AMENDMENT TO THE PROSPECTUS
OF
KEYSTONE HIGH INCOME BOND FUND (B-4)
THE PROSPECTUS IS HEREBY AMENDED TO REFLECT THE FOLLOWING:
The Board of Trustees of the Fund has approved a proposal to reorganize
(the "Reorganization") the Fund into a corresponding series (a "Successor Fund")
of the Evergreen Fixed Income Trust, a Delaware business trust. If shareholders
of the Fund approve the Reorganization and the conditions to the Reorganization
are satisfied, all of the assets and liabilities of the Fund will be transferred
to the corresponding Successor Fund and each shareholder of the Fund will
receive shares of the corresponding Successor Fund. In connection with the
Reorganization, the Board of Trustees has approved, subject to shareholder
approval, the reclassification of the Fund's investment objective from
"fundamental" (i.e., changeable by shareholder vote only) to "nonfundamental"
(i.e., changeable by the vote of the Board), the adoption by the Fund of certain
standardized investment restrictions, and the elimination or reclassification
from fundamental to nonfundamental of the Fund's other currently fundamental
investment restrictions.
The Reorganization and related proposals are scheduled to be voted on at a
joint special meeting of shareholders to be held on December 15, 1997.
Information detailing each proposal was mailed to shareholders on October 27,
1997.
All references to "Evergreen Keystone" are hereby replaced with
"Evergreen".
The "Expense Information" section is replaced entirely by the following:
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."
<TABLE>
<S> <C>
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 Fee...................................................................................... 0.57%
12b-1 Fees(3)....................................................................................... 1.00%
Other Expenses...................................................................................... 0.39%
------
Total Fund Operating Expenses....................................................................... 1.96%
------
------
</TABLE>
<TABLE>
<CAPTION>
1 Year 3 Years 5 Years 10 Years
------ ------- ------- --------
<S> <C> <C> <C> <C>
EXAMPLE(4)
You would pay the following expenses on a $1,000 investment, assuming (1)
5% annual return and (2) redemption at the end of each period:........... $ 60 $82 $ 106 $229
You would pay the following expenses on the same investment, assuming no
redemption:.............................................................. $ 20 $62 $ 106 $229
</TABLE>
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 of purchase. No deferred sales charge is imposed
thereafter.
(2) Expense ratios are for the Fund's fiscal year ended July 31, 1997. 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%.
The "Financial Highlights" section is replaced entirely by the following:
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,
--------------------------------------------------------------------------------------------------
1997 1996 1995 1994 1993 1992 1991 1990 1989
-------- -------- -------- -------- -------- -------- -------- -------- ----------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
NET ASSET VALUE
BEGINNING OF YEAR..... $ 4.10 $ 4.42 $ 4.68 $ 5.13 $ 4.74 $ 4.19 $ 5.02 $ 6.38 $ 6.91
-------- -------- -------- -------- -------- -------- -------- -------- ----------
INCOME FROM INVESTMENT
OPERATIONS
Net investment income... 0.32 0.32 0.38 0.38 0.45 0.49 0.61 0.68 0.83
Net realized and
unrealized gain (loss)
on investments and
foreign currency
related
transactions.......... 0.28 (0.27) (0.15) (0.38) 0.44 0.58 (0.72) (1.18) (0.51)
-------- -------- -------- -------- -------- -------- -------- -------- ----------
Total from investment
operations............ 0.60 0.05 0.23 0 0.89 1.07 (0.11) (0.50) 0.32
-------- -------- -------- -------- -------- -------- -------- -------- ----------
LESS DISTRIBUTIONS FROM:
Net investment income... (0.32) (0.31) (0.37) (0.38) (0.45) (0.50) (0.72) (0.78) (0.85)
In excess of net
investment income..... (0.01) (0.06) (0.02) (0.07) (0.05) (0.02) 0 (0.08) 0
Tax basis return of
capital............... 0 0 (0.10) 0 0 0 0 0 0
-------- -------- -------- -------- -------- -------- -------- -------- ----------
Total distributions..... (0.33) (0.37) (0.49) (0.45) (0.50) (0.52) (0.72) (0.86) (0.85)
-------- -------- -------- -------- -------- -------- -------- -------- ----------
NET ASSET VALUE END OF
YEAR.................. $ 4.37 $ 4.10 $ 4.42 $ 4.68 $ 5.13 $ 4.74 $ 4.19 $ 5.02 $ 6.38
-------- -------- -------- -------- -------- -------- -------- -------- ----------
-------- -------- -------- -------- -------- -------- -------- -------- ----------
TOTAL RETURN (A)........ 15.32% 1.38% 5.66% (0.41%) 20.28% 27.25% 0.03% (7.84%) 4.95%
RATIOS/SUPPLEMENTAL DATA
RATIOS TO AVERAGE NET
ASSETS:
Expenses.............. 1.96% 1.94% 2.03% 1.84% 2.06% 2.17% 2.34% 2.06% 1.97%
Expenses excluding
indirectly paid
expenses............ 1.95% 1.93% -- -- -- -- -- -- --
Net investment
income.............. 7.63% 7.92% 8.64% 7.57% 9.30% 10.86% 14.64% 12.77% 12.36%
PORTFOLIO TURNOVER
RATE.................. 138% 116% 82% 110% 125% 94% 78% 45% 75%
NET ASSETS END OF YEAR
(THOUSANDS)........... $547,390 $593,681 $764,965 $766,283 $972,164 $841,757 $710,590 $820,940 $1,188,660
<CAPTION>
1988
----------
<S> <C>
NET ASSET VALUE
BEGINNING OF YEAR..... $ 7.66
----------
INCOME FROM INVESTMENT
OPERATIONS
Net investment income... 0.80
Net realized and
unrealized gain (loss)
on investments and
foreign currency
related
transactions.......... (0.71)
----------
Total from investment
operations............ 0.09
----------
LESS DISTRIBUTIONS FROM:
Net investment income... (0.84)
In excess of net
investment income..... 0
Tax basis return of
capital............... 0
----------
Total distributions..... (0.84)
----------
NET ASSET VALUE END OF
YEAR.................. $ 6.91
----------
----------
TOTAL RETURN (A)........ 1.66%
RATIOS/SUPPLEMENTAL DATA
RATIOS TO AVERAGE NET
ASSETS:
Expenses.............. 1.82%
Expenses excluding
indirectly paid
expenses............ --
Net investment
income.............. 11.29%
PORTFOLIO TURNOVER
RATE.................. 81%
NET ASSETS END OF YEAR
(THOUSANDS)........... $1,274,673
</TABLE>
- ---------------
(a) Excluding applicable sales charges.
The Fund may invest up to 50% of its assets in securities that are principally
traded in securities markets located outside the United States.
The Asset Composition table located on page 8 of the prospectus is replaced
entirely with the following:
<TABLE>
<CAPTION>
*UNRATED SECURITIES
OF COMPARABLE
RATED SECURITIES QUALITY AS
AS PERCENTAGE PERCENTAGE OF
RATING OF FUND'S ASSETS FUND'S ASSETS
- ------------------- ---------------- -------------------
<S> <C> <C>
AAA 0.00% 0.00%
AA 0.00% 0.00%
A 0.00% 0.00%
BBB 0.00% 0.00%
BBB split 1.68% 0.00%
BB 12.51% 0.00%
BB split 17.64% 0.00%
B 54.84% 4.01%
B split 2.04% 0.00%
CCC 0.35% 0.23%
D 0.00% 0.03%
Unrated* 4.27%
U.S. governments,
cash, equities
and others 6.67%
-------
TOTAL 100.00%
-------
</TABLE>
December 1, 1997
The "Fund Management and Expenses; Sub-Administrator" section is deleted.
The last sentence of the first paragraph and the second paragraph of the "Fund
Management and Expenses; Fund Expenses" section are deleted.
The Fund's portfolio turnover rates for the fiscal years ended July 31, 1996
and 1997, were 116% and 138%, respectively.
The sixth paragraph of the "Distribution Plan" section is deleted.
<PAGE>
STATEMENT OF ADDITIONAL INFORMATION
KEYSTONE HIGH INCOME BOND FUND (B-4)
December 1, 1997
This statement of additional information is not a prospectus, but relates
to, and should be read in conjunction with, the prospectus of Keystone High
Income Bond Fund (B-4) (the "Fund") dated November 29, 1996, as supplemented
from time to time. You may obtain a copy of the prospectus from the Fund's
principal underwriter, Evergreen Distributor, Inc. or your broker-dealer.
- --------------------------------------------------------------------------------
TABLE OF CONTENTS
- --------------------------------------------------------------------------------
Page
The Fund ......................................................................2
Service Providers..............................................................2
Investment Restrictions........................................................3
Distributions and Taxes........................................................4
Valuation of Securities........................................................5
Brokerage......................................................................5
Sales Charge...................................................................7
Distribution Plan..............................................................8
Trustees and Officers.........................................................10
Investment Adviser............................................................14
Principal Underwriter.........................................................15
Sub-administrator.............................................................16
The Trust Agreement...........................................................16
Expenses......................................................................18
Standardized Total Return and Yield Quotations................................19
Financial Statements..........................................................19
Additional Information........................................................20
Appendix.....................................................................A-1
- --------------------------------------------------------------------------------
THE FUND
- --------------------------------------------------------------------------------
The Fund is an open-end, diversified management investment company,
commonly known as a mutual fund. The Fund's investment objective is to provide
shareholders with generous income. To achieve this objective, the Fund invests
primarily in corporate bonds, and its portfolio ordinarily includes a
substantial number of bonds that are rated by Standard & Poor's Ratings Group
("S&P") or Moody's Investors Service ("Moody's") as below investment grade ,
i.e., S&P rating below BBB or Moody's rating below Baa. While Keystone
Investment Management Company ("Keystone"), the Fund's investment adviser
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 are, on
balance, considered predominantly speculative.
Certain information about the Fund is contained in its prospectus. This
statement of additional information provides additional information about the
Fund that may be of interest to some investors.
- --------------------------------------------------------------------------------
SERVICE PROVIDERS
- --------------------------------------------------------------------------------
Service Provider
- ----------------------------------------- ---------------------------------
<TABLE>
<CAPTION>
<S> <C>
Investment adviser (referred to Keystone Investment Management Company,
Berkeley in this SAI as "Keystone") 200 Berkeley Street, Boston,
Massachusetts 02116. (Keystone is
a wholly-owned subsidiary of First
Union Corporation ("First Union"),
located at 301 South College
Street, Charlotte, North Carolina
Principal underwriter (referred to Evergreen Distributor, Inc.,125
in this SAI as "EDI") W. 55th Street, New York, New York
10019
Predecessor to EDI (referred to in Evergreen Investment Services, Inc.
this SAI as "EIS") 200 Berkeley Street, Boston,
Massachusetts 02116
Transfer and dividend disbursing Evergreen Service Company, 200
agent (referred to in this SAI as Berkeley Street, Boston
"ESC") Massachusetts 02116 (ESC is a
subsidiary of First Union.
Independent Auditor 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
- --------------------------------------------------------------------------------
Fundamental Investment Restrictions
The Fund has adopted the fundamental investment restrictions set forth
below, which may not be changed without a vote of the majority of the Fund's
outstanding voting shares (as defined in the Investment Company Act of 1940 (the
"1940 Act")). Unless otherwise stated, all references to Fund assets are in
terms of current market value.
The Fund may not do any of the following:
(1) with respect to 75% of its total assets, invest more than 5% of the
value of its total assets, determined at market or other fair 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, all as determined
immediately after such investment; provided that these limitations do not apply
to investments in securities issued or guaranteed by the United States ("U.S.")
government or its agencies or instrumentalities;
(2) invest more than 5% of the value of its total assets in companies which
have been in operation for less than three years;
(3) borrow money, except that the Fund may (a) 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 (b) enter into reverse repurchase
agreements (bank borrowings and reverse repurchase agreements, in aggregate,
shall not exceed 10% of the value of the Fund's net assets);
(4) underwrite securities, except that the Fund may purchase securities
from issuers thereof or others and dispose of such securities in a manner
consistent with its other investment policies; in the disposition of restricted
securities the Fund may be deemed to be an underwriter, as defined in the
Securities Act of 1933 (the "1933 Act");
(5) purchase or sell real estate or interests in real estate, except that
it may purchase and sell securities secured by real estate and securities of
companies which invest in real estate, and will not purchase or sell commodities
or commodity contracts, except that the Fund may engage in currency or other
financial futures contracts and related options transactions;
(6) invest for the primary purpose of exercising control over or management
of any issuer;
(7) make margin purchases or short sales of securities;
(8) make loans, except that the Fund may make, purchase or hold debt
securities and other debt investments, including loans, consistent with its
investment objective, lend portfolio securities valued at not more than 15% of
its total assets to broker-dealers, and enter into repurchase agreements;
(9) invest more than 25% of its assets in the securities of issuers in
any single industry, other than securities issued by banks and savings and loan
associations or securities issued or guaranteed by the U.S. government, its
agencies or instrumentalities; and
(10) purchase the securities of any other investment company except in the
open market and at customary brokerage rates and in no event more than 3% of the
voting securities of any investment company.
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.
Non-Fundamental Investment Restrictions
The Fund intends to follow policies of the Securities and Exchange
Commission ("SEC") 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 its net assets.
If a percentage limit is satisfied at the time of investment or borrowing,
a later increase or decrease resulting from a change in asset value of a
security or a decrease in Fund assets is not a violation of the limit. With
respect to borrowing, applicable law may require the Fund to reduce the amount
of borrowing.
The Fund has no current intention of attempting to increase its net income
by borrowing and intends to repay any borrowings made in accordance with the
third investment restriction enumerated above before it makes any additional
investments.
- --------------------------------------------------------------------------------
DISTRIBUTIONS AND TAXES
- --------------------------------------------------------------------------------
The Fund will declare dividends from its net investment income daily and
pay such dividends monthly. The Fund will distribute its net capital gains, if
any, at least annually. You will ordinarily receive distributions in shares,
unless you elect before the record date to receive them as cash. Unless the Fund
receives instructions to the contrary, it will assume that you wish to receive
that distribution and future gains and income distributions in share. Your
instructions continue in effect until changed in writng. If you have not opted
to receive cash, the Fund will determine the number of shares that you should
receive based in its net asset value per share as computed at the close of
business on the ex-divedend date after adjustment for the distribution.
The Fund's income distributions are largely derived from interest on bonds
and thus are not to any significant degree eligible, in whole or in part, for
the corporate 70% dividends received deduction. Distributed long-term capital
gains are taxable as such to the shareholder regardless of the period of time
Fund shares have been held by the shareholder. However, if such shares are held
less than six months and redeemed at a loss, the shareholder will recognize a
long-term capital loss on such shares to the extent of the long-term capital
gain distribution received in connection with such shares. If the net asset
value of the Fund's shares is reduced below a shareholder's cost by a capital
gains distribution, such distribution, to the extent of the reduction, would be
a return of investment though taxable as stated above. Since distributions of
capital gains depend upon profits actually realized from the sale of securities
by the Fund, they may or may not occur. The foregoing comments relating to the
taxation of dividends and distributions paid on the Fund's shares relate solely
to federal income taxation. Such dividends and distributions may also be subject
to state and local taxes.
When the Fund makes a distribution, it intends to distribute only its net
capital gains and such income as has been predetermined, to the best of the
Fund's ability, to be taxable as ordinary income. Shareholders of the Fund will
be advised annually of the federal income tax status of distributions.
- --------------------------------------------------------------------------------
VALUATION OF SECURITIES
- --------------------------------------------------------------------------------
Current value for the Fund's portfolio securities is determined as follows:
(1) securities traded on an established exchange are valued on the basis of
the last sales price on the exchange where the securities are primarily traded
prior to the time of the valuation;
(2) securities traded in the over-the-counter market, for which complete
quotations are readily available, are valued at the mean of the bid and asked
prices at the time of valuation, unless otherwise specified by the Fund's Board
of Trustees;
(3) short-term investments maturing in 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;
(4) short-term investments maturing in more than sixty days are valued at
market value;
(5) securities, including restricted securities, for which complete
quotations are not readily available, and other assets are valued at prices
deemed in good faith to be fair under procedures established by the Fund's Board
of Trustees; and
(6) securities for which market quotations are readily available are valued
on a consistent basis at the price quoted that, in the opinion of the Fund's
Board of Trustees or the person designated by the Fund's Board of Trustees to
make the determination, most nearly represents the market value of the
particular security.
The Fund believes that reliable market quotations are generally not readily
available for purposes of valuing fixed income securities. As a result,
depending on the particular securities owned by the Fund, it is likely that most
of the valuations for such securities will be based upon fair value determined
under the 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 the Fund's fixed income securities and certain other
securities.
- --------------------------------------------------------------------------------
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 analyses 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 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 (as defined below).
Keystone believes that the cost, value and specific application of such services
are generally indeterminable and cannot be practically allocated between the
Fund and its other clients who may indirectly benefit from the availability of
such information. 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.
Neither the Fund nor Keystone intends on placing securities transactions
with any particular broker. The Fund's Board of Trustees has determined,
however, that the Fund may consider sales of Fund shares as a factor when
selecting brokers to execute portfolio transactions, subject to the requirements
of best execution described above.
Brokerage Commissions
The Fund expects to purchase and sell its securities and temporary
instruments through principal transactions. Bonds and money market instruments
are normally purchased directly from the issuer or from an underwriter or market
maker for the securities. In general, the Fund will not pay brokerage
commissions 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, EDI, or any of their affiliated persons, as defined in
the Investment Company Act of 1940 (the "1940 Act").
The Fund's 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 Fund's Board of Trustees may
change, modify or eliminate any of the foregoing practices.
- --------------------------------------------------------------------------------
SALES CHARGE
- --------------------------------------------------------------------------------
The Fund may charge a contingent deferred sales charge (a "CDSC") when you
redeem certain of its shares within four calendar years of purchase. 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 EDI 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 will first redeem shares not subject to a CDSC and will
then redeem shares you have held the longest.
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 (the value of your
account with respect to shares purchased prior to January 1, 1997) 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 at
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% 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; or
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 Keystone Classic Fund and/or any Evergreen 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 certain Directors, Trustees, officers and employees
of the Fund, Keystone and certain of their affiliates; and
14. shares purchased by registered representatives of firms with dealer
agreements with EDI.
Exchanges. The Fund does not charge a CDSC on exchanges of shares between
funds in the Keystone Classic Fund Family 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 the 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 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 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 CDSCs paid by shareholders to the
Principal Underwriter or its predecessor).
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; and (2) as shareholder service fees in
respect of shares maintained by the recipients and outstanding on the Fund's
books for specific periods; and (3) as interest. Amounts paid or accrued to the
Principal Underwriter or its predecessor under (1) and (2) in the aggregate may
not exceed the 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.
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 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
pay such Advances, the Principal Underwriter intends to seek full payment of
such Advances from the Fund (together with interest at the rate of prime plus
1%) at such time in the future as, and to the extent that, payment thereof by
the Fund would be within permitted limits. If the Fund's Independent Trustees
(Trustees who are not interested persons, as defined in the 1940 Act, of the
Fund and who have no direct or indirect financial interest in the Fund's
Distribution Plan or any agreement related thereto) authorize such Advances, 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.
The total amounts paid by the Fund under the foregoing arrangements may not
exceed the maximum Distribution Plan limit specified above, and 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 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. 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.
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 and officers of the Fund, their principal occupations and
some of their affiliations over the last five years are as follows:
<TABLE>
<CAPTION>
<S> <C>
FREDERICK AMLING: Trustee of the Fund; Trustee or Director of certain other funds in
the Evergreen Family of Funds; Professor, Finance Department, George
Washington University; President, Amling & Company (investment advice);
and former Member, Board of Advisers, Cre dito Emilano (banking).
LAURENCE B. ASHKIN: Trustee of the Fund; Trustee or Director of certain other funds in
the Evergreen Family of Funds; 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 certain other funds in
the Evergreen Family 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 certain other funds in
the Evergreen Family of Funds; 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 certain other funds in the
Evergreen Family of Funds; Chairman of the Board and Trustee of
the Fund; 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 Advisers, Inc.; 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 certain other funds in
the Evergreen Family 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 certain other funds in
the Evergreen Family of Funds; and former Director, Peoples Bank
(Charlotte, NC).
K. DUN GIFFORD: Trustee of the Fund; Trustee or Director of certain other funds in
the Evergreen Family of Funds; Trustee, Treasurer and Chairman
of the Finance Committee, Cambridge College; Chairman Emeritus
and Director, American Institute of Food and Wine; Chairman and
President, Oldways Preservation and Exchange Trust (education);
former Chairman of the Board, Director, and Executive Vice Presi
dent, The London Harness Company; former Managing Partner,
Roscommon Capital Corp.; former Chief Executive Officer, Gifford
Gifts of Fine Foods; former Chairman, Gifford, Drescher & Asso
ciates (environmental consulting); and former Director, Keystone
Investments, Inc. and Keystone.
JAMES S. HOWELL: Trustee of the Fund; Trustee or Director of all other 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 certain other funds in
the Evergreen Family 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 certain other funds in
the Evergreen Family of Funds; Chairman and Of Counsel, Keyser,
Crowley & Meub, P.C.; Member, Governor's (VT) Council of Eco
nomic 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 Com
pany, 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
Evergreen Family of Funds (except Evergreen Variable Trust); 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
Evergreen Family of Funds (except Evergreen Variable Trust);
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
Evergreen Family of Funds (except Evergreen Variable Trust); and
Partner in the law firm of Holcomb and Pettit, P.A.
DAVID M. RICHARDSON: Trustee of the Fund; Trustee or Director of certain other funds in
the Evergreen Family of Funds; Vice Chair and former Executive
Vice President, DHR International, Inc. (executive recruitment);
former Senior Vice President, Boyden International Inc. (executive
recruitment); 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
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
Evergreen Family of Funds; and Attorney, Law Offices of Michael
S. Scofield.
RICHARD J. SHIMA: Trustee of the Fund; Trustee or Director of certain other funds in
the Evergreen Family of Funds; Chairman, Environmental
Warranty, Inc. (insurance agency); Executive Consultant, Drake
Beam Morin, Inc. (executive outplacement); Director of Connecticut
Natural Gas Corporation, 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 certain other funds in
the Evergreen Family 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 Evergreen Family of Funds; Senior Managing
Director, Furman Selz LLC since 1992; Managing Director from 1984 to 1992;
Consultant, 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
Evergreen Family of Funds; Senior Vice President and Director of
Administration and Regulatory Services, BISYS Fund Services since
1995; 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 the meaning of the 1940 Act.
As of October 30, 1997, 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 the
address of the Fund is 200 Berkeley Street, Boston, Massachusetts 02116-5034.
Set forth below for the fiscal year ended July 31, 1997 is the aggregate
compensation paid to each Trustee by the Fund and the Evergreen Keystone Fund
family:
Name of Person, Aggregate Total
Position Compensation Compensation
From Registrant From Registrant
And Fund
Complex Paid To
Trustees
L.B. Ashkin $2,221 $65,100
F. Bam $1,921 $52,675
R.J. Jeffries $0 $13,100
J.S. Howell $2,371 $102,500
G.M. McDonnell $2,371 $89,200
T.L.McVerry $2,271 $93,700
W.W. Petit $2,271 $91,825
R.A. Salton $2,121 $94,500
M.S. Scofield $2,221 $95,700
F. Amling $3,446 $43,200
C.A. Austin $3,446 $43,200
G.S. Bissell $2,221 $28,500
E.D. Campbell $3,246 $40,800
C.F. Chapin $3,246 $40,800
K.D. Gifford $3,146 $39,600
L. Keith $3,296 $41,400
F.R. Keyser $3,396 $56,950
D.M. Richardson $3,446 $43,200
R.J. Shima $3,296 $55,750
A.J. Simons $3,296 $41,400
- --------------------------------------------------------------------------------
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.
Keystone and is indirectly owned by First Union, headquartered in
Charlotte, North Carolina. First Union and its subsidiaries provide a broad
range of financial services to individuals and businesses throughout the United
States.
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 SEC 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 SEC and other authorities, and all
extraordinary charges and expenses of the Fund.
The Fund pays Keystone a fee for its services at the annual rate set
forth below:
Aggregate Net
Asset Value of the
Management Fee Income Shares of the Fund
- --------------------------------------------------------------------------------
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.
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 EDI, which is not affiliated with First Union.
EIS, the Fund's former principal underwriter, may receive compensation from the
Fund or EDI in respect of underwriting and distribution services performed prior
to the termination of EIS as principal underwriter. In addition, EIS may also be
compensated by EDI for the provision of certain marketing support services to
EDI at an annual rate of up to .75% of the average daily net assets of the Fund,
subject to certain restrictions.
EDI, as agent, has agreed to use its best efforts to find purchasers for
the shares. EDI 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 EDI will bear the expense of preparing, printing, and distributing
advertising and sales literature and prospectuses used by it. In its capacity as
principal underwriter, EDI or EIS, 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 (1) by a vote of a majority
of the Independent Trustees, and (2) 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 EDI's judgment, it could benefit the sales of
Fund shares, EDI 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 personnel 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 TRUST AGREEMENT
- --------------------------------------------------------------------------------
The Fund is a Pennsylvania common law trust established under a Trust
Agreement dated July 15, 1935, as restated and amended (the "Trust Agreement").
The Trust Agreement provides for a Board of Trustees and enables the Fund to
enter into an agreement with an investment manager and/or adviser to provide the
Fund with investment advisory, management, and administrative services. A copy
of the Trust Agreement is on file as an exhibit to the Fund's Registration
Statement, of which this statement of additional information is a part. This
summary is qualified in its entirety by reference to the Trust Agreement.
Description of Shares
The Trust Agreement 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
Pennsylvania common law trust could possibly be held personally liable for the
obligations of the Fund. The possibility of Fund shareholders incurring
financial loss under such circumstances appears to be remote, however, because
the Trust Agreement (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 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 Trust Agreement, 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 Trust
Agreement 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 a meeting as described above, no further meetings of shareholders for
the purpose of electing Trustees will be held, unless required by law, or unless
and 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 shareholders' 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 Trust Agreement provides that a Trustee shall be liable only for his
own willful defaults and, if reasonable care has been exercised in the selection
of officers, agents, employees, or investment advisers, shall not be liable for
any neglect or wrongdoing of any such person; provided, however, that nothing in
the Trust Agreement shall protect a Trustee against any liability for his
willful misfeasance, bad faith, gross negligence, or reckless disregard of his
duties.
The Trustees have absolute and exclusive control over the management and
disposition of all assets of the Fund and may perform such acts as in their sole
judgment and discretion are necessary and proper for conducting the business and
affairs of the Fund or promoting the interests of the Fund and the shareholders.
- --------------------------------------------------------------------------------
EXPENSES
- --------------------------------------------------------------------------------
Investment Advisory Fee
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, Inc.
("Keystone Management"), the Fund's former investment manager, for services
rendered under the Management Agreement and (2) by Keystone Management to
Keystone for services rendered under the Advisory Agreement. For more
information, see "Investment Adviser."
Fee Paid to Keystone Fee Paid to
Management under Keystone under
the Management the Advisory
Fiscal Year Ended Agreement Agreement
July 31, 1997 $1,225,118* $3,259,222
July 31, 1996 $3,788,171 $3,219,945
July 31, 1995 $4,040,007 $3,434,006
* Represents investment advisory fees paid to Keystone Management for the
period September 1, 1996 through December 11, 1996. After December 11, 1996,
management fees were paid directly to Keystone.
Distribution Plan Expenses
For the fiscal year ended July 31, 1997, the Fund paid $5,686,181 to EDI or
EIS 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 to EDI or EIS with respect to the public distribution of the
Fund's shares. The table also indicates the aggregate dollar amount of
underwriting commissions retained by EDI or EIS. For more information, see
"Principal Underwriter" and "Sales Charges."
Aggregate Dollar Amount of
Aggregate Dollar Amount of Underwriting Commissions
Fiscal Year Ended Underwriting Commissions Paid Retained
July 31, 1997 $4,909,107 $4,122,547
July 31, 1996 $6,747,276 $3,208,491
July 31, 1995 $7,116,706 $4,444,407
Brokerage Commissions
Fiscal Year Ended Brokerage Commissions Paid
July 31, 1997 $3,488
July 31, 1996 $275,207
July 31, 1995 $9,302
- --------------------------------------------------------------------------------
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 average annual rates of return for the one, five, and ten year periods
ended July 31, 1997 were 12.32% (including CDSCs), 8.15%, and 6.36%,
respectively.
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 Fund's current yield for
the 30-day period ended July 31, 1997 was 7.40%.
- --------------------------------------------------------------------------------
FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
The Fund's financial statements for the fiscal year ended July 31, 1997,
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.
A copy of the Fund's Annual Report will be furnished upon request and
without charge. Requests may be made in writing to ESC, P.O. Box 2121, Boston,
Massachusetts 02106-2121, or by calling ESC toll free at 1-800-343-2898.
- --------------------------------------------------------------------------------
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.
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.
If conditions arise that would make it undesirable for the Fund to pay for
all redemptions in cash, the Fund may authorize payment to be made in portfolio
securities or other property. The Fund has obligated itself, however, under the
1940 Act, to redeem for cash all shares presented for redemption by any one
shareholder in any 90-day period up to the lesser of $250,000 or 1% of the
Fund's net assets. Securities delivered in payment of redemptions would be
valued at the same value assigned to them in computing the net asset value per
share. Shareholders receiving such securities would incur brokerage costs when
these securities are sold.
The Fund's prospectus and this statement of additional information omit
certain information contained in the registration statement filed with the SEC,
which may be obtained from the SEC's principal office in Washington, D.C. upon
payment of the fee prescribed by the rules and regulations promulgated by the
SEC.
On October 31, 1997, Merrill Lynch, Pierce, Fenner & Smith, Attn: Fund
Administration, 4800 Deer Lake Drive E 3rd Floor, Jacksonville, FL 32246-6484
owned of record 10.88% of the Fund's shares.
________________________________________________________________________________
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 Investors Service ("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 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. 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
("SEC") 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, L.P. (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 U.S. 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 U.S. Government or its agencies or
instrumentalities include direct obligations of the U.S. 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 U.S. Government agencies and instrumentalities, such as
Treasury bills and Government National Mortgage Association ("GNMA")
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 U.S. 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. U.S.
Government securities will not include international agencies or
instrumentalities in which the U.S. 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 U.S. 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. 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 SEC 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 nonfundamental investment restriction prohibiting it
from investing more than 15% of its total assets (taken at current value)
in any combination of illiquid assets and securities.
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 U.S. 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, 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 U.S. 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 U.S. 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, French 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.
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.
