<PAGE>
PAGE 1
KEYSTONE DIVERSIFIED BOND FUND (B-2)
SEEKS GENEROUS INCOME AND CAPITAL PRESERVATION FROM A BROAD SPECTRUM OF BONDS.
Dear Shareholder:
We are pleased to report on the performance of Keystone Diversified Bond Fund
(B-2) for the 12-month fiscal year that ended on August 31, 1997. Following our
report, we have included a discussion with your Fund's manager and complete
financial information.
PERFORMANCE
Your Fund returned 12.25% for the 12-month period that ended on August 31, 1997.
The Lehman Aggregate Bond Index, a broad based index of corporate, government
and mortgage-backed securities, returned 10.00% for the same
12-month period.
We believe your Fund performed very well during the year. This strong
performance was achieved by following an active management strategy that
emphasizes research into sectors and individual bond issues while avoiding
attempts to anticipate interest rate shifts.
ENVIRONMENT
During the year, the U.S. economy was marked by moderate growth, restrained
inflation and, despite some short-term volatility caused by periodic concerns
about either inflation or recession, interest rates that tended to trade in a
well-defined range. Within this relatively healthy environment, corporate bonds
and mortgage-backed securities tended to outperform low risk government bonds,
and high yield securities outperformed investment grade corporate bonds.
Internationally, we witnessed solid economic growth, although the rate of
growth was somewhat slower in Japan and Europe. While foreign interest rates
tended to trend downward, returns from unhedged foreign investments tended to be
limited by the strength of the U.S. dollar.
STRATEGY
During the period, Fund management emphasized corporate bonds and
mortgage-backed securities because of the health of the U.S. economy and the
strength of corporate earnings. More than half the portfolio (56%) was allocated
to corporate bonds at the end of the period. In the investment grade bond area,
the Fund emphasized the finance sector, which benefited from the low inflation
environment. In the high yield area, the Fund emphasized highly liquid, better
quality securities from non-cyclical industries. High yield bonds tended to
outperform other sectors during the year, and as the year progressed your Fund
took profits from high yield bonds and re-allocated assets to other areas,
reducing the high yield commitment from about 30% to about 26% of net assets.
The Fund also invested in foreign opportunities, with about 13% of net assets
in foreign bonds at the end of the fiscal year. All foreign investments,
however, were either hedged or denominated in the U.S. dollar, to minimize
currency risk.
Throughout the year, the Fund minimized interest-rate anticipation as a key
component of its strategy. With interest rate volatility low and relatively
stable rates, little benefit was seen in trying to anticipate the direction of
rates.
At the conclusion of the fiscal year on August 31, 1997, average weighted
maturity was 11.4 years, and average credit quality was A.
-- CONTINUED--
<PAGE>
PAGE 2
KEYSTONE DIVERSIFIED BOND FUND (B-2)
OUTLOOK
Looking toward the future, we expect a general environment of moderate growth to
continue. However, the major uncertainty facing the market is whether cyclical
inflation pressures will rise. If this occurs, it is possible the Federal
Reserve Board may again raise short-term rates, as it did in March, to stave off
inflation.
Given this outlook, fund management intends to keep the fund well positioned
for an environment of growth, seeking relative values in the corporate and
mortgage-backed security areas, while limiting the exposure to short-term
interest rate volatility.
Thank you for your support of Keystone Diversified Bond Fund (B-2).
Sincerely,
Albert H. Elfner, III
CHAIRMAN
KEYSTONE INVESTMENT MANAGEMENT CO.
George S. Bissell
CHAIRMAN OF THE BOARD
KEYSTONE FUNDS
(photo of Albert H. Elfner, III) (photo of George S. Bissell)
ALBERT H. ELFNER, III GEORGE S. BISSELL
October 1997
<PAGE>
PAGE 3
A Discussion With
Your Fund's Manager
(photo of Christopher P. Conkey)
CHRISTOPHER P. CONKEY IS CHIEF INVESTMENT OFFICER OF KEYSTONE'S FIXED
INCOME GROUP AND THE PORTFOLIO MANAGER OF YOUR FUND. A CHARTERED FINANCIAL
ANALYST, MR. CONKEY HAS 14 YEARS OF EXPERIENCE MANAGING FIXED-INCOME
INVESTMENTS. HE HOLDS A BA IN ECONOMICS FROM CLARK UNIVERSITY AND AN MBA
IN FINANCE FROM BOSTON UNIVERSITY. MR. CONKEY IS SUPPORTED IN MANAGING THE
FUND BY RICHARD CRYAN, A KEYSTONE SENIOR VICE PRESIDENT AND PORTFOLIO
MANAGER WHO SPECIALIZES IN MANAGING HIGH YIELD BOND PORTFOLIOS.
WHAT WAS THE ENVIRONMENT LIKE DURING THE YEAR?
If you looked back over the 12 months in the United States, you would see a
period of moderate growth, low inflation, stable monetary policy and excellent
credit conditions. Interest rates traded within a very well defined range.
However, there was significant short-term volatility within the period. Over the
full year, interest rates, as reflected by the 30-year U.S. Treasury bond, went
from 7.12% on August 31, 1996 to 6.61% on August 31, 1997. During the year,
spreads tightened, meaning the difference narrowed between interest rates paid
by one type of bond and another.
Long-term rates declined more than short-term rates, and rates paid by high
yield corporate bonds declined more than rates paid by investment grade bonds or
government bonds.
When you consider the low inflation of the period, bond returns were very
attractive, with low volatility.
WHAT KIND OF INVESTMENT TACTICS DID YOU EMPLOY DURING THE PERIOD?
We use an active management style, and we look for areas in the fixed income
markets where we can find relative value. During the year, there was very little
opportunity to take advantage of trends in interest rates, and we didn't try to
anticipate in which direction rates might move. As a consequence, Treasury bonds
tended to be de-emphasized. Rather, we focused on sector and issue selection and
international opportunities. In particular, we focused on credit opportunities
in the corporate area, as well as in mortgage-backed securities. We tended to
emphasize corporate bonds, both investment grade and high yield, which together
accounted for about 56% of the portfolio at the end of the year. In the
investment grade area, we tended to emphasize debt from the finance sector,
which benefited from the environment of stable growth and low inflation. In the
high yield area, we tended to emphasize liquid, better quality securities.
PORTFOLIO ALLOCATIONS AUGUST 31, 1997
CREDIT QUALITY (AS A PERCENTAGE OF PORTFOLIO ASSETS)
(pie chart with following plot points)
Not rated 1.33%
AAA 33.93%
AA 10.39%
A 13.09%
BBB 14.51%
BB 12.45%
B 14.30%
PORTFOLIO ALLOCATIONS ARE SUBJECT TO CHANGE.
<PAGE>
PAGE 4
KEYSTONE DIVERSIFIED BOND FUND (B-2)
We had our greatest high yield weightings in the cable and media areas, which we
believe are less cyclical than other industrial areas. We also had an emphasis
on mortgage-backed securities, about 22% of the portfolio at the end of the
year. This was a period, because of the health of the economy and the strength
of corporate earnings, in which high yield bonds outperformed other parts of the
fixed income market. Over the period, as relative value changed because of the
superior performance of high yield bonds, we actually took some of our profits
from this sector and redeployed to other areas. High yield bonds, for example,
during the year went from about 30% of the portfolio's net assets to about 26%.
During the year, credit quality and maturity remained relatively unchanged.
Average credit quality at the end of the fiscal period was A. Average weighted
maturity was 11.4 years, while duration-- another indication of interest rate
sensitivity-- was 5.94 years.
HOW DID INTERNATIONAL INVESTMENTS FARE DURING THE YEAR?
Very well. Foreign government bonds tended to outperform domestic bonds during
the year. At the end of the year, 13.4% of net assets were in foreign bonds,
which were either hedged back into the U.S. dollar or denominated in U.S.
dollars. The Fund took no currency risk, which was good, because the strength of
the U.S. dollar tended to undermine gains from unhedged foreign investments. Our
foreign investments were mostly government bonds from Germany, Canada and
Denmark.
We had an environment of solid global economic growth, led by the strength of
the U.S. economy. Growth tended to be slow in Europe and Japan, but overall the
global economy was in balance, with relatively low interest rate volatility.
HOW WOULD YOU DESCRIBE THE INVESTMENT STRATEGY OF THE FUND?
We draw on the Keystone investment process. Our investment philosophy is built
on the premise of active management, with a primary focus on total return. Our
goal is to seek consistently superior performance over full market cycles. The
investment process can best be described as a combination of a policy-driven
(top down) and sector rotation/security selection (bottom up) approach.
HOW DOES THIS PROCESS WORK?
The process consists of three stages. First, our Fixed Income Policy Committee
meets monthly to formulate macroeconomic projections. Specific emphasis is
placed on analysis of the business cycle, monetary policy, fiscal policy,
international issues and social and demographic trends. Second, given this
macroeconomic framework, we determine the optimal exposure to interest rate
risk, credit risk and asset allocation. We are aware of changing interest rates,
but we minimize interest rate anticipation. Finally, portfolio managers and
analysts work together to determine and implement appropriate sector weightings
and issue selection.
WHAT IS YOUR CURRENT OUTLOOK?
Basically, we see a continuation of moderate economic growth. We believe,
however, that cyclical pressures that sometimes lead to inflation are rising.
Unemployment, for example, is relatively low, and this could lead to pressure on
prices. The fixed income market is concerned about the possibility that the
Federal Reserve Board could raise short-term rates in anticipation of inflation.
If the FED does tighten money supply, we think it will move slowly.
Given this outlook, we are emphasizing securities that offer attractive
income, and we are avoiding taking risks with longer maturities. We think the
Fund is very well positioned for an environment of stronger economic growth.
(graphic of diamond)
THIS COLUMN IS INTENDED TO ANSWER QUESTIONS ABOUT YOUR FUND.
IF YOU HAVE A QUESTION YOU WOULD LIKE ANSWERED, PLEASE WRITE TO:
EVERGREEN KEYSTONE INVESTMENT SERVICES, INC.
ATTN: SHAREHOLDER COMMUNICATIONS
201 SOUTH COLLEGE STREET, SUITE 400,
CHARLOTTE, N.C. 28288-1195
<PAGE>
PAGE 5
Growth of an Investment
Keystone Diversified Bond Fund (B-2)
In Thousands
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Dividend Reinvestment 10,000 10,561 11,535 11,254 12,444 14,545 16,397 15,818 17,104 17,793 19,973
Initial Investment 10,000 9,513 9,381 8,202 8,128 8,958 9,022 8,080 7,980 7,747 8,154
Total Value: $19,973
8/87 8/88 8/89 8/90 8/91 8/92 8/93 8/94 8/95 8/96 8/97
</TABLE>
A $10,000 investment in Keystone Diversified Bond Fund (B-2) made on August 31,
1987 with all distributions reinvested was worth $19,973 on August 31,1997. Past
performance is no guarantee of future results.
Comparison of a change in value if a $10,000 investment in Keystone Diversified
Bond Fund (B-2), the Lehman Aggregate Bond Index (LABI) and the Consumer Price
Index (CPI).
In Thousands
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Fund 10,000 10,561 11,535 11,254 12,444 14,545 16,397 15,818 17,104 17,793 $19,973
CPI 10,000 10,460 10,951 11,566 12,006 12,384 12,726 13,094 13,437 13,824 $14,130
LABI 10,000 10,785 12,209 13,088 15,000 17,024 18,894 18,606 20,710 21,556 $23,715
8/87 8/88 8/89 8/90 8/91 8/92 8/93 8/94 8/95 8/96 8/97
</TABLE>
Past performance is no guarntee of future results. The Lehman Aggregate Bond
Index is an unmanaged, marks index. The index does not include transaction costs
associated with buying and selling securities, nor any management fees. The
cunsumer Price Index, a measure of inflation, is through August 31, 1997.
The cumulative and average annual total returns with sales charge calculations
reflect 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 investment earned the returns in the lines called "w/o sales
charge."
The investment return and principal value will fluctuate so that your shares,
when redeemed, may be worth more or less than the original cost. Past
performance is no guarantee of future results.
You may exchange your shares for another Keystone Classic fund by phone or in
writing. The Fund reserves the right to change or terminate the exchange offer.
<TABLE>
<CAPTION>
HISTORICAL RECORD
<S> <C>
CUMULATIVE TOTAL RETURN
<S> <C>
1 year w/o sales charge 12.25%
1 year w/ sales charge 9.25%
5 years 37.31%
10 years 99.73%
AVERAGE ANNUAL TOTAL RETURN
1 year w/o sales charge 12.25%
1 year w/ sales charge 9.25%
5 years 6.55%
10 years 7.16%
</TABLE>
<PAGE>
PAGE 6
KEYSTONE DIVERSIFIED BOND FUND (B-2)
SCHEDULE OF INVESTMENTS-- AUGUST 31, 1997
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
<C> <S> <C>
<CAPTION>
INDUSTRIAL BONDS AND NOTES-- 55.8%
<C> <S> <C>
ADVERTISING & RELATED
SERVICES-- 0.9%
$ 1,000,000 Hollinger International,
Senior Subord. Notes,
9.25%, 2/1/06................. $ 1,030,000
2,000,000 K-III Communications
Corporation,
Senior Note,
8.50%, 2/1/06................. 2,010,000
1,250,000 Lamar Advertising Company,
Senior Subord. Note,
9.625%, 12/1/06............... 1,325,000
4,365,000
AEROSPACE-- 1.2%
5,000,000 Northrop Grumman Corporation,
Debenture,
9.375%, 10/15/24.............. 5,667,400
BUILDING & CONSTRUCTION-- 1.1%
2,000,000 H M H Properties Inc.,
Senior Secured Note, Series B,
9.50%, 5/15/05................ 2,085,000
2,500,000 Johns Manville International
Group Inc., Senior Note,
10.875%, 12/15/04............. 2,796,875
4,881,875
CHEMICALS-- 0.7%
1,500,000 Freedom Chemical Company,
Senior Subord. Note,
10.625%, 10/15/06............. 1,582,500
1,450,000 Huntsman Polymers Corporation,
Senior Note,
11.75%, 12/1/04............... 1,660,250
3,242,750
CONSUMER PRODUCTS &
SERVICES-- 2.5%
1,000,000 Aurora Foods Inc.,
Senior Subord. Note Series C,
9.875%, 2/15/07 (b)........... 1,015,000
1,000,000 Consumers International Inc.,
Senior Secured Note,
10.25%, 4/1/05 (b)............ 1,070,000
2,500,000 Coty Inc.,
Senior Subord. Note,
10.25%, 5/1/05................ 2,681,250
<CAPTION>
PRINCIPAL
AMOUNT VALUE
<C> <S> <C>
<CAPTION>
INDUSTRIAL BONDS AND NOTES-- CONTINUED
<C> <S> <C>
CONSUMER PRODUCTS &
SERVICES-- CONTINUED
$ 1,175,000 Drypers Corporation,
Senior Note, Series B,
10.25%, 6/15/07............... $ 1,175,000
3,500,000 Revlon Worldwide Corporation,
Senior Secured Discount Note,
Series B,
(Eff. Yield 12.95%) (e),
0.00%, 3/15/98................ 3,325,000
2,000,000 Scotts and Sons Company,
Senior Subord. Note,
9.875%, 8/1/04................ 2,145,000
11,411,250
DIVERSIFIED COMPANIES-- 3.0%
6,000,000 General Electric Capital
Corporation,
Guaranteed Notes,
7.50%, 8/21/35................ 6,293,160
5,000,000 Grand Metropolitan Investment
Corporation,
Guaranteed Senior Note,
7.45%, 4/15/35................ 5,314,900
2,000,000 ISP Holdings Inc.,
Senior Note, Series B,
9.75%, 2/15/02................ 2,150,000
13,758,060
ELECTRICAL EQUIPMENT &
ELECTRONICS-- 0.2%
750,000 Amphenol Corporation,
Senior Subord. Note,
9.875%, 5/15/07............... 787,500
ENERGY-- 0.8%
2,000,000 Dawson Production Services Inc.,
Senior Note,
9.375%, 2/1/07................ 2,060,000
1,500,000 Energy Corporation America,
Senior Subord. Note,
9.50%, 5/15/07 (b)............ 1,500,000
3,560,000
FINANCE & BANKING-- 12.3%
3,000,000 ABN-Amro Bank NV,
Subord. Debenture,
7.30%, 12/1/26................ 2,876,580
</TABLE>
<PAGE>
PAGE 7
SCHEDULE OF INVESTMENTS-- AUGUST 31, 1997
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
INDUSTRIAL BONDS AND NOTES-- CONTINUED
<C> <S> <C>
FINANCE & BANKING-- CONTINUED
$10,000,000 Amsouth Bancorporation,
Subord. Debenture,
6.75%, 11/1/25................ $ 9,881,500
5,000,000 Commercial Credit Group, Inc.,
Notes,
10.00%, 5/15/09............... 6,137,900
2,500,000 First Nationwide Holdings Inc.,
Senior Exchange Note,
12.25%, 5/15/01............... 2,775,000
5,000,000 General Motors Acceptance
Corporation, Note,
7.125%, 5/1/01................ 5,082,800
2,400,000 Green Tree Financial
Corporation,
Senior Subord. Note,
10.25%, 6/1/02................ 2,714,448
2,500,000 Hutchinson Whampoa Finance
Limited,
6.988%, 8/1/37................ 2,446,025
2,889,073 Marine Midland Bank,
8.00%, 11/25/24............... 2,883,656
9,000,000 Mellon Bank Capital II,
Debenture,
7.995%, 1/15/27............... 8,998,290
2,000,000 Norwest Financial Inc., Note,
6.625%, 7/15/04............... 1,982,220
5,300,000 PVNGS II Funding Corporation
Inc.,
8.00%, 12/30/15............... 5,554,877
5,000,000 Travelers Insurance Trust
Preferred Debenture,
7.75%, 12/1/36................ 4,864,350
56,197,646
FOOD RETAILING & DISTRIBUTION-- 0.4%
1,750,000 AFC Enterprises Inc.,
Senior Subord. Note,
10.25%, 5/15/07 (b)........... 1,802,500
<CAPTION>
PRINCIPAL
AMOUNT VALUE
<C> <S> <C>
<CAPTION>
INDUSTRIAL BONDS AND NOTES-- CONTINUED
<C> <S> <C>
GAMING-- 0.4%
$ 1,250,000 Horseshoe Gaming LLC,
9.375%, 6/15/07............... $ 1,275,000
750,000 Riviera Holdings Corporation,
Guaranteed 1st Mortgage Note,
10.00%, 8/15/04 (b)........... 740,625
2,015,625
HEALTHCARE PRODUCTS &
SERVICES-- 0.7%
2,000,000 Genesis Health Ventures Inc.,
Senior Subord. Note,
9.25%, 10/1/06................ 2,050,000
1,000,000 Vencor Inc.,
Senior Subord. Note,
8.625%, 7/15/07 (b)........... 1,000,000
3,050,000
HOTELS AND RESTAURANTS-- 0.7%
2,000,000 California Hotel Finance
Corporation,
11.00%, 12/1/02............... 2,105,000
1,000,000 Wyndham Hotel Corporation,
Senior Subord. Note,
10.50%, 5/15/06............... 1,130,000
3,235,000
INDUSTRIAL SPECIALTY PRODUCTS
& SERVICES-- 0.9%
1,000,000 Coach USA Inc.,
Senior Subord. Note,
9.375%, 7/1/07 (b)............ 997,500
2,000,000 HS Resources Inc.,
9.25%, 11/15/06............... 2,020,000
1,250,000 Polymer Group Inc.,
Senior Subord. Note,
9.00%, 7/1/07 (b)............. 1,250,000
4,267,500
INFORMATION SERVICES &
TECHNOLOGY-- 0.5%
2,000,000 Unisys Corporation,
Senior Note,
11.75%, 10/15/04.............. 2,210,000
</TABLE>
<PAGE>
PAGE 8
KEYSTONE DIVERSIFIED BOND FUND (B-2)
SCHEDULE OF INVESTMENTS-- AUGUST 31, 1997
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
INDUSTRIAL BONDS AND NOTES-- CONTINUED
<C> <S> <C>
INSURANCE-- 10.8%
$ 5,000,000 Lumbermens Mutual Casualty
Company,
Senior Subord. Note,
9.15%, 7/1/26 (b)............. $ 5,590,350
MBIA Inc.:
10,500,000 9.375%, 2/15/11................. 12,607,560
3,500,000 7.15%, 7/15/27.................. 3,475,036
10,000,000 Nationwide CSN Trust,
Senior Notes,
9.875%, 2/15/25 (b)........... 11,042,900
4,300,000 Prudential Life Insurance
Corporation,
7.125%, 7/1/07 (b)............ 4,263,719
2,000,000 Reliance Group Holdings Inc.,
Senior Subord. Debenture,
9.75%, 11/15/03............... 2,094,480
10,000,000 SunLife Canada, US Capital Trust
I,
Capital Securities,
8.526%, 5/29/49 (b)........... 10,432,600
49,506,645
METALS & MINING-- 0.5%
2,000,000 AK Steel Corporation,
Senior Note,
10.75%, 4/1/04................ 2,165,000
MACHINERY-- DIVERSIFIED-- 2.1%
8,850,000 John Deere Capital Corporation,
8.625%, 8/1/19................ 9,431,711
LEISURE & TOURISM-- 1.5%
2,500,000 Affinity Group Inc.,
11.50%, 10/15/03.............. 2,681,250
2,000,000 Casino America Inc.,
Senior Secured Note,
12.50%, 8/1/03................ 2,100,000
2,250,000 Six Flags Theme Parks Inc.,
Senior Disc. Notes, Step Bond,
(Eff. Yield 11.12%) (e),
12.25%, 6/15/05............... 2,323,125
7,104,375
<CAPTION>
PRINCIPAL
AMOUNT VALUE
<C> <S> <C>
<CAPTION>
INDUSTRIAL BONDS AND NOTES-- CONTINUED
<C> <S> <C>
OIL-- 0.7%
$ 1,075,000 Synder Oil Corporation,
Senior Subord. Note,
8.75%, 6/15/07................ $ 1,080,375
2,000,000 Triton Energy Ltd,
Senior Note,
9.25%, 4/15/05................ 2,120,000
3,200,375
PAPER & PACKAGING-- 0.5%
2,000,000 Tembec Finance Corporation,
Guaranteed Senior Note,
9.875%, 9/30/05............... 2,095,000
PUBLISHING, BROADCASTING &
ENTERTAINMENT-- 3.2%
1,500,000 American Media Operations Inc.,
Senior Subord. Note,
11.625%, 11/15/04............. 1,642,500
1,000,000 Fox/Liberty Networks LLC,
Senior Discount Note,
(Eff. Yield 10.80%) (e),
0.00%, 8/15/07 (b)............ 615,000
1,175,000 Fundy Cable Limited,
Senior Secured Second Priority
Note,
11.00%, 11/15/05.............. 1,271,938
800,000 Hollywood Entertainment
Corporation,
Senior Subord. Note,
10.625%, 8/15/04 (b).......... 817,000
2,000,000 SFX Broadcasting Inc.,
Senior Subord. Note,
10.75%, 5/15/06............... 2,160,000
2,500,000 Sinclair Broadcast Group Inc.,
Senior Subord. Note,
10.00%, 9/30/05............... 2,612,500
5,000,000 Time Warner Inc.,
9.15%, 2/1/23................. 5,664,750
14,783,688
</TABLE>
<PAGE>
PAGE 9
SCHEDULE OF INVESTMENTS-- AUGUST 31, 1997
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
INDUSTRIAL BONDS AND NOTES-- CONTINUED
<C> <S> <C>
RETAIL-- 1.1%
$ 2,000,000 Cole National Group Inc.,
Senior Note,
11.25%, 10/1/01............... $ 2,185,000
2,000,000 Finlay Fine Jewelry Corporation,
Senior Note,
10.625%, 5/1/03............... 2,100,000
950,000 Marsh Supermarkets Inc.,
Senior Subord. Note,
8.875%, 8/1/07 (b)............ 940,500
5,225,500
STATE & LOCAL DEBT-- 1.1%
4,806,071 Los Angeles, California, Fire
Safety Improvement Bond Act,
Assessment District #1,
8.48%, 9/2/15 (b)............. 5,067,401
TELECOMMUNICATIONS-- 4.4%
2,250,000 Capital Funding
Corporation,
Debenture,
7.12%, 7/15/07................ 2,187,000
5,000,000 Continental Cablevision Inc.,
9.00%, 9/1/08................. 5,679,300
3,750,000 Millicom International Cellular
S.A.,
Senior Subord. Discount Note,
13.50%, 6/1/06................ 2,817,187
1,175,000 Nextel Communications Inc.,
Senior Discount Note,
(Eff. Yield 9.34%) (e),
0.00%, 9/1/03................. 1,116,250
2,000,000 Talton Holdings Inc.,
Senior Note,
11.00%, 6/30/07 (b)........... 2,110,000
4,000,000 Telewest PLC,
Senior Discount Debenture,
(Eff. Yield 9.825%) (e),
0.00%, 10/1/07................ 2,970,000
3,000,000 Vanguard Cellular Systems Inc.,
Senior Debenture,
9.375%, 4/15/06............... 3,082,500
19,962,237
<CAPTION>
PRINCIPAL
AMOUNT VALUE
<C> <S> <C>
<CAPTION>
INDUSTRIAL BONDS AND NOTES-- CONTINUED
<C> <S> <C>
TEXTILE & APPAREL-- 0.6%
$ 700,000 Delta Mills Inc.,
Senior Note,
9.625%, 9/1/07 (b)............ $ 703,500
2,000,000 Dominion Textile USA Inc.,
Senior Note,
8.875%, 11/1/03............... 2,040,000
2,743,500
TRANSPORTATION-- 3.0%
2,000,000 Airplane Pass Through Trust,
Series 1 Class D, Subord.
Bond,
10.88%, 3/15/19............... 2,327,160
500,000 Equimar Shipholdings Limited,
Guaranteed 1st Preferred Ship
Mortgage Note,
9.875%, 7/1/07................ 480,000
4,000,000 Golden State Petroleum
Transportation Corporation,
1st Preferred Mortgage Note,
8.04%, 2/1/19 (b)............. 4,079,600
2,000,000 Hayes Wheels International,
Senior Subord. Note,
9.125%, 7/15/07 (b)........... 2,030,000
4,500,000 Norfolk Southern Corporation,
Note,
7.05%, 5/1/37................. 4,613,355
13,530,115
TOTAL INDUSTRIAL BONDS AND NOTES
(COST $248,816,293)......... 255,267,653
<CAPTION>
COLLATERALIZED MORTGAGE OBLIGATIONS-- 19.3%
<C> <S> <C>
3,000,000 Asset Securitization
Corporation,
Series 96-D3 Class A3,
(Est. Maturity 2010)(a),
7.693%, 10/31/26.............. 3,173,880
3,600,000 BA Mortgage Securities Inc.,
Series 1997-1 Class M,
(Est. Maturity 2009) (a),
7.50%, 7/25/26................ 3,599,438
2,984,358 Chase Mortgage Finance
Corporation,
Series 1994L Class B1,
(Est. Maturity 2005) (a),
7.88%, 11/25/25 (b)........... 2,945,188
</TABLE>
<PAGE>
PAGE 10
KEYSTONE DIVERSIFIED BOND FUND (B-2)
SCHEDULE OF INVESTMENTS-- AUGUST 31, 1997
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
COLLATERALIZED MORTGAGE
OBLIGATIONS-- CONTINUED
<C> <S> <C>
$ 5,000,000 Credit Suisse First Boston
Mortgage,
Series 97 C1 Class A1C,
(Est. Maturity 2007) (a),
7.24%, 4/20/07................ $ 5,107,812
3,100,860 Criimi Mae Financial
Corporation,
Series 1 Class A,
(Est. Maturity 2011) (a),
7.00%, 1/1/33................. 3,019,463
5,000,000 Federal Home Loan Mortgage
Corporation,
Series 47 Class A,
(Est. Maturity 2004) (a),
5.00%, 2/25/22................ 4,500,000
191,912 Federal Home Loan Mortgage PC
Gtd, Series 8 Class SB,
(Est. Maturity 2006) (a)(d),
9.60%, 3/25/23................ 158,147
FHA Charles River Mortgage:
(Est. Maturity 1999) (a)
6,735,768 9.13%, 8/1/34................... 7,264,105
4,996,003 10.25%, 8/1/34.................. 5,286,395
12,510,527 FNMA,
Series 1993-248 Class A,
(Est. Maturity 2004) (a),
3.492%, 8/25/23............... 9,542,279
5,700,000 FNMA, Gtd.,
REMIC Trust 1993 SC,
(Est. Maturity 2004) (a),
5.469%, 10/25/08.............. 4,948,313
5,176,790 GE Capital Mortgage Services
Inc.,
REMIC MC 1994-10 Class A14,
(Est. Maturity 2001) (a),
6.50%, 3/25/24................ 5,026,339
7,958,723 Independent National Mortgage
Corp.,
Series 1997-A,
(Est. Maturity 2006) (a),
7.85%, 12/26/26 (b)........... 8,005,182
<CAPTION>
PRINCIPAL
AMOUNT VALUE
<C> <S> <C>
<CAPTION>
COLLATERALIZED MORTGAGE
OBLIGATIONS-- CONTINUED
<C> <S> <C>
Morgan Stanley Capital I Inc.
Commercial Mortgage:
$ 3,300,000 Certificate 1997-C1 Class B
(Est. Maturity 2007) (a)
7.69%, 2/15/20................ $ 3,456,750
2,000,000 Series 1997 WF1 Class A2
(Est. Maturity 2007) (a) (b)
7.22%, 5/15/07................ 2,048,750
2,832,819 Paine Webber Mortgage
Acceptance Corporation IV,
Series 1993-4 Class M1,
(Est. Maturity 2005) (a),
7.50%, 5/25/23................ 2,862,033
PNC Mortgage Securities
Corporation:
2,498,344 Series 1997-4 Class 2PP1
(Est. Maturity 2000) (a)
7.25%, 7/25/27.............. 2,479,406
4,984,171 Series 1997-4 Class 2PP3
(Est. Maturity 2008) (a)
7.50%, 7/25/27.............. 5,021,553
5,000,000 Residential Asset Securitization
Trust,
Series 1996-A3 Class A9,
(Est. Maturity 2006) (a),
7.50%, 7/25/26................ 4,935,156
4,889,260 Ryland Acceptance Corporation
IV, Series 88 Class E,
(Est. Maturity 2000) (a),
7.95%, 1/1/19................. 4,979,369
TOTAL COLLATERALIZED MORTGAGE
OBLIGATIONS
(COST $86,950,244)............ 88,359,558
<CAPTION>
FOREIGN BONDS (NON U.S. DOLLARS)-- 8.6%
<C> <S> <C>
18,400,000 Canada Government,
CAD 8.75%, 12/1/05.................. 15,676,946
59,177,000 Kingdom of Denmark, Bonds,
DKK 7.00%, 11/15/07................. 9,065,944
24,700,000 Federal Republic of Germany,
DEM Bonds,
6.875%, 5/12/05............... 14,889,246
TOTAL FOREIGN BONDS (NON U.S.
DOLLARS) (COST $42,642,729)... 39,632,136
</TABLE>
<PAGE>
PAGE 11
SCHEDULE OF INVESTMENTS-- AUGUST 31, 1997
<TABLE>
<CAPTION>
PRINCIPAL
AMOUNT VALUE
FOREIGN BONDS (U.S. DOLLARS)-- 4.8%
<C> <S> <C>
$ 2,000,000 APP International Finance
Company B.V.,
Secured Senior Notes,
11.75%, 10/1/05............... $ 2,105,000
650,000 Azteca Holdings S.A. De CV,
Senior Secured Note,
11.00%, 6/15/02 (b)........... 679,250
3,500,000 Grupo Televisa S.A. De CV,
Senior Notes, Series B,
11.875%, 5/15/06 (b).......... 3,989,475
3,000,000 Indah Kiat International Finance
Company B.V.,
Gtd Secured Note,
12.50%, 6/15/06............... 3,277,500
4,000,000 Ispat Mexicana SA,
Senior Unsecured Debenture,
10.375%, 3/15/01.............. 4,225,000
5,000,000 Petrozuata Finance Inc.,
Bond, Series A,
7.63%, 4/1/09 (b)............. 5,091,600
650,000 Polytama International Finance
B.V.,
Guaranteed Secured Note,
11.25%, 6/15/07............... 625,625
2,000,000 Stena AB, Senior Notes,
10.50%, 12/15/05.............. 2,190,000
TOTAL FOREIGN BONDS (U.S.
DOLLARS)
(COST $20,492,316).......... 22,183,450
<CAPTION>
ASSET- BACKED SECURITIES-- 2.5%
<C> <S> <C>
Merrill Lynch Mortgage Investors
Inc.
1,292,601 Series 1992-D Class B
(Est. Maturity 2001) (a)
8.50%, 7/15/17.............. 1,355,330
5,000,000 Series 1996-C1 Class B
(Est. Maturity 2006) (a)
7.42%, 4/25/28.............. 5,133,594
5,000,000 Zale Funding Trust,
Series 94-1 Class A2,
(Est. Maturity 1999) (a),
7.325%, 3/15/03............... 5,062,500
TOTAL ASSET-BACKED SECURITIES
(COST $11,418,706).............. 11,551,424
<CAPTION>
PRINCIPAL
AMOUNT VALUE
<C> <S> <C>
<CAPTION>
U.S. GOVERNMENT & AGENCY OBLIGATIONS-- 6.0%
<C> <S> <C>
$74,050,000 United States Treasury Bond STRIPS
(Eff. Yield 6.83%) (e),
0.00%, 11/15/21............... $ 14,559,711
11,250,000 United States Treasury Bonds,
7.875%, 2/15/21............... 12,786,300
TOTAL U.S. GOVERNMENT & AGENCY
OBLIGATIONS
(COST $26,432,963)............ 27,346,011
<CAPTION>
SHARES
COMMON STOCKS-- 0.1% (COST $2)
<C> <S> <C>
DIVERSIFIED COMPANIES-- 0.1%
1,618 PM Holdings Corporation......... 566,300
<CAPTION>
PREFERRED STOCKS-- 0.4%
(COST $1,600,000)
<C> <S> <C>
TELECOMMUNICATIONS-- 0.4%
16,000 Adelphia Communications
Corporation (b)............... 1,720,000
<CAPTION>
PRINCIPAL
AMOUNT
REPURCHASE AGREEMENT-- 1.0%
(COST $4,425,000)
<C> <S> <C>
$ 4,425,000 Keystone Joint Repurchase
Agreement, (Investments in
repurchase agreements, in a
joint trading account
5.58% dated 8/29/97, due
9/2/97 maturity value
$4,427,746) (c)............... 4,425,000
</TABLE>
<TABLE>
<C> <S> <C> <C>
TOTAL INVESTMENTS--
(COST $442,778,253).................. 98.5% 451,051,532
OTHER ASSETS AND
LIABILITIES-- NET.................... 1.5 6,649,323
NET ASSETS............................. 100.0% $457,700,855
</TABLE>
<PAGE>
PAGE 12
KEYSTONE DIVERSIFIED BOND FUND (B-2)
SCHEDULE OF INVESTMENTS-- AUGUST 31, 1997
(a) 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 dates.
(b) Securities that may be resold to "qualified institutional buyers" under Rule
144A or securities offered pursuant to Section 4(2) of the Federal
Securities Act of 1933, as amended. These securities have been determined to
be liquid under guidelines established by the Board of Trustees.
(c) The repurchase agreements are fully collateralized by U.S. government
and/or agency obligations based on market prices at August 31, 1997.
(d) Inverse floater.
(e) Effective yield (calculated at date of purchase) is the yield at which the
bond accretes on an annualized basis until maturity date.
LEGEND OF PORTFOLIO ABBREVIATIONS:
FHA-- Federal Housing Authority
FNMA-- Federal National Mortgage Association
REMIC-- Real Estate Mortgage Investment Conduit
STRIPS-- Separate Trading of Registered Interest and Principal of Securities
FORWARD FOREIGN CURRENCY EXCHANGE CONTRACTS
<TABLE>
<CAPTION>
NET
EXCHANGE U.S. $ VALUE AT IN EXCHANGE UNREALIZED
DATE AUGUST 31, 1997 FOR U.S. $ DEPRECIATION
<S> <C> <C> <C> <C>
<CAPTION>
Foward Foreign Currency Exchange Contracts to Sell:
Contracts to Deliver
<S> <C> <C> <C> <C>
10/14/97 66,264,000 Danish Krone 9,665,463 9,571,573 $ (93,890)
11/12/97 27,658,000 Deutsche Marks 15,399,906 14,895,319 (504,587)
11/26/97 22,438,000 Canadian Dollars 16,244,776 16,201,891 (42,885)
$(641,362)
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS.
<PAGE>
PAGE 13
FINANCIAL HIGHLIGHTS
(FOR A SHARE OUTSTANDING THROUGHOUT EACH YEAR)
<TABLE>
<CAPTION>
YEAR ENDED AUGUST 31,
1997 1996 1995 1994 1993
<S> <C> <C> <C> <C> <C>
NET ASSET VALUE BEGINNING OF YEAR $14.65 $15.09 $15.28 $17.06 $16.44
INCOME FROM INVESTMENT OPERATIONS
Net investment income 0.91 0.95 1.06 1.06 1.28
Net realized and unrealized gain (loss) on investments and
foreign currency related transactions 0.84 (0.35) 0.11 (1.62) 0.70
Total from investment operations 1.75 0.60 1.17 (0.56) 1.98
LESS DISTRIBUTIONS FROM:
Net investment income (0.93) (0.96) (1.06) (1.22) (1.28)
In excess of net investment income (0.05) 0 (0.22) 0 (0.08)
Tax basis return of capital 0 (0.08) (0.08) 0 0
Net realized gain on investments 0 0 0 0 0
Total distributions (0.98) (1.04) (1.36) (1.22) (1.36)
NET ASSET VALUE END OF YEAR $15.42 $14.65 $15.09 $15.28 $17.06
TOTAL RETURN (A) 12.25% 4.03% 8.13% (3.53%) 12.73%
RATIOS/SUPPLEMENTAL DATA
RATIOS TO AVERAGE NET ASSETS:
Total expenses 1.88% 1.84% 1.81% 1.75% 1.89%
Total expenses excluding indirectly paid expenses 1.87% 1.83% -- -- --
Net investment income 6.07% 6.42% 7.05% 6.48% 7.73%
PORTFOLIO TURNOVER RATE 138% 246% 178% 200% 133%
NET ASSETS END OF YEAR (THOUSANDS) $457,701 $559,792 $734,837 $814,245 $1,004,393
</TABLE>
<TABLE>
<CAPTION>
YEAR ENDED AUGUST 31,
1992 1991 1990 1989 1988
<S> <C> <C> <C> <C> <C>
NET ASSET VALUE BEGINNING OF YEAR $15.37 $15.51 $17.74 $17.99 $18.91
INCOME FROM INVESTMENT OPERATIONS
Net investment income 1.33 1.33 1.53 1.71 1.78
Net realized and unrealized gain (loss) on investments and
foreign currency related transactions 1.14 0.17 (1.94) (0.13) (0.81)
Total from investment operations 2.47 1.50 (0.41) 1.58 0.97
LESS DISTRIBUTIONS FROM:
Net investment income (1.33) (1.63) (1.61) (1.83) (1.85)
In excess of net investment income (0.07) (0.01) (0.21) 0 0
Tax basis return of capital 0 0 0 0 0
Net realized gain on investments 0 0 0 0 (0.04)
Total distributions (1.40) (1.64) (1.82) (1.83) (1.89)
NET ASSET VALUE END OF YEAR $16.44 $15.37 $15.51 $17.74 $17.99
TOTAL RETURN (A) 16.88% 10.58% (2.44%) 9.23% 5.61%
RATIOS/SUPPLEMENTAL DATA
RATIOS TO AVERAGE NET ASSETS:
Total expenses 1.99% 1.94% 1.89% 1.84% 1.68%
Total expenses excluding indirectly paid expenses -- -- -- -- --
Net investment income 8.29% 8.74% 9.26% 9.52% 9.82%
PORTFOLIO TURNOVER RATE 117% 101% 43% 47% 46%
NET ASSETS END OF YEAR (THOUSANDS) $902,339 $814,528 $860,615 $1,000,305 $838,892
</TABLE>
(a) Excluding applicable sales charges.
SEE NOTES TO FINANCIAL STATEMENTS.
<PAGE>
PAGE 14
KEYSTONE DIVERSIFIED BOND FUND (B-2)
STATEMENT OF ASSETS AND LIABILITIES
AUGUST 31, 1997
<TABLE>
<CAPTION>
<S> <C>
ASSETS
Investments at market value
(identified cost-- $442,778,253) $451,051,532
Cash 132
Interest receivable 7,087,330
Receivable for investments sold 1,751,296
Receivable for Fund shares sold 114,872
Prepaid expenses and other assets 128,392
Total assets 460,133,554
LIABILITIES
Distributions payable 1,030,132
Net unrealized depreciation on forward
foreign currency exchange contracts 641,362
Distribution fees payable 473,689
Payable for Fund shares redeemed 193,838
Due to related parties 8,400
Accrued Trustees' fees and expenses 1,093
Accrued expenses and other liabilities 84,185
Total liabilities 2,432,699
NET ASSETS $457,700,855
NET ASSETS REPRESENTED BY
Paid-in capital $607,639,863
Undistributed net investment income 2,801,682
Accumulated net realized loss on investments
and foreign currency related transactions (160,349,985)
Net unrealized appreciation on investments
and foreign currency related transactions 7,609,295
Total net assets $457,700,855
NET ASSET VALUE PER SHARE
Net asset value of $457,700,855(division sign)29,687,317
outstanding shares of beneficial interest $ 15.42
</TABLE>
STATEMENT OF OPERATIONS
YEAR ENDED AUGUST 31, 1997
<TABLE>
<CAPTION>
<S> <C> <C>
INVESTMENT INCOME
Interest $40,714,972
Other income 107,991
Total investment income 40,822,963
EXPENSES
Distribution Plan expenses $ 5,106,010
Management fee 2,835,152
Transfer agent fees 1,203,224
Custodian fees 252,608
Administrative services fees 65,837
Trustees' fees and expenses 47,515
Other 166,909
Total expenses 9,677,255
Less: Indirectly paid expenses (50,654)
Net expenses 9,626,601
Net investment income 31,196,362
NET REALIZED AND UNREALIZED GAIN
ON INVESTMENTS AND FOREIGN
CURRENCY RELATED TRANSACTIONS
Net realized gain on:
Investments 10,233,263
Foreign currency related
transactions 5,320,208
Net realized gain on investments
and foreign currency related
transactions 15,553,471
Net change in unrealized
appreciation (depreciation) on:
Investments 13,588,288
Foreign currency related
transactions (237,516)
Net change in unrealized
appreciation (depreciation) on
investments and foreign currency
related transactions 13,350,772
Net realized and unrealized gain
on investments and foreign
currency related transactions 28,904,243
Net increase in net assets
resulting from operations $60,100,605
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS.
<PAGE>
PAGE 15
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
YEAR ENDED AUGUST 31,
1997 1996
<S> <C> <C>
OPERATIONS
Net investment income $ 31,196,362 $ 42,141,831
Net realized gain on investments and foreign currency related transactions 15,553,471 323,307
Net change in unrealized appreciation (depreciation) on investments and foreign
currency related transactions 13,350,772 (14,654,381)
Net increase in net assets resulting from operations 60,100,605 27,810,757
DISTRIBUTIONS TO SHAREHOLDERS FROM
Net investment income (31,196,362) (42,020,420)
In excess of net investment income (1,746,263) 0
Tax basis return of capital 0 (2,935,918)
Total distributions to shareholders (32,942,625) (44,956,338)
CAPITAL SHARE TRANSACTIONS
Proceeds from shares sold 33,102,013 89,671,653
Payments for shares redeemed (180,458,236) (273,136,100)
Net asset value of shares issued in reinvestment of dividends and distributions 18,107,160 25,564,686
Total decrease from capital share transactions (129,249,063) (157,899,761)
Total decrease in net assets (102,091,083) (175,045,342)
NET ASSETS:
Beginning of year 559,791,938 734,837,280
End of year [Including undistributed net investment income (accumulated distributions
in excess of net investment income) as follows: 1997-- $2,801,682 and
1996-- ($1,446,954)] $457,700,855 $559,791,938
</TABLE>
SEE NOTES TO FINANCIAL STATEMENTS.
<PAGE>
PAGE 16
KEYSTONE DIVERSIFIED BOND FUND (B-2)
NOTES TO FINANCIAL STATEMENTS
1. SIGNIFICANT ACCOUNTING POLICIES
Keystone Diversified Bond Fund (B-2) (the "Fund") is registered under the
Investment Company Act of 1940, as amended (the "1940 Act"), as a diversified,
open-end management investment company.
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. Actual results could differ from these estimates.
A. VALUATION OF SECURITIES
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. Corporate bonds, other fixed income securities and mortgage and other
asset-backed 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 similar securities which are
generally recognized by institutional traders. Securities for which valuations
are 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.
Securities traded on a national securities exchange or included on the NASDAQ
National Market System ("NMS") are valued at the last reported sales price in
the exchange where they are primarily traded. The Fund values securities traded
on an exchange or NMS for which there has been no sale and other securities
traded on the over-the-counter market at the mean between the last reported bid
and asked price.
Short-term investments with remaining maturities of 60 days or less are
carried at amortized cost, which approximates 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 enters 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 its 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.
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)
<PAGE>
PAGE 17
on investments and foreign currency related 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 and foreign currency related transactions.
Net realized foreign currency gains and losses resulting from the difference
between the amounts of interest and dividends recorded on the books of the Fund
and the amount actually received are included in interest and dividend income.
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 related
transactions.
E. 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 or liabilities.
Forward contracts are recorded at the forward rate and 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 their obligations under the contract. Forward contracts
involve elements of market risk in excess of the amount reflected in the
statement of assets and liabilities.
F. 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. Dividend income is recorded on the ex-dividend date.
G. 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
"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 also intends to avoid excise tax
liability by making the required distributions under the Code. Accordingly, no
provision for federal income taxes is required. To the extent that realized
capital gains can be offset by capital loss carryforwards, it is the Fund's
policy not to distribute such gains.
H. DISTRIBUTIONS
Distributions from net investment income for the Fund are declared daily and
paid monthly. Distributions from net realized capital gains, if any, are paid at
least 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 differing tr
eatment for paydown gains (losses) and for foreign securities related
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:
<TABLE>
<CAPTION>
YEAR ENDED AUGUST 31,
1997 1996
<S> <C> <C>
Shares sold 2,182,629 5,954,123
Shares redeemed (11,912,272) (18,152,163)
Shares issued in reinvestment
of dividends and
distributions 1,195,855 1,709,087
Net decrease (8,533,788) (10,488,953)
</TABLE>
<PAGE>
PAGE 18
KEYSTONE DIVERSIFIED BOND FUND (B-2)
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, 1997:
<TABLE>
<CAPTION>
COST OF PROCEEDS
PURCHASES FROM SALES
<S> <C> <C>
Non-U.S.Government $484,209,025 $568,746,313
U.S. Government 201,738,252 244,675,885
</TABLE>
The average daily balance of reverse repurchase agreements outstanding during
the year ended August 31, 1997 was $6,879,127 at a weighted average interest
rate of 4.64%. The maximum amount of borrowing during the year ended August 31,
1997 was $16,852,313 (including accrued interest).
On August 31, 1997, the cost of investments for federal income tax purposes
was $442,778,613, gross unrealized appreciation of investments was $13,048,948
and gross unrealized depreciation of investments was $4,776,029, resulting in
net unrealized appreciation of $8,272,919 for income tax purposes.
As of August 31, 1997, the Fund had a capital loss carryover for federal
income tax purposes of approximately $160,349,000 which expires as follows:
$28,691,000-- 1998; $85,002,000-- 1999; $26,644,000-- 2003 and
$20,012,000-- 2004.
4. DISTRIBUTION PLAN
Evergreen Keystone Distributor, Inc. ("EKD"), a wholly-owned subsidiary of The
BISYS Group Inc. ("BISYS"), serves as principal underwriter to the Fund. Prior
to December 11, 1996, Evergreen Keystone Investment Services, Inc. ("EKIS"), a
wholly-owned subsidiary of Keystone Investment Management Company ("Keystone"),
served as the Fund's principal underwriter.
The Fund has adopted a Distribution Plan (the "Plan") as allowed by Rule 12b-1
of the 1940 Act. The Plan permits the Fund to reimburse its principal
underwriter for costs related to selling shares of the Fund and for various
other services. These costs, which consist primarily of commissions and services
fees to broker-dealers who sell shares of the Fund, are paid by shareholders
through expenses called "Distribution Plan expenses". Under the Plan, the Fund
currently pays a distribution fee which may not exceed 1.00% of the average
daily net assets of the Fund, of which 0.75% is used to pay distribution
expenses and 0.25% may be used to pay shareholder service fees.
The principal underwriter may pay 12b-1 fees greater than the allowable
amounts the Fund is permitted to pay. The Fund may reimburse the principal
underwriter for such excess amounts in later years with annual interest at the
prime rate plus 1.00%.
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, and subject to the
discretion of the Independent Trustees, payments to EKIS and/or EKD may continue
as compensation for services which had been provided while the Plan was in
effect.
EKD intends, but is not obligated, to continue to pay distribution costs
that exceed the current annual payments from the Fund. EKD 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 would be within permitted limits.
Contingent deferred sales charges paid by redeeming shareholders are paid to EKD
or its predecessor.
5. INVESTMENT MANAGEMENT AGREEMENT AND OTHER AFFILIATED TRANSACTIONS
Keystone serves as the investment adviser and manager to the Fund. In return,
Keystone is paid a management fee that is calculated daily and paid monthly. The
management fee is computed 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 average daily net asset value of the Fund. Prior to December 11, 1996,
Keystone Management, Inc. ("KMI"), a wholly-owned subsidiary of Keystone, served
as investment manager to the Fund and provided investment management and
administrative services.
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PAGE 19
Under an investment advisory agreement between KMI and Keystone, Keystone served
as the investment adviser and provided investment advisory and management
services to the Fund. In return for its services, Keystone received an annual
fee equal to 85% of the management fee received by KMI.
Effective January 1, 1997, BISYS became the sub-administrator to the Fund.
This service is paid by Keystone and is not a Fund expense. As sub-
administrator, BISYS provides the officers of the Fund.
During the year ended August 31, 1997, the Fund paid or accrued $65,837 to EKIS
for certain administrative services. Evergreen Keystone Service Company, a
wholly-owned subsidiary of Keystone, serves as the Fund's transfer and dividend
disbursing agent. Officers of the Fund 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. The
assets deposited with the custodian under this expense offset arrangement could
have been invested in income-producing assets.
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PAGE 20
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, 1997, 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, 1997 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, 1997, the results of its
operations for the year then ended, the changes in its net assets for each of
the years in the two-year period then ended, and the financial highlights for
each of the years in the ten-year period then ended in conformity with generally
accepted accounting principles.
KPMG Peat Marwick LLP
Boston, Massachusetts
October 10, 1997
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PAGE 21
KEYSTONE DIVERSIFIED BOND FUND (B-2)
FEDERAL TAX STATUS-- FISCAL 1997 DISTRIBUTIONS (UNAUDITED)
The per share distributions paid to you for fiscal 1997, whether taken in shares
or cash, are as follows:
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<S> <C>
Income Dividends $0.98
</TABLE>
In January 1998, complete information on the calendar year 1997 distributions
will be forwarded to you to assist you in completing your 1997 federal income
tax return.
<PAGE>
KEYSTONE
FAMILY OF FUNDS
(photo of 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.
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 Evergreen Keystone funds, contact
your financial adviser or call Evergreen Keystone.
<TABLE>
<C> <S>
NOT
FDIC MAY LOSE VALUE
INSURED NO BANK GUARANTEE
EVERGREEN KEYSTONE DISTRIBUTOR, INC.
Evergreen KeystoneSM is a Service Mark of
Evergreen
Keystone Investment Services, Inc.
Copyright 1997.
</TABLE>
B2-R Rev 01
KEYSTONE
(Photo Exists in Film ONLY.
Will See on Dylux)
DIVERSIFIED BOND
FUND (B-2)
EVERGREEN KEYSTONE
(LOGO) FUNDS SM (LOGO)
ANNUAL REPORT
AUGUST 31, 1997
