<PAGE>
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PROSPECTUS DECEMBER 29, 1994
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KEYSTONE CUSTODIAN FUND, SERIES B-2
DIVERSIFIED BOND FUND
200 BERKELEY STREET, BOSTON, MASSACHUSETTS 02116-5034
CALL TOLL FREE 1-800-343-2898
Keystone Custodian Fund, Series B-2 (the "Fund") is a mutual fund whose goal
is maximum income without undue risk of principal. The Fund invests primarily in
corporate bonds that are normally characterized by liberal returns and moderate
price fluctuations.
The Fund seeks to maximize return with respect to a portion of its assets.
Such maximum return is ordinarily associated with high yield, high risk bonds
and similar securities in the lower rating categories of the recognized rating
agencies or with securities that are unrated (high yield bonds). Such high
yield, high risk bonds generally involve greater volatility of price and risk of
principal and income than bonds in the higher rating categories and are, on
balance, considered predominantly speculative.
Your purchase payment is fully invested. There is no sales charge when you buy
the Fund's shares. The Fund may, however, impose a deferred sales charge, which
declines from 4% to 1%, if you redeem your shares within four years of purchase.
The Fund has adopted a Distribution Plan (the "Distribution Plan") pursuant to
Rule 12b-1 under the Investment Company Act of 1940 (the "1940 Act"), under
which it bears some of the costs of selling its shares to the public.
This prospectus sets forth concisely the information about the Fund that you
should know before investing. Please read it and retain it for future reference.
Additional information about the Fund is contained in a statement of
additional information dated December 29, 1994, which has been filed with the
Securities and Exchange Commission and is incorporated by reference into this
prospectus. For a free copy, or for other information about the Fund, write to
the address or call the telephone number listed above.
SHARES OF THE FUND ARE NOT DEPOSITS OR OBLIGATIONS OF, OR GUARANTEED OR
ENDORSED BY, ANY BANK, AND SHARES ARE NOT FEDERALLY INSURED BY THE FEDERAL
DEPOSIT INSURANCE CORPORATION, THE FEDERAL RESERVE BOARD, OR ANY OTHER AGENCY.
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THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS
A CRIMINAL OFFENSE.
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<PAGE>
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TABLE OF CONTENTS
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<TABLE>
<CAPTION>
<S> <C> <S> <C>
Page Page
Fee Table ................................. 3 How to Buy Shares ..................... 12
Financial Highlights ..................... 4 Distribution Plan ..................... 13
Fund Description .......................... 5 How to Redeem Shares .................. 15
Fund Objective and Policies .............. 5 Shareholder Services .................. 17
Risk Factors .............................. 6 Performance Data ...................... 18
Investment Restrictions ................... 8 Fund Shares ........................... 18
Pricing Shares ............................ 9 Additional Information ................ 19
Dividends and Taxes ....................... 9 Additional Investment Information ..... (i)
Fund Management and Expenses .............. 10
</TABLE>
<PAGE>
FEE TABLE
KEYSTONE CUSTODIAN FUND, SERIES B-2
DIVERSIFIED BOND FUND
The purpose of the fee table is to assist investors in understanding the
costs and expenses that an investor in the Fund will bear directly or
indirectly. For more complete descriptions of the various costs and expenses,
see the following sections of this prospectus: "Fund Management and Expenses";
"How to Buy Shares"; "Distribution Plan"; and "Shareholder Services."
SHAREHOLDER TRANSACTION EXPENSES
Contingent Deferred Sales Charge<F1> .......................... 4.00%
(as a percentage of the lesser of total cost
or the net asset value of shares redeemed)
Exchange Fee<F2> .............................................. $10.00
(per exchange)
ANNUAL FUND OPERATING EXPENSES<F3>
(as a percentage of average net assets)
Management Fees ............................................... 0.50%
12b-1 Fees<F4> ................................................ 1.00%
Other Expenses ................................................ 0.25%
-----
Total Fund Operating Expenses ................................. 1.75%
=====
<TABLE>
<CAPTION>
EXAMPLE<F5> 1 Year 3 Years 5 Years 10 Years
------ ------- ------- --------
<S> <C> <C> <C> <C>
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: ... $58.00 $75.00 $95.00 $206.00
You would pay the following expenses on the same investment, assuming
no redemption: ....................................................... $18.00 $55.00 $95.00 $206.00
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.
<FN>
- ---------
<F1> The deferred sales charge declines from 4% to 1% of amounts redeemed within
four calendar years after purchase. No deferred sales charge is imposed
thereafter.
<F2> There is no fee for exchange orders received by the Fund directly from a
shareholder over the Keystone Automated Response Line ("KARL"). (For a
description of KARL, see "Shareholder Services".)
<F3> Expense ratios are for the Fund's fiscal year ended August 31, 1994.
<F4> 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. ("NASD").
<F5> 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%.
</TABLE>
<PAGE>
FINANCIAL HIGHLIGHTS
KEYSTONE CUSTODIAN FUND, SERIES B-2
DIVERSIFIED BOND FUND
(For a share outstanding throughout the year)
The following table contains significant financial information with respect 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 auditors' report, in the Fund's Annual Report. The
Fund's financial statements, related notes, and auditors' report are included in
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 AUGUST 31,
-------------------------------------------------------------------------------------------------------------
1994 1993 1992 1991 1990 1989 1988 1987 1986 1985
---- ---- ---- ---- ---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
NET ASSET VALUE,
BEGINNING OF YEAR ... $17.06 $16.44 $15.37 $15.51 $17.74 $17.99 $18.91 $20.08 $18.84 $17.35
Income From Investment
Operations
Investment income --
net ................. 1.06 1.28 1.33 1.33 1.53 1.71 1.78 1.83 2.07 2.00
Net gains (losses) on
investments and
foreign currency
related transactions (1.62) 0.70 1.14 0.17 (1.94) (0.13) (0.81) (1.01) 1.38 1.79
Net commissions paid
on fund share sales
<F1> ................ -0- -0- -0- -0- -0- -0- -0- -0- (0.21) (0.20)
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total from investment
operations .......... (0.56) 1.98 2.47 1.50 (0.41) 1.58 0.97 0.82 3.24 3.59
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Less distributions from:
Investment income--net (1.22) (1.28) (1.33) (1.63) (1.61) (1.83) (1.85) (1.85) (2.00) (2.10)
In excess of
investment income--
net <F2> ............ -0- (0.08) (0.07) (0.01) (0.21) -0- -0- -0- -0- -0-
Realized gains on
investments and
foreign currency
related
transactions--net ... -0- -0- -0- -0- -0- -0- (0.04) (0.14) -0- -0-
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
Total distributions .. (1.22) (1.36) (1.40) (1.64) (1.82) (1.83) (1.89) (1.99) (2.00) (2.10)
------ ------ ------ ------ ------ ------ ------ ------ ------ ------
NET ASSET VALUE, END
OF YEAR ............. $15.28 $17.06 $16.44 $15.37 $15.51 $17.74 $17.99 $18.91 $20.08 $18.84
====== ====== ====== ====== ====== ====== ====== ====== ====== ======
TOTAL RETURN <F3> .... (3.53)% 12.73% 16.88% 10.58% (2.44)% 9.23% 5.61% 4.20% 18.01% 22.19%
RATIOS/SUPPLEMENTAL DATA
Ratios to average net
assets:
Operating and
management expenses . 1.75% 1.89% 1.99% 1.94% 1.89% 1.84% 1.68% 1.68% 1.00% 1.05%
Investment income--net
..................... 6.48% 7.73% 8.29% 8.74% 9.26% 9.52% 9.82% 9.31% 10.37% 11.03%
Portfolio turnover
rate ................ 200% 133% 117% 101% 43% 47% 46% 74% 69% 103%
Net assets, End of
year (thousands) .... $814,245 $1,004,393 $902,339 $814,528 $860,615 $1,000,305 $838,892 $889,333 $558,734 $220,919
<FN>
<F1> Prior to June 30, 1987, net commissions paid on new sales of shares under
the Fund's Rule 12b-1 Distribution Plan had been treated for both financial
statement and tax purposes as capital charges. On June 11, 1987, the
Securities and Exchange Commission adopted a rule which required for
financial statements for the periods ended on or after June 30, 1987, that
net commissions paid under Rule 12b-1 Distribution Plans be treated as
operating expenses rather than capital charges. Accordingly, beginning with
the year ended August 31, 1987, the Fund's financial statements reflect
12b-1 Distribution Plan expenses (i.e., shareholder service fees plus
commissions paid net of deferred sales charges received by the Fund) as a
component of the net investment income section of the financial highlights.
<F2> Effective September 1, 1993, the Fund adopted Statement of Position 93-2:
"Determination, Disclosure and Financial Statement Presentation of Income,
Capital Gain and Return of Capital Distributions by Investment Companies."
As a result, distribution amounts exceeding book basis net investment
income (or tax basis net income on a temporary basis) are presented as
"Distributions in excess of investment income -- net". Similarly, capital
gain distributions in excess of book basis capital gains (or tax basis
capital gains on a temporary basis) are presented as "Distributions in
excess of realized capital gains."
<F3> Excluding deferred sales charges.
</TABLE>
<PAGE>
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FUND DESCRIPTION
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The Fund is an open-end, diversified management investment company, commonly
known as a mutual fund. The Fund was created under Pennsylvania law as a common
law trust and has been offering its shares continuously since September 11,
1935. The Fund is one of twenty funds managed by Keystone Management, Inc.
("Keystone Management"), the Fund's investment manager, and is one of thirty-one
funds managed or advised by Keystone Custodian Funds, Inc. ("Keystone"), the
Fund's investment adviser . Keystone and Keystone Management are, from time to
time, collectively referred to as "Keystone."
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FUND OBJECTIVE AND POLICIES
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The Fund's investment objective is to provide shareholders with maximum income
without undue risk of principal. To achieve this objective, the Fund invests
primarily in bonds and obligations that are normally characterized by liberal
returns and moderate price fluctuations. Such bonds, which include both secured
and unsecured debt obligations and may be of any assigned rating by Standard &
Poor's Corporation ("S&P") or Moody's Investors Service, Inc. ("Moody's") or
unrated, as a group have possessed a fairly high degree of dependability of
interest payments. While the Fund's primary objective is income, the Fund gives
careful consideration to security of principal, marketability and
diversification. In addition to its other investment options, the Fund may
invest in limited partnerships, including master limited partnerships, and may
invest up to 25% of its assets in foreign securities. The Fund may also invest
in participations in bank loans. The Fund seeks to maximize return with respect
to a portion of its assets. Such maximum return is ordinarily associated with
high yield, high risk bonds and similar securities in the lower rating
categories of the recognized rating agencies or with securities that are unrated
(high yield bonds). Such high yield, high risk bonds generally involve greater
volatility of price and risk of principal and income than bonds in the higher
rating categories and are, on balance, considered predominantly speculative.
The Fund's investments may include fixed and adjustable rate or stripped
bonds, including zero coupon bonds and payment-in-kind ("PIK") securities,
debentures, notes, equipment trust certificates, United States ("U.S.")
government securities and debt securities convertible into or exchangeable for
preferred or common stock. The Fund may invest in preferred stock, including
adjustable rate preferred stock, and warrants, which can be used to purchase or
create otherwise permissible investments. The Fund may continue to hold
preferred or common stock received in connection with convertible or
exchangeable securities and may hold common stock received in connection with
the purchase of a permitted security.
When, in the opinion of Keystone, market conditions warrant, the Fund may
adopt a defensive position to preserve shareholders' capital by investing in
money market instruments. Such instruments, which must mature within one year of
their purchase, consist of U.S. government securities; instruments, including
certificates of deposit, demand and time deposits and bankers' acceptances, of
banks that are members of the Federal Deposit Insurance Corporation and have
assets of at least $1 billion, including U.S. branches of foreign banks and
foreign branches of U.S. banks; prime commercial paper, including master demand
notes; and repurchase agreements secured by U.S. government securities.
The Fund intends to follow policies of the Securities and Exchange Commission
as they are adopted from time to time with respect to illiquid securities,
including, at this time, (1) treating as illiquid securities which 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 such securities on its
books and (2) limiting its holdings of such securities to 15% of net assets.
The Fund may write covered call and put options. The Fund may also purchase
call and put options, including call and put options to close out existing
positions, and may employ new investment techniques with respect to such
options.
The Fund may enter into reverse repurchase agreements and firm commitment and
when issued transactions for securities and currencies. In addition, the Fund
may enter into currency and other financial futures contracts and related
options transactions for hedging purposes and not for speculation and may employ
new investment techniques with respect to such futures contracts and related
options.
In addition to the options, futures contracts and forwards mentioned above,
the Fund may also invest in certain other types of derivative instruments,
including collateralized mortgage obligations, structured notes, interest rate
swaps, index swaps, currency swaps and caps and floors. These basic vehicles can
also be combined to create more complex products called hybrid derivatives or
structured securities. Investments in foreign securities, options transactions
and other complex or derivative securities involve certain risks.
For a further explanation of the types of investments and investment
techniques available to the Fund and the associated risks, see the section of
this prospectus entitled "Additional Investment Information" and the statement
of additional information.
Of course, there can be no assurance that the Fund will achieve its investment
objective since there is uncertainty in every investment. The investment
objective of the Fund cannot be changed without a vote of the holders of a
majority (as defined in the 1940 Act) of the Fund's outstanding shares.
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RISK FACTORS
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The Fund's flexible investment policy allows the Fund to invest a portion of
its assets in high yield, high risk bonds and similar securities. The degree to
which the Fund will hold such securities will, among other things, depend upon
its adviser's economic forecast and its judgment as to the comparative values
offered by high yield, high risk securities and higher quality issues. While the
Fund currently intends to invest less than 35% of its assets in high yield, high
risk securities, over the past 10 years portfolio holdings of high yield, high
risk securities have ranged from a low of approximately 25% of total assets to a
high of approximately 60%.
The Fund invests a portion of its assets aggressively and seeks to maximize
return on such assets over time from a combination of many factors, including
high current income and capital appreciation from high yield, high risk
securities. Such aggressive investing involves risks that are greater than the
risks of investing in higher quality debt securities. These risks are discussed
in greater detail below and include risks from (1) interest rate fluctuation;
(2) changes in credit status, including weaker overall credit condition of
issuers and risks of default; (3) industry, market and economic risk; (4)
volatility of price resulting from broad and rapid changes in the value of
underlying securities; and (5) greater price variability and credit risks of
certain high yield, high risk securities such as zero coupon bonds and PIK
securities.
These risks provide the opportunity for maximizing return over time on a
portion of the Fund's assets, but may result in greater upward and downward
movement of the net asset value per share of the Fund. As a result, they should
be carefully considered by investors. The portion of the Fund's assets invested
in high yield, high risk securities may vary and may at times be substantial.
The maximum return sought by the Fund with respect to a portion of its assets
is ordinarily associated with securities in the lower rating categories of the
recognized rating agencies or with securities that are unrated. Such high yield,
high risk securities are generally rated BB or lower by S&P or Ba or lower by
Moody's. The Fund may invest in securities that are rated as low as D by S&P and
C- by Moody's. For a description of these rating categories see "Additional
Investment Information." The Fund intends to invest in D rated debt only in
cases where, in Keystone's judgment, there is a distinct prospect of improvement
in the issuer's financial position as a result of the completion of
reorganization or otherwise. The Fund may also invest in unrated securities
that, in Keystone's judgment, offer comparable yields and risks to those of
securities that are rated as well as in non-investment quality zero coupon and
PIK securities.
While investment in the Fund provides opportunities to maximize return over
time, investors should be aware of the following risks associated with
noninvestment grade bonds:
(1) Securities rated BB or lower by S&P or Ba or lower by Moody's are
considered predominantly speculative with respect to the ability of the issuer
to meet principal and interest payments.
(2) The lower ratings of certain securities held by the Fund reflect a greater
possibility that adverse changes in the financial condition of the issuer or in
general economic conditions, or both, or an unanticipated rise in interest rates
may impair the ability of the issuer to make payments of interest and principal,
especially if the issuer is highly leveraged. Such issuer's ability to meet its
debt obligations may also be adversely affected by specific corporate
developments, the issuer's inability to meet specific projected business
forecasts, or the unavailability of additional financing. Also, an economic
downturn or an increase in interest rates may increase the potential for default
by the issuers of these securities.
(3) The value of certain securities held by the Fund may be more susceptible
to real or perceived adverse economic, company or industry conditions and
publicity than is the case for higher quality securities.
(4) The values of certain securities, like those of other fixed income
securities, fluctuate in response to changes in interest rates. When interest
rates decline, the value of a portfolio invested in bonds can be expected to
rise. Conversely, when interest rates rise, the value of a portfolio invested in
bonds can be expected to decline. For example, in the case of an investment in a
fixed-income security, if interest rates increase after the security is
purchased, the security, if sold prior to maturity, may return less than its
cost. The prices of noninvestment grade bonds, however, are generally less
sensitive to interest rate changes than the prices of higher-rated bonds;
noninvestment grade bonds are more sensitive to adverse or positive economic
changes or individual corporate developments.
(5) The secondary market for certain securities held by the Fund may be less
liquid at certain times than the secondary market for higher quality debt
securities, which may have an adverse effect on market price and the Fund's
ability to dispose of particular issues and may also make it more difficult for
the Fund to obtain accurate market quotations for purposes of valuing its
assets.
(6) Zero coupon bonds and PlKs involve additional special considerations. Zero
coupon bonds do not require the periodic payment of interest. PIK bonds are debt
obligations that provide that the issuer may, at its option, pay interest on
such bonds in cash or in the form of additional debt obligations. Such
investments may experience greater fluctuation in value due to changes in
interest rates than debt obligations that pay interest currently. Even though
these investments do not pay current interest in cash, the Fund is nonetheless
required by tax laws to accrue interest income on such investments and to
distribute such amounts at least annually to shareholders. Thus, the Fund could
be required at times to liquidate investments in order to fulfill its intention
to distribute substantially all of its net income as dividends.
The following table shows the weighted average percentages of the Fund's
assets invested at the end of each month during the last fiscal year in
securities assigned to the various rating categories by S&P and in unrated
securities determined by Keystone to be of comparable quality. Since the
percentages in this table are based on month-end averages throughout the Fund's
fiscal year, they do not reflect the Fund's holdings at any one point in time.
The percentages in each category may be higher or lower on any day than those
shown in the table.
*UNRATED
SECURITIES
OF COMPARABLE
RATED SECURITIES QUALITY AS
AS PERCENTAGE OF PERCENTAGE OF
RATING FUND'S ASSETS FUND'S ASSETS
- ------ ---------------- -------------
AAA 22.23% 0.00%
AA 9.12% 0.00%
A 9.95% 0.00%
BBB 12.10% 0.72%
BB 3.45% 0.93%
B 23.58% 3.05%
CCC 1.20% 0.00%
CC and below 0.00% 0.00%
Unrated* 4.70%
U.S. Governments,
equities and others 13.67%
------ ----
TOTAL 100.00% 4.70%
====== ====
Since the Fund takes an aggressive approach to investing a portion of its
assets, Keystone tries to maximize the return by controlling risk through
diversification, credit analysis, review of sector and industry trends, interest
rate forecasts and economic analysis. Keystone's analysis of securities focuses
on values based on factors such as interest or dividend coverage, asset values,
earnings prospects and the quality of management of the company. In making
investment recommendations, Keystone also considers current income, potential
for capital appreciation, maturity structure, quality guidelines, coupon
structure, average yield, percentage of zeros and PIKs, percentage of
non-accruing items and yield to maturity. Keystone also considers the ratings of
Moody's and S&P assigned to various securities, but does not rely solely on
ratings assigned by Moody's and S&P because (1) Moody's and S&P assigned ratings
are based largely on historical financial data and may not accurately reflect
the current financial outlook of companies, and (2) there can be large
differences among the current financial conditions of issuers within the same
rating category.
Income and yields on high yield, high risk securities, as on all securities,
will fluctuate over time.
The Fund may invest in restricted securities, including securities eligible
for resale pursuant to Rule 144A under the Securities Act of 1933 (the "1933
Act"). Generally, Rule 144A establishes a safe harbor from the registration
requirements of the 1933 Act for resales by large institutional investors of
securities not publicly traded in the U.S. The Fund may purchase Rule 144A
securities when such securities present an attractive investment opportunity and
otherwise meet the Fund's selection criteria. The Board of Trustees has adopted
guidelines and procedures pursuant to which the liquidity of the Fund's Rule
144A securities is determined by Keystone, and the Board of Trustees monitors
Keystone's implementation of such guidelines and procedures.
At the present time, the Fund cannot accurately predict exactly how the market
for Rule 144A securities will develop. A Rule 144A security that was readily
marketable upon purchase may subsequently become illiquid. In such an event, the
Board of Trustees will consider what action, if any, is appropriate.
With respect to derivative or structured securities, the market value of such
securities may vary depending on the manner in which such securities have been
structured. As a result, the value of such investments may change at a more
rapid rate than that of traditional fixed income securities.
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INVESTMENT RESTRICTIONS
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The Fund has adopted the fundamental restrictions summarized below, which may
not be changed without the approval of a majority of the Fund's outstanding
shares. These restrictions and certain other fundamental restrictions are set
forth in the statement of additional information.
Generally, the Fund may not do the following: (1) invest more than 5% of its
total assets, computed at market value at the time of purchase, in the
securities of any one issuer (other than U.S. government securities) except that
up to 25% of its total assets may be invested without regard to this limit; (2)
borrow money, except that the Fund may borrow money from banks for temporary or
emergency purposes in aggregate amounts up to 10% of the value of the Fund's net
assets (computed at cost) or enter into reverse repurchase agreements; and (3)
invest more than 25% of its total assets in securities of issuers in the same
industry.
In addition, the Fund may, notwithstanding any other investment policy or
restriction, invest all of its assets in the securities of a single open-end
management investment company with substantially the same fundamental investment
objectives, policies and restrictions as the Fund. The Fund does not currently
intend to implement this policy and would do so only if the Trustees were to
determine such action to be in the best interest of the Fund and its
shareholders. In the event of such implementation, the Fund will comply with
such requirements as to written notice to shareholders as are then in effect.
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PRICING SHARES
- --------------------------------------------------------------------------------
The net asset value of a Fund share is computed each day on which the New York
Stock Exchange (the "Exchange") is open as of the close of trading on the
Exchange (currently 4:00 p.m. Eastern time for the purpose of pricing Fund
shares) except on days when changes in the value of the Fund's securities do not
affect the current net asset value of its shares. The Exchange currently is
closed on weekends, New Year's Day, Presidents' Day, Good Friday, Memorial Day,
Independence Day, Labor Day, Thanksgiving Day and Christmas Day. The net asset
value per share is arrived at by determining the value of all of the Fund's
assets, subtracting all liabilities and dividing the result by the number of
shares outstanding.
The Fund values short-term investments having maturities of more than sixty
days for which market quotations are readily available at current market value.
Where market quotations are not available, such instruments are valued at fair
value as determined by the Board of Trustees. Short-term investments that are
purchased with maturities of sixty days or less (including all master demand
notes) are valued at amortized cost (original purchase cost as adjusted for
amortization of premium or accretion of discount), which, when combined with
accrued interest, approximates market. Short-term investments maturing in more
than sixty days when purchased that are held on the sixtieth day prior to
maturity are valued at amortized cost (market value on the sixtieth day adjusted
for amortization of premium or accretion of discount), which, when combined with
accrued interest, approximates market; and in any case reflects fair value as
determined by the Board of Trustees.
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 their fair value
determined under procedures that have been approved by the Board of Trustees.
The Board of Trustees has authorized the use of a pricing service to determine
the fair value of the Fund's fixed income securities and certain other
securities. Securities for which market quotations are readily available are
valued on a consistent basis at the price quoted that, in the opinion of the
Board of Trustees or the person designated by the Board of Trustees to make the
determination, most nearly represents the market value of the particular
security. Any securities for which market quotations are not readily available
or other assets are valued on a consistent basis at fair value as determined in
good faith using methods prescribed by the Board of Trustees.
- --------------------------------------------------------------------------------
DIVIDENDS AND TAXES
- --------------------------------------------------------------------------------
The Fund has qualified and intends to qualify in the future as a regulated
investment company under the Internal Revenue Code. The Fund qualifies if, among
other things, it distributes to its shareholders at least 90% of its net
investment income for its fiscal year. The Fund also intends to make timely
distributions, if necessary, sufficient in amount to avoid the nondeductible 4%
excise tax imposed on a regulated investment company when it fails to
distribute, with respect to each calendar year, at least 98% of its ordinary
income for such calendar year and 98% of its net capital gains for the one-year
period ending on October 31 of such calendar year. Any such distributions would
be (1) declared in October, November, or December to shareholders of record in
such month, (2) paid by the following January 31, and (3) includable in the
taxable income of the shareholder for the year in which such distributions were
declared. If the Fund qualifies and if it distributes substantially all of its
net investment income and net capital gains, if any, to shareholders, it will be
relieved of any federal income tax liability. The Fund will make distributions
from its net investment income by the 15th day of January, April, July and
October each year and net capital gains, if any, at least annually.
Currently, commissions paid by the Fund on new sales of shares under the
Fund's Distribution Plan (see "Distribution Plan") and deferred sales charge
receipts are treated as capital charges and capital credits, respectively, in
determining net investment income for tax purposes. For financial statement
purposes, however, these expenses and receipts are treated as operating expenses
and expense offsets. As a result, the amount of dividend distributions required
to satisfy the requirements of the Internal Revenue Code might exceed net
investment income for financial statement purposes, resulting in a portion of
such dividends being a distribution in excess of net investment income for
financial statement purposes. Total investment return is equally affected by
both treatments.
Recently, the Internal Revenue Service ("IRS") issued a ruling that will
require the Fund, effective April 1, 1995, to treat its 12b-1 fees as operating
expenses, instead of as capital charges. The Fund intends to comply with the IRS
ruling by that date. As a result, after April 1, 1995, dividend distributions
are no longer expected to exceed net investment income for financial statement
purposes. Total investment return will not be affected.
The Fund makes distributions in additional shares of the Fund or, at the
shareholder's election (which must be made before the record date for the
distribution), in cash. Income dividends and net short-term gains distributions
are taxable as ordinary income, and net long-term gains distributions are
taxable as capital gains regardless of how long the shareholder has held the
Fund's shares. If Fund shares held for less than six months are sold at a loss,
however, such loss will be treated for tax purposes as a long-term capital loss
to the extent of any long-term capital gains dividends received. Dividends and
distributions may also be subject to state and local taxes. The Fund advises its
shareholders annually as to the federal tax status of all distributions made
during the year.
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FUND MANAGEMENT AND EXPENSES
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FUND MANAGEMENT
Subject to the general supervision of the Fund's Board of Trustees, Keystone
Management, located at 200 Berkeley Street, Boston, Massachusetts 02116-5034,
serves as investment manager to the Fund and is responsible for the overall
management of the Fund's business and affairs.
INVESTMENT MANAGER
Keystone Management, organized in 1989, is a wholly-owned subsidiary of
Keystone. Its directors and principal executive officers have been affiliated
with Keystone, a seasoned investment adviser, for a number of years. Keystone
Management also serves as investment manager to each of the other Keystone
Custodian Funds and to certain other funds in the Keystone Group of Mutual
Funds.
The Fund pays Keystone Management a fee for its services at the annual rate
set forth below:
AGGREGATE
ANNUAL NET ASSET VALUE
MANAGEMENT OF THE SHARES
FEE INCOME OF THE FUND
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2% of
Gross Dividend and
Interest Income
Plus
0.50% of the first $100,000,000 plus
0.45% of the next $100,000,000 plus
0.40% of the next $100,000,000 plus
0.35% of the next $100,000,000 plus
0.30% of the next $100,000,000 plus
0.25% of amounts over $500,000,000;
computed as of the close of business each business day and paid daily.
Pursuant to its Investment Management Agreement with the Fund (the "Management
Agreement"), Keystone Management has delegated its investment management
functions, except for certain administrative and management services, to
Keystone and has entered into an Investment Advisory Agreement with Keystone
(the "Advisory Agreement"), under which Keystone provides investment advisory
and management services to the Fund.
Services currently performed by Keystone Management include (1) performing
research and planning with respect to (a) the Fund's qualification as a
regulated investment company under Subchapter M of the Internal Revenue Code,
(b) tax treatment of the Fund's portfolio investments, (c) tax treatment of
special corporate actions (such as reorganizations), (d) state tax matters
affecting the Fund, and (e) the Fund's distributions of income and capital
gains; (2) preparing the Fund's federal and state tax returns; (3) providing
services to the Fund's shareholders in connection with federal and state
taxation and distributions of income and capital gains; and (4) storing
documents relating to the Fund's activities.
INVESTMENT ADVISER
Keystone, the Fund's investment adviser, located at 200 Berkeley Street,
Boston, Massachusetts 02116-5034, has provided investment advisory and
management services to investment companies and private accounts since it was
organized in 1932. Keystone is a wholly-owned subsidiary of Keystone Group, Inc.
("Keystone Group"), located at 200 Berkeley Street, Boston, Massachusetts
02116-5034.
Keystone Group is a corporation privately owned by current and former members
of management of Keystone and its affiliates. The shares of Keystone Group
common stock beneficially owned by management are held in a number of voting
trusts, the trustees of which are George S. Bissell, Albert H. Elfner, III,
Roger T. Wickers, Edward F. Godfrey and Ralph J. Spuehler, Jr. Keystone Group
provides accounting, bookkeeping, legal, personnel and general corporate
services to Keystone Management, Keystone, their affiliates and the Keystone
Group of Mutual Funds.
Pursuant to the Advisory Agreement, Keystone receives for its services an
annual fee representing 85% of the management fee received by Keystone
Management under the Management Agreement.
During the fiscal year ended August 31, 1994, the Fund paid or accrued to
Keystone Management investment management and administrative services fees of
$4,624,138, which represented 0.50% of the Fund's average net assets. Of such
amount paid to Keystone Management, $3,930,517 was paid to Keystone for its
services to the Fund.
Keystone Management, Keystone and the Fund have each adopted a Code of Ethics
incorporating policies on personal securities trading as recommended by the
Investment Company Institute.
FUND EXPENSES
The Fund will pay all of its expenses. In addition to the investment advisory
and management fees discussed above, the principal expenses that the Fund is
expected to pay include, but are not limited to, expenses of its transfer agent,
its custodian and its independent auditors; expenses under its Distribution
Plan; fees of its Independent Trustees ("Independent Trustees"); expenses of
shareholders' and Trustees' meetings; fees payable to government agencies,
including registration and qualification fees of the Fund and its shares under
federal and state securities laws; expenses of preparing, printing and mailing
Fund prospectuses, notices, reports and proxy material; and certain
extraordinary expenses. In addition to such expenses, the Fund will pay its
brokerage commissions, interest charges and taxes. For the fiscal year ended
August 31, 1994, the Fund paid 1.75% of its average net assets in expenses.
During the fiscal year ended August 31, 1994, the Fund paid or accrued to
Keystone Investor Resource Center, Inc. ("KIRC"), the Fund's transfer and
dividend disbursing agent and Keystone Group, $20,589 for certain accounting
services and $1,911,894 for transfer agent services. KIRC is a wholly-owned
subsidiary of Keystone.
PORTFOLIO MANAGER
Christopher P. Conkey has been the Fund's portfolio manager since January,
1995. He is a Keystone Vice President and Senior Portfolio Manager and has over
eleven years of experience in fixed income investing.
SECURITIES TRANSACTIONS
Keystone selects broker-dealers to execute transactions subject to the receipt
of best execution. When selecting broker-dealers to execute portfolio
transactions for the Fund, Keystone may follow a policy of considering as a
factor the number of shares of the Fund sold by such broker-dealers. In
addition, broker-dealers may, from time to time, be affiliated with the Fund,
Keystone Management, Keystone, the Fund's principal underwriter or their
affiliates.
PORTFOLIO TURNOVER
The Fund's portfolio turnover rates for the fiscal years ended August 31, 1994
and 1993 were 200% and 133%, respectively. High portfolio turnover may involve
correspondingly greater brokerage commissions and other transaction costs, which
will be borne directly by the Fund, as well as additional realized gains and/or
losses to shareholders. The Fund pays brokerage commissions in connection with
the writing of options and effecting the closing purchase or sale transactions,
as well as for certain purchases and sales of portfolio securities.
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HOW TO BUY SHARES
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Shares of the Fund may be purchased from any broker-dealer that has a selling
agreement with Keystone Distributors, Inc. ("KDI"), the Fund's principal
underwriter ("Principal Underwriter"). KDI, a wholly-owned subsidiary of
Keystone, is located at 200 Berkeley Street, Boston, Massachusetts 02116-5034.
In addition, you may open an account for the purchase of Fund shares by
mailing to the Fund, c/o KIRC, P.O. Box 2121, Boston, Massachusetts 02106- 2121,
a completed account application and a check payable to the Fund. Or you may
telephone 1-800-343-2898 to obtain the number of an account to which you can
wire or electronically transfer funds and then send in a completed account
application. Subsequent investments in any amount may be made by check, by
wiring federal funds or by an electronic funds transfer ("EFT").
The Fund's shares are sold at the net asset value per share next computed
after it receives the purchase order. The initial purchase must be at least
$1,000, except for purchases by participants in certain retirement plans for
which the minimum is waived. There is no minimum for subsequent purchases.
Purchase payments are fully invested at net asset value. There are no sales
charges on purchases of Fund shares at the time of purchase.
CONTINGENT DEFERRED SALES CHARGE
With certain exceptions, when shares are redeemed within four calendar years
after their purchase, a contingent deferred sales charge may be imposed at rates
ranging from a maximum of 4% of amounts redeemed during the same calendar year
of purchase to 1% of amounts redeemed during the third calendar year after the
year of purchase. No contingent deferred sales charge is imposed on amounts
redeemed thereafter or on shares purchased through reinvestment of dividends. If
imposed, the contingent deferred sales charge is deducted from the redemption
proceeds otherwise payable to the shareholder. Prior to July 8, 1992, the Fund
retained the deferred sales charge. Since July 8, 1992, the deferred sales
charge attributable to shares purchased prior to January 1, 1992 has been
retained by the Fund, and the deferred sales charge attributable to shares
purchased after January 1, 1992 is, to the extent permitted by NASD rules, paid
to KDI. For the fiscal year ended August 31, 1994, the Fund recovered $188,549
in deferred sales charges.
The contingent deferred sales charge is a declining percentage of the lesser
of (1) the net asset value of the shares redeemed or (2) the total cost of such
shares. No deferred sales charge is imposed when a shareholder redeems amounts
derived from (1) increases in the value of his account above the total cost of
such shares due to increases in the net asset value per share of the Fund; (2)
certain shares with respect to which the Fund did not pay a commission on
issuance, including shares acquired through reinvestment of dividend income and
capital gains distributions; or (3) shares held in all or part of more than four
consecutive calendar years.
In determining whether a contingent deferred sales charge is payable and, if
so, the percentage charge applicable, it is assumed that shares held the longest
are the first to be redeemed. No deferred sales charge is payable on permitted
exchanges of shares between Keystone funds that have adopted distribution plans
pursuant to Rule 12b-1 under the 1940 Act. When shares of one such fund have
been exchanged for shares of another such fund, for purposes of any future
contingent deferred sales charge, the calendar year of the purchase of the
shares of the fund exchanged into, is assumed to be the year shares tendered for
exchange were originally purchased.
In addition, no contingent deferred sales charge is imposed on a redemption of
shares of the Fund in the event of (1) death or disability of the shareholder;
(2) a lump-sum distribution from a 401(k) plan or other benefit plan qualified
under the Employee Retirement Income Security Act of 1974 ("ERISA"); (3)
automatic withdrawals from ERISA plans if the shareholder is at least 59 1/2
years old; (4) involuntary redemptions of accounts having an aggregate net asset
value of less than $1,000; or (5) automatic withdrawals under an automatic
withdrawal plan of up to 1% per month of the shareholder's initial account
balance.
WAIVER OF DEFERRED SALES CHARGE
Shares also may be sold, to the extent permitted by applicable law, at net
asset value without the payment of commissions or the imposition of a deferred
sales charge upon redemption of Fund shares to (1) certain officers, Directors,
Trustees and employees of the Fund, Keystone Management, Keystone and certain of
their affiliates; (2) registered representatives of firms with dealer agreements
with KDI; and (3) a bank or trust company acting as trustee for a single
account.
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DISTRIBUTION PLAN
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The Fund bears some of the costs of selling its shares under a Distribution
Plan adopted on June 1, 1983, pursuant to Rule 12b-1 under the 1940 Act. The
Fund's Distribution Plan provides that the Fund may expend up to 0.3125%
quarterly (approximately 1.25% annually) of the average daily net asset value of
its shares to pay distribution costs for sales of its shares and to pay
shareholder service fees. The NASD currently limits such annual expenditures to
1%, of which 0.75% may be used to pay such distribution costs and 0.25% may be
used to pay shareholder service fees. The aggregate amount that the Fund may pay
for such distribution costs is limited 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 contingent deferred sales charges paid by
shareholders to KDI).
Payments under the Distribution Plan are currently made to KDI (which may
reallow all or part to others, such as dealers) (1) as commissions for Fund
shares sold and (2) as shareholder service fees in respect of shares maintained
by the recipients outstanding on the Fund's books for specified periods. Amounts
paid or accrued to KDI under (1) and (2) in the aggregate may not exceed the
annual limitations referred to above. KDI generally reallows to brokers or
others a commission equal to 4% of the price paid for each Fund share sold as
well as a shareholder service fee at a rate of 0.25% per annum of the net asset
value of shares maintained by such recipients outstanding on the books of the
Fund for specified periods.
If the Fund is unable to pay KDI a commission on a new sale because the annual
maximum (0.75% of average daily net assets) has been reached, KDI intends, but
is not obligated, to continue to accept new orders for the purchase of Fund
shares and to pay or accrue commissions and maintenance fees to dealers in
excess of the amount it currently receives from the Fund. While the Fund is
under no contractual obligation to pay KDI such amounts that exceed the
Distribution Plan limitation, KDI intends to seek full payment of such charges
from the Fund (together with interest at the rate of prime plus one percent) at
such time in the future as, and to the extent that, payment thereof by the Fund
would be within permitted limits. KDI currently intends to seek payment of
interest only on such charges paid or accrued by KDI subsequent to July 7, 1992.
If the Fund's Independent Trustees (the "Independent Trustees") authorize such
payments, the effect would be to extend the period of time during which the Fund
incurs the maximum amount of costs allowed by the Distribution Plan. If the
Distribution Plan is terminated, KDI will ask the Independent Trustees to take
whatever action they deem appropriate under the circumstances with respect to
payment of such amounts.
During the year ended August 31, 1994, the Fund recovered $188,549 in
contingent deferred sales charges. During the year, the Fund paid KDI $9,335,140
under the Distribution Plan. The amount paid by the Fund under its Distribution
Plan, net of contingent deferred sales charges, was $9,146,591 (0.98% of the
Fund's average daily net asset value). For the year ended August 31, 1994, KDI
received $5,118,615 after payments of commissions on new sales and service fees
to dealers and others of $5,770,600. During the year, KDI also received $933,380
in contingent deferred sales charges. At August 31, 1994, KDI's total
unreimbursed 12b-1 expenses amounted to $25,878,976 (2.77% of net assets as of
August 31, 1994), of which $1,554,074 was incurred during the year ended August
31, 1994. The right to certain portions of this amount, if and when receivable,
was assigned by KDI in 1988 in connection with a financial transaction. As of
August 31, 1994, $20,108,977 of the amount assigned remained outstanding.
Accordingly, KDI intends to seek total payment of $25,878,976 with respect to
sales of the Fund's shares from inception of the Distribution Plan to August 31,
1994 to the extent such payments together with payments for future sales will
not exceed the limitations discussed above. At each Trustee's meeting (usually
quarterly), the Independent Trustees of the Fund consider whether to authorize
payments to such extent until the next quarterly Trustees' meeting and, pursuant
to such authorizations, such payments are made. Except as described above, the
Fund has no obligation to pay any portion of this amount, and the times,
conditions for payment of any remainder, and amount, if any, to be paid by the
Fund are solely within the discretion of the Independent Trustees.
The amounts and purposes of expenditures under the Distribution Plan must be
reported to the Independent Trustees quarterly. The Independent Trustees may
require or approve changes in the operation of the Distribution Plan, and may
require that total expenditures by the Fund under the Distribution Plan be kept
within limits lower than the maximum amount permitted by the Distribution Plan
as stated above. 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 Fund's
Independent Trustees or by vote of a majority of the outstanding voting shares
of the Fund. Any change in the Distribution Plan that would materially increase
the distribution expenses of the Fund provided for in the Distribution Plan
requires shareholder approval. Otherwise, the Distribution Plan may be amended
by 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.
Whether any expenditure under the Distribution Plan is subject to a state
expense limit depends upon the nature of the expenditure and the terms of the
state law, regulation or order imposing the limit. A portion of the Fund's
Distribution Plan expenses may be includable in the Fund's total operating
expenses for purposes of determining compliance with state expense limits.
Upon written notice to dealers, KDI, at its own expense, may periodically
sponsor programs that offer additional compensation in connection with sales of
Fund shares. Participation in such programs may be available to all dealers or
to selected dealers who have sold or are expected to sell significant amounts of
shares. Additional compensation may also include financial assistance to dealers
in connection with preapproved seminars, conferences and advertising. No such
programs or additional compensation will be offered to the extent they are
prohibited by the laws of any state or any self-regulatory agency, such as the
NASD.
The Glass-Steagall Act currently limits the ability of a depository
institution (such as a commercial bank or a savings and loan association) to
become an underwriter or distributor of securities. In the event the Glass-
Steagall Act is deemed to prohibit depository institutions from accepting
payments under the arrangement described above, or should Congress relax current
restrictions on depository institutions, the Board of Trustees will consider
what action, if any, is appropriate.
In addition, state securities laws on this issue may differ from the
interpretations of federal law expressed herein and banks and financial
institutions may be required to register as dealers pursuant to state law.
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HOW TO REDEEM SHARES
- --------------------------------------------------------------------------------
Fund shares may be redeemed for cash at the redemption value upon written
order by the shareholder(s) to the Fund, c/o Keystone Investor Resource Center,
Inc., P.O. Box 2121, Boston, Massachusetts 02106-2121, and presentation to the
Fund of a properly endorsed share certificate if certificates have been issued.
The signature(s) of the shareholder(s) on the written order and certificates
must be guaranteed. The redemption value is the net asset value adjusted for
fractions of a cent and may be more or less than the shareholder's cost
depending upon changes in the value of the Fund's portfolio securities between
purchase and redemption. The Fund may impose a deferred sales charge at the time
of redemption of certain shares as explained in "How to Buy Shares." If imposed,
the Fund deducts the deferred sales charge from the redemption proceeds
otherwise payable to the shareholder.
At various times, the Fund may be requested to redeem shares for which it has
not yet received good payment. In such a case the Fund will mail the redemption
proceeds upon clearance of the purchase check, which may take up to 15 days or
more. Any delay as explained in this paragraph may be avoided by purchasing
shares with a certified check drawn on a U.S. bank or by bank wire of funds.
Although the mailing of a redemption check may be delayed, the redemption value
will be determined and the redemption processed in the ordinary course of
business upon receipt of proper documentation. In such a case, after the
redemption and prior to the release of the proceeds, no appreciation or
depreciation will occur in the value of the redeemed shares, and no interest
will be paid on the redemption proceeds. If the mailing of a redemption check
has been delayed, the check will be mailed promptly after good payment has been
collected.
The Fund computes the redemption value at the close of the Exchange at the end
of the day on which it has received all proper documentation from the
shareholder. Payment of the amount due on redemption, less any applicable
deferred sales charge, will be made within seven days thereafter.
Shareholders also may redeem their shares through their broker-dealers. KDI,
acting as agent for the Fund, stands ready to repurchase Fund shares upon orders
from dealers as follows: redemption requests received by broker-dealers prior to
that day's close of trading on the Exchange and transmitted to the Fund prior to
its close of business that day will receive the net asset value per share
computed at the close of trading on the Exchange on the same day. Redemption
requests received by broker-dealers after that day's close of trading on the
Exchange and transmitted to the Fund prior to the close of business on the next
business day will receive the next business day's net asset value price. KDI
will pay the redemption proceeds, less any applicable deferred sales charge, to
the dealer placing the order within seven days thereafter, assuming it has
received proper documentation. KDI charges no fees for this service, but the
shareholder's broker-dealer may do so.
For the protection of shareholders, SIGNATURES ON CERTIFICATES, STOCK POWERS
AND ALL WRITTEN ORDERS OR AUTHORIZATIONS MUST BE GUARANTEED BY A U.S. STOCK
EXCHANGE MEMBER, A BANK OR OTHER PERSONS ELIGIBLE TO GUARANTEE SIGNATURES UNDER
THE SECURITIES EXCHANGE ACT OF 1934 AND KIRC'S POLICIES. The Fund and KIRC may
waive this requirement, but may also require additional documents in certain
cases. Currently, the requirement for a signature guarantee has been waived on
redemptions of $50,000 or less where the account address of record has been the
same for a minimum period of 30 days. The Fund and KIRC reserve the right to
withdraw this waiver at any time.
If the Fund receives a redemption or repurchase order, but the shareholder has
not clearly indicated the amount of money or number of shares involved, the Fund
cannot execute the order. In such cases, the Fund will request the missing
information from the shareholder and process the order the day it receives such
information.
TELEPHONE
Under ordinary circumstances, you may redeem up to $50,000 from your account
by telephone by calling toll free 1-800-343-2898.
In order to insure that instructions received by KIRC are genuine when you
initiate a telephone transaction, you will be asked to verify certain criteria
specific to your account. At the conclusion of the transaction, you will be
given a transaction number confirming your request, and written confirmation of
your transaction will be mailed the next business day. Your telephone
instructions will be recorded. Redemptions by telephone are allowed only if the
address and bank account of record have been the same for a minimum period of of
30 days.
If the redemption proceeds are less than $2,500, they will be mailed by check.
If they are $2,500 or more, they will be mailed, wired or sent by EFT to your
previously designated bank account as you direct. If you do not specify how you
wish your redemption proceeds to be sent, they will be mailed by check.
If you cannot reach the Fund by telephone, you should follow the procedures
for redeeming by mail or through a broker as set forth above.
SMALL ACCOUNTS
Because of the high cost of maintaining small accounts, the Fund reserves the
right to redeem your account if its value falls below $1,000, the current
minimum investment level, as a result of your redemptions (but not as a result
of market action). You will be notified in writing and allowed 60 days to
increase the value of your account to the minimum investment level. No
contingent deferred sales charges are applied to such redemptions.
GENERAL
The Fund reserves the right at any time to terminate, suspend or change the
terms of any redemption method described in this prospectus, except redemption
by mail, and to impose fees.
Except as otherwise noted, neither the Fund, KIRC nor KDI assumes
responsibility for the authenticity of any instructions received by any of them
from a shareholder in writing, over the Keystone Automated Response Line
("KARL") or by telephone. KIRC will employ reasonable procedures to confirm that
instructions received over KARL or by telephone are genuine. Neither the Fund,
KIRC nor KDI will be liable when following instructions received over KARL or by
telephone that KIRC reasonably believes to be genuine.
The Fund may temporarily suspend the right to redeem its shares when (1) the
Exchange is closed, other than customary weekend and holiday closings; (2)
trading on the Exchange is restricted; (3) the Fund cannot dispose of its
investments or fairly determine their value; or (4) the Securities and Exchange
Commission, for the protection of shareholders, so orders.
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SHAREHOLDER SERVICES
- --------------------------------------------------------------------------------
Details on all shareholder services may be obtained from KIRC by calling toll
free 1-800-343-2898.
KEYSTONE AUTOMATED RESPONSE LINE
KARL offers shareholders specific fund account information and price and yield
quotations as well as the ability to effect account transactions, including
investments, exchanges and redemptions. Shareholders may access KARL by dialing
toll free 1-800-346-3858 on any touch-tone telephone, 24 hours a day, seven days
a week.
EXCHANGES
A shareholder who has obtained the appropriate prospectus may exchange shares
of the Fund for shares of any of the other seven Keystone Custodian Funds,
Keystone Precious Metals Holdings, Inc. ("KPMH"), Keystone International Fund
Inc. ("KIF"), Keystone Tax Exempt Trust ("KTET"), Keystone Liquid Trust ("KLT")
or Keystone Tax Free Fund ("KTFF") on the basis of their respective net asset
values by calling toll free 1-800-343-2898 or by writing KIRC at P.O. Box 2121,
Boston, Massachusetts 02106-2121. Fund shares purchased by check may be
exchanged for shares of the named funds, other than KPMH, KTET or KTFF, after 15
days, provided good payment for the purchase of Fund shares has been collected.
In order to exchange Fund shares for shares of KPMH, KTET or KTFF, a shareholder
must have held Fund shares for a period of six months. You may exchange your
shares for another Keystone fund for a $10 fee by calling or writing to
Keystone. The exchange fee is waived for individual investors who make an
exchange using KARL. If the shares being tendered for exchange have been held
for less than four years and are still subject to a deferred sales charge, such
charge will carry over to the shares being acquired in the exchange transaction.
The Fund reserves the right, after 60 days' notice to shareholders, to terminate
this exchange offer or to change its terms, including the right to change the
fee for any exchange.
Orders to exchange shares of the Fund for shares of KLT will be executed by
redeeming the shares of the Fund and purchasing shares of KLT at the net asset
value of KLT shares determined after the proceeds from such redemption become
available, which may be up to seven days after such redemption. In all other
cases, orders for exchanges received by the Fund prior to 4:00 p.m. on any day
the funds are open for business will be executed at the respective net asset
values determined as of the close of business that day. Orders for exchanges
received after 4:00 p.m. on any business day will be executed at the respective
net asset values determined at the close of the next business day.
An excessive number of exchanges may be disadvantageous to the Fund.
Therefore, the Fund, in addition to its right to reject any exchange, reserves
the right to terminate the exchange privilege of any shareholder who makes more
than five exchanges in a year or three in a calendar quarter.
An exchange order must comply with the requirements for a redemption or
repurchase order and must specify the dollar value or number of shares to be
exchanged. Exchanges are subject to the minimum initial purchase requirements of
the fund being acquired. An exchange constitutes a sale for federal income tax
purposes.
The exchange privilege is available only in states where shares of the fund
being acquired may legally be sold.
RETIREMENT PLANS
The Fund has various pension and profit-sharing plans available to investors
including: Individual Retirement Accounts ("IRAs"); Rollover IRAs; Simplified
Employee Pension Plans ("SEPs"); Tax Sheltered Annuity Plans ("TSAs"); 401(k)
Plans; Keogh Plans; Corporate Profit-Sharing Plans; Pension and Target Benefit
Plans; Money Purchase Pension Plans and Salary-Reduction Plans. For details,
including fees and application forms, call KDI toll free at 1-800-247-4075 or
write to KIRC at P.O. Box 2121, Boston, Massachusetts 02106-2121.
AUTOMATIC INVESTMENT PLAN
Shareholders may take advantage of investing on an automatic basis by
establishing an automatic investment plan. Funds are drawn on a shareholder's
checking account monthly and used to purchase Fund shares.
AUTOMATIC WITHDRAWAL PLAN
Under an Automatic Withdrawal Plan, shareholders may arrange for regular
monthly or quarterly fixed withdrawal payments. Each payment must be at least
$100 and may be as much as 1% per month or 3% per quarter of the total net asset
value of the Fund shares in the shareholder's account when the Automatic
Withdrawal Plan is opened. Fixed withdrawal payments are not subject to a
deferred sales charge. Excessive withdrawals may decrease or deplete the value
of a shareholder's account.
OTHER SERVICES
Under certain circumstances shareholders may, within 30 days after a
redemption, reinstate their accounts at current net asset value.
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PERFORMANCE DATA
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From time to time, the Fund may advertise "total return" and "current yield."
BOTH FIGURES ARE BASED ON HISTORICAL EARNINGS AND ARE NOT INTENDED TO INDICATE
FUTURE PERFORMANCE. Total return refers to the Fund's average annual compounded
rates of return over specified periods determined by comparing the initial
amount invested to the ending redeemable value of that amount. The resulting
equation assumes reinvestment of all dividends and distributions and deduction
of all recurring charges, if any, applicable to all shareholder accounts. The
deduction of the contingent deferred sales charge is reflected in the applicable
years. The exchange fee is not included in the calculation.
Current yield quotations represent the yield on an investment for a stated
30-day period computed by dividing net investment income earned per share during
the base period by the maximum offering price per share on the last day of the
base period.
The Fund may include comparative performance information in advertising or
marketing the Fund's shares, such as data from Lipper Analytical Services, Inc.
or other industry publications.
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FUND SHARES
- --------------------------------------------------------------------------------
The Fund currently issues one class of shares, which participate equally in
dividends and distributions and have equal voting, liquidation and other rights.
When issued and paid for, the shares will be fully paid and nonassessable by the
Fund. Shares may be exchanged as explained under "Shareholder Services," but
will have no other preference, conversion, exchange or preemptive rights.
Shareholders are entitled to one vote for each full share owned and fractional
votes for fractional shares. Shares are transferable, redeemable and freely
assignable as collateral. There are no sinking fund provisions. The Fund may
establish additional classes or series of shares.
The Fund does not have annual meetings. The Fund will have special meetings
from time to time as required under its Restatement of Trust Agreement and under
the 1940 Act. As provided in the Fund's Restatement of Trust Agreement,
shareholders have the right to remove Trustees by an affirmative vote of
two-thirds of the outstanding shares. A special meeting of the shareholders will
be held when 10% of the outstanding shares request a meeting for the purpose of
removing a Trustee. The Fund is prepared to assist shareholders in
communications with one another for the purpose of convening such a meeting as
prescribed by Section 16(c) of the 1940 Act.
Under Massachusetts law, it is possible that a Fund shareholder may be held
personally liable for the Fund's obligations. However, the Fund's Restatement of
Trust provides that shareholders shall not be subject to any personal liability
for the Fund's obligations and provides indemnification from Fund assets for any
shareholder held personally liable for the Fund's obligations. Disclaimers of
such liability are included in each Fund agreement.
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ADDITIONAL INFORMATION
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KIRC, located at 101 Main Street, Cambridge, Massachusetts 02142-1519, is a
wholly-owned subsidiary of Keystone and serves as the Fund's transfer agent and
dividend disbursing agent.
When the Fund determines from its records that more than one account in the
Fund is registered in the name of a shareholder or shareholders having the same
address, upon written notice to those shareholders, the Fund intends, when an
annual report or semi-annual report of the Fund is required to be furnished, to
mail one copy of such report to that address.
Except as otherwise stated in this prospectus or required by law, the Fund
reserves the right to change the terms of the offer stated in this prospectus
without shareholder approval, including the right to impose or change fees for
services provided.
<PAGE>
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ADDITIONAL INVESTMENT INFORMATION
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The Fund may engage in the following investment practices to the extent
described in the prospectus and the statement of additional information.
CORPORATE BOND RATINGS
Higher yields are usually available on securities that are lower rated or
that are unrated. Bonds rated Baa by Moody's are considered as medium grade
obligations which are neither highly protected nor poorly secured. Debt rated
BBB by S&P is regarded as having an adequate capacity to pay interest and repay
principal, although adverse economic conditions are more likely to lead to a
weakened capacity to pay interest and repay principal for debt in this category
than in higher rated categories. Lower rated securities are usually defined as
Baa or lower by Moody's or BBB or lower by S&P. The Fund may purchase unrated
securities, which are not necessarily of lower quality than rated securities but
may not be attractive to as many buyers. Debt rated BB, B, CCC, CC and C by S&P
is regarded, on balance, as predominantly speculative with respect to capacity
to pay interest and repay principal in accordance with the terms of the
obligation. BB indicates the lowest degree of speculation and C the highest
degree of speculation. While such debt will likely have some quality and
protective characteristics, these are outweighed by large uncertainties or major
risk exposures to adverse conditions. Debt rated CI by S&P is debt (income
bonds) on which no interest is being paid. Debt rated D by S&P is in default and
payment of interest and/or repayment of principal is in arrears. The Fund
intends to invest in D-rated debt only in cases where in Keystone's judgment
there is a distinct prospect of improvement in the issuer's financial position
as a result of the completion of reorganization or otherwise. Bonds which are
rated Caa by Moody's are of poor standing. Such issues may be in default or
there may be present elements of danger with respect to principal or interest.
Bonds which are rated Ca by Moody's represent obligations which are speculative
in a high degree. Such issues are often in default or have other market
shortcomings. Bonds which are rated C by Moody's are the lowest rated class of
bonds, and issues so rated can be regarded as having extremely poor prospects of
ever attaining any real investment standing.
ZERO COUPON "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 value at
the time of sale) may apply to determine the gain or loss on a sale of any such
zero coupon bonds.
PAYMENT-IN-KIND SECURITIES
Payment-in-kind securities pay interest in either cash or additional
securities, at the issuer's option, for a specified period. The issuer's option
to pay in additional securities typically ranges from one to six years, compared
to an average maturity for all PIK securities of eleven years. Call protection
and sinking fund features are comparable to those offered on traditional debt
issues.
PIKs, like zero coupon bonds, are designed to give an issuer flexibility in
managing cash flow. Several PIKs are senior debt. In other cases, where PIKs are
subordinated, most senior lenders view them as equity equivalents.
An advantage of PIKs for the issuer -- as with zero coupon securities -- is
that interest payments are automatically compounded (reinvested) at the stated
coupon rate, which is not the case with cash-paying securities. However, PIKs
are gaining popularity over zeros since interest payments in additional
securities can be monetized and are more tangible than accretion of a discount.
As a group, PIK bonds trade flat (i.e., without accrued interest). Their price
is expected to reflect an amount representing accreted interest since the last
payment. PIKs generally trade at higher yields than comparable cash- paying
securities of the same issuer. Their premium yield is the result of the lesser
desirability of non-cash interest, the more limited audience for non-cash paying
securities, and the fact that many PIKs have been issued to equity investors who
do not normally own or hold such securities.
Calculating the true yield on a PIK security requires a discounted cash flow
analysis if the security (ex interest) is trading at a premium or a discount
because the realizable value of additional payments is equal to the current
market value of the underlying security, not par.
Regardless of whether PIK securities are senior or deeply subordinated,
issuers are highly motivated to retire them because they are usually their most
costly form of capital.
OBLIGATIONS OF FOREIGN BRANCHES OF UNITED STATES BANKS
The obligations of foreign branches of U.S. banks may be general obligations
of the parent bank in addition to the issuing branch, or may be limited by the
terms of a specific obligation and by government regulation. Payment of interest
and principal upon these obligations may also be affected by governmental action
in the country of domicile of the branch (generally referred to as sovereign
risk). In addition, evidences of ownership of such securities may be held
outside the U.S. and the Fund may be subject to the risks associated with the
holding of such property overseas. Examples of governmental actions would be the
imposition of currency controls, interest limitations, withholding taxes,
seizure of assets or the declaration of a moratorium. Various provisions of
federal law governing domestic branches do not apply to foreign branches of
domestic banks.
OBLIGATIONS OF UNITED STATES BRANCHES OF FOREIGN BANKS
Obligations of U.S. branches of foreign banks may be general obligations of
the parent bank in addition to the issuing branch, or may be limited by the
terms of a specific obligation and by federal and state regulation as well as by
governmental action in the country in which the foreign bank has its head
office. In addition, there may be less publicly available information about a
U.S. branch of a foreign bank than about a domestic bank.
MASTER DEMAND NOTES
Master demand notes are unsecured obligations that permit the investment of
fluctuating amounts by the Fund at varying rates of interest pursuant to direct
arrangements between the Fund, as lender, and the issuer, as borrower. Master
demand notes may permit daily fluctuations in the interest rate and daily
changes in the amount borrowed. The Fund has the right to increase the amount
under the note at any time up to the full amount provided by the note agreement,
or to decrease the amount. The borrower may repay up to the full amount of the
note without penalty. Notes acquired by the Fund must permit the Fund to demand
payment of principal and accrued interest at any time (on not more than seven
days notice). Notes acquired by the Fund may have maturities of more than one
year, provided that (1) the Fund is entitled to payment of principal and accrued
interest upon not more than seven days' notice, and (2) the rate of interest on
such notes is adjusted automatically at periodic intervals which normally will
not exceed 31 days but may extend up to one year. The notes are deemed to have a
maturity equal to the longer of the period remaining to the next interest rate
adjustment or the demand notice period. Because these types of notes are direct
lending arrangements between the lender and borrower, such instruments are not
normally traded and there is no secondary market for these notes, although they
are redeemable and thus repayable by the borrower at face value plus accrued
interest at any time. Accordingly, the Fund's right to redeem is dependent on
the ability of the borrower to pay principal and interest on demand. In
connection with master demand note arrangements, Keystone considers, under
standards established by the Board of Trustees, earning power, cash flow and
other liquidity ratios of the borrower and will monitor the ability of the
borrower to pay principal and interest on demand. These notes are not typically
rated by credit rating agencies. Unless rated, the Fund may invest in them only
if at the time of an investment the issuer meets the criteria established for
commercial paper discussed in the statement of additional information which
limits such investments to commercial paper rated A-1 by S&P, Prime-1 by Moody's
and F-1 by Fitch Investors Service, Inc.
REPURCHASE AGREEMENTS
The Fund may enter into repurchase agreements with member banks of the Federal
Reserve System having at least $1 billion in assets, primary dealers in U.S.
government securities or other financial institutions believed by Keystone to be
credit-worthy. Such persons must be registered as U.S. government securities
dealers with an appropriate regulatory organization. Under such agreements, the
bank, primary dealer or other financial institution agrees upon entering into
the contract to repurchase the security at a mutually agreed upon date and
price, thereby determining the yield during the term of the agreement. This
results in a fixed rate of return insulated from market fluctuations during such
period. Under a repurchase agreement, the seller must maintain the value of the
securities subject to the agreement at not less than the repurchase price, and
such value will be determined on a daily basis by marking the underlying
securities to their market value. Although the securities subject to the
repurchase agreement might bear maturities exceeding a year, the Fund only
intends to enter into repurchase agreements that provide for settlement within a
year and usually within seven days. Securities subject to repurchase agreements
will be held by the Fund's custodian or in the Federal Reserve book entry
system. The Fund does not bear the risk of a decline in the value of the
underlying security unless the seller defaults under its repurchase obligation.
In the event of a bankruptcy or other default of a seller of a repurchase
agreement, the Fund could experience both delays in liquidating the underlying
securities and losses, including (1) possible declines in the value of the
underlying securities during the period while the Fund seeks to enforce its
rights thereto; (2) possible subnormal levels of income and lack of access to
income during this period; and (3) expenses of enforcing its rights. The Board
of Trustees has established procedures to evaluate the creditworthiness of each
party with whom the Fund enters into repurchase agreements by setting guidelines
and standards of review for Keystone and monitoring Keystone's actions with
regard to repurchase agreements.
REVERSE REPURCHASE AGREEMENTS
Under a reverse repurchase agreement, the Fund would sell securities and agree
to repurchase them at a mutually agreed upon date and price. The Fund intends to
enter into reverse repurchase agreements to avoid otherwise having to sell
securities during unfavorable market conditions in order to meet redemptions. At
the time the Fund enters into a reverse repurchase agreement, it will establish
a segregated account with the Fund's custodian containing liquid assets such as
U.S. government securities or other high grade debt securities having a value
not less than the repurchase price (including accrued interest) and will
subsequently monitor the account to ensure such value is maintained. Reverse
repurchase agreements involve the risk that the market value of the securities
which the Fund is obligated to repurchase may decline below the repurchase
price. Borrowing and reverse repurchase agreements magnify the potential for
gain or loss on the portfolio securities of the Fund and, therefore, increase
the possibility of fluctuation in the Fund's net asset value. Such practices may
consititute leveraging. In the event the buyer of securities under a reverse
repurchase agreement files for bankruptcy or becomes insolvent, such buyer or
its trustee or receiver may receive an extension of time to determine whether to
enforce the Fund's obligation to repurchase the securities and the Fund's use of
the proceeds of the reverse repurchase agreement may effectively be restricted
pending such determination. The staff of the Securities and Exchange Commission
has taken the position that the 1940 Act treats reverse repurchase agreements as
being included in the percentage limit on borrowings imposed on the Fund.
"WHEN ISSUED" AND "FORWARD COMMITMENT" TRANSACTIONS
The Fund may also purchase securities on a when issued or delayed delivery
basis and may purchase or sell securities on a forward commitment basis. When
issued and delayed delivery transactions arise when securities are purchased by
the Fund with payment and delivery taking place in the future in order to secure
what is considered to be an advantageous price and yield to the Fund at the time
of purchase. A forward commitment transaction is an agreement by the Fund to
purchase or sell securities at a specified future date. The Fund may also enter
into foreign currency forward contracts which are described in more detail
herein. When the Fund engages in these transactions, the Fund relies on the
buyer or seller, as the case may be, to consummate the sale. Failure to do so
may result in the Fund missing the opportunity to obtain a price or yield
considered to be advantageous. When issued, delayed delivery and forward
commitment transactions may be expected to occur a month or more before delivery
is due. However, no payment or delivery is made by the Fund until it receives
payment or delivery from the other party to the transaction. The Securities and
Exchange Commission has established certain requirements to assure that the Fund
is able to meet its obligations under these contracts, for example a separate
account of liquid assets equal to the value of such purchase commitments may be
maintained until payment is made. When issued, delayed delivery and forward
commitment agreements are subject to risks from changes in value based upon
changes in the level of interest rates, currency rates and other market factors,
both before and after delivery. The Fund does not accrue any income on such
securities or currencies prior to their delivery. To the extent the Fund engages
in any of these transactions, it will do so for the purpose of acquiring
portfolio securities or currencies consistent with its investment objective and
policies and not for the purpose of investment leverage. The Fund currently does
not intend to invest more than 5% of its assets in when issued or delayed
delivery transactions.
FOREIGN SECURITIES
The Fund may invest up to 25% of its assets in securities principally traded
in securities markets outside the U.S. While investment in foreign securities is
intended to reduce risk by providing further diversification, such investments
involve sovereign risk in addition to the credit and market risks normally
associated with domestic securities. Foreign investments may be affected
favorably or unfavorably by changes in currency rates and exchange control
regulations. There may be less publicly available information about a foreign
company than about a U.S. company, and foreign companies may not be subject to
accounting, auditing and financial reporting standards and requirements
comparable to those applicable to U.S. companies. Securities of some foreign
companies are less liquid or more volatile than securities of U.S. companies,
and foreign brokerage commissions and custodian fees are generally higher than
in the United States. Investments in foreign securities may also be subject to
other risks different from those affecting U.S. investments, including local
political or economic developments, expropriation or nationalization of
assets,imposition of withholding taxes on dividend or interest payments and
currency blockage (which would prevent cash from being brought back to the
United States). These risks are carefully considered by Keystone prior to the
purchase of these securities.
LOANS OF SECURITIES TO BROKER-DEALERS
The Fund may lend securities to brokers and dealers pursuant to agreements
requiring that the loans be continuously secured by cash or securities of the
U.S. government, its agencies or instrumentalities, or any combination of cash
and such securities, as collateral equal at all times in value to at least the
market value of the securities loaned. Such securities loans will not be made
with respect to the Fund if as a result the aggregate of all outstanding
securities loans exceeds 15% of the value of the Fund's total assets taken at
their current value. The Fund continues to receive interest or dividends on the
securities loaned and simultaneously earns interest on the investment of the
cash loan collateral in U.S. Treasury notes, certificates of deposit, other
high-grade, short-term obligations or interest bearing cash equivalents.
Although voting rights attendant to securities loaned pass to the borrower, such
loans may be called at any time and will be called so that the securities may be
voted by the Fund if, in the opinion of the Fund, a material event affecting the
investment is to occur. There may be risks of delay in receiving additional
collateral or in recovering the securities loaned or even loss of rights in the
collateral should the borrower of the securities fail financially. Loans may
only be made to borrowers deemed to be of good standing, under standards
approved by the Board of Trustees, when the income to be earned from the loan
justifies the attendant risks.
DERIVATIVES
The Fund may use derivatives while seeking to achieve its investment
objective. Derivatives are financial contracts whose value depends on, or is
derived from, the value of an underlying asset, reference rate or index. These
assets, rates, and indices may include bonds, stocks, mortgages, commodities,
interest rates, currency exchange rates, bond indices and stock indices.
Derivatives can be used to earn income or protect against risk, or both. For
example, one party with unwanted risk may agree to pass that risk to another
party who is willing to accept the risk, the second party being motivated, for
example, by the desire either to earn income in the form of a fee or premium
from the first party, or to reduce its own unwanted risk by attempting to pass
all or part of that risk to the first party.
Derivatives can be used by investors, such as the Fund, to earn income and
enhance returns, to hedge or adjust the risk profile of the portfolio, and
either in place of more traditional direct investments or to obtain exposure to
otherwise inaccessible markets. The Fund is permitted to use derivatives for one
or more of these purposes. The use of derivatives for non-hedging purposes
entails greater risks than if derivatives were used solely for hedging purposes.
The Fund uses futures contracts and related options as well as forwards for
hedging purposes. Derivatives are a valuable tool, which, when used properly,
can provide significant benefit to Fund shareholders. Keystone is not an
aggressive user of derivatives with respect to the Fund. However, the Fund may
take positions in those derivatives that are within its investment policies if,
in Keystone's judgement, this represents an effective response to current or
anticipated market conditions. Keystone's use of derivatives is subject to
continuous risk assessment and control from the standpoint of the Fund's
investment objectives and policies.
Derivatives may be (1) standardized, exchange-traded contracts or (2)
customized, privately negotiated contracts. Exchange-traded derivatives tend to
be more liquid and subject to less credit risk than those that are privately
negotiated.
There are four principal types of derivative instruments--options, futures,
forwards and swaps--from which virtually any type of derivative transaction can
be created. Further information regarding options, futures, forwards and swaps,
is provided later in this section and is provided in the Fund's statement of
additional information.
Debt instruments that incorporate one or more of these building blocks for the
purpose of determining the principal amount of and/or rate of interest payable
on the debt instruments are often referred to as "structured securities." An
example of this type of structured security is indexed commercial paper. The
term is also used to describe certain securities issued in connection with the
restructuring of certain foreign obligations. See "Indexed Commercial Paper" and
"Structured Securities" below. The term "derivative" is also sometimes used to
describe securities involving rights to a portion of the cash flows from an
underlying pool of mortgages or other assets from which payments are passed
through to the owner of, or that collateralize, the securities. See "Mortgage
Related Securities," "Collateralized Mortgage Obligations," "Adjustable Rate
Mortgage Securities," "Stripped Mortgage Securities," "Mortgage Securities -
Special Considerations," and "Other Asset-Backed Securities" and the Fund's
statement of additional information.
While the judicious use of derivatives by experienced investment managers,
such as Keystone, can be beneficial, derivatives also involve risks different
from, and, in certain cases, greater than, the risks presented by more
traditional investments. Following is a general discussion of important risk
factors and issues concerning the use of derivatives that investors should
understand before investing in the Fund.
* Market Risk -- This is the general risk attendant to all investments that the
value of a particular investment will decline or otherwise change in a way
detrimental to the Fund's interest.
* Management Risk -- Derivative products are highly specialized instruments that
require investment techniques and risk analyses different from those
associated with stocks and bonds. The use of a derivative requires an
understanding not only of the underlying instrument, but also of the
derivative itself, without the benefit of observing the performance of the
derivative under all possible market conditions. In particular, the use and
complexity of derivatives require the maintenance of adequate controls to
monitor the transactions entered into, the ability to assess the risk that a
derivative adds to the Fund's portfolio and the ability to forecast price,
interest rate or currency exchange rate movements correctly.
* Credit Risk -- This is the risk that a loss may be sustained by the Fund as a
result of the failure of another party to a derivative (usually referred to as
a "counterparty") to comply with the terms of the derivative contract. The
credit risk for exchange-traded derivatives is generally less than for
privately negotiated derivatives, since the clearing house, which is the
issuer or counterparty to each exchange-traded derivative, provides a
guarantee of performance. This guarantee is supported by a daily payment
system (i.e., margin requirements) operated by the clearing house in order to
reduce overall credit risk. For privately negotiated derivatives, there is no
similar clearing agency guarantee. Therefore, the Fund considers the
creditworthiness of each counterparty to a privately negotiated derivative in
evaluating potential credit risk.
* Liquidity Risk -- Liquidity risk exists when a particular instrument is
difficult to purchase or sell. If a derivative transaction is particularly
large or if the relevant market is illiquid (as is the case with many
privately negotiated derivatives), it may not be possible to initiate a
transaction or liquidate a position at an advantageous price.
* Leverage Risk -- Since many derivatives have a leverage component, adverse
changes in the value or level of the underlying asset, rate or index can
result in a loss substantially greater than the amount invested in the
derivative itself. In the case of swaps, the risk of loss generally is related
to a notional principal amount, even if the parties have not made any initial
investment. Certain derivatives have the potential for unlimited loss,
regardless of the size of the initial investment.
* Other Risks -- Other risks in using derivatives include the risk of mispricing
or improper valuation and the inability of derivatives to correlate perfectly
with underlying assets, rates and indices. Many derivatives, in particular
privately negotiated derivatives, are complex and often valued subjectively.
Improper valuations can result in increased cash payment requirements to
counterparties or a loss of value to the Fund. Derivatives do not always
perfectly or even highly correlate or track the value of the assets, rates or
indices they are designed to closely track. Consequently, the Fund's use of
derivatives may not always be an effective means of, and sometimes could be
counterproductive to, furthering the Fund's investment objective.
OPTIONS TRANSACTIONS
WRITING COVERED OPTIONS. The Fund may write (i.e., sell) covered call and put
options. By writing a call option, the Fund becomes obligated during the term of
the option to deliver the securities underlying the option upon payment of the
exercise price. By writing a put option, the Fund becomes obligated during the
term of the option to purchase the securities underlying the option at the
exercise price if the option is exercised. The Fund also may write straddles
(combinations of covered puts and calls on the same underlying security).
The Fund may only write "covered" options. This means that so long as the Fund
is obligated as the writer of a call option it will own the underlying
securities subject to the option or, in the case of call options on U.S.
Treasury bills, the Fund might own substantially similar U.S. Treasury bills. If
the Fund has written options against all of its securities that are available
for writing options, the Fund may be unable to write additional options unless
it sells a portion of its portfolio holdings to obtain new securities against
which it can write options. If this were to occur, higher portfolio turnover and
correspondingly greater brokerage commissions and other transaction costs may
result. The Fund does not expect, however, that this will occur.
The Fund will be considered "covered" with respect to a put option it writes
if, so long as it is obligated as the writer of the put option, it deposits and
maintains with its custodian in a segregated account liquid assets having a
value equal to or greater than the exercise price of the option.
The principal reason for writing call or put options is to obtain, through a
receipt of premiums, a greater current return than would be realized on the
underlying securities alone. The Fund receives a premium from writing a call or
put option, which it retains whether or not the option is exercised. By writing
a call option, the Fund might lose the potential for gain on the underlying
security while the option is open, and, by writing a put option, the Fund might
become obligated to purchase the underlying security for more than its current
market price upon exercise.
PURCHASING OPTIONS. The Fund may purchase put or call options, including put
or call options for the purpose of offsetting previously written put or call
options of the same series.
If the Fund is unable to effect a closing purchase transaction with respect to
covered options it has written, the Fund will not be able to sell the underlying
securities or dispose of assets held in a segregated account until the options
expire or are exercised.
An option position may be closed out only in a secondary market for an option
of the same series. Although the Fund generally will write only those options
for which there appears to be an active secondary market, there is no assurance
that a liquid secondary market will exist for any particular option at any
particular time, and, for some options, no secondary market may exist. In such
event, it might not be possible to effect a closing transaction in a particular
option.
Options on some securities are relatively new, and it is impossible to predict
the amount of trading interest that will exist in such options. There can be no
assurance that viable markets will develop or continue. The failure of such
markets to develop or continue could significantly impair the Fund's ability to
use such options to achieve its investment objective.
OPTIONS TRADING MARKETS. Options in which the Fund will trade are generally
listed on national securities exchanges. Exchanges on which such options
currently are traded include the Chicago Board Options Exchange and the New
York, American, Pacific and Philadelphia Stock Exchanges. Options on some
securities may not be listed on any exchange, but traded in the over-the-counter
market. Options traded in the over-the-counter market involve the additional
risk that securities dealers participating in such transactions could fail to
meet their obligations to the Fund. The use of options traded in the
over-the-counter market may be subject to limitations imposed by certain state
securities authorities. In addition to the limits on its use of options
discussed herein, the Fund is subject to the investment restrictions described
in this prospectus and in the statement of additional information.
The staff of the Securities and Exchange Commission is of the view that the
premiums that the Fund pays for the purchase of unlisted options and the value
of securities used to cover unlisted options written by the Fund are considered
to be invested in illiquid securities or assets for the purpose of calculating
whether the Fund is in compliance with its policies on illiquid securities.
FUTURES TRANSACTIONS
The Fund may enter into currency and other financial futures contracts and
write options on such contracts. The Fund intends to enter into such contracts
and related options for hedging purposes. The Fund will enter into securities,
currency or index-based futures contracts in order to hedge against changes in
interest or exchange rates or securities prices. A futures contract on
securities or currencies is an agreement to buy or sell securities or currencies
at a specified price during a designated month. A futures contract on a
securities index does not involve the actual delivery of securities, but merely
requires the payment of a cash settlement based on changes in the securities
index. The Fund does not make payment or deliver securities upon entering into a
futures contract. Instead, it puts down a margin deposit, which is adjusted to
reflect changes in the value of the contract and which continues until the
contract is terminated.
The Fund may sell or purchase futures contracts. When a futures contract is
sold by the Fund, the value of the contract will tend to rise when the value of
the underlying securities or currencies declines and to fall when the value of
such securities or currencies increases. Thus, the Fund sells futures contracts
in order to offset a possible decline in the value of its securities or
currencies. If a futures contract is purchased by the Fund, the value of the
contract will tend to rise when the value of the underlying securities or
currencies increases and to fall when the value of such securities or currencies
declines. The Fund intends to purchase futures contracts in order to fix what is
believed by Keystone to be a favorable price and rate of return for securities
or favorable exchange rate for currencies the Fund intends to purchase.
The Fund also intends to purchase put and call options on futures contracts
for hedging purposes. A put option purchased by the Fund would give it the right
to assume a position as the seller of a futures contract. A call option
purchased by the Fund would give it the right to assume a position as the
purchaser of a futures contract. The purchase of an option on a futures contract
requires the Fund to pay a premium. In exchange for the premium, the Fund
becomes entitled to exercise the benefits, if any, provided by the futures
contract, but is not required to take any action under the contract. If the
option cannot be exercised profitably before it expires, the Fund's loss will be
limited to the amount of the premium and any transaction costs.
The Fund may enter into closing purchase and sale transactions in order to
terminate a futures contract and may sell put and call options for the purpose
of closing out its options positions. The Fund's ability to enter into closing
transactions depends on the development and maintenance of a liquid secondary
market. There is no assurance that a liquid secondary market will exist for any
particular contract or at any particular time. As a result, there can be no
assurance that the Fund will be able to enter into an offsetting transaction
with respect to a particular contract at a particular time. If the Fund is not
able to enter into an offsetting transaction, the Fund will continue to be
required to maintain the margin deposits on the contract and to complete the
contract according to its terms, in which case, it would continue to bear market
risk on the transaction.
Although futures and related options transactions are intended to enable the
Fund to manage market, interest rate or exchange rate risk, unanticipated
changes in interest rates, exchange rates or market prices could result in
poorer performance than if it had not entered into these transactions. Even if
Keystone correctly predicts interest or exchange rate movements, a hedge could
be unsuccessful if changes in the value of the Fund's futures position did not
correspond to changes in the value of its investments. This lack of correlation
between the Fund's futures and securities or currencies positions may be caused
by differences between the futures and securities or currencies markets or by
differences between the securities or currencies underlying the Fund's futures
position and the securities or currencies held by or to be purchased for the
Fund. Keystone will attempt to minimize these risks through careful selection
and monitoring of the Fund's futures and options positions.
The Fund does not intend to use futures transactions for speculation or
leverage. The Fund has the ability to write options on futures, but intends to
write such options only to close out options purchased by the Fund. The Fund
will not change these policies without supplementing the information in its
prospectus and statement of additional information.
FOREIGN CURRENCY TRANSACTIONS
As discussed above, the Fund may invest in securities of foreign issuers. When
the Fund invests in foreign securities, they usually will be denominated in
foreign currencies, and the Fund temporarily may hold funds in foreign
currencies. Thus, the value of Fund shares will be affected by changes in
exchange rates.
As one way of managing exchange rate risk, in addition to entering into
currency futures contracts, the Fund may enter into forward currency exchange
contracts (agreements to purchase or sell currencies at a specified price and
date). The exchange rate for the transaction (the amount of currency the Fund
will deliver or receive when the contract is completed) is fixed when the Fund
enters into the contract. The Fund usually will enter into these contracts to
stabilize the U.S. dollar value of a security it has agreed to buy or sell. The
Fund intends to use these contracts to hedge the U.S. dollar value of a security
it already owns, particularly if the Fund expects a decrease in the value of the
currency in which the foreign security is denominated. Although the Fund will
attempt to benefit from using forward contracts, the success of its hedging
strategy will depend on Keystone's ability to predict accurately the future
exchange rates between foreign currencies and the U.S. dollar. The value of the
Fund's investments denominated in foreign currencies will depend on the relative
strength of those currencies and the U.S. dollar, and the Fund may be affected
favorably or unfavorably by changes in the exchange rates or exchange control
regulations between foreign currencies and the dollar. Changes in foreign
currency exchange rates also may affect the value of dividends and interest
earned, gains and losses realized on the sale of securities and net investment
income and gains, if any, to be distributed to shareholders by the Fund.
Although the Fund does not currently intend to do so, the Fund may also purchase
and sell options related to foreign currencies. The Fund does not intend to
enter into foreign currency transactions for speculation or leverage.
INTEREST RATE TRANSACTIONS (SWAPS, CAPS AND FLOORS). If the Fund enters into
interest rate swap, cap or floor transactions, it expects to do so primarily for
hedging purposes, which may include preserving a return or spread on a
particular investment or portion of its portfolio or protecting against an
increase in the price of securities the Fund anticipates purchasing at a later
date. The Fund does not currently intend to use these transactions in a
speculative manner.
Interest rate swaps involve the exchange by the Fund with another party of
their respective commitments to pay or receive interest (e.g., an exchange of
floating rate payments for fixed rate payments). Interest rate caps and floors
are similar to options in that the purchase of an interest rate cap or floor
entitles the purchaser, to the extent that a specified index exceeds (in the
case of a cap) or falls below (in the case of a floor) a predetermined interest
rate, to receive payments of interest on a contractually-based principal
("notional") amount from the party selling the interest rate cap or floor. The
Fund may enter into interest rate swaps, caps and floors on either an
asset-based or liability-based basis, depending upon whether it is hedging its
assets or liabilities, and will usually enter into interest rate swaps on a net
basis (i.e., the two payment streams are netted out, with the Fund receiving or
paying, as the case may be, only the net amount of the two payments).
The swap market has grown substantially in recent years, with a large number
of banks and investment banking firms acting as principals and as agents
utilizing standardized swap documentation. As a result, the swap market has
become more established and relatively liquid. Caps and floors are less liquid
than swaps. These transactions also involve the delivery of securities or other
underlying assets and principal. Accordingly, the risk of loss to the Fund from
interest rate transactions is limited to the net amount of interest payments
that the Fund is contractually obligated to make.
INDEXED COMMERCIAL PAPER. Indexed commercial paper may have its principal linked
to changes in foreign currency exchange rates whereby its principal amount is
adjusted upwards or downwards (but not below zero) at maturity to reflect
changes in the referenced exchange rate. If permitted by its investment
policies, the Fund will purchase such commercial paper with the currency in
which it is denominated and, at maturity, will receive interest and principal
payments thereon in that currency, but the amount of principal payable by the
issuer at maturity will change in proportion to the change (if any) in the
exchange rate between the two specified currencies between the date the
instrument is issued and the date the instrument matures. While such commercial
paper entails the risk of loss of principal, the potential for realizing gains
as a result of changes in foreign currency exchange rates enables the Fund to
hedge (or cross-hedge) against a decline in the U.S. dollar value of investments
denominated in foreign currencies while providing an attractive money market
rate of return.
MORTGAGE-RELATED SECURITIES. The mortgage-related securities in which the Fund
may invest typically are securities representing interests in pools of mortgage
loans made to home owners. Mortgage-related securities bear interest at either a
fixed rate or an adjustable rate determined by reference to an index rate. The
mortgage loan pools may be assembled for sale to investors (such as the Fund) by
governmental or private organizations. Mortgage-related securities issued by the
Government National Mortgage Association ("GNMA") are backed by the full faith
and credit of the U.S. government; those issued by Federal National Mortgage
Associated ("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC") are not
so backed.
Securities representing interests in pools created by private issuers
generally offer a higher rate of interest than securities representing interests
in pools created by governmental issuers because there are no direct or indirect
governmental guarantees of the underlying mortgage payments. However, private
issuers sometimes obtain committed loan facilities, lines of credit, letters of
credit, surety bonds or other forms of liquidity and credit enhancement to
support the timely payment of interest and principal with respect to their
securities if the borrowers on the underlying mortgages fail to make their
mortgage payments. The ratings of such non-governmental securities are generally
dependent upon the ratings of the providers of such liquidity and credit support
and would be adversely affected if the rating of such an enhancer were
downgraded. The Fund may buy mortgage-related securities without credit
enhancement if the securities meet the Fund's investment standards. Although the
market for mortgage-related securities is becoming increasingly liquid, those of
certain private organizations may not be readily marketable.
One type of mortgage-related security is of the "pass-through" variety. The
holder of a pass-through security is considered to own an undivided beneficial
interest in the underlying pool of mortgage loans and receives a pro rata share
of the monthly payments made by the borrowers on their mortgage loans, net of
any fees paid to the issuer or guarantor of the securities. Prepayments of
mortgages resulting from the sale, refinancing or foreclosure of the underlying
properties are also paid to the holders of these securities. Some
mortgage-related securities, such as securities issued by GNMA, are referred to
as "modified pass-through" securities. The holders of these securities are
entitled to the full and timely payment of principal and interest, net of
certain fees, regardless of whether payments are actually made on the underlying
mortgages. Another form of mortgage-related security is a "pay- through"
security, which is a debt obligation of the issuer secured by a pool of mortgage
loans pledged as collateral that is legally required to be paid by the issuer
regardless of whether payments are actually made on the underlying mortgages.
COLLATERALIZED MORTGAGE OBLIGATIONS. ("CMOs") are the predominant type of
"pay-through" mortgage-related security. CMOs are designed to reduce the risk of
prepayment for investors by issuing multiple classes of securities, each having
different maturities, interest rates and payment schedules, and with the
principal and interest on the underlying mortgages allocated among the several
classes in various ways. The collateral securing the CMOs may consist of a pool
of mortgages, but may also consist of mortgage-backed bonds or pass-through
securities. CMOs may be issued by a U.S. government instrumentality or agency or
by a private issuer. Although payment of the principal of, and interest on, the
underlying collateral securing privately issued CMOs may be guaranteed by GNMA,
FNMA or FHLMC, these CMOs represent obligations solely of the private issuer and
are not insured or guaranteed by GNMA, FNMA, FHLMC, any other governmental
agency or any other person or entity.
INVERSE FLOATING RATE COLLATERALIZED MORTGAGE OBLIGATIONS. In addition to
investing in fixed rate and adjustable rate CMOs, the Fund may also invest in
CMOs with rates that move inversely to market rates ("inverse floaters").
An inverse floater bears an interst rate that resets in the opposite direction
of the change in a specified interest rate index. As market interest rates rise,
the interest rate on the inverse floater goes down, and vice versa. Inverse
floaters tend to exhibit greater price volatility than fixed-rate bonds of
similar maturity and credit quality. The interest rates on inverse floaters may
be significantly reduced, even to zero, if interest rates rise. Moreover, the
secondary market for inverse floaters may be limited in rising interest rate
environments.
ADJUSTABLE RATE MORTGAGE SECURITIES. Another type of mortgage-related security,
known as adjustable-rate mortgage securities ("ARMS"), bears interest at a rate
determined by reference to a predetermined interest rate or index. There are two
main categories of rates or indices: (1) rates based on the yield on U.S.
Treasury securities and (2) indices derived from a calculated measure such as a
cost of funds index or a moving average of mortgage rates. Some rates and
indices closely mirror changes in market interest rate levels, while others tend
to lag changes in market rate levels and tend to be somewhat less volatile.
ARMS may be secured by adjustable-rate mortgages or fixed-rate mortgages. ARMS
secured by fixed-rate mortgages generally have lifetime caps on the coupon rates
of the securities. To the extent that general interest rates increase faster
than the interest rates on the ARMS, these ARMS will decline in value. The
adjustable-rate mortgages that secure ARMS will frequently have caps that limit
the maximum amount by which the interest rate or the monthly principal and
interest payments on the mortgages may increase. These payment caps can result
in negative amortization (i.e., an increase in the balance of the mortgage
loan). Furthermore, since many adjustable-rate mortgages only reset on an annual
basis, the values of ARMS tend to fluctuate to the extent that changes in
prevailing interest rates are not immediately reflected in the interest rates
payable on the underlying adjustable-rate mortgages.
STRIPPED MORTGAGE SECURITIES. Stripped mortgage-related securities ("SMRS") are
mortgage-related securities that are usually structured with two classes of
securities collateralized by a pool of mortgages or a pool of mortgaged-backed
bonds or pass-through securities, with each class receiving different
proportions of the principal and interest payments from the underlying assets. A
common type of SMRS has one class of interest-only securities ("IOs") receiving
all of the interest payments from the underlying assets, while the other class
of securities, principal-only securities ("POs"), receives all of the principal
payments from the underlying assets. IOs and POs are extremely sensitive to
interest rate changes and are more volatile than mortgage-related securities
that are not stripped. IOs tend to decrease in value as interest rates decrease,
while POs generally increase in value as interest rates decrease. If prepayments
of the underlying mortgages are greater than anticipated, the amount of interest
earned on the overall pool will decrease due to the decreasing principal balance
of the assets. Changes in the values of IOs and POs can be substantial and occur
quickly, such as occurred in the first half of 1994 when the value of many POs
dropped precipitously due to increase in interest rates. For this reason the
Fund does not rely on IOs and POs as the principal means of furthering its
investment objective.
MORTGAGE-RELATED SECURITIES -- SPECIAL CONSIDERATIONS. The value of
mortgage-related securities is affected by a number of factors. Unlike
traditional debt securities, which have fixed maturity dates, mortgage-related
securities may be paid earlier than expected as a result of prepayment of the
underlying mortgages. If property owners make unscheduled prepayments of their
mortgage loans, these prepayments will result in the early payment of the
applicable mortgage-related securities. In that event the Fund may be unable to
invest the proceeds from the early payment of the mortgage-related securities in
an investment that provides as high a yield as the mortgage-related securities.
Consequently, early payment associated with mortgage-related securities causes
these securities to experience significantly greater price and yield volatility
than experienced by traditional fixed-income securities. The occurrence of
mortgage prepayments is affected by the level of general interest rates, general
economic conditions and other social and demographic factors. During periods of
falling interest rates, the rate of mortgage prepayments tends to increase,
thereby tending to decrease the life of mortgage-related securities. During
periods of rising interest rates, the rate of mortgage prepayments usually
decreases, thereby tending to increase the life of mortgage-related securities.
If the life of a mortgage-related security is inaccurately predicted, the Fund
may not be able to realize the rate of return it expected.
As with fixed-income securities generally, the value of mortgage-related
securities can also be adversely affected by increases in general interest rates
relative to the yield provided by such securities. Such adverse effect is
especially possible with fixed-rate mortgage securities. If the yield available
on other investments rises above the yield of the fixed-rate mortgage securities
as a result of general increases in interest rate levels, the value of the
mortgage-related securities will decline. Although the negative effect could be
lessened if the mortgage-related securities were to be paid earlier (thus
permitting the Fund to reinvest the prepayment proceeds in investments yielding
the higher current interest rate), as described above the rate of mortgage
prepayments and earlier payment of mortgage-related securities generally tends
to decline during a period of rising interest rates.
Although the value of ARMS may not be affected by rising interest rates as
much as the value of fixed-rate mortgage securities is affected by rising
interest rates, ARMS may still decline in value as a result of rising interest
rates. Although, as described above, the yield on ARMS varies with changes in
the applicable interest rate or index, there is often a lag between increases in
general interest rates and increases in the yield on ARMS as a result of
relatively infrequent interest rate reset dates. In addition, adjustable-rate
mortgages and ARMS often have interest rate or payment caps that limit the
ability of the adjustable-rate mortgages or ARMS to fully reflect increases in
the general level of interest rates.
OTHER ASSET-BACKED SECURITIES. The securitization techniques used to develop
mortgage-related securities are being applied to a broad range of financial
assets. Through the use of trusts and special purpose corporations, various
types of assets, including automobile loans and leases, credit card receivables,
home equity loans, equipment leases and trade receivables, are being securitized
in structures similar to the structures used in mortgage securitizations. These
asset-backed securities are subject to risks associated with changes in interest
rates and prepayment of underlying obligations similar to the risks of
investment in mortgage-related securities discussed above.
Each type of asset-backed security also entails unique risks depending on the
type of assets involved and the legal structure used. For example, credit card
receivables are generally unsecured obligations of the credit card holder and
the debtors are entitled to the protection of a number of state and federal
consumer credit laws, many of which give such debtors the right to set off
certain amounts owed on the credit cards, thereby reducing the balance due.
There have also been proposals to cap the interest rate that a credit card
issuer may charge. In some transactions, the value of the asset-backed security
is dependent on the performance of a third party acting as credit enhancer or
servicer. Furthermore, in some transactions (such as those involving the
securitization of vehicle loans or leases) it may be administratively burdensome
to perfect the interest of the security issuer in the underlying collateral and
the underlying collateral may become damaged or stolen.
VARIABLE, FLOATING AND LEVERAGED INVERSE FLOATING RATE INSTRUMENTS. Fixed-
income securities may have fixed, variable or floating rates of interest.
Variable and floating rate securities pay interest at rates that are adjusted
periodically, according to a specified formula. A "variable" interest rate
adjusts at predetermined intervals (e.g., daily, weekly or monthly), while a
"floating" interest rate adjusts whenever a specified benchmark rate (such as
the bank prime lending rate) changes.
If permitted by its investment policies, the Fund may invest in fixed-income
securities that pay interest at a coupon rate equal to a base rate, plus
additional interest for a certain period of time if short-term interest rates
rise above a predetermined level or "cap." The amount of such an additional
interest payment typically is calculated under a formula based on a short-term
interest rate index multiplied by a designated factor.
An inverse floater may be considered to be leveraged to the extent that its
interest rate varies by a magnitude that exceeds the magnitude of the change in
the index rate of interest. The higher degree of leverage inherent in inverse
floaters is associated with greater volatility in market value.
STRUCTURED SECURITIES. Structured securities represent interests in entities
organized and operated solely for the purpose of restructuring the investment
characteristics of sovereign debt obligations or foreign government securities.
This type of restructuring involves the deposit with or purchase by an entity,
such as a corporation or trust, of specified instruments (such as commercial
bank loans or Brady Bonds) and the issuance by that entity of one or more
classes of structured securities backed by, or representing interests in, the
underlying instruments. The cash flow on the underlying instruments may be
apportioned among the newly issued structured securities to create securities
with different investment characteristics such as varying maturities, payment
priorities and interest rate provisions, and the extent of the payments made
with respect to structured securities is dependent on the extent of the cash
flow on the underlying instruments. Because structured securities typically
involve no credit enhancement, their credit risk generally will be equivalent to
that of the underlying instruments. Structured securities of a given class may
be either subordinated or unsubordinated to the right of payment of another
class. Subordinated structured securities typically have higher yields and
present greater risks than unsubordinated structured securities.
BRADY BONDS. Brady Bonds are created through the exchange of existing commercial
bank loans to foreign entities for new obligations in connection with debt
restructurings under a plan introduced by former U.S. Secretary of the Treasury,
Nicholas F. Brady (the "Brady Plan"). Brady Bonds have been issued only
recently, and, accordingly, do not have a long payment history. They may be
collateralized or uncollateralized and issued in various currencies (although
most are U.S. dollar-denominated) and they are actively traded in the
over-the-counter secondary market.
U.S. dollar-denominated, collateralized Brady Bonds, which may be fixed-rate
par bonds or floating rate discount bonds, are generally collateralized in full
as to principal due at maturity by U.S. Treasury zero coupon obligations that
have the same maturity as the Brady Bonds. Interest payments on these Brady
Bonds generally are collateralized by cash or securities in an amount that, in
the case of fixed rate bonds, is equal to at least one year of rolling interest
payments based on the applicable interest rate at that time and is adjusted at
regular intervals thereafter. Certain Brady Bonds are entitled to "value
recovery payments" in certain circumstances, which in effect constitute
supplemental interest payments, but generally are not collateralized. Brady
Bonds are often viewed as having up to four valuation components: (1)
collateralized repayment of principal at final maturity, (2) collateralized
interest payments, (3) uncollateralized interest payments, and (4) any
uncollateralized repayment of principal at maturity (these uncollateralized
amounts constitute the "residual risk"). In the event of a default with respect
to collateralized Brady Bonds as a result of which the payment obligations of
the issuer are accelerated, the U.S. Treasury zero coupon obligations held as
collateral for the payment of principal will not be distributed to investors,
nor will such obligations be sold and the proceeds distributed. The collateral
will be held by the collateral agent to the scheduled maturity of the defaulted
Brady Bonds, which will continue to be outstanding, at which time the face
amount of the collateral will equal the principal payments that would have then
been due on the Brady Bonds in the normal course. In addition, in light of the
residual risk of Brady Bonds and, among other factors, the history of defaults
with respect to commercial bank loans by public and private entities of
countries issuing Brady Bonds, investments in Brady Bonds are to be viewed as
speculative.
<PAGE>
KEYSTONE CUSTODIAN K E Y S T O N E
FAMILY OF FUNDS
*
B-1 High Grade Bond Fund
B-2 Diversified Bond Fund
B-4 High Income Bond Fund
K-1 Balanced Income Fund
K-2 Strategic Growth Fund
S-1 Blue Chip Stock Fund
S-3 Capital Growth Fund
S-4 Small Company Growth Fund
International Fund
Precious Metals Holdings
Tax Free Fund
Tax Exempt Trust B-2 DIVERSIFIED
Liquid Trust BOND FUND
[Logo]
[Logo] KEYSTONE PROSPECTUS AND
Distributors, Inc. APPLICATION
200 Berkeley Street
Boston, Massachusetts 02116-5034
B2-P 12/94
15M
<PAGE>
STATEMENT OF ADDITIONAL INFORMATION
KEYSTONE CUSTODIAN FUND, SERIES B-2
Diversified Bond Fund
December 29, 1994
This statement of additional information is not a prospectus, but
relates to, and should be read in conjunction with, the Fund's prospectus dated
December 29, 1994. A copy of the prospectus may be obtained from Keystone
Distributors, Inc. ("KDI"), the Fund's principal underwriter ("Principal
Underwriter"), 200 Berkeley Street, Boston, Massachusetts, 02116-5034 or your
broker-dealer.
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TABLE OF CONTENTS
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Page
The Fund's Objective and Policies 2
Investment Restrictions 2
Valuation of Securities 4
Distributions and Taxes 5
Sales Charges 6
Distribution Plan 8
The Trust Agreement 10
Investment Manager 12
Investment Adviser 14
Trustees and Officers 16
Principal Underwriter 20
Brokerage 21
Standardized Total Return
and Yield Quotations 23
Additional Information 23
Appendix A-1
Financial Statements F-1
Independent Auditors' Report F-16
<PAGE>
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THE FUND'S OBJECTIVE AND POLICIES
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The Fund is an open-end, diversified management investment company. The
Fund's investment objective is to provide shareholders with maximum income
without undue risk of principal. To achieve this objective, the Fund invests
primarily in bonds and obligations that are normally characterized by liberal
returns and moderate price fluctuations. Such bonds, which include both secured
and unsecured debt obligations, as a group possess a fairly high degree of
dependability of interest payments. While the Fund's primary objective is
income, the Fund gives careful consideration to security of principal,
marketability and diversification. The Fund invests primarily in securities of
domestic companies, but may also invest up to 25% of its assets in foreign
securities. On August 31, 1994, the Fund owned foreign securities equal to 9.7%
(denominated in US dollars) of its net assets.
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INVESTMENT RESTRICTIONS
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None of the restrictions enumerated in this paragraph may be changed
without a vote of the holders of a majority, as defined in the Investment
Company Act of 1940 (the "1940 Act"), of the Fund's outstanding shares. The Fund
will not do the following:
(1) invest more than 5% of its total assets, computed at market value,
in the securities of any one issuer, other than securities issued or guaranteed
by the United States ("U.S.") government, 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;
(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 limited 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.
If a percentage limit is satisfied at the time of investment or
borrowing, a later increase or decrease resulting from a change in the value of
a security or a decrease in Fund assets is not a violation of the limit.
Although not fundamental restrictions or policies requiring a
shareholders' vote to change, the Fund has undertaken to a state securities
authority that, so long as the state authority requires and shares of the Fund
are registered for sale in that state, the Fund will (1) limit its purchase of
warrants to 5% of net assets, of which 2% may be warrants not listed on the New
York or American Stock Exchange; (2) not invest in real estate limited
partnership interests; and (3) not invest in oil, gas or other mineral leases.
Additional restrictions adopted by the Fund, which may be changed by
the Board of Trustees, provide that the Fund may not purchase or retain
securities of an issuer if, to the knowledge of the Fund, officers, Trustees or
Directors of the Fund, Keystone Management, Inc. ("Keystone Management") or
Keystone Custodian Funds, Inc. ("Keystone"), each owning beneficially more than
1/2 of 1% of the securities of such issuer, own, in the aggregate, more than 5%
of the securities of such issuer, or such persons or management personnel of the
Fund, Keystone Management or Keystone have a substantial beneficial interest in
the securities of such issuer. Portfolio securities of the Fund may not be
purchased from or sold or loaned to Keystone Management, Keystone or any
affiliate thereof or any of their Directors, officers or employees.
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.
The Fund intends to follow policies of the Securities and Exchange
Commission as they are adopted from time to time with respect to illiquid
securities, including, at this time, (1) treating as illiquid securities which
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 such securities on
its books and (2) limiting its holdings of such securities to 15% of its net
assets.
In order to permit the sale of Fund shares in certain states, the Fund
may make commitments more restrictive than the investment restrictions described
above. Should the Fund determine that any such commitment is no longer in the
best interests of the Fund, it will revoke the commitment by terminating sales
of its shares in the state involved.
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VALUATION OF SECURITIES
- --------------------------------------------------------------------------------
Current value for the Fund's portfolio securities is determined in the
following manner:
Securities that are 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. 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.
Short- term money market instruments that are purchased with maturities of sixty
days or less are valued at amortized cost (original purchase cost as adjusted
for amortization of premium or accretion of discount), which, when combined with
accrued interest, approximates market. Short-term money market instruments
maturing in more than sixty days for which market quotations are readily
available are valued at current market value. Short-term money market
instruments having maturities of more than sixty days when purchased that are
held on the sixtieth day prior to maturity are valued at amortized cost (market
value on the sixtieth day adjusted for amortization of premium or accretion of
discount), which, when combined with accrued interest, approximates market; and
in any case reflects fair value as determined by the Fund's Board of Trustees.
The Board of Trustees values the following at prices it deems in good
faith to be fair: (1) securities, including restricted securities, for which
complete quotations are not readily available; (2) listed securities, if in the
Fund's opinion the last sales price does not reflect a current market value or
if no sale occurred; and (3) other assets. While market quotations may be
readily available for certain long-term corporate bonds and notes, such
investments are stated at fair value on the basis of valuations furnished by a
pricing service, approved by the Board of Trustees, which determines valuations
for normal, institutional-size trading units of such securities using methods
based on market transactions for comparable securities and various relationships
between securities that are generally recognized by institutional traders.
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DISTRIBUTIONS AND TAXES
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The Fund ordinarily makes distributions in shares of the Fund or, at
the option of the shareholder, in cash. All shareholders may reinvest dividends
without being subject to a deferred sales charge when shares so purchased are
redeemed. Shareholders who have opted prior to the record date to receive shares
with regard to capital gains and/or income distributions will have the number of
such shares determined on the basis of the share value computed at the end of
the day on the record date after adjustment for the distribution. Net asset
value is used in computing the appropriate number of shares in both a capital
gains distribution and an income distribution reinvestment. Account statements
and/or checks as appropriate will be mailed to shareholders by the 15th of the
appropriate month. Unless the Fund receives instructions to the contrary from a
shareholder before the record date, it will assume that the shareholder wishes
to receive that distribution and future gains and income distributions in
shares. Instructions continue in effect until changed in writing.
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 70% corporate dividends received deduction. Distributed long-term
capital gains are taxable as such to the shareholder whether received in cash or
in additional Fund shares and regardless of the period of time Fund shares have
been held by the shareholder. Distributions designated by the Fund as capital
gains dividends are not eligible for the 70% corporate dividends received
deduction. If the net asset value of shares were reduced below a shareholder's
cost by distribution of capital gains realized on sales of securities, 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
securities profits actually realized, 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. Shareholders of the
Fund will be advised annually of the federal tax status of distributions.
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SALES CHARGES
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In order to reimburse the Fund for certain expenses relating to the
sale of its shares (see "Distribution Plan"), a contingent deferred sales charge
may be imposed at the time of redemption of certain Fund shares within four
calendar years after their purchase. If imposed, the contingent deferred sales
charge is deducted from the redemption proceeds otherwise payable to the
shareholder. Since July 8, 1992, the deferred sales charge attributable to
shares purchased prior to January 1, 1992 has been retained by the Fund, and the
deferred sales charge attributable to shares purchased after January 1, 1992 is,
to the extent permitted by the National Association of Securities Dealers, Inc.
("NASD"), paid to KDI. During the fiscal year ended August 31, 1994, the Fund
recovered $188,549 in deferred sales charges.
The contingent deferred sales charge is a declining percentage of the
lesser of (1) the net asset value of the shares redeemed, or (2) the total cost
of such shares. No deferred sales charge is imposed when the shareholder redeems
amounts derived from (1) increases in the value of his account above the total
cost of such shares due to increases in the net asset value per share of the
Fund, or (2) certain shares with respect to which the Fund did not pay a
commission on issuance, including shares acquired through reinvestment of
dividend income and capital gains distributions, or (3) shares held in all or
part of more than four consecutive calendar years.
Subject to the limitations stated above, the Fund imposes the deferred
sales charge according to the following schedule: 4% of amounts redeemed during
the calendar year of purchase; 3% of amounts redeemed during the calendar year
after the year of purchase; 2% of amounts redeemed during the second calendar
year after the year of purchase; and 1% of amounts redeemed during the third
calendar year after the year of purchase. No deferred sales charge is imposed on
amounts redeemed thereafter.
The following example will illustrate the operation of the contingent
deferred sales charge. Assume that an investor makes a purchase payment of
$10,000 during the calendar year 1994 and on a given date in 1995 the value of
the investor's account has grown through investment performance and reinvestment
of distributions to $12,000. On such date in 1995, the investor could redeem up
to $2,000 ($12,000 minus $10,000) without incurring a deferred sales charge. If,
on such date, the investor should redeem $3,000, a deferred sales charge would
be imposed on $1,000 of the redemption (the amount by which the investor's
account was reduced by the redemption below the amount of the initial purchase
payment). The charge would be imposed at the rate of 3% (because the redemption
is made during the calendar year after the calendar year of purchase) and would
total $30.
In determining whether a contingent deferred sales charge is payable
and, if so, the percentage charge applicable, it is assumed that shares held the
longest are the first to be redeemed. There is no deferred sales charge on
permitted exchanges of shares between Keystone funds that have adopted
Distribution Plans pursuant to Rule 12b-1 under the 1940 Act. Moreover, when
shares of one such fund have been exchanged for shares of another such fund, for
purposes of any future contingent deferred sales charge, the calendar year of
the purchase of the shares of the fund exchanged into is assumed to be the year
shares tendered for exchange were originally purchased.
Shares also may be sold, to the extent permitted by applicable law,
regulations, interpretations or exemptions, at net asset value without the
imposition of a deferred sales charge, upon redemption of shares by (1)
officers, Directors, Trustees, full-time employees and sales representatives of
Keystone Management, Keystone, Keystone Group, Inc. ("Keystone Group"), Harbor
Capital Management Company, Inc., their subsidiaries and the Principal
Underwriter who have been such for not less than ninety days; and (2) the
pension and profit-sharing plans established by said companies, their
subsidiaries and affiliates, for the benefit of their officers, Directors,
Trustees, full-time employees and sales representatives, provided all such sales
are made upon the written assurance of the purchaser that the purchase is made
for investment purposes and that the securities will not be resold except
through redemption by the Fund.
In addition, no deferred sales charge is imposed on a redemption of
shares of the Fund purchased by a bank or trust company in a single account in
the name of such bank or trust company as trustee if the initial investment in
shares of the Fund, any other Keystone Custodian Fund (as hereinafter defined),
Keystone Precious Metals Holdings, Inc., Keystone International Fund Inc.,
Keystone Tax Exempt Trust, Keystone Tax Free Fund, Keystone Liquid Trust and/or
any Keystone America Fund (as hereinafter defined) is at least $500,000 and any
commission paid by the Fund and such other funds at the time of such purchase is
not more than 1% of the amount invested.
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DISTRIBUTION PLAN
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Rule 12b-1 under the 1940 Act permits investment companies, such as the
Fund, to use their assets to bear expenses of distributing their shares if they
comply with various conditions, including adoption of a Distribution Plan
containing certain provisions set forth in Rule 12b-1. The Fund bears some of
the costs of selling its shares under a Distribution Plan adopted on June 1,
1983 pursuant to Rule 12b-1.
The Fund's Distribution Plan provides that the Fund may expend up to
0.3125% quarterly (approximately 1.25% annually) of 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%, of
which 0.75% may be used to pay such distribution costs and 0.25% may be used to
pay shareholder service fees. The aggregate amount that the Fund may pay for
such distribution costs is limited 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 contingent deferred sales charges paid by
shareholders to KDI).
Payments under the Distribution Plan are currently made to KDI (which
may reallow all or part to others, such as dealers) (1) as commissions for Fund
shareas sold; and (2) as shareholder service fees in respect of shares
maintained by the recipients outstanding on the Fund's books for specific
periods. Amounts paid or accrued to KDI under (1) and (2) in the aggregate may
not exceed the annual limitation referred to above. KDI generally reallows to
brokers or others a commission equal to 4% of the price paid for each Fund share
sold as well as a shareholder service fee at a rate of 0.25% per annum of the
net asset value of shares maintained by such recipients outstanding on the books
of the Fund for specified periods.
If the Fund is unable to pay KDI a commission on a new sale because the
annual maximum (0.75% of average daily net assets) has been reached, KDI
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 dealers in excess of
the amount it currently receives from the Fund. While the Fund is under no
contractual obligation to repay KDI for such amounts in excess of Distribution
Plan limitations, KDI intends to seek full payment of such charges from the Fund
(together with interest rate of prime plus one percent) at such time in the
future as, and to the extent that, payment thereof by the Fund would be within
permitted limits. KDI currently intends to seek payment of interest only on such
charges paid or accrued by KDI subsequent to July 7, 1992. If the Fund's
independent Trustees ("Independent Trustees") authorize such payments, the
effect will be to extend the period of time during which the Fund incurs the
maximum amount of costs allowed by the Distribution Plan. If the Distribution
Plan is terminated, KDI will ask the Independent Trustees to take whatever
action they deem appropriate under the circumstances with respect to payment of
such amounts. If under changing conditions KDI were to seek payment of interest
on such amounts, any such interest payments also would have to be approved by
the Independent Trustees (and possibly the shareholders).
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 Rule 12b-1 Trustees ("Rule 12b-1 Trustees") quarterly. The Fund's Rule
12b-1 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 Rule
12b-1 Trustees, or by vote of a majority of the outstanding voting securities of
the Fund. Any change in the Distribution Plan that would materially increase the
distribution expenses of the Fund provided for in the Distribution Plan requires
shareholder approval. Otherwise, the Distribution Plan may be amended by the
Trustees, including the Fund's Rule 12b-1 Trustees.
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.
During the fiscal year ended August 31, 1994, the Fund paid KDI
$9,335,140 under the Distribution Plan. During the year, KDI received $5,118,615
after payment of commissions on new sales and service fees to dealers and others
of $5,770,600.
Whether any expenditure under the Distribution Plan is subject to a
state expense limit will depend upon the nature of the expenditure and the terms
of the state law, regulation or order imposing the limit. A portion of the
Fund's Distribution Plan expenses may be includable in the Fund's total
operating expenses for purposes of determining compliance with state expense
limits.
The Independent Trustees of the Fund have determined that the sales of
the Fund's shares resulting from payments under the Distribution Plan have
benefited the Fund.
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THE TRUST AGREEMENT
- --------------------------------------------------------------------------------
The Fund is a Pennsylvania common law trust established under a
Declaration of Trust Agreement, amended and restated as of December 19, 1989
(the "Declaration of Trust"). The Declaration of Trust 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 Declaration of Trust is filed 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 Declaration of Trust.
DESCRIPTION OF SHARES
The Declaration of Trust authorizes the issuance of an unlimited number
of shares of beneficial interest and the creation of additional series and/or
classes of series of Fund shares. Each share represents an equal proportionate
interest in the Fund with each other share of that class. Upon liquidation,
shares are entitled to a pro rata share in the net assets of their class of Fund
shares. Shareholders shall have no preemptive or conversion rights. Shares are
transferable. The Fund currently intends to issue only one class of shares.
SHAREHOLDER LIABILITY
Pursuant to court decisions or other theories of law shareholders of a
Pennsylvania common law trust could possibly be held personally liable for the
obligations of the trust. The possibility of Fund shareholders incurring
financial loss under such circumstances appears to be remote, however, because
the Declaration of Trust (1) contains an express disclaimer of shareholder
liability for obligations of the Fund; (2) requires that notice of such
disclaimer be given in each agreement, obligation or instrument entered into or
executed by the Fund or the Trustees; and (3) provides for indemnification out
of Fund property for any shareholder held personally liable for the obligations
of the Fund.
VOTING RIGHTS
Under the terms of the Declaration of Trust, the Fund does not hold
annual meetings. At shareholder meetings, shares are entitled to one vote per
share. Shares generally vote together as one class on all matters. No amendment
may be made to the Declaration of Trust, however, that adversely affects any
class of shares without the approval of a majority of the shares of that class.
There shall be no cumulative voting in the election of Trustees.
After the initial meeting electing Trustees, no further meetings of
shareholders for the purpose of electing Trustees will be held, unless required
by law or until such time as less than a majority of the Trustees holding office
have been elected by shareholders, at which time the Trustees then in office
will call a 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 two-thirds vote of the remaining Trustees;
(2) when such Trustee becomes mentally or physically incapacitated; or (3) at a
special meeting of shareholders by a two-thirds vote of the outstanding shares.
Any Trustee may voluntarily resign from office.
LIMITATION OF TRUSTEES' LIABILITY
The Declaration of Trust provides that a Trustee 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 Declaration of Trust 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.
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INVESTMENT MANAGER
- --------------------------------------------------------------------------------
Subject to the general supervision of the Fund's Board of Trustees,
Keystone Management, located at 200 Berkeley Street, Boston, Massachusetts
02116-5034, serves as investment manager to the Fund and is responsible for the
overall management of the Fund's business and affairs. Keystone Management,
organized in 1989, is a wholly-owned subsidiary of Keystone and its directors
and principal executive officers have been affiliated with Keystone, a seasoned
investment adviser, for a number of years. Keystone Management also serves as
investment manager to each of the other Keystone Custodian Funds and to certain
other Keystone funds.
Except as otherwise noted below, pursuant to an Investment Management
Agreement with the Fund (the "Management Agreement") and subject to the
supervision of the Fund's Board of Trustees, Keystone Management manages and
administers the operation of the Fund and manages the investment and
reinvestment of the Fund's assets in conformity with the Fund's investment
objectives and restrictions. The Management Agreement stipulates that Keystone
Management shall provide office space, all necessary office facilities,
equipment and personnel in connection with its services under the Management
Agreement and pay or reimburse the Fund for the compensation of Fund officers
and Trustees who are affiliated with the investment manager as well as pay all
expenses of Keystone Management incurred in connection with the provision of its
services. All charges and expenses other than those specifically referred to as
being borne by Keystone Management will be paid by the Fund, including, but not
limited to, custodian charges and expenses; bookkeeping and auditors' charges
and expenses; transfer agent charges and expenses; fees of Independent Trustees;
brokerage commissions, brokers' fees and expenses; issue and transfer taxes;
costs and expenses under the Fund's Distribution Plan; taxes and trust fees
payable to governmental agencies; the cost of share certificates; fees and
expenses of the registration and qualification of the Fund and its shares with
the Securities and Exchange Commission (sometimes referred to herein as the
"SEC" or the "Commission") or under state or other securities laws; expenses of
preparing, printing and mailing prospectuses, statements of additional
information, notices, reports and proxy materials to shareholders of the Fund;
expenses of shareholders' and Trustees' meetings; charges and expenses of legal
counsel for the Fund and for the Trustees of the Fund on matters relating to the
Fund; 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 Management Agreement permits Keystone Management to enter into an
agreement with Keystone or another investment adviser, under which Keystone or
such other investment adviser, as investment adviser, will provide substantially
all the services to be provided by Keystone Management under the Management
Agreement. The Management Agreement also permits Keystone Management to delegate
to Keystone or another investment adviser substantially all of the investment
manager's rights, duties and obligations under the Management Agreement.
Services performed by Keystone Management include (1) performing research and
planning with respect to (a) the Fund's qualification as a regulated investment
company under Subchapter M of the Internal Revenue Code, (b) tax treatment of
the Fund's portfolio investments, (c) tax treatment of special corporate actions
(such as reorganizations), (d) state tax matters affecting the Fund, and (e) the
Fund's distributions of income and capital gains; (2) preparing the Fund's
federal and state tax returns; (3) providing services to the Fund's shareholders
in connection with federal and state taxation and distributions of income and
capital gains; and (4) storing documents relating to the Fund's activities.
The Fund pays Keystone Management a fee for its services at the annual
rate of:
Aggregate Net
Annual Asset Value of the
Management Fee Income Shares of the Fund
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2% of Gross Dividend, and
Interest Income, Plus
0.50% of the first $ 100,000,000 plus
0.45% of the next $ 100,000,000 plus
0.40% of the next $ 100,000,000 plus
0.35% of the next $ 100,000,000 plus
0.30% of the next $ 100,000,000 plus
0.25% of amounts over $ 500,000,000;
computed as of the close of business on each business day and paid daily.
The Fund is subject to certain state annual expense limitations, the
most restrictive of which is as follows:
2.5% of the first $30 million of Fund average net assets;
2.0% of the next $70 million of Fund average net assets; and
1.5% of Fund average net assets over $100 million.
Capital charges and certain expenses, including a portion of the Fund's
Distribution Plan expenses, are not included in the calculation of the state
expense limitation. This limitation may be modified or eliminated in the future.
As a continuing condition of registration of shares in a state,
Keystone Management has agreed to reimburse the Fund annually for certain
operating expenses incurred by the Fund in excess of certain percentages of the
Fund's average daily net assets. Keystone Management is not required, however,
to make such reimbursements to the extent it would result in the Fund's
inability to qualify as a regulated investment company under provisions of the
Internal Revenue Code. This condition may be modified or eliminated in the
future.
The Management Agreement continues in effect only if approved at least
annually by the Fund's Board of Trustees or by a vote of a majority of the
outstanding shares, and such renewal has been 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 Management 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 Management Agreement will terminate
automatically upon its "assignment" as that term is defined in the 1940 Act.
For additional discussion of fees paid to Keystone Management, see
"Investment Adviser" below.
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INVESTMENT ADVISER
- --------------------------------------------------------------------------------
Pursuant to its Management Agreement with the Fund Keystone Management
has delegated its investment management functions, except for certain
administrative and management services to Keystone and has entered into an
Investment Advisory Agreement (the "Advisory Agreement"), with Keystone under
which Keystone provides investment advisory and management services to the Fund.
Keystone, located at 200 Berkeley Street, Boston, Massachusetts
02116-5034, has provided investment advisory and management services to
investment companies and private accounts since it was organized in 1932.
Keystone is a wholly-owned subsidiary of Keystone Group, 200 Berkeley Street,
Boston, Massachusetts 02116-5034.
Keystone Group is a corporation privately owned by current and former
members of Keystone's management and its affiliates. The shares of Keystone
Group common stock beneficially owned by management are held in a number of
voting trusts, the trustees of which are George S. Bissell, Albert H. Elfner,
III, Roger T. Wickers, Edward F. Godfrey, and Ralph J. Spuehler, Jr. Keystone
Group provides accounting, bookkeeping, legal, personnel and general corporate
services to Keystone Management, Keystone, their affiliates and the Keystone
Group of Mutual Funds.
Pursuant to the Advisory Agreement, Keystone receives for its services
an annual fee representing 85% of the management fee received by Keystone
Management under the Management Agreement.
Pursuant to the Advisory Agreement and subject to the supervision of
the Fund's Board of Trustees, Keystone manages and administers the Fund's
operation and manages the investment and reinvestment of the Fund's assets in
conformity with the Fund's investment objectives and restrictions. The Advisory
Agreement stipulates that Keystone shall provide office space, all necessary
office facilities, equipment and personnel in connection with its services under
the Advisory Agreement and pay or reimburse the Fund for the compensation of
Fund officers and Trustees who are affiliated with the investment adviser and
will pay all expenses of Keystone 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, custodian charges and expenses; bookkeeping and auditors' charges and
expenses; transfer agent charges and expenses; fees of Independent Trustees;
brokerage commissions, brokers' fees and expenses; issue and transfer taxes;
costs and expenses under the Fund's Distribution Plan; taxes and trust fees
payable to governmental agencies; the cost of share certificates; fees and
expenses of the registration and qualification of the Fund and its shares with
the SEC or under state or other securities laws; expenses of preparing, printing
and mailing prospectuses, statements of additional information, notices, reports
and proxy materials to shareholders of the Fund; expenses of shareholders' and
Trustees' meetings; charges and expenses of legal counsel for the Fund and for
the Trustees of the Fund on matters relating to the Fund; charges and expenses
of filing annual and other reports with the SEC and other authorities; and all
extraordinary charges and expenses of the Fund.
During the year ended August 31, 1992, the Fund paid or accrued to
Keystone Management investment management and administrative services fees of
$4,613,248, which represented 0.54% of the Fund's average net assets. Of such
amount paid to Keystone Management, $3,921,260 was paid to Keystone for its
services to the Fund.
During the year ended August 31, 1993, the Fund paid or accrued to
Keystone Management investment management and administrative services fees of
$4,866,030 which represented 0.52% of the Fund's average net assets. Of such
amount paid to Keystone Management, $4,136,126 was paid to Keystone for its
services to the Fund.
During the year ended August 31, 1994, the Fund paid or accrued to
Keystone Management investment management and administrative fees of $4,624,138,
representing 0.50% of the Fund's average net assets. Of such amount paid to
Keystone Management, $3,930,517 was paid to Keystone for its services to the
Fund.
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TRUSTEES AND OFFICERS
- --------------------------------------------------------------------------------
Trustees and officers of the Fund, their principal occupations and some
of their affiliations over the last five years are as follows:
*GEORGE S. BISSELL: Chairman of the Board, Trustee and Chief Executive Officer
of the Fund; Chairman of the Board, Director and Chief Executive
Officer of Keystone Group, Keystone, Keystone Management, Keystone
Software Inc. ("Keystone Software"), Keystone Fixed Income Advisers,
Inc. ("KFIA") and Keystone Investor Resource Center, Inc. ("KIRC");
Chairman of the Board, Chief Executive Officer and Trustee or Director
of Keystone America Capital Preservation and Income Fund, Keystone
America Capital Preservation and Income Fund II, Keystone America
Intermediate Term Bond Fund, Keystone America Strategic Income Fund,
Keystone America World Bond Fund, Keystone Tax Free Income Fund,
Keystone America State Tax Free Fund, Keystone America State Tax Free
Fund - Series II, Keystone America Fund for Total Return, Keystone
America Global Opportunities Fund, Keystone America Hartwell Emerging
Growth Fund, Inc., Keystone America Hartwell Growth Fund, Inc.,
Keystone America Omega Fund, Inc., Keystone Fund of the Americas
Luxembourg, Keystone Fund of the Americas - U.S., and Keystone
Strategic Development Fund (collectively, "Keystone America Funds");
Keystone Custodian Funds, Series B-1, B-4, K- 1, K-2, S-1, S-3, and
S-4; Keystone International Fund, Keystone Precious Metals Holdings,
Inc., Keystone Tax Free Fund, Keystone Tax Exempt Trust, Keystone
Liquid Trust (collectively, "Keystone Custodian Funds"); Keystone
Institutional Adjustable Rate Fund and Master Reserves Trust (all such
funds, collectively, "Keystone Group Funds"); Chairman of the Board,
Hartwell Keystone Advisers, Inc. ("Hartwell Keystone"); Director of
Keystone Investment Management Corporation ("KIMCO"); Chairman of the
Board and Trustee of Anatolia College; and Trustee of University
Hospital (and Chairman of its Investment Committee).
FREDERICK AMLING: Trustee of the Fund; Trustee or Director of all other Keystone
Group Funds; Professor, Finance Department, George Washington
University; President, Amling & Company (investment advice); Member,
Board of Advisers, Credito Emilano (banking); and former Economics and
Financial Consultant, Riggs National Bank.
CHARLES A. AUSTIN III: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Managing Director, Seaward Management Corporation
(investment advice); and former Director, Executive Vice President and
Treasurer, State Street Research & Management Company (investment
advice).
*ALBERT H. ELFNER, III: President and Trustee of the Fund; President and
Trustee or Director of all other Keystone Group Funds; Director and
Vice Chairman of Keystone; Chief Operating Officer, President and
Director of Keystone Group; Chairman of the Board and Director of KIMCO
and KFIA; President and Director of Keystone Management, Hartwell
Keystone and Keystone Software; Director of KDI, KIRC, Fiduciary
Investment Company, Inc. ("FICO") and Robert Van Partners, Inc.;
Director of Boston Children's Services Association and Trustee of
Anatolia College, Middlesex School and Middlebury College ; Member,
Board of Governors, New England Medical Center; former Trustee of
Neworld Bank and former President of Keystone.
EDWIN D. CAMPBELL: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Executive Director, Coalition of Essential
Schools, Brown University; Director and former Executive Vice
President, National Alliance of Business; former Vice President,
Educational Testing Services; and former Dean, School of Business,
Adelphi University.
CHARLES F. CHAPIN: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; former Group Vice President, Textron Corp.; and
former Director, Peoples Bank (Charlotte, N.C).
LEROY KEITH, JR.: Trustee of the Fund; Trustee or Director of all other Keystone
Group Funds; 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.
K. DUN GIFFORD: Trustee of the Fund; Trustee or Director of all other Keystone
Group Funds; Chairman of the Board, Director and Executive Vice
President, The London Harness Company; Managing Partner, Roscommon
Capital Corp.; Trustee, Cambridge College; Chairman Emeritus and
Director, American Institute of Food and Wine; Chief Executive Officer,
Gifford Gifts of Fine Foods; Chairman, Gifford, Drescher & Associates
(environmental consulting); President, Oldways Preservation and
Exchange Trust (education); and former Director, Keystone Group and
Keystone.
F. RAY KEYSER, JR.: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Of Counsel, Keyser, Crowley & Meub, P.C.; Member,
Governor's (VT) Council of Economic Advisers; Chairman of the Board and
Director, Central Vermont Public Service Corporation and Hitchcock
Clinic; Director, Vermont Yankee Nuclear Power Corporation, Vermont
Electric Power Company, Inc., Grand Trunk Corporation, Central Vermont
Railway, Inc., S.K.I. Ltd., Sherburne Corporation, Union Mutual Fire
Insurance Company, New England Guaranty Insurance Company, Inc. and the
Investment Company Institute; former Governor of Vermont; former
Director and President, Associated Industries of Vermont; former
Chairman and President, Vermont Marble Company; former Director of
Keystone; and former Director and Chairman of the Board, Green Mountain
Bank.
DAVID M. RICHARDSON: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Executive Vice President, DHR International, Inc.
(executive recruitment); former Senior Vice President, Boyden
International Inc. (executive recruit- ment); and Director, Commerce
and Industry Association of New Jersey, 411 International, Inc. and J &
M Cumming Paper Co.
RICHARD J. SHIMA: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Chairman, Environmental Warranty, Inc., and
Consultant, Drake Beam Morin, Inc. (executive outplacement); Director
of Connecticut Natural Gas Corporation, Trust Company of Connecticut,
Hartford Hospital, Old State House Association and Enhanced Financial
Services, Inc.; Member, Georgetown College Board of Advisors; Chairman,
Board of Trustees, Hartford Graduate Center; Trustee, Kingswood- Oxford
School and Greater Hartford YMCA; former Director, Executive Vice
President and Vice Chairman of The Travelers Corporation; and former
Managing Director of Russell Miller, Inc.
ANDREW J. SIMONS: Trustee of the Fund; Trustee or Director of all other Keystone
Group Funds; Partner, Farrell, Fritz, Caemmerer, Cleary, Barnosky &
Armentano, P.C.; President, Nassau County Bar Association; former
Associate Dean and Professor of Law, St. John's University School of
Law.
EDWARD F. GODFREY: Senior Vice President of the Fund; Senior Vice President of
all other Keystone Group Funds; Senior Vice President, Chief Financial
Officer and Treasurer of Keystone Group and KDI; Director of Keystone
Group; Director, Senior Vice President, Chief Financial Officer and
Treasurer of Keystone; Treasurer of KIMCO, Keystone Management,
Keystone Software, Inc. and FICO; and Treasurer and Director of
Hartwell Keystone.
JAMES R. McCALL: Senior Vice President of the Fund; Senior Vice President of all
other Keystone Group Funds; and President of Keystone.
ROGER T. WICKERS: Senior Vice President of the Fund; Senior Vice President of
all other Keystone Group Funds; Director, Senior Vice President,
General Counsel and Secretary, Keystone Group and KDI; Director and
Secretary, Keystone; and Vice President, Assistant Secretary and
Director, Keystone Management.
KEVIN J. MORRISSEY: Treasurer of the Fund; Treasurer of all other Keystone Group
Funds; Vice President of Keystone Group; and former Vice President and
Treasurer of KIRC.
CHRISTOPHER P. CONKEY: Vice President of the Fund.
ROSEMARY D. VAN ANTWERP: Vice President and Secretary of the Fund; Vice
President and Secretary of all other Keystone Group Funds; Senior Vice
President and General Counsel of Keystone, Keystone Management,
Hartwell Keystone, KIRC, KFIA, Keystone Software and KIMCO; Vice
President, Assistant Secretary and Associate General Counsel of
Keystone Group; Senior Vice President, General Counsel, Director and
Assistant Clerk, FICO; Assistant Secretary of KDI.
* This Trustee may be considered an "interested person" within the meaning of
the 1940 Act.
Mr. Bissell and Mr. Elfner are "interested persons" by virtue of their
positions as officers and/or Directors of Keystone Group and several of its
affiliates including Hartwell Keystone, KDI and KIRC. Mr. Bissell and Mr. Elfner
own shares of Keystone Group. Mr. Bissell is Chairman of the Board, Chief
Executive Officer and Director of Keystone Group. Mr. Elfner is President,
Director and Chief Operating Officer of Keystone Group.
During the fiscal year ended August 31, 1994, no Trustee affiliated
with Keystone or any officer received any direct remuneration from the Fund.
During the same period, the nonaffiliated Trustees received $51,945 in retainers
and fees. On November 30, 1994, the Trustees, officers and members of the
Advisory Board of Keystone beneficially owned less than 1% of the Fund's
outstanding shares.
The address of all the Fund's Trustees, officers and Advisory Board
members is 200 Berkeley Street, Boston, Massachusetts 02116- 5034.
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PRINCIPAL UNDERWRITER
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Pursuant to a Principal Underwriting Agreement ("Underwriting
Agreement"), KDI acts as the Fund's Principal Underwriter. KDI, located at 200
Berkeley Street, Boston, Massachusetts 02116-5034, is a Delaware corporation
wholly-owned by Keystone. KDI, as agent, has agreed to use its best efforts to
find purchasers for the shares. KDI may retain and employ representatives to
promote distribution of the shares and may obtain orders from brokers, dealers
and others, acting as principals, for sales of shares to them. The Underwriting
Agreement provides that KDI will bear the expense of preparing, printing and
distributing advertising and sales literature and prospectuses used by it. In
its capacity as Underwriter, KDI 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 by a majority of the Fund's
Independent Trustees at least annually at a meeting called for that purpose, and
if its continuance is approved annually by vote of a majority of Trustees, or by
vote of a majority of the outstanding shares.
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" as that term is defined in the 1940 Act.
From time to time, if in KDI's judgment it could benefit the sales of
Fund shares, KDI may use its discretion in providing to selected dealers
promotional materials and selling aids including, but not limited to, personal
computers, related software and Fund data files.
For the fiscal years ended August 31, 1992 and 1993, KDI earned
commissions of $3,177,962 and $4,799,745, respectively, after allowing
commissions and service fees of $7,432,151 and $8,804,930, respectively, to
retail dealers under the Distribution Plan. For the fiscal year ended August 31,
1994, KDI received $5,118,615 after payments of commissions on new sales and
services to dealers and others of $5,770,600.
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BROKERAGE
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It is the policy of the Fund, in effecting transactions in portfolio
securities, to seek best execution of orders at the most favorable prices. The
determination of what may constitute best execution and price in the execution
of a securities transaction by a broker involves a number of considerations,
including, without limitation, the overall direct net economic result to the
Fund, involving both price paid or received and any commissions and other costs
paid, the efficiency with which the transaction is effected, the ability to
effect the transaction at all where a large block is involved, the availability
of the broker to stand ready to execute potentially difficult transactions in
the future and the financial strength and stability of the broker. Such
considerations are judgmental and are weighed by management in determining the
overall reasonableness of brokerage commissions paid.
Subject to the foregoing, a factor in the selection of brokers is the
receipt of research services, such as analyses and reports concerning issuers,
industries, securities, economic factors and trends and other statistical and
factual information. Any such research and other statistical and factual
information provided by brokers to the Fund, Keystone Management or Keystone is
considered to be in addition to and not in lieu of services required to be
performed by Keystone Management under its Management Agreement with the Fund or
Keystone under its Advisory Agreement with Keystone Management. The cost, value
and specific application of such information are indeterminable and cannot be
practically allocated among the Fund and other clients of Keystone Management or
Keystone 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 such other clients. Under the Management
Agreement and the Advisory Agreement, Keystone Management and Keystone are
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 Management and Keystone do follow such a practice,
they will do so on a basis which is fair and equitable to the Fund.
The Fund expects that purchases and sales of bonds and money market
instruments usually will be principal transactions. Bonds and money market
instruments are normally purchased directly from the issuer or from an
underwriter or market maker for the securities. There usually will be no
brokerage commissions paid by the Fund for such purchases. Purchases from
underwriters will include the underwriting commission or concession and
purchases from dealers serving as market makers will include the spread between
the bid and asked prices. 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.
The Fund may participate, if and when practicable, in group bidding for
the purchase directly from an issuer of certain securities for the Fund's
portfolio in order to take advantage of the lower purchase price available to
members of such a group.
Neither Keystone, Keystone Management, nor the Fund have any intention
of placing securities transactions with any particular broker-dealer or group
thereof. The Fund's Board of Trustees, however, has determined that the Fund may
follow a policy of considering sales of shares as a factor in the selection of
broker-dealers to execute portfolio transactions, subject to the requirements of
best execution, including best price, described above.
The policy of the Fund with respect to brokerage is and will be
reviewed by the Fund's Board of Trustees from time to time. Because of the
possibility of further regulatory developments affecting the securities
exchanges and brokerage practices generally, the foregoing practices may be
changed, modified or eliminated.
Investment decisions for the Fund are made independently by Keystone
Management or Keystone from those of the other funds and investment accounts
managed by Keystone Management or Keystone. It may frequently develop that the
same investment decision is made for more than one fund. Simultaneous
transactions are inevitable when the same security is suitable for the
investment objective of more than one account. When two or more funds or
accounts are engaged in the purchase or sale of the same security, the
transactions are allocated as to amount in accordance with a formula that is
equitable to each fund or account. It is recognized that in some cases this
system could have a detrimental effect on the price or volume of the security as
far as the Fund is concerned. In other cases, however, it is believed that the
ability of the Fund to participate in volume transactions will produce better
executions for the Fund.
For the fiscal years ended August 31, 1992, 1993 and 1994, the Fund
paid no brokerage commissions.
In no instance are portfolio securities purchased from or sold to
Keystone Management, Keystone, KDI or any of their affiliated persons, as
defined in the 1940 Act and rules and regulations issued thereunder.
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STANDARDIZED TOTAL RETURN AND YIELD QUOTATIONS
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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 cumulative total return of the Fund for the one, five and ten year
periods ended August 31, 1994 were (6.22)% (including contingent deferred sales
charge), 37.12% and 137.69%, respectively. The average annual compounded return
for the five and ten year periods ended August 31, 1994 was 6.52% and 9.04%,
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 current yield of the Fund for the 30-day period ended August 31,
1994 was (0.59)%.
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ADDITIONAL INFORMATION
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State Street Bank and Trust Company, 225 Franklin Street, Boston,
Massachusetts 02110, is custodian of all securities and cash of the Fund (the
"Custodian"). The Custodian may hold securities of some foreign issuers outside
the U.S. The Custodian performs no investment management functions for the Fund
but, in addition to its custodial services, is responsible for accounting and
related recordkeeping on behalf of the Fund.
KPMG Peat Marwick, LLP, One Boston Place, Boston, Massachusetts 02108,
Certified Public Accountants, are the independent auditors for the Fund.
KIRC, 101 Main Street, Cambridge, Massachusetts 02142, a wholly owned
subsidiary of Keystone, acts as transfer agent and dividend disbursing agent for
the Fund.
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.
On November 30, 1994, Merrill Lynch, Pierce, Fenner & Smith, Att.: Book
Entry, 4800 Deer Lake Drive E, 3rd Floor, Jacksonville, FL 32246-6484 owned
14.62% of the Fund's then outstanding shares.
No dealer, salesman or other person is authorized to give any
information or to make any representation not contained in the Fund's
prospectus, this statement of additional information or in supplemental sales
literature issued by the Fund or the Principal Underwriter, and no person is
entitled to rely on any information or representation not contained therein.
The Fund's prospectus and this statement of additional information omit
certain information contained in the Fund's 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.
<PAGE>
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APPENDIX
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COMMON AND PREFERRED STOCK RATINGS
A. S&P'S EARNINGS AND DIVIDEND RANKINGS FOR COMMON STOCKS
Because the investment process involves assessment of various factors,
such as product and industry position, corporate resources and financial policy,
with results that make some common stocks more highly esteemed than others,
Standard & Poor's Corporation ("S&P") believes that earnings and dividend
performance is the end result of the interplay of these factors and that, over
the long run, the record of this performance has a considerable bearing on
relative quality. S&P rankings, however, do not reflect all of the factors,
tangible or intangible, that bear on stock quality.
Growth and stability of earnings and dividends are deemed key elements
in establishing S&P earnings and dividend rankings for common stocks, which
capsulize the nature of this record in a single symbol.
S&P has established a computerized scoring system based on per share
earnings and dividend records of the most recent ten years, a period deemed long
enough to measure a company's performance under varying economic conditions. S&P
measures growth, stability within the trend line and cyclicality. The ranking
system also makes allowances for company size, since large companies have
certain inherent advantages over small ones. From these scores for earnings and
dividends are determined.
The final score for each stock is measured against a scoring matrix
determined by analysis of the scores of a large and representative sample which
is reviewed and sometimes modified with the following ladder of rankings:
A+ Highest B+ Average C Lowest
A High B Below Average D In Reorganization
A- Above Average B- Lower
S&P believes its rankings are not a forecast of future market price
performance, but are basically an appraisal of past performance of earnings and
dividends, and relative current standing.
B. MOODY'S COMMON STOCK RANKINGS
Moody's Investor Service, Inc. ("Moody's") presents a concise statement
of the important characteristics of a company and an evaluation of the grade
(quality) of its common stock. Data presented includes: (a) capsule stock
information which reveals short and long term growth and yield afforded by the
indicated dividend, based on a recent price; (b) a long term price chart which
shows patterns of monthly stock price movements and monthly trading volumes; (c)
a breakdown of a company's capital account which aids in determining the degree
of conservatism or financial leverage in a company's balance sheet; (d) interim
earnings for the current year to date, plus three previous years; (e) dividend
information; (f) company background; (g) recent corporate developments; (h)
prospects for a company in the immediate future and the next few years; and (i)
a ten year comparative statistical analysis.
This information provides investors with information on what a company
does, how it has performed in the past, how it is performing currently and what
its future performance prospects appear to be.
These characteristics are then evaluated and result in a grading, or
indication of quality. The grade is based on an analysis of each company's
financial strength, stability of earnings and record of dividend payments. Other
considerations include conservativeness of capitalization, depth and caliber of
management, accounting practices, technological capabilities and industry
position. Evaluation is represented by the following grades:
(1) High Grade
(2) Investment Grade
(3) Medium Grade
(4) Speculative Grade
C. MOODY'S PREFERRED STOCK RATINGS
Preferred stock ratings and their definitions are as follows:
1. aaa: An issue which 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 which 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 which is rated "a" is considered to be an upper-medium
grade preferred stock. While risks are judged to be somewhat greater than in the
"aaa" and "aa" classification, earnings and asset protection are, nevertheless,
expected to be maintained at adequate levels.
4. baa: An issue which 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 which 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.
6. b: An issue which is rated "b" generally lacks the characteristics
of a desirable investment. Assurance of dividend payments and maintenance of
other terms of the issue over any long period of time may be small.
7. caa: An issue which is rated "caa" is likely to be in arrears on
dividend payments. This rating designation does not purport to indicate the
future status of payments.
8. ca: An issue which is rated "ca" is speculative in a high degree and
is likely to be in arrears on dividends with little likelihood of eventual
payments.
9. c: This is the lowest rated class of preferred or preference stock.
Issues so rated can be regarded as having extremely poor prospects of ever
attaining any real investment standing.
Moody's applies numerical modifiers 1, 2 and 3 in each rating
classification: the modifier 1 indicates thatthe 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.
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 double taxation and to pass through
income to the holder of the partnership unit at lower individual rates.
A master limited partnership is a publicly traded limited partnership.
The partnership units are registered with the Securities and Exchange Commission
and are freely exchanged on a securities exchange or in the over-the-counter
market.
CORPORATE BOND RATINGS
A. S&P CORPORATE BOND RATINGS
An S&P corporate bond rating is a current assessment of the
creditworthiness of an obligor, including obligors outside the United States,
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 "A" 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.
B. MOODY'S CORPORATE BOND RATINGS
Moody's ratings are as follows:
1. Aaa - Bonds which are rated Aaa are judged to be of the best
quality. They carry the smallest degree of investment risk and are generally
referred to as "gilt-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 which are rated Aa are judged to be of high quality by
all standards. Together with the Aaa group they comprise what are generally
known as high grade bonds. They are rated lower than the best bonds because
margins of protection may not be as large as in Aaa securities or fluctuation of
protective elements may be of greater amplitude or there may be other elements
present which make the long term risks appear somewhat larger than in Aaa
securities.
3. A - Bonds which are rated A possess many favorable investment
attributes and are to be considered as upper medium grade obligations. Factors
giving security to principal and interest are considered adequate but elements
may be present which suggest a susceptibility to impairment sometime in the
future.
4. Baa - Bonds which are rated Baa are considered as medium grade
obligations, i.e., they are neither highly protected nor poorly secured.
Interest payments and principal security appear adequate for the present but
certain protective elements may be lacking or may be characteristically
unreliable over any great length of time. Such bonds lack outstanding investment
characteristics and in fact have speculative characteristics as well.
5. Ba - Bonds which are rated Ba are judged to have speculative
elements. Their future cannot be considered as well assured. Often the
protection of interest and principal payments may be very moderate and thereby
not well safeguarded during both good and bad times over the future. Uncertainty
of position characterizes bonds in this class.
6. B - Bonds which are rated B generally lack characteristics of the
desirable investment. Assurance of interest and principal payments or of
maintenance of other terms of the contract over any long period of time may be
small.
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 11 years. Call
protection and sinking fund features are comparable to those offered on
traditional debt issues.
PIKs, like zero coupon bonds, are designed to give an issuer
flexibility in managing cash flow. Several PIKs are senior debt. In other cases,
where PIKs are subordinated, most senior lenders view them as equity
equivalents.
An advantage of PIKs for the issuer - as with zero coupon securities -
is that interest payments are automatically compounded (reinvested) at the
stated coupon rate, which is not the case with cash-paying securities. However,
PIKs are gaining popularity over zeros since interest payments in additional
securities can be monetized and are more tangible than accretion of a discount.
As a group, PIK bonds trade flat (i.e., without accrued interest).
Their price is expected to reflect an amount representing accreted interest
since the last payment. PIKs generally trade at higher yields than comparable
cash-paying securities of the same issuer. Their premium yield is the result of
the lesser desirability of non-cash interest, the more limited audience for
non-cash paying securities, and the fact that many PIKs have been issued to
equity investors who do not normally own or hold such securities.
Calculating the true yield on a PIK security requires a discounted cash
flow analysis if the security (ex interest) is trading at a premium or a
discount, because the realizable value of additional payments is equal to the
current market value of the underlying security, not par.
Regardless of whether PIK securities are senior or deeply subordinated,
issuers are highly motivated to retire them because they are usually their most
costly form of capital. 68% 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 in 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.
MONEY MARKET INSTRUMENTS
The Fund's investments in commercial paper are limited to those rated
A-1 by S&P, Prime-1 by Moody's or F-1 by Fitch Investors Service, Inc.
("Fitch"). These ratings and other money market instruments are described as
follows:
COMMERCIAL PAPER RATINGS
Commercial paper rated A-1 by S&P has the following characteristics:
Liquidity ratios are adequate to meet cash requirements. The issuer's long-term
senior debt is rated "A" or better, although in some cases "BBB" credits may be
allowed. The issuer has access to at least two additional channels of borrowing.
Basic earnings and cash flow have an upward trend with allowance made for
unusual circumstances. Typically, the issuer's industry is well established and
the issuer has a strong position within the industry.
The rating Prime-1 is the highest commercial paper rating assigned by
Moody's. Among the factors considered by Moody's in assigning ratings are the
following: (1) evaluation of the management of the issuer; (2) economic
evaluation of the issuer's industry or industries and an appraisal of
speculative-type risks which may be inherent in certain areas; (3) evaluation of
the issuer's products in relation to competition and customer acceptance; (4)
liquidity; (5) amount and quality of long-term debt; (6) trend of earnings over
a period of ten years; (7) financial strength of a parent company and the
relationships which exist with the issuer; and (8) recognition by the management
of obligations which may be present or may arise as a result of public
preparations to meet such obligations. Relative strength or weakness of the
above factors determines how the issuer's commercial paper is rated within
various categories.
The rating F-1 is the highest rating assigned by Fitch. Among the
factors considered by Fitch in assigning this rating are: (1) the issuer's
liquidity; (2) its standing in the industry; (3) the size of its debt; (4) its
ability to service its debt; (5) its profitability; (6) its return on equity;
(7) its alternative sources of financing; and (8) its ability to access the
capital markets. Analysis of the relative strength or weakness of these factors
and others determines whether an issuer's commercial paper is rated F-1.
UNITED STATES GOVERNMENT SECURITIES
Securities issued or guaranteed by the United States Government include
a variety of Treasury securities that differ only in their interest rates,
maturities and dates of issuance. Treasury bills have maturities of one year or
less. Treasury notes have maturities of one to ten years and Treasury bonds
generally have maturities of greater than ten years at the date of issuance.
Securities issued or guaranteed by the United States Government or its
agencies or instrumentalities include direct obligations of the United States
Treasury and securities issued or guaranteed by the Federal Housing
Administration, Farmers Home Administration, Export-Import Bank of the United
States, Small Business Administration, Government National Mortgage Association,
General Services Administration, Central Bank for Cooperatives, Federal Home
Loan Banks, Federal Loan Mortgage Corporation, Federal Intermediate Credit
Banks, Federal Land Banks, Maritime Administration, The Tennessee Valley
Authority, District of Columbia Armory Board and Federal National Mortgage
Association.
Some obligations of United States Government agencies and
instrumentalities, such as Treasury bills and Government National Mortgage
Association pass-through certificates, are supported by the full faith and
credit of the United States; others, such as securities of Federal Home Loan
Banks, by the right of the issuer to borrow from the Treasury; still others,
such as bonds issued by the Federal National Mortgage Association, a private
corporation, are supported only by the credit of the instrumentality. Because
the United States Government is not obligated by law to provide support to an
instrumentality it sponsors, the Fund will invest in the securities issued by
such an instrumentality only when Keystone determines that the credit risk with
respect to the instrumentality does not make its securities unsuitable
investments. United States Government securities will not include international
agencies or instrumentalities in which the United States Government, its
agencies or instrumentalities participate, such as the World Bank, the Asian
Development Bank or the InterAmerican Development Bank, or issues insured by the
Federal Deposit Insurance Corporation or Federal Savings and Loan Insurance
Corporation.
CERTIFICATES OF DEPOSIT
Certificates of deposit are receipts issued by a bank in exchange for
the deposit of funds. The issuer agrees to pay the amount deposited plus
interest to the bearer of the receipt on the date specified on the certificate.
The certificate usually can be traded in the secondary market prior to maturity.
Certificates of deposit will be limited to U.S. dollar-denominated
certificates of United States banks (including their branches abroad) and of
U.S. branches of foreign banks, which are members of the Federal Reserve System
or the Federal Deposit Insurance Corporation, and have at least $1 billion in
assets as of the date of their most recently published financial statements, or
of savings and loan associations which are members of the Federal Savings and
Loan 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 assets 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 option it has purchased by effecting a
closing sale transaction; for example, the Fund may close out a put option it
has purchased by selling a put option. 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. 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.
In each such instance, the Fund would incur additional transaction costs.
The Fund may also purchase call options for the purpose of offsetting
previously written call options of the same series.
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 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 in 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 New York, American, Pacific, and Philadelphia Stock
Exchanges. Options on some securities may not be listed on any Exchange but
traded in the over-the-counter market. Options traded in the over-the-counter
market involve the additional risk that securities dealers participating in such
transactions would fail to meet their obligations to the Fund. The use of
options traded in the over-the-counter market may be subject to limitations
imposed by certain state securities authorities. In addition to the limits on
its use of options discussed herein, the Fund is subject to the investment
restrictions described in the prospectus and the statement of additional
information.
The staff of the Securities and Exchange Commission is of the view that
the premiums that a Fund pays for the purchase of unlisted options and the value
of securities used to cover unlisted options written by the Fund, are considered
to be invested in illiquid securities or assets for the purpose of calculating
whether the Fund is in compliance with its fundamental investment restrictions
relating to illiquid 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 to 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 indexes as the underlying commodity.
U.S. futures contracts are traded only on national futures exchanges
and are standardized as to maturity date and underlying financial instrument.
The principal financial futures exchanges in the United States are The Board of
Trade of the City of Chicago, the Chicago Mercantile Exchange, the International
Monetary Market (a division of the Chicago Mercantile Exchange), the New York
Futures Exchange and the Kansas City Board of Trade. Each exchange guarantees
performance under contract provisions through a clearing corporation, a
nonprofit organization managed by the exchange membership, which is also
responsible for handling daily accounting of deposits or withdrawals of margin.
A futures commission merchant ("Broker") effects each transaction in connection
with futures contracts for a commission. Futures exchanges and trading are
regulated under the Commodity Exchange Act by the Commodity Futures Trading
Commission ("CFTC") and National Futures Association ("NFA").
INTEREST RATE FUTURES CONTRACTS
The sale of an interest rate futures contract creates an obligation by
the Fund, as seller, to deliver the type of financial instrument specified in
the contract at a specified future time for a specified price. The purchase of
an interest rate futures contract creates an obligation by the Fund, as
purchaser, to accept delivery of the type of financial instrument specified at a
specified future time for a specified price. The specific securities delivered
or accepted, respectively, at settlement date are not determined until at or
near that date. The determination is in accordance with the rules of the
exchange on which the futures contract sale or purchase was made.
Currently interest rate futures contracts can be purchased or sold on
90-day U.S. Treasury bills, U.S. Treasury bonds, U.S. Treasury notes with
maturities between 6 1/2 and 10 years, Government National Mortgage Association
("GNMA") certificates, 90- day domestic bank certificates of deposit, 90-day
commercial paper, and 90-day Eurodollar certificates of deposit. It is expected
that futures contracts trading in additional financial instruments will be
authorized. The standard contract size is $100,000 for futures contracts in U.S.
Treasury bonds, U.S. Treasury notes and GNMA certificates, and $1,000,000 for
the other designated contracts. While U.S. Treasury bonds, U.S. Treasury bills
and U.S. Treasury notes are backed by the full faith and credit of the U.S.
government and GNMA certificates are guaranteed by a U.S. government agency, the
futures contracts in U.S. government securities are not obligations of the U.S.
Treasury.
INDEX BASED FUTURES CONTRACTS
STOCK INDEX FUTURES CONTRACTS
A stock index assigns relative values to the common stocks included in
the index. The index fluctuates with changes in the market values of the common
stocks so included. A stock index futures contract is a bilateral agreement by
which two parties agree to take or make delivery of an amount of cash equal to a
specified dollar amount times the difference between the closing value of the
stock index on the expiration date of the contract and the price at which the
futures contract is originally made. No physical delivery of the underlying
stocks in the index is made.
Currently stock index futures contracts can be purchased or sold on the
Standard and Poor's Corporation ("S&P") Index of 500 Stocks, the S&P Index of
100 Stocks, the New York Stock Exchange Composite Index, the Value Line Index
and the Major Market Index. It is expected that futures contracts trading in
additional stock indices will be authorized. The standard contract size is $500
times the value of the index.
The Fund does not believe that differences between existing stock
indices will create any differences in the price movements of the stock index
futures contracts in relation to the movements in such indices. However, such
differences in the indices may result in differences in correlation of the
futures with movements in the value of the securities being hedged.
OTHER INDEX BASED FUTURES CONTRACTS
It is expected that bond index and other financially based index
futures contracts will be developed in the future. It is anticipated that such
index based futures contracts will be structured in the same way as stock index
futures contracts but will be measured by changes in interest rates, related
indexes 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 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 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 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 and other financial futures
contracts 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 OF FUTURES CONTRACTS AND RELATED OPTIONS ON
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 indexes 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 purhcase or sell currencies
at a specified price and date). Under the contract, the exchange rate for the
transaction (the amount of currency the Fund will deliver or receive when the
contract is completed) is fixed when the Fund enters into the contract. The Fund
usually will enter into these contracts to stabilize the U.S. dollar value of a
security it has agreed to buy or sell. The Fund also may use these contracts to
hedge the U.S. dollar value of a security it already owns, particularly if the
Fund expects a decrease in the value of the currency in which the foreign
security is denominated. Although the Fund will attempt to benefit from using
forward contracts, the success of its hedging strategy will depend on Keystone's
ability to predict accurately the future exchange rate between foreign
currencies and the U.S. dollar. The value of the Fund's investments denominated
in foreign currencies will depend on the relative strength of those currencies
and the U.S. dollar, and the Fund may be affected favorably or unfavorably by
changes in the exchange rate or exchange control regulations between foreign
currencies and the dollar. Changes in foreign currency exchange rates also may
affect the value of dividends and interest earned, gains and losses realized on
the sale of securities and net investment income and gains, if any, to be
distributed to shareholders by the Fund.
CURRENCY FUTURES CONTRACTS
Currency futures contracts are bilateral agreements under which two
parties agree to take or make delivery of a specified amount of a currency at a
specified future time for a specified price. Trading of currency futures
contracts in the United States is regulated under the Commodity Exchange Act by
the Commodity Futures Trading Commission ("CFTC") and National Futures
Association ("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 only engage in currency futures contracts for
hedging purposes, and not for speculation. The Fund may engage in 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 Francs,
C$100,000 for the Canadian Dollar, Y12,500,000 for the Yen, and 1,000,000 for
the Peso. In contrast to Forward Currency Exchange Contracts which can be traded
at any time, only four value dates per year are available, the third Wednesday
of March, June, September and December.
FOREIGN CURRENCY OPTIONS TRANSACTIONS
Foreign currency options (as opposed to futures) are traded in a
variety of currencies in both the United States and Europe. On the Philadelphia
Stock Exchange, for example, contracts for half the size of the corresponding
futures contracts on the Chicago Board Options Exchange are traded with up to
nine months maturity in marks, sterling, yen, Swiss francs and Canadian dollars.
Options can be exercised at any time during the contract life and require a
deposit subject to normal margin requirements. Since a futures contract must be
exercised, the Fund must continually make up the margin balance. As a result, a
wrong price move could result in the Fund losing more than the original
investment as it cannot walk away from the futures contract as it can an option
contract.
The Fund will purchase call and put options and sell such options to
terminate an existing position. Options on foreign currency are similar to
options on stocks except that an option on an interest rate and/or index based
futures contract gives the purchaser the right, in return for the premium paid,
to purchase or sell foreign currency rather than to purchase or sell stock, at a
specified exercise price at any time during the period of the option.
The Fund intends to use foreign currency option transactions in
connection with hedging strategies.
PURCHASE OF PUT OPTIONS ON FOREIGN CURRENCIES
The purchase of protective put options on a foreign currency is
analagous to the purchase of protective puts on individual stocks, where an
absolute level of protection is sought below which no additional economic loss
would be incurred by the Fund. Put options may be purchased to hedge a portfolio
of foreign stocks or foreign debt instruments or a position in the foreign
currency upon which the put option is based.
PURCHASE OF CALL OPTIONS ON FOREIGN CURRENCIES
The purchase of a call option on foreign currency represents a means of
obtaining temporary exposure to market appreciation at limited risk. It is
analogous to the purchase of a call option on an individual stock which can be
used as a substitute for a position in the stock itself. Depending on the
pricing of the option compared to either the foreign currency upon which it is
based, or upon the price of the foreign stock or foreign debt instruments, the
purchase of a call option may be less risky than the ownership of the foreign
currency or the foreign securities. The Fund would purchase a call option on a
foreign currency to hedge against an increase in the foreign currency or a
foreign market advance when the Fund is not fully invested.
The Fund may employ new investment techniques involving forward foreign
currency exchange contracts, foreign currency futures contracts and options on
foreign currencies in order to take advantage of new techniques in these areas
which may be developed from time to time and which are consistent with the
Fund's investment objective. The Fund believes that no additional techniques
have been identified for employment by the Fund in the foreseeable future other
than those described above.
CURRENCY TRADING RISKS
Currency exchange trading may involve significant risks. The four major
type of risk the Fund faces are exchange rate risk, interest rate risk, credit
risk and country risk.
EXCHANGE RATE RISK
Exchange rate risk results from the movement up and down of foreign
currency values in response to shifting market supply and demand. When the Fund
buys or sells a foreign currency, an exposure called an open position is
created. Until the time that position can be "covered" by selling or buying an
equivalent amount of the same currency, the Fund is exposed to the risk that the
exchange rate might move against it. Since exchange rate changes can readily
move in one direction, a position carried overnight or over a number of days
involves greater risk than one carried a few minutes or hours. Techniques such
as foreign currency forward and futures contracts and options on foreign
currency are intended to be used by the Fund to reduce exchange rate risk.
MATURITY GAPS AND INTEREST RATE RISK
Interest rate risk arises whenever there are mismatches or gaps in the
maturity structure of the Fund's foreign exchange currency holdings, which is
the total of its outstanding spot and forward or futures contracts.
Foreign currency transactions often involve borrowing short term and
lending longer term to benefit from the normal tendency of interest rates to be
higher for longer maturities. However in foreign exchange trading, while the
maturity pattern of interest rates for one currency is important, it is the
differential between interest rates for two currencies that is decisive.
CREDIT RISK
Whenever the Fund enters into a foreign exchange contract, it faces a
risk, however small, that the counterparty will not perform under the contract.
As a result there is a credit risk, although no extension of "credit" is
intended. To limit credit risk, the Fund intends to evaluate the
creditworthiness of each other party. The Fund does not intend to trade more
than 5% of its net assets under foreign exchange contracts with one party.
Credit risk exists because the Fund's counterparty may be unable or
unwilling to fulfill its contractual obligations as a result of bankruptcy or
insolvency or when foreign exchange controls prohibit payment. In any foreign
exchange transaction, each party agrees to deliver a certain amount of currency
to the other on a particular date. In establishing its hedges a Fund relies on
each contract being completed. If the contract is not performed, then the Fund's
hedge is eliminated, and the Fund is exposed to any changes in exchange rates
since the contract was originated. To put itself in the same position it would
have been in had the contract been performed, the Fund must arrange a new
transaction. However, the new transaction may have to be arranged at an adverse
exchange rate. The trustee for a bankrupt company may elect to perform those
contracts which are advantageous to the company but disclaim those contracts
which are disadvantageous, resulting in losses to the Fund.
Another form of credit risk stems from the time zone differences
between the U.S. and foreign nations. If the Fund sells sterling it generally
must pay pounds to a counterparty earlier in the day than it will be credited
with dollars in New York. In the intervening hours, the buyer can go into
bankruptcy or can be declared insolvent. Thus, the dollars may never be credited
to the Fund.
COUNTRY RISK
At one time or another, virtually every country has interfered with
international transactions in its currency. Interference has taken the form of
regulation of the local exchange market, restrictions on foreign investment by
residents or limits on inflows of investment funds from abroad. Governments take
such measures for example to improve control over the domestic banking system or
to influence the pattern of receipts and payments between residents and
foreigners. In those cases, restrictions on the exchange market or on
international transactions are intended to affect the level or movement of the
exchange rate. Occasionally a serious foreign exchange shortage may lead to
payment interruptions or debt servicing delays, as well as interference in the
exchange market. It has become increasingly difficult to distinguish foreign
exchange or credit risk from country risk.
Changes in regulations or restrictions usually do have an important
exchange market impact. Most disruptive are changes in rules which interfere
with the normal payments mechanism. If government regulations change and a
counterparty is either forbidden to perform or is required to do something
extra, then the Fund might be left with an unintended open position or an
unintended maturity mismatch. Dealing with such unintended long or short
positions could result in unanticipated costs to the Fund.
Other changes in official regulations influence international
investment transactions. If one of the factors affecting the buying or selling
of a currency changes, the exchange rate is likely to respond. Changes in such
controls often are unpredictable and can create a significant exchange rate
response.
Many major countries have moved toward liberalization of exchange and
payments restrictions in recent years or accepted the principle that
restrictions should be relaxed. A few industrial countries have moved in the
other direction. Important liberalizations were carried out by Switzerland, the
United Kingdom and Japan. They dismantled mechanisms for restricting either
foreign exchange inflows (Switzerland), outflows (Britain) or elements of both
(Japan). By contrast, France and Mexico have recently tightened foreign exchange
controls.
Overall, many exchange markets are still heavily restricted. Several
countries limit access to the forward market to companies financing documented
export or import transactions in an effort to insulate the market from purely
speculative activities. Some of these countries permit local traders to enter
into forward contracts with residents but prohibit certain forward transactions
with nonresidents. By comparison, other countries have strict controls on
exchange transactions by residents, but permit free exchange transactions
between local traders and non-residents. A few countries have established tiered
markets, funneling commercial transactions through one market and financial
transactions through another. Outside the major industrial countries, relatively
free foreign exchange markets are rare and control 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.
<PAGE>
EXHIBIT A
GLOSSARY OF TERMS
CLASS OF OPTIONS. Options covering the same underlying security.
CLEARING CORPORATION. The Options Clearing Corporation, Trans Canada
Options, Inc., The European Options Clearing Corporation B.V., or the London
Options Clearing House.
CLOSING PURCHASE TRANSACTION. A transaction in which an investor who is
obligated as a writer of an option or seller of a futures contract terminates
his obligation by purchasing on an Exchange an option of the same series as the
option previously written or futures contract identical to the futures contract
previously sold, as the case may be. (Such a purchase does not result in the
ownership of an option or futures contract.)
CLOSING SALE TRANSACTION. A transaction in which an investor who is the
holder or buyer of an outstanding option or futures contract liquidates his
position as a holder or seller by selling an option of the same series as the
option previously purchased or futures contract identical to the futures
contract previously purchased. (Such sale does not result in the investor
assuming the obligations of a writer or seller.)
COVERED CALL OPTION WRITER. A writer of a call option who, so long as
he remains obligated as a writer, owns the shares of the underlying security or
holds on a share for share basis a call on the same security where the exercise
price of the call held is equal to or less than the exercise price of the call
written, or, if greater than the exercise price of the call written, the
difference is maintained by the writer in cash, U.S. Treasury bills or other
high grade, short term obligations in a segregated account with the writer's
broker or custodian.
COVERED PUT OPTION WRITER. A writer of a put option who, so long as he
remains obligated as a writer, has deposited Treasury bills with a value equal
to or greater than the exercise price with a securities depository and has
pledged them to the Options Clearing Corporation for the account of the
broker-dealer carrying the writer's position or holds on a share for share basis
a put on the same security as the put written where the exercise price of the
put held is equal to or greater than the exercise price of the put written, or,
if less than the exercise price of the put written, the difference is maintained
by the writer in cash, U.S. Treasury bills or other high grade, short term
obligations in a segregated account with the writer's broker or custodian.
SECURITIES EXCHANGE. A securities exchange on which call and put option
are traded. The U.S. Exchanges are as follows: The Chicago Board Options
Exchange; American Stock Exchange; New York Stock Exchange; Philadelphia Stock
Exchange; and Pacific Stock Exchange. The foreign securities exchanges in Canada
are the Toronto Stock Exchange and the Montreal Stock Exchange; in the
Netherlands, the European Options Exchange; and in the United Kingdom, the Stock
Exchange (London).
Those issuers whose common stocks have been approved by the Exchanges
as underlying securities for options transactions are published in various
financial publications.
COMMODITIES EXCHANGE. A commodities exchange on which futures contracts
are traded which is regulated by exchange rules that have been approved by the
Commodity Futures Trading Commission. The U.S. exchanges are as follows: The
Chicago Board of Trade of the City of Chicago, Chicago Mercantile Exchange,
International Monetary Market, (a division of the Chicago Mercantile Exchange),
the Kansas City Board of Trade and the New York Futures Exchange.
EXERCISE PRICE. The price per unit at which the holder of a call option
may purchase the underlyng security upon exercise or the holder of a put option
may sell the underlying security upon exercise.
EXPIRATION DATE. The latest date when an option may be exercised or a
futures contract must be completed according to its terms.
HEDGING. An action taken by an investor to neutralize an investment
risk by taking an investment position which will move in the opposite direction
as the risk being hedged so that a loss (or gain) on one will tend to be offset
by a gain (or loss) on the other.
OPTION. Unless the context otherwise requires, the term "option" means
either a call or put option issued by a Clearing Corporation, as defined above.
A call option gives a holder the right to buy from such Clearing Corporation the
number of shares of the underlying security covered by the option at the stated
exercise price by the filing of an exercise notice prior to the expiration time
of the option. A put option gives a holder the right to sell to a Clearing
Corporation the number of shares of the underlying security covered by the put
at the stated exercise price by the filing of an exercise notice prior to the
expiration time of the option. The Fund will sell ("write") and purchase puts
only on U.S. Exchanges.
OPTION PERIOD. The time during which an option may be exercised,
generally from the date the option is written through its expiration date.
PREMIUM. The price of an option agreed upon between the buyer and
writer or their agents in a transaction on the floor of an Exchange.
SERIES OF OPTIONS. Options covering the same underlying security and
having the same exercise price and expiration date.
STOCK INDEX. A stock index assigns relative values to the common stocks
included in the index, and the index fluctuates with chanqes in the market
values of the common stocks so included.
INDEX BASED FUTURES CONTRACT. An index based futures contract is a
bilateral agreement pursuant to which a party agrees to buy or deliver at
settlement an amount of cash equal to $500 times the difference between the
closing value of an index on the expiration date and the price at which the
futures contract is originally struck. Index based futures are traded on
Commodities Exchanges. Currently index based stock index futures contracts can
be purchased or sold with respect to the Standard & Poor's Corporation (S&P) 500
Stock Index and S&P 100 Stock Index on the Chicago Mercantile Exchange, the New
York Stock Exchange Composite Index on the New York Futures Exchange and the
Value Line Stock Index and Major Market Index on the Kansas City Board of Trade.
UNDERLYING SECURITY. The security subject to being purchased upon the
exercise of a call option or subject to being sold upon the exercise of a put
option.
<PAGE>
SCHEDULE OF INVESTMENTS--August 31, 1994
See Notes to Schedule of Investments.
<TABLE>
<CAPTION>
Coupon Maturity Par Market
Rate Date Value Value
<S> <C> <C> <C> <C> <C>
FIXED INCOME (96.2%)
CONVERTIBLE BONDS (0.7%)
RESTAURANTS (0.7%)
Boston Chicken, Inc. Conv. Deb. (Subord.) 4.500% 2004 $ 7,000,000 $ 5,862,500
TOTAL CONVERTIBLE BONDS (Cost $7,000,000) 5,862,500
INDUSTRIAL BONDS & NOTES (64.6%)
ADVERTISING AND PUBLISHING (0.5%)
Outlet Broadcast, Inc. Sr. Notes (Subord.) 10.875 2003 4,375,000 4,353,125
AIR TRANSPORTATION (2.0%)
Helicopter Corp. Unit (Sr. Notes
(Subord.)/Wts.) 11.500 2002 5,000,000 4,900,000
Southwest Airlines Deb. (Subord.) 8.750 2003 11,000,000 11,608,520
16,508,520
AMUSEMENTS (2.8%)
Affinity Group, Inc. Gtd. Sr. Notes (Subord.) 11.500 2003 3,050,000 3,034,750
Hemmeter Enterprises, Inc. (f) Unit (Sr. Sec. PIK Notes/
Wts.) 12.000 1999 10,580,000 7,406,000
Time Warner Entertainment Co. Sr. Deb. 8.375 2023 10,000,000 9,099,700
Treasure Bay Gaming & Resorts (f) Unit (1st Mtge. Notes/
Wts.) 12.250 1998 7,950,000 2,941,500
22,481,950
AUTOMOTIVE (2.9%)
Auburn Hills Trust Exchangeable Gtd. Cert. 12.375 2020 10,000,000 13,656,000
General Motors Corp. Global Notes 7.625 1997 9,450,000 9,566,707
23,222,707
BROADCASTING (2.2%)
Cablevision Industries Sr. Notes 10.750 2002 3,000,000 2,955,000
Continental Cablevision, Inc. Sr. Deb. 9.500 2013 7,750,000 7,091,250
MFS Communications, Inc. (effective
yield 9.373%) (b) Sr. Disc. Notes 0.000 2004 13,250,000 7,751,250
17,797,500
BUILDING MATERIALS (1.5%)
Associated Materials, Inc. Sr. Notes (Subord.) 11.500 2003 6,000,000 5,970,000
NVR, Inc. Gtd. Sr. Notes 11.000 2003 7,000,000 6,440,000
12,410,000
<PAGE>
CAPITAL GOODS (1.4%)
Mayfair SuperMarkets, Inc. Sr. Notes (Subord) 11.750% 2003 $ 5,000,000 $ 4,375,000
Tenneco, Inc. Notes 10.375 2000 6,055,000 6,829,798
11,204,798
CHEMICALS (2.0%)
GI Holdings, Inc. (effective yield
11.374%) (b) Sr. Disc. Notes 0.000 1998 6,000,000 3,675,000
UCC Investors Holding, Inc. Sr. Notes (Subord.) 11.000 2003 4,000,000 4,120,000
UCC Investors Holding, Inc.
(effective yield 13.309%) (b) Disc. Notes (Subord.) 0.000 2005 5,000,000 3,300,000
Uniroyal Technology Corp. Sr. Sec. Notes 11.750 2003 5,750,000 5,520,000
16,615,000
CONSUMER GOODS (3.4%)
Drypers Corp. Sr. Notes 12.500 2002 6,000,000 6,270,000
Finlay Fine Jewelry Corp. Sr. Notes 10.625 2003 7,000,000 6,667,500
Key Plastics, Inc.
(11/2/92--$7,000,000) (c) Sr. Notes 14.000 1999 7,000,000 7,840,000
Scotts Co. Sr. Notes (Subord.) 9.875 2004 3,500,000 3,578,750
Sola Group, Ltd. Sr. Notes (Subord.) 6.000 2003 4,250,000 3,250,825
27,607,075
DIVERSIFIED COMPANIES (2.0%)
Corning Glass Works Deb. 8.875 2016 9,700,000 10,176,949
Jordan Industries, Inc. Sr. Notes 10.375 2003 5,000,000 4,600,000
Jordan Industries, Inc. (effective
yield 11.74%) (b) Sr. Disc. Deb. (Subord.) 0.000 2005 3,000,000 1,755,000
16,531,949
FINANCE (10.8%)
Ahmanson (H.F.) & Co. Notes (Subord.) 7.875 2004 8,250,000 8,201,985
Alabama Steel Corp. Sr. Notes 10.750 2004 7,000,000 7,105,000
Chartwell Corp. Sr. Notes 10.250 2004 5,500,000 5,087,500
Commercial Credit Group, Inc. Notes 10.000 2008 5,000,000 5,796,700
DQU II Funding Corp. Coll. Lease 8.700 2016 10,000,000 9,181,200
First Chicago Corp. Notes (Subord.) 8.250 2002 4,000,000 4,101,440
First Interstate Bancorp Sr. Notes 9.125 2004 8,450,000 9,106,227
First National Bank of Boston Notes (Subord.) 8.375 2002 7,690,000 7,846,415
Fleet Financial Group Notes (Subord.) 8.625 2007 5,000,000 5,146,000
Ford Capital B.V. Gtd. Notes 9.375 1998 10,000,000 10,703,600
General Motors Acceptance Corp. Notes 9.625 2001 10,000,000 10,984,100
Marine Midland Bank
(11/20/91-$4,574,556) (c) Asset Backed 8.000 2011 5,143,834 4,803,878
88,064,045
FOODS (3.1%)
Farm Fresh, Inc. Sr. Notes 12.250 2000 9,000,000 8,325,000
<PAGE>
FOODS (continued)
Grand Union Co. Sr. Notes 11.250% 2000 $ 6,000,000 $ 5,580,000
Premium Standard Farms (effective
yield 11.995%)
(10/7/93-$6,918,478) (b) (c) (f) Sr. Sec. Disc. Notes 0.000 2003 9,577,000 7,310,124
Specialty Foods Corp. Sr. Notes (Subord.) 11.250 2003 5,250,000 4,357,500
25,572,624
FOREIGN BONDS (U.S. DOLLARS) (9.7%)
Euro Credit Card Trust Certificates 9.500 1995 13,000,000 13,486,590
Hydro Quebec Deb. 8.050 2024 3,000,000 3,025,950
Indah Kiat International Finance
Co. B.V. Gtd. Sec. Notes 11.875 2002 4,000,000 3,920,000
International Bank for
Reconstruction & Development Unsec. Eurodollar Deb. 9.250 2016 5,000,000 5,559,050
Kansallis Osake Pankki Notes (Subord.) 10.000 2002 4,000,000 4,454,000
Manitoba Province Canada Deb. 9.625 1999 8,750,000 9,552,550
Nova Corporation Of Alberta Notes 7.250 1999 10,000,000 9,978,700
Petro CDA Global Notes 9.250 2021 13,000,000 14,010,100
Republic of Finland Bonds 9.625 2028 10,000,000 11,014,100
Svenska Handelsbanken Notes (Subord.) 8.125 2007 4,000,000 3,962,680
78,963,720
INSURANCE (3.2%)
MBIA, Inc. Global Notes 9.375 2011 15,000,000 16,629,600
Reliance Group Holdings, Inc. Sr. Deb. (Subord.) 9.750 2003 10,000,000 9,000,000
25,629,600
METALS AND MINING (1.4%)
Bethlehem Steel Corp. Sr. Notes 10.375 2003 4,000,000 4,095,000
Republic Engineered Steels, Inc. 1st Mtge. Bds. 9.875 2001 2,500,000 2,362,500
WCI Steel, Inc. Sr. Sec. Notes 10.500 2002 5,000,000 5,012,500
11,470,000
MISCELLANEOUS (2.3%)
Los Angeles, California Fire Safety Improvements
(7/28/94-$5,000,000) (c) (f) Assessment District #1
8.480 2015 5,000,000 4,950,000
Pamida, Inc. Notes (Subord.) 11.750 2003 9,000,000 8,977,500
PM Holdings, Inc. Sr. Disc. Notes/Wts. 11.500 2005 8,812,000 5,022,840
18,950,340
OFFICE AND BUSINESS EQUIPMENT (1.0%)
Specialty Equipment Cos., Inc. Sr. Notes (Subord.) 11.375 2003 8,000,000 8,000,000
<PAGE>
OIL (3.0%)
Gerrity Oil & Gas Corp. Sr. Notes (Subord.) 11.750% 2004 $ 8,000,000 $ 7,800,000
Plains Resources, Inc. Sr. Notes (Subord.) 12.000 1999 8,650,000 8,844,625
Wainoco Oil Corp. Sr. Notes 12.000 2002 7,750,000 8,137,500
24,782,125
RESTAURANTS (0.5%)
S & A Restaurant Corp.
(9/6/91-$5,000,000) (c) (f) Sr. Sec. Fixed Rate Notes 11.340 1996 5,000,000 4,100,000
RETAIL (2.9%)
Big 5 Sporting Goods Sr. Notes (Subord.) 13.625 2002 6,000,000 6,180,000
Cole National Group, Inc. Sr. Notes 11.250 2001 5,000,000 4,900,000
Dayton Hudson Corp. Med. Term Notes 10.000 2010 10,825,000 12,381,202
23,461,202
SERVICES (3.3%)
Browning Ferris Industries, Inc. Deb. 9.250 2021 7,800,000 8,497,865
Comcast Cellar Corp. (effective
yield
11.732%) (b) Sr. Part. Zero Coupon Notes 0.000 2000 15,380,000 9,304,900
Community Health Systems, Inc. Sr. Deb. (Subord.) 10.250 2003 2,500,000 2,437,500
Pilgrims Pridecorp Sr. Notes (Subord.) 10.875 2003 4,500,000 4,365,000
Santa Fe Hotel, Inc. Gtd. 1st Mtge. Notes/
Wts. 11.000 2000 2,250,000 2,025,000
26,630,265
TELECOMMUNICATIONS (0.2%)
Pagemart (effective yield 12.25%)
(3/16/94- $1,676,463) (b) (c) Unit (Sr. Disc. Notes/
Wts.) 0.000 2003 305,000 1,906,250
TRANSPORTATION (1.0%)
Eletson Holdings, Inc. 1st Mtge Notes 9.250 2003 8,499,500 7,989,530
UTILITIES (1.5%)
Chugach Electric Association, Inc. 1st Mtge. Bds. 9.140 2022 11,500,000 12,134,339
TOTAL INDUSTRIAL BONDS & NOTES (Cost $543,507,019) 526,386,664
ADJUSTABLE RATE MORTGAGE SECURITIES (6.0%)
FNMA Pool #124289 Cap 13.432%, Margin 2.005% +
CMT 5.925 2021 24,417,702 25,028,144
FNMA Pool #124901 Cap 10.685%, Margin 2.165% +
CMT 5.876 2023 6,800,664 6,968,572
FNMA Pool #238847 Cap 13.327%, Margin 2.324% +
CMT 6.346 2031 16,258,209 16,852,609
<PAGE>
TOTAL ADJUSTABLE RATE MORTGAGE SECURITIES (Cost $49,408,382) $ 48,849,325
COLLATERALIZED MORTGAGE OBLIGATIONS (15.2%)
Chase Mortgage Finance Corp. (Est.
Mat. 1995) (d) Series 1992 F Class A4 8.250% 2007 $ 2,304,960 2,318,228
Collateralized Mortgage Investors
Trust VI (Est. Mat. 1996) (d) Series 6 Class D 8.800 2006 5,000,000 5,117,102
DeBartolo Capital Partnership (Est.
Mat. 2001) (d) Commercial Mortgage Class B 7.610 2004 9,000,000 8,836,740
FHA Pool #02343143 (Est. Mat. 1995)
(d) Blair House Project 9.125 1995 5,207,039 5,317,688
FHLMC (Est. Mat. 2005) (d) Series G8 Class SB 9.600 2023 368,663 291,244
FNMA Remic Trust (effective yield
5.586%) (Est. Mat. 2000) (b) (d) Series 1992 104 Class C 0.000 2000 11,473,393 6,797,985
FNMA Remic Trust (effective yield
7.97%) (Est. Mat. 1998) (b) (d) Series 1993 244 Class B 0.000 2023 5,943,607 3,982,216
FNMA Remic Trust (Est. Mat. 1999)
(d) Series 1991 137 Class G 8.300 2020 2,000,000 2,028,740
FNMA Remic Trust (Est. Mat. 1998)
(d) Series 1993 180 Class SA 10.000 2000 6,070,323 5,801,893
FNMA Remic Trust (Est. Mat. 2003)
(d) Series 1992 117 Class K 7.500 2021 6,250,000 5,869,125
FNMA Remic Trust (Est. Mat. 2004)
(d) Series 1993 38 Class K 6.750 2021 5,700,000 5,176,341
Green Tree Financial Corp. (Est.
Mat. 1996) (d) Series 1994 A Class A 6.900 2004 3,961,306 3,880,852
Green Tree Financial Corp. (Est.
Mat. 1997) (d) Series 1994 B Class A 7.850 2004 4,851,500 4,840,875
Merrill Lynch Mortgage Investors,
Inc. (Est. Mat. 1999) (d) Series 1992 D Class B 8.500 2017 6,924,032 6,992,441
Paine Webber Mortgage Acceptance
Corp. (Est. Mat. 1996) (d) Series 1993 5 Class A3 6.875 2008 6,294,283 6,256,895
Prudential Home Mortgage Securities
Co. (11/24/92-$13,615,000) (Est.
Mat. 1999) (c) (d) Series 1992 A Class B2-2 7.839 2022 14,000,000 12,880,000
Prudential Home Mortgage Securities
Co. (Est. Mat. 1999) (d) Series 1992 46 Class A5 7.000 2008 14,000,000 13,494,740
Residential Funding Mortgage
Securities I (Est. Mat. 1996) (d) Series 1994 S15 Class A1 7.750 2024 9,923,593 10,044,561
Security Pacific Acceptance Corp.
(Est. Mat. 2000) (d) Series 1992 2 Class B 8.450 2012 8,890,815 8,865,743
U.S. Home Equity Loan (Est. Mat.
1996) (d) Series 1991 2B 9.125 2021 4,569,000 4,713,198
TOTAL COLLATERALIZED MORTGAGE OBLIGATIONS (Cost $129,350,398) 123,506,607
US GOVERNMENT ISSUES (7.4%)
U.S. Treasury Notes 6.125 1996 15,000,000 15,028,050
U.S. Treasury Notes 6.875 1999 9,850,000 9,879,254
U.S. Treasury Notes 8.000 1996 15,000,000 15,529,650
<PAGE>
U.S. Government Issues (continued)
U.S. Treasury Bonds 7.875% 2021 $19,300,000 $ 19,830,750
TOTAL US GOVERNMENT ISSUES (Cost $63,196,388) 60,267,704
MORTGAGE PASS-THROUGH CERTIFICATES (2.3%)
FHLMC Pool #G10049 8.000 2007 8,022,427 8,161,536
FNMA Pool #250086 8.000 2024 10,183,518 10,138,915
TOTAL MORTGAGE PASS-THROUGH CERTIFICATES (Cost $18,352,790) 18,300,451
TOTAL FIXED INCOME (Cost $810,814,977) 783,173,251
SHORT-TERM INVESTMENTS (1.6%)
CERTIFICATE OF DEPOSIT (0.0%)
State Street Bank & Trust Co. (Cost $112,500) 3.750 10/31/94 112,500 112,500
Maturity
Value
REPURCHASE AGREEMENTS (1.6%)
Paine Webber, purchased 8/31/94 (Collateralized by $12,180,000
U.S. Treasury Note, 8.75%, 10/15/97) (Cost $13,212,000) 4.750 9/1/94 13,213,743 13,212,000
TOTAL SHORT-TERM INVESTMENTS (Cost $13,324,500) 13,324,500
Number
of Shares
COMMON STOCKS/RIGHTS/WARRANTS (0.9%)
Drypers Corp. (e) 29,000 387,875
Hollywood Casino Corp. (e) 696,665 5,399,154
Purity Supreme, Inc. wts. (e) 34,655 693
Reliance Group Holdings, Inc. wts. (e) 67,904 101,856
Uniroyal Chemical Aquisition Corp. (e) 119,971 1,559,623
TOTAL COMMON STOCKS/RIGHTS/WARRANTS (Cost $193,835) 7,449,201
TOTAL INVESTMENTS (Cost--$824,333,312) (a) 803,946,952
OTHER ASSETS AND LIABILITIES--NET (1.3%) 10,297,767
NET ASSETS (100.0%) $814,244,719
</TABLE>
<PAGE>
NOTES TO SCHEDULE OF INVESTMENTS:
(a) The cost of investments for federal income tax purposes amounted to
$824,375,374. Gross unrealized appreciation and depreciation on investments,
based on identified tax cost, at August 31, 1994 are as follows:
Gross unrealized appreciation $ 14,576,698
Gross unrealized depreciation $(35,005,120)
Net unrealized depreciation $(20,428,422)
(b) Effective yield (calculated at date of purchase) is the yield at which the
bond accretes on an annual basis until maturity date.
(c) All or a portion of these securities are restricted (i.e., securities
which may not be publicly sold without registration under the Federal
Securities Act of 1933) which are valued using market quotations where readily
available. In the absence of market quotations, the securities are valued
based upon their fair value determined under procedures approved by the Board
of Trustees. The Fund may make investments in an amount up to 15% of the value
of the Fund's net assets in such securities. Dates of acquisition and costs
are set forth in parentheses after the title of the restricted securities. On
the date of acquisition there was no market quotation on similar securities
and the above securities were valued at acquisition cost. At August 31, 1994,
the fair value of these restricted securities was $43,790,252 (5.4% of net
assets). The Fund will not pay the costs of disposition of the above
restricted securities other than ordinary brokerage fees, if any.
(d) The estimated maturity of a Collateralized Mortgage Obligation ("CMO") is
based on current and projected pre-payment rates. Changes in interest rates
can cause the estimate maturity to differ from the listed date. The estimated
maturity dates are unaudited.
(e) Non-income producing.
(f) Securities that may be resold to "qualified institutional buyers" under
Rule 144A or securities offered pursuant to Section 4(2) of the Securities Act
of 1933, as amended. These securities have been determined to be liquid under
guidelines established by the Board of Trustees.
Legend of Portfolio Abbreviations:
CMO--Collateralized Mortgage Obligation
CMT--1, 3, or 5 year Constant Maturity Treasury Index
FHLMC--Federal Home Loan Mortgage Corporation
FNMA--Federal National Mortgage Association
GNMA--Government National Mortgage Association
REMIC--Real Estate Mortgage Investment Conduit
See Notes to Financial Statements.
<PAGE>
FINANCIAL HIGHLIGHTS
(For a share outstanding throughout the year)
<TABLE>
<CAPTION>
Year Ended August 31,
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
1994 1993 1992 1991 1990 1989 1988 1987 1986 1985
Net asset value:
Beginning of year $ 17.06 $ 16.44 $ 15.37 $ 15.51 $ 17.74 $ 17.99 $ 18.91 $ 20.08 $ 18.84 $ 17.35
Income from investment
operations
Investment income--net 1.06 1.28 1.33 1.33 1.53 1.71 1.78 1.83 2.07 2.00
Net gains (losses) on
investments and
foreign currency
related transactions (1.62) 0.70 1.14 0.17 (1.94) (0.13) (0.81) (1.01) 1.38 1.79
Net commissions paid
on fund share
sales (a) 0 0 0 0 0 0 0 0 (0.21) (0.20)
Total from investment
operations (0.56) 1.98 2.47 1.50 (0.41) 1.58 0.97 0.82 3.24 3.59
Less distributions
from:
Investment income--net (1.22) (1.28) (1.33) (1.63) (1.61) (1.83) (1.85) (1.85) (2.00) (2.10)
In excess of
investment
income--net (b) 0 (0.08) (0.07) (0.01) (0.21) 0 0 0 0 0
Realized gains on
investments and
foreign currency
related
transactions--net 0 0 0 0 0 0 (0.04) (0.14) 0 0
Total distributions (1.22) (1.36) (1.40) (1.64) (1.82) (1.83) (1.89) (1.99) (2.00) (2.10)
Net asset value:
End of year $ 15.28 $ 17.06 $ 16.44 $ 15.37 $ 15.51 $ 17.74 $ 17.99 $ 18.91 $ 20.08 $ 18.84
Total return (c) (3.53%) 12.73% 16.88% 10.58% (2.44%) 9.23% 5.61% 4.20% 18.01% 22.19%
Ratios/supplemental
data
Ratios to average net
assets:
Operating and
management expenses 1.75% 1.89% 1.99% 1.94% 1.89% 1.84% 1.68% 1.68% 1.00% 1.05%
Investment
income--net 6.48% 7.73% 8.29% 8.74% 9.26% 9.52% 9.82% 9.31% 10.37% 11.03%
Portfolio turnover
rate 200% 133% 117% 101% 43% 47% 46% 74% 69% 103%
Net assets, end of
year (thousands) $814,245 $1,004,393 $902,339 $814,528 $860,615 $1,000,305 $838,892 $889,333 $558,734 $220,919
<FN>
(a) Prior to June 30, 1987, net commissions paid on new sales of shares under the Fund's Rule 12b-1 Distribution Plan had
been treated for both financial statement and tax purposes as capital charges. On June 11, 1987, the Securities and
Exchange Commission adopted a rule which required for financal statements for periods ended on or after June 30, 1987,
that net commissions paid under Rule 12b-1 Distibution Plans be treated as operating expenses rather than capital
charges. Accordingly, beginning with the fiscal year ended August 31, 1987, the Fund's financial statements reflect
12b-1 Distribution Plan expenses (ie., shareholder service fees plus commissions paid net of deferred sales charges
received by the Fund) as a component of the net investment income section of the financial highlights.
(b) Effective September 1, 1993, the Fund adopted Statement of Position 93-2: "Determination, Disclosure and Financial
Statement Presentation of Income, Capital Gain and Return of Capital Distributions by Investment Companies". As a
result, distribution amounts exceeding book basis net investment income (or tax basis net income on a temporary basis)
are presented as "Distributions in excess of investment income--net". Similarly, capital gain distributions in excess
of book basis capital gains (or tax basis capital gains on a temporary basis) are presented as "Distributions in
excess of realized capital gains."
(c) Excluding deferred sales charges.
</FN>
</TABLE>
<PAGE>
STATEMENT OF ASSETS AND LIABILITIES--
August 31, 1994
Assets:
Investments at market value (identified cost--
$824,333,312) (Note 1) $ 803,946,952
Cash 209
Receivable for:
Investments sold 19,039,990
Fund shares sold 850,404
Interest 15,821,508
Prepaid expenses 117,016
Total assets 839,776,079
Liabilities:
Payable for:
Investments purchased 24,356,172
Fund shares redeemed 1,007,297
Other accrued expenses and liabilities 167,891
Total liabilities 25,531,360
Net assets $ 814,244,719
Net assets represented by (Note 1):
Paid-in capital $ 972,626,861
Undistributed investment income--net 6,280,569
Accumulated realized gains (losses) on investment
and foreign currency related transactions--net (144,276,351)
Net unrealized appreciation (depreciation) on
investment transactions--net (20,386,360)
Total net assets applicable to outstanding shares
of beneficial interest ($15.28 a share on
53,298,917 shares outstanding) (Note 2) $ 814,244,719
STATEMENT OF OPERATIONS--
Year Ended August 31, 1994
Investment income (Note 1):
Interest (net of withholding taxes of
$165,003) $ 76,909,456
Expenses (Notes 2 and 4):
Management fee $ 4,624,138
Transfer agent fees 1,911,894
Accounting, auditing and legal 121,838
Custodian fees 324,357
Printing 50,770
Trustees' fees and expenses 51,945
Distribution Plan expenses 9,146,591
Registration fees 30,741
Miscellaneous expenses 108,107
Total expenses 16,370,381
Investment income--net 60,539,075
Net realized and unrealized gain (loss)
on investments and foreign currency
related transactions (Notes 1 and 3):
Realized gain (loss) on:
Investments (14,846,227)
Foreign currency related transactions 565,552
Realized gain (loss) on investments
and foreign currency
related transactions--net (14,280,675)
Net change in unrealized appreciation
(depreciation) on:
Investments (76,526,234)
Foreign currency related
transactions (739,697)
Net change in unrealized appreciation
or depreciation (77,265,931)
Net gain (loss) on investments and
foreign currency related transactions (91,546,606)
Net increase (decrease) in net assets
resulting from operations ($ 31,007,531)
<PAGE>
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
Year Ended August 31,
1994 1993
<S> <C> <C>
Operations:
Investment income--net (Note 1) $ 60,539,075 $ 71,793,224
Realized gain (loss) on investments and foreign currency related
transactions--net (Notes 1 and 3) (14,280,675) 27,625,102
Net change in unrealized appreciation or depreciation (77,265,931) 13,409,198
Net increase (decrease) in net assets resulting from operations (31,007,531) 112,827,524
Net equalization charges and credits (Note 1) 0 44,777
Distributions to shareholders from (Note 1):
Investment income--net (70,243,075) (71,838,001)
In excess of investment income--net 0 (4,635,202)
Total distributions to shareholders (70,243,075) (76,473,203)
Capital share transactions (Note 2):
Proceeds from shares sold 128,708,064 225,734,182
Payments for shares redeemed (257,623,056) (204,148,203)
Net asset value of shares issued in reinvestment of distributions from
investment income--net and in excess of investment income--net 40,016,840 44,069,094
Net increase (decrease) in net assets resulting from capital share
transactions (88,898,152) 65,655,073
Total increase (decrease) in net assets (190,148,758) 102,054,171
Net assets:
Beginning of year 1,004,393,477 902,339,306
End of year [Including undistributed investment income--net
(distributions in excess of investment income--net) as follows:
August 31, 1994--($9,704,000) and August 31, 1993--$0](Note 1) $ 814,244,719 $1,004,393,477
</TABLE>
<PAGE>
NOTES TO FINANCIAL STATEMENTS
(1.) Significant Accounting Policies
Keystone Custodian Fund, Series B-2 Diversified Bond Fund (the "Fund"), is a
common law trust for which Keystone Management, Inc. ("KMI") is the Investment
Manager and Keystone Custodian Funds, Inc. ("Keystone") is the Investment
Adviser. The Fund is registered under the Investment Company Act of 1940 as a
diversified open-end investment company.
Keystone is a wholly-owned subsidiary of Keystone Group, Inc. ("KGI"), a
Delaware corporation. KGI is privately owned by an investor group consisting
of members of current management of Keystone. Keystone Investor Resource
Center, Inc. ("KIRC"), a wholly-owned subsidiary of Keystone, is the Fund's
transfer agent.
The following is a summary of significant accounting policies consistently
followed by the Fund in the preparation of its financial statements. The
policies are in conformity with generally accepted accounting principles.
A. Investments are usually valued at the closing sales price, or, in the
absence of sales and for over-the-counter securities, the mean of bid and
asked quotations. Management values the following securities at prices it
deems in good faith, by or under the direction of the Board of Trustees, to be
fair: (a) securities (including restricted securities) for which quotations
are not readily available and (b) listed securities if, in the opinion of
management, the last sales price does not reflect a current value or if no
sale occurred. 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. Short-term investments maturing in more than sixty days
for which market quotations are readily available are valued at current market
value. Short-term investments maturing in more than sixty days when purchased
which are held on the sixtieth day prior to maturity are valued at amortized
cost (market value on the sixtieth day adjusted for amortization of premium or
accretion of discount) which when combined with accrued interest approximates
market. Investments denominated in a foreign currency are adjusted daily to
reflect changes in exchange rates. Market quotations are not considered to be
readily available for long-term corporate bonds and notes; such investments
are stated at fair value on the basis of valuations furnished by a pricing
service, approved by the Trustee, which determines valuations for normal
institutional-size trading units of such securities using methods based on
market transactions for comparable securities and various relationships
between securities which are generally recognized by institutional traders.
A futures contract is an agreement between two parties to buy and sell a
specific amount of a commodity, security, financial instrument, or, in the
case of a stock index, cash at a set price on a future date. Upon entering
into a futures contract the Fund is required to deposit with a broker an
amount ("initial margin") equal to a certain percentage of the purchase price
indicated in the futures contract. Subsequent payments ("variation margin")
are made or received by the Fund each day, as the value of the underlying
instrument or index fluctuates, and are recorded for book purposes as
unrealized gains or losses by the Fund. For federal tax purposes, any futures
contracts which remain open at fiscal year end are marked-to-market and the
resultant net gain or loss is included in federal taxable income.
Foreign currency amounts are translated into United States dollars as follows:
market value of investments, assets and liabilities at the daily rate of
exchange, purchase and sales of investment, income and expenses at the rate of
exchange prevailing on the
<PAGE>
respective dates of such transactions. Net unrealized foreign exchange
gains/losses are a component of unrealized appreciation/depreciation of
investments.
B. Securities transactions are accounted for on the trade date. Realized gains
and losses are recorded on the identified cost basis. Interest income is
recorded on the accrual basis and dividend income is recorded on the
ex-dividend date. All original issue discounts are amortized for both
financial reporting and federal income tax purposes. Distributions to
shareholders are recorded at the close of business on the ex-dividend date.
C. The Fund has qualified, and intends to qualify in the future, as a
regulated investment company under the Internal Revenue Code of 1986, as
amended ("Internal Revenue Code"). Thus, the Fund expects to be relieved of
any federal income tax liability by distributing all of its net taxable
investment income and net taxable capital gains, if any, to its shareholders.
The Fund intends to avoid excise tax liability by making the required
distributions under the Internal Revenue Code.
D. For the year ended August 31, 1993, the Fund used the accounting practice
known as equalization by which a portion of the proceeds from the sales and
the cost of redemptions of capital shares (equivalent on a per share basis to
the amount of undistributed net investment income on the date of the
transactions) was credited or charged to undistributed net investment income.
As a result, undistributed net investment income per share was not affected by
sales or redemptions of shares. Effective September 1, 1993, the Fund
discontinued equalization accounting.
E. When the Fund enters into a repurchase agreement (a purchase of securities
whereby the seller agrees to repurchase the securities at a mutually agreed
upon date and price) the repurchase price of the securities will generally
equal the amount paid by the Fund plus a negotiated interest amount. The
seller under the repurchase agreement will be required to provide securities
("collateral") to the Fund whose value will be maintained at an amount not
less than the repurchase price, and which generally will be maintained at 101%
of the repurchase price. The Fund monitors the value of collateral on a daily
basis, and if the value of collateral falls below required levels, the Fund
intends to seek additional collateral from the seller or terminate the
repurchase agreement. If the seller defaults, the Fund would suffer a loss to
the extent that the proceeds from the sale of the underlying securities were
less than the repurchase price. Any such loss would be increased by any cost
incurred on disposing of such securities. If bankruptcy proceedings are
commenced against the seller under the repurchase agreement, the realization
on the collateral may be delayed or limited. Repurchase agreements entered
into by the Fund will be limited to transactions with dealers or domestic
banks believed to present minimal credit risks, and the Fund will take
constructive receipt of all securities underlying repurchase agreements until
such agreements expire.
F. In connection with portfolio purchases and sales of securities denominated
in a foreign currency, the Fund may enter into forward foreign currency
exchange contracts ("contracts"). Additionally, from time to time the Fund may
enter into contracts to hedge certain foreign currency assets. Contracts are
recorded at market value and are marked-to-market daily. Realized gains and
losses arising from such transactions are included in net realized gain (loss)
on foreign currency related transactions. The Fund is subject to the credit
risk that the other party will not complete the obligations of the contract.
G. The Fund distributes net investment income to shareholders quarterly and
net capital gains, if any, annually. Distributions are determined in
accordance with
<PAGE>
income tax regulations. Distributions from taxable net investment income and
net capital gains can exceed book basis net investment income and net capital
gains. Effective September 1, 1993, the Fund adopted Statement of Position
93-2: Determination, Disclosure, and Financial Statement Presentation of
Income, Capital Gain and Return of Capital Distributions by Investment
Companies. As a result of this statement, the Fund changed the classification
of distributions to shareholders to better disclose the differences between
financial statement amounts and distributions determined in accordance with
income tax regulations. Accordingly, the following reclassifications have been
made as of August 31, 1993: an increase in undistributed investment
income--net of $11,734,060 and decreases in accumulated realized gains
(losses) on investments and foreign currency related transactions--net and
paid-in capital of $7,286,637 and $4,447,423, respectively, to reflect
adoption of the statement.
Differences between book basis investment income-- net available for
distribution and tax basis investment income--net available for distribution
are primarily attributable to differences in the treatment of 12b-1
Distribution Plan charges and gains and losses on foreign currency related
transactions.
(2.) Capital Share Transactions
The Trust agreement authorizes the issuance of an unlimited number of shares
of beneficial interest with a par value of $1.00. Transactions in shares of
the Fund were as follows:
Year Ended August 31,
1994 1993
Shares sold 7,793,456 13,741,415
Shares redeemed (15,835,294) (12,458,600)
Shares issued in
reinvestment of
distributions from:
investment income--net
and in excess of
investment income--net 2,454,488 2,711,330
Net increase (decrease) (5,587,350) 3,994,145
The Fund bears some of the costs of selling its shares under a Distribution
Plan adopted pursuant to Rule 12b-1 under the Investment Company Act of 1940.
Under the Distribution Plan, the Fund pays Keystone Distributors, Inc.
("KDI"), the principal underwriter and a wholly-owned subsidiary of Keystone,
amounts which in total may not exceed the Distribution Plan maximum.
In connection with the Distribution Plan and subject to the limitations
discussed below, Fund shares are offered for sale at net asset value without
any initial sales charge. From the amounts received by KDI in connection with
the Distribution Plan, and subject to the limitations discussed below, KDI
generally pays brokers or others a commission equal to 4% of the price paid to
the Fund for each sale of Fund shares as
<PAGE>
well as a shareholder service fee at a rate of 0.25% per annum of the net
asset value of shares sold by such brokers or others and remaining outstanding
on the books of the Fund for specified periods.
To the extent Fund shares purchased prior to July 8, 1992 are redeemed within
four calendar years of original issuance, the Fund may be eligible to receive
a deferred sales charge from the investor as partial reimbursement for sales
commissions previously paid on those shares. This charge is based on declining
rates, which begin at 4.0%, applied to the lesser of the net asset value of
shares redeemed or the total cost of such shares.
Since July 8, 1992, contingent deferred sales charges applicable to shares of
the Fund issued after January 1, 1992 have, to the extent permitted by the
NASD Rule, been paid to KDI rather than to the Fund.
The Distribution Plan provides that the Fund may incur certain expenses which
may not exceed a maximum amount equal to 0.3125% of the Fund's average daily
net assets for any calendar quarter (approximately 1.25% annually) occurring
after the inception of the Distribution Plan. A rule of the National
Association of Securities Dealers, Inc. ("NASD") limits the annual
expenditures, which the Fund may incur under the Distribution Plan to 1%, of
which 0.75% may be used to pay such distribution expenses and 0.25% may be
used to pay shareholder service fees. The NASD Rule also limits the aggregate
amount which 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 contingent
deferred sales charges paid by the shareholders to KDI).
The Fund has operated its Distribution Plan in accordance with both the Plan
and the NASD Rule since July 8, 1992, except that until July 7, 1993, maximum
annual payments with respect to Net Asset Value as represented by shares sold
prior to January 1, 1992 remained at the current rate of 0.3125% quarterly
(approximately 1.25% annually).
KDI intends, but is not obligated, to continue to pay or accrue distribution
charges which exceed current annual payments permitted to be received by KDI
from the Fund. KDI intends to seek full payment of such charges from the Fund
(together with annual interest thereon at the prime rate plus one percent) at
such time in the future as, and to the extent that, payment thereof by the
Fund would be within permitted limits. KDI currently intends to seek payment
of interest only on such charges paid or accrued by KDI subsequent to January
1, 1992.
For the year ended August 31, 1994 the Fund recovered $188,549 in contingent
deferred sales charges. During the year, the Fund paid KDI $9,335,140 under
the Distribution Plan, of which $2,719,553 represented repayment of amounts
("advances") paid by KDI during the year or in previous years in excess of
amounts received by KDI under the Distribution Plan. The amount paid by the
Fund under its Distribution Plan, net of contingent deferred sales charges,
was $9,146,591 (0.98% of the Fund's average daily net asset value during the
year). During the year, KDI retained $5,118,615 and paid commissions on new
sales and maintenance fees to dealers and others of $5,770,600, of which
$1,554,074 was an advance. During the year, KDI received $933,380 in
contingent deferred sales charges, reducing the total advances outstanding to
$25,878,976 (2.77% of the Fund's net asset value as of August 31, 1994). The
right to certain portions of this amount, if and when receivable, was assigned
by KDI in 1988 in connection with a financial transaction. As of August 31,
<PAGE>
1994, $20,108,977 of the amount assigned remained outstanding.
(3.) Securities Transactions
As of August 31, 1994, the Fund had a capital loss carryover for federal tax
income purposes of approximately $123,245,000 which expires as follows:
1998--$38,243,000, 1999--$85,002,000. For the year ended August 31, 1994,
purchases and sales of investment securities were as follows:
Cost of Proceeds
Purchases from Sales
Portfolio securities $1,817,429,982 $1,930,032,619
Short-term investments 5,346,697,997 5,360,714,997
$7,164,127,979 $7,290,747,616
(4.) Investment Management and Transactions with Affiliates
Under the terms of the Investment Management Agreement between KMI and the
Fund, dated December 29, 1989, KMI provides investment management and
administrative services to the Fund. In return, KMI is paid a management fee
computed daily and paid monthly. The management fee is calculated at a rate of
2.0% of the Fund's gross investment income plus an amount determined by
applying percentage rates starting at 0.50% and declining as net assets
increase to 0.25% per annum, to the net asset value of the Fund. KMI has
entered into an Investment Advisory Agreement with Keystone, dated December
30, 1989, under which Keystone provides investment advisory and management
services to the Fund and receives for its services an annual fee representing
85% of the management fee received by KMI. For the year ended August 31, 1994,
the Fund paid or accrued to KMI investment management and administrative
services fees of $4,624,138 which represented 0.50% of the Fund's average net
assets. Of such amount paid to KMI, $3,930,517 was paid to Keystone for its
services to the Fund.
For the year ended August 31, 1994, the Fund paid or accrued to KIRC and KGI
$20,589 for certain accounting services and $1,911,894 for transfer agent
services.
(5) Distributions to Shareholders
A distribution of net investment income of $0.28 per share was declared
payable by October 6, 1994 to shareholders of record September 23, 1994. This
distribution is not reflected in the accompanying financial statements.
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Trustees and Shareholders of
Keystone Custodian Fund, Series B-2
We have audited the accompanying statement of assets and liabilities of
Keystone Custodian Fund, Series B-2, including the schedule of investments, as
of August 31, 1994, and the related statement of operations for the year then
ended, the statements of changes in net assets for each of the years in the
two-year period then ended, and the financial highlights for each of the years
in the ten-year period then ended. These financial statements and financial
highlights are the responsibility of the Fund's management. Our responsibility
is to express an opinion on these financial statements and financial
highlights based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements and
financial highlights are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. Our procedures included confirmation of securities
owned as of August 31, 1994 by correspondence with the custodian and brokers.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements and financial highlights referred to
above present fairly, in all material respects, the financial position of
Keystone Custodian Fund, Series B-2, as of August 31, 1994, the results of its
operations for the year then ended, the changes in its net assets for each of
the years in the two-year period then ended, and the financial highlights for
each of the years in the ten-year period then ended in conformity with
generally accepted accounting principles.
KPMG PEAT MARWICK LLP
Boston, Massachusetts
October 7, 1994
