<PAGE>
- --------------------------------------------------------------------------------
PROSPECTUS OCTOBER 28, 1994
- --------------------------------------------------------------------------------
KEYSTONE CUSTODIAN FUND, SERIES K-1
BALANCED INCOME FUND
200 BERKELEY STREET, BOSTON, MASSACHUSETTS 02116-5034
CALL TOLL FREE 1-800-343-2898
- --------------------------------------------------------------------------------
Keystone Custodian Fund, Series K-1 (the "Fund") is a mutual fund whose goal
is current income.
The Fund may invest in any type of security, but it emphasizes securities
having a liberal current yield consistent with investment quality.
Your purchase payment is fully invested. There is no sales charge when you buy
the Fund's shares. The Fund may impose, however, a deferred sales charge, which
declines from 4% to 1%, if you redeem your shares within four years of purchase.
The Fund has adopted a Distribution Plan (the "Distribution Plan") pursuant to
Rule 12b-1 under the Investment Company Act of 1940 (the "1940 Act") under which
it bears some of the costs of selling its shares to the public.
This prospectus sets forth concisely the information about the Fund that you
should know before investing. Please read it and retain it for future reference.
Additional information about the Fund is contained in a statement of
additional information dated October 28, 1994, which has been filed with the
Securities and Exchange Commission and is incorporated by reference into this
prospectus. For a free copy, or for other information about the Fund, write to
the address or call the telephone number listed above.
SHARES OF THE FUND ARE NOT DEPOSITS OR OBLIGATIONS OF, OR GUARANTEED OR
ENDORSED BY, ANY BANK, AND SHARES ARE NOT FEDERALLY INSURED BY THE FEDERAL
DEPOSIT INSURANCE CORPORATION, THE FEDERAL RESERVE BOARD, OR ANY OTHER AGENCY.
<TABLE>
- ----------------------------------------------------------------------------------------------
TABLE OF CONTENTS
- ----------------------------------------------------------------------------------------------
<CAPTION>
Page Page
<S> <C> <S> <C>
Fee Table .................................... 2 How to Buy Shares ........................ 9
Financial Highlights ......................... 3 Distribution Plan ........................10
Fund Description ............................. 4 How to Redeem Shares .....................12
Fund Objective and Policies .................. 4 Shareholder Services .....................13
Investment Restrictions ...................... 5 Performance Data .........................15
Risk Factors ................................. 5 Fund Shares ..............................15
Pricing Shares ............................... 6 Additional Information ...................15
Dividends and Taxes .......................... 7 Additional Investment Information ........(i)
Fund Management and Expenses ................. 7
</TABLE>
- --------------------------------------------------------------------------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE
ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS
A CRIMINAL OFFENSE.
- --------------------------------------------------------------------------------
<PAGE>
FEE TABLE
KEYSTONE CUSTODIAN FUND, SERIES K-1
Balanced Income Fund
The purpose of the fee table is to assist investors in understanding the
costs and expenses that an investor in the Fund will bear directly or
indirectly. For more complete descriptions of the various costs and expenses,
see the following sections of this prospectus: "Fund Management and Expenses";
"How to Buy Shares"; "Distribution Plan"; and "Shareholder Services."
SHAREHOLDER TRANSACTION EXPENSES
Contingent Deferred Sales Charge\1/ ........................... 4.00%
(as a percentage of the lesser of total cost or the net
asset value of shares redeemed)
Exchange Fee\2/ ............................................... $10.00
(per exchange)
ANNUAL FUND OPERATING EXPENSES\3/
(as a percentage of average net assets)
Management Fee ................................................ 0.45%
12b-1 Fee\4/ .................................................. 0.96%
Other Expenses ................................................ 0.30%
----
Total Fund Operating Expenses ................................. 1.71%
====
EXAMPLE\5/ 1 YEAR 3 YEARS 5 YEARS 10 YEARS
------ ------- ------- --------
You would pay the following
expenses on a $1,000
investment, assuming (1) 5%
annual return and (2)
redemption at the end of
each period ................ $57 $74 $93 $202
You would pay the following
expenses on the same
investment, assuming
no redemption .............. $17 $54 $93 $202
AMOUNTS SHOWN IN THE EXAMPLE SHOULD NOT BE CONSIDERED A REPRESENTATION OF PAST
OR FUTURE EXPENSES; ACTUAL EXPENSES MAY BE GREATER OR LESS THAN THOSE SHOWN.
- ---------
\1/ The deferred sales charge declines from 4% to 1% of amounts redeemed within
four calendar years after purchase. No deferred sales charge is imposed
thereafter.
\2/ There is no exchange fee for exchange orders received by the Fund over the
Keystone Automated Response Line ("KARL") from an individual shareholder.
(For a description of KARL, see "Shareholder Services".)
\3/ Expense ratios are for the Fund's fiscal year ended June 30, 1994.
\4/ The 12b-1 fee represents, on a financial statement basis, the net percentage
attributable to 12b-1 expenses for the fiscal year ending June 30, 1994,
after deduction from gross 12b-1 expenses of deferred sales charges
recovered during such period. Long-term shareholders may pay more than the
economic equivalent of the maximum front-end sales charges permitted by
rules adopted by the National Association of Securities Dealers, Inc.
("NASD"). In accordance with NASD rules, the Fund has limited its annual
12b-1 expenses to 1.00% of average net assets.
\5/ The Securities and Exchange Commission requires use of a 5% annual return
figure for purposes of this example. Actual return for the Fund may be
greater or less than 5%.
<PAGE>
FINANCIAL HIGHLIGHTS
KEYSTONE CUSTODIAN FUND, SERIES K-1
(For a share outstanding throughout the year)
The following table contains important financial information relating to
the Fund and has been audited by KPMG Peat Marwick LLP, the Fund's independent
auditors. The table has been taken from the Fund's Annual Report and should be
read in conjunction with the Fund's financial statements and related notes,
which also appear, together with the auditors" report, in the Fund's Annual
Report. The Fund's financial statements, related notes, and auditors' report are
included in the statement of additional information. Additional information
about the Fund's performance is contained in its Annual Report, which will be
made available upon request and without charge.
<TABLE>
<CAPTION>
YEAR ENDED JUNE 30,
--------------------------------------------------------------------------------------------------------------
1994 1993 1992 1991 1990 1989 1988 1987 1986 1985
---------- ---------- ---------- -------- -------- -------- -------- -------- -------- ------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Net asset value
beginning of year . $10.10 $ 9.77 $ 9.16 $ 9.10 $ 9.12 $ 8.37 $ 9.74 $10.50 $ 9.06 $8.17
------ ------ ------ ------ ------ ------ ------ ------ ------ -----
INCOME FROM INVESTMENT
OPERATIONS:
Investment income --
net .............. 0.28 0.31 0.32 0.45 0.50 0.46 0.47 0.46 0.56 0.59
Net gains (losses)
on investments .... (0.37) 0.66 0.75 0.18 0.20 0.83 (0.82) 0.81 1.87 1.47
Net commissions paid
on fund share sales
<F2> .............. 0 0 0 0 0 0 0 0 (0.09) (0.03)
------ ------ ------ ------ ------ ------ ------ ------ ------ -----
Total from
investment
operations ...... (0.09) 0.97 1.07 0.63 0.70 1.29 (0.35) 1.27 2.34 2.03
------ ------ ------ ------ ------ ------ ------ ------ ------ -----
LESS DISTRIBUTIONS FROM:
Investment income --
net ............... (0.28) (0.31) (0.32) (0.50) (0.50) (0.54) (0.60) (0.54) (0.56) (0.69)
In excess of
investment income
-- net ............ (0.07) (0.09) 0 0 0 0 0 0 0 0
Tax basis return of
capital ........... (0.02) 0 0 0 0 0 0 0 0 0
Realized gains on
investments -- net (0.25) (0.24) 0 (0.03) (0.18) 0 (0.42) (1.49) (0.34) (0.45)
In excess of
realized gains on
investments -- net (0.13) 0 0 0 0 0 0 0 0 0
Distributions from
paid-in capital<F3> 0 0 (0.14) (0.04) (0.04) 0 0 0 0 0
------ ------ ------ ------ ------ ------ ------ ------ ------ -----
Total distributions (0.75) (0.64) (0.46) (0.57) (0.72) (0.54) (1.02) (2.03) (0.90) (1.14)
------ ------ ------ ------ ------ ------ ------ ------ ------ -----
Net asset value, end
of year ........... $ 9.26 $10.10 $ 9.77 $ 9.16 $ 9.10 $ 9.12 $ 8.37 $ 9.74 $10.50 $9.06
====== ====== ====== ====== ====== ====== ====== ====== ====== =====
TOTAL RETURN<F4> ... -1.16% 10.39% 11.86% 7.49% 7.99% 16.06% -3.37% 15.39% 27.81% 27.75%
RATIOS/SUPPLEMENTAL DATA
Ratios to average net
assets:
Operating and
management
expenses ......... 1.71% 1.93% 1.97% 1.88% 1.99% 1.96% 1.91% 1.93% 0.86% 0.87%
Investment income
-- net ........... 2.81% 3.07% 3.25% 4.56% 4.94% 5.48% 5.34% 4.47% 5.82% 6.73%
Portfolio turnover
rate ............. 88% 74% 52% 60% 35% 49% 64% 79% 92% 109%
Net assets, end of
year (thousands) .. $1,389,810 $1,464,066 $1,184,094 $901,994 $826,934 $712,009 $685,427 $727,723 $419,066 $291,028
========== ========== ========== ======== ======== ======== ======== ======== ======== =======
<FN>
- --------
<F1> Calculation is based on average shares outstanding beginning in 1988.
<F2> Prior to June 30, 1987, net commissions paid on new sales of shares under
the Fund's Rule 12b-1 Distribution Plan had been treated for both financial
statement and tax purposes as capital charges. On June 11, 1987, the
Securities and Exchange Commission adopted a rule which required for
financial statements for the periods ended on or after June 30, 1987, that
net commissions paid under Rule 12b-1 be treated as operating expenses
rather than capital charges. Accordingly, beginning with the year ended
June 30, 1987, the Fund's financial statements reflect 12b-1 Distribution
Plan expenses (i.e., shareholder service fees plus commissions paid net of
deferred sales charges received by the Fund) as a component of net
investment income.
<F3> Effective July 1, 1993, the Fund adopted Statement of Position 93-2:
"Determination, Disclosure, and Financial Statement Presentation of Income,
Capital Gain and Return of Capital Distributions by Investment Companies."
As a result, distribution amounts exceeding book basis net investment
income (or tax basis net income on a temporary basis) are presented as
"Distributions in excess of investment income -- net." Similarly, capital
gain distributions in excess of book basis capital gains (or tax basis
capital gains on a temporary basis) are presented as "Distributions in
excess of net realized capital gains." From January 31, 1990 until the date
of adoption of the Statement of Position, distribution amounts exceeding
book basis net investment income were charged to paid-in capital.
<F4> Excluding deferred sales charges.
</TABLE>
<PAGE>
- --------------------------------------------------------------------------------
FUND DESCRIPTION
- --------------------------------------------------------------------------------
The Fund is an open-end, diversified management investment company, commonly
known as a mutual fund. The Fund was created under Pennsylvania law as a common
law trust and has been offering its shares continuously since September 11,
1935. The Fund is one of twenty managed by Keystone Management, Inc. ("Keystone
Management"), the Fund's investment manager, and is one of thirty-one funds
managed or advised by Keystone Custodian Funds, Inc. ("Keystone"), the Fund's
investment adviser. Keystone and Keystone Management are, from time to time,
also collectively referred to as "Keystone".
- --------------------------------------------------------------------------------
FUND OBJECTIVE AND POLICIES
- --------------------------------------------------------------------------------
The Fund's investment objective is to provide shareholders with current
income. In its search for income, the Fund may invest in any type of security,
including bonds, preferred and common stocks and interests in limited
partnerships, including master limited partnerships. The Fund emphasizes,
however, securities having a liberal current yield consistent with investment
quality on which the interest or dividend payments are considered reasonably
secure. Securities appearing to offer attractive possibilities for future growth
of both capital and income may be included in the Fund's portfolio whenever it
seems possible to do so without conflicting with the Fund's primary objective of
securing generous current income for its shareholders. In addition to its other
investment options, the Fund may invest up to 25% of its assets in foreign
securities.
The Fund may invest in non-investment grade securities having a rating range
of BB to CCC by Standard & Poor's Corporation ("S&P") and/or Ba to Caa by
Moody's Investors Service, Inc. ("Moody's"). The Fund may also invest in
non-investment grade rated zero coupon and payment-in-kind ("PIK") securities.
The Fund currently expects that less than 5% of its total assets will be
invested in non-investment grade securities.
Non-investment grade securities are commonly referred to as high yield, high
risk securities. High yield securities are generally riskier than higher quality
securities and are subject to more credit risk, including risk of default, and
volatility than higher quality securities. In addition, such securities may have
less liquidity and experience more price fluctuation than higher quality
securities. Non-investment grade rated zero coupon and PIK securities generally
are more speculative and subject to higher fluctuations in value than other high
yield securities. For additional information about special considerations
applicable to investments in high yield securities, see the Fund's statement of
additional information.
When market conditions warrant, the Fund may adopt a defensive position to
preserve shareholders' capital by investing in money market instruments. Such
instruments, which must mature within one year of their purchase, consist of
United States ("U.S.") government securities; instruments, including
certificates of deposit, demand and time deposits and bankers' acceptances, of
banks that are members of the Federal Deposit Insurance Corporation and have
assets of at least $1 billion, including U.S. branches of foreign banks and
foreign branches of U.S. banks; prime commercial paper, including master demand
notes; and repurchase agreements secured by U.S. government securities.
The Fund intends to follow policies of the Securities and Exchange Commission
as they are adopted from time to time with respect to illiquid securities,
including, at this time, (1) treating as illiquid securities that may not be
sold or disposed of in the ordinary course of business within seven days at
approximately the value at which the Fund has valued such securities on its
books and (2) limiting its holdings of such securities to 15% of net assets.
The Fund may write covered call and put options, may purchase call and put
options, including purchasing call and put options to close out existing
positions, and may employ new investment techniques with respect to such
options. The Fund currently does not intend to invest more than 5% of its assets
in options transactions.
The Fund may enter into reverse repurchase agreements and firm commitment
agreements for securities and currencies. In addition, the Fund may enter into
currency and other financial futures contracts and engage in related options
transactions for hedging purposes and not for speculation and may employ new
investment techniques with respect to such futures contracts and related
options. The Fund may also invest in various mortgage-related securities,
including collateralized mortgage obligations, and certain interest rate
transactions, such as "swaps," "caps," and "floors."
The Fund may invest in restricted securities, including securities eligible
for resale pursuant to Rule 144A under the Securities Act of 1933 (the "1933
Act"). Generally, Rule 144A establishes a safe harbor from the registration
requirements of the 1933 Act for resales by large institutional investors of
securities not publicly traded in the U.S. The Fund intends to purchase Rule
144A securities when such securities present an attractive investment
opportunity and otherwise meet the Fund's selection criteria. Keystone
determines the liquidity of the Fund's Rule 144A securities in accordance with
guidelines adopted by the Board of Trustees.
At the present time, the Fund cannot accurately predict exactly how the market
for Rule 144A securities will develop. A Rule 144A security that was readily
marketable upon purchase may subsequently become illiquid. In such an event, the
Board of Trustees will consider what action, if any, is appropriate.
Investment in foreign securities, options transactions, futures contracts,
forwards, mortgage-related securities and other complex securities (also known
as "derivative instruments") involves certain risks. For further information
about these risks and the types of investments and investment techniques
available to the Fund, see "Additional Investment Information" located at the
back of this prospectus and the statement of additional information.
Of course, there can be no assurance that the Fund will achieve its investment
objective since there is uncertainty in every investment. The investment
objective of the Fund cannot be changed without a vote of the holders of a
majority (as defined in the 1940 Act) of the Fund's outstanding shares.
- --------------------------------------------------------------------------------
INVESTMENT RESTRICTIONS
- --------------------------------------------------------------------------------
The Fund has adopted the fundamental restrictions set forth below, which may
not be changed without the approval of a majority of the Fund's outstanding
shares. These restrictions and certain other fundamental restrictions are set
forth in the statement of additional information.
The Fund may not do the following: (1) invest more than 5% of its total assets
in the securities of any one issuer (other than U.S. government securities); (2)
borrow money, except that the Fund may borrow money from banks for temporary or
emergency purposes in aggregate amounts up to 10% of the value of the Fund's net
assets (computed at cost) or enter into reverse repurchase agreements provided
that bank borrowings and reverse repurchase agreements, in aggregate, shall not
exceed 10% of the value of the Fund's net assets; and (3) invest more than 25%
of its total assets in securities of issuers in the same industry.
In addition, the Fund may, notwithstanding any other investment policy or
restriction, invest all of its assets in the securities of a single open-end
management investment company with substantially the same fundamental investment
objectives, policies and restrictions as the Fund. The Fund does not currently
intend to implement this policy and would do so only if the Trustees were to
determine such action to be in the best interest of the Fund and its
shareholders. In the event of such implementation, the Fund will comply with
such requirements as to written notice to shareholders as are then in effect.
- --------------------------------------------------------------------------------
RISK FACTORS
- --------------------------------------------------------------------------------
Investing in the Fund involves the risk common to investing in any security,
i.e., net asset value will fluctuate in response to changes in economic
conditions, interest rates and the market's perception of the underlying
portfolio securities of the Fund.
By itself, the Fund does not constitute a balanced investment plan. The Fund
stresses providing current income, although it will consider the potential for
capital appreciation. Therefore, you should not expect capital appreciation
comparable to that of funds which have that primary objective. The yield of the
Fund's portfolio securities will fluctuate with changing market conditions and
normally in relation to the yield of stocks in the S&P Index of 500 Common
Stocks. The Fund makes most sense for those investors who can afford to ride out
changes in the stock market because it invests a substantial portion of its
assets in common and preferred stocks.
Current income levels should not be considered representative of income for
any future period of time. Moreover, should many shareholders change from this
Fund to some other investment at about the same time, the Fund might have to
sell portfolio securities at a time when it would be disadvantageous to do so
and at a lower price than if such securities were held to maturity.
The Fund may invest up to 5% of its assets in bonds issued by foreign issuers
rated below investment grade, which entail greater risks of untimely interest
and principal payments, default and price volatility, than higher rated
securities, and may present problems of liquidity and valuation. Investors
should carefully consider these risks before investing.
For additional information regarding the Fund's investments in lower-rated
securities and Rule 144A securities, see "Fund Objective and Policies". For
further information about the types of investments and investment techniques
available to the Fund, including the associated risks, see "Additional
Investment Information" and the statement of additional information.
- --------------------------------------------------------------------------------
PRICING SHARES
- --------------------------------------------------------------------------------
The net asset value of a Fund share is computed each day on which the New York
Stock Exchange (the "Exchange") is open as of the close of trading on the
Exchange (currently 4:00 p.m. Eastern time for the purpose of pricing Fund
shares) except on days when changes in the value of the Fund's securities do not
affect the current net asset value of its shares. The Exchange is currently
closed on weekends, New Year's Day, Presidents' Day, Good Friday, Memorial Day,
Independence Day, Labor Day, Thanksgiving Day and Christmas Day. The net asset
value per share is arrived at by determining the value of all of the Fund's
assets, subtracting all liabilities and dividing the result by the number of
shares outstanding.
Current values for the Fund's portfolio securities are determined as follows:
(1) Securities that are traded on a national securities exchange or the
over-the-counter National Market System ("NMS") are valued on the basis of the
last sales price on the exchange where primarily traded or NMS prior to the time
of the valuation, provided that a sale has occurred and that this price reflects
current market value according to procedures established by the Board of
Trustees.
(2) Securities traded in the over-the-counter market, other than NMS, are
valued at the mean of the bid and asked prices at the time of valuation.
(3) Short-term instruments maturing in sixty days or less (including all
master demand notes) are valued at amortized cost (original purchase cost as
adjusted for amortization of premium or accretion of discount), which, when
combined with accrued interest, approximates market; short-term instruments
maturing in more than sixty days for which market quotations are readily
available are valued at current market value; and short-term instruments
maturing in more than sixty days when purchased that are held on the sixtieth
day prior to maturity are valued at amortized cost (market value on the sixtieth
day adjusted for amortization of premium or accretion of discount), which, when
combined with accrued interest, approximates market, in any case reflecting fair
value as determined by the Board of Trustees.
(4) The following securities are valued at prices deemed in good faith to be
fair under procedures established by the Board of Trustees: (a) securities,
including restricted securities, for which complete quotations are not readily
available; (b) listed securities or those on NMS, if, in the Fund's opinion, the
last sales price does not reflect a current market value or if no sale occurred;
and (c) other assets.
The Fund believes that reliable market quotations are generally not readily
available for purposes of valuing fixed income securities. As a result,
depending on the particular securities owned by the Fund, it is likely that most
of the valuations for such securities will be based upon their fair value
determined under procedures approved by the Board of Trustees. The Board of
Trustees has authorized the use of a pricing service to determine the fair value
of the Fund's fixed income securities and certain other securities. Securities
for which market quotations are readily available are valued on a consistent
basis at the price quoted that, in the opinion of the Trustees or the person
designated by the Trustees to make the determination, most nearly represents the
market value of the particular security.
- --------------------------------------------------------------------------------
DIVIDENDS AND TAXES
- --------------------------------------------------------------------------------
The Fund has qualified and intends to qualify in the future as a regulated
investment company under the Internal Revenue Code (the "Code"). The Fund
qualifies if, among other things, it distributes to its shareholders at least
90% of its net investment income for its fiscal year. The Fund also intends to
make timely distributions, if necessary, sufficient in amount to avoid the
non-deductible 4% excise tax imposed on a regulated investment company when it
fails to distribute, with respect to each calendar year, at least 98% of its
ordinary income for such calendar year and 98% of its net capital gains for the
one-year period ending on October 31 of such calendar year. Any such
distributions would be (1) declared on or before December 31 to shareholders of
record in December, (2) paid by the following January 31 and (3) includable in
the taxable income of shareholders for the year in which such distributions were
declared. If the Fund qualifies and if it distributes all of its net investment
income and net capital gains, if any, to shareholders, it will be relieved of
any federal income tax liability. The Fund distributes its net income to its
shareholders by the 15th day of February, May, August and November each year and
net capital gains, if any, at least annually.
Commissions paid by the Fund on new sales of shares under the Fund's
Distribution Plan (see "Distribution Plan") and deferred sales charge receipts
are treated as capital charges and capital credits, respectively, in determining
net investment income for tax purposes. For financial statement purposes,
however, these expenses and receipts are treated as operating expenses and
expense offsets. As a result, the amount of dividend distributions required to
satisfy the requirements of the Code might exceed net investment income for
financial statement purposes, resulting in a portion of such dividends being a
return of capital for financial statement purposes, but not for tax purposes.
Total investment return is equally affected by both treatments.
The Fund makes distributions in additional shares of the Fund or, at the
shareholder's election (which must be made before the record date for the
distribution), in cash. Income dividends and net short-term gains distributions
are taxable as ordinary income and net long-term gains are taxable as capital
gains regardless of how long the shareholder has held the Fund's shares. If Fund
shares held for less than six months are sold at a loss, however, such loss will
be treated for tax purposes as a long-term capital loss to the extent of any
long-term capital gains dividends received. Dividends and distributions may also
be subject to state and local taxes. The Fund advises its shareholders annually
as to the federal tax status of all distributions made during the year.
- --------------------------------------------------------------------------------
FUND MANAGEMENT AND EXPENSES
- --------------------------------------------------------------------------------
FUND MANAGEMENT
Subject to the general supervision of the Fund's Board of Trustees, Keystone
Management, located at 200 Berkeley Street, Boston, Massachusetts 02116-5034,
serves as investment manager to the Fund and is responsible for the overall
management of the Fund's business and affairs. Keystone Management, organized in
1989, is a wholly-owned subsidiary of Keystone. Its directors and principal
executive officers have been affiliated with Keystone, a seasoned investment
adviser, for a number of years. Keystone Management also serves as investment
manager to each of the other Keystone Custodian Funds and to certain other funds
in the Keystone Group of Mutual Funds.
The Fund currently pays Keystone Management a fee for its services at the
annual rate set forth below:
Aggregate Net
Asset Value
Management of the Shares
Fee of the Fund
Income
- --------------------------------------------------------------------------------
1.5% of
Gross Dividend and
Interest Income
Plus
0.60% of the first $ 100,000,000 plus
0.55% of the next $ 100,000,000 plus
0.50% of the next $ 100,000,000 plus
0.45% of the next $ 100,000,000 plus
0.40% of the next $ 100,000,000 plus
0.35% of the next $ 500,000,000 plus
0.30% of amounts over $1,000,000,000;
computed as of the close of business each business day and paid daily.
Pursuant to its Investment Management Agreement with the Fund, Keystone
Management has delegated its investment management functions, except for certain
administrative and management services; to Keystone and has entered into an
Investment Advisory Agreement with Keystone, under which Keystone provides
investment advisory and management services to the Fund. Services performed by
Keystone Management include (1) performing research and planning with respect to
(a) the Fund's qualification as a regulated investment company under Subchapter
M of the Code, (b) tax treatment of the Fund's portfolio investments, (c) tax
treatment of special corporate actions (such as reorganizations), (d) state tax
matters affecting the Fund, and (e) the Fund's distributions of income and
capital gains; (2) preparing the Fund's federal and state tax returns; (3)
providing services to the Fund's shareholders in connection with federal and
state taxation and distributions of income and capital gains; and (4) storing
documents relating to the Fund's activities.
Keystone, located at 200 Berkeley Street, Boston, Massachusetts 02116-5034,
has provided investment advisory and management services to investment companies
and private accounts since it was organized in 1932. Keystone is a wholly-owned
subsidiary of Keystone Group, Inc. ("Keystone Group"), 200 Berkeley Street,
Boston, Massachusetts 02116-5034.
Keystone Group is a corporation privately owned by current and former members
of management of Keystone and its affiliates. The shares of Keystone Group
common stock beneficially owned by management are held in a number of voting
trusts, the trustees of which are George S. Bissell, Albert H. Elfner, III,
Roger T. Wickers, Edward F. Godfrey and Ralph J. Spuehler, Jr. Keystone Group
provides accounting, bookkeeping, legal, personnel and general corporate
services to Keystone Management, Keystone, their affiliates and the Keystone
Group of Mutual Funds.
Pursuant to its Investment Advisory Agreement, Keystone receives for its
services an annual fee representing 85% of the management fee received by
Keystone Management under its Investment Management Agreement with the Fund.
During the year ended June 30, 1994, the Fund paid or accrued to Keystone
Management investment management and administrative services fees of $6,677,244,
representing 0.45% of the Fund's average net assets. Of such amount, $5,675,657
was paid to Keystone for its services to the Fund.
FUND EXPENSES
In addition to the investment advisory and management fees discussed above,
the principal expenses the Fund is expected to pay include, but are not limited
to, expenses of its transfer agent, its custodian and its independent auditors;
expenses under its Distribution Plan; fees of its independent Trustees
("Independent Trustees"); expenses of shareholders' and Trustees' meetings; fees
payable to government agencies, including registration and qualification fees of
the Fund and its shares under federal and state securities laws; expenses of
preparing, printing and mailing Fund prospectuses, notices, reports and proxy
material; and certain extraordinary expenses. In addition to such expenses, the
Fund pays its brokerage commissions, interest charges and taxes. For the fiscal
year ended June 30, 1994, the Fund paid 1.71% of its average net assets in
expenses.
During the fiscal year ended June 30, 1994, the Fund paid or accrued $43,964
to Keystone Investor Resource Center, Inc. ("KIRC"), the Fund's transfer and
dividend disbursing agent, and Keystone Group for certain accounting services.
The Fund paid $3,589,413 to KIRC for transfer agent services. KIRC is a
wholly-owned subsidiary of Keystone.
PORTFOLIO MANAGER
Walter McCormick has been the Fund's Portfolio Manager since 1984. He is a
Keystone Vice President and a Senior Portfolio Manager and has more than 20
years' experience in equity investing.
SECURITIES TRANSACTIONS
Keystone selects broker-dealers to execute transactions subject to the receipt
of best execution. When selecting broker-dealers to execute portfolio
transactions for the Fund, Keystone may follow a policy of considering as a
factor the number of shares of the Fund sold by such broker-dealers. In
addition, broker-dealers may, from time to time, be affiliated with the Fund,
Keystone Management, Keystone, the Fund's principal underwriter or their
affiliates.
PORTFOLIO TURNOVER
The Fund's portfolio turnover rates for the fiscal years ended June 30, 1994
and 1993 were 88% and 74%, respectively.
- --------------------------------------------------------------------------------
HOW TO BUY SHARES
- --------------------------------------------------------------------------------
Shares of the Fund may be purchased from any broker-dealer that has a selling
agreement with Keystone Distributors, Inc. ("KDI"), the Fund's principal
underwriter ("Principal Underwriter"). KDI, a wholly-owned subsidiary of
Keystone, is located at 200 Berkeley Street, Boston, Massachusetts 02116-5034.
The Fund's shares are sold at the net asset value per share next computed
after it receives the purchase order. The initial purchase must be at least
$1,000, except for purchases by participants in certain retirement plans for
which the minimum is waived. There is no minimum for subsequent purchases.
Purchase payments are fully invested at net asset value. There are no sales
charges on purchases of Fund shares at the time of purchase.
CONTINGENT DEFERRED SALES CHARGE
With certain exceptions, when shares are redeemed within four calendar years
after their purchase, a contingent deferred sales charge may be imposed at rates
ranging from a maximum of 4% of amounts redeemed during the same calendar year
of purchase to 1% of amounts redeemed during the third calendar year after the
year of purchase. No contingent deferred sales charge is imposed on amounts
redeemed thereafter. If imposed, the contingent deferred sales charge is
deducted from the redemption proceeds otherwise payable to the shareholder.
Prior to July 8, 1992, the Fund retained the contingent deferred sales charge.
Since July 8, 1992, the contingent deferred sales charge attributable to shares
purchased prior to January 1, 1992 has been retained by the Fund, and the
contingent deferred sales charge attributable to shares purchased after January
1, 1992 is, to the extent permitted by NASD rules, paid to KDI. For the fiscal
year ended June 30, 1994, the Fund recovered $333,994 in deferred sales charges.
The contingent deferred sales charge is a declining percentage of the lesser
of (1) the net asset value of the shares redeemed or (2) the total cost of such
shares. No contingent deferred sales charge is imposed when a shareholder
redeems amounts derived from (1) increases in the value of his account above the
total cost of such shares due to increases in the net asset value per share of
the Fund; (2) certain shares with respect to which the Fund did not pay a
commission on issuance, including shares acquired through reinvestment of
dividend income and capital gains distributions; or (3) shares held in all or
part of more than four consecutive calendar years.
In determining whether a contingent deferred sales charge is payable and, if
so, the percentage charge applicable, it is assumed that shares held the longest
are the first to be redeemed. There is no deferred sales charge on permitted
exchanges of shares between Keystone funds that have adopted distribution plans
pursuant to Rule 12b-1 under the 1940 Act. When shares of one such fund have
been exchanged for shares of another such fund, for purposes of any future
contingent deferred sales charge, the calendar year of the exchange is assumed
to be the year shares tendered for exchange were originally purchased.
In addition, no contingent deferred sales charge is imposed on a redemption of
shares of the Fund in the event of (1) death or disability of the shareholder;
(2) a lump-sum distribution from 401(k) plan or other benefit plan qualified
under the Employee Retirement Income Security Act of 1974 ("ERISA"); (3)
automatic withdrawals from ERISA plans if the shareholder is at least 59 1/2
years old; (4) involuntary redemptions of accounts having an aggregate net asset
value of less than $1,000; or (5) automatic withdrawals under an automatic
withdrawal plan of up to 1 1/2% per month of the shareholder's initial account
balance.
WAIVER OF DEFERRED SALES CHARGES
Shares may also be sold, to the extent permitted by applicable law, at net
asset value without the payment of commissions or the imposition of a contingent
deferred sales charge to (1) certain officers, Directors, Trustees and employees
of the Fund, Keystone Management, Keystone and certain of their affiliates; (2)
registered representatives of firms with dealer agreements with KDI; and (3) a
bank or trust company acting as trustee for a single account.
- --------------------------------------------------------------------------------
DISTRIBUTION PLAN
- --------------------------------------------------------------------------------
The Fund bears some of the costs of selling its shares under its Distribution
Plan adopted on June 1, 1983 pursuant to Rule 12b-1 under the 1940 Act. The
Fund's Distribution Plan provides that the Fund may expend up to 0.3125%
quarterly (approximately 1.25% annually) of the average daily net asset value of
its shares to pay distribution costs for sales of its shares and to pay
shareholder service fees. NASD rules limit such annual expenditures to 1%, of
which 0.75% may be used to pay such distribution costs and 0.25% may be used to
pay shareholder service fees. The aggregate amount that the Fund may pay for
such distribution costs is limited to 6.25% of gross share sales since the
inception of the Fund's Distribution Plan plus interest at the prime rate plus
1% on unpaid amounts thereof (less any contingent deferred sales charges paid by
shareholders to KDI).
Amounts paid under the Distribution Plan are paid to the Fund's Principal
Underwriter, currently KDI, (1) as commissions for Fund shares sold under the
Distribution Plan, all or any part of which commissions may be reallowed by KDI
to others for selling the Fund's shares, and (2) to enable KDI to pay such
others shareholder service fees in respect of shares maintained by such
recipients and outstanding on the Fund's books for specified periods. Amounts
paid or accrued to KDI under (1) and (2) in the aggregate may not exceed the
annual limitation referred to above. From the amounts received by KDI in
connection with the Distribution Plan and subject to the limitations discussed
above, KDI generally pays brokers or others a commission equal to 4% of the
price paid to the Fund for each sale of Fund shares as well as a shareholder
service fee at a rate of 0.25% per annum of the net asset value of shares
maintained by such recipients and outstanding on the books of the Fund for
specified periods.
If the Fund is unable to pay KDI a commission on a new sale because the annual
maximum (0.75% of average daily net assets) has been reached, KDI intends, but
is not obligated, to continue to accept new orders for the purchase of Fund
shares and to pay or accrue commissions and service fees in excess of the amount
it currently receives from the Fund. While the Fund is under no contractual
obligation to reimburse KDI for advances made by KDI in excess of the
Distribution Plan limitation, KDI intends to seek full payment of such charges
from the Fund (together with interest at the rate of prime plus one percent) at
such time in the future as, and to the extent that, payment thereof by the Fund
would be within permitted limits. KDI currently intends to seek payment of
interest only on such charges paid or accrued by KDI subsequent to January 1,
1992. If the Fund's Independent Trustees authorize such payments, the effect
will be to extend the period of time during which the Fund incurs the maximum
amount of costs allowed by the Distribution Plan. If the Distribution Plan is
terminated, KDI will ask the Independent Trustees to take whatever action they
deem appropriate under the circumstances with respect to payment of such
amounts.
During the year ended June 30, 1994, the Fund recovered $333,994 in deferred
sales charges. During the year, the Fund paid KDI $14,534,084 under the
Distribution Plan. The amount paid by the Fund under its Distribution Plan, net
of deferred sales charges, was $14,200,090 (0.96% of the Fund's average daily
net asset value during the year). For the year ended June 30, 1994, KDI earned
$5,366,134 in commissions and service fees under the Distribution Plan, of which
amount KDI actually received $3,606,244 after payments of commissions on new
sales and service fees to dealers and others of $10,927,840. During the year,
KDI also received $1,286,132 in deferred sales charges. At June 30, 1994, KDI's
total unreimbursed 12b-1 expenses amounted to $10,745,515 (0.77% of the Fund's
daily net asset value on June 30, 1994).
The amounts and purposes of expenditures under the Distribution Plan must be
reported to the Independent Trustees quarterly. The Independent Trustees may
require or approve changes in the operation of the Distribution Plan and may
require that total expenditures by the Fund under the Distribution Plan be kept
within limits lower than the maximum amount permitted by the Distribution Plan
as stated above. If such costs are not limited by the Independent Trustees, such
costs could, for some period of time, be higher than such costs permitted by
most other plans presently adopted by other investment companies.
The Distribution Plan may be terminated at any time by vote of the Independent
Trustees or by vote of a majority of the outstanding voting shares of the Fund.
Any change in the Distribution Plan that would materially increase the
distribution expenses of the Fund provided for in the Distribution Plan requires
shareholder approval. Otherwise, the Distribution Plan may be amended by votes
of the majority of both (1) the Fund's Trustees and (2) the Independent
Trustees, cast in person at a meeting called for the purpose of voting on such
amendment.
While the Distribution Plan is in effect, the Fund is required to commit the
selection and nomination of candidates for Independent Trustees to the
discretion of the Independent Trustees.
Whether any expenditure under the Distribution Plan is subject to a state
expense limit depends upon the nature of the expenditure and the terms of the
state law, regulation or order imposing the limit. A portion of the Fund's
Distribution Plan expenses may be includable in the Fund's total operating
expenses for purposes of determining compliance with state expense limits.
Upon written notice to dealers, KDI, at its own expense may periodically
sponsor programs that offer additional compensation in connection with sales of
Fund shares. Participation in such programs may be available to all dealers or
to selected dealers who have sold or are expected to sell significant amounts of
shares. Additional compensation may include financial assistance to dealers in
connection with preapproved seminars, conferences and advertising. No such
programs or additional compensation will be offered to the extent they are
prohibited by the laws of any state or any self-regulatory agency, such as the
NASD.
The Glass-Steagall Act currently limits the ability of a depository
institution (such as a commercial bank or a savings and loan association) to
become an underwriter or distributor of securities. In the event the Glass-
Steagall Act is deemed to prohibit depository institutions from accepting
payment under the arrangement described above, or should Congress relax current
restrictions on depository institutions, the Board of Trustees will consider
what action, if any, is appropriate.
In addition, state securities laws on this issue may differ from the
interpretations of federal law expressed herein and banks and financial
institutions may be required to register as dealers pursuant to state law.
- --------------------------------------------------------------------------------
HOW TO REDEEM SHARES
- --------------------------------------------------------------------------------
Fund shares may be redeemed for cash at the redemption value upon written
order by the shareholder(s) to the Fund, c/o Keystone Investor Resource Center,
Inc., Box 2121, Boston, Massachusetts 02106-2121, and presentation to the Fund
of a properly endorsed share certificate if certificates have been issued. The
signature(s) of the shareholder(s) on the written order and certificates must be
guaranteed. The redemption value is the net asset value adjusted for fractions
of a cent and may be more or less than the shareholder's cost depending upon
changes in the value of the Fund's portfolio securities between purchase and
redemption. The Fund may impose a deferred sales charge at the time of
redemption of certain shares as explained in "How to Buy Shares." If imposed,
the Fund deducts the deferred sales charge from the redemption proceeds
otherwise payable to the shareholder.
At various times, the Fund may be requested to redeem shares for which it has
not yet received good payment. In such a case, the Fund will mail the redemption
proceeds upon clearance of the purchase check, which may take up to 15 days or
more. Any delay may be avoided by purchasing shares either with a certified
check or by bank wire of funds. Although the mailing of a redemption check may
be delayed, the redemption value will be determined and the redemption processed
in the ordinary course of business upon receipt of proper documentation. In such
a case, after the redemption and prior to the release of the proceeds, no
appreciation or depreciation will occur in the value of the redeemed shares, and
no interest will be paid on the redemption proceeds. If the mailing of a
redemption check has been delayed, the check will be mailed promptly after good
payment has been collected.
The Fund computes the redemption value at the close of the Exchange at the end
of the day on which it has received all proper documentation from the
shareholder. Payment of the amount due on redemption, less any applicable
deferred sales charge, will be made within seven days thereafter.
Shareholders may also redeem their shares through their broker-dealers. KDI,
acting as agent for the Fund, stands ready to repurchase Fund shares upon orders
from dealers as follows: redemption requests received by broker-dealers prior to
that day's close of trading on the Exchange and transmitted to the Fund prior to
its close of business that day will receive the net asset value per share
computed at the close of trading on the Exchange on the same day. Redemption
requests received by broker-dealers after that day's close of trading on the
Exchange and transmitted to the Fund prior to the close of business on the next
business day will receive the next business day's net asset value price.
Assuming it has received proper documentation, KDI will pay the redemption
proceeds, less any applicable deferred sales charge, to the dealer placing the
order within seven days thereafter. KDI charges no fees for this service.
However, your broker-dealer may do so.
For the protection of shareholders, SIGNATURES ON CERTIFICATES, STOCK POWERS
AND ALL WRITTEN ORDERS OR AUTHORIZATIONS MUST BE GUARANTEED BY A U.S. STOCK
EXCHANGE MEMBER, A BANK OR OTHER PERSONS ELIGIBLE TO GUARANTEE SIGNATURES UNDER
THE SECURITIES EXCHANGE ACT OF 1934 AND KIRC'S POLICIES. The Fund and KIRC may
waive this requirement, but may also require additional documents in certain
cases. Currently, the requirement for a signature guarantee has been waived on
redemptions of $50,000 or less where the account address of record has been the
same for a minimum period of 30 days. The Fund and KIRC reserve the right to
withdraw this waiver at any time.
If the Fund receives a redemption or repurchase order, but the shareholder has
not clearly indicated the amount of money or number of shares involved, the Fund
cannot execute the order. In such cases, the Fund will request the missing
information from the shareholder and process the order the day it receives such
information.
TELEPHONE
Under ordinary circumstances, you may redeem up to $50,000 from your account
by telephone by calling toll free 1-800-343-2898. You must complete the
Telephone Redemptions section of the application to enjoy telephone redemption
privileges.
In order to insure that instructions received by KIRC are genuine when you
initiate a telephone transaction, you will be asked to verify certain criteria
specific to your account. At the conclusion of the transaction, you will be
given a transaction number confirming your request, and written confirmation of
your transaction will be mailed the next business day. Your telephone
instructions will be recorded. Redemptions by telephone are allowed only if the
address and bank account of record have been the same for a minimum period of 30
days.
If the redemption proceeds are less than $2,500, they will be mailed by check.
If they are $2,500 or more, they will be mailed, wired or sent by EFT to your
previously designated bank account as you direct. If you do not specify how you
wish your redemption proceeds to be sent, they will be mailed by check. If you
cannot reach the Fund by telephone, you should follow the procedures for
redeeming by mail or through a broker as set forth above.
SMALL ACCOUNTS
Because of the high cost of maintaining small accounts, the Fund reserves the
right to redeem your account if its value has fallen below $1,000, the current
minimum investment level, as a result of your redemptions (but not as a result
of market action). You will be notified in writing and allowed 60 days to
increase the value of your account to the minimum investment level. The Fund
does not impose any contingent deferred sales charges on such redemptions.
GENERAL
The Fund reserves the right at any time to terminate, suspend or change the
terms of any redemption method described in this prospectus, except redemption
by mail, and to impose fees.
Except as otherwise noted, neither the Fund, KIRC nor KDI assumes
responsibility for the authenticity of any instructions received by any of them
from a shareholder in writing, over the Keystone Automated Response Line
("KARL") or by telephone. KIRC will employ reasonable procedures to confirm that
instructions received over KARL or by telephone are genuine. Neither the Fund,
KIRC nor KDI will be liable when following instructions received over KARL or by
telephone that KIRC reasonably believes to be genuine.
The Fund may temporarily suspend the right to redeem its shares when (1) the
Exchange is closed, other than customary weekend and holiday closings; (2)
trading on the Exchange is restricted; (3) the Fund cannot dispose of its
investments or fairly determine their value; or (4) the Securities and Exchange
Commission, for the protection of shareholders, so orders.
- --------------------------------------------------------------------------------
SHAREHOLDER SERVICES
- --------------------------------------------------------------------------------
Details on all shareholder services may be obtained from KIRC by writing or by
calling toll free 1-800-343-2898.
KEYSTONE AUTOMATED RESPONSE LINE
KARL offers shareholders specific fund account information and price and yield
quotations as well as the ability to effect account transactions, including
investments, exchanges and redemptions. Shareholders may access KARL by dialing
toll free 1-800-346-3858 on any touch-tone telephone, 24 hours a day, seven days
a week.
EXCHANGES
A shareholder who has obtained the appropriate prospectus may exchange shares
of the Fund for shares of any of the other seven Keystone Custodian Funds,
Keystone Precious Metals Holdings, Inc. ("KPMH"), Keystone International Fund
Inc. ("KIF"), Keystone Tax Free Fund ("KTFF"), Keystone Tax Exempt Trust
("KTET") or Keystone Liquid Trust ("'KLT") on the basis of their respective net
asset values by calling toll free 1-800-343-2898 or by writing KIRC at Box 2121,
Boston, Massachusetts 02106-2121. Fund shares purchased by check may be
exchanged for shares of the named funds, other than KPMH, KTET or KTFF, after 15
days provided good payment for the purchase of Fund shares has been collected.
In order to exchange Fund shares for shares of KPMH, KTET or KTFF, a shareholder
must have held Fund shares for a period of at least six months.
You may exchange your shares for another Keystone fund for a $10 fee by
calling or writing to Keystone. The exchange fee is waived for individual
investors who make an exchange using KARL. If the shares being tendered for
exchange have been held for less than four years and are still subject to a
contingent deferred sales charge, such charge will carry over to the shares
being acquired in the exchange transaction. The Fund reserves the right to
terminate this exchange offer or to change its terms, including the right to
change the service charge for any exchange.
Orders to exchange shares of the Fund for shares of KLT will be executed by
redeeming the shares of the Fund and purchasing shares of KLT at the net asset
value of KLT shares determined after the proceeds from such redemption become
available, which may be up to seven days after such redemption. In all other
cases, orders for exchanges received by the Fund prior to 4:00 p.m. on any day
the funds are open for business will be executed at the respective net asset
values determined as of the close of business that day. Orders for exchanges
received after 4:00 p.m. on any business day will be executed at the respective
net asset values determined at the close of the next business day.
An excessive number of exchanges may be disadvantageous to the Fund.
Therefore, the Fund, in addition to its right to reject any exchange, reserves
the right to terminate the exchange privilege of any shareholder who makes more
than five exchanges of shares of the funds in a year or three in a calendar
quarter.
An exchange order must comply with the requirements for a redemption or
repurchase order and must specify the dollar value or number of shares to be
exchanged. Exchanges are subject to the minimum initial purchase requirements of
the fund being acquired. An exchange constitutes a sale for federal income tax
purposes.
The exchange privilege is available only in states where shares of the fund
being acquired may legally be sold.
RETIREMENT PLANS
The Fund has various pension and profit-sharing plans available to investors,
including Individual Retirement Accounts ("IRAs"); Rollover IRAs; Simplified
Employee Pension Plans ("SEPs"); Tax Sheltered Annuity Plans ("TSAs"); 401k
Plans; Keogh Plans; Corporate Profit-Sharing Plans; Pension and Target Benefit
Plans; Money Purchase Pension Plans; and Salary-Reduction Plans. For details,
including fees and application forms, call KIRC toll free at 1-800-247-4075 or
write to KIRC at P.O. Box 2121, Boston, Massachusetts 02106-2121.
AUTOMATIC INVESTMENT PLAN
Shareholders may take advantage of investing on an automatic basis by
establishing an automatic investment plan. Funds are drawn on a shareholder's
checking account monthly and used to purchase Fund shares.
AUTOMATIC WITHDRAWAL PLAN
Under an Automatic Withdrawal Plan, shareholders may arrange for regular
monthly or quarterly fixed withdrawal payments. Each payment must be at least
$100 and may be as much as 1% per month or 3% per quarter of the total net asset
value of the Fund shares in the shareholder's account when the Automatic
Withdrawal Plan is opened. Fixed withdrawal payments are not subject to a
contingent deferred sales charge. Excessive withdrawals may decrease or deplete
the value of a shareholder's account.
OTHER SERVICES
Under certain circumstances, shareholders may, within 30 days after a
redemption, reinstate their accounts at current net asset value.
- --------------------------------------------------------------------------------
PERFORMANCE DATA
- --------------------------------------------------------------------------------
From time to time, the Fund may advertise "total return" and "current yield."
BOTH FIGURES ARE BASED ON HISTORICAL EARNINGS AND ARE NOT INTENDED TO INDICATE
FUTURE PERFORMANCE. Total return refers to the Fund's average annual compounded
rates of return over specified periods determined by comparing the initial
amount invested to the ending redeemable value of that amount. The resulting
equation assumes reinvestment of all dividends and distributions and deduction
of all recurring charges applicable to all shareholder accounts. The deduction
of the contingent deferred sales charge is reflected in the applicable years.
The exchange fee is not included in the calculation.
Current yield quotations represent the yield on an investment for a stated
30-day period computed by dividing net investment income earned per share during
the base period by the maximum offering price per share on the last day of the
base period.
The Fund may include comparative performance information in advertising or
marketing the Fund's shares, such data from Lipper Analytical Services, Inc. or
other industry publications.
- --------------------------------------------------------------------------------
FUND SHARES
- --------------------------------------------------------------------------------
The Fund currently issues one class of shares, which participate equally in
dividends and distributions and have equal voting, liquidation and other rights.
When issued and paid for, the shares will be fully paid and nonassessable by the
Fund. Shares may be exchanged as explained under "Shareholder Services," but
will have no other preference, conversion, exchange or preemptive rights.
Shareholders are entitled to one vote for each full share owned and fractional
votes for fractional shares. Shares are redeemable, transferable and freely
assignable as collateral. The Fund may establish additional classes or series of
shares.
The Fund does not have annual meetings. The Fund will have special meetings,
from time to time, as required under its Declaration of Trust and under the 1940
Act. As provided in the Fund's Declaration of Trust, shareholders have the right
to remove Trustees by an affirmative vote of two-thirds of the outstanding
shares. A special meeting of the shareholders will be held when 10% of the
outstanding shares request a meeting for the purpose of removing a Trustee. The
Fund is prepared to assist shareholders in communications with one another for
the purpose of convening such a meeting as prescribed by Section 16(c) of the
1940 Act.
- --------------------------------------------------------------------------------
ADDITIONAL INFORMATION
- --------------------------------------------------------------------------------
KIRC, located at 101 Main Street, Cambridge, Massachusetts 02142-1519, is a
wholly-owned subsidiary of Keystone. As previously mentioned, KIRC serves as the
Fund's transfer agent and dividend disbursing agent.
When the Fund determines from its records that more than one account in the
Fund is registered in the name of a shareholder or shareholders having the same
address, upon written notice to those shareholders, the Fund intends, when an
annual report or semi-annual report of the Fund is required to be furnished, to
mail one copy of such report to that address.
Except as otherwise stated in this prospectus or required by law, the Fund
reserves the right to change the terms of the offer stated in this prospectus
without shareholder approval, including the right to impose or change fees for
services provided.
<PAGE>
- --------------------------------------------------------------------------------
ADDITIONAL INVESTMENT INFORMATION
- --------------------------------------------------------------------------------
The Fund may engage in the following investment practices to the extent
described in the prospectus and the statement of additional information.
OBLIGATIONS OF FOREIGN BRANCHES OF UNITED STATES BANKS
The obligations of foreign branches of U.S. banks may be general obligations
of the parent bank in addition to the issuing branch or may be limited by the
terms of a specific obligation and by government regulation. Payment of interest
and principal upon these obligations may also be affected by governmental action
in the country of domicile of the branch (generally referred to as sovereign
risk). In addition, evidences of ownership of such securities may be held
outside the U.S. and the Fund may be subject to the risks associated with the
holding of such property overseas. Examples of governmental actions would be the
imposition of currency controls, interest limitations, withholding taxes,
seizure of assets or the declaration of a moratorium. Various provisions of
federal law governing domestic branches do not apply to foreign branches of
domestic banks.
OBLIGATIONS OF UNITED STATES BRANCHES OF FOREIGN BANKS
Obligations of U.S. branches of foreign banks may be general obligations of
the parent bank in addition to the issuing branch, or may be limited by the
terms of a specific obligation and by federal and state regulation as well as by
governmental action in the country in which the foreign bank has its head
office. In addition, there may be less publicly available information about a
U.S. branch of a foreign bank than about a domestic bank.
MASTER DEMAND NOTES
Master demand notes are unsecured obligations that permit the investment of
fluctuating amounts by the Fund at varying rates of interest pursuant to direct
arrangements between the Fund, as lender, and the issuer, as borrower. Master
demand notes may permit daily fluctuations in the interest rate and daily
changes in the amounts borrowed. The Fund has the right to increase the amount
under the note at any time up to the full amount provided by the note agreement,
or to decrease the amount. The borrower may repay up to the full amount of the
note without penalty. Notes purchased by the Fund permit the Fund to demand
payment of principal and accrued interest at any time (on not more than seven
days notice). Notes acquired by the Fund may have maturities of more than one
year, provided that (1) the Fund is entitled to payment of principal and accrued
interest upon not more than seven days notice, and (2) the rate of interest on
such notes is adjusted automatically at periodic intervals which normally will
not exceed 31 days, but may extend up to one year. The notes are deemed to have
a maturity equal to the longer of the period remaining to the next interest rate
adjustment or the demand notice period. Because these types of notes are direct
lending arrangements between the lender and borrower, such instruments are not
normally traded and there is no secondary market for these notes, although they
are redeemable and thus repayable by the borrower at face value plus accrued
interest at any time. Accordingly, the Fund's right to redeem is dependent on
the ability of the borrower to pay principal and interest on demand. In
connection with master demand note arrangements, Keystone considers, under
standards established by the Board of Trustees, earning power, cash flow and
other liquidity ratios of the borrower and will monitor the ability of the
borrower to pay principal and interest on demand. These notes are not typically
rated by credit rating agencies. Unless rated, the Fund will invest in them only
if the issuer meets the criteria established for commercial paper.
REPURCHASE AGREEMENTS
The Fund may enter into repurchase agreements with member banks of the Federal
Reserve System having at least $1 billion in assets, primary dealers in U.S.
government securities or other financial institutions believed by Keystone to be
creditworthy. Such persons must be registered as U.S. government securities
dealers with appropriate regulatory organizations. Under such agreements, the
bank, primary dealer or other financial institution agrees upon entering into
the contract to repurchase the security at a mutually agreed upon date and
price, thereby determining the yield during the term of the agreement. This
results in a fixed rate of return insulated from market fluctuations during such
period. Under a repurchase agreement, the seller must maintain the value of the
securities subject to the agreement at not less than the repurchase price, such
value being determined on a daily basis by marking the underlying securities to
their market value. Although the securities subject to the repurchase agreement
might bear maturities exceeding a year, the Fund only intends to enter into
repurchase agreements that provide for settlement within a year and usually
within seven days. Securities subject to repurchase agreements will be held by
the Fund's custodian or in the Federal Reserve book entry system. The Fund does
not bear the risk of a decline in the value of the underlying security unless
the seller defaults under its repurchase obligation. In the event of a
bankruptcy or other default of a seller of a repurchase agreement, the Fund
could experience both delays in liquidating the underlying securities and
losses, including (1) possible declines in the value of the underlying
securities during the period while the Fund seeks to enforce its rights thereto;
(2) possible subnormal levels of income and lack of access to income during this
period; and (3) expenses of enforcing its rights. The Board of Trustees has
established procedures to evaluate the creditworthiness of each party with whom
the Fund enters into repurchase agreements by setting guidelines and standards
of review for Keystone and monitoring Keystone's actions with regard to
repurchase agreements.
REVERSE REPURCHASE AGREEMENTS
Under a reverse repurchase agreement, the Fund would sell securities and agree
to repurchase them at a mutually agreed upon date and price. The Fund intends to
enter into reverse repurchase agreements to avoid otherwise having to sell
securities during unfavorable market conditions in order to meet redemptions. At
the time the Fund enters into a reverse repurchase agreement, it will establish
a segregated account with the Fund's custodian containing liquid assets such as
U.S. government securities or other high grade debt securities having a value
not less than the repurchase price (including accrued interest) and will
subsequently monitor the account to ensure such value is maintained. Reverse
repurchase agreements involve the risk that the market value of the securities
the Fund is obligated to repurchase may decline below the repurchase price.
Borrowing and reverse repurchase agreements magnify the potential for gain or
loss on the portfolio securities of the Fund and, therefore, increase the
possibility of fluctuation in the Fund's net asset value. Such practices may
constitute leveraging. In the event the buyer of securities under a reverse
repurchase agreement files for bankruptcy or becomes insolvent, such buyer or
its trustee or receiver may receive an extension of time to determine whether to
enforce the Fund's obligation to repurchase the securities, and the Fund's use
of the proceeds of the reverse repurchase agreement may effectively be
restricted pending such determination. The staff of the Securities and Exchange
Commission has taken the position that the 1940 Act treats reverse repurchase
agreements as being included in the percentage limit on borrowings imposed on a
Fund.
FOREIGN SECURITIES
The Fund may invest up to 25% of its assets in securities principally traded
in securities markets outside the U.S. While investment in foreign securities is
intended to reduce risk by providing further diversification, such investments
involve sovereign risk in addition to the credit and market risks normally
associated with domestic securities. Foreign investments may be affected
favorably or unfavorably by changes in currency rates and exchange control
regulations. There may be less publicly available information about a foreign
company than about a U.S. company, and foreign companies may not be subject to
accounting, auditing and financial reporting standards and requirements
comparable to those applicable to U.S. companies. Securities of some foreign
companies are less liquid or more volatile than securities of U.S. companies,
and foreign brokerage commissions and custodian fees are generally higher than
in the United States. Investments in foreign securities may also be subject to
other risks different from those affecting U.S. investments, including local
political or economic developments, expropriation or nationalization of assets,
imposition of withholding taxes on dividend or interest payments and currency
blockage (which would prevent cash from being brought back to the U.S.). These
risks are carefully considered by Keystone prior to the purchase of these
securities.
"WHEN ISSUED" SECURITIES
The Fund may also purchase and sell securities and currencies on a when issued
and delayed delivery basis. When issued or delayed delivery transactions arise
when securities or currencies are purchased or sold by the Fund with payment and
delivery taking place in the future in order to secure what is considered to be
an advantageous price and yield to the Fund at the time of entering into the
transaction. When the Fund engages in when issued and delayed delivery
transactions, the Fund relies on the buyer or seller, as the case may be, to
consummate the sale. Failure to do so may result in the Fund missing the
opportunity to obtain a price or yield considered to be advantageous. When
issued and delayed delivery transactions may be expected to occur a month or
more before delivery is due. No payment or delivery is made by the Fund,
however, until it receives payment or delivery from the other party to the
transaction. The Fund will maintain a separate account of liquid assets equal to
the value of such purchase commitments until payment is made. When issued and
delayed delivery agreements are subject to risks from changes in value based
upon changes in the level of interest rates, currency rates and other market
factors, both before and after delivery. The Fund does not accrue any income on
such securities or currencies prior to their delivery. To the extent the Fund
engages in when issued and delayed delivery transactions, it will do so for the
purpose of acquiring portfolio securities or currencies consistent with its
investment objective and policies and not for the purpose of investment
leverage. The Fund currently does not intend to invest more than 5% of its
assets in when issued or delayed delivery transactions.
LOANS OF SECURITIES TO BROKER-DEALERS
The Fund may lend securities to brokers or dealers pursuant to agreements
requiring that the loans be continuously secured by cash or securities of the
U.S. government, its agencies or instrumentalities, or any combination of cash
and such securities, as collateral equal at all times in value to at least the
market value of the securities loaned. Such securities loans will not be made
with respect to the Fund if, as a result, the aggregate of all outstanding
securities loans exceeds 15% of the value of the Fund's total assets taken at
their current value. The Fund continues to receive interest or dividends on the
securities loaned and simultaneously earns interest on the investment of the
cash loan collateral in U.S. Treasury notes, certificates of deposit, other
high-grade, short-term obligations or interest bearing cash equivalents.
Although voting rights attendant to securities loaned pass to the borrower, such
loans may be called at any time and will be called so that the securities may be
voted by the Fund if, in the opinion of the Fund, a material event affecting the
investment is to occur. There may be risks of delay in receiving additional
collateral or in recovering the securities loaned or even loss of rights in the
collateral should the borrower of the securities fail financially. Loans may
only be made, however, to borrowers deemed to be of good standing, under
standards approved by the Board of Trustees, when the income to be earned from
the loan justifies the attendant risks.
DERIVATIVES
The Fund may use derivatives in furtherance of its investment objective.
Derivatives are financial contracts whose value depends on, or is derived from,
the value of an underlying asset, reference rate or index. These assets, rates,
and indices may include bonds, stocks, mortgages, commodities, interest rates,
currency exchange rates, bond indices and stock indices. Derivatives can be used
to earn income or protect against risk, or both. For example, one party with
unwanted risk may agree to pass that risk to another party who is willing to
accept the risk, the second party being motivated, for example, by the desire
either to earn income in the form of a fee or premium from the first party, or
to reduce its own unwanted risk by attempting to pass all or part of that risk
to the first party.
Derivatives can be used by investors such as the Fund to earn income and
enhance returns, to hedge or adjust the risk profile of the portfolio, and
either in place of more traditional direct investments or to obtain exposure to
otherwise inaccessible markets. The Fund is permitted to use derivatives for one
or more of these purposes, although the Fund generally uses derivatives
primarily as direct investments in order to enhance yields and broaden portfolio
diversification. Each of these uses entails greater risk than if derivatives
were used solely for hedging purposes. The Fund uses futures contracts and
related options as well as forwards for hedging purposes. Derivatives are a
valuable tool which, when used properly, can provide significant benefit to Fund
shareholders. Keystone is not an aggressive user of derivatives with respect to
the Fund. However, the Fund may take positions in those derivatives that are
within its investment policies if, in Keystone's judgement, this represents an
effective response to current or anticipated market conditions. Keystone's use
of derivatives is subject to continuous risk assessment and control from the
standpoint of the Fund's investment objectives and policies.
Derivatives may be (1) standardized, exchange-traded contracts or (2)
customized, privately negotiated contracts. Exchange-traded derivatives tend to
be more liquid and subject to less credit risk than those that are privately
negotiated.
There are four principal types of derivative instruments--options, futures,
forwards and swaps--from which virtually any type of derivative transaction can
be created. Further information regarding options, futures, forwards and swaps,
is provided later in this section and is provided in the Fund's statement of
additional information.
Debt instruments that incorporate one or more of these building blocks for the
purpose of determining the principal amount of and/or rate of interest payable
on the debt instruments are often referred to as "structured securities." An
example of this type of structured security is indexed commercial paper. The
term is also used to describe certain securities issued in connection with the
restructuring of certain foreign obligations. See "Indexed Commercial Paper" and
"Structured Securities" below. The term "derivative" is also sometimes used to
describe securities involving rights to a portion of the cash flows from an
underlying pool of mortgages or other assets from which payments are passed
through to the owner of, or that collateralize, the securities. See "Mortgage
Related Securities," "Collateralized Mortgage Obligations," "Adjustable Rate
Mortgage Securities," "Stripped Mortgage Securities," "Mortgage Securities -
Special Considerations," and "Other Asset-Backed Securities" and the Fund's
statement of additional information.
While the judicious use of derivatives by experienced investment managers such
as Keystone can be beneficial, derivatives also involve risks different from,
and, in certain cases, greater than, the risks presented by more traditional
investments. Following is a general discussion of important risk factors and
issues concerning the use of derivatives that investors should understand before
investing in the Fund.
* Market Risk -- This is the general risk attendant to all investments that
the value of a particular investment will decline or otherwise change in a way
detrimental to the Fund's interest.
* Management Risk -- Derivative products are highly specialized instruments that
require investment techniques and risk analyses different from those
associated with stocks and bonds. The use of a derivative requires an
understanding not only of the underlying instrument, but also of the
derivative itself, without the benefit of observing the performance of the
derivative under all possible market conditions. In particular, the use and
complexity of derivatives require the maintenance of adequate controls to
monitor the transactions entered into, the ability to assess the risk that a
derivative adds to the Fund's portfolio and the ability to forecast price,
interest rate or currency exchange rate movements correctly.
* Credit Risk -- This is the risk that a loss may be sustained by the Fund as a
result of the failure of a another party to a derivative (usually referred to
as a "counterparty") to comply with the terms of the derivative contract. The
credit risk for exchange-traded derivatives is generally less than for
privately negotiated derivatives, since the clearing house, which is the
issuer or counterparty to each exchange-traded derivative, provides a
guarantee of performance. This guarantee is supported by a daily payment
system (i.e., margin requirements) operated by the clearing house in order to
reduce overall credit risk. For privately negotiated derivatives, there is no
similar clearing agency guarantee. Therefore, the Fund considers the
creditworthiness of each counterparty to a privately negotiated derivative in
evaluating potential credit risk.
* Liquidity Risk -- Liquidity risk exists when a particular instrument is
difficult to purchase or sell. If a derivative transaction is particularly
large or if the relevant market is illiquid (as is the case with many
privately negotiated derivatives), it may not be possible to initiate a
transaction or liquidate a position at an advantageous price.
* Leverage Risk -- Since many derivatives have a leverage component, adverse
changes in the value or level of the underlying asset, rate or index can
result in a loss substantially greater than the amount invested in the
derivative itself. In the case of swaps, the risk of loss generally is related
to a notional principal amount, even if the parties have not made any initial
investment. Certain derivatives have the potential for unlimited loss,
regardless of the size of the initial investment.
* Other Risks -- Other risks in using derivatives include the risk of mispricing
or improper valuation and the inability of derivatives to correlate perfectly
with underlying assets, rates and indices. Many derivatives, in particular
privately negotiated derivatives, are complex and often valued subjectively.
Improper valuations can result in increased cash payment requirements to
counterparties or a loss of value to a Fund. Derivatives do not always
perfectly or even highly correlate or track the value of the assets, rates or
indices they are designed to closely track. Consequently, the Fund's use of
derivatives may not always be an effective means of, and sometimes could be
counterproductive to, furthering the Fund's investment objective.
OPTIONS TRANSACTIONS
WRITING COVERED OPTIONS. The Fund may write (i.e., sell) covered call and put
options. By writing a call option, the Fund becomes obligated during the term of
the option to deliver the securities underlying the option upon payment of the
exercise price. By writing a put option, the Fund becomes obligated during the
term of the option to purchase the securities underlying the option at the
exercise price if the option is exercised. The Fund also may write straddles
(combinations of covered puts and calls on the same underlying security).
The Fund may only write "covered" options. This means that so long as the Fund
is obligated as the writer of a call option it will own the underlying
securities subject to the option or, in the case of call options on U.S.
Treasury bills, the Fund might own substantially similar U.S. Treasury bills. If
the Fund has written options against all of its securities that are available
for writing options, the Fund may be unable to write additional options unless
it sells a portion of its portfolio holdings to obtain new securities against
which it can write options. If this were to occur, higher portfolio turnover and
correspondingly greater brokerage commissions and other transaction costs may
result. The Fund does not expect, however, that this will occur.
The Fund will be considered "covered" with respect to a put option it writes
if, so long as it is obligated as the writer of the put option, it deposits and
maintains with its custodian in a segregated account liquid assets having a
value equal to or greater than the exercise price of the option.
The principal reason for writing call or put options is to obtain, through a
receipt of premiums, a greater current return than would be realized on the
underlying securities alone. The Fund receives a premium from writing a call or
put option, which it retains whether or not the option is exercised. By writing
a call option, the Fund might lose the potential for gain on the underlying
security while the option is open, and, by writing a put option, the Fund might
become obligated to purchase the underlying security for more than its current
market price upon exercise.
PURCHASING OPTIONS. The Fund may purchase put or call options, including
purchasing put or call options for the purpose of offsetting previously written
put or call options of the same series.
If the Fund is unable to effect a closing purchase transaction with respect to
covered options it has written, the Fund will not be able to sell the underlying
securities or dispose of assets held in a segregated account until the options
expire or are exercised.
An option position may be closed out only in a secondary market for an option
of the same series. Although the Fund generally will write only those options
for which there appears to be an active secondary market, there is no assurance
that a liquid secondary market will exist for any particular option at any
particular time, and, for some options, no secondary market may exist. In such
event, it might not be possible to effect a closing transaction in a particular
option.
Options on some securities are relatively new, and it is impossible to predict
the amount of trading interest that will exist in such options. There can be no
assurance that viable markets will develop or continue. The failure of such
markets to develop or continue could significantly impair the Fund's ability to
use such options to achieve its investment objective.
OPTIONS TRADING MARKETS. Options in which the Fund will trade are generally
listed on national securities exchanges. Exchanges on which such options
currently are traded include the Chicago Board Options Exchange and the New
York, American, Pacific and Philadelphia Stock Exchanges. Options on some
securities may not be listed on any exchange, but traded in the over-the-counter
market. Options traded in the over-the-counter market involve the additional
risk that securities dealers participating in such transactions could fail to
meet their obligations to the Fund. The use of options traded in the
over-the-counter market may be subject to limitations imposed by certain state
securities authorities. In addition to the limits on its use of options
discussed herein, the Fund is subject to the investment restrictions described
in this prospectus and in the statement of additional information.
The staff of the Securities and Exchange Commission is of the view that the
premiums that the Fund pays for the purchase of unlisted options and the value
of securities used to cover unlisted options written by the Fund are considered
to be invested in illiquid securities or assets for the purpose of calculating
whether the Fund is in compliance with its policies on illiquid securities.
FUTURES TRANSACTIONS
The Fund may enter into currency and other financial futures contracts and
write options on such contracts. The Fund intends to enter into such contracts
and related options for hedging purposes. The Fund will enter into securities,
currency or index-based futures contracts in order to hedge against changes in
interest or exchange rates or securities prices. A futures contract on
securities or currencies is an agreement to buy or sell securities or currencies
at a specified price during a designated month. A futures contract on a
securities index does not involve the actual delivery of securities, but merely
requires the payment of a cash settlement based on changes in the securities
index. The Fund does not make payment or deliver securities upon entering into a
futures contract. Instead, it puts down a margin deposit, which is adjusted to
reflect changes in the value of the contract and which continues until the
contract is terminated.
The Fund may sell or purchase futures contracts. When a futures contract is
sold by the Fund, the value of the contract will tend to rise when the value of
the underlying securities or currencies declines and to fall when the value of
such securities or currencies increases. Thus, the Fund sells futures contracts
in order to offset a possible decline in the value of its securities or
currencies. If a futures contract is purchased by the Fund, the value of the
contract will tend to rise when the value of the underlying securities or
currencies increases and to fall when the value of such securities or currencies
declines. The Fund intends to purchase futures contracts in order to fix what is
believed by Keystone to be a favorable price and rate of return for securities
or favorable exchange rate for currencies the Fund intends to purchase.
The Fund also intends to purchase put and call options on futures contracts
for hedging purposes. A put option purchased by the Fund would give it the right
to assume a position as the seller of a futures contract. A call option
purchased by the Fund would give it the right to assume a position as the
purchaser of a futures contract. The purchase of an option on a futures contract
requires the Fund to pay a premium. In exchange for the premium, the Fund
becomes entitled to exercise the benefits, if any, provided by the futures
contract, but is not required to take any action under the contract. If the
option cannot be exercised profitably before it expires, the Fund's loss will be
limited to the amount of the premium and any transaction costs.
The Fund may enter into closing purchase and sale transactions in order to
terminate a futures contract and may sell put and call options for the purpose
of closing out its options positions. The Fund's ability to enter into closing
transactions depends on the development and maintenance of a liquid secondary
market. There is no assurance that a liquid secondary market will exist for any
particular contract or at any particular time. As a result, there can be no
assurance that the Fund will be able to enter into an offsetting transaction
with respect to a particular contract at a particular time. If the Fund is not
able to enter into an offsetting transaction, the Fund will continue to be
required to maintain the margin deposits on the contract and to complete the
contract according to its terms, in which case, it would continue to bear market
risk on the transaction.
Although futures and related options transactions are intended to enable the
Fund to manage market, interest rate or exchange rate risk, unanticipated
changes in interest rates, exchange rates or market prices could result in
poorer performance than if it had not entered into these transactions. Even if
Keystone correctly predicts interest or exchange rate movements, a hedge could
be unsuccessful if changes in the value of the Fund's futures position did not
correspond to changes in the value of its investments. This lack of correlation
between the Fund's futures and securities or currencies positions may be caused
by differences between the futures and securities or currencies markets or by
differences between the securities or currencies underlying the Fund's futures
position and the securities or currencies held by or to be purchased for the
Fund. Keystone will attempt to minimize these risks through careful selection
and monitoring of the Fund's futures and options positions.
The Fund does not intend to use futures transactions for speculation or
leverage. The Fund has the ability to write options on futures, but intends to
write such options only to close out options purchased by the Fund. The Fund
will not change these policies without supplementing the information in its
prospectus and statement of additional information.
FOREIGN CURRENCY TRANSACTIONS
As discussed above, the Fund may invest in securities of foreign issuers. When
the Fund invests in foreign securities, they usually will be denominated in
foreign currencies, and the Fund temporarily may hold funds in foreign
currencies. Thus, the value of Fund shares will be affected by changes in
exchange rates.
As one way of managing exchange rate risk, in addition to entering into
currency futures contracts, the Fund may enter into forward currency exchange
contracts (agreements to purchase or sell currencies at a specified price and
date). The exchange rate for the transaction (the amount of currency the Fund
will deliver or receive when the contract is completed) is fixed when the Fund
enters into the contract. The Fund usually will enter into these contracts to
stabilize the U.S. dollar value of a security it has agreed to buy or sell. The
Fund intends to use these contracts to hedge the U.S. dollar value of a security
it already owns, particularly if the Fund expects a decrease in the value of the
currency in which the foreign security is denominated. Although the Fund will
attempt to benefit from using forward contracts, the success of its hedging
strategy will depend on Keystone's ability to predict accurately the future
exchange rates between foreign currencies and the U.S. dollar. The value of the
Fund's investments denominated in foreign currencies will depend on the relative
strength of those currencies and the U.S. dollar, and the Fund may be affected
favorably or unfavorably by changes in the exchange rates or exchange control
regulations between foreign currencies and the dollar. Changes in foreign
currency exchange rates also may affect the value of dividends and interest
earned, gains and losses realized on the sale of securities and net investment
income and gains, if any, to be distributed to shareholders by the Fund.
Although the Fund does not currently intend to do so, the Fund may also purchase
and sell options related to foreign currencies. The Fund does not intend to
enter into foreign currency transactions for speculation or leverage.
INTEREST RATE TRANSACTIONS (SWAPS, CAPS AND FLOORS). If the Fund enters into
interest rate swap, cap or floor transactions, it expects to do so primarily for
hedging purposes, which may include preserving a return or spread on a
particular investment or portion of its portfolio or protecting against an
increase in the price of securities the Fund anticipates purchasing at a later
date. The Fund does not intend to use these transactions in a speculative
manner.
Interest rate swaps involve the exchange by the Fund with another party of
their respective commitments to pay or receive interest (e.g., an exchange of
floating rate payments for fixed rate payments). Interest rate caps and floors
are similar to options in that the purchase of an interest rate cap or floor
entitles the purchaser, to the extent that a specified index exceeds (in the
case of a cap) or falls below (in the case of a floor) a predetermined interest
rate, to receive payments of interest on a contractually-based principal
("notional") amount from the party selling the interest rate cap or floor. The
Fund may enter into interest rate swaps, caps and floors on either an
asset-based or liability-based basis, depending upon whether it is hedging its
assets or liabilities, and will usually enter into interest rate swaps on a net
basis (i.e., the two payment streams are netted out, with the Fund receiving or
paying, as the case may be, only the net amount of the two payments).
The swap market has grown substantially in recent years, with a large number
of banks and investment banking firms acting as principals and as agents
utilizing standardized swap documentation. As a result, the swap market has
become more established and relatively liquid. Caps and floors are less liquid
than swaps. These transactions also involve the delivery of securities or other
underlying assets and principal. Accordingly, the risk of loss to the Fund from
interest rate transactions is limited to the net amount of interest payments
that the Fund is contractually obligated to make.
INDEXED COMMERCIAL PAPER. Indexed commercial paper may have its principal linked
to changes in foreign currency exchange rates whereby its principal amount is
adjusted upwards or downwards (but not below zero) at maturity to reflect
changes in the referenced exchange rate. A Fund will purchase such commercial
paper with the currency in which it is denominated and, at maturity, will
receive interest and principal payments thereon in that currency, but the amount
of principal payable by the issuer at maturity will change in proportion to the
change (if any) in the exchange rate between the two specified currencies
between the date the instrument is issued and the date the instrument matures.
While such commercial paper entails the risk of loss of principal, the potential
for realizing gains as a result of changes in foreign currency exchange rates
enables the Fund to hedge (or cross-hedge) against a decline in the U.S. dollar
value of investments denominated in foreign currencies while providing an
attractive money market rate of return.
MORTGAGE-RELATED SECURITIES. The mortgage-related securities in which the Fund
may invest typically are securities representing interests in pools of mortgage
loans made to home owners. Mortgage-related securities bear interest at either a
fixed rate or an adjustable rate determined by reference to an index rate. The
mortgage loan pools may be assembled for sale to investors (such as the Fund) by
governmental or private organizations. Mortgage-related securities issued by the
Government National Mortgage Association ("GNMA") are backed by the full faith
and credit of the U.S. government; those issued by Federal National Mortgage
Associated ("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC") are not
so backed.
Securities representing interests in pools created by private issuers
generally offer a higher rate of interest than securities representing interests
in pools created by governmental issuers because there are no direct or indirect
governmental guarantees of the underlying mortgage payments. However, private
issuers sometimes obtain committed loan facilities, lines of credit, letters of
credit, surety bonds or other forms of liquidity and credit enhancement to
support the timely payment of interest and principal with respect to their
securities if the borrowers on the underlying mortgages fail to make their
mortgage payments. The ratings of such non-governmental securities are generally
dependent upon the ratings of the providers of such liquidity and credit support
and would be adversely affected if the rating of such an enhancer were
downgraded. The Fund may buy mortgage-related securities without credit
enhancement if the securities meet the Fund's investment standards. Although the
market for mortgage-related securities is becoming increasingly liquid, those of
certain private organizations may not be readily marketable.
One type of mortgage-related security is of the "pass-through" variety. The
holder of a pass-through security is considered to own an undivided beneficial
interest in the underlying pool of mortgage loans and receives a pro rata share
of the monthly payments made by the borrowers on their mortgage loans, net of
any fees paid to the issuer or guarantor of the securities. Prepayments of
mortgages resulting from the sale, refinancing or foreclosure of the underlying
properties are also paid to the holders of these securities. Some
mortgage-related securities, such as securities issued by GNMA, are referred to
as "modified pass-through" securities. The holders of these securities are
entitled to the full and timely payment of principal and interest, net of
certain fees, regardless of whether payments are actually made on the underlying
mortgages. Another form of mortgage-related security is a "pay-through"
security, which is a debt obligation of the issuer secured by a pool of mortgage
loans pledged as collateral that is legally required to be paid by the issuer
regardless of whether payments are actually made on the underlying mortgages.
COLLATERALIZED MORTGAGE OBLIGATIONS. ("CMOs") are the predominant type of
"pay-through" mortgage-related security. CMOs are designed to reduce the risk of
prepayment for investors by issuing multiple classes of securities, each having
different maturities, interest rates and payment schedules, and with the
principal and interest on the underlying mortgages allocated among the several
classes in various ways. The collateral securing the CMOs may consist of a pool
of mortgages, but may also consist of mortgage-backed bonds or pass-through
securities. CMOs may be issued by a U.S. government instrumentality or agency or
by a private issuer. Although payment of the principal of, and interest on, the
underlying collateral securing privately issued CMOs may be guaranteed by GNMA,
FNMA or FHLMC, these CMOs represent obligations solely of the private issuer and
are not insured or guaranteed by GNMA, FNMA, FHLMC, any other governmental
agency or any other person or entity.
ADJUSTABLE RATE MORTGAGE SECURITIES. Another type of mortgage-related security,
known as adjustable-rate mortgage securities ("ARMS"), bears interest at a rate
determined by reference to a predetermined interest rate or index. There are two
main categories of rates of indices: (1) rates based on the yield on U.S.
Treasury securities and (2) indices derived from a calculated measure such as a
cost of funds index or a moving average of mortgage rates. Some rates and
indices closely mirror changes in market interest rate levels, while others tend
to lag changes in market rate levels and tend to be somewhat less volatile.
ARMS may be secured by adjustable-rate mortgages or fixed-rate mortgages. ARMS
secured by fixed-rate mortgages generally have lifetime caps on the coupon rates
of the securities. To the extent that general interest rates increase faster
than the interest rates on the ARMS, these ARMS will decline in value. The
adjustable-rate mortgages that secure ARMS will frequently have caps that limit
the maximum amount by which the interest rate or the monthly principal and
interest payments on the mortgages may increase. These payment caps can result
in negative amortization (i.e., an increase in the balance of the mortgage
loan). Furthermore, since many adjustable-rate mortgages only reset on an annual
basis, the values of ARMS tend to fluctuate to the extent that changes in
prevailing interest rates are not immediately reflected in the interest rates
payable on the underlying adjustable-rate mortgages.
STRIPPED MORTGAGE SECURITIES. Stripped mortgage-related securities ("SMRS") are
mortgage-related securities that are usually structured with two classes of
securities collateralized by a pool of mortgages or a pool of mortgaged-backed
bonds or pass-through securities, with each class receiving different
proportions of the principal and interest payments from the underlying assets. A
common type of SMRS has one class of interest-only securities ("IOs") receiving
all of the interest payments from the underlying assets, while the other class
of securities, principal-only securities ("POs"), receives all of the principal
payments from the underlying assets. IOs and POs are extremely sensitive to
interest rate changes and are more volatile than mortgage-related securities
that are not stripped. IOs tend to decrease in value as interst rates decrease,
while POs generally increase in value as interest rates decrease. If prepayments
of the underlying mortgages are greater than anticipated, the amount of interest
earned on the overall pool will decrease due to the decreasing principal balance
of the assets. Changes in the values of IOs and POs can be substantial and occur
quickly, such as occurred in the first half of 1994 when the value of many POs
dropped precipitously due to increase in interest rates. For this reason the
Fund does not rely on IOs and POs as the principal means of furthering its
investment objective.
MORTGAGE-RELATED SECURITIES -- SPECIAL CONSIDERATIONS. The value of
mortgage-related securities is affected by a number of factors. Unlike
traditional debt securities, which have fixed maturity dates, mortgage-related
securities may be paid earlier than expected as a result of prepayment of the
underlying mortgages. If property owners make unscheduled prepayments of their
mortgage loans, these prepayments will result in the early payment of the
applicable mortgage-related securities. In that event the Fund may be unable to
invest the proceeds from the early payment of the mortgage-related securities in
an investment that provides as high a yield as the mortgage-related securities.
Consequently, early payment associated with mortgage-related securities causes
these securities to experience significantly greater price and yield volatility
than experienced by traditional fixed-income securities. The occurrence of
mortgage prepayments is affected by the level of general interest rates, general
economic conditions and other social and demographic factors. During periods of
falling interest rates, the rate of mortgage prepayments tends to increase,
thereby tending to decrease the life of mortgage-related securities. During
periods of rising interest rates, the rate of mortgage prepayments usually
decreases, thereby tending to increase the life of mortgage-related securities.
If the life of a mortgage-related security is inaccurately predicted, the Fund
may not be able to realize the rate of return it expected.
As with fixed-income securities generally, the value of mortgage-related
securities can also be adversely affected by increases in general interest rates
relative to the yield provided by such securities. Such adverse effect is
especially possible with fixed-rate mortgage securities. If the yield available
on other investments rises above the yield of the fixed-rate mortgage securities
as a result of general increases in interest rate levels, the value of the
mortgage-related securities will decline. Although the negative effect could be
lessened if the mortgage-related securities were to be paid earlier (thus
permitting the Fund to reinvest the prepayment proceeds in investments yielding
the higher current interest rate), as described above the rate of mortgage
prepayments and earlier payment of mortgage-related securities generally tends
to decline during a period of rising interest rates.
Although the value of ARMS may not be affected by rising interest rates as
much as the value of fixed-rate mortgage securities is affected by rising
interest rates, ARMS may still decline in value as a result of rising interest
rates. Although, as described above, the yield on ARMS varies with changes in
the applicable interest rate or index, there is often a lag between increases in
general interest rates and increases in the yield on ARMS as a result of
relatively infrequent interest rate reset dates. In addition, adjustable-rate
mortgages and ARMS often have interest rate or payment caps that limit the
ability of the adjustable-rate mortgages or ARMS to fully reflect increases in
the general level of interest rates.
OTHER ASSET-BACKED SECURITIES. The securitization techniques used to develop
mortgage-related securities are being applied to a broad range of financial
assets. Through the use of trusts and special purpose corporations, various
types of assets, including automobile loans and leases, credit card receivables,
home equity loans, equipment leases and trade receivables, are being securitized
in structures similar to the structures used in mortgage securitizations. These
asset-backed securities are subject to risks associated with changes in interest
rates and prepayment of underlying obligations similar to the risks of
investment in mortgage-related securities discussed above.
Each type of asset-backed security also entails unique risks depending on the
type of assets involved and the legal structure used. For example, credit card
receivables are generally unsecured obligations of the credit card holder and
the debtors are entitled to the protection of a number of state and federal
consumer credit laws, many of which give such debtors the right to set off
certain amounts owed on the credit cards, thereby reducing the balance due.
There have also been proposals to cap the interest rate that a credit card
issuer may charge. In some transactions, the value of the asset-backed security
is dependent on the performance of a third party acting as credit enhancer or
servicer. Furthermore, in some transactions (such as those involving the
securitization of vehicle loans or leases) it may be administratively burdensome
to perfect the interest of the security issuer in the underlying collateral and
the underlying collateral may become damaged or stolen.
VARIABLE, FLOATING AND INVERSE FLOATING RATE INSTRUMENTS. Fixed-income
securities may have fixed, variable or floating rates of interest. Variable and
floating rate securities pay interest at rates that are adjusted periodically,
according to a specified formula. A "variable" interest rate adjusts at
predetermined intervals (e.g., daily, weekly or monthly), while a "floating"
interest rate adjusts whenever a specified benchmark rate (such as the bank
prime lending rate) changes.
The Fund may invest in fixed-income securities that pay interest at a coupon
rate equal to a base rate, plus additional interest for a certain period of time
if short-term interest rates rise above a predetermined level or "cap." The
amount of such an additional interest payment typically is calculated under a
formula based on a short-term interest rate index multiplied by a designated
factor.
Leveraged inverse floating rate debt instruments are sometimes known as
inverse floaters. The interest rate on an inverse floater resets in the opposite
direction from the market rate of interest to which the inverse floater is
indexed. An inverse floater may be considered to be leveraged to the extent that
its interest rate varies by a magnitude that exceeds the magnitude of the change
in the index rate of interest. The higher degree of leverage inherent in inverse
floaters is associated with greater volatility in market value.
STRUCTURED SECURITIES. Structured securities represent interests in entities
organized and operated solely for the purpose of restructuring the investment
characteristics of sovereign debt obligations or foreign government securities.
This type of restructuring involves the deposit with or purchase by an entity,
such as a corporation or trust, of specified instruments (such as commercial
bank loans or Brady Bonds) and the issuance by that entity of one or more
classes of structured securities backed by, or representing interests in, the
underlying instruments. The cash flow on the underlying instruments may be
apportioned among the newly issued structured securities to create securities
with different investment characteristics such as varying maturities, payment
priorities and interest rate provisions, and the extent of the payments made
with respect to structured securities is dependent on the extent of the cash
flow on the underlying instruments. Because structured securities typically
involve no credit enhancement, their credit risk generally will be equivalent to
that of the underlying instruments. Structured securities of a given class may
be either subordinated or unsubordinated to the right of payment of another
class. Subordinated structured securities typically have higher yields and
present greater risks than unsubordinated structured securities.
BRADY BONDS. Brady Bonds are created through the exchange of existing commercial
bank loans to foreign entities for new obligations in connection with debt
restructurings under a plan introduced by former U.S. Secretary of the Treasury,
Nicholas F. Brady (the "Brady Plan"). Brady Bonds have been issued only
recently, and, accordingly, do not have a long payment history. They may be
collateralized or uncollateralized and issued in various currencies (although
most are U.S. dollar-denominated) and they are actively traded in the
over-the-counter secondary market.
U.S. dollar-denominated, collateralized Brady Bonds, which may be fixed-rate
par bonds or floating rate discount bonds, are generally collateralized in full
as to principal due at maturity by U.S. Treasury zero coupon obligations that
have the same maturity as the Brady Bonds. Interest payments on these Brady
Bonds generally are collateralized by cash or securities in an amount that, in
the case of fixed rate bonds, is equal to at least one year of rolling interest
payments based on the applicable interest rate at that time and is adjusted at
regular intervals thereafter. Certain Brady Bonds are entitled to "value
recovery payments" in certain circumstances, which in effect constitute
supplemental interest payments, but generally are not collateralized. Brady
Bonds are often viewed as having up to four valuation components: (1)
collateralized repayment of principal at final maturity, (2) collateralized
interest payments, (3) uncollateralized interest payments, and (4) any
uncollateralized repayment of principal at maturity (these uncollateralized
amounts constitute the "residual risk"). In the event of a default with respect
to collateralized Brady Bonds as a result of which the payment obligations of
the issuer are accelerated, the U.S. Treasury zero coupon obligations held as
collateral for the payment of principal will not be distributed to investors,
nor will such obligations be sold and the proceeds distributed. The collateral
will be held by the collateral agent to the scheduled maturity of the defaulted
Brady Bonds, which will continue to be outstanding, at which time the face
amount of the collateral will equal the principal payments that would have then
been due on the Brady Bonds in the normal course. In addition, in light of the
residual risk of Brady Bonds and, among other factors, the history of defaults
with respect to commercial bank loans by public and private entities of
countries issuing Brady Bonds, investments in Brady Bonds are to be viewed as
speculative.
<PAGE>
KEYSTONE CUSTODIAN
FAMILY OF FUNDS
*
B-1 High Grade Bond Fund
B-2 Diversified Bond Fund
B-4 High Income Bond Fund
K-1 Balanced Income Fund
K-2 Strategic Growth Fund
S-1 Blue Chip Stock Fund
S-3 Capital Growth Fund
S-4 Small Company Growth Fund
International Fund
Precious Metals Holdings
Tax Free Fund
Tax Exempt Trust
Liquid Trust
[Logo] KEYSTONE
Distributors, Inc.
200 Berkeley Street
Boston, Massachusetts 02116-5034
K E Y S T O N E
K-1 BALANCED
INCOME FUND
[Logo]
PROSPECTUS AND
APPLICATION
<PAGE>
STATEMENT OF ADDITIONAL INFORMATION
KEYSTONE CUSTODIAN FUND, SERIES K-1
BALANCED INCOME FUND
OCTOBER 28, 1994
This statement of additional information is not a prospectus, but
relates to, and should be read in conjunction with, the prospectus of Keystone
Custodian Fund, Series K-1 (the "Fund") dated October 28, 1994. A copy of the
prospectus may be obtained from Keystone Distributors, Inc. ("KDI"), the Fund's
principal underwriter ("Principal Underwriter"), 200 Berkeley Street, Boston,
Massachusetts 02116-5034 or your broker-dealer.
- --------------------------------------------------------------------------------
TABLE OF CONTENTS
- --------------------------------------------------------------------------------
Page
The Fund's Objective and Policies 2
Special Considerations 2
Investment Restrictions 4
Valuation of Securities 6
Distributions and Taxes 7
Sales Charges 8
Distribution Plan 10
The Trust Agreement 12
Investment Manager 14
Investment Adviser 16
Trustees and Officers 18
Principal Underwriter 23
Brokerage 24
Standardized Total Return
and Yield Quotations 26
Additional Information 27
Appendix A-1
Annual Financial Statements F-1
Independent Auditors' Report F-17
<PAGE>
- --------------------------------------------------------------------------------
THE FUND'S OBJECTIVE AND POLICIES
- --------------------------------------------------------------------------------
The Fund is an open-end, diversified management investment company. The
Fund's investment objective is to provide shareholders with current income. In
its search for income, the Fund may invest in any type of security, including
bonds and preferred and common stocks, but the emphasis in selection is on
securities having a liberal current yield consistent with investment quality and
on which the interest or dividend payments are considered reasonably secure.
Securities appearing to offer attractive possibilities for future growth of both
capital and income may be included in the Fund's portfolio whenever it seems
possible to do so without conflicting with the Fund's primary objective of
securing generous current income for its shareholders.
The Fund invests primarily in the securities of domestic companies, but
on June 30, 1994 it also owned foreign securities equal to 2.6% of its net
assets.
- --------------------------------------------------------------------------------
SPECIAL CONSIDERATIONS
- --------------------------------------------------------------------------------
The Fund invests aggressively and seeks to maximize return over time
from a combination of many factors, including high current income and capital
appreciation from high yielding bonds and other similar securities (high yield
securities). Such aggressive investing involves risks that are greater than the
risks of investing in higher quality debt securities. These risks are discussed
in greater detail below and include risks from (1) interest rate fluctuations;
(2) changes in credit status, including weaker overall credit condition of
issuers and risks of default;(3) industry, market and economic risk; (4)
volatility of price resulting from broad and rapid changes in the value of
underlying securities; and (5) greater price variability and credit risks of
certain high yield securities such as zero coupon bonds and payment in kind
("PIK") securities.
These risks provide the opportunity for maximizing return over time,
but may result in greater upward and downward movement of the net asset value
per share of the Fund. As a result, they should be carefully considered by
investors.
While providing opportunities to maximize return over time, investors
should be aware of market, economic and credit factors influencing high yield
securities: (1) securities rated BB or lower by Standard & Poor's Corporation
("S&P") or Ba or lower by Moody's Investors Service, Inc. ("Moody's") are
considered predominantly speculative with respect to the ability of the issuer
to meet principal and interest payments; (2) the value of high yield securities
may be more susceptible to real or perceived adverse economic, company or
industry conditions than is the case for higher quality securities; (3) adverse
market, credit or economic conditions could make it difficult at certain times
to sell certain high yield securities held by the Fund; (4) the secondary market
for high yield securities may be less liquid than the secondary market for
higher quality securities, which may affect the value of certain high yield
securities held by the Fund at certain times; and (5) zero coupon and PIK high
yield securities may be subject to greater changes in value due to market
conditions, the absence of a cash interest payment and the tendency of issuers
of such securities to have weaker overall credit conditions than other high
yield securities. These characteristics of high yield securities make them
generally more appropriate for long-term investment.
Part of the income sought by the Fund is ordinarily associated with
securities in the lower rating categories of the recognized rating agencies or
with securities that are unrated. Such high yield securities are generally rated
BB or lower by S&P or Ba or lower by Moody's. The Fund may invest in securities
that are rated as low as CCC by S&P and Caa by Moody's. Appendix A to this
statement of additional information describes these rating categories. The Fund
may also invest in unrated securities that, in the judgment of Keystone
Custodian Fund, Inc. ("Keystone"), the Fund's investment adviser, offer
comparable yields and risks as securities that are rated, as well as in
non-investment quality zero coupon and PIK securities.
Since the Fund takes an aggressive approach to investing, Keystone
tries to maximize the return by controlling risk through diversification, credit
analysis, review of sector and industry trends, interest rate forecasts and
economic analysis. Keystone's analysis of securities focuses on values based on
factors such as interest or dividend coverage, asset values, earnings prospects
and the quality of management of the company. In making investment
recommendations, Keystone also considers current income, potential for capital
appreciation, maturity structure, quality guidelines, coupon structure, average
yield, percentage of zeros and PIKs, percentage of nonaccruing items and yield
to maturity. Keystone also considers the ratings of Moody's and S&P assigned to
various securities, but does not rely solely on ratings assigned by Moody's and
S&P because (1) Moody's and S&P assigned ratings are based largely on historical
financial data and may not accurately reflect the current financial outlook of
companies, and (2) there can be large differences among the current financial
conditions of issuers within the same rating category.
Income and yields on high yield securities, as on all securities, will
fluctuate over time.
- --------------------------------------------------------------------------------
INVESTMENT RESTRICTIONS
- --------------------------------------------------------------------------------
None of the restrictions enumerated in this paragraph may be changed
without a vote of the holders of a majority, as defined in the Investment
Company Act of 1940 (the "1940 Act"), of the Fund's outstanding shares. The Fund
shall not do any of the following:
(1) invest more than 5% of its total assets, computed at market value,
in the securities, other than securities issued or guaranteed by the United
States ("U.S.") Government, its agencies or instrumentalities, of any one
issuer;
(2) invest in more than 10% of the outstanding voting securities of any
one issuer, other than securities issued or guaranteed by the U.S. Government,
its agencies or instrumentalities;
(3) invest more than 5% of the value of its total assets in companies
which have been in operation for less than three years;
(4) borrow money, except that the Fund may (a) borrow money from banks
for temporary or emergency purposes in aggregate amounts up to 10% of the value
of the Fund's net assets (computed at cost) or (b) enter into reverse repurchase
agreements (bank borrowings and reverse repurchase agreements, in aggregate,
shall not exceed 10% of the value of the Fund's net assets);
(5) underwrite securities, except that the Fund may purchase securities
from issuers thereof or others and dispose of such securities in a manner
consistent with its other investment policies; in the disposition of restricted
securities the Fund may be deemed to be an underwriter, as defined in the
Securities Act of 1933 (the "1933 Act");
(6) purchase or sell real estate or interests in real estate, except
that it may purchase and sell securities secured by real estate and securities
of companies which invest in real estate, and will not purchase or sell
commodities or commodity contracts, except that the Fund may engage in currency
or other financial futures contracts and related options transactions;
(7) invest for the primary purpose of exercising control over or
management of any issuer;
(8) make margin purchases or short sales of securities;
(9) make loans, except that the Fund may purchase money market
securities, enter into repurchase agreements, buy publicly and privately
distributed debt securities and lend limited amounts of its portfolio securities
to broker-dealers; all such investments must be consistent with the Fund's
investment objectives and policies;
(10) invest more than 25% of its assets in the securities of issuers in
any single industry, other than securities issued or guaranteed by the U.S.
Government, its agencies or instrumentalities; and
(11) purchase the securities of any other investment company except in
the open market and at customary brokerage rates and in no event more than 3% of
the voting securities of any investment company.
If a percentage limit is satisfied at the time of investment or
borrowing, a later increase or decrease resulting from a change in the value of
a security or a decrease in Fund assets is not a violation of the limit.
Additional restrictions adopted by the Fund, which may be changed by
the Board of Trustees, provide that the Fund may not purchase or retain
securities of an issuer if, to the knowledge of the Fund, any officer, Trustee
or Director of the Fund, Keystone Management, Inc. ("Keystone Management") or
Keystone, each owning beneficially more than 1/2 of 1% of the securities of such
issuer, own, in the aggregate, more than 5% of the securities of such issuer, or
such persons or management personnel of the Fund, Keystone Management or
Keystone have a substantial beneficial interest in the securities of such
issuer. Portfolio securities of the Fund may not be purchased from or sold or
loaned to Keystone Management, Keystone or any affiliate thereof or any of their
Directors, officers or employees.
The Fund has no current intention of attempting to increase its net income
by borrowing and intends to repay any borrowings made in accordance with the
fourth investment restriction enumerated above before it makes any additional
investments.
In order to permit the sale of Fund shares in certain states, the Fund
may make commitments more restrictive than the investment restrictions described
above. Should the Fund determine that any such commitment is no longer in the
best interests of the Fund, it will revoke the commitment by terminating sales
of its shares in the state involved.
The Fund intends to follow policies of the Securities and Exchange
Commission as they are adopted from time to time with respect to illiquid
securities, including, at this time, (1) treating as illiquid securities that
may not be sold or disposed of in the ordinary course of business within seven
days at approximately the value at which the Fund has valued the investment on
its books and (2) limiting its holdings of such securities to 15% of its net
assets.
Although not fundamental restrictions or policies requiring a
shareholders' vote to change, the Fund has agreed so long as a state authority
requires and shares of the Fund are registered for sale in that state, the Fund
will (1) limit its purchase of warrants to 5% of net assets, of which 2% may be
warrants not listed on the New York or American Stock Exchange and (2) not
invest in oil, gas or other mineral leases.
- --------------------------------------------------------------------------------
VALUATION OF SECURITIES
- --------------------------------------------------------------------------------
Current value for the Fund's portfolio securities is determined in the
following manner:
Securities traded on an established exchange are valued on the basis
of the last sales price on the exchange where the securities are primarily
traded prior to the time of the valuation. Securities traded in the
over-the-counter market, for which complete quotations are readily available,
are valued at the mean of the bid and asked prices at the time of valuation.
Short-term money market instruments purchased with maturities of sixty days or
less are valued at amortized cost (original purchase cost as adjusted for
amortization of premium or accretion of discount), which, when combined with
accrued interest, approximates market. Money market instruments maturing in more
than sixty days are valued at market value. Money market instruments maturing in
more than sixty days when purchased held on the sixtieth day prior to maturity
are valued at amortized cost (market value on the sixtieth day adjusted for
amortization of premium or accretion of discount), which, when combined with
accrued interest, approximates market. In any case, such valuation reflects fair
value as determined by the Board of Trustees.
The Board of Trustees values the following securities at prices it
deems in good faith to be fair: (1) securities, including restricted securities,
for which complete quotations are not readily available; (2) listed securities
if, in the Fund's opinion, the last sales price does not reflect a current
market value or if no sale occurred; and (3) other assets. While market
quotations may be readily available for certain long-term corporate bonds and
notes, such investments are stated at fair value on the basis of valuations
furnished by a pricing service, approved by the Board of Trustees, which
determines valuations for normal, institutional- size trading units of such
securities using methods based on market transactions for comparable securities
and various relationships between securities that are generally recognized by
institutional traders.
- --------------------------------------------------------------------------------
DISTRIBUTIONS AND TAXES
- --------------------------------------------------------------------------------
The Fund ordinarily distributes its net investment income and net
capital gains in shares of the Fund or, at the option of the shareholder, in
cash. All shareholders may reinvest dividends and distributions without being
subject to a deferred sales charge when shares so purchased are redeemed.
Shareholders who have opted prior to the record date to receive shares with
regard to capital gains and/or income distributions will have the number of such
shares determined on the basis of the share value computed at the end of the day
on the record date after adjustment for the distribution. Net asset value is
used in computing the appropriate number of shares in both a capital gains
distribution and in an income distribution reinvestment. Account statements
and/or checks as appropriate will be mailed to shareholders by the 6th of the
appropriate month. Unless the Fund receives instructions to the contrary from a
shareholder before the record date, it will assume that the shareholder wishes
to receive both capital gains distributions and income distributions in shares.
Instructions continue in effect until changed in writing.
The Fund's income distributions may be eligible, in whole or in part,
for the corporate dividends received deduction. Approximately 42% of the Fund's
income dividend for fiscal year end June 30, 1994 was so eligible. Distributed
long-term capital gains are taxable as such to the shareholder whether received
in cash or in additional Fund shares and regardless of the period of time Fund
shares have been held by the shareholder. Distributions designated by the Fund
as capital gains dividends are not eligible for the corporate dividends received
deduction. If the net asset value of shares was reduced below a shareholder's
cost by distribution of capital gains realized on sales of securities, such
distribution, to the extent of the reduction, would be a return of investment,
though taxable as stated above. Since distributions of capital gains depend upon
securities profits actually realized, they may or may not occur. The foregoing
comments relating to the taxation of dividends and distributions paid on the
Fund's shares relate solely to federal income taxation. Such dividends and
distributions may also be subject to state and local taxes.
When the Fund makes a distribution, it intends to distribute only its
net capital gains and such income as has been predetermined to the best of the
Fund's ability, to be taxable as ordinary income. Therefore, net investment
income distributions will not be made on the basis of distributable income as
computed on the books of the Fund, but will be made on a federal taxation basis.
The Fund's income distributions are expected to exceed the Fund's net investment
income (determined for financial statement purposes) by an amount approximately
equal to the amount of distribution plan expenses not deducted by the Fund for
federal income tax purposes. Fund shareholders will continue to be advised of
the tax status of distributions.
- --------------------------------------------------------------------------------
SALES CHARGES
- --------------------------------------------------------------------------------
In order to reimburse the Fund for certain expenses relating to the
sale of its shares (see "Distribution Plan"), a contingent deferred sales charge
may be imposed at the time of redemption of certain Fund shares within four
calendar years after their purchase. If imposed, the contingent deferred sales
charge is deducted from the redemption proceeds otherwise payable to the
shareholder. Since July 8, 1992, the deferred sales charge attributable to
shares purchased prior to January 1, 1992 has been retained by the Fund, and the
deferred sales charge attributable to shares purchased after January 1, 1992 is,
to the extent permitted by a rule adopted by the National Association of
Securities Dealers, Inc. ("NASD"), paid to KDI, the Fund's Principal
Underwriter. For the fiscal year ended June 30, 1994, the Fund recovered
$333,994 in deferred sales charges.
The contingent deferred sales charge is a declining percentage of the
lesser of (1) the net asset value of the shares redeemed, or (2) the total cost
of such shares. No contingent deferred sales charge is imposed when the investor
redeems amounts derived from (1) increases in the value of his account above the
total cost of such shares due to increases in the net asset value per share of
the Fund; (2) certain shares with respect to which the Fund did not pay a
commission on issuance, including shares acquired through reinvestment of
dividend income and capital gains distributions; or (3) shares held in all or
part of more than four consecutive calendar years.
Subject to the limitations stated above, the Fund imposes the
contingent deferred sales charge according to the following schedule: 4% of
amounts redeemed during the calendar year of purchase; 3% of amounts redeemed
during the calendar year after the year of purchase; 2% of amounts redeemed
during the second calendar year after the year of purchase; and 1% of amounts
redeemed during the third calendar year after the year of purchase. No
contingent deferred sales charge is imposed on amounts redeemed thereafter.
The following example illustrates the operation of the contingent
deferred sales charge. Assume that an investor makes a purchase payment of
$10,000 during the calendar year 1994 and on a given date in 1995, the value of
the investor's account has grown through investment performance and reinvestment
of distributions to $12,000. On such date in 1995, the investor could redeem up
to $2,000 ($12,000 minus $10,000) without incurring a deferred sales charge. If,
on such date, the investor should redeem $3,000, a deferred sales charge would
be imposed on $1,000 of the redemption (the amount by which the investor's
account was reduced by the redemption below the amount of the initial purchase
payment). The charge would be imposed at the rate of 3% (because the redemption
is made during the calendar year after the calendar year of purchase) and would
total $30.
In determining whether a contingent deferred sales charge is payable
and, if so, the percentage charge applicable, it is assumed that shares held the
longest are the first to be redeemed. There is no contingent deferred sales
charge on exchanges of shares between Keystone funds that have adopted
distribution plans pursuant to Rule 12b-1 under the 1940 Act. Moreover, when
shares of one such fund have been exchanged for shares of another such fund, the
calendar year of the exchange, for purposes of any future deferred sales charge,
is assumed to be the year shares tendered for exchange were originally
purchased.
Shares also may be sold, to the extent permitted by applicable law,
regulations, interpretations or exemptions, at net asset value without the
imposition of a deferred sales charge upon redemption of shares by (1) officers,
Directors, Trustees, full-time employees and sales representatives of Keystone
Management, Keystone, Keystone Group, Inc. ("Keystone Group"), Harbor Capital
Management Company, Inc., their subsidiaries and KDI who have been such for not
less than ninety days; and (2) the pension and profit-sharing plans established
by such companies, their subsidiaries and affiliates, for the benefit of their
officers, Directors, Trustees, full-time employees and sales representatives;
provided all such sales are made upon the written assurance of the purchaser
that the purchase is made for investment purposes and that the securities will
not be resold except through redemption by the Fund.
In addition, no contingent deferred sales charge is imposed on a
redemption of Fund shares purchased by a bank or trust company in a single
account in the name of such bank or trust company as trustee if the initial
investment in shares of the Fund, any other Keystone Custodian Fund (as
hereinafter defined), Keystone Precious Metals Holdings, Inc., Keystone
International Fund Inc., Keystone Tax Exempt Trust, Keystone Tax Free Fund,
Keystone Liquid Trust and/or any Keystone America Fund (as hereinafter defined)
is at least $500,000 and any commission paid by the Fund and such other funds at
the time of such purchase is not more than 1% of the amount invested.
- --------------------------------------------------------------------------------
DISTRIBUTION PLAN
- --------------------------------------------------------------------------------
Rule 12b-1 under the 1940 Act permits investment companies, such as the
Fund, to use their assets to bear expenses of distributing their shares if they
comply with various conditions, including adoption of a distribution plan
containing certain provisions set forth in Rule 12b-1. The Fund bears some of
the costs of selling its shares under a Distribution Plan adopted on June 1,
1983 pursuant to Rule 12b-1 (the "Distribution Plan").
The Fund's Distribution Plan provides that the Fund may expend up to
0.3125% quarterly (approximately 1.25% annually) of the average daily net asset
value of its shares to pay distribution costs for sales of its shares and to pay
shareholder service fees. NASD Rules limit such annual expenditures to 1%, of
which 0.75% may be used to pay such distribution costs and 0.25% may be used to
pay shareholder service fees. The aggregate amount that the Fund may pay for
such distribution costs is limited to 6.25% of gross share sales since the
inception of the Fund's Distribution Plan plus interest at the prime rate plus
1% on unpaid amounts thereof (less any contingent deferred sales charges paid by
shareholders to KDI).
In connection with the Distribution Plan, Fund shares are offered for
sale at net asset value without any initial sales charge, and the Fund pays or
accrued to the Principal Underwriter a commission for each sale. Specifically,
amounts paid or accrued under the Distribution Plan are paid or accrued to the
Fund's Principal Underwriter, currently KDI, as commissions for Fund shares sold
under the Distribution Plan, all or any part of which commissions may be
reallowed by KDI to others (dealers). In addition, the Fund pays to the
Principal Underwriter amounts sufficient for the Principal Underwriter to pay to
such others a service fee at a rate of 0.25% per annum of the net asset value of
the shares maintained by such recipients outstanding on the books of the Fund
for specified periods.
If the Fund is unable to pay KDI a commission on a new sale because the
annual maximum (0.75% of average daily net assets) has been reached, KDI
intends, but is not obligated, to continue to accept new orders for the purchase
of Fund shares and to pay commissions and service fees to dealers in excess of
the amount it currently receives from the Fund. While the Fund is under no
contractual obligations to reimburse KDI for advances made by KDI in excess of
the Distribution Plan limitation, KDI intends to seek full payment of such
charges from the Fund (together with interest at the rate of prime plus one
percent) at such time in the future as, and to the extent that, payment thereof
by the Fund would be within permitted limits. KDI currently intends to seek
payment of interest only on such charges paid or accrued by KDI subsequent to
January 1, 1992. If the Fund's independent Trustees ("Independent Trustees")
authorize such payments, the effect will be to extend the period of time during
which the Fund incurs the maximum amount of costs allowed by the Distribution
Plan. If the Distribution Plan is terminated, KDI will ask the Independent
Trustees to take whatever action they deem appropriate under the circumstances
with respect to payment of such amounts.
The total amounts paid by the Fund under the foregoing arrangements may
not exceed the maximum Distribution Plan limit specified above, and the amounts
and purposes of expenditures under the Distribution Plan must be reported to the
Fund's Rule 12b-1 Trustees ("Rule 12b-1 Trustees") quarterly. The Fund's Rule
12b-1 Trustees may require or approve changes in the implementation or operation
of the Distribution Plan and may require that total expenditures by the Fund
under the Distribution Plan be kept within limits lower than the maximum amount
permitted by the Distribution Plan as stated above. If such costs are not
limited by the Independent Trustees, such costs could, for some period of time,
be higher than such costs permitted by most other plans presently adopted by
other investment companies.
The Distribution Plan may be terminated at any time by vote of the Rule
12b-1 Trustees or by vote of a majority of the outstanding voting securities of
the Fund. Any change in the Distribution Plan that would materially increase the
distribution expenses of the Fund provided for in the Distribution Plan requires
shareholder approval. Otherwise, the Distribution Plan may be amended by the
Trustees, including the Rule 12b-1 Trustees.
While the Distribution Plan is in effect, the Fund is required to
commit the selection and nomination of candidates for Independent Trustees to
the discretion of the Independent Trustees.
During the year ended June 30, 1994, the Fund recovered $333,994 in
deferred sales charges. During the year, the Fund paid KDI $14,534,084 under the
Distribution Plan. The amount paid by the Fund under its Distribution Plan, net
of deferred sales charges, was $14,200,090 (0.96% of the Fund's average daily
net asset value during the year). For the year ended June 30, 1994, KDI earned
$5,366,134 in commissions and service fees under the Distribution Plan, of which
amount KDI actually received $3,606,244 after payments of commissions on new
sales and service fees to dealers and others of $10,927,840. During the year,
KDI also received $1,286,132 in deferred sales charges. At June 30, 1994, KDI's
total unreimbursed 12b-1 expenses amounted to $10,745,515 (0.77% of the Fund's
daily net asset value on June 30, 1994).
Whether any expenditure under the Distribution Plan is subject to a
state expense limit will depend upon the nature of the expenditure and the terms
of the state law, regulation or order imposing the limit. A portion of the
Fund's Distribution Plan expenses may be includable in the Fund's total
operating expenses for purposes of determining compliance with state expense
limits.
The Fund currently treats net Distribution Plan fees as expenses for
financial statement purposes, whereas for tax purposes, the Fund currently
treats commissions paid on new sales of shares as capital charges.
The Independent Trustees of the Fund have determined that the sales of
the Fund's shares resulting from payments under the Distribution Plan have
benefited the Fund.
- --------------------------------------------------------------------------------
THE TRUST AGREEMENT
- --------------------------------------------------------------------------------
TRUST AGREEMENT
The Fund is a Pennsylvania common law trust established under a Trust
Agreement dated July 15, 1935. Prior to December 19, 1989, Keystone served as
corporate Trustee to the Fund and provided the services of adviser, manager and
administrator. On December 19, 1989, the Fund's shareholders approved a
restatement of the entire Trust Agreement (the "Restatement of Trust"). The
Restatement of Trust restructured the Fund so that its operation would be
substantially similar to that of most other mutual funds. The Restatement of
Trust provides for a Board of Trustees and enables the Fund to enter into an
agreement with an investment manager and/or adviser to provide the Fund with
investment advisory, management and administrative services. A copy of the
Restatement of Trust is filed as an exhibit to the Fund's Registration
Statement, of which this statement of additional information is a part. This
summary is qualified in its entirety by reference to the Restatement of Trust.
DESCRIPTION OF SHARES
The Restatement of Trust authorizes the issuance of an unlimited number
of shares of beneficial interest and the creation of additional series and/or
classes of series of Fund shares. Each share represents an equal proportionate
interest in the Fund with each other share of that class. Upon liquidation,
shares are entitled to a pro rata share in the net assets of their class of Fund
shares. Shareholders shall have no preemptive or conversion rights. Shares are
transferable. The Fund currently intends to issue only one class of shares.
SHAREHOLDER LIABILITY
Pursuant to court decisions or other theories of law, shareholders of a
Pennsylvania common law trust could possibly be personally liable for the
obligations of the trust. The possibility of the Fund shareholders incurring
financial loss under such circumstance appears to be remote, however, because
the Restatement of Trust (1) contains an express disclaimer of shareholder
liability for obligations of the Fund; (2) requires that notice of such
disclaimer be given in each agreement, obligation or instrument entered into or
executed by the Fund or the Trustees; and (3) provides for indemnification out
of Fund property for any shareholder held personally liable for the obligations
of the Fund.
VOTING RIGHTS
Under the terms of the Restatement of Trust, the Fund does not hold
annual meetings. At meetings called for the initial election of Trustees or to
consider other matters, shares are entitled to one vote per share. Shares
generally vote together as one class on all matters. No amendment may be made to
the Restatement of Trust that adversely affects any class of shares without the
approval of a majority of the shares of that class. There shall be no cumulative
voting in the election of Trustees.
After a meeting as described above, no further meetings of shareholders
for the purpose of electing Trustees will be held, unless required by law or
until such time as less than a majority of the Trustees holding office have been
elected by shareholders, at which time the Trustees then in office will call a
shareholders' meeting for the election of Trustees.
Except as set forth above, the Trustees shall continue to hold office
indefinitely unless otherwise required by law and may appoint successor
Trustees. A Trustee may cease to hold office or may be removed from office (as
the case may be) (1) at any time by a two-thirds vote of the remaining Trustees;
(2) when such Trustee becomes mentally or physically incapacitated; or (3) at a
special meeting of shareholders by a two-thirds vote of the outstanding shares.
Any Trustee may voluntarily resign from office.
LIMITATION OF TRUSTEES' LIABILITY
The Restatement of Trust provides that a Trustee shall be liable only
for his own willful defaults and, if reasonable care has been exercised in the
selection of officers, agents, employees or investment advisers, shall not be
liable for any neglect or wrongdoing of any such person; provided, however, that
nothing in the Restatement of Trust shall protect a Trustee against any
liability for his willful misfeasance, bad faith, gross negligence or reckless
disregard of his duties.
The Trustees have absolute and exclusive control over the management
and disposition of all assets of the Fund and may perform such acts as in their
sole judgment and discretion are necessary and proper for conducting the
business and affairs of the Fund or promoting the interests of the Fund and the
shareholders.
- --------------------------------------------------------------------------------
INVESTMENT MANAGER
- --------------------------------------------------------------------------------
Subject to the general supervision of the Fund's Board of Trustees,
Keystone Management, located at 200 Berkeley Street, Boston, MA 02116-5034,
serves as investment manager to the Fund and is responsible for the overall
management of the Fund's business and affairs. Keystone Management, organized in
1989, is a wholly-owned subsidiary of Keystone. Its directors and principal
executive officers have been affiliated with Keystone, a seasoned investment
adviser, for a number of years. Keystone Management also serves as investment
manager to each of the other Keystone Custodian Funds and to certain other
Keystone funds.
Except as otherwise noted below, pursuant to its Investment Management
Agreement with the Fund (the "Management Agreement") and subject to the
supervision of the Fund's Board of Trustees, Keystone Management manages and
administers the operation of the Fund and manages the investment and
reinvestment of the Fund's assets in conformity with the Fund's investment
objectives and restrictions. The Management Agreement stipulates that Keystone
Management shall provide office space, all necessary office facilities,
equipment and personnel in connection with its services under the Management
Agreement and pay or reimburse the Fund for the compensation of Fund officers
and Trustees who are affiliated with the investment manager as well as pay all
expenses of Keystone Management incurred in connection with the provision of its
services. All charges and expenses other than those specifically referred to as
being borne by Keystone Management will be paid by the Fund, including, but not
limited to, custodian charges and expenses; bookkeeping and auditors' charges
and expenses; transfer agent charges and expenses; fees of Independent Trustees;
brokerage commissions, brokers' fees and expenses; issue and transfer taxes;
costs and expenses under the Distribution Plan; taxes and trust fees payable to
governmental agencies; the cost of share certificates; fees and expenses of the
registration and qualification of the Fund and its shares with the Securities
and Exchange Commission (sometimes referred to herein as the "SEC" or the
"Commission") or under state or other securities laws; expenses of preparing,
printing and mailing prospectuses, statements of additional information,
notices, reports and proxy materials to shareholders of the Fund; expenses of
shareholders' and Trustees' meetings; charges and expenses of legal counsel for
the Fund and for the Trustees of the Fund on matters relating to the Fund;
charges and expenses of filing annual and other reports with the SEC and other
authorities; and all extraordinary charges and expenses of the Fund.
The Management Agreement permits Keystone Management to enter into an
agreement with Keystone or another investment adviser, under which Keystone or
another investment adviser, as investment adviser, will provide substantially
all the services to be provided by Keystone Management under the Management
Agreement. The Management Agreement also permits Keystone Management to delegate
to Keystone or another investment adviser substantially all of the investment
manager's rights, duties and obligations under the Management Agreement.
Services performed by Keystone Management include (1) performing research and
planning with respect to (a) the Fund's qualification as a regulated investment
company under Subchapter M of the Code, (b) tax treatment of the Fund's
portfolio investments, (c) tax treatment of special corporate actions (such as
reorganizations), (d) state tax matters affecting the Fund, and (e) the Fund's
distributions of income and capital gains; (2) preparing the Fund's federal and
state tax returns; (3) providing services to the Fund's shareholders in
connection with federal and state taxation and distributions of income and
capital gains; and (4) storing documents relating to the Fund's activities.
The Fund pays Keystone Management a fee for its services at the annual
rate set forth below:
Aggregate Net Asset Value
Management of the Shares
Fee Income of the Fund
- --------------------------------------------------------------------------------
1.5% of Gross Dividend and
Interest Income Plus
0.60% of the first $ 100,000,000 plus
0.55% of the next $ 100,000,000 plus
0.50% of the next $ 100,000,000 plus
0.45% of the next $ 100,000,000 plus
0.40% of the next $ 100,000,000 plus
0.35% of the next $ 500,000,000 plus
0.30% of amounts over $1,000,000,000
Computed as of the close of business each business day and paid daily.
The Fund is subject to certain state annual expense limitations, the
most restrictive of which is as follows:
2.5% of the first $30 million of Fund average net assets;
2.0% of the next $70 million of Fund average net assets; and
1.5% of Fund average net assets over $100 million.
Capital charges and certain expenses, including a portion of the Fund's
Distribution Plan expenses, are not included in the calculation of the state
expense limitations. This limitation may be modified or eliminated in the
future.
As a continuing condition of registration of shares in a particular
state, Keystone Management has agreed to reimburse the Fund annually for certain
operating expenses incurred by the Fund in excess of certain percentages of the
Fund's average daily net assets. Keystone Management is not required, however,
to make such reimbursements to the extent it would result in the Fund's
inability to qualify as a regulated investment company under provisions of the
Code. This condition may be modified or eliminated in the future.
The Management Agreement continues in effect only if approved at least
annually by the Board of Trustees of the Fund or by a vote of a majority of the
outstanding shares, and such renewal has been approved by the vote of a majority
of the Independent Trustees cast in person at a meeting called for the purpose
of voting on such approval. The Management Agreement may be terminated, without
penalty, on 60 days' written notice by the Fund's Board of Trustees or by a vote
of a majority of outstanding shares. The Management Agreement will terminate
automatically upon its "assignment" as that term is defined in the 1940 Act.
For additional discussion of fees paid to Keystone Management, see
"Investment Adviser" below.
- --------------------------------------------------------------------------------
INVESTMENT ADVISER
- --------------------------------------------------------------------------------
Pursuant to the Management Agreement, Keystone Management has delegated
its investment management functions, except for certain administrative and
management services, to Keystone and has entered into an Investment Advisory
Agreement (the "Advisory Agreement") with Keystone, under which Keystone
provides investment advisory and management services to the Fund.
Keystone, located at 200 Berkeley Street, Boston, Massachusetts
02116-5034, has provided investment advisory and management services to
investment companies and private accounts since it was organized in 1932.
Keystone is a wholly-owned subsidiary of Keystone Group, 200 Berkeley Street,
Boston, Massachusetts 02116-5034.
Keystone Group is a corporation privately owned by current and former
members of Keystone management and its affiliates. The shares of Keystone Group
common stock beneficially owned by management are held in a number of voting
trusts, the trustees of which are George S. Bissell, Albert H. Elfner, III,
Roger T. Wickers, Edward F. Godfrey, and Ralph J. Spuehler, Jr. Keystone Group
provides accounting, bookeeping, legal, personnel and general corporate services
to Keystone Management, Keystone, their affiliates and the Keystone Group of
Mutual Funds.
Pursuant to the Advisory Agreement, Keystone receives for its services
an annual fee representing 85% of the management fee received by Keystone
Management under its Management Agreement with the Fund.
Pursuant to the Advisory Agreement and subject to the supervision of
the Fund's Board of Trustees, Keystone manages and administers the Fund's
operations and manages the investment and reinvestment of the Fund's assets in
conformity with the Fund's investment objectives and restrictions. The Advisory
Agreement stipulates that Keystone shall provide office space, all necessary
office facilities, equipment and personnel in connection with its services under
the Advisory Agreement and pay or reimburse the Fund for the compensation of
officers and Trustees of the Fund who are affiliated with the investment manager
as well as pay all expenses of Keystone incurred in connection with the
provision of its services. All charges and expenses other than those
specifically referred to as being borne by Keystone will be paid by the Fund,
including, but not limited to, custodian charges and expenses; bookkeeping and
auditors' charges and expenses; transfer agent charges and expenses; fees of
Independent Trustees; brokerage commissions, brokers' fees and expenses; issue
and transfer taxes; costs and expenses under the Distribution Plan; taxes and
trust fees payable to governmental agencies; the cost of share certificates;
fees and expenses of the registration and qualification of the Fund and its
shares with the SEC or under state or other securities laws; expenses of
preparing, printing and mailing prospectuses, statements of additional
information, notices, reports and proxy materials to shareholders of the Fund;
expenses of shareholders' and Trustees' meetings; charges and expenses of legal
counsel for the Fund and for the Trustees of the Fund on matters relating to the
Fund; charges and expenses of filing annual and other reports with the SEC and
other authorities; and all extraordinary charges and expenses of the Fund.
During the year ended June 30, 1992, the Fund paid or accrued to
Keystone Management investment management and administrative services fees of
$5,170,873, which represented 0.50% of the Fund's average net assets. Of such
amount paid to Keystone Management, $4,395,242 was paid to Keystone for its
services to the Fund.
During the year ended June 30, 1993, the Fund paid or accrued to
Keystone Management investment management and administrative services fees of
$6,247,609, which represented 0.47% of the Fund's average net assets. Of such
amount paid to Keystone Management, $5,310,468 was paid to Keystone for its
services to the Fund.
During the year ended June 30, 1994, the Fund paid or accrued to
Keystone Management investment management and administrative services fees of
$6,677,244, which represented 0.45% of the Fund's average net assets. Of such
amount paid to Keystone Management, $5,675,657 was paid to Keystone for its
services to the Fund.
- --------------------------------------------------------------------------------
TRUSTEES AND OFFICERS
- --------------------------------------------------------------------------------
Trustees and officers of the Fund, their principal occupations and some
of their affiliations over the last five years are as follows:
*GEORGE S. BISSELL: Chairman of the Board, Trustee and Chief Executive Officer
of the Fund; Chairman of the Board, Director and Chief Executive
Officer of Keystone Group, Inc. ("Keystone Group"), Keystone Custodian
Funds, Inc. ("Keystone"), Keystone Management, Inc. ("Keystone
Management"), Keystone Software Inc. ("Keystone Software"), Keystone
Fixed Income Advisers, Inc. ("KFIA") and Keystone Investor Resource
Center, Inc. ("KIRC"); Chairman of the Board, Chief Executive Officer
and Trustee or Director of Keystone America Capital Preservation and
Income Fund, Keystone America Capital Preservation and Income Fund II,
Keystone America Intermediate Term Bond Fund, Keystone America
Strategic Income Fund, Keystone America World Bond Fund, Keystone Tax
Free Income Fund, Keystone America State Tax Free Fund, Keystone
America State Tax Free Fund - Series II, Keystone America Fund for
Total Return, Keystone America Global Opportunities Fund, Keystone
America Hartwell Emerging Growth Fund, Inc., Keystone America Hartwell
Growth Fund, Inc., Keystone America Omega Fund, Inc., Keystone Fund of
the Americas Luxembourg and Keystone Fund of the Americas - U.S.,
Keystone Strategic Development Fund (collectively, "Keystone America
Funds"); Keystone Custodian Funds, Series B- 1, B-2, B-4, K-2, S-1,
S-3, and S-4; Keystone International Fund, Keystone Precious Metals
Holdings, Inc., Keystone Tax Free Fund, Keystone Tax Exempt Trust,
Keystone Liquid Trust (collectively, "Keystone Custodian Funds");
Keystone Institutional Adjustable Rate Fund and Master Reserves Trust
(all such funds, collectively, "Keystone Group Funds"); Chairman of the
Board, Hartwell Keystone Advisers, Inc. ("Hartwell Keystone"); Director
of Keystone Investment Management Corporation ("KIMCO"); Chairman of
the Board and Trustee of Anatolia College; and Trustee of University
Hospital (and Chairman of its Investment Committee).
FREDERICK AMLING: Trustee of the Fund; Trustee or Director of all other Keystone
Group Funds; Professor, Finance Department, George Washington
University; President, Amling & Company (investment advice); Member,
Board of Advisers, Credito Emilano (banking); and former Economics and
Financial Consultant, Riggs National Bank.
CHARLES A. AUSTIN III: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Managing Director, Seaward Management Corporation
(investment advice); and former Director, Executive Vice President and
Treasurer, State Street Research & Management Company (investment
advice).
*ALBERT H. ELFNER, III: President and Trustee of the Fund; President and
Trustee or Director of all other Keystone Group Funds; Director and
Vice Chairman of Keystone; Chief Operating Officer, President and
Director of Keystone Group; Chairman of the Board and Director of KIMCO
and KFIA; President and Director of Keystone Management, Hartwell
Keystone and Keystone Software; Director of Keystone Distributors, Inc.
("KDI"), KIRC, Fiduciary Investment Company, Inc. ("FICO") and Robert
Van Partners, Inc.; Director of Boston Children's Services Association
and Trustee of Anatolia College, Middlesex School and Middlebury
College ; Member, Board of Governors, New England Medical Center;
former Trustee of Neworld Bank and former President of Keystone.
EDWIN D. CAMPBELL: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Executive Director, Coalition of Essential
Schools, Brown University; Director and former Executive Vice
President, National Alliance of Business; former Vice President,
Educational Testing Services; and former Dean, School of Business,
Adelphi University.
CHARLES F. CHAPIN: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; former Group Vice President, Textron Corp.; and
former Director, Peoples Bank (Charlotte, N.C).
LEROY KEITH, JR.: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Director of Phoenix Total Return Fund and
Equifax, Inc.; Trustee of Phoenix Series Fund, Phoenix Multi-Portfolio
Fund and The Phoenix Big Edge Series Fund; and former President,
Morehouse College.
K. DUN GIFFORD: Trustee of the Fund; Trustee or Director of all other Keystone
Group Funds; Chairman of the Board, Director and Executive Vice
President, The London Harness Company; Managing Partner, Roscommon
Capital Corp.; Trustee, Cambridge College; Chairman Emeritus and
Director, American Institute of Food and Wine; Chief Executive Officer,
Gifford Gifts of Fine Foods; Chairman, Gifford, Drescher & Associates
(environmental consulting); President, Oldways Preservation and
Exchange Trust (education); and former Director, Keystone Group and
Keystone.
F. RAY KEYSER, JR.: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Of Counsel, Keyser, Crowley & Meub, P.C.; Member,
Governor's (VT) Council of Economic Advisers; Chairman of the Board and
Director, Central Vermont Public Service Corporation and Hitchcock
Clinic; Director, Vermont Yankee Nuclear Power Corporation, Vermont
Electric Power Company, Inc., Grand Trunk Corporation, Central Vermont
Railway, Inc., S.K.I. Ltd., Sherburne Corporation, Union Mutual Fire
Insurance Company, New England Guaranty Insurance Company, Inc. and the
Investment Company Institute; former Governor of Vermont; former
Director and President, Associated Industries of Vermont; former
Chairman and President, Vermont Marble Company; former Director of
Keystone; and former Director and Chairman of the Board, Green Mountain
Bank.
DAVID M. RICHARDSON: Trustee of the Fund; Trustee or Director of all other
Keystone Group Funds; Executive Vice President, DHR International, Inc.
(executive recruitment); former Senior Vice President, Boyden
International Inc. (executive recruit- ment); and Director, Commerce
and Industry Association of New Jersey, 411 International, Inc. and J &
M Cumming Paper Co.
RICHARD J. SHIMA: Trustee of the Fund; Trustee or Director of all other Keystone
Group Funds; Consultant, Russell Miller, Inc. (investment bankers) and
Consultant, Drake Beam Morin, Inc. (executive outplacement); Director
of Connecticut Natural Gas Corporation, Trust Company of Connecticut,
Hartford Hospital, Old State House Association and Enhanced Financial
Services, Inc.; Member, Georgetown College Board of Advisors; Chairman,
Board of Trustees, Hartford Graduate Center; Trustee, Kingswood-Oxford
School and Greater Hartford YMCA; former Director, Executive Vice
President and Vice Chairman of The Travelers Corporation; and former
Managing Director of Russell Miller, Inc.
ANDREW J. SIMONS: Trustee of the Fund; Trustee or Director of all other Keystone
Group Funds; Partner, Farrell, Fritz, Caemmerer, Cleary, Barnosky &
Armentano, P.C.; President, Nassau County Bar Association; former
Associate Dean and Professor of Law, St. John's University School of
Law.
EDWARD F. GODFREY: Senior Vice President of the Fund; Senior Vice President of
all other Keystone Group Funds; Senior Vice President, Chief Financial
Officer and Treasurer of Keystone Group and KDI; Director, Senior Vice
President, Chief Financial Officer and Treasurer of Keystone; Treasurer
of KIMCO, Keystone Management, Keystone Software, Inc. and FICO; and
Treasurer and Director of Hartwell Keystone.
JAMES R. McCALL: Senior Vice President of the Fund; Senior Vice President of all
other Keystone Group Funds; and President of Keystone.
ROGER T. WICKERS: Senior Vice President of the Fund; Senior Vice President of
all other Keystone Group Funds; Director, Senior Vice President,
General Counsel and Secretary, Keystone Group and KDI; Director and
Secretary, Keystone and Vice President, Assistant Secretary and
Director, Keystone Management.
KEVIN J. MORRISSEY: Treasurer of the Fund; Treasurer of all other Keystone Group
Funds; Vice President of Keystone Group; and former Vice President and
Treasurer of KIRC.
ROSEMARY D. VAN ANTWERP: Vice President and Secretary of the Fund; Vice
President and Secretary of all other Keystone Group Funds; Senior Vice
President and General Counsel of Keystone, Keystone Management,
Hartwell Keystone, KIRC, KFIA, Keystone Software and KIMCO; Vice
President, Assistant Secretary and Associate General Counsel of
Keystone Group; Senior Vice President, General Counsel, Director and
Assistant Clerk, FICO; Assistant Secretary of KDI.
DONALD C. DATES: Vice President of the Fund and Senior Vice President of
Keystone.
WALTER T. MCCORMICK: Vice President of the Fund and Senior Vice President of
Keystone.
* This Trustee may be considered an "interested person" within the meaning of
the 1940 Act.
Mr. Bissell and Mr. Elfner are "interested persons" by virtue of their
positions as officers and/or Directors of Keystone Group and several of its
affiliates including Hartwell Keystone, KDI and KIRC. Mr. Bissell and Mr. Elfner
own shares of Keystone Group. Mr. Bissell is Chairman of the Board, Chief
Executive Officer and Director of Keystone Group. Mr. Elfner is President,
Director and Chief Operating Officer of Keystone Group.
The Board of Trustees of the Fund has established an Advisory Board
composed principally of former Trustees. The members of the Advisory Board are
James R. Dempsey, Knight Edwards, Donald T. Ellis, John M. Haffenreffer, Philip
B. Harley, Everett P. Pope, John W. Sharp, Spencer R. Stuart, Russel R. Taylor,
and Charles M. Williams. The Advisory Board will advise the Board of Trustees
and Keystone with respect to the management and operation of the Fund. The
recommendations of the Advisory Board will be considered by the Board of
Trustees and Keystone, but will not be binding on them.
The principal occupations and affiliations of the members of the
Advisory Board over the past five years are set forth below:
JAMES R. DEMPSEY: a private investor; Director or Trustee, Convest Energy
Corporation and Superior Electric Co.; former Chairman of the Board,
Transatlantic Investment Capital Corporation, Transatlantic Capital
Corporation and former Trustee or Director of 7 Keystone Group Funds
and Phoenix Total Return Fund, Phoenix Multi-Portfolio Fund, Phoenix
Series Fund and The Phoenix Big Edge Series Fund.
KNIGHT EDWARDS: Of Counsel, Edwards & Angell; Member of the Board of Managers
of 7 variable annuity separate accounts of The Travelers Insurance
Company ("Travelers"); Trustee, 5 mutual funds sponsored by Travelers;
and former Trustee or Director
of 8 Keystone Group Funds.
DONALD T. ELLIS: President, D.T. Ellis Associates; Associate, Michael Saunders
& Co., real estate broker; former Senior Vice President, Goldman
Financial Services, Inc.; former President, Chief Executive Officer and
Treasurer, Scott Seaboard Corpora- tion; and former Trustee or Director
of 8 Keystone Group Funds.
JOHN M. HAFFENREFFER: Vice President, Director and Treasurer of Haffenreffer
& Co.; Member of the Corporation and Treasurer of Haffenreffer
Benevolent Corp.; Director and Member of the Executive Committee of
Liberty Bank and Trust Company; Director of the Massachusetts Council
of Churches; Vice President, Director and Treasurer, Forest Hills
Company; former Director of Keystone; and former Trustee or Director of
all Keystone Group Funds.
PHILIP B. HARLEY: Director of General Host Corporation, Stamford, Connecticut; a
private investor; former Director, President and Chief Executive
Officer, Baker Perkins, Inc.; former Director, Baker Perkins Holdings
Ltd. (U.K.); and former Trustee or Director of all Keystone Group
Funds.
EVERETT P. POPE: former Chairman and Trustee, Bowdoin College; former Chairman
of the Board and President of Workingmens Cooperative Bank; former
Chairman, Massachusetts Higher Education Assistance Corporation
(guarantor of student loans); and former Trustee or Director of all
Keystone Group Funds.
JOHN W. SHARP: Governor and past President of Montreal General Hospital, Canada;
Honorary Vice Chairman and former National President of Boy Scouts of
Canada; Honorary Colonel, The Black Watch Royal Highland Regiment of
Canada; former Director of Keystone and Unimed, Inc.; former Chairman
and President, Vilas Industries, Ltd. (Canada); former Chairman, Moyer
School Supplies, Ltd. (Canada); former Senior Economic Adviser,
Province of Quebec, in New York City; former registered representative
with F.H. Deacon Hodgson Ltd.; and former Trustee or Director of all
Keystone Group Funds.
SPENCER R. STUART: Director of U.S. Tobacco Company, Asset Guaranty Inc.,
International Finance Group and Enhanced Financial Services Inc.;
Director and Chairman, Human Resources Committee, Allegheny
International, Inc.; former Director of Western Airlines, Inc.,
International Finance Group and Keystone; former Chairman, Council of
Managing Advisers, Dean Witter Reynolds Bank; Founder/former Chairman
of Spencer Stuart & Associates; and former Trustee or Director of all
Keystone Group Funds.
RUSSEL R. TAYLOR: Trustee of the Gintel Funds, Greenwich, Connecticut; Associate
Professor and Director, H.W. Taylor Institute of Entrepreneurial
Studies, College of New Rochelle; former Director of Annis Furs, Inc.
and Minnetonka, Inc.; and former Trustee or Director of all Keystone
Group Funds.
CHARLES M. WILLIAMS: Director, Horace Mann Educator Corp.; President, Charles
M. Williams Associates; Advisory Director, Orix U.S.A., Inc.; Director
of Fort Dearborn Income Securities, Inc., 4 Merrill Lynch Funds,
National Life Insurance Company of Vermont and the Institute for
Financial Management, Inc.; President of Charles M. Williams
Associates, Inc.; George Gund Professor of Commercial Banking,
Emeritus, at Harvard University Graduate School of Business
Administration; former Director of Keystone, Hammermill Paper Co.,
Sonat, Inc., United States Leasing International, Inc.; and former
Trustee or Director of all Keystone Custodian Funds and Keystone
America Funds.
During the fiscal year ended June 30, 1994, no Trustee affiliated with
Keystone or any officer received any direct remuneration from the Fund. During
the same period, the nonaffiliated Trustees received $45,969 in retainers and
fees. On July 30, 1994, the Fund's Trustees, officers and members of the
Advisory Board beneficially owned less than 1% of the Fund's then outstanding
shares.
The address of all the Fund's Trustees, officers and Advisory Board
members is 200 Berkeley Street, Boston, Massachusetts 02116- 5034.
- --------------------------------------------------------------------------------
PRINCIPAL UNDERWRITER
- --------------------------------------------------------------------------------
Pursuant to a Principal Underwriting Agreement ("Underwriting
Agreement"), KDI acts as the Fund's Principal Underwriter. KDI, located at 200
Berkeley Street, Boston, Massachusetts 02116-5034, is a Delaware corporation
wholly-owned by Keystone. KDI, as agent, has agreed to use its best efforts to
find purchasers for the shares. KDI may retain and employ representatives to
promote distribution of the shares and may obtain orders from brokers, dealers
and others, acting as principals, for sales of shares to them. The Underwriting
Agreement provides that KDI will bear the expense of preparing, printing and
distributing advertising and sales literature and prospectuses used by it. In
its capacity as Principal Underwriter, KDI may receive payments from the Fund
pursuant to the Fund's Distribution Plan.
The Underwriting Agreement provides that it will remain in effect as
long as its terms and continuance are approved by a majority of the Fund's
Independent Trustees at least annually at a meeting called for that purpose, and
if its continuance is approved annually by vote of a majority of Trustees, or by
vote of a majority of the outstanding shares.
The Underwriting Agreement may be terminated, without penalty, on 60
days' written notice by the Board of Trustees or by a vote of a majority of
outstanding shares. The Principal Underwriting Agreement will terminate
automatically upon its "assignment" as that term is defined in the 1940 Act.
From time to time, if in KDI's judgment it could benefit the sales of
Fund shares, KDI may use its discretion in providing to selected dealers
promotional materials and selling aids, including, but not limited to, personal
computers, related software and Fund data files.
For the fiscal years ended June 30, 1992 and 1993, KDI earned
commissions of $1,110,423 and $674,436, respectively, after allowing commissions
and service fees of $13,820,066 and $14,851,296 respectively, to retail dealers
under the Distribution Plan. For the fiscal year ended June 30, 1994, KDI earned
$5,366,134 in commissions and service fees of which amount KDI actually received
$3,606,244 after payments of commissions on new sales and service fees to others
of $10,927,840.
- --------------------------------------------------------------------------------
BROKERAGE
- --------------------------------------------------------------------------------
It is the policy of the Fund, in effecting transactions in portfolio
securities, to seek best execution of orders at the most favorable prices. The
determination of what may constitute best execution and price in the execution
of a securities transaction by a broker involves a number of considerations,
including, without limitation, the overall direct net economic result to the
Fund, involving both price paid or received and any commissions and other costs
paid, the efficiency with which the transaction is effected, the ability to
effect the transaction at all where a large block is involved, the availability
of the broker to stand ready to execute potentially difficult transactions in
the future and the financial strength and stability of the broker. Such
considerations are weighed by management in determining the overall
reasonableness of brokerage commissions paid.
Subject to the foregoing, a factor in the selection of brokers is the
receipt of research services, such as analyses and reports concerning issuers,
industries, securities, economic factors and trends and other statistical and
factual information. Any such research and other statistical and factual
information provided by brokers to the Fund, Keystone Management or Keystone is
considered to be in addition to and not in lieu of services required to be
performed by Keystone Management under the Management Agreement or Keystone
under the Advisory Agreement. The cost, value and specific application of such
information are indeterminable and cannot be practically allocated among the
Fund and other clients of Keystone Management or Keystone who may indirectly
benefit from the availability of such information. Similarly, the Fund may
indirectly benefit from information made available as a result of transactions
effected for such other clients. Under the Management Agreement and the Advisory
Agreement, Keystone Management and Keystone are permitted to pay higher
brokerage commissions for brokerage and research services in accordance with
Section 28(e) of the Securities Exchange Act of 1934. In the event Keystone
Management and Keystone do follow such a practice, they will do so on a basis
which is fair and equitable to the Fund.
The Fund expects that purchases and sales of securities usually will be
effected through brokerage transactions for which commissions are payable.
Purchases from underwriters will include the underwriting commission or
concession. Purchases from dealers serving as market makers will include a
dealer's mark up or reflect a dealer's mark down. Where transactions are made in
the over-the-counter market, the Fund will deal with primary market makers
unless more favorable prices are otherwise obtainable.
The Fund may participate, if and when practicable, in group bidding for
the purchase directly from an issuer of certain securities for the Fund's
portfolio in order to take advantage of the lower purchase price available to
members of such a group.
KDI has agreed to reimburse certain expenses incurred by Mariner
Financial Services, Inc. in connection with its sales of the Fund's shares.
Neither Keystone Management, Keystone, nor the Fund intend to place
securities transactions with any particular broker-dealer or group thereof. The
Fund's Board of Trustees, however, has determined that the Fund may follow a
policy of considering sales of shares as a factor in the selection of
broker-dealers to execute portfolio transactions, subject to the requirements of
best execution, including best price, described above.
The policy of the Fund with respect to brokerage is and will be
reviewed by the Fund's Board of Trustees from time to time. Because of the
possibility of further regulatory developments affecting the securities
exchanges and brokerage practices generally, the foregoing practices may be
changed, modified or eliminated.
Investment decisions for the Fund are made independently by Keystone
Management or Keystone from those of the other funds and investment accounts
managed by Keystone Management or Keystone. It may frequently develop that the
same investment decision is made for more than one fund. Simultaneous
transactions are inevitable when the same security is suitable for the
investment objective of more than one account. When two or more funds or
accounts are engaged in the purchase or sale of the same security, the
transactions are allocated as to amount in accordance with a formula which is
equitable to each fund or account. It is recognized that in some cases this
system could have a detrimental effect on the price or volume of the security as
far as the Fund is concerned. In other cases, however, it is believed that the
ability of the Fund to participate in volume transactions will produce better
executions for the Fund.
During the fiscal years ended June 30, 1994, 1993, 1992, the Fund paid
$566,756, $441,990 and $465,778 respectively, in total brokerage fees. Of the
$566,756 paid in brokerage fees in fiscal year 1994, $21,854 was paid to Kokusai
Securities, Inc.
In no instance will portfolio securities be purchased from or sold to
Keystone Management, Keystone, KDI or any of their affiliated persons, as
defined in the 1940 Act and rules and regulations issued thereunder.
- --------------------------------------------------------------------------------
STANDARDIZED TOTAL RETURN AND YIELD QUOTATIONS
- --------------------------------------------------------------------------------
Total return quotations for the Fund as they may appear, from time to
time, in advertisements are calculated by finding the average annual compounded
rates of return over the one, five and ten year periods on a hypothetical $1,000
investment that would equate the initial amount invested to the ending
redeemable value. To the initial investment all dividends and distributions are
added, and all recurring fees charged to all shareholder accounts are deducted.
The ending redeemable value assumes a complete redemption at the end of the one,
five or ten year periods.
The cumulative total return of the Fund for the one, five and ten year
periods ended June 30, 1994 was (3.91)%, 41.67% and 199.33%, respectively
(assuming no redemptions). The compounded average annual returns for the five
and ten year periods ended June 30, 1994 were 7.21% and 11.59%, respectively
(assuming no redemption).
Current yield quotations as they may appear from time to time in
advertisements will consist of a quotation based on a 30-day period ended on the
date of the most recent balance sheet of the Fund, computed by dividing the net
investment income per share earned during the period by the maximum offering
price per share on the last day of the base period. The Fund's current yield for
the thirty-day period ended June 30, 1994 was 2.99%.
The Fund may also include comparative performance information in
advertising or marketing the Fund's shares, such as data from Lipper Analytical
Services, Inc. or other industry publications.
- --------------------------------------------------------------------------------
ADDITIONAL INFORMATION
- --------------------------------------------------------------------------------
State Street Bank and Trust Company, 225 Franklin Street, Boston,
Massachusetts 02110, is custodian of all securities and cash of the Fund (the
"Custodian"). The Custodian may hold securities of some foreign issuers outside
the United States. The Custodian performs no investment management functions for
the Fund, but, in addition to its custodial services, is responsible for
accounting and related recordkeeping on behalf of the Fund.
KPMG Peat Marwick LLP, One Boston Place, Boston, Massachusetts 02108,
Certified Public Accountants, are the Fund's independent auditors.
KIRC, located at 101 Main Street, Cambridge, Massachusetts 02142-1519,
is a wholly-owned subsidiary of Keystone, acts as transfer agent and dividend
disbursing agent for the Fund.
Except as otherwise stated in its prospectus or required by law, the
Fund reserves the right to change the terms of the offer stated in its
prospectus without shareholder approval, including the right to impose or change
fees for services provided.
No dealer, salesman or other person is authorized to give any
information or to make any representation not contained in the Fund's
prospectus, this statement of additional information or in supplemental sales
literature issued by the Fund or the Principal Underwriter, and no person is
entitled to rely on any information or representation not contained therein.
The Fund's prospectus and this statement of additional information omit
certain information contained in the registration statement filed with the
Securities and Exchange Commission, which may be obtained from the Securities
and Exchange Commission's principal office in Washington, D.C. upon payment of
the fee prescribed by the rules and regulations promulgated by the Securities
and Exchange Commission.
As of September 30, 1994, no shareholder of record owned 5% or more of
the Fund.
<PAGE>
- --------------------------------------------------------------------------------
APPENDIX
- --------------------------------------------------------------------------------
COMMON AND PREFERRED STOCK RATINGS
S&P'S EARNINGS AND DIVIDEND RANKINGS FOR COMMON STOCKS
Because the investment process involves assessment of various factors, such
as product and industry position, corporate resources and financial policy, with
results that make some common stocks more highly esteemed than others, Standard
& Poors' Corporation ("S&P") believes that earnings and dividend performance is
the end result of the interplay of these factors and that, over the long run,
the record of this performance has a considerable bearing on relative quality.
S&P rankings, however, do not reflect all of the factors, tangible or
intangible, that bear on stock quality.
Growth and stability of earnings and dividends are deemed key elements in
establishing S&P earnings and dividend rankings for common stocks, which
capsulize the nature of this record in a single symbol.
S&P has established a computerized scoring system based on per share
earnings and dividend records of the most recent ten years, a period deemed long
enough to measure a company's performance under varying economic conditions. S&P
measures growth, stability within the trend line and cyclicity. The ranking
system also makes allowances for company size, since large companies have
certain inherent advantages over small ones. From these, scores for earnings and
dividends are determined.
The final score for each stock is measured against a scoring matrix
determined by analysis of the scores of a large and representative sample which
is reviewed and sometimes modified with the following ladder of rankings:
A+ Highest B+ Average C Lowest
A High B Below Average D In Reorganization
A- Above Average B- Lower
S&P believes its rankings are not a forecast of future market price
performance but are basically an appraisal of past performance of earnings and
dividends and relative current standing.
MOODY'S COMMON STOCK RANKINGS
Moody's presents a concise statement of the important characteristics of a
company and an evaluation of the grade (quality) of its common stock. Data
presented includes: (a) capsule stock information which reveals short and long
term growth and yield afforded by the indicated dividend, based on a recent
price; (b) a long term price chart which shows patterns of monthly stock price
movements and monthly trading volumes; (c) a breakdown of a company's capital
account which aids in determining the degree of conservatism or financial
leverage in a company's balance sheet; (d) interim earnings for the current year
to date, plus three previous years; (e) dividend information; (f) company
background; (g) recent corporate developments; (h) prospects for a company in
the immediate future and the next few years; and (i) a ten year comparative
statistical analysis.
This information provides investors with information on what a company
does, how it has performed in the past, how it is performing currently and what
its future performance prospects appear to be.
These characteristics are then evaluated and result in a grading, or
indication of quality. The grade is based on an analysis of each company's
financial strength, stability of earnings and record of dividend payments. Other
considerations include conservativeness of capitalization, depth and caliber of
management, accounting practices, technological capabilities and industry
position. Evaluation is represented by the following grades:
(1) High Grade
(2) Investment Grade
(3) Medium Grade
(4) Speculative Grade
MOODY'S PREFERRED STOCK RATINGS
Preferred stock ratings and their definitions are as follows:
1. aaa: An issue which is rated aaa is considered to be a top-quality
preferred stock. This rating indicates good asset protection and the least risk
of dividend impairment within the universe of preferred stocks.
2. aa: An issue which is rated aa is considered a high-grade preferred
stock. This rating indicates that there is a reasonable assurance that earnings
and asset protection will remain relatively well maintained in the foreseeable
future.
3. a: An issue which is rated a is considered to be an upper- medium grade
preferred stock. While risks are judged to be somewhat greater then in the aaa
and aa classification, earnings and asset protection are, nevertheless, expected
to be maintained at adequate levels.
4. baa: An issue which is rated baa is considered to be a medium-grade
preferred stock, neither highly protected nor poorly secured. Earnings and asset
protection appear adequate at present but may be questionable over any great
length of time.
5. ba: An issue which is rated ba is considered to have speculative
elements and its future cannot be considered well assured. Earnings and asset
protection may be very moderate and not well-safeguarded during adverse periods.
Uncertainty of position characterizes preferred stocks in this class.
6. b: An issue which is rated b generally lacks the characteristics of a
desirable investment. Assurance of dividend payments and maintenance of other
terms of the issue over any long period of time may be small.
7. caa: An issue which is rated caa is likely to be in arrears on dividend
payments. This rating designation does not purport to indicate the future status
of payments.
8. ca: An issue which is rated ca is speculative in a high degree and is
likely to be in arrears on dividends with little likelihood of eventual
payments.
9. c: This is the lowest rated class of preferred or preference stock.
Issues so rated can be regarded as having extremely poor prospects of ever
attaining any real investment standing.
Moody's applies numerical modifiers 1, 2 and 3 in each rating
classification: the modifier 1 indicates that the security ranks in the higher
end of its generic rating category, the modifier 2 indicates a mid-range ranking
and the modifier 3 indicates that the issue ranks in the lower end of its
generic rating category.
LIMITED PARTNERSHIPS
The Fund may invest in limited and master limited partnerships. A limited
partnership is a partnership consisting of one or more general partners, jointly
and severally responsible as ordinary partners, and by whom the business is
conducted, and one or more limited partners who contribute cash as capital to
the partnership and who generally are not liable for the debts of the
partnership beyond the amounts contributed. Limited partners are not involved in
the day-to-day management of the partnership. They receive income, capital gains
and other tax benefits associated with the partnership project in accordance
with terms established in the partnership agreement. Typical limited
partnerships are in real estate, oil and gas and equipment leasing, but they
also finance movies, research and development and other projects.
For an organization classified as a partnership under the Internal Revenue
Code, each item of income, gain, loss, deduction and credit is not taxed at the
partnership level but flows through to the holder of the partnership unit. This
allows the partnership to avoid taxation and to pass through income to the
holder of the partnership unit at lower individual rates.
A master limited partnership is a publicly traded limited partnership. The
partnership units are registered with the Securities and Exchange Commission and
are freely exchanged on a securities exchange or in the over-the-counter market.
CORPORATE BOND RATINGS
S&P CORPORATE BOND RATINGS
An S&P corporate bond rating is a current assessment of the
creditworthiness of an obligor, including obligors outside the United States,
with respect to a specific obligation. This assessment may take into
consideration obligors such as guarantors, insurers, or lessees. Ratings of
foreign obligors do not take into account currency exchange and related
uncertainties. The ratings are based on current information furnished by the
issuer or obtained by S&P from other sources it considers reliable.
The ratings are based, in varying degrees, on the following considerations:
a. Likelihood of default-capacity and willingness of the obligor as to the
timely payment of interest and repayment of principal in accordance with the
terms of the obligation;
b. Nature of and provisions of the obligation; and
c. Protection afforded by and relative position of the obligation in the
event of bankruptcy, reorganization or other arrangement under the laws of
bankruptcy and other laws affecting creditors' rights.
PLUS (+) OR MINUS (-): To provide more detailed indications of credit
quality, ratings from AA and to A may be modified by the addition of a plus or
minus sign to show relative standing within the major rating categories.
Bond ratings are as follows:
1. AAA - Debt rated AAA has the highest rating assigned by S&P. Capacity to
pay interest and repay principal is extremely strong.
2. AA - Debt rated AA has a very strong capacity to pay interest and repay
principal and differs from the higher rated issues only in small degree.
3. A - Debt rated A has a strong capacity to pay interest and repay
principal although it is somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than debt in higher rated
categories.
4. BBB - Debt rated BBB is regarded as having an adequate capacity to pay
interest and repay principal. Whereas it normally exhibits adequate protection
parameters, adverse economic conditions or changing circumstances are more
likely to lead to a weakened capacity to pay interest and repay principal for
debt in this category than in higher rated categories.
5. BB, B, CCC, CC AND C - Debt rated BB, B, CCC, CC and C is regarded, on
balance, as predominantly speculative with respect to capacity to pay interest
and repay principal in accordance with the terms of the obligation. BB indicates
the lowest degree of speculation and C the highest degree of speculation. While
such debt will likely have some quality and protective characteristics, these
are outweighed by large uncertainties or major risk exposures to adverse
conditions.
MOODY'S CORPORATE BOND RATINGS
Moody's ratings are as follows:
1. Aaa - Bonds which are rated Aaa are judged to be of the best quality.
They carry the smallest degree of investment risk and are generally referred to
as "gilt-edge." Interest payments are protected by a large or by an
exceptionally stable margin and principal is secure. While the various
protective elements are likely to change, such changes as can be visualized are
most unlikely to impair the fundamentally strong position of such issues.
2. Aa - Bonds which are rated Aa are judged to be of high quality by all
standards. Together with the Aaa group they comprise what are generally known as
high grade bonds. They are rated lower than the best bonds because margins of
protection may not be as large as in Aaa securities or fluctuation of protective
elements may be of greater amplitude or there may be other elements present
which make the long term risks appear somewhat larger than in Aaa securities.
3. A - Bonds which are rated A possess many favorable investment attributes
and are to be considered as upper medium grade obligations. Factors giving
security to principal and interest are considered adequate but elements may be
present which suggest a susceptibility to impairment sometime in the future.
4. Baa - Bonds which are rated Baa are considered as medium grade
obligations, i.e., they are neither highly protected nor poorly secured.
Interest payments and principal security appear adequate for the present but
certain protective elements may be lacking or may be characteristically
unreliable over any great length of time. Such bonds lack outstanding investment
characteristics and in fact have speculative characteristics as well.
5. Ba - Bonds which are rated Ba are judged to have speculative elements.
Their future cannot be considered as well assured. Often the protection of
interest and principal payments may be very moderate and thereby not well
safeguarded during both good and bad times over the future. Uncertainty of
position characterizes bonds in this class.
6. B - Bonds which are rated B generally lack characteristics of the
desirable investment. Assurance of interest and principal payments or of
maintenance of other terms of the contract over any long period of time may be
small.
Moody's applies numerical modifiers, 1, 2 and 3 in each generic rating
classification from Aa through B in its corporate bond rating system. The
modifier 1 indicates that the security ranks in the higher end of its generic
rating category; the modifier 2 indicates a mid-range ranking; and the modifier
3 indicates that the issue ranks in the lower end category.
ZERO COUPON "STRIPPED" BONDS
A zero coupon "stripped" bond represents ownership in serially maturing
interest payments or principal payments on specific underlying notes and bonds,
including coupons relating to such notes and bonds. The interest and principal
payments are direct obligations of the issuer. Coupon zero coupon bonds of any
series mature periodically from the date of issue of such series through the
maturity date of the securities related to such series. Principal zero coupon
bonds mature on the date specified therein, which is the final maturity date of
the related securities. Each zero coupon bond entitles the holder to receive a
single payment at maturity. There are no periodic interest payments on a zero
coupon bond. Zero coupon bonds are offered at discounts from their face amounts.
In general, owners of zero coupon bonds have substantially all the rights
and privileges of owners of the underlying coupon obligations or principal
obligations. Owners of zero coupon bonds have the right upon default on the
underlying coupon obligations or principal obligations to proceed directly and
individually against the issuer and are not required to act in concert with
other holders of zero coupon bonds.
For federal income tax purposes, a purchaser of principal zero coupon bonds
or coupon zero coupon bonds (either initially or in the secondary market) is
treated as if the buyer had purchased a corporate obligation issued on the
purchase date with an original issue discount equal to the excess of the amount
payable at maturity over the purchase price. The purchaser is required to take
into income each year as ordinary income an allocable portion of such discounts
determined on a "constant yield" method. Any such income increases the holder's
tax basis for the zero coupon bond, and any gain or loss on a sale of the zero
coupon bonds relative to the holder's basis, as so adjusted, is a capital gain
or loss. If the holder owns both principal zero coupon bonds and coupon zero
coupon bonds representing interest in the same underlying issue of securities, a
special basis allocation rule (requiring the aggregate basis to be allocated
among the items sold and retained based on their relative fair market values at
the time of sale) may apply to determine the gain or loss on a sale of any such
zero coupon bonds items.
PAYMENT-IN-KIND INSTRUMENTS
Payment-in-Kind ("PIK") securities pay interest in either cash or
additional securities, at the issuer's option, for a specified period. The
issuer's option to pay in additional securities typically ranges from one to six
years, compared to an average maturity for all PIK securities of 11 years. Call
protection and sinking fund features are comparable to those offered on
traditional debt issues.
PIKs, like zero coupon bonds, are designated to give an issuer flexibility
in managing cash flow. Several PIKs are senior debt. In other cases, where PIKs
are subordinated, most senior lenders view them as equity equivalents.
An advantage of PIKs for the issuer - as with zero coupon securities - is
that interest payments are automatically compounded (reinvested) at the stated
coupon rate, which is not he case with cash-paying securities. However, PIKs are
gaining popularity over zeros since interest payments in additional securities
can be monetized and are more tangible than accretion of a discount.
As a group, PIK bonds trade flat (i.e., without accrued interest). Their
price is expected to reflect an amount representing accreted interest since the
last payment. PIKs generally trade at higher yields than comparable cash-paying
securities of the same issuer. Their premium yield is the result of the lesser
desirability of non-cash interest, the more limited audience for non-cash paying
securities, and the fact that many PIKs have been issued to equity investors who
do not normally own or hold such securities.
Calculating the true yield on a PIK security requires a discounted cash
flow analysis if the security (ex interest) is trading at a premium or a
discount, because the realizable value of additional payments is equal to the
current market value of the underlying security, not par.
Regardless of whether PIK securities are senior or deeply subordinated,
issuers are highly motivated to retire them because they are usually their most
costly form of capital. 68% of the PIK debentures issued prior to 1987 have
already been redeemed, and approximately 35% of the over $10 billion PIK
debentures issued through year-end 1988 have been redeemed.
MONEY MARKET INSTRUMENTS
The Fund's investments in commercial paper are limited to those rated A-1
by Standard & Poor's Corporation, PRIME-1 by Moody's Investors Service, Inc. or
F-1 by Fitch Investors Service, Inc. These ratings and other money market
instruments are described as follows:
COMMERCIAL PAPER RATINGS
Commercial paper rated A-1 by Standard & Poor's has the following
characteristics: Liquidity ratios are adequate to meet cash requirements. The
issuer's long-term senior debt is rated A or better, although in some cases BBB
credits may be allowed. The issuer has access to at least two additional
channels of borrowing. Basic earnings and cash flow have an upward trend with
allowance made for unusual circumstances. Typically, the issuer's industry is
well established and the issuer has a strong position within the industry.
The rating PRIME-1 is the highest commercial paper rating assigned by
Moody's. Among the factors considered by Moody's in assigning ratings are the
following: (1) evaluation of the management of the issuer; (2) economic
evaluation of the issuer's industry or industries and an appraisal of
speculative-type risks which may be inherent in certain areas; (3) evaluation of
the issuer's products in relation to competition and customer acceptance; (4)
liquidity; (5) amount and quality of long-term debt; (6) trend of earnings over
a period of ten years; (7) financial strength of a parent company and the
relationships which exist with the issuer; and (8) recognition by the management
of obligations which may be present or may arise as a result of public
preparations to meet such obligations. Relative strength or weakness of the
above factors determines how the issuer's commercial paper is rated within
various categories.
The rating F-1 is the highest rating assigned by Fitch. Among the factors
considered by Fitch in assigning this rating are: (1) the issuer's liquidity;
(2) its standing in the industry; (3) the size of its debt; (4) its ability to
service its debt; (5) its profitability; (6) its return on equity; (7) its
alternative sources of financing; and (8) its ability to access the capital
markets. Analysis of the relative strength or weakness of these factors and
others determines whether an issuer's commercial paper is rated F-1.
UNITED STATES GOVERNMENT SECURITIES
Securities issued or guaranteed by the United States Government include a
variety of Treasury securities that differ only in their interest rates,
maturities and dates of issuance. Treasury bills have maturities of one year or
less. Treasury notes have maturities of one to ten years and Treasury bonds
generally have maturities of greater than ten years at the date of issuance.
Securities issued or guaranteed by the United States Government or its
agencies or instrumentalities include direct obligations of the United States
Treasury and securities issued or guaranteed by the Federal Housing
Administration, Farmers Home Administration, Export-Import Bank of the United
States, Small Business Administration, Government National Mortgage Association,
General Services Administration, Central Bank for Cooperatives, Federal Home
Loan Banks, Federal Loan Mortgage Corporation, Federal Intermediate Credit
Banks, Federal Land Banks, Maritime Administration, The Tennessee Valley
Authority, District of Columbia Armory Board and Federal National Mortgage
Association.
Some obligations of United States Government agencies and
instrumentalities, such as Treasury bills and Government National Mortgage
Association pass-through certificates, are supported by the full faith and
credit of the United States; others, such as securities of Federal Home Loan
Banks, by the right of the issuer to borrow from the Treasury; still others,
such as bonds issued by the Federal National Mortgage Association, a private
corporation, are supported only by the credit of the instrumentality. Because
the United States Government is not obligated by law to provide support to an
instrumentality it sponsors, the Fund will invest in the securities issued by
such an instrumentality only when Keystone determines that the credit risk with
respect to the instrumentality does not make its securities unsuitable
investments. United States Government securities will not include international
agencies or instrumentalities in which the United States Government, its
agencies or instrumentalities participate, such as the World Bank, the Asian
Development Bank or the InterAmerican Development Bank, or issues insured by the
Federal Deposit Insurance Corporation.
CERTIFICATES OF DEPOSIT
Certificates of deposit are receipts issued by a bank in exchange for the
deposit of funds. The issuer agrees to pay the amount deposited plus interest to
the bearer of the receipt on the date specified on the certificate. The
certificate usually can be traded in the secondary market prior to maturity.
Certificates of deposit will be limited to U.S. dollar- denominated
certificates of United States banks, including their branches abroad, and of
U.S. branches of foreign banks which are members of the Federal Reserve System
or the Federal Deposit Insurance Corporation and have at least $1 billion in
assets as of the date of their most recently published financial statements.
The Fund will not acquire time deposits or obligations issued by the
International Bank for Reconstruction and Development, the Asian Development
Bank or the Inter-American Development Bank. Additionally, the Fund does not
currently intend to purchase such foreign securities (except to the extent that
certificates of deposit of foreign branches of U.S. banks may be deemed foreign
securities) or purchase certificates of deposit, bankers' acceptances or other
similar obligations issued by foreign banks.
BANKERS' ACCEPTANCES
Bankers' acceptances typically arise from short term credit arrangements
designed to enable businesses to obtain funds to finance commercial
transactions. Generally, an acceptance is a time draft drawn on a bank by an
exporter or an importer to obtain a stated amount of funds to pay for specific
merchandise. The draft is then "accepted" by the bank that, in effect,
unconditionally guarantees to pay the face value of the instrument on its
maturity date. The acceptance may then be held by the accepting bank as an
earning asset or it may be sold in the secondary market at the going rate of
discount for a specific maturity. Although maturities for acceptances can be as
long as 270 days, most acceptances have maturities of six months or less.
Bankers' acceptances acquired by the Fund must have been accepted by U.S.
commercial banks, including foreign branches of U.S. commercial banks, having
total deposits at the time of purchase in excess of $1 billion and must be
payable in U.S. dollars.
OPTIONS TRANSACTIONS
WRITING COVERED OPTIONS
The Fund writes only covered options. Options written by the Fund will
normally have expiration dates of not more than nine months from the date
written. The exercise price of the options may be below, equal to, or above the
current market values of the underlying securities at the times the options are
written.
Unless the option has been exercised, the Fund may close out an option it
has written by effecting a closing purchase transaction, whereby it purchases an
option covering the same underlying security and having the same exercise price
and expiration date ("of the same series") as the one it has written. If the
Fund desires to sell a particular security on which it has written a call
option, it will effect a closing purchase transaction prior to or concurrently
with the sale of the security. If the Fund is able to enter into a closing
purchase transaction, the Fund will realize a profit (or loss) from such
transaction if the cost of such transaction is less (or more) than the premium
received from the writing of the option.
An option position may be closed out only in a secondary market for an
option of the same series. Although the Fund will generally write only those
options for which there appears to be an active secondary market, there is no
assurance that a liquid secondary market will exist for any particular option at
any particular time, and for some options no secondary market may exist. In such
event it might not be possible to effect a closing transaction in a particular
option. If the Fund as a covered call option writer is unable to effect a
closing purchase transaction, it will not be able to sell the underlying
securities until the option expires or it delivers the underlying securities
upon exercise.
Because the Fund intends to qualify as a regulated investment company under
the Internal Revenue Code, the extent to which the Fund may write covered call
options and enter into so-called "straddle" transactions involving put and call
options may be limited.
Many options are traded on registered securities exchanges. Options traded
on such exchanges are issued by the Options Clearing Corporation ("OCC"), a
clearing corporation which assumes responsibility for the completion of options
transactions.
PURCHASING PUT AND CALL OPTIONS
The Fund can close out a put or call option it has written by effecting a
closing purchase transaction; for example, the Fund may close out a put option
it has written by buying an option identical to the one it has written. If,
however, a secondary market does not exist at a time the Fund wishes to effect a
closing sale transaction, the Fund will have to exercise the option to realize
any profit. If a covered call option writer cannot effect a closing transaction
it cannot sell the underlying security until the option expires or is exercised.
In addition, in a transaction in which the Fund does not own the security
underlying a put option it has purchased, the Fund would be required, in the
absence of a secondary market, to purchase the underlying security before it
could exercise the option, thereby incurring additional transaction costs.
The Fund will not purchase a put option if, as a result of such purchase,
more than 10% of its total assets would be invested in premiums for such
options. The Fund's ability to purchase put and call options may be limited by
the Internal Revenue Code's requirements for qualification as a regulated
investment company.
OPTION WRITING AND RELATED RISKS
The Fund may write covered call and put options. A call option gives the
purchaser of the option the right to buy, and the writer the obligation to sell,
the underlying security at the exercise price during the option period.
Conversely, a put option gives the purchaser the right to sell, and the writer
the obligation to buy, the underlying security at the exercise price during the
option period.
So long as the obligation of the writer continues, the writer may be
assigned an exercise notice by the broker-dealer through whom the option was
sold. The exercise notice would require the writer to deliver, in the case of a
call, or take delivery of, in the case of a put, the underlying security against
payment of the exercise price. This obligation terminates upon expiration of the
option, or at such earlier time as the writer effects a closing purchase
transaction by purchasing an option of the same series as the one previously
sold. Once an option has been exercised, the writer may not execute a closing
purchase transaction. For options traded on national securities exchanges
(Exchanges), to secure the obligation to deliver the underlying security in the
case of a call option, the writer of the option is required to deposit in escrow
the underlying security or other assets in accordance with the rules of the OCC,
an institution created to interpose itself between buyers and sellers of
options. Technically, the OCC assumes the order side of every purchase and sale
transaction on an Exchange and, by doing so, gives its guarantee to the
transaction.
The principal reason for writing options on a securities portfolio is to
attempt to realize, through the receipt of premiums, a greater return than would
be realized on the underlying securities alone. In return for the premium, the
covered call option writer has given up the opportunity for profit from a price
increase in the underlying security above the exercise price so long as the
option remains open, but retains the risk of loss should the price of the
security decline. Conversely, the put option writer gains a profit, in the form
of a premium, so long as the price of the underlying security remains above the
exercise price, but assumes an obligation to purchase the underlying security
from the buyer of the put option at the exercise price, even though the security
may fall below the exercise price, at any time during the option period. If an
option expires, the writer realizes a gain in the amount of the premium. Such a
gain may, in the case of a covered call option, be offset by a decline in the
market value of the underlying security during the option period. If a call
option is exercised, the writer realizes a gain or loss from the sale of the
underlying security. If a put option is exercised, the writer must fulfill his
obligation to purchase the underlying security at the exercise price, which will
usually exceed the then market value of the underlying security. In addition,
the premium paid for the put effectively increases the cost of the underlying
security, thus reducing the yield otherwise available from such securities.
Because the Fund can write only covered options, it may at times be unable
to write additional options unless it sells a portion of its portfolio holdings
to obtain new debt securities against which it can write options. This may
result in higher portfolio turnover and correspondingly greater brokerage
commissions and other transaction costs.
To the extent that a secondary market is available the covered option
writer may close out options it has written prior to the assignment of an
exercise notice by purchasing, in a closing purchase transaction, an option of
the same series as the option previously written. If the cost of such a closing
purchase, plus transaction costs, is greater than the premium received upon
writing the original option, the writer will incur a loss in the transaction.
OPTIONS TRADING MARKETS
Options which the Fund will trade are generally listed on Exchanges.
Exchanges on which such options currently are traded are the New York Stock
Exchange, Chicago Board Options Exchange and the American, Pacific, and
Philadelphia Stock Exchanges. Options on some securities may not be listed on
any Exchange but traded in the over-the-counter market. Options traded in the
over-the-counter market involve the additional risk that securities dealers
participating in such transactions would fail to meet their obligations to the
Fund. The use of options traded in the over-the-counter market may be subject to
limitations imposed by certain state securities authorities. In addition to the
limits on its use of options discussed herein, the Fund is subject to the
investment restrictions described in the prospectus and the statement of
additional information.
SPECIAL CONSIDERATIONS APPLICABLE TO OPTIONS
ON TREASURY BONDS AND NOTES. Because trading interest in U.S. Treasury
bonds and notes tends to center on the most recently auctioned issues, new
series of options with expirations to replace expiring options on particular
issues will not be introduced indefinitely. Instead, the expirations introduced
at the commencement of options trading on a particular issue will be allowed to
run their course, with the possible addition of a limited number of new
expirations as the original ones expire. Options trading on each series of bonds
or notes will thus be phased out as new options are listed on the more recent
issues, and a full range of expiration dates will not ordinarily be available
for every series on which options are traded.
ON TREASURY BILLS. Because the deliverable U.S. Treasury bill changes from
week to week, writers of U.S. Treasury bill call options cannot provide in
advance for their potential exercise settlement obligations by acquiring and
holding the underlying security. However, if the Fund holds a long position in
U.S. Treasury bills with a principal amount corresponding to the option contract
size, the Fund may be hedged from a risk standpoint. In addition, the Fund will
maintain in a segregated account with its Custodian liquid assets maturing no
later than those which would be deliverable in the event of an assignment of an
exercise notice to ensure that it can meet its open option obligations.
ON GNMA CERTIFICATES. Options on GNMA certificates are not currently traded
on any Exchange. However, the Fund may purchase and write such options in the
over the counter market or, should they commence trading, on any Exchange.
Since the remaining principal balance of GNMA certificates declines each
month as a result of mortgage payments, the Fund, as a writer of a covered GNMA
call holding GNMA certificates as "cover" to satisfy its delivery obligation in
the event of assignment of an exercise notice, may find that its GNMA
certificates no longer have a sufficient remaining principal balance for this
purpose. Should this occur, the Fund will enter into a closing purchase
transaction or will purchase additional GNMA certificates from the same pool (if
obtainable) or replacement GNMA certificates in the cash market in order to
remain covered.
A GNMA certificate held by the Fund to cover an option position in any but
the nearest expiration month may cease to present cover for the option in the
event of a decline in the GNMA coupon rate at which new pools are originated
under the FHA/VA loan ceiling in effect at any given time. Should this occur,
the Fund will no longer be covered, and the Fund will either enter into a
closing purchase transaction or replace the GNMA certificate with a certificate
which represents cover. When the Fund closes its position or replaces the GNMA
certificate, it may realize an unanticipated loss and incur transaction costs.
RISKS PERTAINING TO THE SECONDARY MARKET. An option position may be closed
out only in a secondary market for an option of the same series. Although the
Fund will generally purchase or write only those options for which there appears
to be an active secondary market, there is no assurance that a liquid secondary
market will exist for any particular option at any particular time, and for some
options no secondary market may exist. In such event, it might not be possible
to effect closing transactions in particular options, with the result that the
Fund would have to exercise its options in order to realize any profit and might
incur transaction costs in connection therewith. If the Fund as a covered call
option writer is unable to effect a closing purchase transaction in a secondary
market, it will not be able to sell the underlying security until the option
expires or it delivers the underlying security upon exercise.
Reasons for the absence of a liquid secondary market include the following:
(i) insufficient trading interest in certain options; (ii) restrictions imposed
on transactions (iii) trading halts, suspensions or other restrictions imposed
with respect to particular classes or series of options or underlying
securities; (iv) interruption of the normal operations on an Exchange or by a
broker; (v) inadequacy of the facilities of an Exchange, the OCC or a broker to
handle current trading volume; or (vi) a decision by one or more Exchanges or a
broker to discontinue the trading of options (or a particular class or series of
options), in which event the secondary market in that class or series of options
would cease to exist, although outstanding options that had been issued as a
result of trades would generally continue to be exercisable in accordance with
their terms.
The hours of trading for options on U.S. government securities may not
conform to the hours during which the underlying securities are traded. To the
extent that the option markets close before the markets for the underlying
securities, significant price and rate movements can take place in the
underlying markets that cannot be reflected in the option markets.
FUTURES CONTRACTS AND RELATED OPTIONS TRANSACTIONS
The Fund intends to enter into currency and other financial futures
contracts as a hedge against changes in prevailing levels of interest or
currency exchange rates to seek relative stability of principal and to establish
more definitely the effective return on securities held or intended to be
acquired by the Fund or as a hedge against changes in the prices of securities
or currencies held by the Fund or to be acquired by the Fund. The Fund's hedging
may include sales of futures as an offset against the effect of expected
increases in interest or currency exchange rates or securities prices and
purchases of futures as an offset against the effect of expected declines in
interest or currency exchange rates or securities prices.
For example, when the Fund anticipates a significant market or market
sector advance, it will purchase a stock index futures contract as a hedge
against not participating in such advance at a time when the Fund is not fully
invested. The purchase of a futures contract serves as a temporary substitute
for the purchase of individual securities which may then be purchased in an
orderly fashion. As such purchases are made, an equivalent amount of index based
futures contracts would be terminated by offsetting sales. In contrast, the Fund
would sell stock index futures contracts in anticipation of or in a general
market or market sector decline that may adversely affect the market value of
the Fund's portfolio. To the extent that the Fund's portfolio changes in value
in correlation with a given index, the sale of futures contracts on that index
would substantially reduce the risk to the portfolio of a market decline or
change in interest rates, and, by so doing, provide an alternative to the
liquidation of the Fund's securities positions and the resulting transaction
costs.
The Fund intends to engage in options transactions which are related to
commodity futures contracts for hedging purposes and in connection with the
hedging strategies described above.
Although techniques other than sales and purchases of futures contracts and
related options transactions could be used to reduce the Fund's exposure to
interest rate and/or market fluctuations, the Fund may be able to hedge its
exposure more effectively and perhaps at a lower cost through using futures
contracts and related options transactions. While the Fund does not intend to
take delivery of the instruments underlying futures contracts it holds, the Fund
does not intend to engage in such futures contracts for speculation.
FUTURES CONTRACTS
Futures contracts are transactions in the commodities markets rather than
in the securities markets. A futures contract creates an obligation by the
seller to deliver to the buyer the commodity specified in the contract at a
specified future time for a specified price. The futures contract creates an
obligation by the buyer to accept delivery from the seller of the commodity
specified at the specified future time for the specified price. In contrast, a
spot transaction creates an immediate obligation for the seller to deliver and
the buyer to accept delivery of and pay for an identified commodity. In general,
futures contracts involve transactions in fungible goods such as wheat, coffee
and soybeans. However, in the last decade an increasing number of futures
contracts have been developed which specify currencies, financial instruments or
financially based indexes as the underlying commodity.
U.S. futures contracts are traded only on national futures exchanges and
are standardized as to maturity date and underlying financial instrument. The
principal financial futures exchanges in the United States are The Board of
Trade of the City of Chicago, the Chicago Mercantile Exchange, the International
Monetary Market (a division of the Chicago Mercantile Exchange), the New York
Futures Exchange and the Kansas City Board of Trade. Each exchange guarantees
performance under contract provisions through a clearing corporation, a
nonprofit organization managed by the exchange membership, which is also
responsible for handling daily accounting of deposits or withdrawals of margin.
A futures commission merchant (Broker) effects each transaction in connection
with futures contracts for a commission. Futures exchanges and trading are
regulated under the Commodity Exchange Act by the Commodity Futures Trading
Commission (CFTC) and National Futures Association (NFA).
INTEREST RATE FUTURES CONTRACTS
The sale of an interest rate futures contract creates an obligation by the
Fund, as seller, to deliver the type of financial instrument specified in the
contract at a specified future time for a specified price. The purchase of an
interest rate futures contract creates an obligation by the Fund, as purchaser,
to accept delivery of the type of financial instrument specified at a specified
future time for a specified price. The specific securities delivered or
accepted, respectively, at settlement date, are not determined until at or near
that date. The determination is in accordance with the rules of the exchange on
which the futures contract sale or purchase was made.
Currently, interest rate futures contracts can be purchased or sold on
90-day U.S. Treasury bills, U.S. Treasury bonds, U.S. Treasury notes with
maturities between 6 1/2 and 10 years, Government National Mortgage Association
(GNMA) certificates, 90- day domestic bank certificates of deposit, 90-day
commercial paper, and 90-day Eurodollar certificates of deposit. It is expected
that futures contracts trading in additional financial instruments will be
authorized. The standard contract size is $100,000 for futures contracts in U.S.
Treasury bonds, U.S. Treasury notes and GNMA certificates, and $1,000,000 for
the other designated contracts. While U.S. Treasury bonds, U.S. Treasury bills
and U.S. Treasury notes are backed by the full faith and credit of the U.S.
government and GNMA certificates are guaranteed by a U.S. government agency, the
futures contracts in U.S. government securities are not obligations of the U.S.
Treasury.
INDEX BASED FUTURES CONTRACTS
STOCK INDEX FUTURES CONTRACTS
A stock index assigns relative values to the common stocks included in the
index. The index fluctuates with changes in the market values of the common
stocks so included. A stock index futures contract is a bilateral agreement by
which two parties agree to take or make delivery of an amount of cash equal to a
specified dollar amount times the difference between the closing value of the
stock index on the expiration date of the contract and the price at which the
futures contract is originally made. No physical delivery of the underlying
stocks in the index is made.
Currently stock index futures contracts can be purchased or sold on the
Standard and Poor's Corporation ("S&P") Index of 500 Stocks, the S&P Index of
100 Stocks, the New York Stock Exchange Composite Index, the Value Line Index
and the Major Market Index. It is expected that futures contracts trading in
additional stock indices will be authorized. The standard contract size is $500
times the value of the index.
The Fund does not believe that differences between existing stock indices
will create any differences in the price movements of the stock index futures
contracts in relation to the movements in such indices. However, such
differences in the indices may result in differences in correlation of the
futures with movements in the value of the securities being hedged.
OTHER INDEX BASED FUTURES CONTRACTS
It is expected that bond index and other financially based index futures
contracts will be developed in the future. It is anticipated that such index
based futures contracts will be structured in the same way as stock index
futures contracts but will be measured by changes in interest rates, related
indexes or other measures, such as the consumer price index. In the event that
such futures contracts are developed the Fund will sell interest rate index and
other index based futures contracts to hedge against changes which are expected
to affect the Fund's portfolio.
The purchase or sale of a futures contract differs from the purchase or
sale of a security, in that no price or premium is paid or received. Instead, to
initiate trading an amount of cash, cash equivalents, money market instruments,
or U.S. Treasury bills equal to approximately 1 1/2% (up to 5%) of the contract
amount must be deposited by the Fund with the Broker. This amount is known as
initial margin. The nature of initial margin in futures transactions is
different from that of margin in security transactions. Futures contract margin
does not involve the borrowing of funds by the customer to finance the
transactions. Rather, the initial margin is in the nature of a performance bond
or good faith deposit on the contract which is returned to the Fund upon
termination of the futures contract assuming all contractual obligations have
been satisfied. The margin required for a particular futures contract is set by
the exchange on which the contract is traded, and may be significantly modified
from time to time by the exchange during the term of the contract.
Subsequent payments, called variation margin, to the Broker and from the
Broker, are made on a daily basis as the value of the underlying instrument or
index fluctuates making the long and short positions in the futures contract
more or less valuable, a process known as mark-to-market. For example, when the
Fund has purchased a futures contract and the price of the underlying financial
instrument or index has risen, that position will have increased in value and
the Fund will receive from the Broker a variation margin payment equal to that
increase in value. Conversely, where the Fund has purchased a futures contract
and the price of the underlying financial instrument or index has declined, the
position would be less valuable and the Fund would be required to make a
variation margin payment to the Broker. At any time prior to expiration of the
futures contract, the Fund may elect to close the position. A final
determination of variation margin is then made, additional cash is required to
be paid to or released by the Broker, and the Fund realizes a loss or gain.
The Fund intends to enter into arrangements with its custodian and with
Brokers to enable its initial margin and any variation margin to be held in a
segregated account by its custodian on behalf of the Broker.
Although interest rate futures contracts by their terms call for actual
delivery or acceptance of financial instruments, and index based futures
contracts call for the delivery of cash equal to the difference between the
closing value of the index on the expiration date of the contract and the price
at which the futures contract is originally made, in most cases such futures
contracts are closed out before the settlement date without the making or taking
of delivery. Closing out a futures contract sale is effected by an offsetting
transaction in which the Fund enters into a futures contract purchase for the
same aggregate amount of the specific type of financial instrument or index and
same delivery date. If the price in the sale exceeds the price in the offsetting
purchase, the Fund is paid the difference and thus realizes a gain. If the
offsetting purchase price exceeds the sale price, the Fund pays the difference
and realizes a loss. Similarly, the closing out of a futures contract purchase
is effected by an offsetting transaction in which the Fund enters into a futures
contract sale. If the offsetting sale price exceeds the purchase price, the Fund
realizes a gain. If the purchase price exceeds the offsetting sale price the
Fund realizes a loss. The amount of the Fund's gain or loss on any transaction
is reduced or increased, respectively, by the amount of any transaction costs
incurred by the Fund.
As an example of an offsetting transaction, the contractual obligations
arising from the sale of one contract of September U.S. Treasury bills on an
exchange may be fulfilled at any time before delivery of the contract is
required (i.e., on a specified date in September, the "delivery month") by the
purchase of one contract of September U.S. Treasury bills on the same exchange.
In such instance the difference between the price at which the futures contract
was sold and the price paid for the offsetting purchase after allowance for
transaction costs represents the profit or loss to the Fund.
There can be no assurance, however, that the Fund will be able to enter
into an offsetting transaction with respect to a particular contract at a
particular time. If the Fund is not able to enter into an offsetting
transaction, the Fund will continue to be required to maintain the margin
deposits on the contract and to complete the contract according to its terms.
OPTIONS ON CURRENCY AND OTHER FINANCIAL FUTURES
The Fund intends to purchase call and put options on currency and other
financial futures contracts and sell such options to terminate an existing
position. Options on currency and other financial futures contracts are similar
to options on stocks except that an option on a currency or other financial
futures contract gives the purchaser the right, in return for the premium paid,
to assume a position in a futures contract (a long position if the option is a
call and a short position if the option is a put) rather than to purchase or
sell stock, currency or other financial instruments at a specified exercise
price at any time during the period of the option. Upon exercise of the option,
the delivery of the futures position by the writer of the option to the holder
of the option will be accompanied by delivery of the accumulated balance in the
writer's futures margin account. This amount represents the amount by which the
market price of the futures contract at exercise exceeds, in the case of a call,
or is less than, in the case of a put, the exercise price of the option on the
futures contract. If an option is exercised on the last trading day prior to the
expiration date of the option, the settlement will be made entirely in cash
equal to the difference between the exercise price of the option and value of
the futures contract.
The Fund intends to use options on currency and other financial futures
contracts in connection with hedging strategies. In the future the Fund may use
such options for other purposes.
PURCHASE OF PUT OPTIONS ON FUTURES CONTRACTS
The purchase of protective put options on currency or other financial
futures contracts is analagous to the purchase of protective puts on individual
stocks, where an absolute level of protection is sought below which no
additional economic loss would be incurred by the Fund. Put options may be
purchased to hedge a portfolio of stocks or debt instruments or a position in
the futures contract upon which the put option is based.
PURCHASE OF CALL OPTIONS ON FUTURES CONTRACTS
The purchase of a call option on a currency or other financial futures
contract represents a means of obtaining temporary exposure to market
appreciation at limited risk. It is analogous to the purchase of a call option
on an individual stock which can be used as a substitute for a position in the
stock itself. Depending on the pricing of the option compared to either the
futures contract upon which it is based, or upon the price of the underlying
financial instrument or index itself, the purchase of a call option may be less
risky than the ownership of the interest rate or index based futures contract or
the underlying securities. Call options on commodity futures contracts may be
purchased to hedge against an interest rate increase or a market advance when
the Fund is not fully invested.
USE OF NEW INVESTMENT TECHNIQUES INVOLVING CURRENCY OR OTHER
FINANCIAL FUTURES CONTRACTS OR RELATED OPTIONS
The Fund may employ new investment techniques involving currency and other
financial futures contracts and related options. The Fund intends to take
advantage of new techniques in these areas which may be developed from time to
time and which are consistent with the Fund's investment objective. The Fund
believes that no additional techniques have been identified for employment by
the Fund in the foreseeable future other than those described above.
LIMITATIONS ON PURCHASE AND SALE OF FUTURES CONTRACTS AND RELATED OPTIONS ON
SUCH FUTURES CONTRACTS
The Fund will not enter into a futures contract if, as a result thereof,
more than 5% of the Fund's total assets (taken at market value at the time of
entering into the contract) would be committed to margin deposits on such
futures contracts.
The Fund intends that its futures contracts and related options
transactions will be entered into for traditional hedging purposes. That is,
futures contracts will be sold to protect against a decline in the price of
securities that the Fund owns or futures contracts will be purchased to protect
the Fund against an increase in the price of securities it intends to purchase.
The Fund does not intend to enter into futures contracts for speculation.
In instances involving the purchase of futures contracts by the Fund, an
amount of cash and cash equivalents equal to the market value of the futures
contracts will be deposited in a segregated account with the Fund's Custodian
and/or in a margin account with a Broker to collateralize the position and
thereby insure that the use of such futures is unleveraged.
FEDERAL INCOME TAX TREATMENT
For federal income tax purposes, the Fund is required to recognize as
income for each taxable year its net unrealized gains and losses on futures
contracts as of the end of the year as well as those actually realized during
the year. Any gain or loss recognized with respect to a futures contract is
considered to be 60% long term and 40% short term, without regard to the holding
period of the contract. In the case of a futures transaction classified as a
"mixed straddle," the recognition of losses may be deferred to a later taxable
year. The federal income tax treatment of gains or losses from transactions in
options on futures is unclear.
In order for the Fund to continue to qualify for federal income tax
treatment as a regulated investment company, at least 90% of its gross income
for a taxable year must be derived from qualifying income. Any net gain realized
from the closing out of futures contracts, for purposes of the 90% requirement,
will be qualifying income. In addition, gains realized on the sale or other
disposition of securities held for less than three months must be limited to
less than 30% of the Fund's annual gross income. The 1986 Tax Act added a
provision which effectively treats both positions in certain hedging
transactions as a single transaction for the purpose of the 30% requirement. The
provision provides that, in the case of any "designated hedge," increases and
decreases in the value of positions of the hedge are to be netted for the
purposes of the 30% requirement. However, in certain situations, in order to
avoid realizing a gain within a three month period, the Fund may be required to
defer the closing out of a contract beyond the time when it would otherwise be
advantageous to do so.
RISKS OF FUTURES CONTRACTS
Currency and other financial futures contracts prices are volatile and are
influenced, among other things, by changes in stock prices, market conditions,
prevailing interest rates and anticipation of future stock prices, market
movements or interest rate changes, all of which in turn are affected by
economic conditions, such as government fiscal and monetary policies and
actions, and national and international political and economic events.
At best, the correlation between changes in prices of futures contracts and
of the securities being hedged can be only approximate. The degree of
imperfection of correlation depends upon circumstances, such as variations in
speculative market demand for futures contracts and for securities, including
technical influences in futures contracts trading; differences between the
securities being hedged and the financial instruments and indexes underlying the
standard futures contracts available for trading, in such respects as interest
rate levels, maturities and creditworthiness of issuers, or identities of
securities comprising the index and those in the Fund's portfolio. A decision of
whether, when and how to hedge involves the exercise of skill and judgment, and
even a well-conceived hedge may be unsuccessful to some degree because of market
behavior or unexpected interest rate trends.
Because of the low margin deposits required, futures trading involves an
extremely high degree of leverage. As a result, a relatively small price
movement in a futures contract may result in immediate and substantial loss, as
well as gain, to the investor. For example, if at the time of purchase, 10% of
the value of the futures contract is deposited as margin, a 10% decrease in the
value of the futures contract would result in a total loss of the margin
deposit, before any deduction for the transaction costs, if the account were
then closed out, and a 15% decrease would result in a loss equal to 150% of the
original margin deposit. Thus, a purchase or sale of a futures contract may
result in losses in excess of the amount invested in the futures contract.
However, the Fund would presumably have sustained comparable losses if, instead
of entering into the futures contract, it had invested in the underlying
financial instrument. Furthermore, in order to be certain that the Fund has
sufficient assets to satisfy its obligations under a futures contract, the Fund
will establish a segregated account in connection with its futures contracts
which will hold cash or cash equivalents equal in value to the current value of
the underlying instruments or indices less the margins on deposit.
Most U.S. futures exchanges limit the amount of fluctuation permitted in
futures contract prices during a single trading day. The daily limit establishes
the maximum amount that the price of a futures contract may vary either up or
down from the previous day's settlement price at the end of a trading session.
Once the daily limit has been reached in a particular type of contract, no
trades may be made on that day at a price beyond that limit. The daily limit
governs only price movement during a particular trading day and therefore does
not limit potential losses because the limit may prevent the liquidation of
unfavorable positions. Futures contract prices have occasionally moved to the
daily limit for several consecutive trading days with little or no trading,
thereby preventing prompt liquidation of futures positions and subjecting some
futures traders to substantial losses.
RISKS OF OPTIONS ON FUTURES CONTRACTS
In addition to the risks described above for currency and other financial
futures contracts, there are several special risks relating to options on
futures contracts. The ability to establish and close out positions on such
options will be subject to the development and maintenance of a liquid secondary
market. There is no assurance that a liquid secondary market will exist for any
particular contract or at any particular time. The Fund will not purchase
options on any futures contract unless and until it believes that the market for
such options has developed sufficiently that the risks in connection with such
options are not greater than the risks in connection with the futures contracts.
Compared to the use of futures contracts, the purchase of options on such
futures contracts involves less potential risk to the Fund because the maximum
amount at risk is the premium paid for the options (plus transaction costs).
However, there may be circumstances when the use of an option on a futures
contract would result in a loss to the Fund, even though the use of a futures
contract would not, such as when there is no movement in the level of the
futures contract.
FOREIGN CURRENCY TRANSACTIONS
The Fund may invest in securities of foreign issuers. When the Fund invests
in foreign securities they usually will be denominated in foreign currencies and
the Fund temporarily may hold funds in foreign currencies. Thus, the Fund's
share value will be affected by changes in exchange rates.
FORWARD CURRENCY CONTRACTS
As one way of managing exchange rate risk, the Fund may engage in forward
currency exchange contracts (agreements to purchase or sell currencies at a
specified price and date). Under the contract, the exchange rate for the
transaction (the amount of currency the Fund will deliver or receive when the
contract is completed) is fixed when the Fund enters into the contract. The Fund
usually will enter into these contracts to stabilize the U.S. dollar value of a
security it has agreed to buy or sell. The Fund also may use these contracts to
hedge the U.S. dollar value of a security it already owns, particularly if the
Fund expects a decrease in the value of the currency in which the foreign
security is denominated. Although the Fund will attempt to benefit from using
forward contracts, the success of its hedging strategy will depend on Keystone's
ability to predict accurately the future exchange rate between foreign
currencies and the U.S. dollar. The value of the Fund's investments denominated
in foreign currencies will depend on the relative strength of those currencies
and the U.S. dollar, and the Fund may be affected favorably or unfavorably by
changes in the exchange rates or exchange control regulations between foreign
currencies and the dollar. Changes in foreign currency exchange rates also may
affect the value of dividends and interest earned, gains and losses realized on
the sale of securities and net investment income and gains, if any, to be
distributed to shareholders by the Fund.
CURRENCY FUTURES CONTRACTS
Currency futures contracts are bilateral agreements under which two parties
agree to take or make delivery of a specified amount of a currency at a
specified future time for a specified price. Trading of currency futures
contracts in the United States is regulated under the Commodity Exchange Act by
the Commodity Futures Trading Commission (CFTC) and National Futures Association
(NFA). Currently the only national futures exchange on which currency futures
are traded is the International Monetary Market of the Chicago Mercantile
Exchange. Foreign currency futures trading is conducted in the same manner and
subject to the same regulations as trading in interest rate and index based
futures. The Fund intends to engage in currency futures contracts only for
hedging purposes, and not for speculation. The Fund may engage in currency
futures contracts for other purposes if authorized to do so by the Board. The
hedging strategies which will be used by the Fund in connection with foreign
currency futures contracts are similar to those described above for forward
foreign currency exchange contracts.
Currently, currency futures contracts for the British Pound Sterling,
Canadian Dollar, Dutch Guilder, Deutsche Mark, Japanese Yen, Mexican Peso, Swiss
Franc and French Franc can be purchased or sold for U.S. dollars through the
International Monetary Market. It is expected that futures contracts trading in
additional currencies will be authorized. The standard contract sizes are
L125,000 for the Pound, 125,000 for the Guilder, Mark, French Francs and Swiss
Francs, C$100,000 for the Canadian Dollar, Y12,500,000 for the Yen, and
1,000,000 for the Peso. In contrast to forward currency exchange contracts which
can be traded at any time, only four value dates per year are available, the
third Wednesday of March, June, September and December.
FOREIGN CURRENCY OPTIONS TRANSACTIONS
Foreign currency options (as opposed to futures) are traded in a variety of
currencies in both the United States and Europe. On the Philadelphia Stock
Exchange, for example, contracts for half the size of the corresponding futures
contracts on the Chicago Board Options Exchange are traded with up to nine
months maturity in marks, sterling, yen, Swiss francs and Canadian dollars.
Options can be exercised at any time during the contract life and require a
deposit subject to normal margin requirements. Since a futures contract must be
exercised, the Fund must continually make up the margin balance. As a result, a
wrong price move could result in the Fund losing more than the original
investment as it cannot walk away from the futures contract as it can an option
contract.
The Fund will purchase call and put options and sell such op tions to
terminate an existing position. Options on foreign currency are similar to
options on stocks except that an option on an interest rate and/or index based
futures contract gives the purchaser the right, in return for the premium paid,
to purchase or sell foreign currency, rather than to purchase or sell stock, at
a specified exercise price at any time during the period of the option.
The Fund intends to use foreign currency option transactions in connection
with hedging strategies.
PURCHASE OF PUT OPTIONS ON FOREIGN CURRENCIES
The purchase of protective put options on a foreign currency is analagous
to the purchase of protective puts on individual stocks, where an absolute level
of protection is sought below which no additional economic loss would be
incurred by the Fund.
Put options may be purchased to hedge a portfolio of foreign stocks or foreign
debt instruments or a position in the foreign currency upon which the put option
is based.
PURCHASE OF CALL OPTIONS ON FOREIGN CURRENCIES
The purchase of a call option on foreign currency represents a means of
obtaining temporary exposure to market appreciation at limited risk. It is
analogous to the purchase of a call option on an individual stock which can be
used as a substitute for a position in the stock itself. Depending on the
pricing of the option compared to either the foreign currency upon which it is
based, or upon the price of the foreign stock or foreign debt instruments, the
purchase of a call option may be less risky than the ownership of the foreign
currency or the foreign securities. The Fund would purchase a call option on a
foreign currency to hedge against an increase in the foreign currency or a
foreign market advance when the Fund is not fully invested.
The Fund may employ new investment techniques involving forward foreign
currency exchange contracts, foreign currency futures contracts and options on
foreign currencies in order to take advantage of new techniques in these areas
which may be developed from time to time and which are consistent with the
Fund's investment objective. The Fund believes that no additional techniques
have been identified for employment by the Fund in the foreseeable future other
than those described above.
CURRENCY TRADING RISKS
Currency exchange trading may involve significant risks. The four major
types of risk the Fund faces are exchange rate risk, interest rate risk, credit
risk and country risk.
EXCHANGE RATE RISK
Exchange rate risk results from the movement up and down of foreign
currency values in response to shifting market supply and demand. When the Fund
buys or sells a foreign currency, an exposure called an open position is
created. Until the time that position can be "covered" by selling or buying an
equivalent amount of the same currency, the Fund is exposed to the risk that the
exchange rate might move against it. Since exchange rate changes can readily
move in one direction, a position carried overnight or over a number of days
involves greater risk than one carried a few minutes or hours. Techniques such
as foreign currency forward and futures contracts and options on foreign
currency are intended to be used by the Fund to reduce exchange rate risk.
MATURITY GAPS AND INTEREST RATE RISK
Interest rate risk arises whenever there are mismatches or gaps in the
maturity structure of the Fund's foreign exchange currency holdings, which is
the total of its outstanding spot and forward or futures contracts.
Foreign currency transactions often involve borrowing short term and
lending longer term to benefit from the normal tendency of interest rates to be
higher for longer maturities. However in foreign exchange trading, while the
maturity pattern of interest rates for one currency is important, it is the
differential between interest rates for two currencies that is decisive.
CREDIT RISK
Whenever the Fund enters into a foreign exchange contract, it faces a risk,
however small, that the counterparty will not perform under the contract. As a
result there is a credit risk, although no extension of "credit" is intended. To
limit credit risk, the Fund intends to evaluate the creditworthiness of each
other party. The Fund does not intend to trade more than 5% of its net assets
under foreign exchange contracts with one party.
Credit risk exists because the Fund's counterparty may be unable or
unwilling to fulfill its contractual obligations as a result of bankruptcy or
insolvency or when foreign exchange controls prohibit payment. In any foreign
exchange transaction, each party agrees to deliver a certain amount of currency
to the other on a particular date. In establishing its hedges a Fund relies on
each contract being completed. If the contract is not performed, then the Fund's
hedge is eliminated, and the Fund is exposed to any changes in exchange rates
since the contract was originated. To put itself in the same position it would
have been in had the contract been performed, the Fund must arrange a new
transaction. However, the new transaction may have to be arranged at an adverse
exchange rate. The trustee for a bankrupt company may elect to perform those
contracts which are advantageous to the company but disclaim those contracts
which are disadvantageous, resulting in losses to the Fund.
Another form of credit risk stems from the time zone differences between
the U.S. and foreign nations. If the Fund sells sterling it generally must pay
pounds to a counterparty earlier in the day than it will be credited with
dollars in New York. In the intervening hours, the buyer can go into bankruptcy
or can be declared insolvent. Thus, the dollars may never be credited to the
Fund.
COUNTRY RISK
At one time or another, virtually every country has interfered with
international transactions in its currency. Interference has taken the form of
regulation of the local exchange market, restrictions on foreign investment by
residents or limits on inflows of investment funds from abroad. Governments take
such measures for example to improve control over the domestic banking system or
to influence the pattern of receipts and payments between residents and
foreigners. In those cases, restrictions on the exchange market or on
international transactions are intended to affect the level or movement of the
exchange rate. Occasionally a serious foreign exchange shortage may lead to
payment interruptions or debt servicing delays, as well as interference in the
exchange market. It has become increasingly difficult to distinguish foreign
exchange or credit risk from country risk.
Changes in regulations or restrictions usually do have an important
exchange market impact. Most disruptive are changes in rules which interfere
with the normal payments mechanism. If government regulations change and a
counterparty is either forbidden to perform or is required to do something
extra, then the Fund might be left with an unintended open position or an
unintended maturity mismatch. Dealing with such unintended long or short
positions could result in unanticipated costs to the Fund.
Other changes in official regulations influence international investment
transactions. If one of the factors affecting the buying or selling of a
currency changes, the exchange rate is likely to respond. Changes in such
controls often are unpredictable and can create a significant exchange rate
response.
Many major countries have moved toward liberalization of exchange and
payments restrictions in recent years or accepted the principle that
restrictions should be relaxed. A few industrial countries have moved in the
other direction. Important liberalizations were carried out by Switzerland, the
United Kingdom and Japan. They dismantled mechanisms for restricting either
foreign exchange inflows (Switzerland), outflows (Britain) or elements of both
(Japan). By contrast, France and Mexico have tightened foreign exchange
controls.
Overall, many exchange markets are still heavily restricted. Several
countries limit access to the forward market to companies financing documented
export or import transactions in an effort to insulate the market from purely
speculative activities. Some of these countries permit local traders to enter
into forward contracts with residents but prohibit certain forward transactions
with nonresidents. By comparison, other countries have strict controls on
exchange transactions by residents, but permit free exchange transactions
between local traders and non-residents. A few countries have established tiered
markets, funneling commercial transactions through one market and financial
transactions through another. Outside the major industrial countries, relatively
free foreign exchange markets are rare and controls on foreign currency
transactions are extensive.
Another aspect of country risk has to do with the possibility that the Fund
may be dealing with a foreign trader whose home country is facing a payments
problem. Even though the foreign trader intends to perform on its foreign
exchange contracts, the contracts are tied to other external liabilities the
country has incurred. As a result performance may be delayed, and can result in
unanticipated cost to the Fund. This aspect of country risk is a major element
in the Fund's credit judgment as to with whom it will deal and in what amounts.
<PAGE>
SCHEDULE OF INVESTMENTS--June 30, 1994
See Notes to Schedule of Investments.
Number Market
of Shares Value
COMMON STOCKS (57.5%)
ADVERTISING AND PUBLISHING (1.1%)
Donnelly (R.R.) & Sons Co. 70,000 $ 1,942,500
Dun & Bradstreet Corp. 48,600 2,697,300
Gannett Inc. 46,800 2,316,600
Readers Digest Association, Inc.
Class A 20,000 830,000
Times Mirror, Class A 39,400 1,186,925
Tribune Co. 118,700 6,320,775
15,294,100
AEROSPACE (0.7%)
Boeing Co. 59,500 2,751,875
Honeywell Inc. 49,600 1,537,600
Raytheon Co. 34,000 2,201,500
Rockwell International Corp. 50,000 1,868,750
United Technologies Corp. 31,100 1,998,175
10,357,900
AMUSEMENTS (0.2%)
Carnival Corp., Class A 26,000 1,150,500
Hilton Hotels Corp. 20,000 1,060,000
2,210,500
AUTOMOTIVE (5.0%)
Eaton Corp. 250,000 13,000,000
Federal-Mogul Corp. 300,000 8,737,500
Ford Motor Co. 360,000 21,240,000
General Motors Corp. 450,000 22,612,500
Genuine Parts Co. 62,025 2,240,653
Simpson Industries Inc. 71,200 1,299,400
69,130,053
BUILDING MATERIALS (0.9%)
Armstrong World Industries, Inc. 10,000 466,250
Masco Corp. 435,000 11,962,500
Sherwin-Williams Co. 15,000 472,500
12,901,250
CAPITAL GOODS (3.7%)
Cooper Industries, Inc. 21,200 763,200
Deere & Co. 20,000 1,352,500
Emerson Electric Co. 54,000 3,071,250
General Electric Co. 756,000 $ 35,248,500
Ingersoll-Rand Co. 50,500 1,773,812
Johnson Controls, Inc. 18,500 894,938
Sundstrand Corp. 17,000 799,000
Tecumseh Products Co.,
Class A 140,000 6,492,500
Westinghouse Electric Corp. 60,000 697,500
51,093,200
CHEMICALS (7.6%)
Air Products & Chemicals, Inc. 28,000 1,186,500
American Cyanamid Co. 20,600 1,153,600
Dow Chemical Co. 123,200 8,054,200
duPont (E.I.) de Nemours & Co. 431,000 25,159,625
Grace (W. R.) & Co. 39,500 1,575,062
Hercules Inc. 13,000 1,391,000
Monsanto Co. 233,400 17,650,875
PPG Industries, Inc. 456,000 17,100,000
Praxair Inc. 30,000 585,000
Rohm & Haas Co. 235,000 14,628,750
Union Carbide Corp. 630,000 16,852,500
105,337,112
CONSUMER GOODS (1.2%)
Avon Products Inc. 16,300 959,663
Colgate-Palmolive Co. 35,000 1,820,000
Eastman Kodak Co. 78,500 3,777,812
International Flavors & Fragrances 48,000 1,878,000
Procter & Gamble Co. 110,000 5,871,250
Tambrands Inc. 27,000 992,250
Whirlpool Corp. 29,800 1,564,500
16,863,475
DIVERSIFIED COMPANIES (1.7%)
Allied-Signal, Inc. 71,300 2,468,763
Corning Inc. 61,200 1,996,650
ITT Corp. 33,400 2,726,275
Minnesota Mining & Manufacturing Co. 280,000 13,860,000
Tenneco Inc. 25,000 1,159,375
Textron, Inc. 16,600 869,425
23,080,488
<PAGE>
DRUGS (4.0%)
Abbott Laboratories 168,000 $ 4,872,000
American Home Products Corp. 90,000 5,107,500
Baxter International Inc. 47,400 1,244,250
Bristol Myers Squibb Co. 55,000 2,949,375
Johnson & Johnson 455,200 19,516,700
Lilly (Eli) & Co. 66,000 3,753,750
Merck & Co., Inc. 213,000 6,336,750
Pfizer Inc. 72,600 4,582,875
Schering-Plough Corp. 51,200 3,136,000
SmithKline Beecham Corp. PLC, ADR 57,200 1,608,750
Warner-Lambert Co. 42,000 2,772,000
55,879,950
ELECTRONICS PRODUCTS (0.3%)
AMP Inc. 25,000 1,731,250
General Signal Corp. 20,000 660,000
Thomas & Betts Corp. 20,000 1,230,000
3,621,250
FINANCE (5.3%)
American Express Co. 100,000 2,575,000
Banc One Corp. 405,000 13,871,250
BankAmerica Corp. 36,960 1,690,920
Bankers Trust New York Corp. 40,901 2,725,029
Chase Manhattan Corp. 350,000 13,387,500
Chemical Banking Corp. 108,089 4,161,426
Dean Witter, Discover & Co. 27,321 1,024,538
Federal Home Loan Mortgage Corp. 103,600 6,267,800
Federal National Mortgage Association 50,000 4,175,000
Fleet Financial Group Inc. 60,000 2,265,000
Merrill Lynch & Co., Inc. 42,000 1,470,000
Morgan (J.P.) & Co. Inc. 42,000 2,598,750
Nationsbank Corp. 50,000 2,568,750
Salomon Inc. 60,000 2,865,000
State Street Boston Corp. 200,000 7,750,000
Wells Fargo & Co. 24,200 3,639,075
73,035,038
FOODS (2.2%)
Anheuser-Busch Cos., Inc. 52,000 $ 2,639,000
Borden, Inc. 42,600 527,175
CPC International Inc. 46,800 2,258,100
General Mills, Inc. 30,000 1,638,750
Gerber Products Co. 40,000 2,040,000
Heinz (H.J.) Co. 52,800 1,683,000
Kellogg Co. 44,000 2,392,500
PepsiCo Inc. 145,000 4,440,625
Philip Morris Cos., Inc. 200,000 10,300,000
Sara Lee Corp. 86,000 1,827,500
UST Inc. 46,200 1,253,175
30,999,825
INSURANCE (1.5%)
Aetna Life & Casualty Co. 30,000 1,676,250
American General Corp. 80,000 2,210,000
CIGNA Corp. 20,000 1,462,500
General Reinsurance Corp. 95,000 10,355,000
SAFECO Corp. 34,100 1,894,681
St. Paul Companies, Inc. 40,000 1,605,000
Torchmark Corp. 17,550 684,450
Transamerica Corp. 14,000 729,750
20,617,631
METALS AND MINING (0.4%)
Aluminum Co. of America 20,000 1,462,500
Freeport McMoRan, Inc. 80,000 1,300,000
Phelps Dodge Corp. 22,000 1,254,000
Reynolds Metals Co. 24,400 1,171,200
5,187,700
NATURAL GAS (1.3%)
Coastal Corp. 24,000 648,000
Consolidated Natural Gas Co. 17,500 660,625
Enron Corp. 54,000 1,768,500
Panhandle Eastern Corp. 34,800 687,300
Sonat, Inc. 455,000 13,991,250
17,755,675
OFFICE AND BUSINESS EQUIPMENT (0.1%)
Xerox Corp. 20,923 2,045,223
<PAGE>
OIL (5.6%)
Amoco Corp. 96,600 $ 5,506,200
Atlantic Richfield Co. 144,500 14,757,062
Chevron Corp. 463,600 19,413,250
Exxon Corp. 63,500 3,595,688
Freeport McMoRan Oil + Gas Realty 8,000 36,000
Mobil Corp. 155,400 12,684,525
Occidental Petroleum Corp. 157,000 2,963,375
Royal Dutch Petroleum Corp. 70,100 7,334,212
Texaco Inc. 150,000 9,056,250
Unocal Corp. 100,000 2,862,500
78,209,062
OIL SERVICES (2.0%)
Halliburton Co. 295,200 9,963,000
McDermott International Inc. 38,000 950,000
Schlumberger, Ltd. 281,100 16,620,038
27,533,038
PAPER AND PACKAGING (1.6%)
Georgia-Pacific Corp. 30,800 1,844,150
International Paper Co. 28,500 1,888,125
Kimberly Clark Corp. 34,800 1,840,050
Union Camp Corp. 25,500 1,157,063
Weyerhaeuser Co. 370,350 14,814,000
21,543,388
REAL ESTATE (0.7%)
Beacon Properties (R.E.I.T.) 400,000 7,200,000
Liberty Property (R.E.I.T.) 100,000 2,000,000
9,200,000
RETAIL (2.4%)
K Mart Corp. 100,000 1,550,000
May Department Stores Co. 60,000 2,355,000
Melville Corp. 30,000 1,162,500
Penney (J.C.) Co., Inc. 449,200 24,369,100
Sears, Roebuck & Co. 70,000 3,360,000
Woolworth (F.W.) Co. 48,000 762,000
33,558,600
SERVICES (0.2%)
Block (H&R), Inc. 37,200 $ 1,460,100
Browning Ferris Industries Inc. 40,000 1,215,000
De Luxe Corp. 15,000 395,625
Ogden Corp. 17,500 385,000
3,455,725
SOFTWARE SERVICES (0.6%)
General Motors Corp, Class E 247,100 8,617,613
TELECOMMUNICATIONS (3.6%)
American Telephone & Telegraph Corp. 233,000 12,669,375
Ameritech Corp. 124,000 4,743,000
Bell Atlantic Corp. 380,000 21,280,000
GTE Corp. 162,000 5,103,000
NYNEX Corp. 88,088 3,336,333
Southern New England
Telecommunications Corp. 30,000 915,000
Sprint Corp. 75,480 2,632,365
50,679,073
TRANSPORTATION (2.5%)
Burlington Northern, Inc. 20,300 1,083,513
Canadian Pacific Ltd. 78,300 1,154,925
Conrail, Inc. 330,000 18,067,500
Norfolk Southern Corp. 190,000 11,970,000
Union Pacific Corp. 46,800 2,650,050
34,925,988
UTILITIES (1.1%)
American Electric Power Inc. 39,500 1,115,875
Central & South West Corp. 40,600 862,750
Commonwealth Edison Co. 36,000 819,000
Consolidated Edison Co. of New York,
Inc. 74,000 1,961,000
Dominion Resources, Inc. 31,050 1,129,444
Duke Power Co. 42,000 1,501,500
Florida Progress Corp. 71,400 1,847,475
FPL Group, Inc. 27,000 806,625
Houston Industries, Inc. 43,400 1,415,925
<PAGE>
UTILITIES (continued)
Ohio Edison Co. 34,400 $ 614,900
Pacificorp. (Maine) 35,400 597,375
Public Service Enterprise Group 54,969 1,429,194
Texas Utilities Co. 44,100 1,383,637
15,484,700
TOTAL COMMON STOCKS
(Cost--$668,960,990) 798,617,557
CONVERTIBLE/PREFERRED STOCKS (4.6%)
Alco Standard Corp., $2.375 200,000 $ 13,400,000
Burlington Northern, Inc., $3.125 100,000 6,325,000
Chrysler Corp., $4.625, Series 144A
(4/30/92--$11,341,275) (b) 187,000 24,777,500
Equitable Cos, Inc., $3.000, Series
144A (4/14/93-- $14,400,000) (b) 288,000 13,284,000
Rouse Co., $3.25 125,000 6,406,250
TOTAL CONVERTIBLE/PREFERRED STOCKS (Cost--$46,910,872) 64,192,750
<TABLE>
<CAPTION>
Coupon Maturity Par Market
Rate Date Value Value
<S> <C> <C> <C> <C> <C>
FIXED INCOME (37.0%)
CONVERTIBLE BONDS (2.4%)
FOREIGN BONDS (NON-U.S. DOLLARS) (1.1%)
Banco Nacional De Mexico SA, Series 144A
(12/1/92--$14,000,000) (b) Conv. Deb. 7.000% 1999 $14,000,000 $15,120,000
HEALTH CARE SERVICES (0.4%)
Empresas Ica Sociedad Control Sub. Deb. Conv. 5.000 2004 5,875,000 5,316,875
OFFICE AND BUSINESS EQUIPMENT (0.9%)
E M C Corporation Massachusetts Convert. 4.250 2001 10,000,000 9,150,000
International Business Machines Deb. 8.375 2019 4,000,000 3,914,320
13,064,320
TOTAL CONVERTIBLE BONDS (Cost--$34,461,402) 33,501,195
FOREIGN BONDS (U.S. DOLLARS) (2.6%)
Bet Icecalm Deb. 8.625 2001 5,500,000 5,557,310
British Columbia Hydro & Power Authority Gtd. Bond Series GG 15.000 2011 1,500,000 1,780,905
British Columbia Hydro & Power Authority Gtd. Bond Series FH 15.500 2011 1,000,000 1,218,320
Nova Corp. of Alberta Notes 7.250 1999 5,000,000 4,952,850
Nova Scotia Province Canada Global Notes 9.125 2021 5,500,000 5,812,950
Ontario Province Canada Deb. 15.125 2011 2,000,000 2,375,400
Ontario Province Canada Deb. 15.750 2012 1,000,000 1,255,570
Ontario Province Canada Deb. 17.000 2011 1,000,000 1,268,230
Ontario Province Canada Global Note 7.625 2004 5,000,000 4,879,350
Rolls Royce Capital Euro Dollar Deb. 7.125 2003 5,000,000 4,667,700
Spintab Snr. Unsub. Euro Dollar 7.500 1997 2,500,000 2,533,450
TOTAL FOREIGN BONDS (U.S. DOLLARS) (Cost--$36,944,965) 36,302,035
<PAGE>
COLLATERALIZED MORTGAGE OBLIGATIONS (2.0%)
Advanta Home Equity Loan Trust (Est.
Mat. 2004) (c) Series 1991-2 Class A 8.800% 2006 $ 1,297,379 $ 1,323,729
Federal Home Loan Mortgage Corp. (Est.
Mat. 1994) (c) Series 127 Class C 8.650 2017 220,541 220,541
Merrill Lynch Mortage Investors Inc.
(Est. Mat. 2000) (c) Series 92B Class B 8.500 2012 3,028,268 3,062,972
Merrill Lynch Mortage Investors Inc.
(Est. Mat. 2004) (c) Series 92D Class B 8.500 2017 3,564,429 3,582,786
Merrill Lynch Mortage Investors Inc.
(Est. Mat. 2004) (c) Series 91D Class B 9.850 2011 5,000,000 5,194,550
Paine Webber Mortgage Acceptance Corp.
IV (Est. Mat. 2008) (c) Series 1993 5 Class A3 6.875 2008 3,013,339 2,965,306
Resolution Funding Corp.
(6/18/92--$729,615) (b) (Est. Mat.
2002) (c) Series 2-B-4 7.970 2004 781,316 742,250
Residential Funding Mortgage Secs I
(Est. Mat. 2000) (c) Series 1994 S1 Class A7 6.573 2024 4,896,000 4,528,800
Security Pacific Acceptance Corp. (Est.
Mat. 2002) (c) Series 1992-1 Class B 9.150 2012 3,851,061 3,902,781
University Support Services Inc. (Est.
Mat. 2003) (c) Series 1992 D 9.000 2007 2,605,000 2,618,025
TOTAL COLLATERALIZED MORTGAGE OBLIGATIONS (Cost--$28,449,818) 28,141,740
MORTGAGE PASS-THROUGH CERTIFICATES (8.7%)
FNMA Pool #125306 8.000 2024 15,100,000 14,873,500
FNMA Pool #050926 6.000 2008 7,618,950 7,004,634
FNMA Pool #050929 6.500 2023 37,990,096 34,214,640
FNMA Pool #190765 7.000 2009 15,005,387 14,498,956
FNMA Pool #247872 6.000 2008 22,367,197 20,563,730
FNMA Pool #248519 6.000 2008 7,783,171 7,155,613
GNMA Pool #310122 7.500 2022 3,021,238 2,881,506
GNMA Pool #371724 7.500 2024 5,077,148 4,842,330
GNMA Pool #383754 7.500 2024 4,892,807 4,666,514
GNMA Pool #389229 7.500 2024 4,891,797 4,665,552
GNMA Pool #391406 7.500 2024 4,891,810 4,665,564
TOTAL MORTGAGE PASS-THROUGH CERTIFICATES (Cost--$129,302,061) 120,032,539
EXCHANGE RATE LINKED SECURITIES (0.3%)
FNMA MTN (2 Canadian $--1 Yen) 13.050 1995 7,200,000 1,584,000
General Electric Capital Corp. (2 Australian $--1 Yen) 10.900 1996 5,500,000 2,585,000
TOTAL EXCHANGE RATE LINKED SECURITIES (Cost--$13,017,512) 4,169,000
<PAGE>
ADJUSTABLE RATE MORTGAGES (9.7%)
FHLMC PC #609178 5.508% 2023 $ 7,732,635 $ 7,904,223
FHLMC PC #845170 5.697 2022 29,145,895 29,997,538
FHLMC PC #845279 5.695 2023 18,460,149 18,690,901
FHLMC PC #845454 4.059 2023 9,246,447 9,301,370
FHLMC PC #845475 4.016 2023 16,907,832 16,696,484
FHLMC PC #845497 4.111 2030 25,147,532 24,833,188
FNMA Pool #124289 5.500 2021 9,028,140 9,287,699
FNMA Pool #124901 5.321 2023 5,652,224 5,821,791
GNMA Pool #008200 6.000 2023 11,879,494 11,768,184
TOTAL ADJUSTABLE RATE MORTGAGES (Cost--$137,308,246) 134,301,378
INDUSTRY BONDS & NOTES (4.1%)
AIR TRANSPORTATION (0.4%)
Southwest Airlines Co. Sr. Notes 9.400 2001 5,000,000 5,387,450
AUTOMOTIVE (0.3%)
Ford Holdings Inc. Deb. 9.250 2000 3,500,000 3,737,755
CHEMICALS (0.3%)
Olin Corp. Notes 8.000 2002 5,000,000 4,925,650
CONSUMER GOODS (0.4%)
Procter & Gamble ESOP Deb. Series A 9.360 2021 5,000,000 5,575,400
OIL & NATURAL GAS (1.1%)
Atlantic Richfield Company Deb. 9.875 2016 3,000,000 3,416,640
Exxon Capital Corporation Std. Notes 6.625 2002 5,000,000 4,681,950
Occidental Petroleum Corp. Sr. Notes 11.125 2010 2,600,000 3,084,458
Tennessee Gas Pipeline Co. Deb. 6.000 2011 5,000,000 3,830,850
15,013,898
RETAIL (0.4%)
Dayton Hudson Corp Deb. 9.250 2011 5,000,000 5,312,650
TELECOMMUNICATIONS (0.4%)
Cincinnati Bell Inc. Deb. 9.100 2000 5,000,000 5,309,600
UTILITIES (0.8%)
Cincinnati Gas & Electric Co. 1st Mtge. 10.200 2020 1,000,000 1,090,550
System Energy Resources Inc. 1st Mtge. 11.375 2016 2,568,000 2,696,400
Texas Utilities Electric Company 7.875 2023 6,000,000 5,514,600
Texas Utilities Electric Company 1st Mtge. 9.750 2021 2,000,000 2,144,760
11,446,310
TOTAL INDUSTRY BONDS & NOTES (Cost--$60,100,764) 56,708,713
<PAGE>
U.S. GOVERNMENT (AND AGENCY) ISSUES (5.1%)
Federal National Mortgage Association 6.420% 2004 $ 5,500,000 $ 4,947,250
U.S. Treasury Bonds 6.250 2023 7,500,000 6,302,325
U.S. Treasury Bonds 7.875 2021 29,000,000 29,416,730
U.S. Treasury Notes 5.500 1997 7,000,000 6,800,920
U.S. Treasury Notes 6.250 2003 5,030,000 4,688,916
U.S. Treasury Notes 6.375 1999 5,000,000 4,903,100
U.S. Treasury Notes 6.500 1997 14,000,000 14,004,340
TOTAL U.S. GOVERNMENT (AND AGENCY) ISSUES (Cost--$80,198,688) 71,063,581
BANK & FINANCE BONDS & NOTES (2.1%)
Bank Of Boston Corp. Floating Rate Euro
Dollar Sub. Notes 5.000 2001 5,000,000 4,900,000
Chrysler Financial Corp. 6.500 1998 6,000,000 5,852,640
Discover Credit Corp. Mtn. Notes 00063 8.350 1999 5,000,000 5,141,900
General Motors Acceptance Corp. Mtn. Notes 00435 7.375 1999 5,000,000 4,922,150
Goldman Sachs Group L P Euro Dollar Ftg. Rate
Notes 4.350 1999 5,000,000 4,775,000
Household Finance Corp. Notes 7.625 1999 4,000,000 4,000,960
TOTAL BANK & FINANCE BONDS & NOTES (Cost--$30,517,911) 29,592,650
TOTAL FIXED INCOME (Cost--$550,301,367) 513,812,831
SHORT-TERM INVESTMENTS (0.3%)
CERTIFICATE OF DEPOSIT (0.0%)
State Street Bank & Trust Co. (Cost $150,800) 3.250 08/01/94 150,800 150,800
Maturity
Value
REPURCHASE AGREEMENT (0.3%)
Sanwa Bank, purchased 6/30/94 (collateralized by $4,800,000 GNMA
pool # 8447, 6.5%, 6/20/24) 4.35% 7/1/94 4,871,589 4,871,000
TOTAL SHORT-TERM INVESTMENTS (Cost--$5,021,800) 5,021,800
TOTAL INVESTMENTS (Cost--$1,271,195,029) (a) 1,381,644,938
OTHER ASSETS AND LIABILITIES--NET (0.6%) 8,164,792
NET ASSETS (100.0%) $1,389,809,730
</TABLE>
<PAGE>
NOTES TO SCHEDULE OF INVESTMENTS:
(a) The cost of investments for federal income tax purposes amounted to
$1,271,242,035. Gross unrealized appreciation and depreciation on investments,
based on identified tax cost, at June 30, 1994 are as follows:
Gross unrealized appreciation $172,621,728
Gross unrealized depreciation (62,218,825)
Net unrealized appreciation $110,402,903
(b) All or a portion of these securities are restricted (i.e., securities
which may not be publicly sold without registration under the Federal
Securities Act of 1933) which are valued using market quotations where readily
available. In the absence of market quotations, the securities are valued
based upon their fair value determined under procedures approved by the Board
of Trustees. The Fund may make investments in an amount up to 15% of the value
of the Funds' net assets in such securities. Dates of acquisition and costs
are set forth in parentheses after the title of the restricted securities. On
the date of acquisition there was no market quotation on similar securities
and the above securities were valued at acquisition cost. At June 30, 1994,
the fair value of these restricted securities was $53,923,750 (3.9% of net
assets). The Fund will not pay the costs of disposition of the above
restricted securities other than ordinary brokerage fees, if any.
(c) The estimated maturity of a Collateralized Mortgage Obligation ("CMO") is
based on current and projected pre-payment rates. Changes in interest rates
can cause the estimated maturity to differ from the listed date.
(d) Non-income producing.
Legend of Portfolio Abbreviations:
GNMA--Government National Mortgage Association
FHLMC--Federal Home Loan Mortgage Corporation
FNMA--Federal National Mortgage Association
<PAGE>
FINANCIAL HIGHLIGHTS
(For a share outstanding throughout the year)
<TABLE>
<CAPTION>
Year Ended June 30,
1994 1993 1992 1991 1990 1989 1988 1987 1986 1985
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Net Asset Value:
Beginning of year $ 10.10 $ 9.77 $ 9.16 $ 9.10 $ 9.12 $ 8.37 $ 9.74 $ 10.50 $ 9.06 $ 8.17
Income from investment
operations:
Investment income--net 0.28 0.31 0.32 0.45 0.50 0.46 0.47 0.46 0.56 0.59
Net gains (losses) on
investments (0.37) 0.66 0.75 0.18 0.20 0.83 (0.82) 0.81 1.87 1.47
Net commissions paid on
fund share sales (b) 0 0 0 0 0 0 0 0 (0.09) (0.03)
Total from investment
operations (0.09) 0.97 1.07 0.63 0.70 1.29 (0.35) 1.27 2.34 2.03
Less Distributions
from:
Investment income--net (0.28) (0.31) (0.32) (0.50) (0.50) (0.54) (0.60) (0.54) (0.56) (0.69)
In excess of investment
income--net (0.07) (0.09) 0 0 0 0 0 0 0 0
Tax basis return of
capital (0.02) 0 0 0 0 0 0 0 0 0
Realized gains on
investments--net (0.25) (0.24) 0 (0.03) (0.18) 0 (0.42) (1.49) (0.34) (0.45)
In excess of realized
gains on
investments--net (0.13) 0 0 0 0 0 0 0 0 0
Distributions from
paid-in capital (c) 0 0 (0.14) (0.04) (0.04) 0 0 0 0 0
Total distributions (0.75) (0.64) (0.46) (0.57) (0.72) (0.54) (1.02) (2.03) (0.90) (1.14)
Net asset value,
end of year $ 9.26 $ 10.10 $ 9.77 $ 9.16 $ 9.10 $ 9.12 $ 8.37 $ 9.74 $ 10.50 $ 9.06
Total return (d) -1.16% 10.39% 11.86% 7.49% 7.99% 16.06% -3.37% 15.39% 27.81% 27.75%
Ratios/supplemental data
Ratios to average net assets:
Operating and
management expenses 1.71% 1.93% 1.97% 1.88% 1.99% 1.96% 1.91% 1.93% 0.86% 0.87%
Investment income--net 2.81% 3.07% 3.25% 4.56% 4.94% 5.48% 5.34% 4.47% 5.82% 6.73%
Portfolio turnover rate 88% 74% 52% 60% 35% 49% 64% 79% 92% 109%
Net assets, end of year
(thousands) $1,389,810 $1,464,066 $1,184,094 $901,994 $826,934 $712,009 $685,427 $727,723 $419,066 $291,028
</TABLE>
(a) Calculation is based on average shares outstanding beginning in 1988.
(b) Prior to June 30, 1987, net commissions paid on new sales of shares under
the Fund's Rule 12b-1 Distribution Plan had been treated for both financial
statement and tax purposes as capital charges. On June 11, 1987, the
Securities and Exchange Commission adopted a rule which required for financial
statements for the periods ended on or after June 30, 1987, that net
commissions paid under Rule 12b-1 be treated as operating expenses rather than
capital charges. Accordingly, beginning with the year ended June 30, 1987, the
Fund's financial statements reflect 12b-1 Distribution Plan expenses (i.e.,
shareholder service fees plus commissions paid net of deferred sales charges
received by the Fund) as a component of net investment income.
(c) Effective July 1, 1993, the Fund adopted Statement of Position 93-2:
"Determination, Disclosure and Financial Statement Presentation of Income,
Capital Gain and Return of Capital Distributions by Investment Companies." As
a result, distribution amounts exceeding book basis net investment income (or
tax basis net income on a temporary basis) are presented as "Distributions in
excess of investment income--net." Similarly, capital gain distributions in
excess of book basis capital gains (or tax basis capital gains on a temporary
basis) are presented as "Distributions in excess of net realized capital
gains." From January 31, 1990 until the date of adoption of the Statement of
Position, distribution amounts exceeding book basis net investment income were
charged to paid-in capital.
(d) Excluding deferred sales charges.
See Notes to Financial Statements.
<PAGE>
STATEMENT OF ASSETS AND LIABILITIES -
June 30, 1994
Assets:
Investments at market value (identified
cost--$1,271,195,029 ) (Note 1) $1,381,644,938
Receivable for:
Investments sold 6,841,085
Fund shares sold 1,059,161
Dividends 2,172,615
Interest 6,738,039
Prepaid expenses 115,230
Other assets 106,213
Total assets 1,398,677,281
Liabilities:
Payable for:
Investments purchased 7,606,628
Fund shares redeemed 1,094,588
Other accrued expenses 166,335
Total liabilities 8,867,551
Net assets $1,389,809,730
Net assets represented by (Note 1):
Paid-in capital $1,272,095,988
Undistributed investment income--net 678,093
Accumulated realized gains (losses) on investment
and foreign currency related transactions--net 6,585,740
Net unrealized appreciation (depreciation) on
investments and foreign currency related
transactions (Note 1) 110,449,909
Total net assets applicable to outstanding
shares of beneficial interest ($9.26 per
share on 150,091,123 shares outstanding)
(Note 2) $1,389,809,730
See Notes to Financial Statements.
STATEMENT OF OPERATIONS -
Year Ended June 30, 1994
Investment income: (Note 1)
Interest (net of withholding taxes
of $63,527) $ 39,028,362
Dividends (net of withholding taxes
of $32,455) 27,770,697
Total income 66,799,059
Expenses (Notes 2 and 4):
Management fee $ 6,677,244
Transfer agent fees 3,589,413
Accounting, auditing and legal 94,254
Custodian fees 379,096
Printing 92,581
Trustees' fees and expenses 45,969
Distribution Plan expenses 14,200,090
Registration fees 209,206
Miscellaneous expenses 36,327
Total expenses 25,324,180
Investment income--net 41,474,879
Realized and unrealized gain (loss) on
investments and foreign currency
related transactions (Notes 1 and 3):
Realized gain (loss) on:
Investments 33,751,847
Foreign currency related
transactions 2,245,052
Realized gain (loss) on investments and foreign
currency related transactions--net 35,996,899
Net change in unrealized
appreciation (depreciation) on:
Investments (91,265,069)
Foreign currency related
transactions (1,531,025)
Net increase (decrease) in unrealized
appreciation or depreciation (92,796,094)
Net gain (loss) on investments and foreign
currency related transactions (56,799,195)
Net increase (decrease) in net assets resulting from
operations ($ 15,324,316)
<PAGE>
STATEMENTS OF CHANGES IN NET ASSETS
<TABLE>
<CAPTION>
Year Ended June 30,
1994 1993
<S> <C> <C>
Operations:
Investment income--net (Note 1) $ 41,474,879 $ 40,891,902
Realized gain (loss) on investments and foreign currency related transactions--
net (Note 3) 35,996,899 38,592,912
Net increase (decrease) in unrealized appreciation or depreciation (92,796,094) 53,131,101
Net increase (decrease) in net assets resulting from operations (15,324,316) 132,615,915
Net equalization charges and credits (Note 1) 0 69,024
Distributions to shareholders from (Note 1):
Investment income--net (41,474,879) (40,960,925)
In excess of investment income--net (11,163,134) (12,452,776)
Tax basis return of capital (2,510,713) 0
Realized gain on investments--net (35,996,899) (31,067,826)
In excess of realized gain on investments--net (19,761,716) 0
Total distributions to shareholders (110,907,341) (84,481,527)
Capital share transactions (Note 2):
Proceeds from shares sold 228,457,731 340,217,240
Payments for shares redeemed (271,898,085) (178,825,373)
Net asset value of shares issued in reinvestment of distributions from:
Investment income--net and in excess of investment income--net 44,707,410 42,511,343
Realized gain on investments--net and in excess of realized gain on
investments--net 50,708,277 27,865,791
Net increase in net assets resulting from capital share transactions 51,975,333 231,769,001
Total increase (decrease) in net assets (74,256,324) 279,972,413
Net assets:
Beginning of year 1,464,066,054 1,184,093,641
End of year $1,389,809,730 $1,464,066,054
</TABLE>
See Notes to Financial Statements.
<PAGE>
NOTES TO FINANCIAL STATEMENTS
(1.) Significant Accounting Policies
Keystone Custodian Fund, Series K-1 Balanced Income Fund, (the "Fund"), is a
common law trust for which Keystone Management, Inc. ("KMI") is the Investment
Manager and Keystone Custodian Funds, Inc. ("Keystone") is the Investment
Adviser. The Fund is registered under the Investment Company Act of 1940 as a
diversified open-end investment company.
Keystone is a wholly-owned subsidiary of Keystone Group, Inc. ("KGI"), a
Delaware corporation. KGI is privately owned by an investor group consisting
of members of current and former management of Keystone. Keystone Investor
Resource Center, Inc. ("KIRC"), a wholly-owned subsidiary of Keystone, is the
Fund's transfer agent.
The following is a summary of significant accounting policies consistently
followed by the Fund in the preparation of its financial statements. The
policies are in conformity with generally accepted accounting principles.
A. Investments are usually valued at the closing sales price, or, in the
absence of sales and for over-the- counter securities, the mean of bid and
asked quotations. Management values the following securities at prices it
deems in good faith, by or under the direction of the Board of Trustees, to be
fair: (a) securities (including restricted securities) for which complete
quotations are not readily available and (b) listed securities if, in the
opinion of management, the last sales price does not reflect a current value
or if no sale occurred. Short-term investments maturing in sixty days or less
are valued at amortized cost (original purchase cost as adjusted for
amortization of premium or accretion of discount) which when combined with
accrued interest approximates market. Short-term investments maturing in more
than sixty days for which market quotations are readily available are valued
at current market value. Short-term investments maturing in more than sixty
days when purchased which are held on the sixtieth day prior to maturity are
valued at amortized cost (market value on the sixtieth day adjusted for
amortization of premium or accretion of discount) which when combined with
accrued interest approximates market. Short-term investments denominated in a
foreign currency are adjusted daily to reflect changes in exchange rates.
Market quotations are not considered to be readily available for long-term
corporate bonds and notes; such investments are stated at fair value on the
basis of valuations furnished by a pricing service, approved by the Trustee,
which determines valuations for normal institutional-size trading units of
such securities using methods based on market transactions for comparable
securities and various relationships between securities which are generally
recognized by institutional traders.
A futures contract is an agreement between two parties to buy and sell a
specific amount of a commodity, security, financial instrument, or, in the
case of a stock index, cash at a set price on a future date. Upon entering
into a futures contract the Fund is required to deposit with a broker an
amount ("initial margin") equal to a certain percentage of the purchase price
indicated in the futures contract. Subsequent payments ("variation margin")
are made or received by the Fund each day, as the value of the underlying
instrument or index fluctuates, and are recorded for book purposes as
unrealized gains or losses by the Fund. For federal tax purposes, any futures
contracts which remain open at fiscal year end are marked-to-market and the
resultant net gain or loss is included in federal taxable income.
Exchange rate linked securities are debt securities which are indexed to
certain specific foreign currency exchange rates. The exchange rate linked
securities which the Fund will purchase are dollar denominated
<PAGE>
and pay interest and principal in U.S. dollars. The principal amount of these
securities will be adjusted upwards or downwards at maturity to reflect
changes in the exchange rate between the dollar and one or more indexed
currencies while the obligation is outstanding.
Foreign currency amounts are translated into United States dollars as follows:
market value of investments, assets and liabilities at the daily rate of
exchange, purchases and sales of investments, income and expenses at the rate
of exchange prevailing on the respective dates of such transactions. Net
unrealized foreign exchange gains/losses are a component of net unrealized
appreciation (depreciation) of investments and foreign currency related
transactions.
B. Securities transactions are accounted for on the trade date. Realized gains
and losses are recorded on the identified cost basis. Interest income is
recorded on the accrual basis and dividend income is recorded on the
ex-dividend date. All original issue discounts are amortized for both
financial reporting and federal income tax purposes. Distributions to
shareholders are recorded at the close of business on the ex-dividend date.
C. The Fund has qualified, and intends to qualify in the future, as a
regulated investment company under the Internal Revenue Code. Thus, the Fund
expects to be relieved of any federal income tax liability by distributing all
of its net taxable investment income and net taxable capital gains, if any, to
its shareholders. The Fund intends to avoid excise tax liability by making the
required distributions under the Internal Revenue Code.
D. For the year ended June 30, 1993, the Fund used the accounting practice
known as equalization by which a portion of the proceeds from sales and the
cost of redemptions of capital shares (equivalent on a per share basis to the
amount of undistributed net investment income on the date of the transactions)
was credited or charged to undistributed net investment income. As a result,
undistributed net investment income per share was not affected by sales or
redemptions of shares. Effective July 1, 1993, the Fund discontinued
equalization accounting.
E. When the Fund enters into a repurchase agreement (a purchase of securities
whereby the seller agrees to repurchase the securities at a mutually agreed
upon date and price) the repurchase price of the securities will generally
equal the amount paid by the Fund plus a negotiated interest amount. The
seller under the repurchase agreement will be required to provide securities
("collateral") to the Fund whose value will be maintained at an amount not
less than the repurchase price, and which generally will be maintained at 101%
of the repurchase price. The Fund monitors the value of collateral on a daily
basis, and if the value of collateral falls below required levels, the Fund
intends to seek additional collateral from the seller or terminate the
repurchase agreement. If the seller defaults, the Fund would suffer a loss to
the extent that the proceeds from the sale of the underlying securities were
less than the repurchase price. Any such loss would be increased by any cost
incurred on disposing of such securities. If bankruptcy proceedings are
commenced against the seller under the repurchase agreement, the realization
on the collateral may be delayed or limited. Repurchase agreements entered
into by the Fund will be limited to transactions with dealers or domestic
banks believed to present minimal credit risks, and the Fund will take
constructive receipt of all securities underlying repurchase agreements until
such agreements expire.
F. In connection with portfolio purchases and sales of securities denominated
in a foreign currency, the Fund may enter into forward foreign currency
exchange con
<PAGE>
tracts ("contracts"). Additionally, from time to time the Fund may enter into
contracts to hedge certain foreign currency assets. Contracts are recorded at
market value and are marked-to-market daily. Realized gains and losses arising
from such transactions, if any, are included in net realized gain (loss) on
foreign currency related transactions. The Fund is subject to the credit risk
that the other party will not complete the obligations of the contract.
G. The Fund distributes net investment income to shareholders quarterly and
capital gains, if any, annually. Distributions are determined in accordance
with income tax regulations. Distributions from taxable net investment income
and net capital gains can exceed book basis net investment income and net
capital gains. Effective July 1, 1993, the Fund adopted Statement of Position
93-2: Determination, Disclosure, and Financial Statement Presentation of
Income, Capital Gain and Return of Capital Distributions by Investment
Companies. As a result of this statement, the Fund changed the classification
of distributions to shareholders to better disclose the differences between
financial statement amounts and distributions determined in accordance with
income tax regulations. Accordingly, amounts as of June 30, 1994 have been
reclassified to reflect a decrease in paid-in-capital of $38,372,434 and
increases in accumulated realized gains (losses) on investment transactions
and undistributed investment income - net of $24,020,494 and $14,351,940,
respectively, to reflect adoption of the statement.
(2.) Capital Share Transactions
The Trust agreement authorizes the issuance of an unlimited number of shares
of beneficial interest with a par value of $1.00. Transactions in shares of
the Fund were as follows:
Year Ended June 30,
1994 1993
Shares sold 23,134,606 34,592,725
Shares redeemed (27,733,373) (18,111,719)
Shares issued in
reinvestment of
distributions from:
Investment
income--net,
in excess of
investment income--
net and paid-in
capital 4,568,990 4,359,106
Realized gain--net
and in excess of
realized gain--net 5,153,280 2,945,644
Net increase 5,123,503 23,785,756
The Fund bears some of the costs of selling its shares under a Distribution
Plan adopted pursuant to Rule 12b-1 under the Investment Company Act of 1940.
Under the Distribution Plan, the Fund pays Keystone Distributors, Inc.
("KDI"), the principal underwriter and a wholly-owned subsidiary of Keystone,
amounts which in total may not exceed the Distribution Plan maximum.
In connection with the Distribution Plan and subject to the limitations
discussed below, Fund shares are offered for sale at net asset value without
any initial sales charge. From the amounts received by KDI in connection with
the Distribution Plan, and subject to the limitations discussed below, KDI
generally pays brokers or others a commission equal to 4% of the price paid to
the Fund for each sale of Fund shares as well as a shareholder service fee at
a rate of 0.25% per annum of the net asset value of shares sold by such
brokers or others and remaining outstanding on the books of the Fund for
specified periods.
<PAGE>
To the extent Fund shares purchased prior to July 8, 1992 are redeemed within
four calendar years of original issuance, the Fund may be eligible to receive
a deferred sales charge from the investor as partial reimbursement for sales
commissions previously paid on those shares. This charge is based on declining
rates, which begin at 4.0%, applied to the lesser of the net asset value of
shares redeemed or the total cost of such shares.
The Distribution Plan provides that the Fund may incur certain expenses which
may not exceed a maximum amount equal to 0.3125% of the Fund's average daily
net assets for any calendar quarter (approximately 1.25% annually) occurring
after the inception of the Distribution Plan. A new rule of the National
Association of Securities Dealers, Inc. ("NASD Rule") limits the annual
expenditures which the Fund may incur under the Distribution Plan to 1% of
which 0.75% may be used to pay such distribution expenses and 0.25% may be
used to pay shareholder service fees. The new NASD Rule also limits the
aggregate amount which the Fund may pay for such distribution costs to 6.25%
of gross share sales since the inception of the Fund's Distribution Plan, plus
interest at the prime rate plus 1% on unpaid amounts thereof (less any
contingent deferred sales charges paid by the shareholders to KDI).
The Fund has operated its Distribution Plan in accordance with both the Plan
and the NASD Rule since July 8, 1992, except that until July 7, 1993, maximum
annual payments with respect to Net Asset Value as represented by shares sold
prior to January 1, 1992 remained at the then current rate of 0.3125%
quarterly (approximately 1.25% annually).
KDI intends, but is not obligated, to continue to pay or accrue distribution
charges which exceed current annual payments permitted to be received by KDI
from the Fund. KDI intends to seek full payment of such charges from the Fund
(together with annual interest thereon at the prime rate plus one percent) at
such time in the future as, and to the extent that, payment thereof by the
Fund would be within permitted limits. KDI currently intends to seek payment
of interest only on such charges paid or accrued by KDI since January 1, 1992.
Since July 8, 1992, contingent deferred sales charges applicable to shares of
the Fund issued after January 1, 1992 have, to the extent permitted by the
NASD Rule, been paid to KDI rather than to the Fund.
During the year ended June 30, 1994, the Fund recovered $333,994 in deferred
sales charges. During the year, the Fund paid KDI $14,534,084 under the
Distribution Plan. The amount paid by the Fund under its Distribution Plan,
net of deferred sales charges, was $14,200,090 (0.96% of the Fund's average
daily net asset value during the year). During the year, KDI retained
$5,366,134 and paid commissions on new sales and maintenance fees to dealers
and others of $10,927,840 of which $1,759,890 was an advance. During the year,
KDI received $1,286,132 in deferred sales charges, bringing the total advances
outstanding to $10,745,515 (0.77% of the Fund's daily net asset value on June
30, 1994).
(3.) Securities Transactions
For the year ended June 30, 1994, purchases and sales of investment securities
were as follows:
Cost of Proceeds
Purchases from Sales
Portfolio securities $ 1,242,445,982 $ 1,244,912,654
Short-term investments 13,809,979,474 13,821,417,476
$15,052,425,456 $15,066,330,130
<PAGE>
(4) Investment Management and Transactions with Affiliates
Under the terms of the Investment Management Agreement between KMI and the
Fund, dated December 29, 1989, KMI provides investment management and
administrative services to the Fund. In return, KMI is paid a management fee
computed daily and paid monthly. The management fee is calculated at a rate of
1.5% of the Fund's gross investment income plus an amount determined by
applying percentage rates starting at 0.60% and declining as net assets
increase to 0.30% per annum, to the net asset value of the Fund. KMI has
entered into an Investment Advisory Agreement with Keystone, dated December
30, 1989, under which Keystone provides investment advisory and management
services to the Fund and receives for its services an annual fee representing
85% of the management fee received by KMI.
During the year ended June 30, 1994, the Fund paid or accrued to KMI
investment management and administrative services fees of $6,677,244 which
represented 0.45% of the Fund's average net assets on an annualized basis. Of
such amount paid to KMI, $5,675,657 was paid to Keystone for its services to
the Fund.
During the year ended June 30, 1994, the Fund paid or accrued $43,964 to KIRC
and KGI for certain accounting services, and $3,589,413 to KIRC for transfer
agent services.
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Trustees and Shareholders
Keystone Custodian Fund, Series K-1
We have audited the accompanying statement of assets and liabilities of
Keystone Custodian Fund, Series K-1, including the schedule of investments, as
of June 30, 1994, and the related statement of operations for the year then
ended, the statements of changes in net assets for each of the years in the
two-year period then ended, and the financial highlights for each of the years
in the ten-year period then ended. These financial statements and financial
highlights are the responsibility of the Fund's management. Our responsibility
is to express an opinion on these financial statements and financial
highlights based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements and
financial highlights are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. Our procedures included confirmation of securities
owned as of June 30, 1994 by correspondence with the custodian and brokers. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the financial statements and financial highlights referred to
above present fairly, in all material respects, the financial position of
Keystone Custodian Fund, Series K-1, as of June 30, 1994, the results of its
operations for the year then ended, the changes in its net assets for each of
the years in the two-year period then ended, and the financial highlights for
each of the years in the ten-year period then ended in conformity with
generally accepted accounting principles.
KPMG PEAT MARWICK
Boston, Massachusetts
August 5, 1994
