Keystone Diversified Bond Fund (B-2)
(formerly Keystone Custodian Fund, Series B-2)
Seeks generous income and capital preservation from a broad spectrum of
bonds.
Dear Shareholder:
We would like to take this opportunity to report on the performance of
Keystone Diversified Bond Fund (B-2) for the Fund's fiscal year which ended
August 31, 1995.
Performance
Your Fund returned 8.13% for the twelve-month period which ended August 31,
1995. Most of this performance was achieved during the last six months of
this period, returning 6.26% from February 28 to August 31. The Lehman
Aggregate Bond Index, a broad-based index of corporate, government and
mortgage securities, returned 11.31% for the twelve-month period and 7.79%
for the six-month period.
After underperforming in 1994, bonds made strong gains in 1995, as
interest rates declined and bond prices rose. Slowing economic growth and
evidence of moderate inflation in the first half of 1995 contributed to the
favorable environment for bonds and the performance of most Fund holdings.
High quality corporate bonds provided some of the best returns, an area we
emphasized in the first half of 1995. The Fund's high yield bond holdings,
which have been an important source of attractive income to the Fund for some
time, also performed well. However, a few of the portfolio's high yield bond
holdings experienced sharp price declines during the period. The overall
effect on your Fund was relatively small, but it contributed to the slight
underperformance during the twelve-month period.
Keystone Diversified Bond Fund (B-2) was designed to seek current income
by investing in a variety of bonds, including corporate, U.S. Treasury, and
mortgage-backed securities. We maintain a flexible and diversified approach
to managing the Fund which is based on changes in the economic and business
cycles. As a result, we made several adjustments to the portfolio in an
attempt to capitalize on attractive income and return opportunities.
To take advantage of rising short-term interest rates and relatively
stable long-term rates during the last half of 1994, we invested in bonds
with one- to three-year maturities and ten-year or longer maturities. In the
higher interest rate environment, the Fund's increased emphasis on short-term
securities provided attractive income and the Fund's long-term bonds provided
relative price stability. As interest rates declined in 1995, we emphasized
bonds with maturities in the three- to ten-year range. This approach helped
the Fund generate a steady stream of income and some capital appreciation.
Throughout the twelve-month period we upgraded the credit quality of the
bonds in the portfolio in anticipation of slower economic growth. When
economic growth slows, higher quality bonds tend to outperform lower quality
issues.
Our Outlook
The "soft landing" we expected for the U.S. economy has arrived. We believe
it should give way to non-inflationary growth and an environment of improved
stability for bond investors. Over the next several months, we expect
short-term rates to decline more than long-term rates. We anticipate that
long-term rates will remain stable or decline slightly. Combined with our
emphasis on higher quality bonds, we expect the Fund's dividend may need to be
reduced in the short term.
We believe there are positive fundamental trends occurring in corporate
America and in the U.S. government that bode well for the bond market. As
corporations restructured their businesses over the past several years, they
have paid down debt, reduced costs and kept prices relatively stable. If
these events continue, inflation risk and
--continued--
1
<PAGE>
Keystone Diversified Bond Fund (B-2)
(formerly Keystone Custodian Fund, Series B-2)
interest rate risk should be kept to a minimum. We will monitor these
developments carefully and will adjust our investment strategy as conditions
warrant.
We believe your Fund's flexible investment approach, our intensive credit
research, and our selective allocation of Fund assets among a variety of
different types of bonds--U.S. government obligations, mortgage-backed
securities, and high grade and high yield corporate bonds--can continue to
provide investors with attractive income and total returns over the long
term.
Thank you for your continued support of Keystone Diversified Bond Fund
(B-2). If you have any questions or comments about your investment, we
encourage you to write us.
Sincerely,
/s/ Albert H. Elfner, III
Chairman and President
Keystone Investments, Inc.
/s/ George S. Bissell
Chairman of the Board
Keystone Funds
[Photo Albert H. Elfner, III] [Photo George S. Bissell]
Albert H. Elfner, III George S. Bissell
October 1995
2
<PAGE>
A Discussion With
Your Fund Manager
[Photo: Christopher P. Conkey]
Christopher P. Conkey is senior portfolio manager of Keystone Diversified
Bond Fund (B-2). Mr. Conkey is a senior vice president and leads Keystone's
high grade bond group. A Chartered Financial Analyst, he has 11 years of
experience managing fixed-income investments. Mr. Conkey holds a BA in
economics from Clark University and an MBA in finance from Boston University.
Q What was the economic environment like during the twelve-month period?
A The economic environment improved significantly for bonds during the
twelve-month period. From August through December 1994, economic growth was
strong, and there were concerns that inflation might rise. The Federal
Reserve Board (the Fed) maintained its policy of raising interest rates in
order to keep inflation in check. At the beginning of 1995, economic growth
began to slow, inflation fears waned, and interest rates began to decline.
The Fed reacted to these events by decreasing short-term interest rates in
July 1995.
Q How did you manage the Fund in this environment?
A We employed two distinct investment strategies. During the first half of
the period, when short-term interest rates rose, we structured the portfolio
in a barbelled configuration. That is, we emphasized shorter term (one- to
three-year maturities) and longer term bonds (ten-year maturities or longer).
We believed that intermediate term bonds, those with three- to ten-year
maturities, would underperform in a rising rate environment. The barbelled
strategy allowed the Fund to take advantage of rising short-term interest
rates and, at the same time, benefit from the stability that long-term rates
provided.
When interest rates declined early in 1995, we changed this strategy to
focus on bonds in the three- to ten-year maturity range. We thought these
intermediate term bonds were attractively priced and believed they would
perform better in a declining interest rate environment.
Q What types of bonds did you emphasize during the period?
A At the beginning of the twelve-month period, we emphasized long-term
Treasury bonds and adjustable-rate mortgage securities (ARMS). As short-term
rates rose in 1994, ARMS provided automatic increases in income. At the same
time, the portfolio's long-term Treasuries offered better price stability
than short-term securities.
- --------------------------------------------------------------------------------
Fund Profile
Objective: Seeks generous income and capital preservation from a broad
spectrum of bonds.
Commencement of investment operations: September 11, 1935
Average maturity: 11 years
Average quality: A
Net assets: $735 million
Newspaper listing: DivrB2
- --------------------------------------------------------------------------------
3
<PAGE>
[Pie chart]
Asset Allocation as of August 31, 1995
Short-term investments (6.6%)
Other (2.7%)(1)
Corporate bonds (50.3%)
Mortgage-backed securities (19.1%)
US government obligations (15.3%)
Foreign bonds (US dollar-denominated) (6.0%)
(as a percentage of net assets)
Early in 1995, when it appeared that interest rates would decline, we
ended our barbelled strategy instead favoring investment grade corporate
bonds with intermediate term maturities and asset-backed securities. As we
made this change we reduced the Fund's holdings of Treasuries to 17% of net
assets and sold nearly all of the ARMS.
Q In what economic sectors did you find the most attractive high grade
bonds?
A We favored interest sensitive sectors such as banking and finance. From
February 1995 through August 1995, the finance weighting in the portfolio
increased from 10% to 14% of net assets. During periods of declining interest
rates, profits of banks and other financial institutions tend to rise and
this enhances the credit quality and the attractiveness of their bonds.
We also invested in industrial bonds. We concentrated in areas that we
believed were benefiting from strong economic growth, a weaker US dollar, and
an increase in the productivity and competitiveness of US corporations. These
included the automotive, shipping, and energy sectors of the economy. The
appeal of industrial bonds was further enhanced by the low level of new
issuance. These bonds were attractive to investors seeking high quality
securities, and this boosted their prices. When adding new bonds to the
portfolio, we focused on those with the highest credit quality ratings, that
is, those rated A and AA by Standard & Poor's Corporation or Moody's
Investors Service, Inc.
Q What was your strategy for high-yield bonds?
A The high-yield bond weighting in the Fund remained at approximately 30%
of net assets during the period. We invested in 57 different issuers, and the
average size of each position was less than 1% of net assets. Because we
believed economic growth would slow in 1995, we adopted a more defensive
strategy by adding higher quality bonds, especially BB-rated bonds. BB-rated
bonds have the potential to provide stability and liquidity when the economy
slows, but typically have lower yields. During 1995, a number of the
portfolio's BB-rated bonds outperformed lower quality high yield securities.
We shifted the Fund's sector allocation away from cyclical industries--those
that tend to be affected by an acceleration in economic activity--to more
defensive industries. These included companies in the food and beverage,
healthcare, media, and cable areas.
Q What is your outlook?
A We believe that the economy will continue to expand over the next
several months. However, we anticipate that economic growth will be more
moderate than the level we experienced in 1995. We expect interest rates to
continue to decline and inflation to remain relatively low. Although lower
market rates and a higher quality portfolio may result in less income for the
Fund's investors, we think this should be a modestly favorable environment
with most of the Fund's return coming from income rather than price
appreciation.
[diamond]
This column is intended to answer
questions about your Fund. If you have a question
you would like answered, please write to:
Keystone Investment Distributors Company, Inc.
Attn: Manager, Shareholder Communications, 22nd Floor
200 Berkeley Street, Boston, Massachusetts 02116-5034.
(1) Includes common stock and warrants, a convertible bond and other assets
and liabilities.
4
<PAGE>
Your Fund's Performance
[Mountain chart]
Growth of an investment in
Keystone Diversified Bond Fund (B-2)
In Thousands
Initial Reinvested
Investment Distributions
8/85 10000 10000
8/86 10658 11801
8/87 10037 12297
8/88 9549 12987
8/89 9416 14186
8/90 8233 13840
8/91 8158 15304
8/92 8726 17888
8/93 9055 20165
8/94 8110 19453
8/95 8010 21034
A $10,000 investment in Keystone Diversified Bond
Fund (B-2) made on August 31, 1985 with all
distributions reinvested was worth $21,034 on
August 31, 1995. Past performance is no
guarantee of future results.
Twelve-Month Performance as of August 31, 1995
========================================================
Total return* 8.13%
Net asset value 8/31/94 $15.28
8/31/95 $15.09
Dividends $ 1.36
Capital gains None
* Before deduction of contingent deferred sales charge (CDSC).
Historical Record as of August 31, 1995
========================================================
If you If you did
Cumulative total return redeemed not redeem
1-year 5.17% 8.13%
5-year 51.98% 51.98%
10-year 110.34% 110.34%
Average annual total return
1-year 5.17% 8.13%
5-year 8.73% 8.73%
10-year 7.72% 7.72%
The one-year return reflects the deduction of the 3% contingent deferred
sales charge for those investors who sold Fund shares after one calendar
year. Investors who retained their fund investment received the one-year
return reported in the second column of the table.
The investment return and principal value will fluctuate so that your
shares, when redeemed, may be worth more or less than the original cost.
You may exchange your shares to another Keystone fund for a $10 fee by
contacting Keystone directly. The exchange fee is waived for individual
investors who make an exchange using Keystone's Automated Response Line
(KARL). The Fund reserves the right to change or terminate the exchange
offer.
5
<PAGE>
Growth of an Investment
[Line chart]
Comparison of change in value of a $10,000 investment
in Keystone Diversified Bond Fund (B-2), the Lehman
Aggregate Bond Index and the Consumer Price Index.
Fund Average Annual Total Return
1 Year 5 Year 10 Year
5.17% 8.73% 7.72%
In Thousands August 31, 1985 through August 31, 1995
Fund LABI CPI
8/85 10000 10000 10000
8/86 11801 12274 10157
8/87 12297 12392 10593
8/88 12987 13436 11019
8/89 14186 15210 11537
8/90 13840 16306 12185
8/91 15304 18687 12648
8/92 17888 21209 13046
8/93 20165 23539 13407
8/94 19453 23180 13796
8/95 21034 25802 14120
Past performance is no guarantee of future results. The one-year
return reflects the deduction of the Fund's 3% contingent deferred
sales charge for shares held for at least one year. Consumer Price
Index is through July 31, 1995.
This chart graphically compares your Fund's total return performance to
certain investment indexes. It is the result of fund performance guidelines
issued by the Securities and Exchange Commission. The intent is to provide
investors with more information about their investment.
Components of the Chart
The chart is composed of several lines that represent the accumulated value
of an initial $10,000 investment for the period indicated. The lines
illustrate a hypothetical investment in:
1. Keystone Diversified Bond Fund (B-2)
The Fund seeks generous income and capital preservation from a broad spectrum
of bonds. Total return quotations are stated after deducting sales charges
(if applicable), fund expenses and transaction costs, and assumes
reinvestment of all distributions.
2. Lehman Aggregate Bond Index (LABI)
The LABI is a broad-based, unmanaged fixed-income index of US government,
corporate and mortgage-backed securities. It represents the price change and
coupon income of several thousand securities of various credit qualities and
maturities. Securities are selected and compiled by Lehman Brothers, Inc.
according to criteria that may be unrelated to your Fund's investment
objective. It would be difficult for most individual investors to duplicate
this index.
3. Consumer Price Index (CPI)
This index is a widely recognized measure of the cost of goods and services
produced in the US. The index contains factors such as prices of services,
housing, food, transportation and electricity which are compiled by the US
Bureau of Labor Statistics. The CPI is generally considered a valuable
benchmark for investors who seek to outperform increases in the cost of
living.
These indexes do not include transaction costs associated with buying and
selling securities, and do not hold cash to meet redemptions. It would be
difficult for most individual investors to duplicate these indexes.
Understanding What the Chart Means
The chart demonstrates your Fund's total return performance in relation to a
well known investment index and to increases in the cost of living. It is
important to understand what the chart shows and does not show.
This illustration is useful because it charts Fund and index performance
over the same time frame and over a long period. Long-term performance is a
more reliable and useful measure of performance than measurements of short-term
returns or temporary swings in the market. Your financial adviser can help
you evaluate fund performance in conjunction with the other important
financial considerations such as safety, stability and consistency.
6
<PAGE>
Limitations of the Chart
The chart, however, limits the evaluation of Fund performance in several
ways. Because the measurement is based on total returns over an extended
period of time, the comparison often favors those funds which emphasize
capital appreciation when the market is rising. Likewise, when the market is
declining, the comparison usually favors those funds which take less risk.
Performance Can Be Distorted
Funds which are more conservative in their orientation and which place an
emphasis on capital preservation will tend to compare less favorably when the
market is rising. In addition, funds which have income as one of their
objectives also will tend to compare less favorably to relevant indexes.
Indexes may also reflect the performance of some securities which a fund may
be prohibited from buying. A bond fund, for example, may be limited to
investments in only high quality bonds, or a stock fund may only be able to
buy stocks that have been traded on a stock exchange for a minimum number of
years or stocks that have a certain market capitalization. Indexes usually do
not have the same investment restrictions as your Fund.
Indexes Do Not Include Costs of Investing
The comparison is further limited in its utility because the indexes do not
take into account any deductions for sales charges, transaction costs or
other fund expenses. Your Fund's performance figures do reflect such
deductions. Sales charges--whether up-front or deferred--pay for the cost of
the investment advice of your financial adviser. Transaction costs pay for
the costs of buying and selling securities for your Fund's portfolio. Fund
expenses pay for the costs of investment management and various shareholder
services. None of these costs are reflected in index total returns. The
comparison is not completely realistic because an index cannot be duplicated
by an investor--even an unmanaged index--without incurring some charges and
expenses.
One of Several Measures
The chart is one of several tools you can use to understand your investment.
It should be read in conjunction with the Fund's prospectus, and annual and
semiannual reports. Also, your financial adviser, who understands your
personal financial situation, can best explain the features of your Keystone
fund and how it applies to your financial needs.
Future Returns May Be Different
Shareholders also should be mindful that the long-run performance of either
the Fund or the indexes is not representative of what shareholders should
expect to receive from their Fund investment in the future; it is presented
to illustrate only past performance and is not a guarantee of future returns.
7
<PAGE>
Keystone Diversified Bond Fund (B-2)
(formerly Keystone Custodian Fund, Series B-2)
SCHEDULE OF INVESTMENTS--August 31, 1995
<TABLE>
<CAPTION>
Interest Maturity Par Market
Rate Date Value Value
=============================================================================================================
<S> <C> <C> <C> <C> <C>
FIXED INCOME (91.1%)
CONVERTIBLE BONDS (0.4%)
RESTAURANTS (0.4%)
Boston Market, Inc. Conv. Deb.
(Subord.) 4.500% 2004 $ 3,250,000 $ 3,083,438
- -------------------------------------------------------------------------------------------------------------
TOTAL CONVERTIBLE BONDS
(Cost $3,250,000) 3,083,438
- -------------------------------------------------------------------------------------------------------------
INDUSTRIAL BONDS & NOTES (50.3%)
ADVERTISING & PUBLISHING (0.7%)
Outlet Broadcast, Inc. Sr. Notes (Subord.) 10.875 2003 4,375,000 4,725,000
- -------------------------------------------------------------------------------------------------------------
AMUSEMENTS (1.3%)
Affinity Group, Inc. Gtd. Sr. Notes
(Subord.) 11.500 2003 3,000,000 3,007,500
Boyd Gaming Corp. Sr. Notes (Subord.) 10.750 2003 3,000,000 3,105,000
Six Flags Theme Parks, Inc.
(Effective Yield 11.123%) (c)
(f) Sr. Disc. Notes 0.000 2005 4,250,000 3,113,125
- -------------------------------------------------------------------------------------------------------------
9,225,625
- -------------------------------------------------------------------------------------------------------------
AUTOMOTIVE (1.5%)
Olympic Automobile Series 1995 C Class
A2 6.200 2002 10,730,000 10,717,875
- -------------------------------------------------------------------------------------------------------------
BROADCASTING (2.0%)
Continental Cablevision, Inc. Sr. Deb. 9.500 2013 7,750,000 8,089,063
MFS Communications, Inc.
(Effective Yield 9.373%) (c) Sr. Disc. Notes 0.000 2004 4,000,000 2,980,000
Sinclair Broadcast Group, Inc. Sr. Notes (Subord.) 10.000 2005 3,575,000 3,610,750
- -------------------------------------------------------------------------------------------------------------
14,679,813
- -------------------------------------------------------------------------------------------------------------
BUILDING MATERIALS (1.3%)
Associated Materials, Inc. Sr. Notes (Subord.) 11.500 2003 2,000,000 1,840,000
HMH Properties, Inc. (f) Sr. Secd. Notes 9.500 2005 5,000,000 4,800,000
Schuller International Group, Inc. Sr. Notes 10.875 2004 3,000,000 3,285,000
- -------------------------------------------------------------------------------------------------------------
9,925,000
- -------------------------------------------------------------------------------------------------------------
CAPITAL GOODS (1.2%)
Inland Steel Industries, Inc. Notes 12.750 2002 4,200,000 4,714,500
Tenneco, Inc. Notes 10.375 2000 3,555,000 4,092,338
- -------------------------------------------------------------------------------------------------------------
8,806,838
- -------------------------------------------------------------------------------------------------------------
CHEMICALS (1.4%)
Key Plastics, Inc. Sr. Notes Series B 14.000 1999 6,500,000 6,565,000
Uniroyal Chemical Corp. Investors
Holding, Inc. Sr. Notes (Subord.) 11.000 2003 4,000,000 4,020,000
- -------------------------------------------------------------------------------------------------------------
10,585,000
- -------------------------------------------------------------------------------------------------------------
See Notes to Schedule of Investments.
8
<PAGE>
CONSUMER GOODS (1.7%)
Coty, Inc. Sr. Notes (Subord.) 10.250% 2005 $ 4,500,000 $ 4,635,000
Drypers Corp. Sr. Notes Series B 12.500 2002 5,000,000 2,750,000
Ralphs Grocery Co. Sr. Notes 10.450 2004 5,000,000 4,887,500
- -------------------------------------------------------------------------------------------------------------
12,272,500
- -------------------------------------------------------------------------------------------------------------
DIVERSIFIED COMPANIES (2.5%)
General Electric Capital Corp. Notes 8.750 2007 10,275,000 11,822,621
Jordan Industries, Inc. Sr. Notes 10.375 2003 5,000,000 4,637,500
Jordan Industries, Inc. Sr. Disc. Deb.
(Effective Yield 11.740%) (c) (Subord.) 0.000 2005 3,000,000 1,815,000
- -------------------------------------------------------------------------------------------------------------
18,275,121
- -------------------------------------------------------------------------------------------------------------
FINANCE (13.9%)
American Life Holding Co. Sr. Notes (Subord.) 11.250 2004 4,000,000 4,200,000
Banc One Credit Card Master Trust Series 1994-A
Class A 7.150 1998 7,260,000 7,346,176
Comerica, Inc. Subord. Notes 7.250 2007 5,000,000 5,038,650
Commercial Credit Group, Inc. Notes 10.000 2009 5,000,000 6,163,400
Commercial Credit Group, Inc. Notes 10.000 2008 6,000,000 7,368,180
Corestates Home Equity Loan Notes 6.650 2009 1,563,106 1,552,414
European Investment Bank Deb. 9.125 2002 6,750,000 7,684,808
Ford Motor Credit Co. Notes 6.750 2008 9,000,000 8,707,590
General Motors Acceptance Corp. Med. Term Notes 7.375 1998 3,300,000 3,371,742
Marine Midland Asset Backed 8.000 2024 4,579,169 4,476,138
MBNA Master Credit Card Trust II Series 1995-C
Class A 6.450 2008 9,000,000 8,797,500
Norwest Corp. Med. Term Notes 6.500 2005 9,250,000 9,001,453
Paine Webber Group, Inc. Notes 8.250 2002 6,650,000 6,934,953
Premium Standard Farms Finance L P Sr. Secd. Disc.
(b) (h) Exch. Notes 12.000 2003 9,577,000 6,991,210
Sears Roebuck Acceptance Corp. Med. Term Notes 6.240 1999 3,725,000 3,673,446
Standard Credit Card Trust Series 1990 Class A 9.500 1998 6,890,000 7,230,159
Tembec Finance Corp. Sr. Notes 9.875 2005 3,700,000 3,700,000
- -------------------------------------------------------------------------------------------------------------
102,237,819
- -------------------------------------------------------------------------------------------------------------
FOODS (2.2%)
Brunos, Inc. Sr. Notes 10.500 2005 3,500,000 3,403,750
Cott Corp. Quebec Sr. Notes 9.375 2005 5,000,000 5,000,000
PM Holdings Corp. Units (Sr. Disc.
Notes/Wts.) 11.500 2005 4,812,000 2,502,240
Specialty Foods Corp. Sr. Notes (Subord.)
Series B 11.250 2003 5,250,000 5,145,000
- -------------------------------------------------------------------------------------------------------------
16,050,990
- -------------------------------------------------------------------------------------------------------------
HEALTHCARE (0.5%)
Ornda Healthcorp Sr. Notes (Subord.) 11.375 2004 3,000,000 3,300,000
- -------------------------------------------------------------------------------------------------------------
(continued on next page)
9
<PAGE>
- -------------------------------------------------------------------------------------------------------------
INSURANCE (4.2%)
CCP Insurance Sr. Notes 10.500% 2004 $ 5,000,000 $ 5,237,500
Chartwell Re Corp. Sr. Notes 10.250 2004 4,000,000 3,940,000
MBIA, Inc. Deb. 9.375 2011 15,000,000 17,701,050
Reliance Group Holdings, Inc. Sr. Deb. (Subord.) 9.750 2003 4,000,000 3,880,000
- -------------------------------------------------------------------------------------------------------------
30,758,550
- -------------------------------------------------------------------------------------------------------------
MISCELLANEOUS (0.7%)
Los Angeles, California Fire Safety
Improvements
Assessment Dist. #1 8.480 2015 5,000,000 5,181,250
- -------------------------------------------------------------------------------------------------------------
NATURAL GAS (0.7%)
TransTexas Gas Corp. Sr. Secd. Notes 11.500 2002 5,000,000 5,237,500
- -------------------------------------------------------------------------------------------------------------
OFFICE & BUSINESS EQUIPMENT (0.4%)
Specialty Equipment Companies,
Inc. Sr. Notes (Subord.) 11.375 2003 2,500,000 2,625,000
- -------------------------------------------------------------------------------------------------------------
OIL (2.0%)
Occidental Petroleum Corp. Med. Term Notes 6.350 2000 1,900,000 1,852,405
Occidental Petroleum Corp. Med. Term Notes 6.240 2000 5,550,000 5,383,334
Plains Resources, Inc. Sr. Notes (Subord.) 12.000 1999 4,000,000 4,120,000
Wainoco Oil Corp. Sr. Notes 12.000 2002 3,250,000 3,315,000
- -------------------------------------------------------------------------------------------------------------
14,670,739
- -------------------------------------------------------------------------------------------------------------
PAPER & PACKAGING (1.4%)
Owens Illinois, Inc. Deb. 11.000 2003 4,500,000 4,916,250
Rainy River Forest Products, Inc. Sr. Secd. Notes 11.000 2001 5,000,000 5,350,000
- -------------------------------------------------------------------------------------------------------------
10,266,250
- -------------------------------------------------------------------------------------------------------------
RETAIL (2.2%)
Big 5 Holdings, Inc. Sr. Notes (Subord.) 13.625 2002 1,000,000 980,000
Cole National Group, Inc. Sr. Notes 11.250 2001 4,000,000 3,960,000
Hills Stores Co. Sr. Notes 10.250 2003 3,500,000 3,325,000
Pamida, Inc. Sr. Notes (Subord.) 11.750 2003 4,500,000 3,960,000
Service Merchandise Co. Sr. Deb. (Subord.) 9.000 2004 5,000,000 4,175,000
- -------------------------------------------------------------------------------------------------------------
16,400,000
- -------------------------------------------------------------------------------------------------------------
SERVICES (1.1%)
Comcast Cellular Corp. (Effective
Yield 11.732%) (c) Sr. Part. Notes 0.000 2000 7,380,000 5,535,000
Community Health Systems, Inc. Sr. Deb. (Subord.) 10.250 2003 2,500,000 2,637,500
Santa Fe Hotel, Inc. 1st Mtge. Notes 11.000 2000 530,000 471,700
- -------------------------------------------------------------------------------------------------------------
8,644,200
- -------------------------------------------------------------------------------------------------------------
See Notes to Schedule of Investments.
10
<PAGE>
- -------------------------------------------------------------------------------------------------------------
TELECOMMUNICATIONS (3.2%)
Adelphia Communications Corp. Sr. Notes 12.500% 2002 $ 3,000,000 $ 3,045,000
Pagemart, Inc. (Effective Yield Unit (Sr. Disc.
12.250%) (c) Notes/Wts.) 0.000 2003 3,050,000 1,986,313
Rogers Cablesystems Ltd. Sr. Secd. 2nd
Priority Note 10.000 2005 5,500,000 5,651,250
Time Warner Entertainment Co. Notes 8.875 2012 7,500,000 8,027,325
Videotron Group Ltd. Voting Conv. Deb.
(Subord.) 10.625 2005 5,000,000 5,225,000
- -------------------------------------------------------------------------------------------------------------
23,934,888
- -------------------------------------------------------------------------------------------------------------
TRANSPORTATION (1.9%)
California Petroleum Transport
Corp. 1st Mtge. Notes 8.520 2015 5,000,000 5,252,450
Eletson Holdings, Inc. 1st Mtge. Notes 9.250 2003 4,999,500 4,799,520
Gearbulk Holding Ltd. Sr. Notes 11.250 2004 4,000,000 4,180,000
- -------------------------------------------------------------------------------------------------------------
14,231,970
- -------------------------------------------------------------------------------------------------------------
UTILITIES (2.3%)
Chugach Electric Association, Inc. 1st Mtge. Bds. 9.140 2022 13,150,000 14,683,290
Montana Power Co. 1st Mtge. Notes 7.700 1999 2,400,000 2,496,792
- -------------------------------------------------------------------------------------------------------------
17,180,082
- -------------------------------------------------------------------------------------------------------------
TOTAL INDUSTRIAL BONDS & NOTES (Cost--$368,010,432) 369,932,010
- -------------------------------------------------------------------------------------------------------------
FOREIGN BONDS (U.S. DOLLARS)
(6.0%)
Gulf Canada Resources Ltd. Sr. Notes (Subord.) 9.625 2005 3,500,000 3,500,000
Indah Kiat International Finance Gtd. Sr. Secd.
Co. B. V. Notes 11.875 2002 4,000,000 4,080,000
Ispat Mexicana S.A. Sr. Unsecd. Deb. 10.375 2001 5,000,000 4,400,000
Manitoba Province, Canada Deb. 9.625 1999 8,750,000 9,637,600
Midland Amern Capital Corp Gtd. Notes 12.750 2003 2,500,000 2,931,475
Northern Telecom Ltd. Notes 8.250 1996 3,500,000 3,556,140
Republic of Argentina Sr. Notes 8.375 2003 5,500,000 4,028,750
Republic of Argentina Sr. Notes 5.000 2023 3,500,000 1,645,000
Wharf International Capital 1994
Ltd. Gtd. Notes 8.875 2004 10,000,000 10,258,300
- -------------------------------------------------------------------------------------------------------------
TOTAL FOREIGN BONDS (U.S. DOLLARS) (Cost--$42,126,720) 44,037,265
- -------------------------------------------------------------------------------------------------------------
ADJUSTABLE RATE MORTGAGE SECURITIES (1.4%)
FNMA Pool #070119 Cap 12.018%, Margin
2.000% + CMT 7.173 2017 3,265,861 3,361,796
FNMA Pool #124289 Cap 13.432%, Margin
2.005% + CMT 7.678 2021 6,844,955 7,027,852
- -------------------------------------------------------------------------------------------------------------
TOTAL ADJUSTABLE RATE MORTGAGE SECURITIES (Cost--$10,473,461) 10,389,648
- -------------------------------------------------------------------------------------------------------------
COLLATERALIZED MORTGAGE OBLIGATIONS (16.7%)
Chase Mortgage Finance Corp. Series 1992 F Class 8.250 2007 421,552 420,642
(Est. Mat. 1995) (g) A4
(continued on next page)
11
<PAGE>
COLLATERALIZED MORTGAGE OBLIGATIONS (continued)
Collateralized Mortgage Investors
Trust
(Est. Mat. 1996) (g) Series 6 Class D 8.800% 2006 $ 5,000,000 $ 5,060,750
Debartolo Capital Partnership
(Est. Mat. 2000) (g) Commercial Mtge. 7.610 2004 9,000,000 9,185,625
Class B
FHA Pool #02043143 (Est. Mat.
1999) (g) Blair House Project 9.125 2034 3,284,180 3,382,706
FHA Pool #02043143 (Est. Mat.
1999) (g) Blair House Project 10.250 2034 2,508,755 2,584,018
FHLMC (Est. Mat. 2010) (g) Series G8 Class SB
inverse floater 9.600 2023 191,912 144,894
FHLMC (Est. Mat. 2005) (g) Series 1615 Class
SB inverse floater 3.214 2008 5,265,900 3,218,781
FHLMC (Est. Mat. 2005) (g) Series 1666 inverse
floater 5.360 2024 7,101,893 4,678,159
FHLMC (Est. Mat. 1999) (g) Series 1684 Class
JC 5.507 2020 6,161,109 6,072,543
FHLMC (Est. Mat. 1999) (g) Series 1684 Class
JD COFI inverse IO 3.493 2020 6,385,302 381,123
FHLMC (Est. Mat. 2004) (g) Series 1360 Class
PK 10.000 2020 5,000,000 5,638,650
FNMA REMIC Trust (Est. Mat. 2001) Series 1992 117
(g) Class K 7.500 2021 7,250,000 7,261,745
FNMA REMIC Trust (Est. Mat. 2007) Series 1993 038
(g) Class L 5.000 2022 5,000,000 4,117,750
Green Tree Financial Corp. (Est. Series 1994 A Class
Mat. 1998) (g) A 6.900 2004 3,222,499 3,183,217
Green Tree Financial Corp. (Est. Series 1994 B Class
Mat. 1997) (g) A 7.850 2004 3,551,783 3,551,783
Merrill Lynch Mortgage Investors, Series 1992 D Class
Inc. (Est. Mat. 1999) (g) B 8.500 2017 3,081,199 3,192,461
The Money Store Home Equity Trust Series 1995 A Class
(Est. Mat. 1997) (g) A 7.925 2014 7,270,000 7,431,031
Paine Webber Mortgage Acceptance Series 1993 5 Class
Corp. IV (Est. Mat. 1997) (g) A3 6.875 2008 5,553,412 5,553,412
Prudential Home Mortgage Series 1992 A Class
(Est. Mat. 2001) (g) 2B2 (Subord.) 7.900 2022 14,000,000 12,950,000
Prudential Home Mortgage Series 1995 A Class
(Est. Mat. 2007) (g) B (Subord.) 8.980 2025 6,440,073 6,472,274
Residential Funding Mortgage
Securities I Series 1994 S15
(Est. Mat. 1997) (g) Class A1 7.750 2024 7,404,153 7,540,611
U.S. Home Equity Loan (Est. Mat. Series 1991 2 Class
1997) (g) B 9.125 2021 4,569,000 4,698,897
Volvo Car Finance Grantor Trust
(Effective Yield 6.62%) Series 1993 2 Class
(Est. Mat. 1996) (c) (f) (g) A 0.000 1997 4,601,203 4,363,235
Zale Funding Trust (Est. Mat. Series 1994 1 Class
1999) (f) (g) A2 7.325 2003 11,000,000 11,292,188
- -------------------------------------------------------------------------------------------------------------
TOTAL COLLATERALIZED MORTGAGE OBLIGATIONS (Cost--$123,014,375) 122,376,495
- -------------------------------------------------------------------------------------------------------------
MORTGAGE PASS-THROUGH CERTIFICATE (1.0%)
Resolution Trust Corp. Mortgage Series 1995 Class
Pass-Through (Cost $7,137,846) 2C 7.500 2028 7,250,000 7,277,188
- -------------------------------------------------------------------------------------------------------------
See Notes to Schedule of Investments.
12
<PAGE>
- -------------------------------------------------------------------------------------------------------------
UNITED STATES GOVERNMENT ISSUES (15.3%)
U.S. Treasury Notes 6.500% 2005 $ 5,000,000 $ 5,076,550
U.S. Treasury Notes 6.750 2000 15,500,000 15,899,583
U.S. Treasury Notes 7.500 2002 3,200,000 3,429,984
U.S. Treasury Notes 7.875 2004 16,700,000 18,450,828
U.S. Treasury Notes 8.875 1998 14,350,000 15,547,364
U.S. Treasury Notes 8.875 2000 9,750,000 10,845,315
U.S. Treasury Bonds 6.875 2025 7,500,000 7,707,450
U.S. Treasury Bonds 7.625 2025 31,730,000 35,354,201
- -------------------------------------------------------------------------------------------------------------
TOTAL UNITED STATES GOVERNMENT ISSUES (Cost--$112,908,472) 112,311,275
- -------------------------------------------------------------------------------------------------------------
TOTAL FIXED INCOME (Cost--$666,921,306) 669,407,319
=============================================================================================================
COMMON STOCKS/RIGHTS/WARRANTS (0.9%)
Hollywood Casino Corp. (d) 611,665 5,160,923
Pagemart, Inc., wts. (b) (d) (f) 14,030 56,120
PM Holdings Corp. (d) 2,964 3
Purity Supreme, Inc. wts. (d) 34,655 347
Reliance Group Holdings, Inc. wts.
(d) 67,904 135,808
Santa Fe Hotel, Inc. wts. (d) 53,000 530
Uniroyal Chemical Corp. Investors
Holding, Inc. (d) 119,971 1,244,699
- -------------------------------------------------------------------------------------------------------------
TOTAL COMMON STOCKS/RIGHTS/WARRANTS (Cost--$173,560) 6,598,430
=============================================================================================================
SHORT-TERM INVESTMENTS (6.6%)
United States Government or Agency
Issues (4.7%)
Federal Home Loan Bank Discount
Notes 1995 20,000,000 19,943,400
U.S. Treasury Bills 1995 14,800,000 14,695,068
- -------------------------------------------------------------------------------------------------------------
TOTAL UNITED STATES GOVERNMENT OR AGENCY ISSUES (Cost $34,636,447) 34,638,468
- -------------------------------------------------------------------------------------------------------------
Maturity
Value
- -------------------------------------------------------------------------------------------------------------
REPURCHASE AGREEMENT (1.9%)
Goldman Sachs Group LP, purchased 8/31/95, (Collateralized
by $13,894,431 FHLMC, 6.257%, 4/1/31) (Cost $13,633,000)
(e) 5.820 9/1/95 $13,635,204 13,633,000
- -------------------------------------------------------------------------------------------------------------
TOTAL SHORT-TERM INVESTMENTS (Cost--$48,269,447) 48,271,468
=============================================================================================================
TOTAL INVESTMENTS (Cost--$715,364,313) (a) (98.6%) 724,277,217
- -------------------------------------------------------------------------------------------------------------
OTHER ASSETS AND LIABILITIES--NET (1.4%) 10,560,063
- -------------------------------------------------------------------------------------------------------------
NET ASSETS (100%) $734,837,280
=============================================================================================================
(continued on next page)
</TABLE>
13
<PAGE>
Notes to Schedule of Investments:
(a) The cost of investments for federal income tax purposes amounted to
$715,969,343. Gross unrealized appreciation and depreciation of
investments, based on identified tax cost, at August 31, 1995, are as
follows:
Gross unrealized appreciation $ 19,064,680
Gross unrealized depreciation (10,756,806)
-----------
Net unrealized appreciation $ 8,307,874
===========
(b) Illiquid securities which may not be sold or disposed of in the ordinary
course of business within seven days at approximately the current market
value. The combined value of such securities at August 31, 1995 was
$7,047,330 (1.0% of the Fund's net assets at August 31, 1995).
(c) Effective yield (calculated at date of purchase) is the yield at which
the bond accretes on an annual basis until maturity date.
(d) Non-income-producing security.
(e) The repurchase ageements are fully collateralized by U.S. Government
and/or agency obligations based on market prices at August 31, 1995.
(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.
(g) 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 estimated maturity to differ from the listed date.
The estimated maturity dates are unaudited.
(h) Securities valued in good faith by management under procedures approved
by the Fund's Board of Trustees. At August 31, 1995, the fair value of
these securities was $6,991,210 (1.0% of the Fund's net assets at August
31, 1995).
Legend of Portfolio Abbreviations:
CMO--Collateralized Mortgage Obligation
CMT--1, 3 or 5 year Constant Maturity Treasury Index
COFI--Cost of Funds Index
FHLMC--Federal Home Loan Mortgage Corporation
FNMA--Federal National Mortgage Association
GNMA--Government National Mortgage Association
IO--Interest Only
REMIC--Real Estate Mortgage Investment Conduit
See Notes to Financial Statements.
14
<PAGE>
FINANCIAL HIGHLIGHTS
(For a share outstanding throughout the year)
<TABLE>
<CAPTION>
Year Ended August 31,
------------------------------------------------------------------------------------------------------------------
1995 1994 1993 1992 1991 1990 1989 1988 1987 1986
===================================================================================================================================
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Net asset
value
beginning
of year $15.28 $17.06 $16.44 $15.37 $15.51 $17.74 $17.99 $18.91 $20.08 $18.84
- -----------------------------------------------------------------------------------------------------------------------------------
Income from
investment
operations:
Net
investment
income 1.06 1.06 1.28 1.33 1.33 1.53 1.71 1.78 1.83 2.07
Net gain
(loss) on
investments
and closed
futures
contracts 0.11 (1.62) 0.70 1.14 0.17 (1.94) (0.13) (0.81) (1.01) 1.38
Net
commissions
paid on
fund share
sales (a) 0 0 0 0 0 0 0 0 0 (0.21)
- -----------------------------------------------------------------------------------------------------------------------------------
Total from
investment
operations 1.17 (0.56) 1.98 2.47 1.50 (0.41) 1.58 0.97 0.82 3.24
- -----------------------------------------------------------------------------------------------------------------------------------
Less
distributions
from:
Net
investment
income (1.06) (1.22) (1.28) (1.33) (1.63) (1.61) (1.83) (1.85) (1.85) (2.00)
In excess of
net
investment
income (0.22) 0 (0.08) (0.07) (0.01) (0.21) 0 0 0 0
Tax basis
return of
capital (0.08) 0 0 0 0 0 0 0 0 0
Net realized
gain on
investments 0 0 0 0 0 0 0 (0.04) (0.14) 0
- -----------------------------------------------------------------------------------------------------------------------------------
Total
distributions (1.36) (1.22) (1.36) (1.40) (1.64) (1.82) (1.83) (1.89) (1.99) (2.00)
- -----------------------------------------------------------------------------------------------------------------------------------
Net asset
value end
of year $15.09 $15.28 $17.06 $16.44 $15.37 $15.51 $17.74 $17.99 $18.91 $20.08
- -----------------------------------------------------------------------------------------------------------------------------------
Total return
(b) 8.13% (3.53%) 12.73% 16.88% 10.58% (2.44%) 9.23% 5.61% 4.20% 18.01%
Ratios/supple-
mental data
Ratios to
average net
assets:
Total
expenses 1.81% 1.75% 1.89% 1.99% 1.94% 1.89% 1.84% 1.68% 1.68% 1.00%
Net
investment
income 7.05% 6.48% 7.73% 8.29% 8.74% 9.26% 9.52% 9.82% 9.31% 10.37%
Portfolio
turnover
rate 178% 200% 133% 117% 101% 43% 47% 46% 74% 69%
- -----------------------------------------------------------------------------------------------------------------------------------
Net assets
end of year
(thousands) $734,837 $814,245 $1,004,393 $902,339 $814,528 $860,615 $1,000,305 $838,892 $889,333 $558,734
- -----------------------------------------------------------------------------------------------------------------------------------
</TABLE>
(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 financial statements for the periods ended on or after June
30, 1987, that net commissions paid under Rule 12b-1 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 net investment income.
(b) Excluding applicable sales charges.
See Notes to Financial Statements.
15
<PAGE>
STATEMENT OF ASSETS AND LIABILITIES
August 31, 1995
===================================================================
Assets: (Note 1):
Investments at market value
(identified cost--$715,364,313) $ 724,277,217
Cash 103
Receivable for:
Investments sold 3,705,516
Fund shares sold 354,497
Interest 11,346,054
Prepaid expenses 116,450
- -------------------------------------------------------------------
Total assets 739,799,837
- -------------------------------------------------------------------
Liabilities (Notes 2, 4 and 5):
Payable for:
Investments purchased 244,800
Fund shares redeemed 2,341,151
Distributions to shareholders 2,237,949
Due to related parties 13,385
Other accrued expenses 125,272
- -------------------------------------------------------------------
Total liabilities 4,962,557
- -------------------------------------------------------------------
Net assets $ 734,837,280
===================================================================
Net assets represented by (Note 1):
Paid-in capital $ 897,724,605
Accumulated distributions in excess of net
investment income (2,237,949)
Accumulated net realized gain (loss) on investments (169,562,280)
Net unrealized appreciation (depreciation) on
investments 8,912,904
- -------------------------------------------------------------------
Total net assets applicable to outstanding
shares of beneficial interest ($15.09 a
share on 48,710,058 shares outstanding) $ 734,837,280
===================================================================
STATEMENT OF OPERATIONS
Year Ended August 31, 1995
===================================================================
Investment income (Note 1):
Interest $ 67,051,003
- -------------------------------------------------------------------
Expenses (Notes 2 and 4):
Management fee $ 3,982,976
Transfer agent fees 1,674,129
Accounting, auditing and legal 88,904
Custodian fees 259,614
Printing 34,214
Trustees' fees and expenses 40,014
Distribution plan expenses 7,512,556
Registration fees 46,386
Miscellaneous 51,615
- -------------------------------------------------------------------
Total expenses 13,690,408
- -------------------------------------------------------------------
Net investment income 53,360,595
- -------------------------------------------------------------------
Net realized and unrealized gain (loss) on investments and
closed futures contracts (Notes 1 and 3):
Net realized gain (loss) on:
Investments (24,643,115)
Closed futures contracts (627,562)
- -------------------------------------------------------------------
Net realized gain (loss) on
investments
and closed futures contracts (25,270,677)
- -------------------------------------------------------------------
Net change in unrealized appreciation
(depreciation) on investments 29,299,264
- -------------------------------------------------------------------
Net gain (loss) on investments and
closed futures contracts 4,028,587
- -------------------------------------------------------------------
Net increase (decrease) in net assets
resulting from operations $ 57,389,182
===================================================================
See Notes to Financial Statements.
16
<PAGE>
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
Year Ended August 31,
------------------------------
1995 1994
==========================================================================================================
<S> <C> <C>
Operations:
Net investment income $ 53,360,595 $ 60,539,075
Net realized gain (loss) on investments and closed futures contracts (25,270,677) (14,280,675)
Net change in unrealized appreciation (depreciation) on investments 29,299,264 (77,265,931)
- ----------------------------------------------------------------------------------------------------------
Net increase (decrease) in net assets resulting from operations 57,389,182 (31,007,531)
- ----------------------------------------------------------------------------------------------------------
Distributions to shareholders from (Notes 1 and 5):
Net investment income (53,360,595) (70,243,075)
In excess of net investment income (11,593,245) 0
Tax basis return of capital (3,726,265) 0
- ----------------------------------------------------------------------------------------------------------
Total distributions to shareholders (68,680,105) (70,243,075)
- ----------------------------------------------------------------------------------------------------------
Capital share transactions (Note 2):
Proceeds from shares sold 115,263,649 128,708,064
Payments for shares redeemed (222,230,419) (257,623,056)
Net asset value of shares issued in reinvestment of dividends and
distributions 38,850,254 40,016,840
- ----------------------------------------------------------------------------------------------------------
Net increase (decrease) in net assets resulting from capital share
transactions (68,116,516) (88,898,152)
- ----------------------------------------------------------------------------------------------------------
Total increase (decrease) in net assets (79,407,439) (190,148,758)
- ----------------------------------------------------------------------------------------------------------
Net assets:
Beginning of year 814,244,719 1,004,393,477
- ----------------------------------------------------------------------------------------------------------
End of year [Accumulated distributions in excess of net investment
income as follows: 1995--($2,237,949) and 1994--($6,280,569)] (Note 1) $ 734,837,280 $ 814,244,719
==========================================================================================================
</TABLE>
See Notes to Financial Statements.
17
<PAGE>
NOTES TO FINANCIAL STATEMENTS
(1.) Significant Accounting Policies
Keystone Diversified Bond Fund (B-2) (formerly Keystone Custodian Fund,
Series B-2), (the "Fund") is a common law trust for which Keystone
Management, Inc. ("KMI") is the Investment Manager and Keystone Investment
Management Company (formerly 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 Investments Inc. (fomerly
Keystone Group, Inc.) ("KII"), a Delaware corporation. KII is privately owned
by an investor group consisting of members of current and former members of
management of Keystone and its affiliates. 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 to be fair: (a) securities (including restricted
securities) for which complete 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 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 which are generally recognized by
institutional traders.
The Fund enters into currency and other financial futures contracts as a
hedge against changes in interest or currency rates. 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
18
<PAGE>
loss is included in federal taxable income. In addition to market risk, the
Fund is subject to the credit risk that the other party will not be able to
complete the obligations of the contract.
Foreign currency amounts are translated into United States dollars as
follows: market value of investments, assets and liabilities at the daily
rate of exchange, purchases and sales of investments, income and expenses at
the rate of exchange prevailing on the respective dates of such transactions.
Net unrealized foreign exchange gains/losses are a component of unrealized
appreciation/depreciation of investments.
B. Securities transactions are accounted for no later than one business day
after 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 discounts are
amortized for both financial reporting and federal income tax purposes.
Distributions to shareholders are recorded at the close of business on the
record 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 any excise tax liability by making the required
distributions under the Internal Revenue Code.
D. 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 the 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.
Pursuant to an exemptive order issued by the Securities and Exchange
Commission, the Fund, along with certain other Keystone funds, may transfer
uninvested cash balances into a joint trading account. These balances are
invested in one or more repurchase agreements that are fully collateralized
by U.S. Treasury and/or Federal Agency obligations.
E. The Fund may enter into forward foreign currency exchange contracts
("contracts") to settle portfolio purchases and sales of securities
denominated in a foreign currency and 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.
19
<PAGE>
The Fund is subject to the credit risk that the other party will not complete
the obligations of the contract.
F. The Fund distributes net investment income monthly and net capital gains,
if any, annually. Distributions are determined in accordance with income tax
regulations. The significant differences between financial statement amounts
available for distribution and distributions made in accordance with income
tax regulations are primarily due to the different treatment of 12b-1
expenses prior to April 1995, differences in the treatment of paydown losses
and the deferral of losses for income tax purposes that have been recognized
for financial statement purposes.
(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,
1995 1994
- ----------------------------------------------------------
Shares sold 7,685,412 7,793,456
Shares redeemed (14,886,517) (15,835,294)
Shares issued in
reinvestment of
dividends and
distributions 2,612,246 2,454,488
- ----------------------------------------------------------
Net increase (decrease) (4,588,859) (5,587,350)
==========================================================
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 Investment
Distributors Company (formerly Keystone Distributors, Inc.) ("KIDC"), 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 KIDC in connection
with the Distribution Plan, and subject to the limitations discussed below,
KIDC generally pays dealers or others a commission equal to 4.00% of the
price paid to the Fund for each sale of Fund shares as 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 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 4.00%, applied to the lesser of the net asset value of shares
redeemed or the total cost of such shares.
Commencing on 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 KIDC 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 year (approximately 1.25% annually)
occuring after the inception of the Distribution Plan. A rule of the National
Association of Securities Dealers, Inc. ("NASD Rule") 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 will limit the
aggregate amount which the
20
<PAGE>
Fund may pay for such distribution costs to 6.25% of gross share sales since
the inception of the Fund's 12b-1 Distribution Plan, plus interest at the
prime rate plus 1.00% on unpaid amounts thereof (less any contingent deferred
sales charges paid by the shareholders to KIDC).
KIDC intends, but is not obligated, to continue to pay or accrue
distribution charges which exceed current annual payments permitted to be
received by KIDC from the Fund. KIDC 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. KIDC currently
intends to seek payment of interest only on such charges paid or accrued by
KIDC subsequent to January 1, 1992.
During the year ended August 31, 1995, the Fund paid KIDC $7,545,356 under
its Distribution Plan. The amount paid by the Fund under its Distribution
Plan, net of deferred sales charges, was $7,512,556 (1.00% of the Fund's
average daily net asset value). During the year ended August 31, 1995, KIDC
received $5,813,521 after payments of commissions on new sales to dealers and
others of $3,216,034.
Under the NASD Rule, the maximum uncollected amount for which KIDC may
seek payment from the Fund under its distribution Plan is $22,382,869 (3.05%
of the Fund's net assets at August 31, 1995).
(3.) Securities Transactions
As of August 31, 1995, the Fund had a capital loss carryover for federal
income tax purposes of approximately $149,889,000 which expires as follows:
1998--$38,243,000; 1999--$85,002,000; and 2003--$26,644,000. For the year
ended August 31, 1995, purchases and sales of investment securities were as
follows:
Cost of Proceeds
Purchases from Sales
- ---------------------------------------------------------
Portfolio securities $1,303,878,601 $1,394,796,648
Short-term investments 3,233,485,118 3,233,177,500
- ---------------------------------------------------------
$4,537,363,719 $4,627,974,148
=========================================================
(4.) Investment Management and Transactions with Affiliates
Under the terms of the Investment Management Agreement between KMI and the
Fund, 1989, KMI provides investment management and administrative services to
the Fund. In return, KMI is paid a management fee computed and paid daily
which is based upon both Fund net assets and gross income earned by the Fund.
The fee is calculated at a rate of 2.0% of the Fund's gross investment income
plus an amount determined by applying percentage rates, that start at 0.50%
and decline, 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, 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. During the year ended August 31,
1995, the Fund paid or accrued to KMI investment management and
administrative services fees of $3,982,976 which represented 0.53% of the
Fund's average net assets. Of such amount paid to KMI, $3,385,529 was paid to
Keystone for its services to the Fund.
During the year ended August 31, 1995, the Fund paid or accrued to KII
$26,592 for certain accounting services and to KIRC $1,674,129 for transfer
agent fees.
(5.) Distributions to Shareholders
A distribution of net investment income of $0.10 per share was declared
payable by October 5, 1995 to shareholders of record September 25, 1995. This
distribution is not reflected in the accompanying financial statements.
21
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Trustees
Keystone Diversified Bond Fund (B-2)
(formerly Keystone Custodian Fund, Series B-2)
We have audited the accompanying statement of assets and liabilities of
Keystone Diversified Bond Fund (B-2), including the schedule of investments,
as of August 31, 1995, 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, 1995 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 Diversified Bond Fund (B-2) as of August 31, 1995, 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
September 29, 1995
22
<PAGE>
FEDERAL TAX STATUS--FISCAL 1995 DISTRIBUTIONS (Unaudited)
During the fiscal year ended August 31, 1995, distributions of $1.36 per
share were paid in shares or cash. This total includes a nontaxable return of
capital equal to $0.076 per share. The remaining dividends are taxable to
shareholders as ordinary income in the year in which received by them or
credited to their accounts and are not eligible for the corporate dividends
received deduction.
In January 1996, we will send you complete information on the
distributions paid during the calendar year 1995 to help you in completing
your federal tax return.
23
<PAGE>
[Back Cover]
Keystone
Family Of Funds
[diamond]
Balanced Fund (K-1)
Diversified Bond Fund (B-2)
Growth and Income Fund (S-1)
High Income Bond Fund (B-4)
International Fund
Liquid Trust
Mid-Cap Growth Fund (S-3)
Precious Metals Holdings
Quality Bond Fund (B-1)
Small Company Growth Fund (S-4)
Strategic Growth Fund (K-2)
Tax Exempt Trust
Tax Free Fund
This report was prepared primarily for the information of the Fund's
shareholders. It is authorized for distribution if preceded or accompanied
by the Fund's current prospectus. The prospectus contains important
information about the Fund including fees and expenses. Read it carefully
before you invest or send money. For a free prospectus on other Keystone
funds, contact your financial adviser or call Keystone at 1-800-343-2898.
[Keystone Logo] KEYSTONE
INVESTMENTS
P.O. Box 2121
Boston, Massachusetts 02106-2121
DBF-AR-10/95
41.5M ["Recycled" symbol]
<PAGE>
[Front Cover]
K E Y S T O N E
[Photo: Family (with baby on Dad's shoulders) strolls through park with
picnic basket]
DIVERSIFIED
BOND FUND (B-2)
[Keystone Logo]
ANNUAL REPORT
AUGUST 31, 1995
