PRUDENTIAL GNMA FUND INC, 497, 1995-03-07

PRUDENTIAL GNMA FUND INC
497, 1995-03-07

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PRUDENTIAL GNMA FUND, INC.
STATEMENT OF ADDITIONAL INFORMATION
DATED MARCH 2, 1995

Prudential GNMA Fund, Inc. (the Fund), is an open-end, diversified
management investment company whose investment objective is to achieve a high
level of income over the long term consistent with providing reasonable safety
in the value of each shareholder's investment. In pursuing this objective, the
Fund will invest primarily in mortgage-backed securities guaranteed as to timely
payment of principal and interest by the Government National Mortgage
Association (GNMA) and other readily marketable fixed-income securities. The
Fund may utilize other derivatives, including writing covered call and put
options on U.S. Government securities and entering into closing purchase and
sale transactions with respect to certain of such options. To hedge against
changes in interest rates, the Fund may also purchase put options and engage in
transactions involving interest rate futures contracts, options on such
contracts and interest rate swap contracts. There can be no assurance that the
Fund's investment objective will be achieved. See "Investment Objective and
Policies."

The Fund's address is One Seaport Plaza, New York, New York 10292, and its
telephone number is (800) 225-1852.

This Statement of Additional Information is not a prospectus and should be
read in conjunction with the Fund's Prospectus, dated March 2, 1995, a copy of
which may be obtained from the Fund upon request.

TABLE OF CONTENTS

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CROSS- REFERENCE
TO PAGE IN
PAGE PROSPECTUS
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General Information and History.................................................................. B-2 20
Investment Objective and Policies................................................................ B-2 8
Investment Restrictions.......................................................................... B-9 14
Directors and Officers........................................................................... B-10 14
Manager.......................................................................................... B-13 14
Distributor...................................................................................... B-15 15
Portfolio Transactions and Brokerage............................................................. B-17 17
Purchase and Redemption of Fund Shares........................................................... B-18 21
Shareholder Investment Account................................................................... B-22 29
Net Asset Value.................................................................................. B-25 17
Dividends and Distributions...................................................................... B-25 18
Taxes............................................................................................ B-26 18
Performance Information.......................................................................... B-27 18
Custodian, Transfer and Dividend Disbursing Agent and Independent Accountants.................... B-29 17
Financial Statements............................................................................. B-30 --
Report of Independent Accountants................................................................ B-37 --
Appendix A....................................................................................... A-1 --
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MF102B
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GENERAL INFORMATION AND HISTORY

At a special meeting held on July 19, 1994, shareholders approved an
amendment to the Fund's Articles of Incorporation to change the Fund's name from
Prudential-Bache GNMA Fund, Inc. to Prudential GNMA Fund, Inc.

INVESTMENT OBJECTIVE AND POLICIES

The Fund's investment objective is to achieve a high level of income over
the long term consistent with providing reasonable safety in the value of each
shareholder's investment. In pursuing this objective it is expected that, under
normal market conditions, the Fund will invest at least 65% of its total assets
in securities backed by the Government National Mortgage Association (GNMA). The
Fund also intends to invest in other mortgage-backed securities and other
readily marketable fixed-income securities which provide attractive yields but
which do not involve substantial risk of loss of capital through default, and
may engage in the writing of covered put and call options, closing purchase and
sale transactions with respect to such options and interest rate futures and
options thereon. There can be no assurance that the Fund's investment objective
will be achieved. See "How the Fund Invests--Investment Objective and Policies"
in the Prospectus.

GNMA SECURITIES. The Fund's investments are expected to consist principally
of GNMA securities. A description of their characteristics follows.

GNMA CERTIFICATES. Certificates of the Government National Mortgage
Association (GNMA Certificates) are mortgage-backed securities, which evidence
an undivided interest in a pool or pools of mortgages. GNMA Certificates differ
from bonds in that principal is repaid monthly by the borrower over the term of
the loan rather than returned in a lump sum at maturity. GNMA Certificates that
the Fund purchases are the "modified pass-through" type. "Modified pass-through"
GNMA Certificates entitle the holder to receive timely payment of all interest
and principal payments due on the mortgage pool, net of fees paid to the
"issuer" and GNMA regardless of whether or not the mortgagor actually makes the
payment. The GNMA Certificates will represent a PRO RATA interest in one or more
pools of the following types of mortgage loans: (i) fixed rate level payment
mortgage loans; (ii) fixed rate graduated payment mortgage loans; (iii) fixed
rate growing equity mortgage loans; (iv) fixed rate mortgage loans secured by
manufactured (mobile) homes; (v) mortgage loans on multifamily residential
properties under construction; (vi) mortgage loans on completed multifamily
projects; (vii) fixed rate mortgage loans as to which escrowed funds are used to
reduce the borrower's monthly payments during the early years of the mortgage
loans ("buydown" mortgage loans); (viii) mortgage loans that provide for
adjustments in payments based on periodic changes in interest rates or in other
payment terms of the mortgage loans; and (ix) mortgage-backed serial notes. All
of these mortgage loans will be FHA Loans or VA Loans and, except as otherwise
specified above, will be fully-amortizing loans secured by first liens on
one-to-four-family housing units.

GNMA GUARANTEE. The National Housing Act authorizes GNMA to guarantee the
timely payment of principal and interest on securities backed by a pool of
mortgages insured by the Federal Housing Administration (FHA) or the Farmers'
Home Administration (FMHA), or guaranteed by the Veterans Administration (VA).
The GNMA guarantee is backed by the full faith and credit of the United States.
The GNMA is also empowered to borrow without limitation from the U.S. Treasury
if necessary to make any payments required under its guarantee.

LIFE OF GNMA CERTIFICATES. The average life of a GNMA Certificate is likely
to be substantially shorter than the original maturity of the mortgages
underlying the securities. Prepayments of principal by mortgagors and mortgage
foreclosures will usually result in the return of the greater part of principal
investment long before the maturity of the mortgages in the pool. Foreclosures
impose no risk to principal investment because of the GNMA guarantee, except to
the extent that the Fund has purchased the certificates above par in the
secondary market.

As prepayment rates of individual mortgage pools vary widely, it is not
possible to predict accurately the average life of a particular issue of GNMA
Certificates. However, statistics published by the FHA indicate that the average
life of single-family dwelling mortgages with 25- to 30-year maturities, the
type of mortgages backing the vast majority of GNMA Certificates, is
approximately 12 years. Therefore, it is customary to treat GNMA Certificates as
30-year mortgage-backed securities which prepay fully in the twelfth year. The
prepayment experience of the underlying mortgage pool also affects the actual
yield of a GNMA Certificate. For example, if the higher-yielding mortgages from
the pool are prepaid, the yield on the remaining pool will be reduced.

Mortgage-backed securities are often subject to more rapid repayment than
their stated maturity date would indicate as a result of the pass-through of
prepayments of principal on the underlying mortgage obligations. During periods
of declining

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interest rates, prepayment of mortgages underlying mortgage-backed securities
can be expected to accelerate. Accordingly, the Fund's ability to maintain
positions in high-yielding mortgage-backed securities will be affected by
reductions in the principal amount of such securities resulting from such
prepayments, and its ability to reinvest the returns of principal at comparable
yields is subject to generally prevailing interest rates at that time. The
Fund's net asset value will vary with changes in the values of the Fund's
portfolio securities. Such values will vary with changes in market interest
rates generally and the differentials in yields among various kinds of U.S.
Government securities.

COLLATERALIZED MORTGAGE OBLIGATIONS. Certain issuers of mortgage-backed
obligations (CMOs), including certain CMOs that have elected to be treated as
Real Estate Mortgage Investment Conduits (REMICS), are not considered investment
companies pursuant to a rule recently adopted by the Securities and Exchange
Commission (SEC), and the Fund may invest in the securities of such issuers
without the limitations imposed by the Investment Company Act of 1940, as
amended (the Investment Company Act) on investments by the Fund in other
investment companies. In addition, in reliance on an earlier SEC interpretation,
the Fund's investments in certain other qualifying CMOs, which cannot or do not
rely on the rule, are also not subject to the limitation of the Investment
Company Act on acquiring interests in other investment companies. In order to be
able to rely on the SEC's interpretation, these CMOs must be unmanaged, fixed
asset issuers, that (a) invest primarily in mortgage-backed securities, (b) do
not issue redeemable securities, (c) operate under general exemptive orders
exempting them from all provisions of the Investment Company Act and (d) are not
registered or regulated under the Investment Company Act as investment
companies. To the extent that the Fund selects CMOs or REMICs that cannot rely
on the rule or do not meet the above requirements, the Fund may not invest more
than 10% of its assets in all such entities and may not acquire more than 3% of
the voting securities of any single such entity.

LENDING OF PORTFOLIO SECURITIES. The Fund may lend its portfolio securities
without limit to broker-dealers, banks or other recognized institutional
borrowers of securities, provided that the borrower at all times maintains cash
or equivalent collateral or secures a letter of credit in favor of the Fund
equal in value to at least 100% of the value of the securities loaned. During
the time portfolio securities are on loan, the borrower pays the Fund an amount
equivalent to any interest paid on such securities, and the Fund may invest the
cash collateral and earn additional income, or it may receive an agreed-upon
amount of interest income from the borrower who has delivered equivalent
collateral or secured a letter of credit. Loans are subject to termination at
the option of the Fund or the borrower. The Fund may pay reasonable
administrative and custodial fees in connection with a loan and may pay a
negotiated portion of the interest earned on the cash or equivalent collateral
to the borrower or placing broker. The Fund does not have the right to vote
securities on loan, but would terminate the loan and regain the right to vote if
that were considered important with respect to the investment.

REPURCHASE AGREEMENTS. The Fund's repurchase agreements will be
collateralized by U.S. Government obligations. The Fund will enter into
repurchase transactions only with parties meeting creditworthiness standards
approved by the Fund's Board of Directors. The Fund's investment adviser will
monitor the creditworthiness of such parties, under the general supervision of
the Board of Directors. In the event of a default or bankruptcy by a seller, the
Fund will promptly seek to liquidate the collateral. To the extent that the
proceeds from any sale of such collateral upon a default in the obligation to
repurchase are less than the repurchase price, the Fund will suffer a loss.

The Fund participates in a joint repurchase account with other investment
companies managed by Prudential Mutual Fund Management, Inc. (PMF) pursuant to
an order of the SEC. On a daily basis, any uninvested cash balances of the Fund
may be aggregated with those of such investment companies and invested in one or
more repurchase agreements. Each fund participates in the income earned or
accrued in the joint account based on the percentage of its investment.

PORTFOLIO TURNOVER. Although the Fund has no fixed policy with respect to
portfolio turnover, it may sell portfolio securities without regard to the
length of time that they have been held in order to take advantage of new
investment opportunities or yield differentials, or because the Fund desires to
preserve gains or limit losses due to changing economic conditions. Accordingly,
it is possible that the portfolio turnover rate of the Fund may reach, or even
exceed, 350%. The portfolio turnover rate is computed by dividing the lesser of
the amount of the securities purchased or securities sold (excluding all
securities whose maturities at acquisition were one year or less) by the average
monthly value of such securities owned during the year. A 100% turnover rate
would occur, for example, if all of the securities held in the portfolio of the
Fund were sold and replaced within one year. However, when portfolio changes are
deemed appropriate due to market or other conditions, such turnover rate may be
greater than anticipated. A higher rate of turnover results in increased
transaction costs to the Fund. The portfolio turnover rate for the Fund for the
fiscal years ended December 31, 1993 and 1994 was 134% and 560%, respectively.
The increase in the Fund's portfolio turnover rate resulted in part from the
repositioning of its portfolio by its current portfolio manager, who commenced
managing

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the Fund's portfolio in November 1993. It also resulted from efforts to take
advantage of yield differentials which existed between mortgage "pass-through"
securities and U.S. Treasuries during a year when short-term interest rates were
particularly volatile. These efforts, which involved sales of pass-through
securities in order to buy Treasuries and vice versa, added significantly to the
Fund's higher turnover rate.

ILLIQUID SECURITIES. The Fund may not invest more than 15% of its net assets
in repurchase agreements which have a maturity of longer than seven days or in
other illiquid securities, including securities that are illiquid by virtue of
the absence of a readily available market or legal or contractual restrictions
on resale. Historically, illiquid securities have included securities subject to
contractual or legal restrictions on resale because they have not been
registered under the Securities Act of 1933, as amended (Securities Act),
securities which are otherwise not readily marketable and repurchase agreements
having a maturity of longer than seven days. Securities which have not been
registered under the Securities Act are referred to as private placements or
restricted securities and are purchased directly from the issuer or in the
secondary market. Mutual funds do not typically hold a significant amount of
these restricted or other illiquid securities because of the potential for
delays on resale and uncertainty in valuation. Limitations on resale may have an
adverse effect on the marketability of portfolio securities and a mutual fund
might be unable to dispose of restricted or other illiquid securities promptly
or at reasonable prices and might thereby experience difficulty satisfying
redemptions within seven days. A mutual fund might also have to register such
restricted securities in order to dispose of them resulting in additional
expense and delay. Adverse market conditions could impede such a public offering
of securities.

In recent years, however, a large institutional market has developed for
certain securities that are not registered under the Securities Act, including
repurchase agreements, commercial paper, foreign securities, municipal
securities, convertible securities and corporate bonds and notes. Institutional
investors depend on an efficient institutional market in which the unregistered
security can be readily resold or on an issuer's ability to honor a demand for
repayment. The fact that there are contractual or legal restrictions on resale
to the general public or to certain institutions may not be indicative of the
liquidity of such investments.

Rule 144A under the Securities Act allows for a broader institutional
trading market for securities otherwise subject to restriction on resale to the
general public. Rule 144A establishes a "safe harbor" from the registration
requirements of the Securities Act for resales of certain securities to
qualified institutional buyers. The investment adviser anticipates that the
market for certain restricted securities such as institutional commercial paper
and foreign securities will expand further as a result of this regulation and
the development of automated systems for the trading, clearance and settlement
of unregistered securities of domestic and foreign issuers, such as the PORTAL
System sponsored by the National Association of Securities Dealers, Inc. (the
NASD).

Restricted securities eligible for resale pursuant to Rule 144A under the
Securities Act and commercial paper for which there is a readily available
market will not be deemed to be illiquid. The investment adviser will monitor
the liquidity of such restricted securities subject to the supervision of the
Board of Directors. In reaching liquidity decisions, the investment adviser will
consider, INTER ALIA, the following factors: (1) the frequency of trades and
quotes for the security; (2) the number of dealers wishing to purchase or sell
the security and the number of other potential purchasers; (3) dealer
undertakings to make a market in the security and (4) the nature of the security
and the nature of the marketplace trades (E.G., the time needed to dispose of
the security, the method of soliciting offers and the mechanics of the
transfer). In addition, in order for commercial paper that is issued in reliance
on Section 4(2) of the Securities Act to be considered liquid, (i) it must be
rated in one of the two highest rating categories by at least two nationally
recognized statistical rating organizations (NRSRO), or if only one NRSRO rates
the securities, by that NRSRO, or, if unrated, be of comparable quality in the
view of the investment adviser; and (ii) it must not be "traded flat" (I.E.,
without accrued interest) or in default as to principal or interest. Repurchase
agreements subject to demand are deemed to have a maturity equal to the notice
period.

OPTION WRITING AND RELATED RISKS

CHARACTERISTICS. The Fund may write (I.E., sell) covered put and call
options on U.S. Government securities which are traded on registered securities
exchanges or which result from separate, privately negotiated transactions with
primary U.S. Government securities dealers recognized by the Board of Governors
of the Federal Reserve System (OTC 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.

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So long as the obligation of the writer of the option continues, the writer
is subject to the exercise of the option, either by the assignment of an
exercise notice by the broker-dealer through whom the option was sold in the
case of an exchange-traded option or directly by notice from the holder in the
case of an OTC option. Upon exercise the Fund is required 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 that the Fund effects a
closing purchase transaction, either by purchasing an option covering the same
underlying security and having the same exercise price and expiration date (of
the same series) as that on which it desires to terminate its obligation or by
terminating the option contract through separate negotiation. The effect of such
closing purchase is that the writer's position will be cancelled. Once an
exchange-traded option has been exercised, the writer may not execute a closing
purchase transaction with respect thereto. Effecting closing purchase
transactions in OTC options is subject to negotiation between the Fund and the
holder of the option.

The principal reason for writing options on a securities portfolio is to
attempt to realize, through the receipt of premiums, a greater current return
than would be realized on the underlying securities alone. The premium paid by
the purchaser of an option will reflect, among other things, the relationship of
the exercise price to the market price and volatility of the underlying
security, the remaining term of the option, supply and demand and interest
rates. 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 the 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 price of 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 its obligation to purchase the
underlying security at the exercise price, which will usually exceed the then
current market value of the underlying security. The Fund would then incur a
loss equal to the difference between the price at which it is required to
purchase the underlying security and its market value at the time the option is
exercised, less the premium received for writing the option. If the Fund is able
to enter into a closing purchase transaction, it will realize a profit or loss
from such transaction if the cost of such transaction is less or more than the
premium received from writing the option.

Because the Fund may 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.

PURCHASING OPTIONS. The Fund may purchase put options in an effort to
protect the value of a security that it owns against a decline in market value,
and may also purchase put or call options for the purpose of offsetting
previously written put or call options of the same series. For a further
description of such transactions see "How the Fund Invests--Hedging and Income
Enhancement Strategies--Options Transactions" in the Prospectus.

RISKS AND LIMITATIONS PERTAINING TO OPTIONS TRANSACTIONS. When the Fund
enters into options transactions as a hedge against its portfolio of mortgage
securities, it intends to use OTC options because there is currently no GNMA
option listed on a national securities exchange. There is currently no secondary
market for OTC options.

Exchange-traded options are currently available for other U.S. Government
securities. An exchange-traded option position may be closed out only on an
exchange that provides a secondary market for an option of the same series. OTC
options are not generally terminable at the option of the writer and may be
closed out only by negotiation with the holder. There is no assurance that a
liquid secondary market on an exchange will exist. In addition, because OTC
options are issued in privately negotiated transactions exempt from registration
under the Securities Act, there is no assurance that the Fund will succeed in
negotiating a closing out of an OTC option for any particular option at any
particular time. In such event, it might not be possible to effect closing
transactions in particular options. If the Fund, as a covered call option
writer, is unable to effect a closing purchase transaction in the secondary
market or otherwise, 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 on an exchange include
the following: (i) insufficient trading interest in certain options; (ii)
restrictions on transactions imposed by an exchange; (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; (v) inadequacy of the facilities of an exchange or a
clearing corporation to handle current trading volume; or

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(vi) a decision by one or more exchanges to discontinue the trading of options
(or a particular class or series of options), in which event the secondary
market on that exchange (or in that class or series of options) would cease to
exist, although outstanding options on that exchange that had been issued by a
clearing corporation as a result of trades on that exchange would generally
continue to be exercisable in accordance with their terms.

The Fund's ability to write exchange-traded options on U.S. Government
securities is subject to limitations established by each of the applicable
exchanges governing the maximum number of options in each class which may be
written by a single investor or group of investors acting in concert, regardless
of whether the options are written on the same or different exchanges or are
held or written in one or more accounts or through one or more brokers. Thus,
the number of exchange-traded options which the Fund may write may be limited by
options written by other investment advisory clients of its investment adviser.
An exchange may order the liquidation of positions found to be in excess of
these limits, and it may impose certain other sanctions.

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.

SPECIAL CONSIDERATIONS APPLICABLE TO OPTIONS

ON TREASURY BONDS AND NOTES. Because trading interest in Treasury Bonds and
Notes tends to center on the most recently auctioned issues, the exchanges will
not indefinitely continue to introduce new series of options with expirations to
replace expiring options on particular issues. 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 Treasury Bill changes from week
to week, writers of 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 Treasury
Bills with a principal amount corresponding to the option contract size, the
Fund may be hedged from a risk standpoint, although the long position may be in
Treasury Bills with maturities varying from those on which the options were
written. The Fund will maintain in a segregated account with its custodian
Treasury Bills 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 MORTGAGE CERTIFICATES. Options on Mortgage Certificates are not currently
traded on any exchange. However, the Fund intends to engage in transactions in
OTC options on Mortgage Certificates.

Since the remaining principal balance of Mortgage Certificates declines each
month as a result of mortgage principal payments and prepayments, the Fund, as a
writer of a covered call option holding Mortgage Certificates as "cover" to
satisfy its delivery obligation in the event that the option is exercised, may
find that its Mortgage Certificates no longer have a sufficient remaining
principal balance for this purpose. Should this occur, the Fund will attempt to
effect a closing purchase transaction or will purchase additional Mortgage
Certificates from the same pool (if obtainable) or replacement Mortgage
Certificates in the cash market in order to remain covered.

INTEREST RATE FUTURES AND OPTIONS THEREON

INTEREST RATE FUTURES CONTRACTS. The Fund may purchase and sell interest
rate futures contracts (futures contracts) that are traded on U.S. commodities
exchanges as a hedge against interest rate related fluctuations in the value of
securities which are held in the Fund's portfolio or which the Fund intends to
purchase. The Fund will engage in such transactions consistent with the Fund's
investment objective. Currently futures contracts are available on several types
of fixed-income securities, including U.S. Treasury Bonds, U.S. Treasury Notes
and on U.S. Treasury Bills and Certificates of Deposit on the International
Monetary Market Division of the Chicago Mercantile Exchange. The Fund may also
purchase and sell Eurodollar futures and options thereon which are U.S. dollar
denominated instruments linked to the London Interbank rate and currently traded
on the Chicago Mercantile Exchange.

There are a number of reasons why entering into interest rate futures
contracts for hedging purposes can be beneficial to the Fund. First, futures
markets may be more liquid than the corresponding cash markets on the underlying
securities. Such enhanced liquidity results from the standardization of the
futures contracts and the large transaction volumes. Greater liquidity

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permits a portfolio manager to effect a desired hedge both more quickly and in
greater volume than would be possible in the cash market. Second, a desired sale
and subsequent purchase can generally be accomplished in the futures market for
a fraction of the transaction costs that might be incurred in the cash market.

When a purchase or sale of an interest rate futures contract occurs, a
deposit of high quality, liquid securities called "initial margin" is made by
both buyer and seller with a custodian or otherwise for the benefit of the
broker. Unlike other types of margin, a futures margin account does not involve
any loan or borrowing but is merely a good faith deposit that must be maintained
in a minimum amount of cash or U.S. Treasury Bills, currently equal to 2% of the
contract amount for futures on Treasury Bonds, 1 1/2% of the contract amount for
futures on Treasury Notes, 1/10 of 1% of the contract amount for futures on
Treasury Bills and 2% for GNMA securities. All futures positions, both long and
short, are marked-to-market daily, with cash payments called "variation margin"
being made by buyers and sellers to the custodian, and passed through to the
sellers and buyers, to reflect daily changes in contract values.

Although most interest rate futures contracts call for making or taking
delivery of the underlying securities, these obligations are typically cancelled
or closed out before the scheduled settlement date. The closing is accomplished
by purchasing (or selling) an identical futures contract to offset a short (or
long) position. Such an offsetting transaction cancels the contractual
obligations established by the original futures transaction. Other financial
futures contracts call for cash settlements rather than delivery of securities.

If the price of an offsetting futures transaction varies from the price of
the original futures transaction, the hedger will realize a gain or loss
corresponding to the difference. That gain or loss will tend to offset the
unrealized loss or gain on the hedged securities position, but may not always or
completely do so.

In accordance with current rules of the Commodity Futures Trading Commission
(the CFTC), the Fund may not purchase or sell any interest rate futures
contracts or options thereon for return enhancement or risk management purposes
if, immediately thereafter, the sum of initial margin deposits on the Fund's
futures positions and premiums paid for options thereon would exceed 5% of the
liquidation value of the Fund's total assets. The Fund may purchase and sell
futures contracts and options thereon for BONA FIDE hedging purposes without
limitation.

RISKS AND LIMITATIONS INVOLVED IN FUTURES HEDGING. There are a number of
risks associated with futures hedging. Changes in the price of a futures
contract generally parallel but do not necessarily equal changes in the prices
of the securities being hedged. The risk of imperfect correlation increases if
the composition of the Fund's securities portfolio diverges from the securities
that are the subject of the futures contract. Because the change in price of the
futures contract may be more or less than the change in prices of the underlying
securities, even a correct forecast of interest rate changes may not result in a
successful hedging transaction.

The Fund intends to purchase and sell futures contracts only on exchanges
where there appears to be a market in such futures sufficiently active to
accommodate the volume of its trading activity. There can be no assurance that a
liquid market will always exist for any particular contract at any particular
time. Accordingly, there can be no assurance that it will always be possible to
close a futures position when such closing is desired and, in the event of
adverse price movements, the Fund would continue to be required to make daily
cash payments of variation margin. However, in the event futures contracts have
been sold to hedge portfolio securities, such securities will not be sold until
the offsetting futures contracts can be executed. Similarly, in the event
futures have been bought to hedge anticipated securities purchases, such
purchases will not be executed until the offsetting futures contracts can be
sold.

Successful use of futures contracts by the Fund is also subject to the
ability of the investment adviser to predict correctly movements in the
direction of interest rates and other factors affecting markets for securities.
For example, if the Fund has hedged against the possibility of an increase in
interest rates that would adversely affect the price of securities in its
portfolio and prices of such securities increase instead, the Fund will lose
part or all of the benefit of the increased value of its securities because it
will have offsetting losses in its futures positions. In addition, in such
situations, if the Fund has insufficient cash to meet daily variation margin
requirements, it may have to sell securities to meet such requirements. Such
sales of securities may be, but will not necessarily be, at increased prices
that reflect the rising market. The Fund may have to sell securities at a time
when it is disadvantageous to do so. Where futures are purchased to hedge
against a possible increase in the price of securities before the Fund is able
to invest its cash in an orderly fashion, it is possible that the market may
decline instead; if the Fund then concludes not to invest in securities at that
time because of concern as to possible further market decline or for other
reasons, the Fund will realize a loss on the futures contract that is not offset
by a reduction in the price of the securities purchased.

B-7
<PAGE>
The selling of futures contracts by the Fund and use of related transactions
in options on futures contracts (discussed below) are subject to position
limits, which are affected by the activities of the Fund's investment adviser,
similar to the option trading limits discussed under "Option Writing and Related
Risks."

The hours of trading of interest rate futures contracts may not conform to
the hours during which the Fund may trade U.S. Government securities. To the
extent that the futures markets close before the U.S. Government securities
markets, significant price and rate movements can take place in the U.S.
Government securities markets that cannot be reflected in the futures markets.

Pursuant to Rule 4.5 under the Commodity Exchange Act, investment companies
registered under the Investment Company Act are exempt from the definition of
"commodity pool operator" in the Commodity Exchange Act, subject to compliance
with certain conditions. The exemption is conditioned upon a requirement that
all of the investment company's commodity futures transactions and options
thereon constitute BONA FIDE hedging transactions, except that the Fund may
purchase and sell futures and options thereon for any other purpose to the
extent that the aggregate initial margin and option premiums do not exceed 5% of
the liquidation value of the Fund's total assets. With respect to long positions
assumed by the Fund, the Fund will segregate with its custodian, or in a margin
account with a broker, an amount of cash and other assets permitted by CFTC
regulations equal to the market value of the futures contracts and thereby
insure that the use of futures contracts is unleveraged. The Fund will use
interest rate futures in a manner consistent with these requirements.

OPTIONS ON FUTURES CONTRACTS. The Fund will purchase put options on futures
contracts to hedge its portfolio of debt securities against the risk of rising
interest rates, and the consequent decline in the prices of U.S. Government
securities it owns. The Fund will also write call options on futures contracts
as a hedge against a modest decline in prices of debt securities held in the
Fund's portfolio. If the futures price at expiration of a written call option is
below the exercise price, the Fund will retain the full amount of the option
premium, thereby partially hedging against any decline that may have occurred in
the Fund's holdings of debt securities. If the futures price when the option is
exercised is above the exercise price, however, the Fund will incur a loss,
which may be wholly or partially offset by the increase of the value of the
security in the Fund's portfolio which was being hedged.

INTEREST RATE TRANSACTIONS

The Fund may enter into interest rate swaps, 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 net amount of the excess, if any, of the Fund's
obligations over its entitlements with respect to each interest rate swap will
be accrued on a daily basis and an amount of cash or liquid high-grade debt
securities having an aggregate net asset value at least equal to the accrued
excess will be maintained in a segregated account by a custodian that satisfies
the requirements of the Investment Company Act. To the extent that the Fund
enters into interest rate swaps on other than a net basis, the amount maintained
in a segregated account will be the full amount of the Fund's obligations, if
any, with respect to such interest rate swaps, accrued on a daily basis.
Inasmuch as segregated accounts are established for these hedging transactions,
the investment adviser and the Fund believe such obligations do not constitute
senior securities and, accordingly, will not treat them as being subject to its
borrowing restrictions. The Fund will not enter into any interest rate swaps
unless the short-term debt of the other party thereto is rated in the highest
rating category of at least one nationally recognized rating organization at the
time of entering into such transaction. If there is a default by the other party
to such a transaction, the Fund will have contractual remedies pursuant to the
agreement related to the transaction. The swap market has grown substantially in
recent years with a large number of banks and investment banking firms acting
both as principals and as agents utilizing standardized swap documentation. As a
result, the swap market has become relatively liquid.

The use of interest rate swaps is a highly speculative activity which
involves investment techniques and risks different from those associated with
ordinary portfolio securities transactions. If incorrect in its forecast of
market values, interest rates and other applicable factors, the investment
performance of the Fund would diminish compared to what it would have been if
this investment technique was never used.

The Fund may only enter into interest rate swaps to hedge its portfolio.
Interest rate swaps do not involve the delivery of securities or other
underlying assets or principal. Accordingly, the risk of loss with respect to
interest rates swaps is limited to the net amount of interest payments that the
Fund is contractually obligated to make. If the other party to an interest rate
swap defaults, the Fund's risk of loss consists of the net amount of interest
payments that the Fund is contractually entitled to receive.

B-8
<PAGE>
Since interest rate swaps are individually negotiated, the Fund expects to
achieve an acceptable degree of correlation between its rights to receive
interest on its portfolio securities and its rights and obligations to receive
and pay interest pursuant to interest rate swaps.

INVESTMENT RESTRICTIONS

The following restrictions are fundamental policies. Fundamental policies
are those which cannot be changed without the approval of the holders of a
majority of the Fund's outstanding voting securities. A "majority of the Fund's
outstanding voting securities," when used in this Statement of Additional
Information, means the lesser of (i) 67% of the voting shares represented at a
meeting at which more than 50% of the outstanding voting shares are present in
person or represented by proxy or (ii) more than 50% of the outstanding voting
shares.

The Fund may not:

(1) Purchase any security (other than obligations of the U.S. Government,
its agencies, or instrumentalities) if as a result with respect to 75% of the
Fund's total assets, more than 5% of the Fund's total assets (taken at current
value) would then be invested in securities of a single issuer.

(2) Make short sales of securities or purchase securities on margin (but the
Fund may obtain such short-term credits as may be necessary for the clearance of
transactions). For purposes of this investment restriction, the deposit or
payment by the Fund of initial or variation margin in connection with
transactions in interest rate futures contracts or related options transactions
and collateralization arrangements with respect to exchange-traded and OTC
options on debt securities are not considered the purchase of a security on
margin.

(3) Concentrate its investments in any one industry (no more than 25% of the
Fund's total assets will be invested in any one industry or in the securities of
issuers located in any one foreign country); however, there is no limitation as
to investments in obligations of the U.S. Government, its agencies or
instrumentalities.

(4) Issue senior securities, borrow money or pledge its assets, except that
the Fund may borrow up to 20% of the value of its total assets (calculated when
the loan is made) for temporary, extraordinary or emergency purposes or for the
clearance of transactions. The Fund may pledge up to 20% of the value of its
total assets to secure such borrowings. For purposes of this restriction,
obligations of the Fund to Directors pursuant to deferred compensation
arrangements, the purchase or sale of securities on a when-issued or delayed
delivery basis, the purchase and sale of options and futures contracts and
collateral arrangements with respect to the purchase and sale of options and
futures contracts are not deemed to be the issuance of a senior security or a
pledge of assets.

(5) Purchase any security if as a result the Fund would then have more than
5% of its total assets (taken at current value) invested in securities of
companies (including predecessors) less than three years old.

(6) Buy or sell commodities or commodity contracts, or real estate or
interests in real estate, except it may purchase and sell securities which are
secured by real estate and securities of companies which invest or deal in real
estate, interest rate futures contracts and other financial futures contracts
and options thereon.

(7) Act as underwriter except to the extent that, in connection with the
disposition of portfolio securities, it may be deemed to be an underwriter under
certain federal securities laws.

(8) Make investments for the purpose of exercising control or management.

(9) Invest in securities of other investment companies, except by purchases
in the open market involving only customary brokerage commissions and as a
result of which not more than 5% of its total assets (taken at current value)
would be invested in such securities, or except as part of a merger,
consolidation or other acquisition.

(10) Invest in interests in oil, gas or other mineral exploration or
development programs.

(11) Make loans, except through (i) repurchase agreements and (ii) loans of
portfolio securities. (The purchase of a portion of an issue of securities
distributed publicly, whether or not the purchase is made on the original
issuance, is not considered the making of a loan.)

B-9
<PAGE>
(12) Purchase securities of foreign issuers other than U.S. dollar
denominated debt securities rated at least Aa by Moody's or AA by S&P or U.S.
dollar denominated obligations of foreign branches of domestic banks or of any
bank organized under the laws of Canada, France, Germany, Japan, the
Netherlands, Switzerland or the United Kingdom, provided that such bank has, at
the time of the Fund's investment, total assets of at least $10 billion or the
equivalent.

(13) Purchase or sell puts or calls or combinations thereof, except that the
Fund may write covered put and call options on U.S. Government securities,
purchase put and call options on U.S. Government securities and purchase and
sell interest rate futures contracts and other financial futures contracts and
options thereon, and, in connection with the purchase of other securities, it
may acquire warrants or other rights to subscribe for securities of companies or
parents or subsidiaries of such companies.

Whenever any fundamental investment policy or investment restriction states
a maximum percentage of the Fund's assets, it is intended that if the percentage
limitation is met at the time the investment is made, a later change in
percentage resulting from changing total or net asset values will not be
considered a violation of such policy. However, in the event that the Fund's
asset coverage for borrowings falls below 300%, the Fund will take prompt action
to reduce its borrowings, as required by applicable law.

In order to comply with certain state "blue sky" restrictions, the Fund will
not as a matter of operating policy (i) purchase any security if as a result the
Fund would hold more than 10% of any class of securities of an issuer (taking
all debt issues of an issuer as a single class) in companies in which officers
and directors of the Fund or the manager own more than 1/2 of 1% of the
outstanding securities of such company, (ii) purchase securities of any issuer
if, to the knowledge of the Fund, any officer or director of the Fund or of the
Manager owns more than 1/2 of 1% of the outstanding securities of such issuer,
and such officers and directors who own more than 1/2 of 1% own in the aggregate
more than 5% of the outstanding securities of such issuer or (iii) purchase
warrants if as a result the Fund would then have more than 5% of its net assets
(determined at the time of investment) invested in warrants. Warrants will be
valued at the lower of cost or market and investment in warrants which are not
listed on the New York Stock Exchange or American Stock Exchange will be limited
to 2% of the Fund's net assets (determined at the time of investment). For the
purpose of this limitation, warrants acquired in units or attached to securities
are deemed to be without value.

DIRECTORS AND OFFICERS

B-10
<PAGE>

<TABLE>
<CAPTION>
POSITION PRINCIPAL OCCUPATIONS
NAME, ADDRESS AND AGE WITH FUND DURING PAST FIVE YEARS
- -------------------------------- -------------- -----------------------------------------------------------------------
<S> <C> <C>
*Harry A. Jacobs, Jr. (73) Director Senior Director (since January 1986) of Prudential Securities
One Seaport Plaza Incorporated (Prudential Securities); formerly Interim Chairman and
New York, New York Chief Executive Officer of PMF (June-September 1993); formerly
Chairman of the Board of Prudential Securities (1982-1985) and
Chairman of the Board and Chief Executive Officer of Bache Group Inc.
(1977-1982); Director of The First Australia Fund, Inc., The First
Australia Prime Income Fund, Inc., The Global Government Plus Fund,
Inc. and The Global Total Return Fund, Inc.; Trustee of The Trudeau
Institute.
*Lawrence C. McQuade (67) President and Vice Chairman of PMF (since 1988); Managing Director, Investment
One Seaport Plaza Director Banking, of Prudential Securities (1988-1991); Director, Czech and
New York, New York Slovak American Enterprise Fund (since October 1994), Quixote
Corporation (since February 1992) and BUNZL, PLC (since June 1991);
formerly Director of Crazy Eddie Inc. (1987-1990) and Kaiser Tech.
Ltd. and Kaiser Aluminum and Chemical Corp. (March 1987-November
1988); formerly Executive Vice President and Director of W.R. Grace &
Company; President and Director of The High Yield Income Fund, Inc.,
The Global Total Return Fund, Inc. and The Global Government Plus
Fund, Inc.
Thomas T. Mooney (53) Director President of the Greater Rochester Metro Chamber of Commerce; former
c/o Prudential Mutual Fund Rochester City Manager; Trustee of Center for Governmental Research,
Management, Inc. Inc.; Director of Blue Cross of Rochester, Monroe County Water
One Seaport Plaza Authority, Rochester Jobs, Inc., Northeast Midwest Institute,
New York, New York Executive Service Corps of Rochester and Monroe County Industrial
Development Corporation, First Financial Fund, Inc., The Global
Government Plus Fund, Inc., The Global Total Return Fund, Inc. and
The High Yield Plus Fund, Inc.
Thomas H. O'Brien (70) Director President, O'Brien Associates (financial and management consultants)
c/o Prudential Mutual Fund (since April 1984); formerly President of Jamaica Water Securities
Management, Inc. Corp. (holding company) (February 1989-August 1990), Director
One Seaport Plaza (September 1987-April 1991) and Chairman of the Board and Chief
New York, New York Executive Officer (September 1987-February 1989) of Jamaica Water
Supply Company; formerly, Director of Trans Canada Pipelines U.S.A.
Ltd. (1984-June 1989) and Winthrop University Hospital (November
1976-June 1988); Director of Ridgewood Savings Bank and Yankee Energy
System, Inc.; Secretary and Trustee of Hofstra University.
*Richard A. Redeker (51) Director President, Chief Executive Officer and Director (since October 1993),
One Seaport Plaza PMF; Executive Vice President, Director and Member of the Operating
New York, New York Committee (since October 1993), Prudential Securities; Director
(since October 1993) of Prudential Securities Group, Inc.; Executive
Vice President, The Prudential Investment Corporation (since July
1994); Director (since January 1994) of Prudential Mutual Fund
Distributors, Inc. (PMFD) and Prudential Mutual Fund Services, Inc.
(PMFS); formerly Senior Executive Vice President and Director of
Kemper Financial Services, Inc. (September 1978-September 1993);
Director of The Global Government Plus Fund, Inc., The Global Total
Return Fund, Inc. and The High Yield Income Fund, Inc.
<FN>
- ------------
* "Interested" Director, as defined in the Investment Company Act, by reason of
his affiliation with Prudential Securities or PMF.
</TABLE>

B-11
<PAGE>

Robert F. Gunia (48) Vice President Chief Administrative Officer (since July 1990), Director (since
One Seaport Plaza January 1989) and Executive Vice President, Treasurer and Chief
New York, New York Financial Officer (since June 1987) of PMF; Senior Vice President
(since March 1987) of Prudential Securities; Executive Vice
President, Treasurer, Comptroller and Director (since March 1991)
of PMFD; Director (since June 1987) of PMFS; Vice President and
Director of The Asia Pacific Fund, Inc. (since May 1989).
S. Jane Rose (49) Secretary Senior Vice President (since January 1991), Senior Counsel (since
One Seaport Plaza June 1987) and First Vice President (June 1987-December 1990) of
New York, New York PMF; Senior Vice President and Senior Counsel (since July 1992) of
Prudential Securities; formerly Vice President and Associate
General Counsel of Prudential Securities.
Grace Torres (35) Treasurer and First Vice President (since March 1994) Prudential Mutual Fund
One Seaport Plaza Chief Financial Management, Inc.; First Vice President of Prudential Securities
New York, New York and Accounting (since March 1994); prior thereto, Vice President of Bankers Trust
Officer Corporation.

Deborah A. Docs (37) Assistant Vice President, Associate General Counsel (since January 1993),
One Seaport Plaza Secretary Associate Vice President (January 1990-December 1992), Assistant
New York, New York General Counsel (November 1991-December 1992) and Assistant Vice
President (January 1989-December 1989) of PMF; Vice President and
Associate General Counsel (since January 1993), Associate Vice
President (January 1992-December 1992) and Assistant General
Counsel (January 1992-January 1993) of Prudential Securities.
</TABLE>

Directors and officers of the Fund are also trustees, directors and officers
of some or all of the other investment companies distributed by Prudential
Securities or Prudential Mutual Fund Distributors, Inc.

The officers conduct and supervise the daily business operations of the
Fund, while the Directors, in addition to their functions set forth under
"Manager" and "Distributor," review such actions and decide on general policy.

The Fund pays each of its Directors who is not an affiliated person of the
Manager annual compensation of $7,500, in addition to certain out-of-pocket
expenses.

Directors may receive their Director's fees pursuant to a deferred fee
arrangement with the Fund. Under the terms of the agreement, the Fund accrues
daily the amount of such Director's fee which accrue interest at a rate
equivalent to the prevailing rate applicable to 90-day U.S. Treasury bills at
the beginning of each calendar quarter or, pursuant to an SEC exemptive order,
at the daily rate of return of the Fund. Payment of the interest so accrued is
also deferred and accruals become payable at the option of the Director. The
Fund's obligation to make payments of deferred Director's fees, together with
interest thereon, is a general obligation of the Fund. Mr. Dorsey elected to
receive his Director's fee pursuant to a deferred fee agreement with the Fund
for the fiscal year ended December 31, 1994.

B-12
<PAGE>
The following table sets forth the aggregate compensation paid by the Fund
for the fiscal year ended December 31, 1994 to the Directors who are not
affiliated with the Manager and the aggregate compensation paid to such
Directors for service on the Fund's Board and the Boards of any other investment
companies managed by PMF (Fund Complex) for the calendar year ended December 31,
1994.

COMPENSATION TABLE

<TABLE>
<CAPTION>
Total
Pension or Compensation
Retirement From Fund
Aggregate Benefits Accrued Estimated Annual and Fund
Compensation As Part of Fund Benefits Upon Complex Paid
Name and Position From Fund Expenses Retirement to Directors
- --------------------------------------------------- ------------- ----------------- ------------------- ------------
<S> <C> <C> <C> <C>
Edward D. Beach, Director $ 7,500 None N/A $ 159,000*(20)**
Eugene C. Dorsey, Director $ 7,500 None N/A $ 61,000*(7)**
Delayne Dedrick Gold, Director $ 7,500 None N/A $ 185,000(24)**
Thomas T. Mooney, Director $ 7,500 None N/A $ 126,000(15)**
Thomas H. O'Brien, Director $ 7,500 None N/A $ 44,000(6)**
Nancy H. Teeters, Director $ 7,500 None N/A $ 95,000(12)**
</TABLE>

- ---------------------------

* All compensation for the calendar year ended December 31, 1994 represents
deferred compensation. Aggregate compensation from the Fund for the fiscal
year ended December 31, 1994, including accrued interest, amounted to $7,914.
Aggregate compensation from all of the funds in the Fund Complex for the
calendar year ended December 31, 1994, including accrued interest, amounted
to approximately $61,000.

** Indicates number of funds in Fund Complex (including the Fund) to which
aggregate compensation relates.

As of January 27, 1995, the Directors and officers of the Fund, as a group,
owned less than 1% of the outstanding shares of common stock of the Fund.

As of January 27,1995, the only beneficial owners, directly or indirectly,
of more than 5% of the outstanding shares of any class of common stock of the
Fund were Prudential Insurance Company of America, Stock Operations Division,
1111 Durham Avenue, South Plainfield, NJ 07080-230, which held 1,042,084 Class B
shares of the Fund (5.8%); Patricia A. Vogel, 1660 Oliver Springs Hwy, Clinton,
TN 37716-5246, who held 5,052 Class C shares of the Fund (13.2%); EDW J.
Carland, Annette S. Cohen, 2600 Main Place Tower, Buffalo, NY 14202-3785, who
held 3,429 Class C shares of the Fund (9.0%); and Catherine S. Dalton, 24 Chapel
Woods, Williamsville, NY 14221-1813, who held 2,216 Class C shares of the Fund
(5.8%).

As of January 27, 1995, Prudential Securities was the record holder for
other beneficial owners of 296,849 Class A shares (or 46% of the outstanding
Class A shares), 5,789,536 Class B shares (or 32% of the outstanding Class B
shares) and 35,926 Class C shares (or 94% of the outstanding Class C shares) of
the Fund. In the event of any meetings of shareholders, Prudential Securities
will forward, or cause the forwarding of, proxy materials to the beneficial
owners for which it is the record holder.

MANAGER

The manager of the Fund is Prudential Mutual Fund Management, Inc. (PMF or
the Manager), One Seaport Plaza, New York, New York 10292. PMF serves as manager
to all of the other investment companies that, together with the Fund, comprise
the Prudential Mutual Funds. See "How the Fund is Managed--Manager" in the
Prospectus. As of January 31, 1995, PMF managed and/or administered open-end and
closed-end management investment companies with assets of approximately $45
billion. According to the Investment Company Institute, as of August 31, 1994,
the Prudential Mutual Funds were the 12th largest family of mutual funds in the
United States.

Pursuant to the Management Agreement with the Fund (the Management
Agreement), PMF, subject to the supervision of the Fund's Board of Directors and
in conformity with the stated policies of the Fund, manages both the investment
operations of the Fund and the composition of the Fund's portfolio, including
the purchase, retention, disposition and loan of securities. In connection
therewith, PMF is obligated to keep certain books and records of the Fund. PMF
also administers the Fund's corporate affairs and, in connection therewith,
furnishes the Fund with office facilities, together with those ordinary clerical
and

B-13
<PAGE>
bookkeeping services which are not being furnished by State Street Bank and
Trust Company, the Fund's custodian, and Prudential Mutual Fund Services, Inc.
(PMFS or the Transfer Agent), the Fund's transfer and dividend disbursing agent.
The management services of PMF for the Fund are not exclusive under the terms of
the Management Agreement and PMF is free to, and does, render management
services to others.

For its services, PMF receives, pursuant to the Management Agreement, a fee
at an annual rate of .50 of 1% of the Fund's average daily net assets. The fee
is computed daily and payable monthly. The Management Agreement also provides
that, in the event the expenses of the Fund (including the fees of PMF, but
excluding interest, taxes, brokerage commissions, distribution fees and
litigation and indemnification expenses and other extraordinary expenses not
incurred in the ordinary course of the Fund's business) for any fiscal year
exceed the lowest applicable annual expense limitation established and enforced
pursuant to the statutes or regulations of any jurisdiction in which the Fund's
shares are qualified for offer and sale, the compensation due PMF will be
reduced by the amount of such excess. Reductions in excess of the total
compensation payable to PMF will be paid by PMF to the Fund. No such reductions
were required during the fiscal year ended December 31, 1994. Currently, the
Fund believes that the most restrictive expense limitation of state securities
commissions is 2 1/2% of the Fund's average daily net assets up to $30 million,
2% of the next $70 million of such assets and 1 1/2% of such assets in excess of
$100 million.

In connection with its management of the corporate affairs of the Fund, PMF
bears the following expenses:

(a) the salaries and expenses of all of its and the Fund's personnel except
the fees and expenses of Directors who are not affiliated persons of PMF or the
Fund's investment adviser;

(b) all expenses incurred by PMF or by the Fund in connection with managing
the ordinary course of the Fund's business, other than those assumed by the Fund
as described below; and

(c) the costs and expenses payable to The Prudential Investment Corporation
(PIC) pursuant to the subadvisory agreement between PMF and PIC (the Subadvisory
Agreement).

Under the terms of the Management Agreement, the Fund is responsible for the
payment of the following expenses: (a) the fees payable to the Manager, (b) the
fees and expenses of Directors who are not affiliated persons of the Manager or
the Fund's investment adviser, (c) the fees and certain expenses of the
Custodian and Transfer and Dividend Disbursing Agent, including the cost of
providing records to the Manager in connection with its obligation of
maintaining required records of the Fund and of pricing the Fund's shares, (d)
the charges and expenses of legal counsel and independent accountants for the
Fund, (e) brokerage commissions and any issue or transfer taxes chargeable to
the Fund in connection with its securities transactions, (f) all taxes and
corporate fees payable by the Fund to governmental agencies, (g) the fees of any
trade associations of which the Fund may be a member, (h) the cost of stock
certificates representing shares of the Fund, (i) the cost of fidelity and
liability insurance, (j) the fees and expenses involved in registering and
maintaining registration of the Fund and of its shares with the SEC, registering
the Fund and qualifying its shares under state securities laws, including the
preparation and printing of the Fund's registration statements and prospectuses
for such purposes, (k) allocable communications expenses with respect to
investor services and all expenses of shareholders' and Directors' meetings and
of preparing, printing and mailing reports, proxy statements and prospectuses to
shareholders in the amount necessary for distribution to the shareholders, (l)
litigation and indemnification expenses and other extraordinary expenses not
incurred in the ordinary course of the Fund's business and (m) distribution
fees.

The Management Agreement provides that PMF will not be liable for any error
of judgment or for any loss suffered by the Fund in connection with the matters
to which the Management Agreement relates, except a loss resulting from willful
misfeasance, bad faith, gross negligence or reckless disregard of duty. The
Management Agreement provides that it will terminate automatically if assigned,
and that it may be terminated without penalty by either party upon not more than
60 days' nor less than 30 days' written notice. The Management Agreement will
continue in effect for a period of more than two years from the date of
execution only so long as such continuance is specifically approved at least
annually in conformity with the Investment Company Act. The Management Agreement
was last approved by the Board of Directors of the Fund, including a majority of
the Directors who are not parties to the contract or interested persons of any
such party as defined in the Investment Company Act, on May 4, 1994 and by
shareholders of the Fund on April 29, 1988.

For the fiscal years ended December 31, 1992, 1993 and 1994, the Fund paid
management fees to PMF of $1,509,499, $1,714,652 and $1,450,053, respectively.

B-14
<PAGE>
PMF has entered into the Subadvisory Agreement with PIC (the Subadviser).
The Subadvisory Agreement provides that PIC will furnish investment advisory
services in connection with the management of the Fund. In connection therewith,
PIC is obligated to keep certain books and records of the Fund. PMF continues to
have responsibility for all investment advisory services pursuant to the
Management Agreement and supervises PIC's performance of such services. PIC is
reimbursed by PMF for the reasonable costs and expenses incurred by PIC in
furnishing those services.

The Subadvisory Agreement was last approved by the Board of Directors,
including a majority of the Directors who are not parties to the contract or
interested persons of any such party as defined in the Investment Company Act,
on May 4, 1994, and by shareholders of the Fund on April 29, 1988.

The Subadvisory Agreement provides that it will terminate in the event of
its assignment (as defined in the Investment Company Act) or upon the
termination of the Management Agreement. The Subadvisory Agreement may be
terminated by the Fund, PMF or PIC upon not more than 60 days', nor less than 30
days', written notice. The Subadvisory Agreement provides that it will continue
in effect for a period of more than two years from its execution only so long as
such continuance is specifically approved at least annually in accordance with
the requirements of the Investment Company Act.

The Manager and the Subadviser are subsidiaries of The Prudential Insurance
Company of America (Prudential) which, as of December 31, 1993, is one of the
largest financial institutions in the world and the largest insurance company in
North America. Prudential has been engaged in the insurance business since 1875.
In July 1994, INSTITUTIONAL INVESTOR ranked Prudential the second largest
institutional money manager of the 300 largest money management organizations in
the United States as of December 31, 1993.

DISTRIBUTOR

Prudential Mutual Fund Distributors, Inc. (PMFD), One Seaport Plaza, New
York, New York 10292, acts as the distributor of the Class A shares of the Fund.
Prudential Securities Incorporated, One Seaport Plaza, New York, New York 10292
(Prudential Securities or PSI), acts as the distributor of the Class B and Class
C shares of the Fund.

Pursuant to separate Distribution and Service Plans (the Class A Plan, the
Class B Plan and the Class C Plan, collectively, the Plans) adopted by the Fund
under Rule 12b-1 under the Investment Company Act and separate distribution
agreements (the Distribution Agreements), PMFD and Prudential Securities
(collectively, the Distributor) incur the expenses of distributing the Fund's
Class A, Class B and Class C shares. See "How the Fund is Managed--Distributor"
in the Prospectus.

Prior to January 22, 1990, the Fund offered only one class of shares (the
then existing Class B shares). On October 19, 1989, the Board of Directors,
including a majority of the Directors who are not interested persons of the Fund
and who have no direct or indirect financial interest in the operation of the
Class A or Class B Plan or in any agreement related to either Plan (the Rule
12b-1 Directors), at a meeting called for the purpose of voting on each Plan,
adopted a new plan of distribution for the Class A shares of the Fund (the Class
A Plan) and approved an amended and restated plan of distribution with respect
to the Class B shares of the Fund (the Class B Plan). On May 6, 1993, the Board
of Directors, including a majority of the Rule12b-1 Directors, at a meeting
called for the purpose of voting on each Plan, approved modifications of the
Fund's Class A and Class B Plans and Distribution Agreements to conform them
with recent amendments to the National Association of Securities Dealers, Inc.
(NASD) maximum sales charge rule described below. As so modified, the Class A
Plan provides that (i) up to .25 of 1% of the average daily net assets of the
Class A shares may be used to pay for personal service and/or the maintenance of
shareholder accounts (service fee) and (ii) total distribution fees (including
the service fee of .25 of 1%) may not exceed .30 of 1%. As so modified, the
Class B Plan provides that (i) up to .25 of 1% of the average daily net assets
of the Class B shares may be paid as a service fee and (ii) up to .75 of 1% of
the average daily net assets of the Class B shares (asset-based sales charge)
may be used as reimbursement for distribution-related expenses with respect to
the Class B shares. The aggregate distribution fee for Class B shares
(asset-based sales charge plus service fee) may not exceed .75 of 1% of the
average daily net assets of Class B shares. On May 6, 1993, the Board of
Directors, including a majority of the Rule 12b-1 Directors, at a meeting called
for the purpose of voting on each Plan, adopted a plan of distribution for the
Class C shares of the Fund and approved further amendments to the plans of
distribution for the Fund's Class A and Class B shares changing them from
reimbursement type plans to compensation type plans. The Plans were last
approved by the Board of Directors, including a majority of the Rule 12b-1
Directors, on May 4, 1994. The Class A Plan, as amended, was approved by the
Class A and Class B shareholders and the Class B Plan, as amended, was approved
by Class B shareholders on July 19, 1994. The Class C Plan was approved by the
sole shareholder of the Class C shares on August 1, 1994.

B-15
<PAGE>
CLASS A PLAN. For the fiscal year ended December 31, 1994, PMFD received
payments of $14,811 under the Class A Plan. This amount was primarily expended
for payment of account servicing fees to financial advisers and other persons
who sell Class A shares. For the fiscal year ended December 31, 1994, PMFD also
received approximately $57,000 in initial sales charges.

CLASS B PLAN. For the fiscal year ended December 31, 1994, the Distributor
received $2,099,597 from the Fund under the Class B Plan and spent approximately
$1,029,600 in distributing the Fund's shares. It is estimated that of the latter
amount approximately $65,400 or 6.4% was spent on printing and mailing of
prospectuses to other than current shareholders; $539,800 or 52.4% on
compensation to Pruco Securities Corporation (Prusec), an affiliated
broker-dealer, for commissions to its representatives and other expenses,
including an allocation on account of overhead and other branch office
distribution-related expenses, incurred by it for distribution of Fund shares;
$267,400 or 26.0% in interest and/or carrying charges; and $157,000 or 15.2% on
the aggregate of (i) payments of commissions to financial advisers ($144,500 or
14.0%) and (ii) an allocation on account of overhead and other branch office
distribution-related expenses ($12,500 or 1.2%). The term "overhead and other
branch office distribution-related expenses" represents (a) the expenses of
operating the Distributor's branch offices in connection with the sale of Fund
shares, including lease costs, the salaries and employee benefits of operations
and sales support personnel, utility costs, communications costs and the costs
of stationery and supplies, (b) the costs of client sales seminars, (c) expenses
of mutual fund sales coordinators to promote the sale of Fund shares and (d)
other incidental expenses relating to branch promotion of Fund sales.

Prudential Securities also receives the proceeds of contingent deferred
sales charges paid by holders of Class B shares upon certain redemptions of
Class B shares. See "Shareholder Guide--How to Sell Your Shares--Contingent
Deferred Sales Charges" in the Prospectus. For the fiscal year ended December
31, 1994, Prudential Securities received approximately $737,000 in contingent
deferred sales charges.

CLASS C PLAN. For the period August 1, 1994 (inception of Class C shares)
through December 31, 1994, Prudential Securities received $1,428 from the Fund
under the Class C Plan and spent approximately $4,000 in distributing the Fund's
Class C shares. Prudential Securities also receives the proceeds of contingent
deferred sales charges paid by investors upon certain redemptions of Class C
shares. See "Shareholder Guide--How to Sell Your Shares--Contingent Deferred
Sales Charges" in the Prospectus. For the period August 1, 1994 (inception of
Class C shares) through December 31, 1994, Prudential Securities did not receive
any proceeds from contingent deferred sales charges.

The Class A, Class B and Class C Plans continue in effect from year to year,
provided that each such continuance is approved at least annually by a vote of
the Board of Directors, including a majority vote of the Rule 12b-1 Directors,
cast in person at a meeting called for the purpose of voting on such
continuance. The Plans may each be terminated at any time, without penalty, by
the vote of a majority of the Rule 12b-1 Directors or by the vote of the holders
of a majority of the outstanding shares of the applicable class on not more than
30 days' written notice to any other party to the Plans. The Plans may not be
amended to increase materially the amounts to be spent for the services
described therein without approval by the shareholders of the applicable class
(by both Class A and Class B shareholders, voting separately, in the case of
material amendments to the Class A Plan), and all material amendments are
required to be approved by the Board of Directors in the manner described above.
Each Plan will automatically terminate in the event of its assignment. The Fund
will not be contractually obligated to pay expenses incurred under any Plan if
it is terminated or not continued.

Pursuant to each Plan, the Board of Directors will review at least quarterly
a written report of the distribution expenses incurred on behalf of each class
of shares of the Fund by the Distributor. The report includes an itemization of
the distribution expenses and the purposes of such expenditures. In addition, as
long as the Plans remain in effect, the selection and nomination of Rule 12b-1
Directors shall be committed to the Rule 12b-1 Directors.

Pursuant to each Distribution Agreement, the Fund has agreed to indemnify
PMFD and Prudential Securities to the extent permitted by applicable law against
certain liabilities under the Securities Act of 1933, as amended. Each
Distribution Agreement was last approved by the Board of Directors, including a
majority of the Rule 12b-1 Directors, on May 4, 1994.

NASD MAXIMUM SALES CHARGE RULE. Pursuant to rules of the NASD, the
Distributor is required to limit aggregate initial sales charges, deferred sales
charges and asset-based sales charges to 6.25% of total gross sales of each
class of shares. Interest charges on unreimbursed distribution expenses equal to
the prime rate plus one percent per annum may be added to the 6.25% limitation.
Sales from the reinvestment of dividends and distributions are not included in
the calculation of the 6.25%

B-16
<PAGE>
limitation. The annual asset-based sales charge on shares of the Fund may not
exceed .75 of 1% per class. The 6.25% limitation applies to each class of the
Fund rather than on a per shareholder basis. If aggregate sales charges were to
exceed 6.25% of total gross sales of any class, all sales charges on shares of
that class would be suspended.

On October 21, 1993, PSI entered into an omnibus settlement with the SEC,
state securities regulators in 51 jurisdictions and the NASD to resolve
allegations that PSI sold interests in more than 700 limited partnerships (and a
limited number of other types of securities) from January 1, 1980 through
December 31, 1990, in violation of securities laws to persons for whom such
securities were not suitable in light of the individuals' financial condition or
investment objectives. It was also alleged that the safety, potential returns
and liquidity of the investments had been misrepresented. The limited
partnerships principally involved real estate, oil and gas producing properties
and aircraft leasing ventures. The SEC Order (i) included findings that PSI's
conduct violated the federal securities laws and that an order issued by the SEC
in 1986 requiring PSI to adopt, implement and maintain certain supervisory
procedures had not been complied with; (ii) directed PSI to cease and desist
from violating the federal securities laws and imposed a $10 million civil
penalty; and (iii) required PSI to adopt certain remedial measures including the
establishment of a Compliance Committee of its Board of Directors. Pursuant to
the terms of the SEC settlement, PSI established a settlement fund in the amount
of $330,000,000 and procedures, overseen by a court approved Claims
Administrator, to resolve legitimate claims for compensatory damages by
purchasers of the partnership interests. PSI has agreed to provide additional
funds, if necessary, for that purpose. PSI's settlement with the state
securities regulators included an agreement to pay a penalty of $500,000 per
jurisdiction. PSI consented to a censure and to the payment of a $5,000,000 fine
in settling the NASD action. In settling the above referenced matters, PSI
neither admitted nor denied the allegations asserted against it.

On January 18, 1994, PSI agreed to the entry of a Final Consent Order and a
Parallel Consent Order by the Texas Securities Commissioner. The firm also
entered into a related agreement with the Texas Securities Commissioner. The
allegations were that the firm had engaged in improper sales practices and other
improper conduct resulting in pecuniary losses and other harm to investors
residing in Texas with respect to purchases and sales of limited partnership
interests during the period of January 1, 1980 through December 31, 1990.
Without admitting or denying the allegations, PSI consented to a reprimand,
agreed to cease and desist from future violations, and to provide voluntary
donations to the State of Texas in the aggregate amount of $1,500,000. The firm
agreed to suspend the creation of new customer accounts, the general
solicitation of new accounts, and the offer for sale of securities in or from
PSI's North Dallas office to new customers during a period of twenty consecutive
business days, and agreed that its other Texas offices would be subject to the
same restrictions for a period of five consecutive business days. PSI also
agreed to institute training programs for its securities salesmen in Texas.

On October 27, 1994, Prudential Securities Group, Inc. (PSG) and PSI entered
into agreements with the United States Attorney deferring prosecution (provided
PSI complies with the terms of the agreement for three years) for any alleged
criminal activity related to the sale of certain limited partnership programs
from 1983 to 1990. In connection with these agreements, PSI agreed to add the
sum of $330,000,000 to the fund established by the SEC and executed a
stipulation providing for a reversion of such funds to the United States Postal
Inspection Service. PSI further agreed to obtain a mutually acceptable outside
director to sit on the Board of Directors of PSG and the Compliance Committee of
PSI. The new director will also serve as an independent "ombudsman" whom PSI
employees can call anonymously with complaints about ethics and compliance.
Prudential Securities shall report any allegations or instances of criminal
conduct and material improprieties to the new director. The new director will
submit compliance reports which shall identify all such allegations or instances
of criminal conduct and material improprieties every three months for a
three-year period.

PORTFOLIO TRANSACTIONS AND BROKERAGE

The Manager is responsible for decisions to buy and sell securities and
futures contracts for the Fund, the selection of brokers, dealers and futures
commission merchants to effect the transactions and the negotiation of brokerage
commissions, if any. For purposes of this section, the term "Manager" includes
the Subadviser. Fixed-income securities are generally traded on a "net" basis
with dealers acting as principal for their own accounts without a stated
commission, although the price of the security usually includes a profit to the
dealer. In underwritten offerings, securities are purchased at a fixed price
which includes an amount of compensation to the underwriter, generally referred
to as the underwriter's concession or discount. On occasion, certain money
market instruments may be purchased directly from an issuer, in which case no
commissions or discounts are paid. The Fund will not deal with Prudential
Securities in any transaction in which Prudential Securities acts as principal.
Purchases and sales of securities or futures contracts on a securities exchange
or board of trade will be effected through brokers or futures commission
merchants who charge a commission for their services. Orders may be directed to
any broker or futures commission merchant including, to the extent and in the
manner permitted by applicable law, Prudential Securities and its affiliates.

B-17
<PAGE>
In placing orders for portfolio securities of the Fund, the Manager is
required to give primary consideration to obtaining the most favorable price and
efficient execution. This means that the Manager will seek to execute each
transaction at a price and commission, if any, which provide the most favorable
total cost or proceeds reasonably attainable in the circumstances. While the
Manager generally seeks reasonably competitive spreads or commissions, the Fund
will not necessarily be paying the lowest spread or commission available. Within
the framework of the policy of obtaining the most favorable price and efficient
execution, the Manager will consider research and investment services provided
by brokers, dealers or futures commission merchants who effect or are parties to
portfolio transactions of the Fund, the Manager or the Manager's other clients.
Such research and investment services are those which brokerage houses
customarily provide to institutional investors and include statistical and
economic data and research reports on particular companies and industries. Such
services are used by the Manager in connection with all of its investment
activities, and some of such services obtained in connection with the execution
of transactions for the Fund may be used in managing other investment accounts.
Conversely, brokers, dealers or futures commission merchants furnishing such
services may be selected for the execution of transactions of such other
accounts, whose aggregate assets are far larger than the Fund, and the services
furnished by such brokers, dealers or futures commission merchant may be used by
the Manager in providing investment management for the Fund. Commission rates
are established pursuant to negotiations with the broker, dealer or futures
commission merchant based on the quality and quantity of execution services
provided by the broker, dealer or futures commission merchant in the light of
generally prevailing rates. The Manager's policy is to pay higher commissions to
brokers, dealers and futures commission merchants, other than Prudential
Securities, for particular transactions than might be charged if a different
broker, dealer or futures commission merchant had been selected, on occasions
when, in the Manager's opinion, this policy furthers the objective of obtaining
best price and execution. In addition, the Manager is authorized to pay higher
commissions on brokerage transactions for the Fund to brokers, dealers and
futures commission merchants other than Prudential Securities in order to secure
research and investment services described above, subject to the primary
consideration of obtaining the most favorable price and efficient execution in
the circumstances and subject to review by the Fund's Board of Directors from
time to time as to the extent and continuation of this practice. The allocation
of orders among brokers, dealers and futures commission merchants and the
commission rates paid are reviewed periodically by the Fund's Board of
Directors. Portfolio securities may not be purchased from any underwriting or
selling syndicate of which Prudential Securities (or any affiliate), during the
existence of the syndicate, is a principal underwriter (as defined in the
Investment Company Act), except in accordance with rules of the SEC. This
limitation, in the opinion of the Fund, will not significantly affect the Fund's
ability to pursue its present investment objective. However, in the future in
other circumstances, the Fund may be at a disadvantage because of this
limitation in comparison to other funds with similar objectives but not subject
to such limitations.

Subject to the above considerations, Prudential Securities may act as a
broker or futures commission merchant for the Fund. In order for Prudential
Securities (or any affiliate) to effect any portfolio transactions for the Fund,
the commissions, fees or other remuneration received by Prudential Securities
(or any affiliate) must be reasonable and fair compared to the commissions, fees
or other remuneration paid to other brokers or futures commission merchants in
connection with comparable transactions involving similar securities or futures
being purchased or sold on an exchange or board of trade during a comparable
period of time. This standard would allow Prudential Securities (or any
affiliate) to receive no more than the remuneration which would be expected to
be received by an unaffiliated broker or futures commission merchant in a
commensurate arm's-length transaction. Furthermore, the Board of Directors of
the Fund, including a majority of the non-interested Directors, has adopted
procedures which are reasonably designed to provide that any commissions, fees
or other remuneration paid to Prudential Securities (or any affiliate) are
consistent with the foregoing standard. In accordance with Section 11(a) of the
Securities Exchange Act of 1934, Prudential Securities may not retain
compensation for effecting transactions on a national securities exchange for
the Fund unless the Fund has expressly authorized the retention of such
compensation. Prudential Securities must furnish to the Fund at least annually a
statement setting forth the total amount of all compensation retained by
Prudential Securities from transactions effected for the Fund during the
applicable period. Brokerage and futures transactions with Prudential Securities
(or any affiliate) are also subject to such fiduciary standards as may be
imposed upon Prudential Securities (or such affiliate) by applicable law. During
the years ended December 31, 1994, 1993 and 1992, no brokerage commissions were
paid by the Fund to Prudential Securities.

PURCHASE AND REDEMPTION OF FUND SHARES

Shares of the Fund may be purchased at a price equal to the next determined
net asset value per share plus a sales charge which, at the election of the
investor, may be imposed either (i) at the time of purchase (Class A shares) or
(ii) on a deferred basis (Class B or Class C shares). See "Shareholder
Guide--How to Buy Shares of the Fund" in the Prospectus.

B-18
<PAGE>
Each class of shares represents an interest in the same portfolio of
investments of the Fund and has the same rights, except that (i) each class
bears the separate expenses of its Rule 12b-1 distribution and service plan,
(ii) each class has exclusive voting rights with respect to its plan (except
that the Fund has agreed with the SEC in connection with the offering of a
conversion feature on Class B shares to submit any amendment of the Class A
distribution and service plan to both Class A and Class B shareholders) and
(iii) only Class B shares have a conversion feature. See "Distributor." Each
class also has separate exchange privileges. See "Shareholder Investment
Account--Exchange Privilege."

SPECIMEN PRICE MAKE-UP

Under the current distribution arrangements between the Fund and the
Distributor, Class A shares of the Fund are sold at a maximum sales charge of 4%
and Class B* and Class C* shares of the Fund are sold at net asset value. Using
the Fund's net asset value at December 31, 1994, the maximum offering price of
the Fund's shares is as follows:

<TABLE>
<S> <C>
CLASS A
Net asset value and redemption price per Class A share................... $ 13.50
---------
Maximum sales charge (4% of offering price).............................. .56
---------
Maximum offering price to public......................................... $ 14.06
---------
---------
CLASS B
Net asset value, offering price and redemption price per Class B
share*.................................................................. $ 13.47
---------
---------
CLASS C
Net asset value, offering price and redemption price per Class C
share*.................................................................. $ 13.47
---------
---------
<FN>
- ------------
* Class B and Class C shares are subject to a contingent deferred sales charge
on certain redemptions. See "Shareholder Guide--How to Sell Your
Shares--Contingent Deferred Sales Charges" in the Prospectus.
</TABLE>

REDUCTION AND WAIVER OF INITIAL SALES CHARGES--CLASS A SHARES

COMBINED PURCHASE AND CUMULATIVE PURCHASE PRIVILEGE. If an investor or
eligible group of related investors purchases Class A shares of the Fund
concurrently with Class A shares of other Prudential Mutual Funds, the purchases
may be combined to take advantage of the reduced sales charges applicable to
larger purchases. See the table of breakpoints under "Shareholder
Guide--Alternative Purchase Plan" in the Prospectus.

An eligible group of related Fund investors includes any combination of the
following:

(a) an individual;

(b) the individual's spouse, their children and their parents;

(d) any company controlled by the individual (a person, entity or group that
holds 25% or more of the outstanding voting securities of a corporation will be
deemed to control the corporation, and a partnership will be deemed to be
controlled by each of its general partners);

(e) a trust created by the individual, the beneficiaries of which are the
individual, his or her spouse, parents or children;

(f) a Uniform Gifts to Minors Act/Uniform Transfers to Minors Act account
created by the individual or the individual's spouse; and

(g) one or more employee benefit plans of a company controlled by an
individual.

In addition, an eligible group of related Fund investors may include an
employer (or group of related employers) and one or more qualified retirement
plans of such employer or employers (an employer controlling, controlled by or
under common control with another employer is deemed related to that employer).

The Distributor must be notified at the time of purchase that the investor
is entitled to a reduced sales charge. The reduced sales charge will be granted
subject to confirmation of the investor's holdings. The Combined Purchase and
Cumulative Purchase Privilege does not apply to individual participants in any
retirement or group plans.

RIGHTS OF ACCUMULATION. Reduced sales charges are also available through
Rights of Accumulation, under which an investor or an eligible group of related
investors, as described above under "Combined Purchase and Cumulative Purchase

B-19
<PAGE>
Privilege," may aggregate the value of their existing holdings of shares of the
Fund and shares of other Prudential Mutual Funds (excluding money market funds
other than those acquired pursuant to the exchange privilege) to determine the
reduced sales charge. However, the value of shares held directly with the
Transfer Agent or through Prudential Securities will not be aggregated to
determine the reduced sales charge. All shares must be held either directly with
the Transfer Agent or through Prudential Securities. The value of existing
holdings for purposes of determining the reduced sales charge is calculated
using the maximum offering price (net asset value plus maximum sales charge) as
of the previous business day. See "How the Fund Values its Shares" in the
Prospectus. The Distributor must be notified at the time of purchase that the
investor is entitled to a reduced sales charge. The reduced sales charges will
be granted subject to confirmation of the investor's holdings. Rights of
Accumulation are not available to individual participants in any retirement or
group plans.

LETTER OF INTENT. Reduced sales charges are available to investors (or an
eligible group of related investors), including retirement and group plans, who
enter into a written Letter of Intent providing for the purchase, within a
thirteen-month period, of shares of the Fund and shares of other Prudential
Mutual Funds. All shares of the Fund and shares of other Prudential Mutual Funds
(excluding money market funds other than those acquired pursuant to the exchange
privilege) which were previously purchased and are still owned are also included
in determining the applicable reduction. However, the value of shares held
directly with the Transfer Agent and through Prudential Securities will not be
aggregated to determine the reduced sales charge. All shares must be held either
directly with the Transfer Agent or through Prudential Securities. The
Distributor must be notified at the time of purchase that the investor is
entitled to a reduced sales charge. The reduced sales charge will be granted
subject to confirmation of the investor's holdings. Letters of Intent are not
available to individual participants in any retirement or group plans.

A Letter of Intent permits a purchaser to establish a total investment goal
to be achieved by any number of investments over a thirteen-month period. Each
investment made during the period will receive the reduced sales charge
applicable to the amount represented by the goal, as if it were a single
investment. Escrowed Class A shares totaling 5% of the dollar amount of the
Letter of Intent will be held by the Transfer Agent in the name of the
purchaser, except in the case of retirement and group plans where the employer
or plan sponsor will be responsible for paying any applicable sales charge. The
effective date of a Letter of Intent may be back-dated up to 90 days, in order
that any investments made during this 90-day period, valued at the purchaser's
cost, can be applied to the fulfillment of the Letter of Intent goal, except in
the case of retirement and group plans.

The Letter of Intent does not obligate the investor to purchase, nor the
Fund to sell, the indicated amount. In the event the Letter of Intent goal is
not achieved within the thirteen-month period, the purchaser (or the employer or
plan sponsor in the case of any retirement or group plan) is required to pay the
difference between the sales charge otherwise applicable to the purchases made
during this period and sales charges actually paid. Such payment may be made
directly to the Distributor or, if not paid, the Distributor will liquidate
sufficient escrowed shares to obtain such difference. Investors electing to
purchase Class A shares of the Fund pursuant to a Letter of Intent should
carefully read such Letter of Intent.

B-20
<PAGE>
WAIVER OF THE CONTINGENT DEFERRED SALES CHARGE--CLASS B SHARES

The contingent deferred sales charge is waived under circumstances described
in the Prospectus. See "Shareholder Guide--How to Sell Your Shares--Waiver of
the Contingent Deferred Sales Charges--Class B Shares" in the Prospectus. In
connection with these waivers, the Transfer Agent will require you to submit the
supporting documentation set forth below.

<TABLE>
<CAPTION>
CATEGORY OF WAIVER REQUIRED DOCUMENTATION
<S> <C>
Death A copy of the shareholder's death certificate
or, in the case of a trust, a copy of the
grantor's death certificate, plus a copy of
the trust agreement identifying the grantor.
Disability--An individual will be considered A copy of the Social Security Administration
disabled if he or she is unable to engage in award letter or a letter from a physician on
any substantial gainful activity by reason of the physician's letterhead stating that the
any medically determinable physical or mental shareholder (or, in the case of a trust, the
impairment which can be expected to result in grantor) is permanently disabled. The letter
death or to be of long-continued and must also indicate the date of disability.
indefinite duration.
Distribution from an IRA or 403(b) Custodial A copy of the distribution form from the
Account custodial firm indicating (i) the date of
birth of the shareholder and (ii) that the
shareholder is over age 59 1/2 and is taking a
normal distribution--signed by the
shareholder.
Distribution from Retirement Plan A letter signed by the plan
administrator/trustee indicating the reason
for the distribution.
Excess Contributions A letter from the shareholder (for an IRA) or
the plan administrator/trustee on company
letterhead indicating the amount of the excess
and whether or not taxes have been paid.
</TABLE>

The Transfer Agent reserves the right to request such additional documents
as it may deem appropriate.

QUANTITY DISCOUNT--CLASS B SHARES PURCHASED PRIOR TO AUGUST 1, 1994

The CDSC is reduced on redemptions of Class B shares of the Fund purchased
prior to August 1, 1994 if immediately after a purchase of such shares, the
aggregate cost of all Class B shares of the Fund owned by you in a single
account exceeded $500,000. For example, if you purchased $100,000 of Class B
shares of the Fund and the following year purchase an additional $450,000 of
Class B shares with the result that the aggregate cost of your Class B shares of
the Fund following the second purchase was $550,000, the quantity discount would
be available for the second purchase of $450,000 but not for the first purchase
of $100,000. The quantity discount will be imposed at the following rates
depending on whether the aggregate value exceeded $500,000 or $1 million:

<TABLE>
<CAPTION>
CONTINGENT DEFERRED SALES CHARGE
AS A PERCENTAGE OF DOLLARS INVESTED
OR REDEMPTION PROCEEDS
----------------------------------------
YEAR SINCE PURCHASE $500,001 TO $1
PAYMENT MADE MILLION OVER $1 MILLION
- ------------------------------------------------------ --------------------- -----------------
<S> <C> <C>
First................................................. 3.0% 2.0%
Second................................................ 2.0% 1.0%
Third................................................. 1.0% 0%
Fourth and thereafter................................. 0% 0%
</TABLE>

You must notify the Fund's Transfer Agent either directly or through
Prudential Securities or Prusec, at the time of redemption, that you are
entitled to the reduced CDSC. The reduced CDSC will be granted subject to
confirmation of your holdings.

B-21
<PAGE>
SHAREHOLDER INVESTMENT ACCOUNT

Upon the initial purchase of Fund shares, a Shareholder Investment Account
is established for each investor under which a record of the shares held is
maintained by the Transfer Agent. If delivery of a stock certificate is desired,
it must be requested in writing for each transaction. Certificates are issued
only for full shares and may be redeposited in the Shareholder Investment
Account at any time. There is no charge to the investor for issuance of a
certificate. The Fund makes available to its shareholders the following
privileges and plans.

AUTOMATIC REINVESTMENT OF DIVIDENDS AND/OR DISTRIBUTIONS

For the convenience of investors, all dividends and distributions are
automatically reinvested in full and fractional shares of the Fund. An investor
may direct the Transfer Agent in writing not less than 5 full business days
prior to the record date to have subsequent dividends and/or distributions sent
in cash rather than reinvested. In the case of recently purchased shares for
which registration instructions have not been received on the record date, cash
payment will be made directly to the dealer. Any shareholder who receives a cash
payment representing a dividend or distribution may reinvest such distribution
at net asset value by returning the check or the proceeds to the Transfer Agent
within 30 days after the payment date. Such investment will be made at the net
asset value per share next determined after receipt of the check or proceeds by
the Transfer Agent. A shareholder will receive credit for any contingent
deferred sales charge paid in connection with the amount of proceeds being
reinvested.

EXCHANGE PRIVILEGE

The Fund makes available to its shareholders the privilege of exchanging
their shares of the Fund for shares of certain other Prudential Mutual Funds,
including one or more specified money market funds, subject in each case to the
minimum investment requirements of such funds. Shares of such other Prudential
Mutual Funds may also be exchanged for shares of the Fund. All exchanges are
made on the basis of relative net asset value next determined after receipt of
an order in proper form. An exchange will be treated as a redemption and
purchase for tax purposes. Shares may be exchanged for shares of another fund
only if shares of such fund may legally be sold under applicable state laws. For
retirement and group plans having a limited menu of Prudential Mutual Funds, the
Exchange Privilege is available for those funds eligible for investment in the
particular program.

It is contemplated that the exchange privilege may be applicable to new
mutual funds whose shares may be distributed by the Distributor.

CLASS A. Shareholders of the Fund may exchange their Class A shares for
Class A shares of certain other Prudential Mutual Funds, shares of Prudential
Government Securities Trust (Intermediate Term Series) and shares of the money
market funds specified below. No fee or sales load will be imposed upon the
exchange. Shareholders of money market funds who acquired such shares upon
exchange of Class A shares may use the Exchange Privilege only to acquire Class
A shares of the Prudential Mutual Funds participating in the Exchange Privilege.

The following money market funds participate in the Class A Exchange
Privilege:

Prudential California Municipal Fund
(California Money Market Series)
Prudential Government Securities Trust
(Money Market Series)
(U.S. Treasury Money Market Series)
Prudential Municipal Series Fund
(Connecticut Money Market Series)
(Massachusetts Money Market Series)
(New Jersey Money Market Series)
(New York Money Market Series)
Prudential MoneyMart Assets
Prudential Tax-Free Money Fund

CLASS B AND CLASS C. Shareholders of the Fund may exchange their Class B and
Class C shares for Class B and Class C shares, respectively, of certain other
Prudential Mutual Funds and shares of Prudential Special Money Market Fund, a
money market fund. No CDSC will be payable upon such exchange but a CDSC may be
payable upon the redemption of the Class B and

B-22
<PAGE>
Class C shares acquired as a result of an exchange. The applicable sales charge
will be that imposed by the fund in which shares were initially purchased and
the purchase date will be deemed to be the first day of the month after the
initial purchase, rather than the date of the exchange.

Class B and Class C shares of the Fund may also be exchanged for shares of
Prudential Special Money Market Fund without imposition of any CDSC at the time
of exchange. Upon subsequent redemption from such money market fund or after re-
exchange into the Fund, such shares may be subject to the CDSC calculated by
excluding the time such shares were held in the money market fund. In order to
minimize the period of time in which shares are subject to a CDSC, shares
exchanged out of the money market fund will be exchanged on the basis of their
remaining holding periods, with the longest remaining holding periods being
transferred first. In measuring the time period shares are held in a money
market fund and "tolled" for purposes of calculating the CDSC holding period,
exchanges are deemed to have been made on the last day of the month. Thus, if
shares are exchanged into the Fund from a money market fund during the month
(and are held in the Fund at the end of the month), the entire month will be
included in the CDSC holding period. Conversely, if shares are exchanged into a
money market fund prior to the last day of the month (and are held in the money
market fund on the last day of the month), the entire month will be excluded
from the CDSC holding period. For purposes of calculating the seven-year holding
period applicable to the Class B conversion feature, the time period during
which Class B shares were held in a money market fund will be excluded.

At any time after acquiring shares of other funds participating in the Class
B or Class C exchange privilege, a shareholder may again exchange those shares
(and any reinvested dividends and distributions) for Class B or Class C shares
of the Fund, respectively, without subjecting such shares to any CDSC. Shares of
any fund participating in the Class B or Class C exchange privilege that were
acquired through reinvestment of dividends or distributions may be exchanged for
Class B or Class C shares of other funds, respectively, without being subject to
any CDSC.

Additional details about the Exchange Privilege and prospectuses for each of
the Prudential Mutual Funds are available from the Fund's Transfer Agent,
Prudential Securities or Prusec. The Exchange Privilege may be modified,
terminated or suspended on sixty days' notice, and any fund, including the Fund,
or the Distributor, has the right to reject any exchange application relating to
such fund's shares.

DOLLAR COST AVERAGING

Dollar cost averaging is a method of accumulating shares by investing a
fixed amount of dollars in shares at set intervals. An investor buys more shares
when the price is low and fewer shares when the price is high. The average cost
per share is lower than it would be if a constant number of shares were bought
at set intervals.

Dollar cost averaging may be used, for example, to plan for retirement, to
save for a major expenditure, such as the purchase of a home, or to finance a
college education. The cost of a year's education at a four-year college today
averages around $14,000 at a private college and around $4,800 at a public
university. Assuming these costs increase at a rate of 7% a year, as has been
projected, for the freshman class of 2007, the cost of four years at a private
college could reach $163,000 and over $97,000 at a public university.(1)

The following chart shows how much you would need in monthly investments to
achieve specified lump sums to finance your investment goals.(2)

<TABLE>
<CAPTION>
PERIOD OF
MONTHLY INVESTMENTS: $100,000 $150,000 $200,000 $250,000
- ------------------------------------ -------- -------- -------- --------
<S> <C> <C> <C> <C>
25 Years............................ $ 110 $ 165 $ 220 $ 275
20 Years............................ 176 264 352 440
15 Years............................ 296 444 592 740
10 Years............................ 555 833 1,110 1,388
5 Years............................ 1,371 2,057 2,742 3,428
See "Automatic Savings Accumulation Plan."
<FN>
- ------------
(1) Source information concerning the costs of education at public
universities is available from The College Board Annual Survey of
Colleges, 1992. Information about the costs of private colleges is from
the Digest of Education Statistics, 1992; The National Center for
Educational Statistics; and the U.S. Department of Education. Average
costs for private institutions include tuition, fees, room and board.
</TABLE>

B-23
<PAGE>
<TABLE>
<S> <C>
(2) The chart assumes an effective rate of return of 8% (assuming monthly
compounding). This example is for illustrative purposes only and is not
intended to reflect the performance of an investment in shares of the
Fund. The investment return and principal value of an investment will
fluctuate so that an investor's shares when redeemed may be worth more or
less than their original cost.
</TABLE>

AUTOMATIC SAVINGS ACCUMULATION PLAN (ASAP)

Under ASAP, an investor may arrange to have a fixed amount automatically
invested in shares of the Fund monthly by authorizing his or her bank account or
Prudential Securities account (including a Command Account) to be debited to
invest specified dollar amounts in shares of the Fund. The investor's bank must
be a member of the Automatic Clearing House System. Share certificates are not
issued to ASAP participants.

Further information about this program and an application form can be
obtained from the Transfer Agent, Prudential Securities or Prusec.

SYSTEMATIC WITHDRAWAL PLAN

A systematic withdrawal plan is available to shareholders through Prudential
Securities or the Transfer Agent. Such withdrawal plan provides for monthly or
quarterly checks in any amount, except as provided below, up to the value of the
shares in the shareholder's account. Withdrawals of Class B or Class C shares
may be subject to a CDSC. See "Shareholder Guide-- How to Sell Your
Shares--Contingent Deferred Sales Charges" in the Prospectus.

In the case of shares held through the Transfer Agent (i) a $10,000 minimum
account value applies, (ii) withdrawals may not be for less than $100 and (iii)
the shareholder must elect to have all dividends and/or distributions
automatically reinvested in additional full and fractional shares at net asset
value on shares held under this plan. See "Automatic Reinvestment of Dividends
and/or Distributions."

Prudential Securities and the Transfer Agent act as agents for the
shareholder in redeeming sufficient full and fractional shares to provide the
amount of the periodic withdrawal payment. The systematic withdrawal plan may be
terminated at any time, and the Distributor reserves the right to initiate a fee
of up to $5 per withdrawal, upon 30 days' written notice to the shareholder.

Withdrawal payments should not be considered as dividends, yield or income.
If periodic withdrawals continuously exceed reinvested dividends and
distributions, the shareholder's original investment will be correspondingly
reduced and ultimately exhausted.

Furthermore, each withdrawal constitutes a redemption of shares, and any
gain or loss realized must generally be recognized for federal income tax
purposes. In addition, withdrawals made concurrently with purchases of
additional shares are inadvisable because of the sales charge applicable to (i)
the purchase of Class A shares and (ii) the withdrawal of Class B and Class C
shares. Each shareholder should consult his or her own tax adviser with regard
to the tax consequences of the plan, particularly if used in connection with a
retirement plan.

TAX-DEFERRED RETIREMENT PLANS

Various tax-deferred retirement plans, including a 401(k) plan,
self-directed individual retirement accounts and "tax sheltered accounts" under
Section 403(b)(7) of the Internal Revenue Code are available through the
Distributor. These plans are for use by both self-employed individuals and
corporate employers. These plans permit either self-direction of accounts by
participants, or a pooled account arrangement. Information regarding the
establishment of these plans, the administration, custodial fees and other
details are available from Prudential Securities or the Transfer Agent.

Investors who are considering the adoption of such a plan should consult
with their own legal counsel or tax adviser with respect to the establishment
and maintenance of any such plan.

INDIVIDUAL RETIREMENT ACCOUNTS. An individual retirement account (IRA)
permits the deferral of federal income tax on income earned in the account until
the earnings are withdrawn. The following chart represents a comparison of the
earnings in a personal savings account with those in an IRA, assuming a $2,000
annual contribution, an 8% rate of return and a 39.6% federal income tax bracket
and shows how much more retirement income can accumulate within an IRA as
opposed to a taxable individual savings account.

B-24
<PAGE>
TAX-DEFERRED COMPOUNDING(1)

<TABLE>
<CAPTION>
CONTRIBUTIONS PERSONAL
MADE OVER: SAVINGS IRA
--------------- -------- --------
<S> <C> <C>
10 years $ 26,165 $ 31,291
15 years 44,675 58,649
20 years 68,109 98,846
25 years 97,780 157,909
30 years 135,346 244,692
<FN>
- ------------
(1) The chart is for illustrative purposes only and does not represent the
performance of the Fund or any specific investment. It shows taxable versus
tax-deferred compounding for the periods and on the terms indicated. Earnings
in the IRA account will be subject to tax when withdrawn from the account.
</TABLE>

NET ASSET VALUE

The net asset value per share is the net worth of the Fund (assets including
securities at value minus liabilities) divided by the number of shares
outstanding. Net asset value is calculated separately for each class. The
securities owned by the Fund are traded on national securities exchanges as well
as in the over-the-counter market. Currently, the value of portfolio securities,
including GNMA securities, is determined by reference to quotations received
from a pricing service as of 2:30 and 3:00 P.M., New York time. In addition to
market prices, the pricing service considers such factors as maturities, yields,
call features, and developments relating to specific securities in arriving at
valuations for normal institutional size trading units of securities.

Short-term securities which mature in more than 60 days are valued at
current market quotations. Short-term securities which mature in 60 days or less
are valued at amortized cost, if their term to maturity from date of purchase
was 60 days or less, or by amortizing their value on the 61st day prior to
maturity, if their term to maturity from date of purchase exceeded 60 days,
unless such valuation is determined not to represent fair value by the Board of
Directors.

Exchange-traded options on U.S. Government securities are valued at their
last sale price as of the close of options trading on the applicable exchanges,
which is currently 4:10 P.M., New York time. If there is no sale on the
applicable options exchange on a given day, options are valued at the average of
the quoted bid and asked prices as of the close of the applicable exchange.
Futures contracts are marked to market daily, and options thereon are valued at
their last sale price, as of the close of the applicable commodities exchanges,
which is currently 4:15 P.M., New York time. Securities or other assets for
which market quotations are not readily available (including OTC options) will
be valued at their fair value as determined in good faith by the Manager under
procedures established by the Fund's Board of Directors.

The Fund will compute its net asset value once daily at 4:15 P.M., New York
time, on each day the New York Stock Exchange is open for trading except on days
on which no orders to purchase, sell or redeem Fund shares have been received or
days on which changes in the value of the Fund's portfolio securities do not
affect the net asset value. In the event the New York Stock Exchange closes
early on any business day, the net asset value of the Fund's shares shall be
determined at a time between such closing and 4:15 P.M., New York time. The New
York Stock Exchange is closed on the following holidays: New Year's Day,
Presidents' Day, Good Friday, Memorial Day, Independence Day, Labor Day,
Thanksgiving Day and Christmas Day.

In the event that the New York Stock Exchange or the national securities
exchanges on which stock options are traded adopt different trading hours on
either a permanent or temporary basis, the Board of Directors of the Fund will
reconsider the time at which net asset value is computed. In addition, the Fund
may compute its net asset value as of any time permitted pursuant to any
exemption, order or statement of the SEC or its staff.

DIVIDENDS AND DISTRIBUTIONS

The Fund declares dividends daily based on actual net investment income
determined in accordance with generally accepted accounting principles. A
portion of such dividends may also include projected net investment income. Such
dividends will be payable monthly. The Fund expects to make distributions of net
capital gains, if any, at least annually. In determining the amount of capital
gains to be distributed, any capital loss carryforwards from prior years will be
offset against capital gains. For federal income tax purposes, the Fund has a
capital loss carryforward as of December 31, 1994 of approximately $27,545,000
of which $5,602,500 expires in 1996, $3,073,700 expires in 1997, $2,647,800
expires in 1998, and $16,221,000 expires in

B-25
<PAGE>
2002. Accordingly, no capital gains distribution is expected to be paid to
shareholders until net capital gains have been realized in excess of such
carryforwards. Distributions will be paid in additional Fund shares based on net
asset value, unless the shareholder elects in writing not less than five full
business days prior to the record date to receive such distributions in cash.

The per share dividends on Class B and Class C shares will be lower than the
per share dividends on Class A shares as a result of the higher
distribution-related fee applicable to the Class B and Class C shares. The per
share distributions of net capital gains, if any, will be paid in the same
amount for Class A, Class B and Class C shares. See "Net Asset Value."

TAXES

The Fund has elected to qualify and intends to remain qualified as a
regulated investment company under Subchapter M of the Internal Revenue Code of
1986, as amended (the Internal Revenue Code). Under Subchapter M, the Fund is
not subject to federal income taxes on the taxable income it distributes to
shareholders, provided it distributes to shareholders each year at least 90% of
its net investment income and net short-term capital gains in excess of net
long-term capital losses, if any. In addition, Subchapter M permits net capital
gains of the Fund (I.E., the excess of net long-term capital gains over net
short-term capital losses) to be treated as long-term capital gains of the
shareholders, regardless of how long shares in the Fund are held.

Qualification as a regulated investment company under the Internal Revenue
Code requires, among other things, that (a) at least 90% of the Fund's annual
gross income be derived from interest, proceeds from loans of securities,
dividends and gains from the sale or other disposition of securities or foreign
currencies, or other income (including, but not limited to, gains from options,
futures or forward contracts) derived with respect to its business of investing
in such securities or currencies; (b) the Fund derives less than 30% of its
annual gross income from gains from the sale or other disposition of securities
or options thereon held for less than three months; and (c) the Fund diversify
its holdings so that, at the end of each fiscal quarter, (i) at least 50% of the
market value of the Fund's assets is represented by cash, U.S. Government
securities and other securities limited in respect of any one issuer to an
amount not greater than 5% of the market value of the Fund's assets and 10% of
the outstanding voting securities of such issuer, and (ii) not more than 25% of
the value of the Fund's assets is invested in the securities of any one issuer
(other than U.S. Government securities). The Fund generally will be subject to a
nondeductible excise tax of 4% to the extent that it does not meet certain
minimum distribution requirements as of the end of each calendar year. The Fund
intends to make timely distributions of the Fund's income in compliance with
these requirements. As a result, it is anticipated that the Fund will not be
subject to the excise tax.

The "straddle" provisions of the Internal Revenue Code may also affect the
taxation of the Fund's transactions in options on securities, and limit the
deductibility of any loss from the disposition of a position to the extent of
the unrealized gain on any offsetting position. Further, any position in the
straddle (E.G., a put option acquired by the Fund) may affect the holding period
of the offsetting position for purposes of the 30% of gross income test
described above, and accordingly the Fund's ability to enter into straddles and
dispose of the offsetting positions may be limited.

Any loss realized on a sale, redemption or exchange of shares of the Fund by
a shareholder will be disallowed to the extent the shares are replaced within a
61-day period (beginning 30 days before the disposition of shares). Shares
purchased pursuant to the reinvestment of a dividend will constitute a
replacement of shares.

A shareholder who acquires shares of the Fund and sells or otherwise
disposes of such shares within 90 days of acquisition may not be allowed to
include certain sales charges incurred in acquiring such shares for purposes of
calculating gain or loss realized upon a sale or exchange of shares of the Fund.

The Fund has obtained a written letter of determination from the
Pennsylvania Department of Revenue that, as a registered foreign corporation
"doing business" in Pennsylvania, the Fund is subject to the Pennsylvania
foreign franchise tax. Accordingly, it is believed that Fund shares are exempt
from Pennsylvania personal property taxes. The Fund anticipates that it will
continue such business activities but reserves the right to suspend them at any
time, resulting in the termination of the exemption.

The Fund may be subject to state or local tax in certain other states where
it is deemed to be doing business. Further, in those states which have income
tax laws, the tax treatment of the Fund and of shareholders of the Fund with
respect to distributions by the Fund may differ from federal tax treatment.
Distributions to shareholders may be subject to additional state and local
taxes. Shareholders are urged to consult their own tax advisers regarding
specific questions as to federal, state or local taxes.

B-26
<PAGE>
PERFORMANCE INFORMATION

YIELD. The Fund may from time to time advertise its yield as calculated over
a 30-day period. Yield is calculated separately for Class A, Class B and Class C
shares. The yield will be computed by dividing the Fund's net investment income
per share earned during this 30-day period by the maximum offering price per
share on the last day of this period. Yield is calculated according to the
following formula:

a - b
YIELD = 2[( ----------- +1)to the power of 6 - 1]
cd

Where: a = dividends and interest earned during the period.
b = expenses accrued for the period (net of reimbursements).
c = the average daily number of shares outstanding during the
period that were entitled to receive dividends.
d = the maximum offering price per share on the last day of the
period.

Yield fluctuates and an annualized yield quotation is not a representation
by the Fund as to what an investment in the Fund will actually yield for any
given period.

The Fund's 30-day yields for the 30 days ended December 31, 1994 were 6.25%,
5.90% and 5.89% for the Fund's Class A, Class B and Class C shares,
respectively.

AVERAGE ANNUAL TOTAL RETURN. The Fund may also advertise its average annual
total return. Average annual total return is determined separately for Class A,
Class B and Class C shares. See "How the Fund Calculates Performance" in the
Prospectus.

Average annual total return is computed according to the following formula:

P(1+T)to the power of n = ERV

Where: P = a hypothetical initial payment of $1000.
T = average annual total return.
n = number of years.
ERV = Ending Redeemable Value at the end of the 1, 5 or 10 year
periods (or fractional portion thereof) of a hypothetical $1000
investment made at the beginning of the 1, 5 or 10 year
periods.

Average annual total return takes into account any applicable initial or
contingent deferred sales charges but does not take into account any federal or
state income taxes that may be payable upon redemption.

The average annual total return for Class A shares for the one year and
since inception (January 22, 1990) periods ended December 31, 1994 was (6.0)%
and 5.4%, respectively. The average annual total return for the Class B shares
of the Fund for the one, five and ten year periods ended on December 31, 1994
was 7.6%, 5.3% and 7.3%, respectively. The average annual total return for Class
C shares for the since inception (August 1, 1994) period ended December 31, 1994
was (5.5)%.

AGGREGATE TOTAL RETURN. The Fund may also advertise its aggregate total
return. Aggregate total return is determined separately for Class A, Class B and
Class C shares. See "How the Fund Calculates Performance" in the Prospectus.

Aggregate total return represents the cumulative change in the value of an
investment in the Fund and is computed by the following formula:

Where: P = a hypothetical initial payment of $1000.
ERV = Ending Redeemable Value at the end of the 1, 5 or 10 year
periods (or fractional portion thereof) of a hypothetical $1000
payment made at the beginning of the 1, 5 or 10 year periods.

Aggregate total return does not take into account any federal or state
income taxes that may be payable upon redemption or any applicable initial or
contingent deferred sales charges.

B-27
<PAGE>
The Fund's aggregate total return for Class A shares for the one year and
since inception periods ended on December 31, 1994 was (2.0)% and 34.7%,
respectively. The aggregate total return for Class B shares for the one, five
and ten year periods ended on December 31, 1994 was (2.6)%, 30.7% and 102.6%,
respectively. The aggregate total return for Class C shares for the since
inception period ended December 31, 1994 was (1.3)%.

From time to time, the performance of the Fund may be measured against
various indices. Set forth below is a chart which compares the performance of
different types of investments over the long-term and the rate of inflation.(1)

[GRAPHIC]

(1)Source: Ibbotson Associates, "Stocks, Bonds, Bills and Inflation--1993
Yearbook," (annually updates the work of Roger G. Ibbotson and Rex A.
Sinquefield). Common stock returns are based on the Standard & Poor's 500 Stock
Index, a market-weighted, unmanaged index of 500 common stocks in a variety of
industry sectors. It is a commonly used indicator of broad stock price
movements. This chart is for illustrative purposes only, and is not intended to
represent the performance of any particular investment or fund.

B-28
<PAGE>
CUSTODIAN, TRANSFER AND DIVIDEND DISBURSING AGENT
AND INDEPENDENT ACCOUNTANTS

State Street Bank and Trust Company, One Heritage Drive, North Quincy,
Massachusetts 02171, serves as Custodian for the Fund's portfolio securities and
cash and in that capacity maintains certain financial and accounting books and
records pursuant to an agreement with the Fund. See "How the Fund is
Managed--Custodian and Transfer and Dividend Disbursing Agent" in the Propectus.

Prudential Mutual Fund Services, Inc. (PMFS), Raritan Plaza One, Edison, New
Jersey 08837, serves as the Transfer and Dividend Disbursing Agent of the Fund.
PMFS is a wholly-owned subsidiary of PMF. PMFS provides customary transfer
agency services to the Fund, including the handling of shareholder
communications, the processing of shareholder transactions, the maintenance of
shareholder account records, the payment of dividends and distributions, and
related functions. For these services, PMFS receives an annual fee per
shareholder account, a new account set-up fee for each manually established
account and a monthly inactive zero balance account fee per shareholder account.
PMFS is also reimbursed for its out-of-pocket expenses, including, but not
limited to, postage, stationery, printing, allocable communications expenses and
other costs. For the fiscal year ended December 31, 1994, the Fund incurred fees
of $372,000 for the services of PMFS.

Price Waterhouse LLP, 1177 Avenue of the Americas, New York, New York 10036
serves as the Fund's independent accountants and in that capacity audits the
Fund's annual financial statements.

B-29
<PAGE>

PRUDENTIAL GNMA FUND PORTFOLIO OF INVESTMENTS
DECEMBER 31, 1994
<TABLE>
<CAPTION>
- -----------------------------------------------------------
Principal
Amount Value
(000) Description (Note 1)
- -----------------------------------------------------------
<S> <C> <C>
LONG-TERM INVESTMENTS--99.5%
U.S. GOVERNMENT AGENCY MORTGAGE
PASS-THROUGH OBLIGATIONS--97.6%
Federal National Mortgage
Association,
$ 12 7.00%, 4/01/08................ $ 10,948
Government National Mortgage
Association,
17,000 6.50%, 12/20/99, ARM.......... 16,325,313
62,101 7.00%, 11/15/22 - 8/15/24..... 55,735,439
13,000 7.50%, 6/20/24, ARM........... 12,918,720
48,606 7.50%, 1/20/99 - 9/15/24...... 45,479,310
46,426 8.00%, 9/15/17 - 11/15/29..... 44,450,972
21,138 8.50%, 6/15/16 - 8/15/24...... 20,847,434
32,612 9.00%, 6/15/16 - 8/15/24...... 32,940,943
18,166 9.50%, 5/15/17 - 7/15/17...... 18,784,756
901 12.00%, 12/15/12 - 6/15/15.... 1,001,340
------------
Total U.S. government agency
mortgage pass-through
obligations
(cost $253,307,436)........... 248,495,175
------------
COLLATERALIZED MORTGAGE
OBLIGATION--1.9%
Greenwich Capital Acceptance,
Inc.,
100,637 2.24%, 1/25/24, ARM/IO
(cost $6,926,583)............. 4,780,273
------------
Total long-term investments
(cost $260,234,019)........... 253,275,448
------------
SHORT-TERM INVESTMENTS--18.8%
REPURCHASE AGREEMENTS--18.8%
Joint Repurchase Agreement
Account,
$ 47,927 5.82%, 1/03/95 (Note 5)
(cost $47,927,000)............ $ 47,927,000
------------
TOTAL INVESTMENTS--118.3%
(cost $308,161,019; Note
4)............................ 301,202,448
Liabilities in excess of
other assets--(18.3%)......... (46,488,429)
------------
NET ASSETS--100%................ $254,714,019
------------
------------
</TABLE>

- ---------------
ARM--Adjustable Rate Mortgage.
IO--Interest Only.

See Notes to Financial Statements.

B-30

<PAGE>

- -------------------------------------------------------------------------------
PRUDENTIAL GNMA FUND
STATEMENT OF ASSETS AND LIABILITIES
- -------------------------------------------------------------------------------

<TABLE>
<CAPTION>
DECEMBER 31,
ASSETS 1994
------------
<S> <C>
Investments, at value (cost $308,161,019)................................................. $301,202,448
Receivable for investments sold........................................................... 21,263,035
Interest receivable....................................................................... 1,508,588
Receivable for Fund shares sold........................................................... 34,923
Deferred expenses and other assets........................................................ 4,887
------------
Total assets.......................................................................... 324,013,881
------------
LIABILITIES
Bank overdraft............................................................................ 9,698
Payable for investments purchased......................................................... 68,306,646
Payable for Fund shares reacquired........................................................ 540,607
Due to distributor........................................................................ 159,512
Accrued expenses.......................................................................... 126,875
Due to manager............................................................................ 109,321
Dividends payable......................................................................... 31,706
Deferred directors fees................................................................... 15,497
------------
Total liabilities..................................................................... 69,299,862
------------
NET ASSETS................................................................................ $254,714,019
------------
------------
Net assets were comprised of:
Common stock, at par.................................................................... $ 189,100
Paid-in capital in excess of par........................................................ 290,350,233
------------
290,539,333
Undistributed net investment income..................................................... 1,063,490
Accumulated net realized loss on investments............................................ (29,930,233)
Net unrealized depreciation on investments.............................................. (6,958,571)
------------
Net assets, December 31, 1994............................................................. $254,714,019
------------
------------
Class A:
Net asset value and redemption price per share
($8,762,062 / 648,891 shares of common stock issued and outstanding).................. $13.50
Maximum sales charge (4% of offering price)............................................. .56
------------
Maximum offering price to public........................................................ $14.06
------------
------------
Class B:
Net asset value, offering price and redemption price per share
($245,437,265 / 18,222,895 shares of common stock issued and outstanding)............. $13.47
------------
------------
Class C:
Net asset value, offering price and redemption price per share
($514,692 / 38,214 shares of common stock issued and outstanding)..................... $13.47
------------
------------
</TABLE>

See Notes to Financial Statements.

B-31

<PAGE>

- ----------------------------------------------------
PRUDENTIAL GNMA FUND
STATEMENT OF OPERATIONS
- ----------------------------------------------------
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
INVESTMENT INCOME 1994
------------
<S> <C>
Income
Interest............................ $ 21,882,005
------------
Expenses
Distribution fee--Class A........... 14,811
Distribution fee--Class B........... 2,099,597
Distribution fee--Class C........... 1,428
Management fee...................... 1,450,053
Transfer agent's fees and
expenses............................ 500,000
Custodian's fees and expenses....... 468,000
Reports to shareholders............. 181,000
Audit fee........................... 50,000
Registration fees................... 56,500
Franchise taxes..................... 50,500
Directors' fees..................... 46,000
Legal fees.......................... 25,000
Miscellaneous....................... 12,316
------------
Total expenses.................... 4,955,205
------------
Net investment income................. 16,926,800
------------
REALIZED AND UNREALIZED LOSS ON
INVESTMENTS

Net realized loss on investment
transactions........................ (18,606,161)
Net change in unrealized
appreciation/depreciation
of investments...................... (6,286,536)
------------
Net loss on investments............... (24,892,697)
------------
NET DECREASE IN NET ASSETS
RESULTING FROM OPERATIONS............. $ (7,965,897)
------------
------------
</TABLE>

See Notes to Financial Statements.

- ---------------------------------------------------------
PRUDENTIAL GNMA FUND
STATEMENT OF CHANGES IN NET ASSETS
- ---------------------------------------------------------
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
INCREASE (DECREASE) IN ------------------------------
NET ASSETS 1994 1993
-------------- ------------
<S> <C> <C>
Operations
Net investment
income............... $ 16,926,800 $ 20,023,887
Net realized gain
(loss) on
investments.......... (18,606,161) 3,445,442
Net change in
unrealized apprecia-
tion/depreciation
of investments....... (6,286,536) (9,007,572)
------------- ------------
Net increase (decrease)
in net assets
resulting from
operations........... (7,965,897) 14,461,757
------------- ------------
Dividends and
distributions (Note 1)
Dividends to
shareholders from net
investment income
Class A.............. (634,109) (646,676)
Class B.............. (16,282,437) (19,377,211)
Class C.............. (10,254) --
------------- ------------
(16,926,800) (20,023,887)
------------- ------------
Dividends to
shareholders in
excess of net
investment income
Class A.............. -- (66,983)
Class B.............. -- (2,007,109)
------------- ------------
-- (2,074,092)
------------- ------------
Tax return of capital
distributions
Class A.............. (37,535) --
Class B.............. (1,004,614) --
Class C.............. (1,833) --
------------- ------------
(1,043,982) --
------------- ------------
Fund share transactions
(Note 6)
Proceeds from shares
sold................. 27,166,084 67,747,553
Net asset value of
shares issued in
reinvestment of
dividends............ 10,985,801 13,613,736
Cost of shares
reacquired........... (87,764,556) (78,475,417)
------------- ------------
Net increase (decrease)
in net assets from
Fund share
transactions......... (49,612,671) 2,885,872
------------- ------------
Total decrease........... (75,549,350) (4,750,350)

NET ASSETS

Beginning of year........ 330,263,369 335,013,719
------------- ------------
End of year.............. $ 254,714,019 $330,263,369
------------- ------------
------------- ------------
</TABLE>

See Notes to Financial Statements.

B-32

<PAGE>

- -------------------------------------------------------------------------------
PRUDENTIAL GNMA FUND
NOTES TO FINANCIAL STATEMENTS
- -------------------------------------------------------------------------------

The Prudential GNMA Fund Inc. (the "Fund"), is registered under the
Investment Company Act of 1940 as a diversified, open-end management investment
company. The investment objective of the Fund is to achieve a high level of
income over the long-term consistent with providing reasonable safety by
investing primarily in mortgage-backed securities guaranteed as to timely
payment of principal and interest by the Government National Mortgage
Association (GNMA) and other readily marketable fixed-income securities. The
ability of issuers of debt securities, other than those issued or guaranteed by
the U.S. Government, held by the Fund to meet their obligations may be affected
by economic developments in a specific industry or region.

NOTE 1. ACCOUNTING POLICIES

The following is a summary of significant accounting policies followed by the
Fund in the preparation of its financial statements.

SECURITY VALUATION: The Fund values portfolio securities on the basis of prices
provided by dealers or by a pricing service which uses information such as
market values, maturities, yields, call features and developments relating to
specific securities in determining values.

In connection with transactions in repurchase agreements with U.S. financial
institutions, it is the Fund's policy that its custodian or designated
subcustodians, as the case may be under triparty repurchasement agreements,
takes possession of the underlying collateral securities, the value of which
exceeds the principal amount of the repurchase transaction, including accrued
interest. If the seller defaults and the value of the collateral declines or if
bankruptcy proceedings are commenced with respect to the seller of the security,
realization of the collateral by the Fund may be delayed or limited.

SECURITIES TRANSACTIONS AND INVESTMENT INCOME: Securities transactions are
recorded on the trade date. Since certain mortgage-backed securities, such as
GNMAs, only settle on one day each month, there can be occasions when, pending
settlement, there may be substantial short-term securities in the portfolio
available to fund the purchases of these mortgage-backed securities. Realized
gains and losses on sales of investments are calculated on the identified cost
basis. Interest income is recorded on the accrual basis. The Fund amortizes
original issue discount paid on purchases of portfolio securities as adjustments
to interest income.

Net investment income (other than distribution fees) and unrealized and
realized gains or losses are allocated daily to each class of shares based upon
the relative proportion of net assets of each class at the beginning of the day.

DOLLAR ROLLS: The Fund enters into mortgage dollar rolls in which the Fund sells
mortgage securities for delivery in the current month, realizing a gain or loss,
and simultaneously contracts to repurchase somewhat similar (same type, coupon
and maturity) securities on a specified future date. During the roll period the
Fund forgoes principal and interest paid on the securities. The Fund is
compensated by the interest earned on the cash proceeds of the initial sale and
by the lower repurchase price at the future date. The difference between the
sale proceeds and the lower repurchase price is taken into income. The Fund
maintains a segregated account, the dollar value of which is equal to its
obligations, in respect of dollar rolls.

FEDERAL INCOME TAXES: It is the Fund's policy to continue to meet the
requirements of the Internal Revenue Code applicable to regulated investment
companies and to distribute all of its taxable net income and net capital gains,
if any, to its shareholders. Therefore, no federal income tax provision is
required.

DIVIDENDS AND DISTRIBUTIONS: Dividends from net investment income are declared
daily and paid monthly. The Fund will distribute at least annually any net
capital gains in excess of loss carryforwards. Dividends and distributions are
recorded on the ex-dividend date.

Income distributions and capital gain distributions are determined in
accordance with income tax regulations which may differ from generally accepted
accounting principles.

RECLASSIFICATION OF CAPITAL ACCOUNTS: The Fund accounts and reports for
distributions to shareholders in accordance with Statement of Position 93-2:
Determination, Disclosure, and Financial Statement Presentation of Income,
Capital Gain, and Return of Capital Distributions by Investment Companies. The
effect of applying this statement was to decrease paid-in capital and increase
undistributed net investment income by $1,066,350 for the year ended December
31, 1994. Tax return of capital distributions are charged to paid-in capital.
Net investment income, net realized gains and net assets were not affected by
this change.

B-33

<PAGE>

NOTE 2. AGREEMENTS
The Fund has a management agreement with Prudential Mutual Fund Management,
Inc. ("PMF"). Pursuant to this agreement, PMF has responsibility for all
investment advisory services and supervises the subadviser's performance of such
services. PMF has entered into a subadvisory agreement with The Prudential
Investment Corporation ("PIC"); PIC furnishes investment advisory services in
connection with the management of the Fund. PMF pays for the cost of the
subadviser's services, the compensation of officers of the Fund, occupancy and
certain clerical and bookkeeping costs of the Fund. The Fund bears all other
costs and expenses.

The management fee paid PMF is computed daily and payable monthly, at an
annual rate of .50 of 1% of the Fund's average daily net assets.

The Fund has distribution agreements with Prudential Mutual Fund
Distributors, Inc. ("PMFD"), which acts as the distributor of the Class A
shares of the Fund, and with Prudential Securities Incorporated ("PSI"), which
acts as distributor of the Class B and Class C shares of the Fund (collectively
the "Distributors"). The Fund compensates the Distributors for distributing
and servicing the Fund's Class A, Class B and Class C shares, pursuant to plans
of distribution, (the "Class A, B and C Plans") regardless of expenses
actually incurred by them. The distribution fees are accrued daily and payable
monthly.

On July 19, 1994, shareholders of the Fund approved amendments to the Class A
and Class B Plans under which the distribution plans became compensation plans,
effective August 1, 1994. Prior thereto, the distribution plans were
reimbursement plans, under which PMFD and PSI were reimbursed for expenses
actually incurred by them up to the amount permitted under the Class A and Class
B Plans, respectively. The Fund is not obligated to pay any prior or future
excess distribution costs (costs incurred by the Distributors in excess of
distribution fees paid by the Fund or contingent deferred sales charges received
by the Distributors). The rate of the distribution fees charged to Class A and
Class B shares of the Fund did not change under the amended plans of
distribution. The Fund began offering Class C shares on August 1, 1994.

Pursuant to the Class A, B and C Plans, the Fund compensates the Distributors
for distribution-related activities at an annual rate of up to .30 of 1%, .75%
of 1% and 1%, of the average daily net assets of the Class A, B and C shares,
respectively. Such expenses under the Class A Plan were .15 of 1% of the average
daily net assets of Class A shares and .75 of 1% of the average daily net assets
under the Class B and C Plans of, both, the Class B and Class C shares,
respectively for the fiscal year ended December 31, 1994.

PMFD has advised the Fund that it has received approximately $57,000 in
front-end sales charges resulting from sales of Class A shares during the year
ended December 31, 1994. From these fees, PMFD paid such sales charges to
dealers (PSI and Prusec) which in turn paid commissions to salespersons.

PSI advised the Fund that for the fiscal year ended December 31, 1994, it
received approximately $737,000 in contingent deferred sales charges imposed
upon certain redemptions by Class B and C shareholders.

PMFD is a wholly-owned subsidiary of PMF; PSI, PMF and PIC are indirect,
wholly-owned subsidiaries of The Prudential Insurance Company of America.

NOTE 3. OTHER TRANSACTIONS WITH AFFILIATES

Prudential Mutual Fund Services, Inc. ("PMFS"), a wholly-owned subsidiary of
PMF, serves as the Fund's transfer agent and during the year ended December 31,
1994, the Fund incurred fees of approximately $372,000 for the services of PMFS.
As of December 31, 1994, approximately $28,000 of such fees were due to PMFS.
Transfer agent fees and expenses in the Statement of Operations include certain
out-of-pocket expenses paid to non-affiliates.

NOTE 4. PORTFOLIO SECURITIES

Purchases and sales of investment securities, other than short-term
investments and dollar rolls, for the year ended December 31, 1994 aggregated
$1,506,169,540 and $1,501,725,759, respectively.

The cost basis of investments for federal income tax purposes is
substantially the same as the basis for financial reporting purposes and,
accordingly, as of December 31, 1994 net unrealized depreciation of investments
for federal income tax purposes was $6,958,571 (gross unrealized
appreciation--$18,800; gross unrealized depreciation--$6,977,371).

The Fund had a capital loss carryforward as of December 31, 1994 of
approximately $27,545,000 of which $5,602,500 expires in 1996, $3,073,700
expires in 1997, $2,647,800 expires in 1998 and $16,221,000 expires in 2002. No
capital gains distribution is expected to be paid to shareholders until net
gains have been realized in excess of such carryforward.

The Fund will elect to treat net capital losses of approximately $2,385,000
incurred in the two month period ended

B-34

<PAGE>

December 31, 1994 as having been incurred in the following fiscal year.

NOTE 5. JOINT REPURCHASE AGREEMENT ACCOUNT

The Fund, along with other affiliated registered investment companies,
transfers uninvested cash balances into a single joint account, the daily
aggregate balance of which is invested in one or more repurchase agreements
collateralized by U.S. Treasury or Federal agency obligations. As of December
31, 1994, the Fund has a 6.22% undivided interest in the joint account. The
undivided interest for the Fund represents $47,927,000 in the principal amount.
As of such date, each repurchase agreement in the joint account and the value of
the collateral therefor were as follows:

Goldman, Sachs & Co., 5.75%, in the principal amount of $250,000,000,
repurchase price $250,159,722, due 1/3/95. The value of the collateral including
accrued interest is $255,000,108.

Lehman Government Securities Inc., 5.90%, in the principal amount of
$70,000,000, repurchase price $70,045,889, due 1/3/95. The value of the
collateral including accrued interest is $71,379,084.

Morgan Stanley & Co., 5.75%, in the principal amount of $250,000,000,
repurchase price $250,159,722, due 1/3/95. The value of the collateral including
accrued interest is $255,146,220.

Smith Barney Inc., 5.95%, in the principal amount of $200,000,000, repurchase
price $200,132,222, due 1/3/95. The value of the collateral including accrued
interest is $204,036,161.

NOTE 6. CAPITAL

The Fund offers Class A, Class B and Class C shares. Class A shares are
sold with a front-end sales charge of up to 4%. Class B shares are sold with a
contingent deferred sales charge which declines from 5% to zero depending on the
period of time the shares are held. Class C shares are sold with a contingent
deferred sales charge of 1% during the first year. Class B shares will
automatically convert to Class A shares on a quarterly basis approximately seven
years after purchase commencing on or about February 1995. Each class of shares
has equal rights as to earnings, assets and voting privileges except that each
class bears different distribution expenses and has exclusive voting rights with
respect to its distribution plan. The Fund has authorized 500 million shares of
common stock, $.01 par value per share, equally divided into three classes,
designated Class A, Class B and Class C.

Transactions in shares of common stock were as follows:

Class A Shares Amount
- ------------------------------- ------------ ------------
<S> <C> <C>
Year ended December 31, 1994:
Shares sold.................... 160,285 $ 2,252,534
Shares issued in reinvestment
of dividends and
distributions................ 23,025 322,132
Shares reacquired.............. (271,037) (3,788,946)
------------ ------------
Net decrease in shares
outstanding.................. (87,727) $ (1,214,280)
------------ ------------
------------ ------------
Year ended December 31, 1993:
Shares sold.................... 324,094 $ 4,896,635
Shares issued in reinvestment
of dividends and
distributions................ 24,707 372,441
Shares reacquired.............. (212,210) (3,195,829)
------------ ------------
Net increase in shares
outstanding.................. 136,591 $ 2,073,247
------------ ------------
------------ ------------
Class B
- -------------------------------
Year ended December 31, 1994:
Shares sold.................... 1,730,458 $ 24,377,281
Shares issued in reinvestment
of dividends and
distributions................ 764,245 10,662,126
Shares reacquired.............. (5,988,535) (83,970,630)
------------ ------------
Net decrease in shares
outstanding.................. (3,493,832) $(48,931,223)
------------ ------------
------------ ------------
Year ended December 31, 1993:
Shares sold.................... 4,168,502 $ 62,850,918
Shares issued in reinvestment
of dividends and
distributions................ 880,221 13,241,295
Shares reacquired.............. (5,009,649) (75,279,588)
------------ ------------
Net increase in shares
outstanding.................. 39,074 $ 812,625
------------ ------------
------------ ------------
Class C
- -------------------------------
August 1, 1994* through
December 31, 1994:
Shares sold.................... 38,470 $ 536,269
Shares issued in reinvestment
of dividends and
distributions................ 114 1,543
Shares reacquired.............. (370) (4,980)
------------ ------------
Net increase in shares
outstanding.................. 38,214 $ 532,832
------------ ------------
------------ ------------
<FN>
- ---------------
* Commencement of offering of Class C shares.
</TABLE>

B-35

<PAGE>
- -------------------------------------------------------------------------------
PRUDENTIAL GNMA FUND
FINANCIAL HIGHLIGHTS
- -------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Class A Class C
--------------------------------------------- Class B ------------
January 22, ------------------------------------------------ August
Year Ended 1990* 1994**
December 31, through Year Ended December 31, through
------------------------------- December 31, ------------------------------------------------ December 31,
1994 1993 1992 1991 1990 1994 1993 1992 1991 1990 1994
------ ------- ------ ------ ------------ -------- -------- -------- -------- -------- ------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
PER SHARE
OPERATING
PERFORMANCE:
Net asset value,
beginning of
period........ $14.75 $ 15.07 $15.30 $14.84 $14.73 $ 14.71 $ 15.04 $ 15.27 $ 14.81 $ 14.86 $14.01
------ ------- ------ ------ ------------ -------- -------- -------- -------- -------- ------------
INCOME FROM
- -----------
INVESTMENT
----------
OPERATIONS
----------
Net investment
income........ .90 .95 1.10 1.14 1.17 .82 .87 1.02 1.06 1.15 .30
Net realized and
unrealized
gain (loss) on
investment
transactions... (1.19) (.21) (.15) .61 .15 (1.19) (.23) (.16) .60 (.01) (.49)
------ ------- ------ ------ ------------ -------- -------- -------- -------- -------- ------------
Total from
investment
operations... (.29) .74 .95 1.75 1.32 (.37) .64 .86 1.66 1.14 (.19)
------ ------- ------ ------ ------------ -------- -------- -------- -------- -------- ------------
LESS
- ----
DISTRIBUTIONS
-------------
Dividends to
shareholders
from net
investment
income........ (.90) (.95) (1.10) (1.14) (1.17) (.82) (.87) (1.02) (1.06) (1.15) (.30)
Dividends to
shareholders
in excess of
net investment
income........ -- (.11) (.08) (.15) (.04) -- (.10) (.07) (.14) (.04) --
Tax return of
capital
distributions. (.06) -- -- -- -- (.05) -- -- -- -- (.05)
------ ------- ------ ------ ------------ -------- -------- -------- -------- -------- ------------
Total
distributions. (.96) (1.06) (1.18) (1.29) (1.21) (.87) (.97) (1.09) (1.20) (1.19) (.35)
------ ------- ------ ------ ------------ -------- -------- -------- -------- -------- ------------
Net asset value,
end of
period........ $13.50 $ 14.75 $15.07 $15.30 $14.84 $ 13.47 $ 14.71 $ 15.04 $ 15.27 $ 14.81 $13.47
------ ------- ------ ------ ------------ -------- -------- -------- -------- -------- ------------
------ ------- ------ ------ ------------ -------- -------- -------- -------- -------- ------------
TOTAL
RETURN@:...... (2.01)% 4.97% 6.42% 12.48% 9.41% (2.57)% 4.29% 5.80% 11.82% 8.10% (1.32)%
RATIOS TO
AVERAGE NET
ASSETS:
Net assets, end
of period
(000)......... $8,762 $10,863 $9,045 $6,268 $1,604 $245,437 $319,401 $325,969 $272,661 $226,605 $515
Average net
assets
(000)......... $9,874 $10,199 $6,651 $3,035 $756 $279,946 $332,731 $295,255 $243,749 $218,749 $460
Ratios to
average net
assets:@@
Expenses,
including
distribution
fees........ 1.13% 1.00% 1.00% 1.11% 1.15%(D) 1.73% 1.60% 1.60% 1.71% 1.74% 1.82%(D)
Expenses,
excluding
distribution
fees........ .98% .85% .85% .96% .99%(D) .98% .85% .85% .96% .99% 1.08%(D)
Net investment
income...... 6.42% 6.42% 7.26% 7.81% 9.16%(D) 5.82% 5.82% 6.66% 7.21% 7.96% 5.32%(D)
Portfolio
turnover...... 560% 134% 33% 118% 481% 560% 134% 33% 118% 481% 560%

<FN>
- ---------------
* Commencement of offering of Class A shares.
** Commencement of offering of Class C shares.
(D) Annualized.
@ Total return does not consider the effects of sales loads. Total return is
calculated assuming a purchase of shares on the first day and a sale on the
last day of each period reported and includes reinvestment of dividends and
distributions. Total returns for periods of less than a full year are not
annualized.
@@ Because of the recent commencement of its offering, the ratios for the
Class C shares are not necessarily comparable to that of Class A or B
shares and are not necessarily indicative of future ratios.
</TABLE>

See Notes to Financial Statements.

B-36

<PAGE>
- -------------------------------------------------------------------------------
REPORT OF INDEPENDENT ACCOUNTANTS
- -------------------------------------------------------------------------------

To the Shareholders and Board of Directors of
Prudential GNMA Fund, Inc.

In our opinion, the accompanying statement of assets and liabilities, including
the portfolio of investments, and the related statements of operations and of
changes in net assets and the financial highlights present fairly, in all
material respects, the financial position of Prudential GNMA Fund, Inc. (the
"Fund") at December 31, 1994, the results of its operations for the year then
ended, the changes in its net assets for each of the two years in the period
then ended and the financial highlights for each of the five years in the period
then ended, in conformity with generally accepted accounting principles. These
financial statements and financial highlights (hereafter referred to as
"financial statements") are the responsibility of the Fund's management; our
responsibility is to express an opinion on these financial statements based on
our audits. We conducted our audits of these financial statements in accordance
with generally accepted auditing standards which require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits, which included confirmation of securities at
December 31, 1994 by correspondence with the custodian and brokers, provide a
reasonable basis for the opinion expressed above.

PRICE WATERHOUSE LLP

1177 Avenue of the Americas
New York, New York
February 23, 1995

B-37
<PAGE>
APPENDIX A
DESCRIPTION OF CORPORATE BOND RATINGS

MOODY'S INVESTORS SERVICE CORPORATE BOND RATINGS:

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 edged." 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.

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 Aaa 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.

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 some time in the future.

Moody's applies numerical modifiers 1, 2 and 3 in the Aa and A rating
categories. The modifier 1 indicates that the company 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 company ranks at the lower end of its generic
rating category.

STANDARD & POOR'S RATINGS GROUP DEBT RATINGS:

AAA--Debt rated AAA has the highest rating assigned by S&P. Capacity to pay
interest and repay principal is extremely strong.

AA--Debt rated AA has a very strong capacity to pay interest and repay
principal and differs from the highest rated issues only in small degree.

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.

A-1