its shareholders annually as to the federal tax status of all
distributions made during the year. Dividends and distributions also may be
subject to state and local taxes.
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FUND MANAGEMENT AND EXPENSES
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FUND MANAGEMENT
The Fund's Board of Trustees has absolute and exclusive control over the
management and disposition of all assets of the Fund. Subject to the authority
of the Fund's Board of Trustees, Keystone provides investment advice, management
and administrative services to the Fund.
INVESTMENT ADVISER
Keystone has provided investment advisory and management services to
investment companies and private accounts since 1932. Keystone is a wholly-owned
subsidiary of First Union Keystone, Inc. ("First Union Keystone"). First Union
Keystone provides accounting, bookkeeping, legal, personnel and general
corporate services to Keystone, its affiliates and the Keystone Families of
Funds. Both First Union Keystone and Keystone are located at 200 Berkeley
Street, Boston, Massachusetts 02116-5034.
On December 11, 1996, First Union Keystone succeeded to the business of a
corporation under different ownership. First Union Keystone is a wholly-owned
subsidiary of First Union National Bank of North Carolina ("FUNB"). FUNB is a
subsidiary of First Union Corporation ("First Union"), the sixth largest bank
holding company in the U.S. based on total assets as of December 31, 1996.
First Union is headquartered in Charlotte, North Carolina, and had $140
billion in consolidated assets as of December 31, 1996. First Union and its
subsidiaries provide a broad range of financial services to individuals and
businesses throughout the U.S. The Capital Management Group of FUNB, together
with Lieber & Company and Evergreen Asset Management Corp., wholly-owned
subsidiaries of FUNB, manage or otherwise oversee the investment of over $60
billion in assets as of December 31, 1996 belonging to a wide range of clients,
including the Evergreen Family of Funds.
Pursuant to its Investment Advisory and Management Agreement with the Fund
(the "Advisory Agreement"), Keystone manages the investment and reinvestment of
the Fund's assets, supervises the operation of the Fund and provides all
necessary office space, facilities and equipment.
The Fund pays Keystone a fee for its services at the annual rate set forth
below:
AGGREGATE NET ASSET VALUE
MANAGEMENT OF THE SHARES
FEE INCOME OF THE FUND
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2% of
gross dividend and
interest income
plus
0.50% of the first $100,000,000, plus
0.45% of the next $100,000,000, plus
0.40% of the next $100,000,000, plus
0.35% of the next $100,000,000, plus
0.30% of the next $100,000,000, plus
0.25% of amounts over $500,000,000;
Keystone's fee is computed as of the close of business each business day and
payable monthly.
The Advisory Agreement continues in effect for two years from its effective
date and, thereafter, from year to year only so long as such continuance is
specifically approved at least annually by the Board of Trustees or by the vote
of shareholders of the Fund. In addition, the terms and annual continuance of
the Advisory Agreement must be approved by the vote of a majority of the
Independent Trustees (Trustees who are not interested persons (as defined in the
1940 Act) of the Fund cast in person at a meeting called for the purpose of
voting on such approval. The Advisory Agreement may be terminated, without
penalty, on 60 days' written notice by the Fund or Keystone or may be terminated
by a vote of shareholders of the Fund. The Advisory Agreement will terminate
automatically upon its "assignment," as defined in the 1940 Act.
PRINCIPAL UNDERWRITER
Evergreen Keystone Distributor, Inc. ("EKD" or the "Principal Underwriter"), a
subsidiary of The BISYS Group, Inc., ("BISYS") which is not affiliated with
First Union, is the Fund's principal underwriter. EKD replaced Evergreen
Keystone Investment Services, Inc. (formerly Keystone Investment Distributors
Company) ("EKIS") as the Fund's principal underwriter. EKIS may no longer act as
principal underwriter of the Fund due to regulatory restrictions imposed by the
Glass-Steagall Act upon national banks such as FUNB and their affiliates, that
prohibit such entities from acting as the underwriters or distributors of mutual
fund shares. While EKIS may no longer act as principal underwriter of the Fund
as discussed above, EKIS may continue to receive compensation from the Fund or
the Principal Underwriter in respect of underwriting and distribution services
performed prior to the termination of EKIS as principal underwriter. In
addition, EKIS may also be compensated by the Principal Underwriter for the
provision of certain marketing support services to the Principal Underwriter at
an annual rate of up to 0.75% of the average daily net assets of the Fund,
subject to certain restrictions. EKD is located at 125 W. 55th Street, New York
10019.
SUB-ADMINISTRATOR
BISYS, or an affiliate, provides officers and certain administrative services
to the Fund pursuant to a sub-administrator agreement. For its services under
that agreement, BISYS, or an affiliate, receives a fee from Keystone at the
maximum annual rate of 0.01% of the average daily net assets of the Fund. BISYS
is located at 3435 Stelzer Road, Columbus, Ohio 43219.
CODE OF ETHICS
The Fund has adopted a Code of Ethics incorporating policies on personal
securities trading as recommended by the Investment Company Institute.
PORTFOLIO MANAGER
Prescott B. Crocker, a Senior Vice President and Portfolio Manager, is manager
of the Fund's portfolio. Prior to joining Keystone in February, 1997, Mr.
Crocker was president and chief investment officer of Boston Security
Counsellors, a private accounts investment management firm and a subsidiary of
Advest Co. Inc. He has more than 20 years of fixed-income investment experience.
FUND EXPENSES
The Fund will pay all of its expenses. In addition to the investment advisory
and management fees discussed above, the principal expenses that the Fund is
expected to pay include, but are not limited to, expenses of its transfer agent,
its custodian, its independent auditors; expenses of legal counsel for the Fund
and for its Trustees in connection with legal matters relating to the Fund;
expenses under its Distribution Plan; fees and expenses of its Independent
Trustees (Trustees who are not interested persons, as defined in the 1940 Act,
of the Fund); expenses of shareholders' and Trustees' meetings; fees payable to
government agencies, including registration and qualification fees of the Fund
and its shares under federal and state securities laws; expenses of preparing,
printing and mailing Fund prospectuses, notices, reports, and proxy material;
and certain extraordinary expenses. In addition to such expenses, the Fund pays
its brokerage commissions, interest charges, and taxes. For the fiscal year
ended July 31, 1996, the Fund paid 1.94% of its average net assets in expenses.
During the fiscal year ended July 31, 1996, the Fund paid or accrued to
Keystone Management, Inc., the Fund's former investment manager, investment
management and advisory fees of $3,788,171 (0.56% of the Fund's average daily
net assets). Of such amount, $3,219,945 was paid to Keystone for investment
advisory services to the Fund. During the same period, the Fund paid or accrued
$18,334 to Keystone for certain accounting services and $1,927,228 to Evergreen
Keystone Service Company, (formerly Keystone Investor Resource Center, Inc.)
("EKSC"), for services rendered as the Fund's transfer and dividend disbursing
agent. EKSC, a wholly-owned subsidiary of Keystone, is located at 200 Berkeley
Street, Boston, Massachusetts 02116-5034.
SECURITIES TRANSACTIONS
Under policies established by the Board of Trustees, Keystone selects
broker-dealers to execute transactions subject to the receipt of best execution.
When selecting broker-dealers to execute portfolio transactions for the Fund,
Keystone may consider the number of shares of the Fund sold by such
broker-dealers. In addition, broker-dealers executing portfolio transactions
may, from time to time, be affiliated with the Fund, First Union Keystone,
Keystone, the Fund's principal underwriter, or their affiliates. The Fund may
pay higher commissions to broker-dealers that provide research services.
Keystone may use these services in advising the Fund as well as in advising its
other clients.
PORTFOLIO TURNOVER
The Fund's portfolio turnover rates for the fiscal years ended July 31, 1996
and 1995 were 116% and 82%, respectively. High portfolio turnover may involve
correspondingly greater brokerage commissions and other transaction costs, which
would be borne directly by the Fund, as well as additional realized gains and/or
losses to shareholders. For further information on the tax consequences of such
realized gains and/or losses, see the "Dividends and Taxes" section of this
prospectus. For further information about brokerage and distributions, see the
statement of additional information.
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DISTRIBUTION PLAN
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The Fund bears some of the costs of selling its shares under the Distribution
Plan. The Fund's Distribution Plan provides that the Fund may expend up to
0.3125% quarterly (1.25% annually) of the average daily net asset value of its
shares to pay distribution costs for sales of its shares and to pay shareholder
service fees. The NASD currently limits such annual expenditures to 1.00% of the
aggregate average daily net asset value of its shares, of which 0.75% may be
used to pay such distribution costs and 0.25% may be used to pay shareholder
service fees. The NASD also limits the aggregate amount that the Fund may pay
for such distribution costs to 6.25% of gross share sales since the inception of
the Fund's Distribution Plan, plus interest at the prime rate plus 1.00% on such
amounts (less any contingent deferred sales charge (a "CDSC") paid by
shareholders to the Principal Underwriter) remaining unpaid from time to time.
Payments under the Distribution Plan are currently made to the Principal
Underwriter or its predecessor, EKIS, (which may reallow all or part to others,
such as broker-dealers) (1) as commissions for Fund shares sold; (2) as
shareholder service fees in respect of shares maintained by the recipients and
outstanding on the Fund's books for specified periods; and (3) interest. Amounts
paid or accrued to the Principal Underwriter and its predecessor in the
aggregate may not exceed the annual limitation referred to above.
The Principal Underwriter generally reallows to broker-dealers or others a
commission equal to 4.00% of the price paid for each Fund share sold. In
addition, the Principal Underwriter generally reallows to broker-dealers or
others a shareholder service fee at a rate of 0.25% per annum of the net asset
value of shares maintained by such recipients and outstanding on the books of
the Fund for specified periods. See also "Arrangements with Broker-Dealers and
Others" below.
The financing of payments made by the Principal Underwriter to compensate
broker-dealers or other persons for distributing shares of the Fund will be
provided by FUNB or its affiliates.
If the Fund is unable to pay the Principal Underwriter a commission on a new
sale because the annual maximum (0.75% of average daily net assets) has been
reached, the Principal Underwriter intends, but is not obligated, to continue to
accept new orders for the purchase of Fund shares and to pay or accrue
commissions and service fees to broker-dealers in excess of the amount it
currently receives from the Fund ("Advances"). While the Fund is under no
contractual obligation to reimburse the Principal Underwriter or its predecessor
for Advances, the Principal Underwriter and its predecessor intend to seek full
payment of such Advances from the Fund (together with interest at the rate of
prime plus 1.00%) at such time in the future as, and to the extent that, payment
thereof by the Fund would be within permitted limits. EKIS currently intends to
seek payment of interest only on such Advances paid or accrued by the Principal
Underwriter subsequent to July 7, 1992. If the Fund's Independent Trustees
authorize such payments, the effect will be to extend the period of time during
which the Fund incurs the maximum amount of costs allowed by the Distribution
Plan.
As of July 31, 1996, the maximum uncollected amounts for which EKIS, the
predecessor to the Principal Underwriter, may seek payment from the Fund under
its Distribution Plan is $5,597,863 (0.94% of the Fund's net asset value).
The amounts and purposes of expenditures under the Distribution Plan must be
reported to the Independent Trustees quarterly. The Independent Trustees may
require or approve changes in the operation of the Distribution Plan and may
require that total expenditures by the Fund under the Distribution Plan be kept
within limits lower than the maximum amount permitted by the Distribution Plan
as stated above. Unless limited by the Independent Trustees, such costs could,
for some period of time, be higher than such costs permitted by most other plans
presently adopted by other investment companies.
The Distribution Plan may be terminated at any time by vote of the Fund's
Independent Trustees or by vote of a majority of the outstanding voting shares
of the Fund. If the Distribution Plan is terminated, the Principal Underwriter
will ask the Independent Trustees to take whatever action they deem appropriate
under the circumstances with respect to payment of Advances.
Any change in the Distribution Plan that would materially increase the
distribution expenses of the Fund provided for in the Distribution Plan requires
shareholder approval. Otherwise, the Distribution Plan may be amended by votes
of the majority of both (1) the Fund's Trustees and (2) the Independent Trustees
cast in person at a meeting called for the purpose of voting on such amendment.
While the Distribution Plan is in effect, the Fund is required to commit the
selection and nomination of candidates for Independent Trustees to the
discretion of the Independent Trustees.
ARRANGEMENTS WITH BROKER-DEALERS AND OTHERS
Upon written notice to broker-dealers, the Principal Underwriter may, at its
own expense, periodically sponsor programs that offer additional compensation in
connection with sales of Fund shares. Participation in such programs may be
available to all broker-dealers or to selected broker-dealers who have sold or
are expected to sell significant amounts of shares. Additional compensation may
also include financial assistance to broker-dealers in connection with
preapproved seminars, conferences, and advertising. No such programs or
additional compensation will be offered to the extent they are prohibited by the
laws of any state or any self-regulatory agency, such as the NASD.
The Principal Underwriter may, at its own expense, pay concessions in addition
to those described above to broker-dealers that satisfy certain criteria
established from time to time by the Principal Underwriter. These conditions
relate to increasing sales of shares of the Keystone funds over specified
periods and certain other factors. Such payments depending on the
broker-dealer's satisfaction of the required conditions, may be periodic and may
be up to 1.00% of the value of shares sold by such broker-dealer.
The Principal Underwriter also may pay banks and other financial services
firms that facilitate transactions in shares of the Fund for their clients a
transaction fee up to the level of the payments made allowable to broker-dealers
for the sale of such shares as described above.
The Glass-Steagall Act and other banking laws and regulations presently
prohibit member banks of the Federal Reserve System ("Member Banks") or their
non-bank affiliates from sponsoring, organizing, controlling or distributing the
shares of registered open-end investment companies such as the Fund. Such laws
and regulations also prohibit banks from issuing, underwriting or distributing
securities in general. However, under the Glass-Steagall Act and such other laws
and regulations, a Member Bank or an affiliate thereof may act as investment
adviser, transfer agent or custodian to a registered open-end investment company
and may also act as agent in connection with the purchase of shares of such an
investment company upon the order of its customer. Keystone and its affiliates,
since they are direct or indirect subsidiaries of FUNB, are subject to and in
compliance with the aforementioned laws and regulations. In the event the
Glass-Steagall Act is deemed to prohibit depository institutions from accepting
certain payments from the Fund, or should Congress relax current restrictions on
depository institutions, the Board of Trustees will consider what action, if
any, is appropriate.
In addition, state securities laws on this issue may differ from the
interpretations of federal law expressed herein, and banks and financial
institutions may be required to register as broker-dealers pursuant to state
law.
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HOW TO BUY SHARES
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You may purchase shares of the Fund from any broker-dealer that has a selling
agreement with the Principal Underwriter.
In addition, you may purchase Fund shares by mailing to the Fund, c/o
Evergreen Keystone Service Company, P.O. Box 2121, Boston, Massachusetts
02106-2121, a completed account application and a check payable to the Fund. You
may also telephone 1-800-343-2898 to obtain the number of an account to which
you can wire or electronically transfer funds and then send in a completed
account application. Subsequent investments in the Fund's shares in any amount
may be made by check, by wiring Federal funds, by direct deposit or by
electronic funds transfer ("EFT").
The Fund's shares are sold at the public offering price, which is equal to the
net asset value per share next computed after the Fund receives the purchase
order. The initial purchase must be at least $1,000, except for purchases by
participants in certain retirement plans for which the minimum is waived. There
is no minimum for subsequent purchases. Purchase payments are fully invested at
net asset value. There are no sales charges on purchases of Fund shares at the
time of purchase.
CONTINGENT DEFERRED SALES CHARGE
With certain exceptions, when shares of the Fund are redeemed within four
calendar years after their purchase, the Fund may charge a CDSC as follows:
During the calendar year of purchase ................................... 4.00%
During the first calendar year after the year of purchase .............. 3.00%
During the second calendar year after the year of purchase ............. 2.00%
During the third calendar year after the year of purchase .............. 1.00%
Thereafter ............................................................. 0.00%
If imposed, the CDSC is deducted from the redemption proceeds otherwise
payable to you. CDSCs are, to the extent permitted by the NASD, paid to the
Principal Underwriter or its predecessor.
The CDSC is a declining percentage of the lesser of (1) the net asset value of
the shares redeemed or (2) the total cost of such shares. With respect to shares
purchased after January 1, 1997, no CDSC is imposed when a shareholder redeems
amounts derived from (1) increases in the value of the shares redeemed account
above the total cost of such shares due to increases in the net asset value per
share of the Fund; (2) certain shares with respect to which the Fund did not pay
a commission on issuance, including shares acquired through reinvestment of
dividend income and capital gains distributions; or (3) shares held in all or
part of more than four consecutive calendar years.
Upon request for redemption, shares not subject to a CDSC will be redeemed
first. Thereafter, shares held the longest will be the first to be redeemed. No
CDSC is payable on permitted exchanges of shares between the funds in the
Keystone Classic Fund Family that have adopted distribution plans pursuant to
Rule 12b-1 under the 1940 Act. For purposes of computing CDSCs, when shares of
one fund are exchanged for shares of another fund, the date of purchase of the
shares being acquired by exchange is deemed to be the date the shares being
tendered for exchange were originally purchased.
WAIVER OF DEFERRED SALES CHARGE
No CDSC is imposed on a redemption of shares of the Fund in the event of (1)
death or disability of the shareholder; (2) a lump-sum distribution from a 401
(k) plan or other benefit plan qualified under the Employee Retirement Income
Security Act of 1974 ("ERISA"); (3) automatic withdrawals from ERISA plans if
the shareholder is at least 59 1/2 years old; (4) involuntary redemptions of
accounts having an aggregate net asset value of less than $1,000; (5) automatic
withdrawals under a Systematic Income Plan of up to 1% per month of the
shareholder's initial account balance; (6) withdrawals consisting of loan
proceeds to a retirement plan participant; (7) financial hardship withdrawals
made by a retirement plan participant; or (8) withdrawals consisting of returns
of excess contributions or excess deferral amounts made to a retirement plan
participant.
Shares also may be sold, to the extent permitted by applicable law, at net
asset value without the payment of commissions or the imposition of a CDSC to
(1) certain Directors, Trustees, officers, and employees of the Fund, First
Union Keystone, Keystone, and certain of their affiliates; (2) registered
representatives of firms with dealer agreements with the Principal Underwriter;
and (3) a bank or trust company acting as a trustee for a single account. For
more details, see the statement of additional information.
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HOW TO REDEEM SHARES
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You may redeem Fund shares for cash at the redemption value by writing to
the Fund, c/o Evergreen Keystone Service Company, Box 2121, Boston,
Massachusetts 02106-2121, and presenting a properly endorsed share certificate
(if certificates have been issued) to the Fund. Your signature(s) on the written
order and certificates must be guaranteed, as described below.
You may also redeem your shares through your broker-dealer. The Principal
Underwriter, acting as agent for the Fund, stands ready to repurchase Fund
shares upon orders from broker-dealers and will calculate the net asset value on
the same terms as those orders for the purchase of shares received from
broker-dealers and described under "How to Buy Shares." If the Principal
Underwriter has received proper documentation, it will pay the redemption
proceeds, less any applicable CDSC, to the broker-dealer placing the order
within seven days thereafter. The Principal Underwriter charges no fee for this
service. Your broker-dealer, however, may charge a service fee.
The redemption value equals the net asset value adjusted for fractions of a
cent and may be more or less than your cost depending upon changes in the value
of the Fund's portfolio securities between purchase and redemption. The Fund may
impose a CDSC at the time of redemption of certain shares as explained in "How
to Buy Shares." If imposed, the Fund deducts the CDSC from the redemption
proceeds otherwise payable to you.
REDEMPTION OF SHARES IN GENERAL
At various times, the Fund may be requested to redeem shares for which it has
not yet received good payment. In such a case, the Fund will mail the redemption
proceeds upon clearance of the purchase check, which may take up to 15 days. Any
delay may be avoided by purchasing shares with a certified check, by Federal
Reserve or bank wire of funds, by direct deposit or by EFT. Although the mailing
of a redemption check may be delayed, the redemption value will be determined
and the redemption processed in the ordinary course of business upon receipt of
proper documentation. In such a case, after redemption and prior to the release
of the proceeds, no appreciation or depreciation will occur in the value of the
redeemed shares, and no interest will be paid on the redemption proceeds. If the
payment of a redemption has been delayed, the check will be mailed or the
proceeds wired or sent EFT promptly after good payment has been collected.
The Fund computes the amount due you at the close of the Exchange at the end
of the day on which it has received all proper documentation from you. Payment
of the amount due on redemption, less any applicable CDSC, will be made within
seven days thereafter, except as discussed herein.
For your protection, SIGNATURES ON CERTIFICATES, STOCK POWERS AND ALL WRITTEN
ORDERS OR AUTHORIZATIONS MUST BE GUARANTEED BY A U.S. STOCK EXCHANGE MEMBER, A
BANK OR OTHER PERSONS ELIGIBLE TO GUARANTEE SIGNATURES UNDER THE SECURITIES
EXCHANGE ACT OF 1934 AND EKSC'S POLICIES. The Fund and EKSC may waive this
requirement or require additional documents in certain cases. Currently, the
requirement for a signature guarantee has been waived on redemptions of $50,000
or less where the account address of record has been the same for a minimum
period of 30 days. The Fund and EKSC reserve the right to withdraw this waiver
at any time.
If the Fund receives a redemption or repurchase order, but you have not
clearly indicated the amount of money or number of shares involved, the Fund
cannot execute the order. In such cases, the Fund will request the missing
information from you and process the order on the day such information is
received.
TELEPHONE REDEMPTIONS
Under ordinary circumstances, you may redeem up to $50,000 from your account
by calling toll free 1-800-343-2898. As mentioned above, to engage in telephone
transactions generally, you must complete the appropriate sections of the
application.
In order to insure that instructions received by EKSC are genuine when you
initiate a telephone transaction, you will be asked to verify certain criteria
specific to your account. At the conclusion of the transaction, you will be
given a transaction number confirming your request. Written confirmation of your
transaction will be mailed the next business day. Your telephone instructions
will be recorded. Redemptions by telephone are allowed only if the address and
bank account of record have been the same for a minimum period of 30 days.
If you cannot reach the Fund by telephone, you should follow the procedures
for redeeming by mail or through a broker-dealer as set forth above.
SMALL ACCOUNTS
Because of the high cost of maintaining small accounts, the Fund reserves the
right to redeem your account if its value has fallen below $1,000, the current
minimum investment level, as a result of your redemptions (but not as a result
of market action). You will be notified in writing and allowed 60 days to
increase the value of your account to the minimum investment level. No CDSCs are
applied to such redemptions.
GENERAL
The Fund reserves the right at any time to terminate, suspend, or change the
terms of any redemption method described in this prospectus, except redemption
by mail, and to impose fees.
Except as otherwise noted, neither the Fund, EKSC, nor the Principal
Underwriter assumes responsibility for the authenticity of any instructions
received by any of them from a shareholder over the Keystone Automated Response
Line ("KARL"), or by telephone. EKSC will employ reasonable procedures to
confirm that instructions received over KARL or by telephone are genuine.
Neither the Fund, EKSC, nor the Principal Underwriter will be liable when
following instructions received over KARL or by telephone that EKSC reasonably
believes to be genuine.
The Fund may temporarily suspend the right to redeem its shares when (1) the
Exchange is closed, other than customary weekend and holiday closings; (2)
trading on the Exchange is restricted; (3) the Fund cannot dispose of its
investments or fairly determine their value; or (4) the Securities and Exchange
Commission so orders.
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SHAREHOLDER SERVICES
- ------------------------------------------------------------------------------
Details on all shareholder services may be obtained from EKSC by writing or by
calling toll free 1-800-343-2898.
KEYSTONE AUTOMATED RESPONSE LINE
KARL offers shareholders specific fund account information and price and yield
quotations as well as the ability to effect account transactions, including
investments, exchanges, and redemptions. Shareholders may access KARL by dialing
toll free 1-800-346-3858 on any touch-tone telephone, 24 hours a day, seven days
a week.
EXCHANGES
If you have obtained the appropriate prospectus, you may exchange shares of
the Fund for shares of any of the other funds in the Keystone Classic Fund
Family, on the basis of their respective net asset values, by calling toll free
1-800-343-2898 or by writing to Evergreen Keystone Service Company at P.O. Box
2121, Boston, Massachusetts 02106-2121. (See "How to Redeem Shares" for
additional information with respect to telephone transactions.)
Fund shares purchased by check may be exchanged for shares of any of the funds
in the Keystone Classic Fund Family, other than Keystone Precious Metals
Holdings, Inc. ("KPMH"). In order to exchange Fund shares for shares of KPMH, a
shareholder must have held Fund shares for a period of at least six months. All
exchanges may be made without a fee. If the shares being tendered for exchange
have been held for less than four years and are still subject to a deferred
sales charge, such charge will carry over to the shares being acquired in the
exchange transaction. The Fund reserves the right to terminate this exchange
offer or to change its terms, including the right to charge for any exchange,
upon notice to shareholders pursuant to applicable law.
Orders to exchange shares of the Fund for shares of Keystone Liquid Trust
("KLT") will be executed by redeeming the shares of the Fund and purchasing
shares of KLT at the net asset value of KLT shares determined after the proceeds
from such redemption become available, which may be up to seven days after such
redemption. In all other cases, orders for exchanges received by the Fund prior
to 4:00 p.m. (eastern time) on any business day will be executed at the
respective net asset values determined as of the close of the next business day.
Orders for exchanges received after 4:00 p.m. (eastern time) on any business day
will be executed at the respective net asset values determined at the close of
the next business day.
An excessive number of exchanges may be disadvantageous to the Fund.
Therefore, the Fund, in addition to its right to reject any exchange, reserves
the right to terminate the exchange privilege of any shareholder who makes more
than five exchanges of shares of the funds in a year or three in a calendar
quarter.
An exchange order must comply with the requirements for a redemption or
repurchase order and must specify the dollar value or number of shares to be
exchanged. Exchanges are subject to the minimum initial purchase requirements of
the fund being acquired. An exchange constitutes a sale for federal income tax
purposes.
The exchange privilege is available only in states where shares of the fund
being acquired may legally be sold.
RETIREMENT PLANS
The Fund has various retirement plans available to investors, including
Individual Retirement Accounts (IRAs); Rollover IRAs; Simplified Employee
Pension Plans (SEPs); Salary Reduction Plans (SARSEPs); Tax Sheltered Annuity
Plans (TSAs); 403(b)(7) Plans; 401(k) Plans; Keogh Plans; Corporate Profit-
Sharing Plans; and Money Purchase Pension Plans. For details, including fees and
application forms, call EKSC toll free at 1-800-247-4075 or write to KIRC at
P.O. Box 2121, Boston, Massachusetts 02106-2121.
AUTOMATIC INVESTMENT PLAN
With an Automatic Investment Plan, you can automatically transfer as little as
$100 per month or quarter from your bank account or KLT to the Keystone fund of
your choice. Your bank account will be debited for each transfer. You will
receive confirmation with your next account statement.
To establish or terminate an Automatic Investment Plan or to change the amount
or schedule of your automatic investments, you may write to or call EKSC. Please
include your account numbers. Termination of an Automatic Investment Plan may
take up to 30 days.
SYSTEMATIC INCOME PLAN
Under a Systematic Income Plan, shareholders may arrange for regular monthly
or quarterly fixed withdrawal payments. Each payment must be at least $100 and
may be as much as 1% per month or 3% per quarter of the total net asset value of
the Fund shares in the shareholder's account when the Systematic Income Plan is
opened. Fixed withdrawal payments are not subject to a CDSC. Excessive
withdrawals may decrease or deplete the value of a shareholder's account.
OTHER SERVICES
Under certain circumstances shareholders may, within 30 days after a
redemption, reinstate their accounts at current net asset value.
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PERFORMANCE DATA
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From time to time, the Fund may advertise "total return" and "current yield."
BOTH FIGURES ARE BASED ON HISTORICAL EARNINGS. PAST PERFORMANCE SHOULD NOT BE
CONSIDERED REPRESENTATIVE OF RESULTS FOR ANY FUTURE PERIOD OF TIME. Total return
refers to the Fund's average annual compounded rates of return over specified
periods determined by comparing the initial amount invested to the ending
redeemable value of that amount. The resulting equation assumes reinvestment of
all dividends and distributions and deduction of all recurring charges, if any,
applicable to all shareholder accounts. The deduction of the contingent deferred
sales charge is reflected in the applicable years.
Current yield quotations represent the yield on an investment for a stated
30-day period computed by dividing net investment income earned per share during
the base period by the maximum offering price per share on the last day of the
base period.
The Fund may include comparative performance information in advertising or
marketing the Fund's shares, such as data from Lipper Analytical Services, Inc.,
Morningstar, Inc., Standard & Poor's Corporation, Ibbotson Associates or
other industry publications.
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FUND SHARES
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The Fund currently issues one class of shares, which participate equally in
dividends and distributions and have equal voting, liquidation and other rights.
When issued and paid for, the shares will be fully paid and nonassessable by the
Fund. Shares may be exchanged as explained under "Shareholder Services," but
will have no other preference, conversion, exchange, or preemptive rights.
Shareholders are entitled to one vote for each full share owned and fractional
votes for fractional shares. Shares are redeemable, transferable, and freely
assignable as collateral. There are no sinking fund provisions. The Fund may
establish additional classes or series of shares.
The Fund does not have annual meetings. The Fund will have special meetings
from time to time as required under its Restatement of Trust Agreement (the
"Trust Agreement") and under the 1940 Act. As provided in the Fund's Trust
Agreement, shareholders have the right to remove Trustees by an affirmative vote
of two-thirds of the outstanding shares. A special meeting of the shareholders
will be held when holders of 10% of the outstanding shares request a meeting for
the purpose of removing a Trustee. The Fund is prepared to assist shareholders
in communications with one another for the purpose of convening such a meeting
as prescribed by Section 16(c) of the 1940 Act.
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ADDITIONAL INFORMATION
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When the Fund determines from its records that more than one account in the
Fund is registered in the name of a shareholder or shareholders having the same
address, upon written notice to those shareholders, the Fund intends, when an
annual report or semi-annual report of the Fund is required to be furnished, to
mail one copy of such report to that address.
Except as otherwise stated in this prospectus or required by law, the Fund
reserves the right to change the terms of the offer stated in this prospectus
without shareholder approval, including the right to impose or change fees for
services provided.
<PAGE>
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ADDITIONAL INVESTMENT INFORMATION
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DESCRIPTION OF CERTAIN TYPES OF INVESTMENTS
AND INVESTMENT TECHNIQUES AVAILABLE TO THE FUND
The Fund may engage in the following investment practices to the extent
described in the prospectus and the statement of additional information.
CORPORATE BOND RATINGS
Higher yields are usually available on securities that are lower rated or that
are unrated. Bonds rated Baa by Moody's are considered as medium grade
obligations, which are neither highly protected nor poorly secured. Debt rated
BBB by S&P is regarded as having an adequate capacity to pay interest and repay
principal, although adverse economic conditions are more likely to lead to a
weakened capacity to pay interest and repay principal for debt in this category
than in higher rated categories. Lower rated securities are usually defined as
Baa or lower by Moody's or BBB or lower by S&P. The Fund may purchase unrated
securities, which are not necessarily of lower quality than rated securities but
may not be attractive to as many buyers. Debt rated BB, B, CCC, CC and C by S&P
is regarded, on balance, as predominantly speculative with respect to capacity
to pay interest and repay principal in accordance with the terms of the
obligation. BB indicates the lowest degree of speculation and C the highest
degree of speculation. While such debt will likely have some quality and
protective characteristics, these are outweighed by large uncertainties or major
risk exposures to adverse conditions. Debt rated CI by S&P is debt (income
bonds) on which no interest is being paid. Debt rated D by S&P is in default and
payment of interest and/or repayment of principal is in arrears. The Fund
intends to invest in D-rated debt only in cases where, in Keystone's judgment,
there is a distinct prospect of improvement in the issuer's financial position
as a result of the completion of reorganization or otherwise. Bonds that are
rated Caa by Moody's are of poor standing. Such issues may be in default or
there may be present elements of danger with respect to principal or interest.
Bonds that are rated Ca by Moody's represent obligations that are speculative in
a high degree. Such issues are often in default or have other market
shortcomings. Bonds that are rated C by Moody's are the lowest rated class of
bonds, and issues so rated can be regarded as having extremely poor prospects of
ever attaining any real investment standing.
ZERO COUPON BONDS
A zero coupon "stripped" bond represents ownership in serially maturing
interest payments or principal payments on specific underlying notes and bonds,
including coupons relating to such notes and bonds. The interest and principal
payments are direct obligations of the issuer. Coupon zero coupon bonds of any
series mature periodically from the date of issue of such series through the
maturity date of the securities related to such series. Principal zero coupon
bonds mature on the date specified therein, which is the final maturity date of
the related securities. Each zero coupon bond entitles the holder to receive a
single payment at maturity. There are no periodic interest payments on a zero
coupon bond. Zero coupon bonds are offered at discounts from their face amounts.
In general, owners of zero coupon bonds have substantially all the rights and
privileges of owners of the underlying coupon obligations or principal
obligations. Owners of zero coupon bonds have the right upon default on the
underlying coupon obligations or principal obligations to proceed directly and
individually against the issuer and are not required to act in concert with
other holders of zero coupon bonds.
For federal income tax purposes, a purchaser of principal zero coupon bonds or
coupon zero coupon bonds (either initially or in the secondary market) is
treated as if the buyer had purchased a corporate obligation issued on the
purchase date with an original issue discount equal to the excess of the amount
payable at maturity over the purchase price. The purchaser is required to take
into income each year as ordinary income an allocable portion of such discounts
determined on a "constant yield" method. Any such income increases the holder's
tax basis for the zero coupon bond, and any gain or loss on a sale of the zero
coupon bonds relative to the holder's basis, as so adjusted, is a capital gain
or loss. If the holder owns both principal zero coupon bonds and coupon zero
coupon bonds representing interest in the same underlying issue of securities, a
special basis allocation rule (requiring the aggregate basis to be allocated
among the items sold and retained based on their relative fair market value at
the time of sale) may apply to determine the gain or loss on a sale of any such
zero coupon bonds.
PAYMENT-IN-KIND SECURITIES
Payment-in-kind securities pay interest in either cash or additional
securities, at the issuer's option, for a specified period. The issuer's option
to pay in additional securities typically ranges from one to six years, compared
to an average maturity for all PIK securities of eleven years. Call protection
and sinking fund features are comparable to those offered on traditional debt
issues.
PIKs, like zero coupon bonds, are designed to give an issuer flexibility in
managing cash flow. Several PIKs are senior debt. In other cases, where PIKs are
subordinated, most senior lenders view them as equity equivalents.
An advantage of PIKs for the issuer -- as with zero coupon securities -- is
that interest payments are automatically compounded (reinvested) at the stated
coupon rate, which is not the case with cash-paying securities. However, PIKs
are gaining popularity over zeros since interest payments in additional
securities can be monetized and are more tangible than accretion of a discount.
As a group, PIK bonds trade flat (i.e., without accrued interest). Their price
is expected to reflect an amount representing accreted interest since the last
payment. PIKs generally trade at higher yields than comparable cash- paying
securities of the same issuer. Their premium yield is the result of the lesser
desirability of non-cash interest, the more limited audience for non-cash paying
securities, and the fact that many PIKs have been issued to equity investors who
do not normally own or hold such securities.
Calculating the true yield on a PIK security requires a discounted cash flow
analysis if the security (ex interest) is trading at a premium or a discount
because the realizable value of additional payments is equal to the current
market value of the underlying security, not par.
Regardless of whether PIK securities are senior or deeply subordinated,
issuers are highly motivated to retire them because they are usually their most
costly form of capital.
OBLIGATIONS OF FOREIGN BRANCHES OF UNITED STATES BANKS
The obligations of foreign branches of U.S. banks may be general obligations
of the parent bank in addition to the issuing branch, or may be limited by the
terms of a specific obligation and by government regulation. Payment of interest
and principal upon these obligations may also be affected by governmental action
in the country of domicile of the branch (generally referred to as sovereign
risk). In addition, evidences of ownership of such securities may be held
outside the U.S. and the Fund may be subject to the risks associated with the
holding of such property overseas. Examples of governmental actions would be the
imposition of currency controls, interest limitations, withholding taxes,
seizure of assets or the declaration of a moratorium. Various provisions of
federal law governing domestic branches do not apply to foreign branches of
domestic banks.
OBLIGATIONS OF UNITED STATES BRANCHES OF FOREIGN BANKS
Obligations of U.S. branches of foreign banks may be general obligations of
the parent bank in addition to the issuing branch, or may be limited by the
terms of a specific obligation and by federal and state regulation as well as by
governmental action in the country in which the foreign bank has its head
office. In addition, there may be less publicly available information about a
U.S. branch of a foreign bank than about a domestic bank.
MASTER DEMAND NOTES
Master demand notes are unsecured obligations that permit the investment of
fluctuating amounts by the Fund at varying rates of interest pursuant to direct
arrangements between the Fund, as lender, and the issuer, as borrower. Master
demand notes may permit daily fluctuations in the interest rate and daily
changes in the amount borrowed. The Fund has the right to increase the amount at
any time up to the full amount provided by the note agreement, or to decrease
the amount. The borrower may repay up to the full amount of the note without
penalty. Notes purchased by the Fund permit the Fund to demand payment of
principal and accrued interest at any time (on not more than seven days'
notice). Notes acquired by the Fund may have maturities of more than one year,
provided that (1) the Fund is entitled to payment of principal and accrued
interest upon not more than seven days' notice, and (2) the rate of interest on
such notes is adjusted automatically at periodic intervals, which normally will
not exceed 31 days, but may extend up to one year. The notes are deemed to have
a maturity equal to the longer of the period remaining to the next interest rate
adjustment or the demand notice period. Because these types of notes are direct
lending arrangements between the lender and the borrower, such instruments are
not normally traded and there is no secondary market for these notes, although
they are redeemable and thus repayable by the borrower at face value plus
accrued interest at any time. Accordingly, the Fund's right to redeem is
dependent on the ability of the borrower to pay principal and interest on
demand. In connection with master demand note arrangements, Keystone considers,
under standards established by the Board of Trustees, earning power, cash flow
and other liquidity ratios of the borrower and will monitor the ability of the
borrower to pay principal and interest on demand. These notes are not typically
rated by credit rating agencies. Unless rated, the Fund will invest in them only
if at the time of an investment the issuer meets the criteria established for
commercial paper discussed in the statement of additional information (which
limit such investments to commercial paper rated A-1 by S&P, Prime-1 by Moody's
or F-1 by Fitch Investors Service, Inc.).
REPURCHASE AGREEMENTS
The Fund may enter into repurchase agreements with member banks of the Federal
Reserve System having at least $1 billion in assets, primary dealers in U.S.
government securities or other financial institutions believed by Keystone to be
creditworthy. Such persons must be registered as U.S. government securities
dealers with an appropriate regulatory organization. Under such agreements, the
bank, primary dealer or other financial institution agrees, upon entering into
the contract, to repurchase the security at a mutually agreed upon date and
price, thereby determining the yield during the term of the agreement. This
results in a fixed rate of return insulated from market fluctuations during such
period. Under a repurchase agreement, the seller must maintain the value of the
securities subject to the agreement at not less than the repurchase price, such
value being determined on a daily basis by marking the underlying securities to
their market value. Although the securities subject to the repurchase agreement
might bear maturities exceeding a year, the Fund only intends to enter into
repurchase agreements that provide for settlement within a year and usually
within seven days. Securities subject to repurchase agreements will be held by
the Fund's custodian or in the Federal Reserve book entry system. The Fund does
not bear the risk of a decline in the value of the underlying security unless
the seller defaults under its repurchase obligation. In the event of a
bankruptcy or other default of a seller of a repurchase agreement, the Fund
could experience both delays in liquidating the underlying securities and
losses, including (1) possible declines in the value of the underlying
securities during the period while the Fund seeks to enforce its rights thereto;
(2) possible subnormal levels of income and lack of access to income during this
period; and (3) expenses of enforcing its rights. The Board of Trustees has
established procedures to evaluate the creditworthiness of each party with whom
the Fund enters into repurchase agreements by setting guidelines and standards
of review for Keystone and monitoring Keystone's actions with regard to
repurchase agreements.
REVERSE REPURCHASE AGREEMENTS
Under a reverse repurchase agreement, the Fund would sell securities and agree
to repurchase them at a mutually agreed upon date and price. The Fund intends to
enter into reverse repurchase agreements to avoid otherwise having to sell
securities during unfavorable market conditions in order to meet redemptions. At
the time the Fund enters into a reverse repurchase agreement, it will establish
a segregated account with the Fund's custodian containing liquid assets, such as
U.S. government securities or other high grade debt securities, having a value
not less than the repurchase price (including accrued interest) and will
subsequently monitor the account to ensure such value is maintained. Reverse
repurchase agreements involve the risk that the market value of the securities
the Fund is obligated to repurchase may decline below the repurchase price.
"WHEN ISSUED" AND "FORWARD COMMITMENT" TRANSACTIONS
The Fund may also purchase securities on a when issued or delayed delivery
basis and may purchase or sell securities on a forward commitment basis. When
issued and delayed delivery transactions arise when securities are purchased by
the Fund with payment and delivery taking place in the future in order to secure
what is considered to be an advantageous price and yield to the Fund at the time
of purchase. A forward commitment transaction is an agreement by the Fund to
purchase or sell securities at a specified future date. The Fund may also enter
into foreign currency forward contracts which are described in more detail in
the section of this Exhibit entitled "Foreign Currency Transactions." When the
Fund engages in these transactions, the Fund relies on the buyer or seller, as
the case may be, to consummate the sale. Failure to do so may result in the Fund
missing the opportunity to obtain a price or yield considered to be
advantageous. When issued, delayed delivery and forward commitment transactions
may be expected to occur a month or more before delivery is due. However, no
payment or delivery is made by the Fund until it receives payment or delivery
from the other party to the transaction. The Securities and Exchange Commission
has established certain requirements to assure that a Fund is able to meet its
obligations under these contracts, for example a separate account of liquid
assets equal to the value of such purchase commitments may be maintained until
payment is made. When issued, delayed delivery and firm commitment transactions
are subject to risks from changes in value based upon changes in the level of
interest rates, currency rates and other market factors, both before and after
delivery. The Fund does not accrue any income on such securities or currencies
prior to their delivery. To the extent the Fund engages in any of these
transactions, it will do so for the purpose of acquiring portfolio securities or
currencies consistent with its investment objective and policies and not for the
purpose of investment leverage. The Fund currently does not intend to invest
more than 5% of its assets in when issued or delayed delivery transactions.
LOANS OF SECURITIES TO BROKER-DEALERS
The Fund may lend securities to brokers and dealers pursuant to agreements
requiring that the loans be continuously secured by cash or securities of the
U.S. government, its agencies or instrumentalities, or any combination of cash
and such securities, as collateral equal at all times in value to at least the
market value of the securities loaned. Such securities loans will not be made
with respect to the Fund, if as a result, the aggregate of all outstanding
securities loans exceeds 15% of the value of the Fund's total assets taken at
their current value. The Fund continues to receive interest or dividends on the
securities loaned and simultaneously earns interest on the investment of the
cash loan collateral in U.S. Treasury notes, certificates of deposit, other
high-grade, short-term obligations or interest bearing cash equivalents.
Although voting rights attendant to securities loaned pass to the borrower, such
loans may be called at any time and will be called so that the securities may be
voted by the Fund if, in the opinion of the Fund, a material event affecting the
investment is to occur. There may be risks of delay in receiving additional
collateral or in recovering the securities loaned or even loss of rights in the
collateral should the borrower of the securities fail financially. Loans may
only be made to borrowers deemed to be of good standing, under standards
approved by the Board of Trustees, when the income to be earned from the loan
justifies the attendant risks.
DERIVATIVES
The Fund may use derivatives in furtherance of its investment objective.
Derivatives are financial contracts whose value depends on, or is derived from,
the value of an underlying asset, reference rate or index. These assets, rates,
and indices may include bonds, stocks, mortgages, commodities, interest rates,
currency exchange rates, bond indices, and stock indices. Derivatives can be
used to earn income or protect against risk, or both. For example, one party
with unwanted risk may agree to pass that risk to another party who is willing
to accept the risk, the second party being motivated, for example, by the desire
either to earn income in the form of a fee or premium from the first party, or
to reduce its own unwanted risk by attempting to pass all or part of that risk
to the first party.
Derivatives can be used by investors, such as the Fund, to earn income and
enhance returns, to hedge or adjust the risk profile of the portfolio, and
either in place of more traditional direct investments or to obtain exposure to
otherwise inaccessible markets. The Fund is permitted to use derivatives for one
or more of these purposes. The use of derivatives for non-hedging purposes
entails greater risks than if derivatives were used solely for hedging purposes.
The Fund uses futures contracts and related options as well as forwards for
hedging purposes. Derivatives are a valuable tool, which, when used properly,
can provide significant benefit to Fund shareholders. Keystone is not an
aggressive user of derivatives with respect to the Fund. However, the Fund may
take positions in those derivatives that are within its investment policies if,
in Keystone's judgment, this represents an effective response to current or
anticipated market conditions. Keystone's use of derivatives is subject to
continuous risk assessment and control from the standpoint of the Fund's
investment objective and policies.
Derivatives may be (1) standardized, exchange-traded contracts or (2)
customized, privately negotiated contracts. Exchange-traded derivatives tend to
be more liquid and subject to less credit risk than those that are privately
negotiated.
There are four principal types of derivative instruments--options, futures,
forwards, and swaps--from which virtually any type of derivative transaction can
be created. Further information regarding options, futures, forwards, and swaps,
is provided later in this section and is provided in the Fund's statement of
additional information.
Debt instruments that incorporate one or more of these building blocks for the
purpose of determining the principal amount of and/or rate of interest payable
on the debt instruments are often referred to as "structured securities." An
example of this type of structured security is indexed commercial paper. The
term is also used to describe certain securities issued in connection with the
restructuring of certain foreign obligations. See "Indexed Commercial Paper" and
"Structured Securities" below. The term "derivative" is also sometimes used to
describe securities involving rights to a portion of the cash flows from an
underlying pool of mortgages or other assets from which payments are passed
through to the owner of, or that collateralize, the securities. See "Mortgage
Related Securities," "Collateralized Mortgage Obligations," "Adjustable Rate
Mortgage Securities," "Stripped Mortgage Securities," "Mortgage Securities -
Special Considerations," and "Other Asset-Backed Securities" and the Fund's
statement of additional information.
While the judicious use of derivatives by experienced investment managers,
such as Keystone, can be beneficial, derivatives also involve risks different
from, and, in certain cases, greater than, the risks presented by more
traditional investments. Following is a general discussion of important risk
factors and issues concerning the use of derivatives that investors should
understand before investing in the Fund.
o Market Risk -- This is the general risk attendant to all investments that the
value of a particular investment will decline or otherwise change in a way
detrimental to the Fund's interest.
o Management Risk -- Derivative products are highly specialized instruments that
require investment techniques and risk analyses different from those
associated with stocks and bonds. The use of a derivative requires an
understanding not only of the underlying instrument, but also of the
derivative itself, without the benefit of observing the performance of the
derivative under all possible market conditions. In particular, the use and
complexity of derivatives require the maintenance of adequate controls to
monitor the transactions entered into, the ability to assess the risk that a
derivative adds to the Fund's portfolio and the ability to forecast price,
interest rate or currency exchange rate movements correctly.
o Credit Risk -- This is the risk that a loss may be sustained by the Fund as a
result of the failure of another party to a derivative (usually referred to as
a "counterparty") to comply with the terms of the derivative contract. The
credit risk for exchange-traded derivatives is generally less than for
privately negotiated derivatives, since the clearing house, which is the
issuer or counterparty to each exchange-traded derivative, provides a
guarantee of performance. This guarantee is supported by a daily payment
system (i.e., margin requirements) operated by the clearing house in order to
reduce overall credit risk. For privately negotiated derivatives, there is no
similar clearing agency guarantee. Therefore, the Fund considers the
creditworthiness of each counterparty to a privately negotiated derivative in
evaluating potential credit risk.
o Liquidity Risk -- Liquidity risk exists when a particular instrument is
difficult to purchase or sell. If a derivative transaction is particularly
large or if the relevant market is illiquid (as is the case with many
privately negotiated derivatives), it may not be possible to initiate a
transaction or liquidate a position at an advantageous price.
o Leverage Risk -- Since many derivatives have a leverage component, adverse
changes in the value or level of the underlying asset, rate or index can
result in a loss substantially greater than the amount invested in the
derivative itself. In the case of swaps, the risk of loss generally is related
to a notional principal amount, even if the parties have not made any initial
investment. Certain derivatives have the potential for unlimited loss,
regardless of the size of the initial investment.
o Other Risks -- Other risks in using derivatives include the risk of mispricing
or improper valuation and the inability of derivatives to correlate perfectly
with underlying assets, rates, and indices. Many derivatives, in particular
privately negotiated derivatives, are complex and often valued subjectively.
Improper valuations can result in increased cash payment requirements to
counterparties or a loss of value to the Fund. Derivatives do not always
perfectly or even highly correlate or track the value of the assets, rates or
indices they are designed to closely track. Consequently, the Fund's use of
derivatives may not always be an effective means of, and sometimes could be
counterproductive to, furthering the Fund's investment objective.
OPTIONS TRANSACTIONS
WRITING COVERED OPTIONS. The Fund may write (i.e., sell) covered call and put
options. By writing a call option, the Fund becomes obligated during the term of
the option to deliver the securities underlying the option upon payment of the
exercise price. By writing a put option, the Fund becomes obligated during the
term of the option to purchase the securities underlying the option at the
exercise price if the option is exercised. The Fund also may write straddles
(combinations of covered puts and calls on the same underlying security).
The Fund may only write "covered" options. This means that so long as the Fund
is obligated as the writer of a call option it will own the underlying
securities subject to the option or, in the case of call options on U.S.
Treasury bills, the Fund might own substantially similar U.S. Treasury bills. If
the Fund has written options against all of its securities that are available
for writing options, the Fund may be unable to write additional options unless
it sells a portion of its portfolio holdings to obtain new securities against
which it can write options. If this were to occur, higher portfolio turnover and
correspondingly greater brokerage commissions and other transaction costs may
result. The Fund does not expect, however, that this will occur.
The Fund will be considered "covered" with respect to a put option it writes
if, so long as it is obligated as the writer of the put option, it deposits and
maintains with its custodian in a segregated account liquid assets having a
value equal to or greater than the exercise price of the option.
The principal reason for writing call or put options is to obtain, through a
receipt of premiums, a greater current return than would be realized on the
underlying securities alone. The Fund receives a premium from writing a call or
put option, which it retains whether or not the option is exercised. By writing
a call option, the Fund might lose the potential for gain on the underlying
security while the option is open, and, by writing a put option, the Fund might
become obligated to purchase the underlying security for more than its current
market price upon exercise.
PURCHASING OPTIONS. The Fund may purchase put or call options, including put
or call options for the purpose of offsetting previously written put or call
options of the same series.
If the Fund is unable to effect a closing purchase transaction with respect to
covered options it has written, the Fund will not be able to sell the underlying
securities or dispose of assets held in a segregated account until the options
expire or are exercised.
An option position may be closed out only in a secondary market for an option
of the same series. Although the Fund generally will write only those options
for which there appears to be an active secondary market, there is no assurance
that a liquid secondary market will exist for any particular option at any
particular time, and, for some options, no secondary market may exist. In such
event, it might not be possible to effect a closing transaction in a particular
option.
Options on some securities are relatively new, and it is impossible to predict
the amount of trading interest that will exist in such options. There can be no
assurance that viable markets will develop or continue. The failure of such
markets to develop or continue could significantly impair the Fund's ability to
use such options to achieve its investment objective.
OPTIONS TRADING MARKETS. Options in which the Fund will trade are generally
listed on national securities exchanges. Exchanges on which such options
currently are traded include the Chicago Board Options Exchange and the New
York, American, Pacific, and Philadelphia Stock Exchanges. Options on some
securities may not be listed on any exchange, but traded in the over-the-counter
market. Options traded in the over-the-counter market involve the additional
risk that securities dealers participating in such transactions could fail to
meet their obligations to the Fund. The use of options traded in the
over-the-counter market may be subject to limitations imposed by certain state
securities authorities. In addition to the limits on its use of options
discussed herein, the Fund is subject to the investment restrictions described
in this prospectus and in the statement of additional information.
The staff of the Securities and Exchange Commission is of the view that the
premiums that the Fund pays for the purchase of unlisted options and the value
of securities used to cover unlisted options written by the Fund are considered
to be invested in illiquid securities or assets for the purpose of calculating
whether the Fund is in compliance with its policies on illiquid securities.
FUTURES TRANSACTIONS
The Fund may enter into currency and other financial futures contracts and
write options on such contracts. The Fund intends to enter into such contracts
and related options for hedging purposes. The Fund will enter into securities,
currency or index-based futures contracts in order to hedge against changes in
interest or exchange rates or securities prices. A futures contract on
securities or currencies is an agreement to buy or sell securities or currencies
at a specified price during a designated month. A futures contract on a
securities index does not involve the actual delivery of securities, but merely
requires the payment of a cash settlement based on changes in the securities
index. The Fund does not make payment or deliver securities upon entering into a
futures contract. Instead, it puts down a margin deposit, which is adjusted to
reflect changes in the value of the contract and which continues until the
contract is terminated.
The Fund may sell or purchase futures contracts. When a futures contract is
sold by the Fund, the value of the contract will tend to rise when the value of
the underlying securities or currencies declines and to fall when the value of
such securities or currencies increases. Thus, the Fund sells futures contracts
in order to offset a possible decline in the value of its securities or
currencies. If a futures contract is purchased by the Fund, the value of the
contract will tend to rise when the value of the underlying securities or
currencies increases and to fall when the value of such securities or currencies
declines. The Fund intends to purchase futures contracts in order to establish
what is believed by Keystone to be a favorable price and rate of return for
securities or favorable exchange rate for currencies the Fund intends to
purchase.
The Fund also intends to purchase put and call options on futures contracts
for hedging purposes. A put option purchased by the Fund would give it the right
to assume a position as the seller of a futures contract. A call option
purchased by the Fund would give it the right to assume a position as the
purchaser of a futures contract. The purchase of an option on a futures contract
requires the Fund to pay a premium. In exchange for the premium, the Fund
becomes entitled to exercise the benefits, if any, provided by the futures
contract, but is not required to take any action under the contract. If the
option cannot be exercised profitably before it expires, the Fund's loss will be
limited to the amount of the premium and any transaction costs.
The Fund may enter into closing purchase and sale transactions in order to
terminate a futures contract and may sell put and call options for the purpose
of closing out its options positions. The Fund's ability to enter into closing
transactions depends on the development and maintenance of a liquid secondary
market. There is no assurance that a liquid secondary market will exist for any
particular contract or at any particular time. As a result, there can be no
assurance that the Fund will be able to enter into an offsetting transaction
with respect to a particular contract at a particular time. If the Fund is not
able to enter into an offsetting transaction, the Fund will continue to be
required to maintain the margin deposits on the contract and to complete the
contract according to its terms, in which case, it would continue to bear market
risk on the transaction.
Although futures and related options transactions are intended to enable the
Fund to manage market, interest rate or exchange rate risk, unanticipated
changes in interest rates, exchange rates or market prices could result in
poorer performance than if it had not entered into these transactions. Even if
Keystone correctly predicts interest or exchange rate movements, a hedge could
be unsuccessful if changes in the value of the Fund's futures position did not
correspond to changes in the value of its investments. This lack of correlation
between the Fund's futures and securities or currencies positions may be caused
by differences between the futures and securities or currencies markets or by
differences between the securities or currencies underlying the Fund's futures
position and the securities or currencies held by or to be purchased for the
Fund. Keystone will attempt to minimize these risks through careful selection
and monitoring of the Fund's futures and options positions.
The Fund does not intend to use futures transactions for speculation or
leverage. The Fund has the ability to write options on futures, but intends to
write such options only to close out options purchased by the Fund. The Fund
will not change these policies without supplementing the information in its
prospectus and statement of additional information.
FOREIGN CURRENCY TRANSACTIONS
As discussed above, the Fund may invest in securities of foreign issuers. When
the Fund invests in foreign securities, they usually will be denominated in
foreign currencies, and the Fund temporarily may hold funds in foreign
currencies. Thus, the value of Fund shares will be affected by changes in
exchange rates.
As one way of managing exchange rate risk, in addition to entering into
currency futures contracts, the Fund may enter into forward currency exchange
contracts (agreements to purchase or sell currencies at a specified price and
date). The exchange rate for the transaction (the amount of currency the Fund
will deliver or receive when the contract is completed) is fixed when the Fund
enters into the contract. The Fund usually will enter into these contracts to
stabilize the U.S. dollar value of a security it has agreed to buy or sell. The
Fund intends to use these contracts to hedge the U.S. dollar value of a security
it already owns, particularly if the Fund expects a decrease in the value of the
currency in which the foreign security is denominated. Although the Fund will
attempt to benefit from using forward contracts, the success of its hedging
strategy will depend on Keystone's ability to predict accurately the future
exchange rates between foreign currencies and the U.S. dollar. The value of the
Fund's investments denominated in foreign currencies will depend on the relative
strength of those currencies and the U.S. dollar, and the Fund may be affected
favorably or unfavorably by changes in the exchange rates or exchange control
regulations between foreign currencies and the U.S. dollar. Changes in foreign
currency exchange rates also may affect the value of dividends and interest
earned, gains and losses realized on the sale of securities and net investment
income and gains, if any, to be distributed to shareholders by the Fund.
Although the Fund does not currently intend to do so, the Fund may also purchase
and sell options related to foreign currencies. The Fund does not intend to
enter into foreign currency transactions for speculation or leverage.
INTEREST RATE TRANSACTIONS (SWAPS, CAPS, AND FLOORS). If the Fund enters into
interest rate swap, cap or floor transactions, it expects to do so primarily for
hedging purposes, which may include preserving a return or spread on a
particular investment or portion of its portfolio or protecting against an
increase in the price of securities the Fund anticipates purchasing at a later
date. The Fund does not currently intend to use these transactions in a
speculative manner.
Interest rate swaps involve the exchange by the Fund with another party of
their respective commitments to pay or receive interest (e.g., an exchange of
floating rate payments for fixed rate payments). Interest rate caps and floors
are similar to options in that the purchase of an interest rate cap or floor
entitles the purchaser, to the extent that a specified index exceeds (in the
case of a cap) or falls below (in the case of a floor) a predetermined interest
rate, to receive payments of interest on a contractually-based principal
("notional") amount from the party selling the interest rate cap or floor. The
Fund may enter into interest rate swaps, caps, and floors on either an
asset-based or liability-based basis, depending upon whether it is hedging its
assets or liabilities, and will usually enter into interest rate swaps on a net
basis (i.e., the two payment streams are netted out, with the Fund receiving or
paying, as the case may be, only the net amount of the two payments).
The swap market has grown substantially in recent years, with a large number
of banks and investment banking firms acting as principals and as agents
utilizing standardized swap documentation. As a result, the swap market has
become more established and relatively liquid. Caps and floors are less liquid
than swaps. These transactions also involve the delivery of securities or other
underlying assets and principal. Accordingly, the risk of loss to the Fund from
interest rate transactions is limited to the net amount of interest payments
that the Fund is contractually obligated to make.
INDEXED COMMERCIAL PAPER. Indexed commercial paper may have its principal linked
to changes in foreign currency exchange rates whereby its principal amount is
adjusted upwards or downwards (but not below zero) at maturity to reflect
changes in the referenced exchange rate. If permitted by its investment
policies, the Fund will purchase such commercial paper with the currency in
which it is denominated and, at maturity, will receive interest and principal
payments thereon in that currency, but the amount of principal payable by the
issuer at maturity will change in proportion to the change (if any) in the
exchange rate between the two specified currencies between the date the
instrument is issued and the date the instrument matures. While such commercial
paper entails the risk of loss of principal, the potential for realizing gains
as a result of changes in foreign currency exchange rates enables the Fund to
hedge (or cross-hedge) against a decline in the U.S. dollar value of investments
denominated in foreign currencies while providing an attractive money market
rate of return.
MORTGAGE-RELATED SECURITIES. The mortgage-related securities in which the Fund
may invest typically are securities representing interests in pools of mortgage
loans made to home owners. Mortgage-related securities bear interest at either a
fixed rate or an adjustable rate determined by reference to an index rate. The
mortgage loan pools may be assembled for sale to investors (such as the Fund) by
governmental or private organizations. Mortgage-related securities issued by the
Government National Mortgage Association ("GNMA") are backed by the full faith
and credit of the U.S. government; those issued by Federal National Mortgage
Associated ("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC") are not
so backed.
Securities representing interests in pools created by private issuers
generally offer a higher rate of interest than securities representing interests
in pools created by governmental issuers because there are no direct or indirect
governmental guarantees of the underlying mortgage payments. However, private
issuers sometimes obtain committed loan facilities, lines of credit, letters of
credit, surety bonds or other forms of liquidity and credit enhancement to
support the timely payment of interest and principal with respect to their
securities if the borrowers on the underlying mortgages fail to make their
mortgage payments. The ratings of such non-governmental securities are generally
dependent upon the ratings of the providers of such liquidity and credit support
and would be adversely affected if the rating of such an enhancer were
downgraded. The Fund may buy mortgage-related securities without credit
enhancement if the securities meet the Fund's investment standards. Although the
market for mortgage-related securities is becoming increasingly liquid, those of
certain private organizations may not be readily marketable.
One type of mortgage-related security is of the "pass-through" variety. The
holder of a pass-through security is considered to own an undivided beneficial
interest in the underlying pool of mortgage loans and receives a pro rata share
of the monthly payments made by the borrowers on their mortgage loans, net of
any fees paid to the issuer or guarantor of the securities. Prepayments of
mortgages resulting from the sale, refinancing or foreclosure of the underlying
properties are also paid to the holders of these securities. Some
mortgage-related securities, such as securities issued by GNMA, are referred to
as "modified pass-through" securities. The holders of these securities are
entitled to the full and timely payment of principal and interest, net of
certain fees, regardless of whether payments are actually made on the underlying
mortgages. Another form of mortgage-related security is a "pay- through"
security, which is a debt obligation of the issuer secured by a pool of mortgage
loans pledged as collateral that is legally required to be paid by the issuer
regardless of whether payments are actually made on the underlying mortgages.
COLLATERALIZED MORTGAGE OBLIGATIONS ("CMOS"). CMOs are the predominant type of
"pay-through" mortgage-related security. CMOs are designed to reduce the risk of
prepayment for investors by issuing multiple classes of securities, each having
different maturities, interest rates and payment schedules, and with the
principal and interest on the underlying mortgages allocated among the several
classes in various ways. The collateral securing the CMOs may consist of a pool
of mortgages, but may also consist of mortgage-backed bonds or pass-through
securities. CMOs may be issued by a U.S. government instrumentality or agency,
or by a private issuer. Although payment of the principal of, and interest on,
the underlying collateral securing privately issued CMOs may be guaranteed by
GNMA, FNMA or FHLMC, these CMOs represent obligations solely of the private
issuer and are not insured or guaranteed by GNMA, FNMA, FHLMC, any other
governmental agency, or any other person or entity.
INVERSE FLOATING RATE COLLATERALIZED MORTGAGE OBLIGATIONS. In addition to
investing in fixed rate and adjustable rate CMOs, the Fund may also invest in
CMOs with rates that move inversely to market rates ("inverse floaters").
An inverse floater bears an interst rate that resets in the opposite direction
of the change in a specified interest rate index. As market interest rates rise,
the interest rate on the inverse floater goes down, and vice versa. Inverse
floaters tend to exhibit greater price volatility than fixed-rate bonds of
similar maturity and credit quality. The interest rates on inverse floaters may
be significantly reduced, even to zero, if interest rates rise. Moreover, the
secondary market for inverse floaters may be limited in rising interest rate
environments.
ADJUSTABLE RATE MORTGAGE SECURITIES. Another type of mortgage-related security,
known as adjustable-rate mortgage securities ("ARMS"), bears interest at a rate
determined by reference to a predetermined interest rate or index. There are two
main categories of rates or indices: (1) rates based on the yield on U.S.
Treasury securities and (2) indices derived from a calculated measure such as a
cost of funds index or a moving average of mortgage rates. Some rates and
indices closely mirror changes in market interest rate levels, while others tend
to lag changes in market rate levels and tend to be somewhat less volatile.
ARMS may be secured by adjustable-rate mortgages or fixed-rate mortgages. ARMS
secured by fixed-rate mortgages generally have lifetime caps on the coupon rates
of the securities. To the extent that general interest rates increase faster
than the interest rates on the ARMS, these ARMS will decline in value. The
adjustable-rate mortgages that secure ARMS will frequently have caps that limit
the maximum amount by which the interest rate or the monthly principal and
interest payments on the mortgages may increase. These payment caps can result
in negative amortization (i.e., an increase in the balance of the mortgage
loan). Furthermore, since many adjustable-rate mortgages only reset on an annual
basis, the values of ARMS tend to fluctuate to the extent that changes in
prevailing interest rates are not immediately reflected in the interest rates
payable on the underlying adjustable-rate mortgages.
STRIPPED MORTGAGE SECURITIES. Stripped mortgage-related securities ("SMRS") are
mortgage-related securities that are usually structured with two classes of
securities collateralized by a pool of mortgages or a pool of mortgaged-backed
bonds or pass-through securities, with each class receiving different
proportions of the principal and interest payments from the underlying assets. A
common type of SMRS has one class of interest-only securities ("IOs") receiving
all of the interest payments from the underlying assets, while the other class
of securities, principal-only securities ("POs"), receives all of the principal
payments from the underlying assets. IOs and POs are extremely sensitive to
interest rate changes and are more volatile than mortgage-related securities
that are not stripped. IOs tend to decrease in value as interest rates decrease,
while POs generally increase in value as interest rates decrease. If prepayments
of the underlying mortgages are greater than anticipated, the amount of interest
earned on the overall pool will decrease due to the decreasing principal balance
of the assets. Changes in the values of IOs and POs can be substantial and occur
quickly, such as occurred in the first half of 1994 when the value of many POs
dropped precipitously due to an increase in interest rates. For this reason, the
Fund does not rely on IOs and POs as the principal means of furthering its
investment objective.
MORTGAGE-RELATED SECURITIES -- SPECIAL CONSIDERATIONS. The value of
mortgage-related securities is affected by a number of factors. Unlike
traditional debt securities, which have fixed maturity dates, mortgage-related
securities may be paid earlier than expected as a result of prepayment of the
underlying mortgages. If property owners make unscheduled prepayments of their
mortgage loans, these prepayments will result in the early payment of the
applicable mortgage-related securities. In that event, the Fund may be unable to
invest the proceeds from the early payment of the mortgage-related securities in
an investment that provides as high a yield as the mortgage-related securities.
Consequently, early payment associated with mortgage-related securities causes
these securities to experience significantly greater price and yield volatility
than experienced by traditional fixed-income securities. The occurrence of
mortgage prepayments is affected by the level of general interest rates, general
economic conditions, and other social and demographic factors. During periods of
falling interest rates, the rate of mortgage prepayments tends to increase,
thereby tending to decrease the life of mortgage-related securities. During
periods of rising interest rates, the rate of mortgage prepayments usually
decreases, thereby tending to increase the life of mortgage-related securities.
If the life of a mortgage-related security is inaccurately predicted, the Fund
may not be able to realize the rate of return it expected.
As with fixed-income securities generally, the value of mortgage-related
securities can also be adversely affected by increases in general interest rates
relative to the yield provided by such securities. Such adverse effect is
especially possible with fixed-rate mortgage securities. If the yield available
on other investments rises above the yield of the fixed-rate mortgage securities
as a result of general increases in interest rate levels, the value of the
mortgage-related securities will decline. Although the negative effect could be
lessened if the mortgage-related securities were to be paid earlier (thus
permitting the Fund to reinvest the prepayment proceeds in investments yielding
the higher current interest rate), as described above the rate of mortgage
prepayments and earlier payment of mortgage-related securities generally tends
to decline during a period of rising interest rates.
Although the value of ARMS may not be affected by rising interest rates as
much as the value of fixed-rate mortgage securities is affected by rising
interest rates, ARMS may still decline in value as a result of rising interest
rates. Although, as described above, the yield on ARMS varies with changes in
the applicable interest rate or index, there is often a lag between increases in
general interest rates and increases in the yield on ARMS as a result of
relatively infrequent interest rate reset dates. In addition, adjustable-rate
mortgages and ARMS often have interest rate or payment caps that limit the
ability of the adjustable-rate mortgages or ARMS to fully reflect increases in
the general level of interest rates.
OTHER ASSET-BACKED SECURITIES. The securitization techniques used to develop
mortgage-related securities are being applied to a broad range of financial
assets. Through the use of trusts and special purpose corporations, various
types of assets, including automobile loans and leases, credit card receivables,
home equity loans, equipment leases, and trade receivables, are being
securitized in structures similar to the structures used in mortgage
securitizations. These asset-backed securities are subject to risks associated
with changes in interest rates and prepayment of underlying obligations similar
to the risks of investment in mortgage-related securities discussed above.
Each type of asset-backed security also entails unique risks depending on the
type of assets involved and the legal structure used. For example, credit card
receivables are generally unsecured obligations of the credit card holder and
the debtors are entitled to the protection of a number of state and federal
consumer credit laws, many of which give such debtors the right to set off
certain amounts owed on the credit cards, thereby reducing the balance due.
There have also been proposals to cap the interest rate that a credit card
issuer may charge. In some transactions, the value of the asset-backed security
is dependent on the performance of a third party acting as credit enhancer or
servicer. Furthermore, in some transactions (such as those involving the
securitization of vehicle loans or leases) it may be administratively burdensome
to perfect the interest of the security issuer in the underlying collateral and
the underlying collateral may become damaged or stolen.
VARIABLE, FLOATING, AND LEVERAGED INVERSE FLOATING RATE INSTRUMENTS. Fixed-
income securities may have fixed, variable or floating rates of interest.
Variable and floating rate securities pay interest at rates that are adjusted
periodically, according to a specified formula. A "variable" interest rate
adjusts at predetermined intervals (e.g., daily, weekly or monthly), while a
"floating" interest rate adjusts whenever a specified benchmark rate (such as
the bank prime lending rate) changes.
The Fund may invest in fixed-income securities that pay interest at a coupon
rate equal to a base rate, plus additional interest for a certain period of time
if short-term interest rates rise above a predetermined level or "cap." The
amount of such an additional interest payment typically is calculated under a
formula based on a short-term interest rate index multiplied by a designated
factor.
An inverse floater may be considered to be leveraged to the extent that its
interest rate varies by a magnitude that exceeds the magnitude of the change in
the index rate of interest. The higher degree of leverage inherent in inverse
floaters is associated with greater volatility in market value.
STRUCTURED SECURITIES. Structured securities represent interests in entities
organized and operated solely for the purpose of restructuring the investment
characteristics of sovereign debt obligations or foreign government securities.
This type of restructuring involves the deposit with or purchase by an entity,
such as a corporation or trust, of specified instruments (such as commercial
bank loans or Brady Bonds) and the issuance by that entity of one or more
classes of structured securities backed by, or representing interests in, the
underlying instruments. The cash flow on the underlying instruments may be
apportioned among the newly issued structured securities to create securities
with different investment characteristics such as varying maturities, payment
priorities and interest rate provisions, and the extent of the payments made
with respect to structured securities is dependent on the extent of the cash
flow on the underlying instruments. Because structured securities typically
involve no credit enhancement, their credit risk generally will be equivalent to
that of the underlying instruments. Structured securities of a given class may
be either subordinated or unsubordinated to the right of payment of another
class. Subordinated structured securities typically have higher yields and
present greater risks than unsubordinated structured securities.
BRADY BONDS. Brady Bonds are created through the exchange of existing commercial
bank loans to foreign entities for new obligations in connection with debt
restructurings under a plan introduced by former U.S. Secretary of the Treasury,
Nicholas F. Brady (the "Brady Plan"). Brady Bonds have been issued only
recently, and, accordingly, do not have a long payment history. They may be
collateralized or uncollateralized and issued in various currencies (although
most are U.S. dollar-denominated) and they are actively traded in the
over-the-counter secondary market.
U.S. dollar-denominated, collateralized Brady Bonds, which may be fixed-rate
par bonds or floating rate discount bonds, are generally collateralized in full
as to principal due at maturity by U.S. Treasury zero coupon obligations that
have the same maturity as the Brady Bonds. Interest payments on these Brady
Bonds generally are collateralized by cash or securities in an amount that, in
the case of fixed rate bonds, is equal to at least one year of rolling interest
payments based on the applicable interest rate at that time and is adjusted at
regular intervals thereafter. Certain Brady Bonds are entitled to "value
recovery payments" in certain circumstances, which in effect constitute
supplemental interest payments, but generally are not collateralized. Brady
Bonds are often viewed as having up to four valuation components: (1)
collateralized repayment of principal at final maturity, (2) collateralized
interest payments, (3) uncollateralized interest payments, and (4) any
uncollateralized repayment of principal at maturity (these uncollateralized
amounts constitute the "residual risk"). In the event of a default with respect
to collateralized Brady Bonds as a result of which the payment obligations of
the issuer are accelerated, the U.S. Treasury zero coupon obligations held as
collateral for the payment of principal will not be distributed to investors,
nor will such obligations be sold and the proceeds distributed. The collateral
will be held by the collateral agent to the scheduled maturity of the defaulted
Brady Bonds, which will continue to be outstanding, at which time the face
amount of the collateral will equal the principal payments that would have then
been due on the Brady Bonds in the normal course. In addition, in light of the
residual risk of Brady Bonds and, among other factors, the history of defaults
with respect to commercial bank loans by public and private entities of
countries issuing Brady Bonds, investments in Brady Bonds are to be viewed as
speculative.
<PAGE>
--------------------------------------
KEYSTONE
CLASSIC
FUND FAMILY
+
Quality Bond Fund (B-1)
Diversified Bond Fund (B-2)
High Income Bond Fund (B-4)
Balanced Fund (K-1)
Strategic Growth Fund (K-2)
Growth and Income Fund (S-2)
Mid-Cap Growth Fund (S-3)
Small Company Growth Fund (S-4)
International Fund
Precious Metals Holdings
Tax Free Fund
Liquid Trust
--------------------------------------
- ---------------------------------
Evergreen Keystone
[logo] FUNDS [logo]
- ---------------------------------
Evergreen Keystone Distributor, Inc.
125 W. 55th Street
New York, New York 10019
B4-P Sup. 5/97
17M
540112 [recycle logo]
---------------------------------------
KEYSTONE
[graphic omitted]
HIGH INCOME
BOND FUND (B-4)
---------------------------------------
[LOGO]
PROSPECTUS AND
APPLICATION
KEYSTONE TAX FREE FUND
STATEMENT OF ADDITIONAL INFORMATION
April 30, 1997
This statement of additional information is not a prospectus, but
relates to, and should be read in conjunction with, the prospectus of Keystone
Tax Free Fund (the "Fund") dated April 30, 1997, as supplemented from time to
time. A copy of the prospectus may be obtained from Evergreen Keystone
Distributor, Inc., or your broker-dealer.
TABLE OF CONTENTS
The Fund ............................................................3
Service Providers....................................................3
Investment Restrictions..............................................4
Valuation of Securities..............................................6
Brokerage............................................................6
Sales Charges........................................................8
Distribution Plan....................................................9
Trustees And Officers...............................................11
Investment Adviser..................................................15
Principal Underwriter...............................................17
Sub-administrator...................................................17
Declaration of Trust................................................18
Expenses............................................................19
Financial Statements................................................20
Standardized Total Return And Yield Quotations......................20
Additional Information..............................................21
Appendix...........................................................A-1
<PAGE>
THE FUND
The Fund is an open-end diversified management investment company. The
Fund's investment objective is to provide shareholders with the highest possible
current income, exempt from federal income taxes, while preserving capital. The
Fund invests primarily in municipal bonds, but also may invest in certain other
securities as described in the Appendix hereto and in the "Additional Investment
Information" section of the Fund's prospectus.
Certain information about the Fund is contained in its prospectus. This
statement of additional information (the "SAI") provides additional information
about the Fund that may be of interest to some investors.
SERVICE PROVIDERS
<TABLE>
<S> <C>
Service Provider
- ----------------------------------------- -----------------------------------------------------------------------
Investment adviser (referred to Keystone Investment Management Company, 200 Berkeley
in this SAI as "Keystone") Street, Boston, Massachusetts 02116. (Keystone is a
wholly-owned subsidiary of First Union Keystone, Inc.,
(formerly Keystone Investments, Inc.) ("First Union
Keystone") also located at 200
Berkeley Street, Boston,
Massachusetts 02116.
Principal underwriter ( referred Evergreen Keystone Distributor, Inc. (formerly Evergreen
to in this SAI as "EKD") Funds Distributor, Inc.), 125 W. 55th Street, New York,
New York 10019.
Marketing services agent and Evergreen Keystone Investment Services, Inc. (formerly
predecessor to EKD (referred to Keystone Investment Distributors Company), 200 Berkeley
in this SAI as "EKIS") Street, Boston, Massachusetts 02116.
Sub-administrator (referred to in BISYS Fund Services, Inc., 125 W. 55th Street, New York,
this SAI as "BISYS") New York 10019.
Transfer and dividend Evergreen Keystone Service Company, 200 Berkeley
disbursing agent (referred to in Street, Boston, Massachusetts 02116. (EKSC is a wholly-
this SAI as "EKSC") owned subsidiary of Keystone.)
Independent auditors KPMG Peat Marwick LLP, 99 High Street, Boston,
Massachusetts 02110, Certified Public Accountants
Custodian State Street Bank and Trust Company, 225 Franklin
Street, Boston, Massachusetts 02110.
</TABLE>
INVESTMENT RESTRICTIONS
None of the restrictions enumerated in this paragraph may be changed
without a vote of the holders of a majority of the Fund's outstanding shares as
defined in the Investment Company Act of 1940 (the "1940 Act") as the lesser of
(1) 67% of the shares, represented at a meeting at which more than 50% of the
outstanding shares are represented or (2) more than 50% of the outstanding
shares. The Fund shall not do the following:
(1) purchase securities on margin, but the Fund may obtain such
short-term credits as may be necessary for the clearance of purchases and sales
of securities;
(2) make short sales of securities or maintain a short position, unless
at all times when a short position is open it owns an equal amount of such
securities or of securities which without payment of any further consideration
are convertible into or exchangeable for securities of the same issue as, and
equal in amount to, the securities sold short;
(3) borrow money, except that the Fund may (a) borrow money from banks
for emergency or extraordinary purposes in aggregate amounts up to one-third of
its net assets, and (b) enter into reverse repurchase agreements;
(4) pledge, mortgage or hypothecate its assets except to secure
indebtedness permitted by subparagraph (3) above, with pledged assets to be no
more than 15% of its total assets;
(5) purchase any security other than United States ("U.S.") government
securities of any issuer if as a result more than 25% of its total assets would
be invested in a single industry, including industrial development bonds from
the same facility or similar types of facilities; governmental issuers of
municipal bonds are not regarded as members of an industry and the Fund may
invest more than 25% of its assets in industrial development bonds;
(6) purchase any security, other than U.S. government securities, if as
a result more than 5% of the Fund's total assets would be invested in securities
of the issuer, or the Fund would hold more than 10% of the voting securities of
the issuer;
(7) invest for the purpose of exercising control over or management of
any company;
(8) invest in securities of other investment companies, except as part
of a merger, consolidation, purchase of assets or similar transaction approved
by the Fund's shareholders;
(9) purchase or sell commodities or commodity contracts or real estate,
except that it may purchase and sell securities secured by real estate and
securities of companies which invest in real estate, and may engage in currency
or other financial futures and related options transactions;
(10) act as an underwriter except to the extent that, in connection
with the disposition of its portfolio investments, it may be deemed to be an
underwriter under federal securities laws; or purchase securities which are not
readily marketable except for repurchase agreements;
(11) purchase or retain securities of an issuer if, to the knowledge of
the Fund, an officer, Trustee or Director of the Fund or Keystone owns
beneficially more than 1/2 of 1% of the shares or securities of such issuer and
all such officers, Trustees and Directors owning more than 1/2 of 1% of such
shares or securities together own more than 5% of such shares or securities;
(12) purchase securities of any issuer if the person responsible for
payment, together with any predecessor, has been in operation for less than
three years if, as a result, the aggregate of such investments would exceed 5%
of the Fund's total assets; provided, however, that this restriction shall not
apply to U.S. government securities or to any obligation the payment of which
involves the credit and taxing power of any person authorized to issue municipal
bonds;
(13) invest in interests in oil, gas or other mineral exploration or
development programs;
(14) make loans, except to the extent that the purchase of debt
instruments or repurchase agreements may be deemed to be loans; repurchase
agreements maturing in more than seven days will not exceed 10% of the Fund's
total assets; and
(15) purchase securities of foreign issuers.
The foregoing percentage restrictions will apply at the time of the
purchase of a security and shall not be considered violated unless an excess or
deficiency occurs or exists immediately after and as a result of a purchase of
such security. For the purpose of Investment Restrictions (5) and (6), the Fund
will treat each state, territory and possession of the U.S., the District of
Columbia and, if its assets and revenues are separate from those of the entity
or entities creating it, each political subdivision, agency and instrumentality
of any one (or more, as in the case of a multistate authority or agency) of the
foregoing as an issuer of all securities that are backed primarily by its assets
or revenues; each company as an issuer of all securities that are backed
primarily by its assets or revenues; and each of the foregoing entities as an
issuer of all securities that it guarantees; provided, however, that for the
purpose of limitation (6) no entity shall be deemed to be an issuer of a
security that it guarantees so long as no more than 10% of the Fund's total
assets (taken at current value) are invested in securities guaranteed by the
entity and securities of which it is otherwise deemed to be an issuer.
The Fund does not presently intend to invest more than 25% of its total
assets in (1) municipal bonds of a single state and its subdivisions, agencies
and instrumentalities; of a single territory or possession of the U.S. and its
subdivisions, agencies or instrumentalities; or of the District of Columbia and
any subdivision, agency or instrumentality thereof; or (2) municipal bonds the
payment of which depends on revenues derived from a single facility or similar
types of facilities. Since certain municipal bonds may be related in such a way
that an economic, business or political development or change affecting one such
security could likewise affect the other securities, a change in this policy
could result in increased investment risk, but no change is presently
contemplated. The Fund may invest more than 25% of its total assets in
industrial development bonds.
In addition, the Fund will not issue senior securities, except as
appropriate to evidence indebtedness which the Fund is permitted to incur
pursuant to Investment Restriction (3) above and except for shares of any
additional series or portfolios which may be established by the Trustees.
Notwithstanding the eighth investment restriction enumerated above or
any of the other limitations above, the Fund may invest all of its assets in the
securities of a single open-end management investment company with substantially
the same fundamental investment objectives, policies, and restrictions as the
Fund. See "Investment Objective and Policies" in the prospectus.
VALUATION OF SECURITIES
The Fund believes that reliable market quotations generally are not
readily available for purposes of valuing municipal bonds. As a result,
depending on the particular municipal bonds owned by the Fund, it is likely that
most of the valuations for such bonds will be based upon their fair value
determined under procedures that have been approved by the Fund's Board of
Trustees. The Fund's Board of Trustees has authorized the use of a pricing
service to determine the fair value of its municipal bonds and other securities.
Non-tax exempt securities for which market quotations are readily
available are valued on a consistent basis at that price quoted that, in the
opinion of the Fund's Board of Trustees or the person designated by the Board of
Trustees to make the determination, most nearly represents the market value of
the particular security.
Short-term investments that are purchased with maturities of sixty days
or less are valued at amortized cost (original purchase cost as adjusted for
amortization of premium or accretion of discount), which, when combined with
accrued interest, approximates market; short-term investments maturing in more
than sixty days for which market quotations are readily available are valued at
current market value; and short-term investments maturing in more than sixty
days when purchased that are held on the sixtieth day prior to maturity are
valued at amortized cost (market value on the sixtieth day adjusted for
amortization of premium or accretion of discount), which, when combined with
accrued interest, approximates market and which, in any case, reflects fair
value as determined by the Fund's Board of Trustees.
Any securities for which market quotations are not readily available
are valued on a consistent basis at fair value as determined in good faith using
methods prescribed by the Fund's Board of Trustees.
BROKERAGE
Selection of Brokers
In effecting transactions in portfolio securities for the Fund,
Keystone seeks the best execution of orders at the most favorable prices.
Keystone determines whether a broker has provided the Fund with best execution
and price in the execution of a securities transaction by evaluating, among
other things:
1. overall direct net economic result to the Fund;
2. the efficiency with which the transaction is effected;
3. the broker's ability to effect the transaction where a large
block is involved;
4. the broker's readiness to execute potentially difficult
transactions in the future;
5. the financial strength and stability of the broker; and
6. the receipt of research services, such as analyes and reports
concerning issuers, industries, securities, economic factors
and trends and other statistical and factual information
("research services.")
The Fund's management weighs these considerations in determining the
overall reasonableness of the brokerage commissions paid.
Should the Fund or Keystone receive research services from a broker,
the Fund would consider such services to be in addition to, and not in lieu of,
the services Keystone is required to perform under the Advisory Agreement.
Keystone believes that the cost, value and specific application of research
services are indeterminable and cannot be practically allocated between the Fund
and its other clients who may indirectly benefit from the availability of
research services. Similarly, the Fund may indirectly benefit from information
made available as a result of transactions effected for Keystone's other
clients. Under the Advisory Agreement, Keystone is permitted to pay higher
brokerage commissions for brokerage and research services in accordance with
Section 28(e) of the Securities Exchange Act of 1934. In the event Keystone
follows such a practice, it will do so on a basis that is fair and equitable to
the Fund.
The Fund's Board of Trustees has determined that the Fund may consider
sales of Fund shares as a factor when selecting brokers-dealers to execute
portfolio transactions, subject to the requirements of best execution described
above.
Brokerage Commissions
The Fund expects that purchases and sales of municipal bonds and temporary
instruments usually will be principal transactions. Municipal bonds and
temporary instruments are normally purchased directly from the issuer or from an
underwriter or market maker for the securities. There usually will be no
brokerage commissions paid by the Fund for such purchases. Purchases from
underwriters will include the underwriting commission or concession, and
purchases from dealers serving as market makers will include a dealer's mark up
or reflect a dealer's mark down. Where transactions are made in the
over-the-counter market, the Fund will deal with primary market makers unless
more favorable prices are otherwise obtainable.
General Brokerage Policies
In order to take advantage of the availability of lower purchase
prices, the Fund may participate, if and when practicable, in group bidding for
the direct purchase from an issuer of certain securities.
Keystone makes investment decisions for the Fund independently from
those of its other clients. It may frequently develop, however, that Keystone
will make the same investment decision for more than one client. Simultaneous
transactions are inevitable when the same security is suitable for the
investment objective of more than one account. When two or more of its clients
are engaged in the purchase or sale of the same security, Keystone will allocate
the transactions according to a formula that is equitable to each of its
clients. Although, in some cases, this system could have a detrimental effect on
the price or volume of the Fund's securities, the Fund believes that in other
cases its ability to participate in volume transactions will produce better
executions.
The Fund does not purchase portfolio securities from or sell portfolio
securities to Keystone, EKD or any of their affiliated persons, as defined in
the 1940 Act.
The Board of Trustees periodically reviews the Fund's brokerage policy.
In the event of further regulatory developments affecting the securities
exchanges and brokerage practices generally, the Board of Trustees may change,
modify or eliminate any of the foregoing practices.
SALES CHARGES
The Fund may charge a contingent deferred sales charge (a "CDSC") when
you redeem certain of its shares within four calendar years after you purchase
the shares. The Fund charges a CDSC as reimbursement for certain expenses, such
as commissions or shareholder servicing fees, that it has incurred in connection
with the sale of its shares (see "Distribution Plan"). If imposed, the Fund
deducts the CDSC from the redemption proceeds you would otherwise receive. CDSCs
attributable to your shares are, to the extent permitted by the National
Association of Securities Dealers, Inc. ("NASD"), paid to EKD or its
predecessor.
Calculating the CDSC
The CDSC is a declining percentage of the lesser of (1) the net asset
value of the shares you redeemed, or (2) the total cost of such shares. The CDSC
is calculated according to the following schedule:
Redemption Timing CDSC
During the calendar year of purchase......................4.00%
During the calendar year after the
year of purchase........................................3.00%
During the second calendar
year after the year of purchase.........................2.00%
During the third calendar year
after the year of purchase..............................1.00%
Thereafter................................................0.00%
In determining whether a CDSC is payable and, if so, the percentage
charge applicable, the Fund assumes that you have redeemed shares not subject to
a CDSC first and then it will redeem shares you have held the longest first.
CDSC Waivers. The Fund does not impose a CDSC when the amount you are
redeeming represents:
1. an increase in the value of the shares redeemed above the
total cost of such shares due to increases in the net asset
value per share of the Fund;
2. certain shares for which the Fund did not pay a commission on
issuance, including shares acquired through reinvestment of
dividend income and capital gains distributions;
3. shares you have held for all or part of more than four
consecutive calendar years;
4. shares that are held in the accounts of a shareholder who has
died or become disabled;
5. a lump-sum distribution from a 401(k) plan or other benefit
plan qualified under the Employee Retirement Income Security
Act of 1974 ("ERISA");
6. automatic withdrawals from the ERISA plan of a shareholder who
is a least 59 1/2 years old;
7. shares in an account that the Fund has closed because the
account has an aggregate net asset value of less than $1,000;
8. automatic withdrawals under a Systematic Withdrawal Plan of up
to 1.00% per month of your initial account balance;
9. withdrawals consisting of loan proceeds to a retirement plan
participant;
10. financial hardship withdrawals made by a retirement plan
participant;
11. withdrawals consisting of returns of excess contributions or
excess deferral amounts made to a retirement plan;
12. shares purchased by a bank or trust company in a single
account in the name of such bank or trust company as trustee
if the initial investment in shares of the Fund, any other
Keystone Classic fund, and/or any Evergreen Keystone fund, is
at least $500,000 and any commission paid by the Fund and such
other fund at the time of such purchase is not more than 1% of
the amount invested;
13. shares purchased by any Director, Trustee, officer, full-time
employee or sales representative of the Fund, Keystone, First
Union Keystone, EKD or their affiliates, who has held such
position for at least ninety days; or
14. shares purchased by pension and profit-sharing plans
established by such companies and their affiliates, for the
benefit of their Directors, Trustees, officers, full-time
employees and sales representatives.
Exchanges. The Fund does not charge a CDSC on exchanges of shares
between Keystone Classic funds that have adopted distribution plans pursuant to
Rule 12b-1 under the 1940 Act. If you do exchange shares of one such fund for
shares of another such fund, the Fund will deem the calendar year of the
exchange, for purposes of any future CDSC, to be the year the shares tendered
for exchange were originally purchased.
- --------------------------------------------------------------------------------
DISTRIBUTION PLAN
- --------------------------------------------------------------------------------
Rule 12b-1 under the 1940 Act permits investment companies, such as the
Fund to use their assets to bear the expenses of distributing their shares, if
they comply with various conditions, including adoption of a distribution plan
containing certain provisions set forth in Rule 12b-1. The Fund bears some of
the costs of selling its shares under a Distribution Plan adopted on June 1,
1983 pursuant to Rule 12b-1 (the "Distribution Plan").
The Fund's Distribution Plan provides that the Fund may expend up to
0.3125% quarterly (1.25% annually) of the average daily net asset value of its
shares to pay distribution costs for sales of its shares and to pay shareholder
service fees. The NASD currently limits such annual expenditures to 1.00%, of
which 0.75% may be used to pay such distribution costs and 0.25% may be used to
pay shareholder service fees. The NASD also limits the aggregate amount that the
Fund may pay for such distribution costs to 6.25% of gross share sales since the
inception of the Fund's Distribution Plan plus interest at the prime rate plus
1% on unpaid amounts thereof (less any CDSC paid by shareholders to the
Principal Underwriter).
Payments under the Distribution Plan are currently made to the
Principal Underwriter (which may reallow all or part to others, such as
broker-dealers) (1) as commissions for Fund shares sold, (2) as shareholder
service fees in respect to shares maintained by the recipient and outstanding on
the Fund's books for specified periods and (3) as interest. Amounts paid or
accrued to the Principal Underwriter and its predecessor in the aggregate may
not exceed the annual limitations referred to above. The Principal Underwriter
generally reallows to broker-dealers or others a commission equal to 4.00% of
the price paid for each Fund share sold as well as a shareholder service fee at
a rate of 0.25% per annum of the net asset value of shares maintained by such
recipient and outstanding on the books of the Fund for specified periods.
If the Fund is unable to pay the Principal Underwriter a commission on
a new sale because the annual maximum (0.75% of average daily net assets) has
been reached, the Principal Underwriter intends, but is not obligated, to
continue to accept new orders for the purchase of Fund shares and to pay or
accrue commissions and service fees to broker-dealers in excess of the amount it
currently receives from the Fund ("Advances"). While the Fund is under no
contractual obligation to reimburse the Principal Underwriter or its predecessor
for Advances, the Principal Underwriter and its predecessor intend to seek full
payment for such Advances from the Fund (together with interest at the prime
rate plus 1.00%) at such time in the future as, and to the extent that, payment
thereof by the Fund would be within permitted limits. EKIS currently intends to
seek payment of interest only on such Advances paid or accrued by EKIS
subsequent to July 7, 1992. If the Fund's Independent Trustees authorize such
payments, the effect would be to extend the period of time during which the Fund
incurs the maximum amount of costs allowed by the Distribution Plan.
The Distribution Plan may be terminated at any time by vote of a
majority of the Independent Trustees or by vote of a majority of the outstanding
voting shares of the Fund. If the Distribution Plan is terminated, EKD will ask
the Independent Trustees to take whatever action they deem appropriate under the
circumstances with respect to payment of such Advances.
The total amounts paid by the Fund under the foregoing arrangements may
not exceed the maximum Distribution Plan limit specified above. In addition, the
amounts and purposes of expenditures under the Distribution Plan must be
reported to the Fund's Independent Trustees quarterly. The Fund's Independent
Trustees may require or approve changes in the implementation or operation of
the Distribution Plan, and may also require that total expenditures by the Fund
under the Distribution Plan be kept within limits lower than the maximum amount
permitted by the Distribution Plan as stated above. If such costs are not
limited by the Independent Trustees, such costs could, for some period of time,
be higher than such costs permitted by most other plans presently adopted by
other investment companies.
The Distribution Plan may be terminated at any time by vote of the
Independent Trustees or by vote of a majority of the outstanding voting
securities of the Fund. Any change in the Distribution Plan that would
materially increase the distribution expenses of the Fund provided for in the
Distribution Plan requires shareholder approval. Otherwise, the Distribution
Plan may be amended by the votes of the majority of both (1) the Fund's Board of
Trustees and (2) the Independent Trustees, cast in person at a meeting called
for the purpose of voting on such amendment.
While the Distribution Plan is in effect, the Fund will be required to
commit the selection and nomination of candidates for Independent Trustees to
the discretion of the Independent Trustees.
Whether any expenditure under the Distribution Plan is subject to a
state expense limit will depend upon the nature of the expenditure and the terms
of the state law, regulation or order imposing the limit. A portion of the
Fund's Distribution Plan expenses may be includable in the Fund's total
operating expenses for purposes of determining compliance with state expense
limits.
The Independent Trustees of the Fund have determined that the sales of
the Fund's shares resulting from payments under the Distribution Plan have
benefited the Fund.
TRUSTEES AND OFFICERS
The Trustees of the Fund, their principal occupations and some of their
affiliations over the last five years, and the officers of the Fund are as
follows:
<TABLE>
<S> <C>
FREDERICK AMLING: Trustee of the Fund; Trustee or Director of all other funds in the Key
stone Families of Funds; Professor, Finance
Department, George Washington University;
President, Amling & Company (investment
advice); and former Member, Board of
Advisers, Credito Emilano (bank ing).
LAURENCE B. ASHKIN: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Trustee or Director of all of the funds in the
Evergreen Family of Funds other than Evergreen Investment Trust;
real estate developer and construction consultant; and President of
Centrum Equities and Centrum Properties, Inc.
CHARLES A. AUSTIN III: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Investment Counselor to Appleton
Partners, Inc.; and former Managing Director, Seaward Management
Corporation (investment advice).
FOSTER BAM: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Trustee or Director of all of the funds in the
Evergreen Family of Funds other than Evergreen Investment Trust;
Partner in the law firm of Cummings & Lockwood; Director, Symmetrix,
Inc. (sulphur company) and Pet Practice, Inc. (veterinary services); and
former Director, Chartwell Group Ltd. (manufacturer of office
furnishings and accessories), Waste Disposal Equipment Acquisition
Corporation and Rehabilitation Corporation of America (rehabilitation
hospitals).
*GEORGE S. BISSELL: Chief Executive Officer of the Fund and each of the other funds in the
Keystone Families of Funds; Chairman of the Board and Trustee of the
Fund; Chairman of the Board and Trustee or Director of all other funds
in the Keystone Families of Funds; Chairman of the Board and Trustee
of Anatolia College; Trustee of University Hospital (and Chairman of its
Investment Committee); former Director and Chairman of the Board of
Hartwell Keystone; and former Chairman of the Board, Director and
Chief Executive Officer of Keystone Investments, Inc.
EDWIN D. CAMPBELL: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Principal, Padanaram Associates, Inc.; and
former Executive Director, Coalition of Essential Schools, Brown
University.
CHARLES F. CHAPIN: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; and former Director, Peoples Bank
(Charlotte, NC).
K. DUN GIFFORD: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Trustee, Treasurer and Chairman of the
Finance Committee, Cambridge College; Chairman Emeritus and Direc
tor, American Institute of Food and Wine; Chairman and President,
Oldways Preservation and Exchange Trust (education); former
Chairman of the Board, Director, and Executive Vice President, The
London Harness Company; former Managing Partner, Roscommon
Capital Corp.; former Chief Executive Officer, Gifford Gifts of Fine
Foods; former Chairman, Gifford, Drescher & Associates (environmental
consulting); and former Director, Keystone Investments, Inc.
JAMES S. HOWELL: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Chairman and Trustee or Director of all of
the funds in the Evergreen Family of Funds; former Chairman of the
Distribution Foundation for the Carolinas; and former Vice President of
Lance Inc. (food manufacturing).
LEROY KEITH, JR.: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Chairman of the Board and Chief
Executive Officer, Carson Products Company; Director of Phoenix Total
Return Fund and Equifax, Inc.; Trustee of Phoenix Series Fund, Phoenix
Multi-Portfolio Fund, and The Phoenix Big Edge Series Fund; and
former President, Morehouse College.
F. RAY KEYSER, JR.: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Chairman and Of Counsel, Keyser, Crowley
& Meub, P.C.; Member, Governor's (VT) Council of Economic Advisers;
Chairman of the Board and Director, Central Vermont Public Service
Corporation and Lahey Hitchcock Clinic; Director, Vermont Yankee
Nuclear Power Corporation, Grand Trunk Corporation, Grand Trunk
Western Railroad, Union Mutual Fire Insurance Company, New
England Guaranty Insurance Company, Inc., and the Investment
Company Institute; former Director and
President, Associated Industries of Vermont;
former Director of Keystone, Central Vermont
Railway, Inc., S.K.I. Ltd., and Arrow
Financial Corp.; and former Director and
Chairman of the Board, Proctor Bank and
Green Mountain Bank.
GERALD M. MCDONNELL: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Trustee or Director of all of the funds in the
Evergreen Family of Funds; and Sales Representative with Nucor-
Yamoto, Inc. (steel producer).
THOMAS L. MCVERRY: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Trustee or Director of all of the funds in the
Evergreen Family of Funds; former Vice President and Director of
Rexham Corporation; and former Director of Carolina Cooperative
Federal Credit Union.
*WILLIAM WALT PETTIT: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Trustee or Director of all of the funds in the
Evergreen Family of Funds; and Partner in the law firm of Holcomb and
Pettit, P.A.
DAVID M. RICHARDSON: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Vice Chair and former Executive Vice
President, DHR International, Inc. (executive recruitment); former
Senior Vice President, Boyden International Inc. (executive recruit
ment); and Director, Commerce and Industry Association of New Jersey,
411 International, Inc., and J&M Cumming Paper Co.
RUSSELL A.
SALTON, III MD: Trustee of the Fund; Trustee or
Director of all other funds in the Keystone
Families of Funds; Trustee or Director of
all of the funds in the Evergreen Family of
Funds; Medical Director, U.S. Health
Care/Aetna Health Services; and former
Managed Health Care Consultant; former
President, Primary Physician Care.
MICHAEL S. SCOFIELD: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Trustee or Director of all of the funds in the
Evergreen Family of Funds; and Attorney, Law Offices of Michael S.
Scofield.
RICHARD J. SHIMA: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Chairman, Environmental Warranty, Inc.
(insurance agency); Executive Consultant, Drake Beam Morin, Inc.
(executive outplacement); Director of Connecticut Natural Gas Corpora
tion, Hartford Hospital, Old State House Association, Middlesex Mutual
Assurance Company, and Enhance Financial Services, Inc.; Chairman,
Board of Trustees, Hartford Graduate Center; Trustee, Greater Hartford
YMCA; former Director, Vice Chairman and Chief Investment Officer,
The Travelers Corporation; former Trustee,
Kingswood-Oxford School; and former Managing
Director and Consultant, Russell Miller,
Inc.
ANDREW J. SIMONS: Trustee of the Fund; Trustee or Director of all other funds in the
Keystone Families of Funds; Partner, Farrell, Fritz, Caemmerer, Cleary,
Barnosky & Armentano, P.C.; Adjunct Professor of Law and former
Associate Dean, St. John's University School of Law; Adjunct Professor
of Law, Touro College School of Law; and former President, Nassau
County Bar Association.
JOHN J. PILEGGI: President and Treasurer of the Fund; President and Treasurer of all
other funds in the Keystone Families of Funds; President and Treasurer
of all of the funds in the Evergreen Family of Funds; Senior Managing
Director, Furman Selz LLC since 1992; Managing Director from 1984 to
1992; Consultant to BISYS Fund Services since 1996; 230 Park Avenue,
Suite 910, New York, NY.
GEORGE O. MARTINEZ: Secretary of the Fund; Secretary of all other funds in the Keystone
Families of Funds; Secretary of all the
funds in the Evergreen Family of Funds;
Senior Vice President and Director of
Administration and Regulatory Services,
BISYS Fund Services; Vice
President/Assistant General Counsel,
Alliance Capital Management from 1988 to
1995;
3435 Stelzer Road, Columbus, Ohio.
</TABLE>
* This Trustee may be considered an "interested person" of the Fund within the
meaning of the 1940 Act.
For the fiscal year ended December 31, 1996, none of the affiliated or
Independent Trustees and officers of the Fund received any direct remuneration
from the Fund. For the year ending December 31, 1996, fees paid to Independent
Trustees on a fund complex wide basis (which included approximately 60 mutual
funds) were approximately $846,350. On March 29, 1996, the Trustees and officers
of the Fund, as a group, beneficially owned less than 1% of the Fund's then
outstanding shares.
Except as set forth above, the address of all the Fund's Trustees and
officers is 200 Berkeley Street, Boston, Massachusetts 02116-5034.
Set forth below for each of the Trustees receiving in excess of $60,000
for the fiscal period of January 1, 1996 through December 31, 1996 is the
aggregate compensation paid to such Trustee by the Evergreen-Keystone Funds:
Aggregate Total Compensation
Compensation From Registrant
from and Fund Complex
Name Registrant Pd. To Trustee
James S. Howell $0 $66,000
Russell A Salton, III M.D. $0 $61,000
Michael S. Scofield $0 $61,000
INVESTMENT ADVISER
Subject to the general supervision of the Fund's Board of Trustees,
Keystone provides investment advice, management and administrative services to
the Fund.
On December 11, 1996, the predecessor corporation to First Union
Keystone, Keystone Investments, Inc. ("Keystone Investments") and indirectly
each subsidiary of Keystone Investments, including Keystone, were acquired (the
"Acquisition") by First Union National Bank of North Carolina ("FUNB"), a
wholly-owned subsidiary of First Union Corporation ("First Union"). Keystone
Investments was acquired by FUNB by merger into a wholly-owned subsidiary of
FUNB, which entity then assumed the name "First Union Keystone, Inc." and
succeeded to the business of the predecessor corporation. Contemporaneously with
the Acquisition, the Fund entered into a new investment advisory agreement with
Keystone and into a principal underwriting agreement with EKD, a wholly-owned
subsidiary of The BISYS Group, Inc. The new investment management and advisory
agreement (the "Advisory Agreement") was approved by the shareholders of the
Fund on December 9, 1996, and became effective on December 11, 1996. As a result
of the above transactions, Keystone Management, Inc. ("Keystone Management"),
which, prior to the Acquisition, acted as the Fund's investment manager, no
longer acts as such to the Fund. Keystone currently provides the Fund with all
the services that may previously have been provided by Keystone Management.
First Union Keystone and each of its subsidiaries, including Keystone,
are now indirectly owned by First Union. First Union is headquartered in
Charlotte, North Carolina, and had $140 billion in consolidated assets as of
December 31, 1996. First Union and its subsidiaries provide a broad range of
financial services to individuals and businesses throughout the United States.
The Capital Management Group of FUNB, Keystone and Evergreen Asset Management
Corp., a wholly-owned subsidiary of FUNB, manage or otherwise oversee the
investment of over $60 billion in assets as of December 31, 1996, belonging to a
wide range of clients, including the Evergreen Keystone Family of Funds.
Pursuant to the Advisory Agreement and subject to the supervision of
the Fund's Board of Trustees, Keystone furnishes to the Fund investment
advisory, management and administrative services, office facilities, and
equipment in connection with its services for managing the investment and
reinvestment of the Fund's assets. Keystone pays for all of the expenses
incurred in connection with the provision of its services.
All charges and expenses, other than those specifically referred to as
being borne by Keystone, will be paid by the Fund, including, but not limited
to, (1) custodian charges and expenses; (2) bookkeeping and auditors' charges
and expenses; (3) transfer agent charges and expenses; (4) fees and expenses of
Independent Trustees; (5) brokerage commissions, brokers' fees and expenses; (6)
issue and transfer taxes; (7) costs and expenses under the Distribution Plan;
(8) taxes and trust fees payable to governmental agencies; (9) the cost of share
certificates; (10) fees and expenses of the registration and qualification of
the Fund and its shares with the Securities and Exchange Commission (the
"Commission") or under state or other securities laws; (11) expenses of
preparing, printing and mailing prospectuses, statements of additional
information, notices, reports and proxy materials to shareholders of the Fund;
(12) expenses of shareholders' and Trustees' meetings; (13) charges and expenses
of legal counsel for the Fund and for the Independent Trustees of the Fund on
matters relating to the Fund; and (14) charges and expenses of filing annual and
other reports with the Commission and other authorities, and all extraordinary
charges and expenses of the Fund.
The Fund pays Keystone a fee at the end of each month for its services
consisting of (i) an amount calculated as set forth below:
Aggregate Net Asset
Management Value of the Shares
Fee Income of the Fund
- --------------------------------------------------------------------------------
0.50% of the next 2.0% of Gross Dividend $ 100,000,000, plus
0.45% of the next and Interest Income Plus $ 100,000,000, plus
0.40% of the next $ 100,000,000, plus
0.35% of the next $ 100,000,000, plus
0.30% of the next $ 100,000,000, plus
0.25% of amounts over $ 500,000.000;
and (ii) an amount equal to the amount of the reimbursable expenses of Keystone
accrued during such calendar month.
Under the Advisory Agreement, any liability of Keystone in connection
with rendering services thereunder is limited to situations involving its
willful misfeasance, bad faith, gross negligence or reckless disregard of its
duties.
The Advisory Agreement continues in effect for two years from its
effective date and, thereafter, from year to year only if approved at least
annually by the Board of Trustees of the Fund or by a vote of a majority of the
Fund's outstanding shares (as defined in the 1940 Act). In either case, the
terms of the Advisory Agreement and continuance thereof must be approved by the
vote of a majority of the Independent Trustees cast in person at a meeting
called for the purpose of voting on such approval. The Advisory Agreement may be
terminated, without penalty, on 60 days' written notice by the Fund's Board of
Trustees or by a vote of a majority of outstanding shares. The Advisory
Agreement will terminate automatically upon its assignment.
- --------------------------------------------------------------------------------
PRINCIPAL UNDERWRITER
- --------------------------------------------------------------------------------
The Fund has entered into a Principal Underwriting Agreement (the
"Underwriting Agreement") with EKD. EKD, which is not affiliated with First
Union, replaces EKIS as the Fund's principal underwriter. EKIS may no longer act
as principal underwriter of the Fund due to regulatory restrictions imposed by
the Glass-Steagall Act upon national banks such as FUNB and their affiliates,
that prohibit such entities from acting as the underwriters of mutual fund
shares. While EKIS may no longer act as principal underwriter of the Fund as
discussed above, EKIS may continue to receive compensation from the Fund or EKD
in respect of underwriting and distribution services performed prior to the
termination of EKIS as principal underwriter. In addition, EKIS may also be
compensated by EKD for the provision of certain marketing support services to
EKD at an annual rate of up to 0.75% of the average daily net assets of the
Fund, subject to certain restrictions.
EKD, as agent, has agreed to use its best efforts to find purchasers
for the shares. EKD may retain and employ representatives to promote
distribution of the shares and may obtain orders from broker-dealers, and
others, acting as principals, for sales of shares to them. The Underwriting
Agreement provides that EKD will bear the expense of preparing, printing, and
distributing advertising and sales literature and prospectuses used by it. In
its capacity as principal underwriter, EKD or EKIS, its predecessor, may receive
payments from the Fund pursuant to the Fund's Distribution Plan.
The Underwriting Agreement provides that it will remain in effect as
long as its terms and continuance are approved annually (i) by a vote of a
majority of the Independent Trustees, and (ii) by vote of a majority of the
Trustees, in each case, cast in person at a meeting called for that purpose.
The Underwriting Agreement may be terminated, without penalty, on 60
days' written notice by the Board of Trustees or by a vote of a majority of
outstanding shares. The Underwriting Agreement will terminate automatically upon
its assignment.
From time to time, if, in EKD's judgment, it could benefit the sales of
Fund shares, EKD may provide to selected broker-dealers promotional materials
and selling aids, including, but not limited to, personal computers, related
software and Fund data files.
- --------------------------------------------------------------------------------
SUB-ADMINISTRATOR
- --------------------------------------------------------------------------------
BISYS provides personel to serve as officers of the Fund, and provides
certain administrative services to the Fund pursuant to a sub-administrator
agreement. For its services under that agreement, BISYS receives from Keystone a
fee based on the aggregate average daily net assets of the Fund at a rate based
on the total assets of all mutual funds administered by BISYS for which FUNB
affiliates also serve as investment adviser. The sub-administrator fee is
calculated in accordance with the following schedule:
Aggregate Average Daily Net Assets Of Mutual Funds
Sub-Administrator Administered By BISYS For Which Any Affiliate Of
Fee FUNB Serves As Investment Adviser
- --------------------------------------------------------------------------------
0.0100% on the first $7 billion
0.0075% on the next $3 billion
0.0050% on the next $15 billion
0.0040% on assets in excess of $25 billion
The total assets of the mutual funds for which FUNB affiliates also
serve as investment advisers were approximately $29.2 billion as of February 28,
1997.
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DECLARATION OF TRUST
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The Fund is a Massachusetts business trust originally established under
a Declaration of Trust dated April 12, 1977, as amended and restated on July 27,
1993 (the "Declaration of Trust"). The Fund is similar in most respects to a
business corporation. The principal distinction between the Fund and a
corporation relates to the shareholder liability described below. This summary
is qualified in its entirety by reference to the Declaration of Trust.
Description of Shares
The Declaration of Trust authorizes the issuance of an unlimited number
of shares of beneficial interest and the creation of additional series and/or
classes of series of Fund shares. Each share represents an equal proportionate
interest in the Fund with each other share of that class. Upon liquidation,
shares are entitled to a pro rata share in the net assets of their class of Fund
shares. Shareholders shall have no preemptive or conversion rights. Shares are
transferable. The Fund currently intends to issue only one class of shares.
Shareholder Liability
Pursuant to court decisions or other theories of law, shareholders of a
Massachusetts business trust could possibly be held personally liable as
partners for the obligations of the Fund. The possibility of Fund shareholders
incurring financial loss for that reason appears remote, however, because the
Declaration of Trust (1) contains an express disclaimer of shareholder liability
for obligations of the Fund; (2) requires that notice of such disclaimer be
given in each agreement, obligation or instrument entered into or executed by
the Fund or the Fund's Board of Trustees; and (3) provides for indemnification
out of Fund property for any shareholder held personally liable for the
obligations of the Fund.
Voting Rights
Under the terms of the Declaration of Trust, the Fund does not hold
annual meetings. At meetings called for the initial election of Trustees or to
consider other matters, shares are entitled to one vote per share. Shares
generally vote together as one class on all matters. No amendment may be made to
the Declaration of Trust that adversely affects any class of shares without the
approval of a majority of the shares of that class. There shall be no cumulative
voting in the election of Trustees.
After the initial meeting as described above, no further meetings of
shareholders for the purpose of electing Trustees will be held, unless required
by law or until such time as less than a majority of the Trustees holding office
have been elected by shareholders, at which time, the Trustees then in office
will call a shareholder's meeting for the election of Trustees.
Except as set forth above, the Trustees shall continue to hold office
indefinitely unless otherwise required by law and may appoint successor
Trustees. A Trustee may cease to hold office or may be removed from office (as
the case may be) (1) at any time by a two-thirds vote of the remaining Trustees;
(2) when such Trustee becomes mentally or physically incapacitated; or (3) at a
special meeting of shareholders by a two-thirds vote of the outstanding shares.
Any Trustee may voluntarily resign from office. Limitation of Trustees'
Liability
The Declaration of Trust provides that a Trustee will not be liable for
errors of judgment or mistakes of fact or law, but nothing in the Declaration of
Trust protects a Trustee against any liability to which he would otherwise be
subject by any reason of willful misfeasance, bad faith, gross negligence or
reckless disregard of his duties involved in the conduct of his office.
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EXPENSES
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Investment Advisory Fees
For each of the Fund's last three fiscal years, the table below lists
the total dollar amounts paid by (1) the Fund to Keystone Management, the Fund's
former investment manager, for investment management and administrative services
rendered and (2) by Keystone Management to Keystone for investment advisory
services rendered. For more information, see "Investment Adviser."
<TABLE>
<S> <C> <C> <C>
Percent of Fund's
Fee Paid to Keystone Average Net Assets Fee Paid to
Management under represented by Keystone under
Fiscal Year Ended the Management Keystone the Advisory
December 31, Agreement Management's Fee Agreement
- ------------------------- ---------------------------- ---------------------------- -----------------------
1996 $6,272,478 0.42% $5,331,606
1995 $5,327,202 0.44% $4,528,122
1994 $5,941,545 0.43% $5,050,313
</TABLE>
Distribution Plan Expenses
For the fiscal year ended December 31, 1996, the Fund paid $4,706,968
to EKD and EKIS under its Distribution Plan. For more information, see
"Distribution Plan."
Underwriting Commissions
For each of the Fund's last three fiscal years, the table below lists
the aggregate dollar amounts of underwriting commissions (distribution fees plus
CDSCs) paid with respect to the public distribution of the Fund's shares. The
table also indicates the aggregate dollar amount of underwriting commissions
retained by EKIS and/or EKD. For more information, see "Principal Underwriter"
and "Sales Charges."
<TABLE>
<S> <C> <C>
Aggregate Dollar Amount of
Fiscal Year Ended Aggregate Dollar Amount of Underwriting Commissions
December 31, Underwriting Commissions Retained by EKIS and/or EKD
- -------------------------- ---------------------------------------- -----------------------------------------
1996 $2,402,158 $632,014
1995 $2,537,213 $845,504
1994 $10,904,376 $9,742,842
</TABLE>
Brokerage Commissions
The Fund paid no brokerage commissions for the fiscal years ended
December 31, 1996, 1995 and 1994.
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FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
The Fund's financial statements for the fiscal year ended December 31,
1996, and the report thereon of KPMG Peat Marwick LLP, are incorporated by
reference herein from the Fund's Annual Report, as filed with the Commission
pursuant to Section 30(d) of the 1940 Act and Rule 30d-1 thereunder.
You may obtain a copy of the Fund's Annual Report without charge by
writing to EKSC, P.O. Box 2121, Boston, Massachusetts 02106-2121, or by calling
EKSC toll free at 1-800-343-2898.
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STANDARDIZED TOTAL RETURN AND YIELD QUOTATIONS
- --------------------------------------------------------------------------------
Total return quotations for the Fund as they may appear from time to
time in advertisements are calculated by finding the average annual compounded
rates of return over the one-, five- and ten-year periods on a hypothetical
$1,000 investment that would equate the initial amount invested to the ending
redeemable value. To the initial investment all dividends and distributions are
added, and all recurring fees charged to all shareholder accounts are deducted.
The ending redeemable value assumes a complete redemption at the end of the one,
five or ten year periods.
The annual total return of the Fund for the one year period ended
December 31, 1996, including applicable sales charge, was 0.21%. The average
annual returns for the five- and ten-years ended December 31, 1996 were 5.91%
and 6.64%, respectively (including CDSCs).
Current yield quotations as they may appear from time to time in
advertisements will consist of a quotation based on a 30-day period ended on the
date of the most recent balance sheet of the Fund, 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 base period. The current yield for the
30-day period ended December 31, 1996 was 5.09%.
Tax equivalent yield is, in general, the current yield divided by a
factor equal to one minus a stated income tax rate and reflects the yield a
taxable investment would have to achieve in order to equal on an after tax-basis
a tax exempt yield. The tax equivalent yield for an investor in the 31% federal
tax bracket for the 30-day period ended December 31, 1996 was 7.38%.
Any given yield or total return quotation should not be considered
representative of the Fund's yield or total return for any future period.
- --------------------------------------------------------------------------------
ADDITIONAL INFORMATION
- --------------------------------------------------------------------------------
Except as otherwise stated in its prospectus or required by law, the
Fund reserves the right to change the terms of the offer stated in its
prospectus without shareholder approval, including the right to impose or change
fees for services provided.
As of April 1, 1997, Merrill Lynch Pierce Fenner & Smith, For Sole
Benefit of its Customers, Attn: Fund Administration, 4800 Deer Lake Dr. E., 3rd
Floor, Jacksonville, FL 32246-6484 owned of record 12.97% of the Fund's
outstanding shares.
No dealer, salesman or other person is authorized to give any
information or to make any representation not contained in the Fund's
prospectus, this statement of additional information, or in supplemental sales
literature issued by the Fund or the Principal Underwriter, and no person is
entitled to rely on any information or representation not contained therein.
For information on taxes, particularly with respect to dividends and
the Fund's qualifications as a registered investment company, please refer to
the section of your prospectus entitled "Dividends and Taxes."
The Fund's prospectus and this statement of additional information omit
certain information contained in the registration statement filed with the
Commission, which may be obtained from the Commission's principal office in
Washington, D.C. upon payment of the fee prescribed by the rules and regulations
promulgated by the Commission.
APPENDIX
CORPORATE BOND RATINGS
A. S&P Corporate Bond Ratings
A S&P corporate bond rating is a current assessment of the
creditworthiness of an obligor, including obligors outside the U.S., with
respect to a specific obligation. This assessment may take into consideration
obligors such as guarantors, insurers or lessees. Ratings of foreign obligors do
not take into account currency exchange and related uncertainties. The ratings
are based on current information furnished by the issuer or obtained by S&P from
other sources it considers reliable.
The ratings are based, in varying degrees, on the following
considerations:
a. Likelihood of default - capacity and willingness of the obligor as
to the timely payment of interest and repayment of principal in accordance with
the terms of the obligation;
b. Nature of and provisions of the obligation; and
c. Protection afforded by and relative position of the obligation in
the event of bankruptcy reorganization or other arrangement under the laws of
bankruptcy and other laws affecting creditors' rights.
PLUS (+) OR MINUS (-): To provide more detailed indications of credit
quality, 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.
Bond ratings are as follows:
1. AAA - Debt rated AAA has the highest rating assigned by S&P.
Capacity to pay interest and repay principal is extremely strong.
2. AA - Debt rated AA has a very strong capacity to pay interest and
repay principal and differs from the higher rated issues only in small degree.
3. A - Debt rated A has a strong capacity to pay interest and repay
principal although it is somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than debt in higher rated
categories.
4. BBB - Debt rated BBB is regarded as having an adequate capacity to
pay interest and repay principal. Whereas it normally exhibits adequate
protection parameters, adverse economic conditions or changing circumstances are
more likely to lead to a weakened capacity to pay interest and repay principal
for debt in this category than in higher rated categories.
5. BB, B, CCC, CC and C - Debt rated BB, B, CCC, CC and C is regarded,
on balance, as predominantly speculative with respect to capacity to pay
interest and repay principal in accordance with the terms of the obligation. BB
indicates the lowest degree of speculation and C the highest degree of
speculation. While such debt will likely have some quality and protective
characteristics, these are outweighed by large uncertainties or major risk
exposures to adverse conditions.
6. CI - The rating CI is reserved for income bonds on which no interest
is being paid.
7. D - Debt rated D is in default, and payment of interest and/or
repayment of principal is in arrears.
B. Moody's Corporate Bond Ratings
Moody's ratings are as follows:
1. Aaa - Bonds that 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-edge." Interest payments are protected by a large or by an
exceptionally stable margin and principal is secure. While the various
protective elements are likely to change, such changes as can be visualized are
most unlikely to impair the fundamentally strong position of such issues.
2. Aa - Bonds that 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 that
make the long term risks appear somewhat larger than in Aaa securities.
3. A - Bonds that 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 that suggest a susceptibility to impairment sometime in the
future.
4. Baa - Bonds that 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.
5. Ba - Bonds that are rated Ba are judged to have speculative
elements. Their future cannot be considered as well assured. Often the
protection of interest and principal payments may be very moderate and thereby
not well safeguarded during both good and bad times over the future.
Uncertainty of position characterizes bonds in this class.
6. B - Bonds that are rated B generally lack characteristics of the
desirable investment. Assurance of interest and principal payments or of
maintenance of other terms of the contract over any long period of time may be
small.
7. Caa - Bonds that are rated Caa are of poor standing. Such issues may
be in default or there may be present elements of danger with respect to
principal or interest.
8. Ca - Bonds that are rated Ca represent obligations which are
speculative in a high degree. Such issues are often in default or have other
market shortcomings.
9. C - Bonds that are rated as C are the lowest rated class of bonds
and issues so rated can be regarded as having extremely poor prospects of ever
attaining any real investment standing.
Moody's applies numerical modifiers, 1, 2 and 3 in each generic rating
classification from Aa through B in its corporate bond rating system. The
modifier 1 indicates that the security ranks in the higher end of its generic
rating category; the modifier 2 indicates a mid-range ranking; and the modifier
3 indicates that the issue ranks in the lower end of its generic rating
category.
ZERO COUPON "STRIPPED" BONDS
A zero coupon "stripped" bond represents ownership in serially maturing
interest payments or principal payments on specific underlying notes and bonds,
including coupons relating to such notes and bonds. The interest and principal
payments are direct obligations of the issuer. Coupon zero coupon bonds of any
series mature periodically from the date of issue of such series through the
maturity date of the securities related to such series. Principal zero coupon
bonds mature on the date specified therein, which is the final maturity date of
the related securities. Each zero coupon bond entitles the holder to receive a
single payment at maturity. There are no periodic interest payments on a zero
coupon bond.
Zero coupon bonds are offered at discounts from their face amounts.
In general, owners of zero coupon bonds have substantially all the
rights and privileges of owners of the underlying coupon obligations or
principal obligations. Owners of zero coupon bonds have the right upon default
on the underlying coupon obligations or principal obligations to proceed
directly and individually against the issuer and are not required to act in
concert with other holders of zero coupon bonds.
For federal income tax purposes, a purchaser of principal zero coupon
bonds or coupon zero coupon bonds (either initially or in the secondary market)
is treated as if the buyer had purchased a corporate obligation issued on the
purchase date with an original issue discount equal to the excess of the amount
payable at maturity over the purchase price. The purchaser is required to take
into income each year as ordinary income an allocable portion of such discounts
determined on a "constant yield" method. Any such income increases the holder's
tax basis for the zero coupon bond, and any gain or loss on a sale of the zero
coupon bonds relative to the holder's basis, as so adjusted, is a capital gain
or loss. If the holder owns both principal zero coupon bonds and coupon zero
coupon bonds representing interest in the same underlying issue of securities, a
special basis allocation rule (requiring the aggregate basis to be allocated
among the items sold and retained based on their relative fair market values at
the time of sale) may apply to determine the gain or loss on a sale of any such
zero coupon bonds items.
PAYMENT-IN-KIND SECURITIES
Payment-in-kind ("PIK") securities pay interest in either cash or
additional securities, at the issuer's option, for a specified period. The
issuer's option to pay in additional securities typically ranges from one to six
years, compared to an average maturity for all PIK securities of eleven years.
Call protection and sinking fund features are comparable to those offered on
traditional debt issues.
PIKs, like zero coupon bonds, are designated to give an issuer
flexibility in managing cash flow. Several PIKs are senior debt. In other cases,
where PIKs are subordinated, most senior lenders view them as equity
equivalents.
An advantage of PIKs for the issuer - as with zero coupon securities -
is that interest payments are automatically compounded (reinvested) at the
stated coupon rate, which is not the case with cashpaying securities. However,
PIKs are gaining popularity over zeros since interest payments in additional
securities can be monetized and are more tangible than accretion of a discount.
As a group, PIK bonds trade flat (i.e., without accrued interest).
Their price is expected to reflect an amount representing accreted interest
since the last payment. PIKs generally trade at higher yields than comparable
cash-paying securities of the same issuer. Their premium yield is the result of
the lesser desirability of non-cash interest, the more limited audience for
non-cash paying securities, and the fact that many PIKs have been issued to
equity investors who do not normally own or hold such securities.
Calculating the true yield on a PIK security requires a discounted cash
flow analysis if the security (ex interest) is trading at a premium or a
discount, because the realizable value of additional payments is equal to the
current market value of the underlying security, not par.
Regardless of whether PIK securities are senior or deeply subordinated,
issuers are highly motivated to retire them because they are usually their most
costly form of capital. Sixty-eight percent of the PIK debentures issued prior
to 1987 have already been redeemed, and approximately 35% of the over $10
billion PIK debentures issued through year-end 1988 have been retired.
EQUIPMENT TRUST CERTIFICATES
Equipment Trust Certificates are a mechanism for financing the purchase
of transportation equipment, such as railroad cars and locomotives, trucks,
airplanes and oil tankers.
Under an equipment trust certificate, the equipment is used as the
security for the debt and title to the equipment is vested in a trustee. The
trustee leases the equipment to the user, i.e., the railroad, airline, trucking
or oil company. At the same time equipment trust certificates in an aggregate
amount equal to a certain percentage of the equipment's purchase price are sold
to lenders. The trustee pays the proceeds from the sale of certificates to the
manufacturer. In addition, the company using the equipment makes an initial
payment of rent equal to their balance of the purchase price to the trustee,
which the trustee then pays to the manufacturer. The trustee collects lease
payments from the company and uses the payments to pay interest and principal on
the certificates. At maturity, the certificates are redeemed and paid, the
equipment is sold to the company and the lease is terminated.
Generally, these certificates are regarded as obligations of the
company that is leasing the equipment and are shown as liabilities on its
balance sheet. However, the company does not own the equipment until all the
certificates are redeemed and paid. In the event the company defaults under its
lease, the trustee terminates the lease. If another lessee is available, the
trustee leases the equipment to another user and makes payments on the
certificates from new lease rentals.
LIMITED PARTNERSHIPS
The Fund may invest in limited and master limited partnerships. A
limited partnership is a partnership consisting of one or more general partners,
jointly and severally responsible as ordinary partners, and by whom the business
is conducted, and one or more limited partners who contribute cash as capital to
the partnership and who generally are not liable for the debts of the
partnership beyond the amounts contributed. Limited partners are not involved in
the day-to-day management of the partnership. They receive income, capital gains
and other tax benefits associated with the partnership project in accordance
with terms established in the partnership agreement. Typical limited
partnerships are in real estate, oil and gas and equipment leasing, but they
also finance movies, research and development and other projects.
For an organization classified as a partnership under the Internal
Revenue Code, each item of income, gain, loss, deduction and credit is not taxed
at the partnership level but flows through to the holder of the partnership
unit. This allows the partnership to avoid taxation and to pass through income
to the holder of the partnership unit at lower individual rates.
A master limited partnership is a publicly traded limited partnership.
The partnership units are registered with the Securities and Exchange Commission
and are freely exchanged on a securities exchange or in the over-the-counter
market.
MOODY'S PREFERRED STOCK RATINGS
Preferred stock ratings and their definitions are as follows:
1. aaa: An issue that is rated aaa is considered to be a top-quality
preferred stock. This rating indicates good asset protection and the least risk
of dividend impairment within the universe of preferred stocks.
2. aa: An issue that is rated aa is considered a high-grade preferred
stock. This rating indicates that there is a reasonable assurance that earnings
and asset protection will remain relatively well maintained in the foreseeable
future.
3. a: An issue that is rated a is considered to be an upper-medium
grade preferred stock. While risks are judged to be somewhat greater then in the
aaa and aa classification, earnings and asset protection are, nevertheless,
expected to be maintained at adequate levels.
4. baa: An issue that is rated baa is considered to be a medium-grade
preferred stock, neither highly protected nor poorly secured. Earnings and asset
protection appear adequate at present but may be questionable over any great
length of time.
5. ba: An issue that is rated ba is considered to have speculative
elements and its future cannot be considered well assured. Earnings and asset
protection may be very moderate and not well safeguarded during adverse periods.
Uncertainty of position characterizes preferred stocks in this class.
Moody's applies numerical modifiers 1, 2 and 3 in each rating
classification. The modifier 1 indicates that the security ranks in the higher
end of its generic rating category. The modifier 2 indicates a mid-range
ranking, and the modifier 3 indicates that the issue ranks in the lower end of
its generic rating category.
MONEY MARKET INSTRUMENTS
The Fund's investments in commercial paper are limited to those rated
A-1 by S&P, Prime-1 by Moody's or F-1 by Fitch Investors Service, Inc. (Fitch).
These ratings and other money market instruments are described as follows:
Commercial Paper Ratings
Commercial paper rated A-1 by Standard & Poor's has the following
characteristics: Liquidity ratios are adequate to meet cash requirements. The
issuer's long-term senior debt is rated A or better, although in some cases BBB
credits may be allowed. The issuer has access to at least two additional
channels of borrowing. Basic earnings and cash flow have an upward trend with
allowance made for unusual circumstances. Typically, the issuer's industry is
well established and the issuer has a strong position within the industry.
The rating Prime-1 is the highest commercial paper rating assigned by
Moody's. Among the factors considered by Moody's in assigning ratings are the
following: (1) evaluation of the management of the issuer; (2) economic
evaluation of the issuer's industry or industries and an appraisal of
speculative-type risks which may be inherent in certain areas; (3) evaluation of
the issuer's products in relation to competition and customer acceptance; (4)
liquidity; (5) amount and quality of long-term debt; (6) trend of earnings over
a period of ten years; (7) financial strength of a parent company and the
relationships which exist with the issuer; and (8) recognition by the management
of obligations which may be present or may arise as a result of public
preparations to meet such obligations. Relative strength or weakness of the
above factors determines how the issuer's commercial paper is rated within
various categories.
The rating F-1 is the highest rating assigned by Fitch. Among the
factors considered by Fitch in assigning this rating are: (1) the issuer's
liquidity; (2) its standing in the industry; (3) the size of its debt; (4) its
ability to service its debt; (5) its profitability; (6) its return on equity;
(7) its alternative sources of financing; and (8) its ability to access the
capital markets. Analysis of the relative strength or weakness of these factors
and others determines whether an issuer's commercial paper is rated F-1.
United States Government Securities
Securities issued or guaranteed by the United States Government include
a variety of Treasury securities that differ only in their interest rates,
maturities and dates of issuance. Treasury bills have maturities of one year or
less. Treasury notes have maturities of one to ten years, and Treasury bonds
generally have maturities of greater than ten years at the date of issuance.
Securities issued or guaranteed by the United States Government or its
agencies or instrumentalities include direct obligations of the United States
Treasury and securities issued or guaranteed by the Federal Housing
Administration, Farmers Home Administration, Export-Import Bank of the United
States, Small Business Administration, Government National Mortgage Association,
General Services Administration, Central Bank for Cooperatives, Federal Home
Loan Banks, Federal Loan Mortgage Corporation, Federal Intermediate Credit
Banks, Federal Land Banks, Maritime Administration, The Tennessee Valley
Authority, District of Columbia Armory Board and Federal National Mortgage
Association.
Some obligations of United States Government agencies and
instrumentalities, such as Treasury bills and Government National Mortgage
Association pass-through certificates, are supported by the full faith and
credit of the United States; others, such as securities of Federal Home Loan
Banks, by the right of the issuer to borrow from the Treasury; still others,
such as bonds issued by the Federal National Mortgage Association, a private
corporation, are supported only by the credit of the instrumentality. Because
the United States Government is not obligated by law to provide support to an
instrumentality it sponsors, the Fund will invest in the securities issued by
such an instrumentality only when Keystone determines that the credit risk with
respect to the instrumentality does not make its securities unsuitable
investments. United States Government securities will not include international
agencies or instrumentalities in which the United States Government, its
agencies or instrumentalities participate, such as the World Bank, the Asian
Development Bank or the InterAmerican Development Bank, or issues insured by the
Federal Deposit Insurance Corporation.
Certificates of Deposit
Certificates of deposit are receipts issued by a bank in exchange for
the deposit of funds. The issuer agrees to pay the amount deposited plus
interest to the bearer of the receipt on the date specified on the certificate.
The certificate usually can be traded in the secondary market prior to maturity.
Certificates of deposit will be limited to U.S. dollar-denominated
certificates of United States banks, including their branches abroad, and of
U.S. branches of foreign banks which are members of the Federal Reserve System
or the Federal Deposit Insurance Corporation and have at least $1 billion in
deposits as of the date of their most recently published financial statements.
The Fund will not acquire time deposits or obligations issued by the
International Bank for Reconstruction and Development, the Asian Development
Bank or the Inter-American Development Bank. Additionally, the Fund does not
currently intend to purchase such foreign securities (except to the extent that
certificates of deposit of foreign branches of U.S. banks may be deemed foreign
securities) or purchase certificates of deposit, bankers' acceptances or other
similar obligations issued by foreign banks.
Bankers' Acceptances
Bankers' acceptances typically arise from short term credit
arrangements designed to enable businesses to obtain funds to finance commercial
transactions. Generally, an acceptance is a time draft drawn on a bank by an
exporter or an importer to obtain a stated amount of funds to pay for specific
merchandise. The draft is then "accepted" by the bank that, in effect,
unconditionally guarantees to pay the face value of the instrument on its
maturity date. The acceptance may then be held by the accepting bank as an
earning asset or it may be sold in the secondary market at the going rate of
discount for a specific maturity. Although maturities for acceptances can be as
long as 270 days, most acceptances have maturities of six months or less.
Bankers' acceptances acquired by the Fund must have been accepted by U.S.
commercial banks, including foreign branches of U.S. commercial banks, having
total deposits at the time of purchase in excess of $1 billion and must be
payable in U.S. dollars.
OPTIONS TRANSACTIONS
Writing Covered Options
The Fund writes only covered options. Options written by the Fund will
normally have expiration dates of not more than nine months from the date
written. The exercise price of the options may be below, equal to, or above the
current market values of the underlying securities at the times the options are
written.
Unless the option has been exercised, the Fund may close out an option
it has written by effecting a closing purchase transaction, whereby it purchases
an option covering the same underlying security and having the same exercise
price and expiration date ("of the same series") as the one it has written. If
the Fund desires to sell a particular security on which it has written a call
option, it will effect a closing purchase transaction prior to or concurrently
with the sale of the security. If the Fund is able to enter into a closing
purchase transaction, the Fund will realize a profit (or loss) from such
transaction if the cost of such transaction is less (or more) than the premium
received from the writing of the option.
An option position may be closed out only in a secondary market for an
option of the same series. Although the Fund will generally write only those
options for which there appears to be an active secondary market, there is no
assurance that a liquid secondary market will exist for any particular option at
any particular time, and for some options no secondary market may exist. In such
event it might not be possible to effect a closing transaction in a particular
option. If the Fund as a covered call option writer is unable to effect a
closing purchase transaction, it will not be able to sell the underlying
securities until the option expires or it delivers the underlying securities
upon exercise.
Because the Fund intends to qualify as a regulated investment company
under the Internal Revenue Code, the extent to which the Fund may write covered
call options and enter into so-called "straddle" transactions involving put and
call options may be limited.
Many options are traded on registered securities exchanges. Options
traded on such exchanges are issued by the Options Clearing Corporation (OCC), a
clearing corporation which assumes responsibility for the completion of options
transactions.
Purchasing Put and Call Options
The Fund can close out a put or call option it has written by effecting
a closing purchase transaction; for example, the Fund may close out a put or
call option it has written by buying an option identical to the one it has
written. If, however, a secondary market does not exist at a time the Fund
wishes to effect a closing sale transaction, the Fund will have to exercise the
option to realize any profit. If a covered call option writer cannot effect a
closing transaction, it cannot sell the underlying securities until the option
expires or is exercised. In addition, in a transaction in which the Fund does
not own the security underlying a put option it has purchased, the Fund would be
required, in the absence of a secondary market, to purchase the underlying
security before it could exercise the option, thereby incurring additional
transaction costs.
The Fund will not purchase a put option if, as a result of such
purchase, more than 10% of its total assets would be invested in premiums for
such options. The Fund's ability to purchase put and call options may be limited
by the Internal Revenue Code's requirements for qualification as a regulated
investment company.
Option Writing and Related Risks
The Fund may write covered call and put options. A call option gives
the purchaser of the option the right to buy, and the writer the obligation to
sell, the underlying security at the exercise price during the option period.
Conversely, a put option gives the purchaser the right to sell, and the writer
the obligation to buy, the underlying security at the exercise price during the
option period.
So long as the obligation of the writer continues, the writer may be
assigned an exercise notice by the broker-dealer through whom the option was
sold. The exercise notice would require the writer to deliver, in the case of a
call, or take delivery of, in the case of a put, the underlying security against
payment of the exercise price. This obligation terminates upon expiration of the
option, or at such earlier time as the writer effects a closing purchase
transaction by purchasing an option of the same series as the one previously
sold. Once an option has been exercised, the writer may not execute a closing
purchase transaction. For options traded on national securities exchanges
(Exchanges), to secure the obligation to deliver the underlying security in the
case of a call option, the writer of the option is required to deposit in escrow
the underlying security or other assets in accordance with the rules of the OCC,
an institution created to interpose itself between buyers and sellers of
options. Technically, the OCC assumes the order side of every purchase and sale
transaction on an Exchange and by doing so, gives its guarantee to the
transaction.
The principal reason for writing options on a securities portfolio is
to attempt to realize, through the receipt of premiums, a greater return than
would be realized on the underlying securities alone. In return for the premium,
the covered call option writer has given up the opportunity for profit from a
price increase in the underlying security above the exercise price so long as
the option remains open, but retains the risk of loss should the price of the
security decline. Conversely, the put option writer gains a profit, in the form
of a premium, so long as the price of the underlying security remains above the
exercise price, but assumes an obligation to purchase the underlying security
from the buyer of the put option at the exercise price, even though the price of
the security may fall below the exercise price, at any time during the option
period. If an option expires, the writer realizes a gain in the amount of the
premium. Such a gain may, in the case of a covered call option, be offset by a
decline in the market value of the underlying security during the option period.
If a call option is exercised, the writer realizes a gain or loss from the sale
of the underlying security. If a put option is exercised, the writer must
fulfill his obligation to purchase the underlying security at the exercise
price, which will usually exceed the then market value of the underlying
security. In addition, the premium paid for the put effectively increases the
cost of the underlying security, thus reducing the yield otherwise available
from such securities.
Because the Fund can write only covered options, it may at times be
unable to write additional options unless it sells a portion of its portfolio
holdings to obtain new debt securities against which it can write options. This
may result in higher portfolio turnover and correspondingly greater brokerage
commissions and other transaction costs.
To the extent that a secondary market is available the covered option
writer may close out options it has written prior to the assignment of an
exercise notice by purchasing, in a closing purchase transaction, an option of
the same series as the option previously written. If the cost of such a closing
purchase, plus transaction costs, is greater than the premium received upon
writing the original option, the writer will incur a loss on the transaction.
Options Trading Markets
Options which the Fund will trade are generally listed on Exchanges.
Exchanges on which such options currently are traded are the Chicago Board
Options Exchange and the American, New York, Pacific, and Philadelphia Stock
Exchanges. Options on some securities may not be listed on any Exchange but
traded in the over-the-counter market. Options traded in the over-the-counter
market involve the additional risk that securities dealers participating in such
transactions would fail to meet their obligations to the Fund. The use of
options traded in the over-the-counter market may be subject to limitations
imposed by certain state securities authorities. In addition to the limits on
its use of options discussed herein, the Fund is subject to the investment
restrictions described in the prospectus and the statement of additional
information.
The staff of the Commission is of the view that the premiums which the
Fund pays for the purchase of unlisted options, and the value of securities used
to cover unlisted options written by the Fund are considered to be invested in
illiquid securities or assets for the purpose of calculating whether the Fund is
in compliance with its fundamental investment restriction prohibiting it from
investing more than 10% of its total assets (taken at current value) in any
combination of illiquid assets and securities. The Fund intends to request that
the Commission staff reconsider its view. It is the intention of the Fund to
comply with the staff's current position and the outcome of such
reconsideration.
Special Considerations Applicable to Options
On Treasury Bonds and Notes. Because trading interest in U.S. Treasury
bonds and notes tends to center on the most recently auctioned issues, new
series of options with expirations to replace expiring options on particular
issues will not be introduced indefinitely. Instead, the expirations introduced
at the commencement of options trading on a particular issue will be allowed to
run their course, with the possible addition of a limited number of new
expirations as the original ones expire. Options trading on each series of bonds
or notes will thus be phased out as new options are listed on the more recent
issues, and a full range of expiration dates will not ordinarily be available
for every series on which options are traded.
On Treasury Bills. Because the deliverable U.S. Treasury bill changes
from week to week, writers of U.S. Treasury bill call options cannot provide in
advance for their potential exercise settlement obligations by acquiring and
holding the underlying security. However, if the Fund holds a long position in
U.S. Treasury bills with a principal amount corresponding to the option contract
size, the Fund may be hedged from a risk standpoint. In addition, the Fund will
maintain in a segregated account with its Custodian liquid assets maturing no
later than those which would be deliverable in the event of an assignment of an
exercise notice to ensure that it can meet its open option obligations.
On GNMA Certificates. Options on GNMA certificates are not currently
traded on any Exchange. However, the Fund may purchase and write such options in
the over-the-counter market or, should they commence trading, on any Exchange.
Since the remaining principal balance of GNMA certificates declines
each month as a result of mortgage payments, the Fund, as a writer of a covered
GNMA call holding GNMA certificates as "cover" to satisfy its delivery
obligation in the event of assignment of an exercise notice, may find that its
GNMA certificates no longer have a sufficient remaining principal balance for
this purpose. Should this occur, the Fund will enter into a closing purchase
transaction or will purchase additional GNMA certificates from the same pool (if
obtainable) or replacement GNMA certificates in the cash market in order to
remain covered.
A GNMA certificate held by the Fund to cover an option position in any
but the nearest expiration month may cease to present cover for the option in
the event of a decline in the GNMA coupon rate at which new pools are originated
under the FHA/VA loan ceiling in effect at any given time. Should this occur,
the Fund will no longer be covered, and the Fund will either enter into a
closing purchase transaction or replace the GNMA certificate with a certificate
which represents cover. When the Fund closes its position or replaces the GNMA
certificate, it may realize an unanticipated loss and incur transaction costs.
Risks Pertaining to the Secondary Market. An option position may be
closed out only in a secondary market for an option of the same series. Although
the Fund will generally purchase or write only those options for which there
appears to be an active secondary market, there is no assurance that a liquid
secondary market will exist for any particular option at any particular time,
and for some options no secondary market may exist. In such event, it might not
be possible to effect closing transactions in particular options, with the
result that the Fund would have to exercise its options in order to realize any
profit and might incur transaction costs in connection therewith. If the Fund as
a covered call option writer is unable to effect a closing purchase transaction
in a secondary market, it will not be able to sell the underlying security until
the option expires or it delivers the underlying security upon exercise.
Reasons for the absence of a liquid secondary market include the
following: (i) insufficient trading interest in certain options; (ii)
restrictions imposed on transactions; (iii) trading halts, suspensions or other
restrictions imposed with respect to particular classes or series of options or
underlying securities; (iv) interruption of the normal operations on an Exchange
or by a broker; (v) inadequacy of the facilities of an Exchange, the OCC or a
broker handle current trading volume; or (vi) a decision by one or more
Exchanges or a broker to discontinue the trading of options (or a particular
class or series of options), in which event the secondary market in that class
or series of options would cease to exist, although outstanding options that had
been issued as a result of trades would generally continue to be exercisable in
accordance with their terms.
The hours of trading for options on U.S. government securities may not
conform to the hours during which the underlying securities are traded. To the
extent that the option markets close before the markets for the underlying
securities, significant price and rate movements can take place in the
underlying markets that cannot be reflected in the option markets.
FUTURES CONTRACTS AND RELATED OPTIONS TRANSACTIONS
The Fund intends to enter into currency and other financial futures
contracts as a hedge against changes in prevailing levels of interest or
currency exchange rates to seek relative stability of principal and to establish
more definitely the effective return on securities held or intended to be
acquired by the Fund or as a hedge against changes in the prices of securities
or currencies held by the Fund or to be acquired by the Fund. The Fund's hedging
may include sales of futures as an offset against the effect of expected
increases in interest or currency exchange rates or securities prices and
purchases of futures as an offset against the effect of expected declines in
interest or currency exchange rates.
For example, when the Fund anticipates a significant market or market
sector advance, it will purchase a stock index futures contract as a hedge
against not participating in such advance at a time when the Fund is not fully
invested. The purchase of a futures contract serves as a temporary substitute
for the purchase of individual securities which may then be purchased in an
orderly fashion. As such purchases are made, an equivalent amount of index based
futures contracts would be terminated by offsetting sales. In contrast, the Fund
would sell stock index futures contracts in anticipation of or in a general
market or market sector decline that may adversely affect the market value of
the Fund's portfolio. To the extent that the Fund's portfolio changes in value
in correlation with a given index, the sale of futures contracts on that index
would substantially reduce the risk to the portfolio of a market decline or
change in interest rates, and, by so doing, provide an alternative to the
liquidation of the Fund's securities positions and the resulting transaction
costs.
The Fund intends to engage in options transactions which are related to
commodity futures contracts for hedging purposes and in connection with the
hedging strategies described above.
Although techniques other than sales and purchases of futures contracts
and related options transactions could be used to reduce the Fund's exposure to
interest rate and/or market fluctuations, the Fund may be able to hedge its
exposure more effectively and perhaps at a lower cost through using futures
contracts and related options transactions. While the Fund does not intend to
take delivery of the instruments underlying futures contracts it holds, the Fund
does not intend to engage in such futures contracts for speculation.
Futures Contracts
Futures contracts are transactions in the commodities markets rather
than in the securities markets. A futures contract creates an obligation by the
seller to deliver to the buyer the commodity specified in the contract at a
specified future time for a specified price. The futures contract creates an
obligation by the buyer to accept delivery from the seller of the commodity
specified at the specified future time for the specified price. In contrast, a
spot transaction creates an immediate obligation for the seller to deliver and
the buyer to accept delivery of and pay for an identified commodity. In general,
futures contracts involve transactions in fungible goods such as wheat, coffee
and soybeans. However, in the last decade an increasing number of futures
contracts have been developed which specify currencies, financial instruments or
financially based indices as the underlying commodity.
U.S. futures contracts are traded only on national futures exchanges
and are standardized as to maturity date and underlying financial instrument.
The principal financial futures exchanges in the United States are The Board of
Trade of the City of Chicago, the Chicago Mercantile Exchange, the International
Monetary Market (a division of the Chicago Mercantile Exchange), the New York
Futures Exchange and the Kansas City Board of Trade. Each exchange guarantees
performance under contract provisions through a clearing corporation, a
nonprofit organization managed by the exchange membership, which is also
responsible for handling daily accounting of deposits or withdrawals of margin.
A futures commission merchant ("Broker") effects each transaction in connection
with futures contracts for a commission. Futures exchanges and trading are
regulated under the Commodity Exchange Act by the Commodity Futures Trading
Commission ("CFTC") and National Futures Association ("NFA").
Interest Rate Futures Contracts
The sale of an interest rate futures contract creates an obligation by
the Fund, as seller, to deliver the type of financial instrument specified in
the contract at a specified future time for a specified price. The purchase of
an interest rate futures contract creates an obligation by the Fund, as
purchaser, to accept delivery of the type of financial instrument specified at a
specified future time for a specified price. The specific securities delivered
or accepted, respectively, at settlement date, are not determined until at or
near that date. The determination is in accordance with the rules of the
exchange on which the futures contract sale or purchase was made.
Currently interest rate futures contracts can be purchased or sold on
90-day U.S. Treasury bills, U.S. Treasury bonds, U.S. Treasury notes with
maturities between 6 1/2 and 10 years, Government National Mortgage Association
("GNMA") certificates, 90-day domestic bank certificates of deposit, 90- day
commercial paper, and 90-day Eurodollar certificates of deposit. It is expected
that futures contracts trading in additional financial instruments will be
authorized. The standard contract size is $100,000 for futures contracts in U.S.
Treasury bonds, U.S. Treasury notes and GNMA certificates, and $1,000,000 for
the other designated contracts. While U.S. Treasury bonds, U.S. Treasury bills
and U.S. Treasury notes are backed by the full faith and credit of the U.S.
government and GNMA certificates are guaranteed by a U.S. government agency, the
futures contracts in U.S. government securities are not obligations of the U.S.
Treasury.
Index Based Futures Contracts
Stock Index Futures Contracts
A stock index assigns relative values to the common stocks included in
the index. The index fluctuates with changes in the market values of the common
stocks so included. A stock index futures contract is a bilateral agreement by
which two parties agree to take or make delivery of an amount of cash equal to a
specified dollar amount times the difference between the closing value of the
stock index on the expiration date of the contract and the price at which the
futures contract is originally made. No physical delivery of the underlying
stocks in the index is made.
Currently, stock index futures contracts can be purchased or sold on
the Standard and Poor's Corporation ("S&P") Index of 500 Stocks, the S&P Index
of 100 Stocks, the New York Stock Exchange Composite Index, the Value Line Index
and the Major Market Index. It is expected that futures contracts trading in
additional stock indices will be authorized. The standard contract size is $500
times the value of the index.
The Fund does not believe that differences between existing stock
indices will create any differences in the price movements of the stock index
futures contracts in relation to the movements in such indices. However, such
differences in the indices may result in differences in correlation of the
futures with movements in the value of the securities being hedged.
Other Index Based Futures Contracts
It is expected that bond index and other financially based index
futures contracts will be developed in the future. It is anticipated that such
index based futures contracts will be structured in the same way as stock index
futures contracts but will be measured by changes in interest rates, related
indices or other measures, such as the consumer price index. In the event that
such futures contracts are developed the Fund will sell interest rate index and
other index based futures contracts to hedge against changes which are expected
to affect the Fund's portfolio.
The purchase or sale of a futures contract differs from the purchase or
sale of a security, in that no price or premium is paid or received. Instead, to
initiate trading an amount of cash, cash equivalents, money market instruments,
or U.S. Treasury bills equal to approximately 1 1/2% (up to 5%) of the contract
amount must be deposited by the Fund with the Broker. This amount is known as
initial margin. The nature of initial margin in futures transactions is
different from that of margin in security transactions. Futures contract margin
does not involve the borrowing of funds by the customer to finance the
transactions.
Rather, the initial margin is in the nature of a performance bond or
good faith deposit on the contract which is returned to the Fund upon
termination of the futures contract assuming all contractual obligations have
been satisfied. The margin required for a particular futures contract is set by
the exchange on which the contract is traded, and may be significantly modified
from time to time by the exchange during the term of the contract.
Subsequent payments, called variation margin, to the Broker and from
the Broker, are made on a daily basis as the value of the underlying instrument
or index fluctuates making the long and short positions in the futures contract
more or less valuable, a process known as mark-to-market. For example, when the
Fund has purchased a futures contract and the price of the underlying financial
instrument or index has risen, that position will have increased in value and
the Fund will receive from the Broker a variation margin payment equal to that
increase in value. Conversely, where the Fund has purchased a futures contract
and the price of the underlying financial instrument or index has declined, the
position would be less valuable and the Fund would be required to make a
variation margin payment to the Broker. At any time prior to expiration of the
futures contract, the Fund may elect to close the position. A final
determination of variation margin is then made, additional cash is required to
be paid to or released by the Broker, and the Fund realizes a loss or gain.
The Fund intends to enter into arrangements with its custodian and with
Brokers to enable its initial margin and any variation margin to be held in a
segregated account by its custodian on behalf of the Broker.
Although interest rate futures contracts by their terms call for actual
delivery or acceptance of financial instruments, and index based futures
contracts call for the delivery of cash equal to a specified dollar amount times
the difference between the closing value of the index on the expiration date of
the contract and the price at which the futures contract is originally made, in
most cases such futures contracts are closed out before the settlement date
without the making or taking of delivery. Closing out a futures contract sale is
effected by an offsetting transaction in which the Fund enters into a futures
contract purchase for the same aggregate amount of the specific type of
financial instrument or index and same delivery date. If the price in the sale
exceeds the price in the offsetting purchase, the Fund is paid the difference
and thus realizes a gain. If the offsetting purchase price exceeds the sale
price, the Fund pays the difference and realizes a loss. Similarly, the closing
out of a futures contract purchase is effected by an offsetting transaction in
which the Fund enters into a futures contract sale. If the offsetting sale price
exceeds the purchase price, the Fund realizes a gain. If the purchase price
exceeds the offsetting sale price the Fund realizes a loss. The amount of the
Fund's gain or loss on any transaction is reduced or increased, respectively, by
the amount of any transaction costs incurred by the Fund.
As an example of an offsetting transaction, the contractual obligations
arising from the sale of one contract of September U.S. Treasury bills on an
exchange may be fulfilled at any time before delivery of the contract is
required (i.e., on a specified date in September, the "delivery month") by the
purchase of one contract of September U.S. Treasury bills on the same exchange.
In such instance the difference between the price at which the futures contract
was sold and the price paid for the offsetting purchase after allowance for
transaction costs represents the profit or loss to the Fund.
There can be no assurance, however, that the Fund will be able to enter
into an offsetting transaction with respect to a particular contract at a
particular time. If the Fund is not able to enter into an offsetting
transaction, the Fund will continue to be required to maintain the margin
deposits on the contract and to complete the contract according to its terms.
Options on Currency and Other Financial Futures
The Fund intends to purchase call and put options on currency and other
financial futures contracts and sell such options to terminate an existing
position. Options on currency and other financial futures contracts are similar
to options on stocks except that an option on a currency or other financial
futures contract gives the purchaser the right, in return for the premium paid,
to assume a position in a futures contract (a long position if the option is a
call and a short position if the option is a put) rather than to purchase or
sell stock, currency or other financial instruments at a specified exercise
price at any time during the period of the option. Upon exercise of the option,
the delivery of the futures position by the writer of the option to the holder
of the option will be accompanied by delivery of the accumulated balance in the
writer's futures margin account. This amount represents the amount by which the
market price of the futures contract at exercise exceeds, in the case of a call,
or is less than, in the case of a put, the exercise price of the option on the
futures contract. If an option is exercised the last trading day prior to the
expiration date of the option, the settlement will be made entirely in cash
equal to the difference between the exercise price of the option and value of
the futures contract.
The Fund intends to use options on currency and other financial futures
contracts in connection with hedging strategies. In the future the Fund may use
such options for other purposes.
Purchase of Put Options on Futures Contracts
The purchase of protective put options on commodity futures
contracts is analogous to the purchase of protective puts on individual stocks,
where an absolute level of protection is sought below which no additional
economic loss would be incurred by the Fund. Put options may be purchased to
hedge a portfolio of stocks or debt instruments or a position in the futures
contract upon which the put option is based.
Purchase of Call Options on Futures Contracts
The purchase of a call option on a currency or other financial futures
contract represents a means of obtaining temporary exposure to market
appreciation at limited risk. It is analogous to the purchase of a call option
on an individual stock which can be used as a substitute for a position in the
stock itself. Depending on the pricing of the option compared to either the
futures contract upon which it is based, or upon the price of the underlying
financial instrument or index itself, the purchase of a call option may be less
risky than the ownership of the interest rate or index based futures contract or
the underlying securities. Call options on currency or other financial futures
contracts may be purchased to hedge against an interest rate increase or a
market advance when the Fund is not fully invested.
Use of New Investment Techniques Involving Currency and Other Financial Futures
Contracts or Related Options
The Fund may employ new investment techniques involving currency and
other financial futures contracts and related options. The Fund intends to take
advantage of new techniques in these areas which may be developed from time to
time and which are consistent with the Fund's investment objective. The Fund
believes that no additional techniques have been identified for employment by
the Fund in the foreseeable future other than those described above.
Limitations on Purchase and Sale of Futures Contracts and Related Options on
Such Futures Contracts
The Fund will not enter into a futures contract if, as a result
thereof, more than 5% of the Fund's total assets (taken at market value at the
time of entering into the contract) would be committed to margin deposits on
such futures contracts.
The Fund intends that its futures contracts and related options
transactions will be entered into for traditional hedging purposes. That is,
futures contracts will be sold to protect against a decline in the price of
securities that the Fund owns or futures contracts will be purchased to protect
the Fund against an increase in the price of securities it intends to purchase.
The Fund does not intend to enter into futures contracts for speculation.
In instances involving the purchase of futures contracts by the Fund,
an amount of cash and cash equivalents, equal to the market value of the futures
contracts will be deposited in a segregated account with the Fund's Custodian
and/or in a margin account with a Broker to collateralize the position and
thereby insure that the use of such futures is unleveraged.
Federal Income Tax Treatment
For federal income tax purposes, the Fund is required to recognize as
income for each taxable year its net unrealized gains and losses on futures
contracts as of the end of the year as well as those actually realized during
the year. Any gain or loss recognized with respect to a futures contract is
considered to be 60% long term and 40% short term, without regard to the holding
period of the contract. In the case of a futures transaction classified as a
"mixed straddle," the recognition of losses may be deferred to a later taxable
year. The federal income tax treatment of gains or losses from transactions in
options on futures is unclear.
In order for the Fund to continue to qualify for federal income tax
treatment as a regulated investment company, at least 90% of its gross income
for a taxable year must be derived from qualifying income. Any net gain realized
from the closing out of futures contracts, for purposes of the 90% requirement,
will be qualifying income. In addition, gains realized on the sale or other
disposition of securities held for less than three months must be limited to
less than 30% of the Fund's annual gross income. The 1986 Tax Act added a
provision which effectively treats both positions in certain hedging
transactions as a single transaction for the purpose of the 30% requirement. The
provision provides that, in the case of any "designated hedge," increases and
decreases in the value of positions of the hedge are to be netted for the
purposes of the 30% requirement. However, in certain situations, in order to
avoid realizing a gain within a three month period, the Fund may be required to
defer the closing out of a contract beyond the time when it would otherwise be
advantageous to do so.
Risks of Futures Contracts
Currency and other financial futures contracts prices are volatile and
are influenced, among other things, by changes in stock prices, market
conditions, prevailing interest rates and anticipation of future stock prices,
market movements or interest rate changes, all of which in turn are affected by
economic conditions, such as government fiscal and monetary policies and
actions, and national and international political and economic events.
At best, the correlation between changes in prices of futures contracts
and of the securities being hedged can be only approximate. The degree of
imperfection of correlation depends upon circumstances, such as variations in
speculative market demand for futures contracts and for securities, including
technical influences in futures contracts trading; differences between the
securities being hedged and the financial instruments and indices underlying the
standard futures contracts available for trading, in such respects as interest
rate levels, maturities and creditworthiness of issuers, or identities of
securities comprising the index and those in the Fund's portfolio. A decision of
whether, when and how to hedge involves the exercise of skill and judgment, and
even a well-conceived hedge may be unsuccessful to some degree because of market
behavior or unexpected interest rate trends.
Because of the low margin deposits required, futures trading involves
an extremely high degree of leverage. As a result, a relatively small price
movement in a futures contract may result in immediate and substantial loss, as
well as gain, to the investor. For example, if at the time of purchase, 10% of
the value of the futures contract is deposited as margin, a 10% decrease in the
value of the futures contract would result in a total loss of the margin
deposit, before any deduction for the transaction costs, if the account were
then closed out, and a 15% decrease would result in a loss equal to 150% of the
original margin deposit. Thus, a purchase or sale of a futures contract may
result in losses in excess of the amount invested in the futures contract.
However, the Fund would presumably have sustained comparable losses if, instead
of entering into the futures contract, it had invested in the underlying
financial instrument. Furthermore, in order to be certain that the Fund has
sufficient assets to satisfy its obligations under a futures contract, the Fund
will establish a segregated account in connection with its futures contracts
which will hold cash or cash equivalents equal in value to the current value of
the underlying instruments or indices less the margins on deposit.
Most U.S. futures exchanges limit the amount of fluctuation permitted
in futures contract prices during a single trading day. The daily limit
establishes the maximum amount that the price of a futures contract may vary
either up or down from the previous day's settlement price at the end of a
trading session. Once the daily limit has been reached in a particular type of
contract, no trades may be made on that day at a price beyond that limit. The
daily limit governs only price movement during a particular trading day and
therefore does not limit potential losses because the limit may prevent the
liquidation of unfavorable positions. Futures contract prices have occasionally
moved to the daily limit for several consecutive trading days with little or no
trading, thereby preventing prompt liquidation of futures positions and
subjecting some futures traders to substantial losses.
Risks of Options on Futures Contracts
In addition to the risks described above for currency and other
financial futures contracts, there are several special risks relating to options
on futures contracts. The ability to establish and close out positions on such
options will be subject to the development and maintenance of a liquid secondary
market. There is no assurance that a liquid secondary market will exist for any
particular contract or at any particular time. The Fund will not purchase
options on any futures contract unless and until it believes that the market for
such options has developed sufficiently that the risks in connection with such
options are not greater than the risks in connection with the futures contracts.
Compared to the use of futures contracts, the purchase of options on such
futures involves less potential risk to the Fund because the maximum amount at
risk is the premium paid for the options (plus transaction costs). However,
there may be circumstances when the use of an option on a futures contract would
result in a loss to the Fund, even though the use of a futures contract would
not, such as when there is no movement in the level of the futures contract.
FOREIGN CURRENCY TRANSACTIONS
The Fund may invest in securities of foreign issuers. When the Fund
invests in foreign securities they usually will be denominated in foreign
currencies and the Fund temporarily may hold funds in foreign currencies. Thus,
the Fund's share value will be affected by changes in exchange rates.
Forward Currency Contracts
As one way of managing exchange rate risk, the Fund may engage in
forward currency exchange contracts (agreements to purchase or sell currencies
at a specified price and date). Under the contract, the exchange rate for the
transaction (the amount of currency the Fund will deliver or receive when the
contract is completed) is fixed when the Fund enters into the contract. The Fund
usually will enter into these contracts to stabilize the U.S. dollar value of a
security it has agreed to buy or sell. The Fund also may use these contracts to
hedge the U.S. dollar value of a security it already owns, particularly if the
Fund expects a decrease in the value of the currency in which the foreign
security is denominated. Although the Fund will attempt to benefit from using
forward contracts, the success of its hedging strategy will depend on Keystone's
ability to predict accurately the future exchange rate between foreign
currencies and the U.S. dollar. The value of the Fund's investments denominated
in foreign currencies will depend on the relative strength of those currencies
and the U.S. dollar, and the Fund may be affected favorably or unfavorably by
changes in the exchange rate or exchange control regulations between foreign
currencies and the dollar. Changes in foreign currency exchange rates also may
affect the value of dividends and interest earned, gains and losses realized on
the sale of securities and net investment income and gains, if any, to be
distributed to shareholders by the Fund.
Currency Futures Contracts
Currency futures contracts are bilateral agreements under which two
parties agree to take or make delivery of a specified amount of a currency at a
specified future time for a specified price. Trading of currency futures
contracts in the United States is regulated under the Commodity Exchange Act by
the CFTC and NFA. Currently, the only national futures exchange on which
currency futures are traded is the International Monetary Market of the Chicago
Mercantile Exchange. Foreign currency futures trading is conducted in the same
manner and subject to the same regulations as trading in interest rate and index
based futures. The Fund intends to engage in currency futures contracts only for
hedging purposes, and not for speculation. The Fund may enter into currency
futures contracts for other purposes if authorized to do so by the Board. The
hedging strategies which will be used by the Fund in connection with foreign
currency futures contracts are similar to those described above for forward
foreign currency exchange contracts.
Currently, currency futures contracts for the British pound sterling,
Canadian dollar, Dutch guilder, Deutsche mark, Japanese yen, Mexican peso, Swiss
franc and French franc can be purchased or sold for U.S. dollars through the
International Monetary Market. It is expected that futures contracts trading in
additional currencies will be authorized. The standard contract sizes are
L125,000 for the pound, 125,000 for the guilder, mark and Swiss and French
francs, C$100,000 for the Canadian dollar, Y12,500,000 for the yen, and
1,000,000 for the peso. In contrast to Forward Currency Exchange Contracts which
can be traded at any time, only four value dates per year are available, the
third Wednesday of March, June, September and December.
Foreign Currency Options Transactions
Foreign currency options (as opposed to futures) are traded in a
variety of currencies in both the United States and Europe. On the Philadelphia
Stock Exchange, for example, contracts for half the size of the corresponding
futures contracts on the Chicago Board Options Exchange are traded with up to
nine months maturity in marks, sterling, yen, Swiss francs and Canadian dollars.
Options can be exercised at any time during the contract life and require a
deposit subject to normal margin requirements. Since a futures contract must be
exercised, the Fund must continually make up the margin balance. As a result, a
wrong price move could result in the Fund losing more than the original
investment as it cannot walk away from the futures contract as it can an option
contract.
The Fund will purchase call and put options and sell such options to
terminate an existing position. Options on foreign currency are similar to
options on stocks except that an option on an interest rate and/or index based
futures contract gives the purchaser the right, in return for the premium paid,
to purchase or sell foreign currency, rather than to purchase or sell stock, at
a specified exercise price at any time during the period of the option.
The Fund intends to use foreign currency option transactions in
connection with hedging strategies.
Purchase of Put Options on Foreign Currencies
The purchase of protective put options on a foreign currency is
analagous to the purchase of protective puts on individual stocks, where an
absolute level of protection is sought below which no additional economic loss
would be incurred by the Fund. Put options may be purchased to hedge a portfolio
of foreign stocks or foreign debt instruments or a position in the foreign
currency upon which the put option is based.
Purchase of Call Options on Foreign Currencies
The purchase of a call option on foreign currency represents a means of
obtaining temporary exposure to market appreciation at limited risk. It is
analogous to the purchase of a call option on an individual stock which can be
used as a substitute for a position in the stock itself. Depending on the
pricing of the option compared to either the foreign currency upon which it is
based, or upon the price of the foreign stock or foreign debt instruments, the
purchase of a call option may be less risky than the ownership of the foreign
currency or the foreign securities. The Fund would purchase a call option on a
foreign currency to hedge against an increase in the foreign currency or a
foreign market advance when the Fund is not fully invested.
The Fund may employ new investment techniques involving forward foreign
currency exchange contracts, foreign currency futures contracts and options on
foreign currencies in order to take advantage of new techniques in these areas
which may be developed from time to time and which are consistent with the
Fund's investment objective. The Fund believes that no additional techniques
have been identified for employment by the Fund in the foreseeable future other
than those described above.
Currency Trading Risks
Currency exchange trading may involve significant risks. The four major
types of risk the Fund faces are exchange rate risk, interest rate risk, credit
risk and country risk.
Exchange Rate Risk
Exchange rate risk results from the movement up and down of foreign
currency values in response to shifting market supply and demand. When the Fund
buys or sells a foreign currency, an exposure called an open position is
created. Until the time that position can be "covered" by selling or buying an
equivalent amount of the same currency, the Fund is exposed to the risk that the
exchange rate might move against it. Since exchange rate changes can readily
move in one direction, a position carried overnight or over a number of days
involves greater risk than one carried a few minutes or hours. Techniques such
as foreign currency forward and futures contracts and options on foreign
currency are intended to be used by the Fund to reduce exchange rate risk.
Maturity Gaps and Interest Rate Risk
Interest rate risk arises whenever there are mismatches or gaps in the
maturity structure of the Fund's foreign exchange currency holdings, which is
the total of its outstanding spot and forward or futures contracts.
Foreign currency transactions often involve borrowing short term and
lending longer term to benefit from the normal tendency of interest rates to be
higher for longer maturities. However in foreign exchange trading, while the
maturity pattern of interest rates for one currency is important, it is the
differential between interest rates for two currencies that is decisive.
Credit Risk
Whenever the Fund enters into a foreign exchange contract, it faces a
risk, however small, that the counterparty will not perform under the contract.
As a result there is a credit risk, although no extension of "credit" is
intended. To limit credit risk, the Fund intends to evaluate the
creditworthiness of each other party. The Fund does not intend to trade more
than 5% of its net assets under foreign exchange contracts with one party.
Credit risk exists because the Fund's counterparty may be unable or
unwilling to fulfill its contractual obligations as a result of bankruptcy or
insolvency or when foreign exchange controls prohibit payment. In any foreign
exchange transaction, each party agrees to deliver a certain amount of currency
to the other on a particular date. In establishing its hedges a Fund relies on
each contract being completed. If the contract is not performed, then the Fund's
hedge is eliminated, and the Fund is exposed to any changes in exchange rates
since the contract was originated. To put itself in the same position it would
have been in had the contract been performed, the Fund must arrange a new
transaction. However, the new transaction may have to be arranged at an adverse
exchange rate. The trustee for a bankrupt company may elect to perform those
contracts which are advantageous to the company but disclaim those contracts
which are disadvantageous, resulting in losses to the Fund.
Another form of credit risk stems from the time zone differences
between the U.S. and foreign nations. If the Fund sells sterling it generally
must pay pounds to a counterparty earlier in the day than it will be credited
with dollars in New York. In the intervening hours, the buyer can go into
bankruptcy or can be declared insolvent. Thus, the dollars may never be credited
to the Fund.
Country Risk
At one time or another, virtually every country has interfered with
international transactions in its currency. Interference has taken the form of
regulation of the local exchange market, restrictions on foreign investment by
residents or limits on inflows of investment funds from abroad. Governments take
such measures for example, to improve control over the domestic banking system
or to influence the pattern of receipts and payments between residents and
foreigners. In those cases, restrictions on the exchange market or on
international transactions are intended to affect the level or movement of the
exchange rate. Occasionally a serious foreign exchange shortage may lead to
payment interruptions or debt servicing delays, as well as interference in the
exchange market. It has become increasingly difficult to distinguish foreign
exchange or credit risk from country risk.
Changes in regulations or restrictions usually do have an important
exchange market impact. Most disruptive are changes in rules which interfere
with the normal payments mechanism. If government regulations change and a
counterparty is either forbidden to perform or is required to do something
extra, then the Fund might be left with an unintended open position or an
unintended maturity mismatch. Dealing with such unintended long or short
positions could result in unanticipated costs to the Fund.
Other changes in official regulations influence international
investment transactions. If one of the factors affecting the buying or selling
of a currency changes, the exchange rate is likely to respond. Changes in such
controls often are unpredictable and can create a significant exchange rate
response.
Many major countries have moved toward liberalization of exchange and
payments restrictions in recent years or accepted the principle that
restrictions should be relaxed. A few industrial countries have moved in the
other direction. Important liberalizations were carried out by Switzerland, the
United Kingdom and Japan. They dismantled mechanisms for restricting either
foreign exchange inflows (Switzerland), outflows (Britain) or elements of both
(Japan). By contrast, France and Mexico have recently tightened foreign exchange
controls.
Overall, many exchange markets are still heavily restricted. Several
countries limit access to the forward market to companies financing documented
export or import transactions in an effort to insulate the market from purely
speculative activities. Some of these countries permit local traders to enter
into forward contracts with residents but prohibit certain forward transactions
with nonresidents. By comparison, other countries have strict controls on
exchange transactions by residents, but permit free exchange transactions
between local traders and non-residents. A few countries have established tiered
markets, funneling commercial transactions through one market and financial
transactions through another. Outside the major industrial countries, relatively
free foreign exchange markets are rare and controls on foreign currency
transactions are extensive.
Another aspect of country risk has to do with the possibility that the
Fund may be dealing with a foreign trader whose home country is facing a
payments problem. Even though the foreign trader intends to perform on its
foreign exchange contracts, the contracts are tied to other external liabilities
the country has incurred. As a result performance may be delayed, and can result
in unanticipated cost to the Fund. This aspect of country risk is a major
element in the Fund's credit judgment as to with whom it will deal and in what
amounts.
