[front cover]
K E Y S T O N E
[photo of lighthouse on cliff overlooking ocean]
DIVERSIFIED
BOND FUND (B-2)
[Keystone logo]
ANNUAL REPORT
AUGUST 31, 1996
<PAGE>
PAGE 1
Keystone Diversified Bond Fund (B-2)
Seeks maximum income without undue risk of principal.
Dear Shareholder:
We are writing to report to you on the performance of Keystone Diversified
Bond Fund (B-2) for the Fund's fiscal year which ended August 31, 1996.
Following our report we have included a discussion with your Fund's
management team and complete financial information.
Performance
Your Fund returned 4.03% for the twelve-month period which ended August 31,
1996. The Lehman Aggregate Bond Index, a broad-based index of corporate,
government and mortgage-backed securities, returned 4.09% for the same
twelve-month period. Your Fund's relative performance was particularly strong
during the last six months of the period when it returned 0.70%; the Lehman
Aggregate Bond Index returned -0.03% for the same six-month period. These
return figures include price changes and reinvested dividends.
We were pleased with your Fund's performance, especially during the second
half of the twelve-month period.
Keystone Diversified Bond Fund (B-2) is a flexible fund focused on seeking
maximum income without undue risk of principal. The Fund seeks this objective
by investing primarily in corporate and government bonds, mortgage-backed
securities and foreign bonds. We believe the Fund's ability to invest in a
wide range of fixed-income securities provided valuable diversification and
flexibility during the changing environment of the last twelve months.
Market environment
In the second half of 1995, the economy grew at a slow-to-moderate pace,
corporate profits remained strong, and inflation was under control. This was
a favorable environment for bonds. The yield on the benchmark 30-year
Treasury bond declined from 6.65% on August 31, 1995 to below 6% at the
beginning of 1996. As yields declined, bond prices rose.
In the first quarter of 1996, this environment changed. There were
increasing concerns that the economy might be growing more rapidly than
expected. In March monthly unemployment figures were reported substantially
lower than expected. This was a turning point for the bond market as economic
statistics in subsequent months confirmed stronger growth in the first half
of 1996. As a result, yields rose, with the 30-year Treasury reaching 7.12%
by August 30.
As yields rose in the U.S., the opposite was true overseas. In Europe and
Japan, the economic environment remained subdued despite an easing of
monetary policies by some central banks to stimulate growth. While the U.S.
economy was strong during the first half of 1996, many countries continued to
struggle with slow economic growth. We believe this created an opportunity to
benefit from rising bond prices in selected foreign markets.
Investment strategy
As interest rates rose in the first quarter of 1996, we employed several
strategies that were aimed at protecting income and minimizing price
declines. We decreased our U.S. Treasury holdings and increased holdings of
mortgage-backed securities. These securities historically have provided more
attractive income and better price protection in a rising interest rate
environment. We also saw opportunities abroad to increase diversification and
quality by adding government bonds from Spain, Germany and Canada. These
bonds were protected from currency fluctuations by hedging the positions into
U.S. dollars.
--continued--
<PAGE>
PAGE 2
Keystone Diversified Bond Fund (B-2)
Our outlook
We expect a favorable environment for bonds in the fourth quarter of 1996
both in the U.S. and in selected foreign markets. We believe concerns about
revived inflationary pressures in the U.S. have been overstated and the
economy should eventually slow in the fourth quarter. However, there is the
potential for some short-term price volatility. Overseas, we expect the
economic environment in industrialized countries to remain slow, but improve
over 1995.
We believe your Fund's flexible approach to invest in nearly any sector of
the bond market can be particularly valuable in a changing environment. This
flexibility allows us to take advantage of attractive income opportunities
and provide diversification. At Keystone, we conduct intensive credit
research on securities we select for the portfolio. We build upon these
individual selections by carefully analyzing sectors, markets, and the
overall economic environment as we allocate portfolio assets. We believe that
this approach can provide the potential for attractive income and total
returns over the long term.
We are pleased to inform you that Keystone has agreed to be acquired by
First Union Corporation. The acquisition is subject to a number of
conditions, including approvals of investment advisory agreements with
Keystone by fund shareholders. First Union is a financial services firm based
in Charlotte, North Carolina. It is the nation's sixth largest bank holding
company with assets of approximately $140 billion. First Union, through its
wholly-owned subsidiary Evergreen Asset Management Corp., manages more than
$16 billion in 36 mutual funds. Keystone will remain a separate entity after
its acquisition and will continue to provide investment advisory and
management services to the Fund. We believe First Union's acquisition of
Keystone should strengthen the investment management services we provide to
you.
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 to us.
Sincerely,
/s/Albert H. Elfner, III
Albert H. Elfner, III
Chairman and President
Keystone Investments, Inc.
/s/George S. Bissell
George S. Bissell
Chairman of the Board
Keystone Funds
October 1996 [Photos of Albert H. Elfner, III and George S. Bissell]
Albert H. Elfner, III George S. Bissell
<PAGE>
PAGE 3
A Discussion With
Your Fund Manager
[photo of Christopher P. Conkey]
Christopher P. Conkey is portfolio manager of your Fund and heads
Keystone's high grade bond team. A Chartered Financial Analyst,
Mr. Conkey has 13 years of experience managing fixed-income
investments. He holds a BA in economics from Clark University and
an MBA in finance from Boston University. Together with high yield
portfolio manager Kristine Cloyes, and domestic analysts David J.
Bowers and Gary E. Pzegeo, and international bond analyst Richard
Wisentaner, the team evaluates credit quality and the economic
environment in selecting bonds for your Fund.
Q What was the environment like for bonds over the last twelve months?
A In the U.S., the bond market experienced two different investment
climates. In the second half of 1995, interest rates declined and bond prices
rose. However, the environment changed in the first quarter of 1996, as
stronger than expected economic growth caused interest rates to rise and bond
prices to decline. This growth, led by strong employment and consumer
spending reports, stimulated concerns about an acceleration of the inflation
rate. Bonds endured some price volatility as investors tried to get a clearer
picture of the economy. So far this strength has not rekindled inflation.
Inflation has remained well contained, and we expect that to continue in the
foreseeable future.
Q What was your asset allocation at the end of the period?
A As of August 31, 1996, your Fund's asset allocation was 49.9% corporate
bonds, 20.1% mortgage-backed securities, 19.2% foreign bonds, 8.9% U.S.
government securities and 1.9% cash and other assets and liabilities (see
chart on page four). At the end of the period the Fund's average maturity was
11 years. During the twelve-month period, we focused on upgrading the Fund's
high yield holdings and increasing your Fund's foreign component.
Q How did you manage the Fund in this changing environment?
A The biggest structural change for the Fund was our establishment of a
position in the foreign sector. We invested in the government bonds of
Canada, Spain and Germany. These are high quality bonds which represent
countries with large, liquid securities markets. Further, the transactions
were hedged into U.S. dollars to help limit the effects of foreign currency
fluctuations. The Fund's foreign sector has recently benefitted from an
easing of monetary policy in each of these countries.
- -----------------------------------------------------------------------------
Fund Profile
Objective: Seeks maximum income without undue risk of principal.
Commencement of investment operations: September 11, 1935
Average maturity: 11 years
Average quality: A
Net assets: $560 million
Newspaper listing: "DivrB2"
- -----------------------------------------------------------------------------
<PAGE>
PAGE 4
Keystone Diversified Bond Fund (B-2)
[typeset representation of pie chart]
Asset Allocation
as of August 31, 1996
Corporate bonds (49.9%)
Mortgage-backed securities (20.1%)
Foreign bonds (non-U.S.$) (17.0%)
U.S. government obligations (8.9%)
Foreign bonds (U.S.$) (2.2%)
Cash(1) (1.9%)
(as a percentage of net assets)
[end pie chart]
Q What made you choose these countries?
A Canada has solid economic fundamentals and low inflation. Spain and
Germany are undergoing what we consider to be positive economic, political
and social changes. They are striving to meet the standards required for
European monetary unification in 1997, as outlined in the Maastricht
agreement. Their policies have continually demonstrated the fiscal constraint
and responsibility necessary to meet those standards. We eliminated our
holdings of Spanish government bonds and increased our holdings of German
bonds by the end of the period because of the appreciation of Spanish bonds
relative to German bonds.
Q What other strategies did you employ?
A A year ago, the portfolio had a larger position in U.S. Treasuries. These
securities historically perform well when interest rates decline. We reduced
our Treasury holdings as interest rates rose, increasing the Fund's holdings
of mortgage-backed securities. These securities have typically outperformed
U.S. Treasuries during periods of rising interest rates. These bonds are also
rated AAA, the highest bond rating available, and provide higher yields than
U.S. Treasuries.
(1) Includes short-term obligations, common stocks, and other assets and
liabilities.
Q High yield corporate bonds have been an important component of the Fund's
strategy for some time. Did you make any changes in this sector?
A These holdings, which comprised 32% of net assets on August 31, 1996, tend
to perform the best when the economy is strong and inflation is low. High
yield bonds were strong contributors to Fund's performance during a period of
generally falling bond prices. In fact, high yield bonds have been the best
performing fixed income sector year-to-date through August 31, 1996.
We improved the quality, liquidity and diversification of the Fund's high
yield corporate bond holdings during the period. We accomplished this by
increasing our holdings of higher rated bonds, primarily bonds rated BB.
Bonds with BB ratings are considered the highest quality in the high yield
sector. As of August 31, 1996, about 19% of the Fund's high yield holdings
were rated BB.
We also improved the liquidity of our high yield holdings. We eliminated the
Fund's investments in issues that were less than $100 million in size.
Further, we significantly increased the portfolio's position in issues that
totaled between $200 million and $300 million.
Portfolio Quality Summary
as of August 31, 1996
S&P rating(2)
[typeset representation of pie chart]
AAA (30.2%)
AA (21.7%)
A (9.2%)
BBB (5.1%)
BB (6.1%)
B (24.8%)
Other(3) (2.9%)
[end pie chart]
Average portfolio quality: A
(as a percentage of portfolio assets)
(2) Where Standard & Poor's (S&P) ratings were not available, we have used
ratings from Moody's Investor Service, Inc., Fitch Investor's Service,
Inc. or ratings assigned by another nationally recognized statistical
rating organization.
(3) Includes CCC rated bonds, unrated bonds, short-term investments, and
common stocks.
<PAGE>
PAGE 5
In the high yield sector, we added to the Fund's industry weightings in
businesses that are not closely tied to fluctuations in the business cycle.
These included the broadcasting and cable industries.
We emphasized these industries because we believed they represented the
potential for significant opportunity, including acquisitions and credit
quality upgrades.
Q What is your outlook for the bond market over the next six months?
A We expect interest rates to trend lower later this year, continuing
through the beginning of 1997. This year's higher interest rates already
appear to be having an impact on economic growth. We think higher rates will
continue to slow the economy. Inflation has remained well-contained, despite
some preliminary pressures from wages. Wage-inflation bears watching, but we
believe that inflation will stay in the 3-3.5% range. This combination of a
slowing economy and low inflation should provide a more favorable environment
for bonds. Further, the Fund's ability to diversify enabled us to seek
opportunities in a variety of fixed-income sectors. We believe this should
help the portfolio generate attractive returns over the long term.
Top 10 Holdings
as of August 31, 1996
Percentage of
Bond/coupon/maturity date net assets
- ------------------------------------------------------------------
Commonwealth of Canada, 8.750%, 2005 6.2
- ------------------------------------------------------------------
U.S. Treasury bonds, 7.875%, 2021 5.8
- ------------------------------------------------------------------
Commonwealth of Canada, 7.500%, 2003 4.5
- ------------------------------------------------------------------
Federal Republic of Germany, 6.875%, 2005 3.7
- ------------------------------------------------------------------
MBIA, 9.375%, 2011 3.1
- ------------------------------------------------------------------
U.S. Treasury bonds, 8.470%(4), 2020 3.0
- ------------------------------------------------------------------
Federal Republic of Germany, 6.500%, 2003 2.6
- ------------------------------------------------------------------
Zale Funding Trust, 7.325%, 1999(5) 2.0
- ------------------------------------------------------------------
GS Mortgage Securities Corp., 7.410%, 2027 1.9
- ------------------------------------------------------------------
Nationwide CSN Trust, 9.875%, 2025 1.9
- ------------------------------------------------------------------
(4) Effective yield
(5) Estimated maturity
[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
Attn: Shareholder Communications, 22nd Floor
200 Berkeley Street, Boston, Massachusetts 02116-5034.
<PAGE>
PAGE 6
Keystone Diversified Bond Fund (B2)
Your Fund's Performance
Growth of an investment in
Keystone Diversified Bond Fund (B-2)
In Thousands
Total Value: $18,541
[typeset representation of mountain chart]
Initial Reinvested
Investment Distributions
8/86 10000 10000
9417 10420
8/88 8959 11005
8835 12021
8/90 7724 11728
7654 12968
8/92 8187 15157
8496 17087
8/94 7610 16484
7515 17824
8/96 7296 18541
[end mountain chart]
A $10,000 investment in Keystone Diversified Bond Fund (B-2) made on August
31, 1986 with all distributions reinvested was worth $18,541 on August 31,
1996. Past performance is no guarantee of future results.
Twelve-Month Performance as of August 31, 1996
Total return* 4.03%
Net asset value 8/31/95 $15.09
8/31/96 $14.65
Distributions $ 1.04
Capital gains None
* Before deduction of contingent deferred sales charge (CDSC).
Historical Record as of August 31, 1996
If you If you did
Cumulative total return redeemed not redeem
1-year 1.12% 4.03%
5-year 42.98% 42.98%
10-year 85.41% 85.41%
Average annual total return
1-year 1.12% 4.03%
5-year 7.41% 7.41%
10-year 6.37% 6.37%
There is no sales charge when you buy Fund shares. The Fund currently imposes
a contingent deferred sales charge that declines from 4% to 1% if you redeem
shares within four years of purchase. The one-year return reflects the
deduction of the 3% contingent deferred sales charge (CDSC) 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.
<PAGE>
PAGE 7
Growth of an Investment
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.
In Thousands August 31, 1986 through August 31, 1996
Fund Average
Annual Total Return
- --------------------------------------------
1 Year 5 Year 10 Year
1.12% 7.41% 6.37%
[typeset representation of line chart]
Fund LABI CPI
8/86 10000 10000 10000
10420 10097 10428
8/88 11005 10947 10848
12021 12392 11358
8/90 11728 13285 11996
12968 15707 12452
8/92 15157 17280 12844
17087 19178 13200
8/94 16484 18886 13583
17824 21021 13938
8/96 18541 21880 14312
[end line chart]
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 more than one year. Consumer Price Index is through August
31, 1996.
This chart graphically compares your Fund's performance to certain investment
indexes. It is the result of fund performance guidelines issued by the
Securities and Exchange Commission. The intent is to provide investors with
more information about their investment.
Components of the chart
The chart is composed of several lines that represent the accumulated value
of an initial $10,000 investment for the period indicated. The lines
illustrate a hypothetical investment in:
1. Keystone Diversified Bond Fund (B-2)
The Fund seeks maximum income without undue risk of principal. 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 U.S. government,
corporate and mortgage-backed securities. It represents the price change and
coupon income of several thousand securities of various credit qualities and
maturities. Securities are selected and compiled by Lehman Brothers, Inc.
according to criteria that may be unrelated to your Fund's investment
objective.
3. Consumer Price Index (CPI)
This index is a widely recognized measure of the cost of goods and services
produced in the U.S. The index contains factors such as prices of services,
housing, food, transportation and electricity which are compiled by the U.S.
Bureau of Labor Statistics. The CPI is generally considered a valuable
benchmark for investors who seek to outperform increases in the cost of
living.
These indexes do not include transaction costs associated with buying and
selling securities, and do not hold cash to meet redemptions. It would be
difficult for most individual investors to duplicate these indexes.
Understanding what the chart means
The chart demonstrates your Fund's performance in relation to a well known
investment index and to increases in the cost of living. It is important to
understand what the chart shows and does not show.
This illustration is useful because it charts Fund and index performance
over the same time frame and over a long period. Long-term performance is a
more reliable and useful measure of performance than measurements of
short-term returns or temporary swings in the market. Your financial adviser
can help you evaluate fund performance in conjunction with the other
important financial considerations such as safety, stability and consistency.
<PAGE>
PAGE 8
Keystone Diversified Bond Fund (B-2)
Limitations of the chart
The chart, however, limits the evaluation of Fund performance in several
ways. Because the measurement is based on total returns over an extended
period of time, the comparison often favors those funds which emphasize
capital appreciation when the market is rising. Likewise, when the market is
declining, the comparison usually favors those funds which take less risk.
Performance can be distorted
Funds which are more conservative in their orientation and which place an
emphasis on capital preservation will tend to compare less favorably when the
market is rising. In addition, funds which have income as one of their
objectives also will tend to compare less favorably to relevant indexes.
Indexes may also reflect the performance of some securities which a fund may
be prohibited from buying. A bond fund, for example, may be limited to
investments in only high quality bonds, or a stock fund may only be able to
buy stocks that have been traded on a stock exchange for a minimum number of
years or stocks that have a certain market capitalization. Indexes usually do
not have the same investment restrictions as your Fund.
Indexes do not include costs of investing
The comparison is further limited in its utility because the indexes do not
take into account any deductions for sales charges, transaction costs or
other fund expenses. Your Fund's performance figures do reflect such
deductions. Sales charges--whether up-front or deferred--pay for the cost of
the investment advice of your financial adviser. Transaction costs pay for
the costs of buying and selling securities for your Fund's portfolio. Fund
expenses pay for the costs of investment management and various shareholder
services. None of these costs are reflected in index total returns. The
comparison is not completely realistic because an index cannot be duplicated
by an investor--even an unmanaged index--without incurring some charges and
expenses.
One of several measures
The chart is one of several tools you can use to understand your investment.
It should be read in conjunction with the Fund's prospectus, and annual and
semiannual reports. Also, your financial adviser, who understands your
personal financial situation, can best explain the features of your Keystone
fund and how it applies to your financial needs.
Future returns may be different
Shareholders also should be mindful that the long-run performance of either
the Fund or the indexes is not representative of what shareholders should
expect to receive from their Fund investment in the future; it is presented
to illustrate only past performance and is not a guarantee of future returns.
<PAGE>
PAGE 9
SCHEDULE OF INVESTMENTS--August 31, 1996
<TABLE>
<CAPTION>
Interest Maturity Par Market
Rate Date Value Value
-----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
FIXED INCOME (98.1%)
INDUSTRIAL BONDS & NOTES (49.9%)
ADVERTISING & PUBLISHING (0.3%)
K-III Communications Sr. Notes 8.500% 2006 $2,000,000 $ 1,860,000
Corporation
----------------------------------------------------------------------------------------------------------
AMUSEMENTS (3.7%)
Boyd Gaming Corporation Sr. Notes (Subord.) 10.750 2003 4,000,000 4,150,000
Casino America, Incorporated Sr. Secd. Notes 12.500 2003 3,500,000 3,517,500
Grand Casino, Incorporated 1st Mtge. Notes 10.125 2003 2,500,000 2,425,000
Harvey's Casino Resorts Sr. Notes (Subord.) 10.625 2006 2,000,000 2,065,000
Six Flags Theme Parks, Sr. Disc. Notes 0.000 2005 4,250,000 3,612,500
Incorporated (Eff. Yield
11.12%) (d)
Trump Atlantic City 1st Mtge. Notes 11.250 2006 5,000,000 4,775,000
Associates
----------------------------------------------------------------------------------------------------------
20,545,000
----------------------------------------------------------------------------------------------------------
BROADCASTING (0.4%)
Sinclair Broadcast Group, Sr. Notes (Subord.) 10.000 2005 2,500,000 2,443,750
Incorporated
----------------------------------------------------------------------------------------------------------
BUILDING MATERIALS (2.4%)
Continental Homes Holding Sr. Notes 10.000 2006 3,000,000 2,985,000
Corporation
HMH Properties, Incorporated Sr. Secd. Notes 9.500 2005 5,000,000 4,875,000
Schuller International Group, Sr. Notes 10.875 2004 5,000,000 5,425,000
Incorporated
----------------------------------------------------------------------------------------------------------
13,285,000
----------------------------------------------------------------------------------------------------------
CABLE (0.6%)
Comcast Corporation (Eff. Sr. (Subord.) Disc. 0.000 2000 3,380,000 2,366,000
Yield 11.72%) (d) Deb.
Fundy Cable Limited Sr. Secd. Second 11.000 2005 1,175,000 1,204,375
Priority Note
----------------------------------------------------------------------------------------------------------
3,570,375
----------------------------------------------------------------------------------------------------------
CAPITAL GOODS (1.6%)
John Deere Capital Deb. 8.625 2019 8,850,000 9,349,317
Corporation
----------------------------------------------------------------------------------------------------------
CHEMICALS (0.8%)
GI Holdings, Incorporated Sr. Notes 10.000 2006 2,166,000 2,106,435
Rexene Corporation Sr. Notes 11.750 2004 2,175,000 2,316,375
----------------------------------------------------------------------------------------------------------
4,422,810
----------------------------------------------------------------------------------------------------------
CONSUMER GOODS (2.3%)
Coty, Incorporated Sr. Notes (Subord.) 10.250 2005 2,500,000 2,650,000
Lenfest Communications, Sr. Secd. Notes 8.375 2005 5,000,000 4,625,000
Incorporated
Revlon Worldwide Corporation Sr. Secd. Disc. 0.000 1998 6,500,000 5,525,000
(Eff. Yield 12.95%) (d) Notes
----------------------------------------------------------------------------------------------------------
12,800,000
----------------------------------------------------------------------------------------------------------
(continued on next page)
<PAGE>
PAGE 10
Keystone Diversified Bond Fund (B-2)
SCHEDULE OF INVESTMENTS--August 31, 1996
Interest Maturity Par Market
Rate Date Value Value
-----------------------------------------------------------------------------------------------------------
DIVERSIFIED COMPANIES (4.4%)
General Electric Capital Notes 7.500% 2035 $11,000,000 $10,653,830
Corporation
Grand Metropolitan Investment Sr. Notes 7.450 2035 9,000,000 9,173,160
Corporation
Jordan Industries, Sr. Notes 10.375 2003 5,000,000 4,800,000
Incorporated
----------------------------------------------------------------------------------------------------------
24,626,990
----------------------------------------------------------------------------------------------------------
ENERGY AND ELECTRICAL PRODUCTS (0.6%)
Nuevo Energy Company Sr. Notes (Subord.) 9.500 2006 3,500,000 3,517,500
----------------------------------------------------------------------------------------------------------
FINANCE (8.3%)
American Life Holding Company Sr. Notes (Subord.) 11.250 2004 4,000,000 4,510,000
Amsouth Bancorporation Subord. Debs. 6.750 2025 10,000,000 9,511,300
APP International Finance Secd. Sr. Notes 11.750 2005 2,000,000 2,020,000
Company B. V.
Commercial Credit Group, Notes 10.000 2009 5,000,000 5,899,750
Incorporated
First Nationwide Holdings Sr. Notes 12.500 2003 2,500,000 2,581,250
NationsBank Corporation Subord. Notes 6.500 2006 9,000,000 8,328,330
Paine Webber Group, Medium Term Notes 6.730 2004 9,385,000 8,763,244
Incorporated
Tembec Finance Corporation Sr. Notes 9.875 2005 5,000,000 4,712,500
----------------------------------------------------------------------------------------------------------
46,326,374
----------------------------------------------------------------------------------------------------------
FOODS (0.6%)
TLC Beatrice International Sr. Secd. Notes 11.500 2005 3,000,000 3,060,000
Holdings, Incorporated
----------------------------------------------------------------------------------------------------------
HEALTHCARE (0.8%)
Dynacare, Incorporated Sr. Notes 10.750 2006 600,000 601,500
Mariner Health Group, Sr. Notes (Subord.) 9.500 2006 4,000,000 4,010,000
Incorporated
----------------------------------------------------------------------------------------------------------
4,611,500
----------------------------------------------------------------------------------------------------------
INSURANCE (5.9%)
MBIA, Incorporated Deb. 9.375 2011 15,250,000 17,175,008
Nationwide CSN Trust (c) Sr. Notes 9.875 2025 10,000,000 10,664,500
Reliance Group Holdings, Sr. Deb. (Subord.) 9.750 2003 4,000,000 4,010,000
Incorporated
Travelers/Aetna Property and Sr. Notes 7.750 2026 1,000,000 967,220
Casualty Corporation
----------------------------------------------------------------------------------------------------------
32,816,728
----------------------------------------------------------------------------------------------------------
METALS AND MINING (1.1%)
Koppers Industries, Sr. Notes 8.500 2004 3,500,000 3,307,500
Incorporated
Wheeling Pittsburgh Sr. Notes 9.375 2003 3,000,000 2,820,000
Corporation
----------------------------------------------------------------------------------------------------------
6,127,500
----------------------------------------------------------------------------------------------------------
MUNICIPALS (0.9%)
Los Angeles, California (c) Fire Safety 8.480 2015 5,000,000 5,031,250
Improvements
Assessment Dist.
#1
----------------------------------------------------------------------------------------------------------
<PAGE>
PAGE 11
SCHEDULE OF INVESTMENTS--August 31, 1996
Interest Maturity Par Market
Rate Date Value Value
-----------------------------------------------------------------------------------------------------------
NATURAL GAS (0.7%)
TransTexas Gas Corporation Sr. Secd. Notes 11.500% 2002 $ 4,000,000 $ 4,170,000
----------------------------------------------------------------------------------------------------------
OIL AND OIL SERVICES (2.6%)
Gulf CDA Resources Sr. Deb. (Subord.) 9.625 2005 2,500,000 2,581,250
Oslo Seismic (c) 1st Prf. Mtg. Notes 8.280 2011 10,000,000 9,968,750
Stena AB Sr. Notes 10.500 2005 2,000,000 2,030,000
----------------------------------------------------------------------------------------------------------
14,580,000
----------------------------------------------------------------------------------------------------------
PAPER & PACKAGING (0.4%)
Packaging Resources, Sr. Notes (Subord.) 11.625 2003 2,000,000 2,030,000
Incorporated (c)
----------------------------------------------------------------------------------------------------------
RETAIL (1.3%)
Cole National Group, Sr. Notes 11.250 2001 4,000,000 4,210,000
Incorporated
Michaels Stores, Incorporated Sr. Notes 10.875 2006 3,000,000 2,977,500
----------------------------------------------------------------------------------------------------------
7,187,500
----------------------------------------------------------------------------------------------------------
TELECOMMUNICATIONS (8.8%)
Adelphia Communications Sr. Notes 12.500 2002 5,000,000 5,150,000
Corporation
American Media Operations Sr. Notes (Subord.) 11.625 2004 4,000,000 4,140,000
Corporation
Benedek Communications Sr. (Subord.) Disc. 0.000 2006 4,750,000 2,612,500
(Eff. Yield 12.24%) (c) (d) Notes
Cablevision Systems Sr. Deb. (Subord.) 10.500 2016 3,000,000 2,940,000
Corporation
Comcast Corporation Sr. Deb. (Subord.) 10.625 2012 5,000,000 5,250,000
Marcus Cable Operations Sr. (Subord.) Disc. 0.000 2004 4,000,000 2,940,000
Limited Partnership (Eff. Notes
Yield 10.91%) (d)
Millicom International Sr. (Subord.) Notes 13.500 2006 3,750,000 2,015,625
Cellular S. A. (c)
Mobile Telecommunications Sr. (Subord.) Notes 13.500 2002 3,500,000 3,640,000
Technology
Park Broadcasting, Sr. Notes 11.750 2004 3,000,000 3,412,500
Incorporated (c)
Pricecellular Wireless Sr. Disc. Notes 0.000 2003 4,025,000 3,179,750
Corporation (Eff. Yield
10.52%) (d)
SFX Broadcasting, Sr. Notes (Subord.) 10.750 2006 3,500,000 3,570,000
Incorporated (c)
Telewest PLC (Eff. Yield Sr. Disc. Deb. 0.000 2007 7,000,000 4,322,500
9.83%) (d)
Vanguard Cellular Systems, Sr. Deb. 9.375 2006 3,000,000 2,910,000
Incorporated
Videotron Group Limited Voting Conv. Deb. 10.625 2005 3,000,000 3,225,000
(Subord.)
----------------------------------------------------------------------------------------------------------
49,307,875
----------------------------------------------------------------------------------------------------------
TRANSPORTATION (0.5%)
Gearbulk Holding Limited Sr. Notes 11.250 2004 2,500,000 2,693,750
----------------------------------------------------------------------------------------------------------
UTILITIES (0.9%)
El Paso Electric Company 1st Mtge. Notes 9.400 2011 5,000,000 5,075,000
----------------------------------------------------------------------------------------------------------
TOTAL INDUSTRIAL BONDS & NOTES (Cost--$282,378,023) 279,438,219
----------------------------------------------------------------------------------------------------------
(continued on next page)
<PAGE>
PAGE 12
Keystone Diversified Bond Fund (B-2)
SCHEDULE OF INVESTMENTS--August 31, 1996
Interest Maturity Par Market
Rate Date Value Value
-----------------------------------------------------------------------------------------------------------
FOREIGN BONDS (U.S. DOLLARS) (2.2%)
Grupo Televisa S.A. (c) Sr. Notes 11.875% 2006 $1,500,000 $ 1,548,750
Grupo Televisa S.A. (Eff. Sr. Disc. Deb. 0.000 2008 3,000,000 1,695,000
Yield 11.87%) (c) (d)
Indah Kiat International Sr. Secd. Notes 11.875 2002 3,000,000 3,135,000
Finance Company B. V.
Ispat Mexicana S.A. Sr. Unsecd. Deb. 10.375 2001 4,000,000 3,920,000
Republic of Argentina Sr. Notes 8.375 2003 2,500,000 2,134,375
----------------------------------------------------------------------------------------------------------
TOTAL FOREIGN BONDS (U.S. DOLLARS) (Cost--$11,241,132) 12,433,125
----------------------------------------------------------------------------------------------------------
FOREIGN BONDS (NON U.S. DOLLARS) (17.0%)
Commonwealth of Canada Deb. 7.500 2003 33,750,000 25,105,468
Canadian Dollars
Commonwealth of Canada Deb. 8.750 2005 43,400,000 34,578,579
Canadian Dollars
Federal Republic of Germany Deb. 6.500 2003 21,293,000 14,801,182
German Marks
Federal Republic of Germany Deb. 6.875 2005 29,600,000 20,701,595
German Marks
----------------------------------------------------------------------------------------------------------
TOTAL FOREIGN BONDS (NON U.S. DOLLARS) (Cost--$94,753,152) 95,186,824
----------------------------------------------------------------------------------------------------------
COLLATERALIZED MORTGAGE OBLIGATIONS (19.0%)
Chase Mortgage Finance Series 1994-L 7.875 2025 3,045,111 2,897,614
Corporation (Est. Mat. 2005)
(b) (c)
Collateralized Mortgage Series 6 Class D 8.800 2006 2,104,147 2,112,206
Investors Trust (Est. Mat.
1997) (b)
Criimi Mae Financial Series 1 Class A 7.000 2033 3,480,559 3,280,427
Corporation (Est. Mat. 2003)
(b)
Debartolo Capital Partnership Commercial Mtge. 7.610 2004 9,000,000 9,061,875
(Est. Mat. 2000) (b) (c) Class B
FHA Pool #02043143 (Est. Mat. Blair House Project 9.125 2034 3,379,123 3,539,632
1999) (b)
FHA Pool #02043143 (Est. Mat. Blair House Project 10.250 2034 2,503,772 2,622,702
1999) (b)
FHLMC (Est. Mat. 2010) (b) Series G8 Class SB 9.600 2023 191,912 142,015
inverse floater
FHLMC Trust (Est. Mat. 2004) Series 47, Class A 5.000 2022 5,000,000 4,250,000
(b)
FNMA (Est. Mat. 2004) (b) Series 1993-248 3.168 2023 12,510,527 8,280,405
Class SA
FNMA Trust (Est. Mat. 2007) Series 1993 038 5.000 2022 5,000,000 4,023,250
(b) Class L
GS Mortgage Securities Series 1996-PL 7.410 2027 11,000,000 10,876,250
Corporation (Est. Mat. 2007)
(b)
Marine Midland (Est. Mat. Series 1991-3 8.000 2024 3,589,872 3,576,409
1997) (b)
Merrill Lynch Mortgage Series 1996-C1 7.420 2026 5,000,000 4,876,050
Investors, Incorporated
(Est. Mat. 2007) (b)
Merrill Lynch Mortgage Series 1992 D Class 8.500 2017 1,533,536 1,550,758
Investors, Incorporated B
(Est. Mat. 2000) (b)
<PAGE>
PAGE 13
SCHEDULE OF INVESTMENTS--August 31, 1996
Interest Maturity Par Market
Rate Date Value Value
-----------------------------------------------------------------------------------------------------------
COLLATERALIZED MORTGAGE OBLIGATIONS (Continued)
Morgan Stanley, Incorporated Series 1996 Class A 6.475% 2010 $4,952,360 $ 4,737,241
(Est. Mat. 2001) (b) (c)
Paine Webber Mortgage Series 1993-4 7.500 2023 2,869,958 2,759,636
Acceptance Corporation IV
(Est. Mat. 2006) (b)
Residential Asset Series 1996-A6 7.500 2026 5,000,000 4,646,875
Securitization Trust (Est.
Mat. 2007) (b)
Ryland Acceptance Corporation Series 88 Class E 7.950 2019 9,847,346 9,826,273
(Est. Mat. 2000) (b)
Shearson Lehman, Incorporated Series V Class 5 7.500 2019 3,500,000 3,461,719
(Est. Mat. 2004) (b)
Structured Asset Securities Series 1996 Class B 6.303 2028 8,349,662 7,994,801
Corporation (Est. Mat. 2001)
(b)
Volvo Car Finance Grantor Series 1993-2 Class 0.000 1997 702,712 672,407
Trust (Eff. Yield 6.62%) A
(Est. Mat. 1996) (b) (c) (d)
Zale Funding Trust (Est. Mat. Series 1994-1 Class 7.325 2003 11,000,000 11,041,250
1999) (b) (c) A2
----------------------------------------------------------------------------------------------------------
TOTAL COLLATERALIZED MORTGAGE OBLIGATIONS (Cost--$108,334,906) 106,229,795
----------------------------------------------------------------------------------------------------------
ADJUSTABLE RATE MORTGAGE SECURITIES (1.1%) (Cost--$6,155,575)
FNMA Pool #124945 Cap 12.54% Margin, 7.599 2031 5,907,284 6,162,066
2.00% + CMT
----------------------------------------------------------------------------------------------------------
UNITED STATES GOVERNMENT ISSUES (8.9%)
U.S. Treasury Bonds (Eff. 0.000 2020 98,000,000 16,980,460
Yield 8.47%) (d)
U.S. Treasury Bonds 7.875 2021 30,500,000 32,549,295
----------------------------------------------------------------------------------------------------------
TOTAL UNITED STATES GOVERNMENT ISSUES (Cost--$51,432,004) 49,529,755
----------------------------------------------------------------------------------------------------------
TOTAL FIXED INCOME (Cost--$554,294,792) 548,979,784
----------------------------------------------------------------------------------------------------------
Shares
----------------------------------------------------------------------------------------------------------
COMMON STOCKS (0.0%) (COST--$2)
PM Holdings Corporation (e) 1,618 2
----------------------------------------------------------------------------------------------------------
Maturity
Value
----------------------------------------------------------------------------------------------------------
REPURCHASE AGREEMENT (0.5%) (COST--$2,930,000)
Keystone Joint Repurchase 5.243 9/3/96 $2,931,707 2,930,000
Agreement (Investments in
repurchase agreements, in a
joint trading account,
purchased 8/30/96) (f)
----------------------------------------------------------------------------------------------------------
TOTAL INVESTMENTS (Cost--$557,224,794) (a) 551,909,786
OTHER ASSETS AND LIABILITIES--NET (1.4%) 7,882,152
----------------------------------------------------------------------------------------------------------
NET ASSETS (100%) $559,791,938
----------------------------------------------------------------------------------------------------------
(continued on next page)
</TABLE>
<PAGE>
PAGE 14
Keystone Diversified Bond Fund (B-2)
SCHEDULE OF INVESTMENTS--August 31, 1996
(a) The cost of investments for federal income tax purposes is $557,231,919.
Gross unrealized appreciation and depreciation of investments, based on
identified tax cost at August 31, 1996, are as follows:
Gross unrealized appreciation $ 7,461,734
Gross unrealized depreciation (12,783,867)
Net unrealized depreciation ($ 5,322,133)
==============
(b) The estimated maturity of a Collateralized Mortgage Obligation ("CMO") is
based on current and projected prepayment rates. Changes in interest
rates can cause the estimated maturity to differ from the listed date.
(c) 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.
(d) Effective yield (calculated at date of purchase) is the yield at which
the bond accretes on an annual basis until maturity date.
(e) Non-income producing security.
(f) The repurchase agreements are fully collateralized by U.S. government
and/or agency obligations based on market prices at August 31, 1996.
Legend of Portfolio Abbreviations:
CMT--1 year Constant Maturity Treasury
FHA--Federal Housing Administration
FHLMC--Federal Home Loan Mortgage Corporation
FNMA--Federal National Mortgage Association
FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS
<TABLE>
<CAPTION>
Net Unrealized
Exchange U.S. value at In Exchange Appreciation/
Date August 31, 1996 for U.S. $ (Depreciation)
- --------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Forward Foreign Currency Exchange Contracts to Buy:
Contracts to Receive
--------------------------------------------------------
10/15/96 2,838,000,000 Spanish Peseta $22,624,878 $22,502,477 $ 122,401
Forward Foreign Currency Exchange Contracts to Sell:
Contracts to Deliver
--------------------------------------------------------
11/29/96 85,624,000 Canadian Dollars $62,773,273 $62,829,469 $ 56,196
11/07/96 54,104,500 German Marks 36,732,667 36,726,807 (5,860)
10/15/96 2,838,000,000 Spanish Peseta 22,624,878 22,024,983 (599,895)
</TABLE>
See Notes to Financial Statements.
<PAGE>
PAGE 15
FINANCIAL HIGHLIGHTS
(For a share outstanding throughout each year)
<TABLE>
<CAPTION>
Year Ended August 31,
-----------------------------------------------------------
<S> <C> <C> <C> <C> <C>
1996 1995 1994 1993 1992
--------------------------------------------------------------------------------------------------
Net asset value beginning of year $15.09 $15.28 $17.06 $16.44 $15.37
--------------------------------------------------------------------------------------------------
Income from investment operations:
Net investment income 0.95 1.06 1.06 1.28 1.33
Net realized and unrealized gain
(loss) on investments and foreign
currency related transactions (0.35) 0.11 (1.62) 0.70 1.14
--------------------------------------------------------------------------------------------------
Total from investment operations 0.60 1.17 (0.56) 1.98 2.47
--------------------------------------------------------------------------------------------------
Less distributions from:
Net investment income (0.96) (1.06) (1.22) (1.28) (1.33)
In excess of net investment income 0 (0.22) 0 (0.08) (0.07)
Tax basis return of capital (0.08) (0.08) 0 0 0
Net realized gain on investments 0 0 0 0 0
--------------------------------------------------------------------------------------------------
Total distributions (1.04) (1.36) (1.22) (1.36) (1.40)
--------------------------------------------------------------------------------------------------
Net asset value end of year $14.65 $15.09 $15.28 $17.06 $16.44
--------------------------------------------------------------------------------------------------
Total return (a) 4.03% 8.13% (3.53%) 12.73% 16.88%
Ratios/supplemental data
Ratios to average net assets:
Total expenses 1.84%(b) 1.81% 1.75% 1.89% 1.99%
Net investment income 6.42% 7.05% 6.48% 7.73% 8.29%
Portfolio turnover rate 246% 178% 200% 133% 117%
--------------------------------------------------------------------------------------------------
Net assets end of year (thousands) $559,792 $734,837 $814,245 $1,004,393 $902,339
--------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
Year Ended August 31,
-----------------------------------------------------------
<S> <C> <C> <C> <C> <C>
1991 1990 1989 1988 1987
--------------------------------------------------------------------------------------------------
Net asset value beginning of year $15.51 $17.74 $17.99 $18.91 $20.08
--------------------------------------------------------------------------------------------------
Income from investment operations:
Net investment income 1.33 1.53 1.71 1.78 1.83
Net realized and unrealized gain
(loss) on investments and foreign
currency related transactions 0.17 (1.94) (0.13) (0.81) (1.01)
--------------------------------------------------------------------------------------------------
Total from investment operations 1.50 (0.41) 1.58 0.97 0.82
--------------------------------------------------------------------------------------------------
Less distributions from:
Net investment income (1.63) (1.61) (1.83) (1.85) (1.85)
In excess of net investment income (0.01) (0.21) 0 0 0
Tax basis return of capital 0 0 0 0 0
Net realized gain on investments 0 0 0 (0.04) (0.14)
--------------------------------------------------------------------------------------------------
Total distributions (1.64) (1.82) (1.83) (1.89) (1.99)
--------------------------------------------------------------------------------------------------
Net asset value end of year $15.37 $15.51 $17.74 $17.99 $18.91
--------------------------------------------------------------------------------------------------
Total return (a) 10.58% (2.44%) 9.23% 5.61% 4.20%
Ratios/supplemental data
Ratios to average net assets:
Total expenses 1.94% 1.89% 1.84% 1.68% 1.68%
Net investment income 8.74% 9.26% 9.52% 9.82% 9.31%
Portfolio turnover rate 101% 43% 47% 46% 74%
--------------------------------------------------------------------------------------------------
Net assets end of year (thousands) $814,528 $860,615 $1,000,305 $838,892 $889,333
--------------------------------------------------------------------------------------------------
</TABLE>
(a) Excluding applicable sales charges.
(b) Ratio of expenses to average net assets includes indirectly paid expenses
for the year ended August 31, 1996. Excluding indirectly paid expenses,
the expense ratio would have been 1.83%.
See Notes to Financial Statements.
<PAGE>
PAGE 16
Keystone Diversified Bond Fund (B-2)
STATEMENT OF ASSETS AND LIABILITIES
August 31, 1996
Assets (Note 2)
Investments at market value
(identified cost--$557,224,794) $ 551,909,786
Cash 161
Receivable for:
Investments sold 49,575
Fund shares sold 233,257
Interest 9,995,518
Net unrealized appreciation on forward foreign
currency exchange contracts 178,597
Prepaid expenses and other assets 113,377
----------------------------------------------------------------------
Total assets 562,480,271
----------------------------------------------------------------------
Liabilities (Notes 2 and 5)
Payable for:
Fund shares redeemed 593,382
Distributions to shareholders 1,396,617
Net unrealized depreciation on forward foreign
currency exchange contracts 605,755
Due to related parties 2,043
Other accrued expenses 90,536
----------------------------------------------------------------------
Total liabilities 2,688,333
----------------------------------------------------------------------
Net assets $ 559,791,938
======================================================================
Net assets represented by
Paid-in capital $ 736,888,926
Accumulated distributions in excess of net
investment income (1,446,954)
Accumulated net realized loss on investments and
foreign currency related transactions (169,908,557)
Net unrealized depreciation on investments and
foreign currency related transactions (5,741,477)
----------------------------------------------------------------------
Total net assets $ 559,791,938
======================================================================
Net Asset Value Per Share (Note 2)
Net asset value of $559,791,938 / 38,221,105
outstanding shares of beneficial interest 14.65
======================================================================
STATEMENT OF OPERATIONS
Year Ended August 31, 1996
Investment income
Interest $ 54,151,923
- --------------------------------------------------------------------------
Expenses (Notes 4 and 5)
Management fee $ 3,481,728
Transfer agent fees 1,454,352
Accounting, auditing and legal 67,591
Custodian fees 319,543
Trustees' fees and expenses 35,248
Distribution Plan expenses 6,610,025
Other 131,639
- --------------------------------------------------------------------------
Total expenses 12,100,126
Less: Expenses paid indirectly (Note 6) (90,034)
- --------------------------------------------------------------------------
Net expenses 12,010,092
- --------------------------------------------------------------------------
Net investment income 42,141,831
- --------------------------------------------------------------------------
Net realized and unrealized loss on investments and
foreign currency related transactions (Notes 1 and 3)
Net realized gain (loss) on:
Investments 440,321
Foreign currency related transactions (117,014)
- --------------------------------------------------------------------------
Net realized gain (loss) on investments
and foreign currency related transactions 323,307
- --------------------------------------------------------------------------
Net change in unrealized depreciation on:
Investments (14,227,912)
Foreign currency related transactions (426,469)
- --------------------------------------------------------------------------
Net change in unrealized depreciation
on investments and foreign currency
related transactions (14,654,381)
- --------------------------------------------------------------------------
Net realized and unrealized loss on
investments and foreign currency
related transactions (14,331,074)
- --------------------------------------------------------------------------
Net increase in net assets resulting
from operations $ 27,810,757
==========================================================================
See Notes to Financial Statements.
<PAGE>
PAGE 17
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
Year Ended August 31,
--------------------------------
1996 1995
--------------------------------------------------------------------------------------------------
<S> <C> <C>
Operations:
Net investment income $ 42,141,831 $ 53,360,595
Net realized gain (loss) on investments, closed futures
contracts and foreign currency related transactions 323,307 (25,270,677)
Net change in unrealized appreciation (depreciation) on
investments and foreign currency related transactions (14,654,381) 29,299,264
--------------------------------------------------------------------------------------------------
Net increase in net assets resulting from operations 27,810,757 57,389,182
--------------------------------------------------------------------------------------------------
Distributions to shareholders from (Note 1)
Net investment income (42,020,420) (53,360,595)
In excess of net investment income 0 (11,593,245)
Tax basis return of capital (2,935,918) (3,726,265)
--------------------------------------------------------------------------------------------------
Total distributions to shareholders (44,956,338) (68,680,105)
--------------------------------------------------------------------------------------------------
Capital share transactions (Note 2)
Proceeds from shares sold 89,671,653 115,263,649
Payments for shares redeemed (273,136,100) (222,230,419)
Net asset value of shares issued in reinvestment of dividends
and distributions 25,564,686 38,850,254
--------------------------------------------------------------------------------------------------
Net decrease in net assets resulting from capital share
transactions (157,899,761) (68,116,516)
--------------------------------------------------------------------------------------------------
Total decrease in net assets (175,045,342) (79,407,439)
--------------------------------------------------------------------------------------------------
Net assets:
Beginning of year 734,837,280 814,244,719
--------------------------------------------------------------------------------------------------
End of year [Including accumulated distributions in excess
of net investment income as follows: 1996--($1,446,954) and
1995--($2,237,949)] (Note 1) $ 559,791,938 $ 734,837,280
==================================================================================================
</TABLE>
See Notes to Financial Statements.
<PAGE>
PAGE 18
Keystone Diversified Bond Fund (B-2)
NOTES TO FINANCIAL STATEMENTS
(1.) Significant Accounting Policies
Keystone Diversified Bond Fund (B-2) (the "Fund") is a common law trust for
which Keystone Management, Inc. ("KMI") is the Investment Manager and
Keystone Investment Management Company ("Keystone") is the Investment
Adviser. Keystone is a wholly-owned subsidiary of Keystone Investments, Inc.
("KII") and KMI is in turn, a wholly-owned subsidiary of Keystone. The Fund
is registered under the Investment Company Act of 1940, as amended (the "1940
Act"), as a diversified, open-end investment company. The Fund's investment
objective is to provide maximum income without undue risk of principal.
The following is a summary of significant accounting policies consistently
followed by the Fund in the preparation of its financial statements. The
policies are in conformity with generally accepted accounting principles,
which require management to make estimates and assumptions that affect
amounts reported herein. Although actual results could differ from these
estimates, any such differences are expected to be immaterial to the net
assets of the Fund.
A. Valuation of Securities
Investments are usually valued at the closing sales price, or, in the absence
of sales and for over-the-counter securities, the mean of the bid and asked
prices. U.S. Government obligations held by the Fund are valued at the mean
between the over-the-counter bid and asked prices, as furnished by an
independent pricing service. Listed corporate bonds, other fixed income
securities, mortgage and other asset-backed securities, and other related
securities are valued at prices provided by an independent pricing service.
In determining value for normal institutional-size transactions, the pricing
service uses methods based on market transactions for comparable securities
and various relationships between securities that are generally recognized by
institutional traders. Security valuations not available from an independent
pricing service (including restricted securities) are valued at fair value as
determined in good faith according to procedures established by the Board of
Trustees.
Short-term investments with remaining maturities of 60 days or less are
carried at amortized cost, which approximates market value. Short-term
securities with greater than 60 days to maturity are valued at market value.
B. Repurchase Agreements
Pursuant to an exemptive order issued by the Securities and Exchange
Commission, the Fund, along with certain other Keystone funds, may transfer
uninvested cash balances into a joint trading account. These balances are
invested in one or more repurchase agreements that are fully collateralized
by U.S. Treasury and/or Federal Agency obligations.
Securities pledged as collateral for repurchase agreements are held by the
custodian on the Fund's behalf. The Fund monitors the adequacy of the
collateral daily and will require the seller to provide additional collateral
in the event the market value of the securities pledged falls below the
carrying value of the repurchase agreement.
C. Reverse Repurchase Agreements
The Fund may enter into reverse repurchase agreements with qualified
third-party broker-dealers. Interest on the value of reverse repurchase
agreements is based upon competitive market rates at the time of issuance. At
the time the Fund enters into a reverse repurchase agreement, it will
establish and maintain a segregated account with the custodian containing
liquid assets having a value not less than the repurchase price (including
accrued interest). If the counterparty to the transaction is rendered
insolvent, the ultimate realization of the securities to be repurchased by
the Fund may be delayed or limited.
<PAGE>
PAGE 19
D. Foreign Currency
The books and records of the Fund are maintained in United States (U.S.)
dollars. Foreign currency amounts are translated into United States dollars
as follows: market value of investments, assets and liabilities at the daily
rate of exchange; purchases and sales of investments, income and expenses at
the rate of exchange prevailing on the respective dates of such transactions.
Net unrealized foreign exchange gain (loss) resulting from changes in foreign
currency exchange rates is a component of net unrealized appreciation
(depreciation) on investments and foreign currency transactions. Net realized
foreign currency gains and losses resulting from changes in exchange rates
include foreign currency gains and losses between trade date and settlement
date on investment securities transactions, foreign currency transactions and
the difference between the amounts of interest and dividends recorded on the
books of the Fund and the amount actually received. The portion of foreign
currency gains and losses related to fluctuations in exchange rates between
the initial purchase trade date and subsequent sale trade date is included in
realized gain (loss) on foreign currency transactions
E. Futures Contracts
In order to gain exposure to or protect against changes in security values,
the Fund may buy and sell futures contracts.
The initial margin deposited with a broker when entering into a futures
transaction is subsequently adjusted by daily payments or receipts as the
value of the contract changes. Such changes are recorded as unrealized gains
or losses. Realized gains or losses are recognized on closing the contract.
Risks of entering into futures contracts include (i) the possibility of an
illiquid market for the contract, (ii) the possibility that a change in the
value of the contract may not correlate with changes in the value of the
underlying instrument or index, (iii) the possibility that Keystone will not
accurately predict changes in exchange rates, interest rates or market
prices, and (iv) the credit risk that the other party will not fulfill the
obligations of the contract. Futures contracts also involve elements of
market risk in excess of the amount reflected in the statement of assets and
liabilities
F. Forward Foreign Currency Exchange Contracts
The Fund may enter into forward foreign currency exchange contracts ("forward
contracts") to settle portfolio purchases and sales of securities denominated
in a foreign currency and to hedge certain foreign currency assets. Forward
contracts are recorded at the forward rate and are marked-to-market daily.
Realized gains and losses arising from such transactions are included in net
realized gain (loss) on foreign currency related transactions. The Fund bears
the risk of an unfavorable change in the foreign currency exchange rate
underlying the forward contract and is subject to the credit risk that the
other party will not fulfill the obligations of the contract. Forward
contracts involve elements of market risk in excess of the amount reflected
in the statement of assets and liabilities.
G. Security Transactions and Investment Income
Securities transactions are accounted for no later than one business day
after the trade date. Realized gains and losses are computed on the
identified cost basis. Interest income is recorded on the accrual basis and
includes amortization of discounts and premiums. Dividend income is recorded
on the ex-dividend date.
H. Federal Income Taxes
The Fund has qualified and intends to qualify in the future as a regulated
investment company under the Internal Revenue Code of 1986, as amended (the
<PAGE>
PAGE 20
Keystone Diversified Bond Fund (B-2)
"Code"). Thus, the Fund is 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 Code. Accordingly,
no provision for federal income tax is required.
I. Distributions
The Fund distributes net investment income monthly and net capital gains, if
any, annually. Distributions to shareholders are recorded at the close of
business on the ex-dividend date.
Income and capital gains distributions to shareholders are determined in
accordance with income tax regulations, which may differ from generally
accepted accounting principles. These differences are primarily due to
paydown gains (losses) and foreign securities transactions.
(2.) Capital Share Transactions
The Fund's Restatement of 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,
1996 1995
- --------------------------------------------------
Shares sold 5,954,123 7,685,412
Shares redeemed (18,152,163) (14,886,517)
Shares issued in
reinvestment of
dividends and
distributions 1,709,087 2,612,246
- --------------------------------------------------
Net decrease (10,488,953) (4,588,859)
- --------------------------------------------------
(3.) Securities Transactions
Cost of purchases and proceeds from sales of investment securities (excluding
short-term securities) were as follows for the year ended August 31, 1996:
Cost of Proceeds
Purchases From Sales
-----------------------------------------------------
Non-U.S. Government $735,937,996 $849,095,470
U.S. Government 832,763,261 869,058,011
-----------------------------------------------------
As of August 31, 1996, the Fund had a capital loss carryover for federal
income tax purposes of approximately $169,901,000, which expire as follows:
$38,243,000--1998; $85,002,000--1999; $26,644,000--2003; and
$20,012,000--2004.
The average daily balance of reverse repurchase agreements outstanding during
the year ended August 31, 1996 was $6,558,128 at a weighted average interest
rate of 3.99%. The maximum amount of reverse repurchase agreements at one
time during the year was $58,660,402 (including accrued interest).
(4.) Distribution Plan
The Fund bears some of the costs of selling its shares under a Distribution
Plan (the "Plan") adopted pursuant to Rule 12b-1 under the 1940 Act. Under
the Plan, the Fund pays its principal underwriter, Keystone Investment
Distributors Company ("KIDC"), a wholly-owned subsidiary of Keystone, amounts
that are calculated and paid daily.
Under the Plan, the Fund pays a distribution fee which may not exceed 1.00%
of the Fund's average daily net assets. Of that amount, 0.75% is used to pay
distribution expenses and 0.25% may be used to pay service fees.
Contingent deferred sales charges paid by redeeming shareholders may be paid
to KIDC.
<PAGE>
PAGE 21
The Plan may be terminated at any time by vote of the Independent Trustees
or by vote of a majority of the outstanding voting shares of the Fund.
However, after the termination of the Plan, at the discretion of the Board of
Trustees, payments to KIDC may continue as compensation for its services
which had been earned while the Plan was in effect.
KIDC intends, but is not obligated, to continue to pay distribution costs
that exceed the current annual payments from the Fund. KIDC intends to seek
full payment of such distribution costs from the Fund at such time in the
future as, and to the extent that, payment thereof by the Fund would be
within permitted limits.
Total unpaid distribution costs at August 31, 1996 amounted to $18,143,554.
(5.) Investment Management Agreement and Other Affiliated Transactions
Under the terms of the Investment Management Agreement between KMI and the
Fund, KMI provides investment management and administrative services to the
Fund. In return, KMI is paid a management fee, computed and paid daily, at an
annual rate of 2.00% of the Fund's gross investment income plus an amount
determined by applying percentage rates, starting at 0.50% and declining as
net assets increase to 0.25% per annum, to the net asset value of the Fund.
KMI has entered into an Investment Advisory Agreement with Keystone under
which Keystone provides investment advisory and management services to the
Fund. In return for its services, Keystone receives an annual fee
representing 85% of the management fee received by KMI.
During the year ended August 31, 1996, the Fund paid or accrued $22,638 to
Keystone for certain accounting services. The Fund paid or accrued $1,454,352
to Keystone Investor Resource Center, Inc., a wholly-owned subsidiary of
Keystone, for services rendered as the Fund's transfer and dividend
disbursing agent.
Certain officers and/or Directors of Keystone are also officers and/or
Trustees of the Fund. Officers of Keystone and affiliated Trustees receive no
compensation directly from the Fund.
(6.) Expense Offset Arrangement
The Fund has entered into an expense offset arrangement with its custodian.
For the year ended August 31, 1996, the Fund incurred total custody fees of
$319,543 and received a credit of $90,034 pursuant to this expense offset
arrangement, resulting in a net custody expense of $229,509. The assets
deposited with the custodian under this expense offset arrangement could have
been invested in income-producing assets.
(7.) Subsequent Distribution to Shareholders
A distribution from net investment income of $0.085 per share was declared
payable on October 4, 1996 to shareholders of record on September 25, 1996.
This distribution is not reflected in the accompanying financial statements.
(8.) Subsequent Event
On September 6, 1996, Keystone Investments, Inc. entered into an Agreement
and Plan of Acquisition and Merger (the "Acquisition") with First Union
Corporation and First Union National Bank of North Carolina ("First Union")
whereby First Union would acquire all the assets and liabilities of Keystone
Investments, Inc. in exchange for shares of First Union. Subject to the
receipt of the required regulatory and shareholder approvals, the Acquisition
is expected to take place in late December 1996.
<PAGE>
PAGE 22
Keystone Diversified Bond Fund (B-2)
INDEPENDENT AUDITORS' REPORT
The Trustees and Shareholders
Keystone Diversified Bond Fund (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, 1996, and the related statement of operations for the year
then ended, the statements of changes in net assets for each of the years in
the two-year period then ended, and the financial highlights for each of the
years in the ten-year period then ended. These financial statements and
financial highlights are the responsibility of the Fund's management. Our
responsibility is to express an opinion on these financial statements and
financial highlights based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements and
financial highlights are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures
in the financial statements. Our procedures included confirmation of
securities owned as of August 31, 1996 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, 1996, the results of
its operations for the year then ended, the changes in its net assets for
each of the years in the two-year period then ended, and the financial
highlights for each of the years in the ten-year period then ended in
conformity with generally accepted accounting principles.
KPMG Peat Marwick LLP
Boston, Massachusetts
September 27, 1996
<PAGE>
PAGE 23
FEDERAL TAX STATUS--FISCAL 1996 DISTRIBUTIONS (Unaudited)
During the fiscal year ended August 31, 1996, distributions of $1.04 per
share were paid in shares or cash. This total includes a nontaxable return of
capital equal to $0.08 per share. The remaining dividends are taxable to
shareholders as ordinary income in the year in which received by them or
credited to their accounts and are not eligible for the corporate dividend
received deduction.
In January 1997, we will send you complete information on the distributions
paid during the calendar year 1996 to help you in completing your federal tax
return.
<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 Inc.
Liquid Trust
Mid-Cap Growth Fund (S-3)
Precious Metals Holdings, Inc.
Quality Bond Fund (B-1)
Small Company Growth Fund (S-4)
Strategic Growth Fund (K-2)
Tax Free Fund
This report was prepared primarily for the information of the Fund's
shareholders. It is authorized for distribution if preceded or accompanied by
the Fund's current prospectus. The prospectus contains important information
about the Fund including fees and expenses. Read it carefully before you
invest or send money. For a free prospectus on other Keystone funds, contact
your financial adviser or call Keystone.
[Keystone logo] KEYSTONE
I N V E S T M E N T S
P.O. Box 2121
Boston, Massachusetts 02106-2121
B2-R-10/96
17.6M [Recycle logo]
