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PAINEWEBBER CALIFORNIA TAX-FREE INCOME FUND
PAINEWEBBER NATIONAL TAX-FREE INCOME FUND
PAINEWEBBER MUNICIPAL HIGH INCOME FUND
PAINEWEBBER NEW YORK TAX-FREE INCOME FUND
1285 AVENUE OF THE AMERICAS
NEW YORK, NEW YORK 10019
STATEMENT OF ADDITIONAL INFORMATION
The four funds named above (each a 'Fund' and, collectively, 'Funds') are
series of either PaineWebber Mutual Fund Trust or PaineWebber Municipal Series
(each a 'Trust'), professionally managed mutual funds. PaineWebber California
Tax-Free Income Fund ('California Tax-Free Income Fund') seeks high current
income exempt from federal income tax and California personal income tax,
consistent with the preservation of capital and liquidity within the Fund's
quality standards. PaineWebber National Tax-Free Income Fund ('National Tax-Free
Income Fund') seeks high current income exempt from federal income tax,
consistent with the preservation of capital and liquidity within the Fund's
quality standards. PaineWebber Municipal High Income Fund ('Municipal High
Income Fund') seeks high current income exempt from federal income tax.
PaineWebber New York Tax-Free Income Fund ('New York Tax-Free Income Fund')
seeks high current income exempt from federal income tax and from New York State
and New York City personal income taxes.
The investment adviser, administrator and distributor for each Fund is
Mitchell Hutchins Asset Management Inc. ('Mitchell Hutchins'), a wholly owned
subsidiary of PaineWebber Incorporated ('PaineWebber'). As distributor for the
Funds, Mitchell Hutchins has appointed PaineWebber to serve as the exclusive
dealer for the sale of Fund shares.
This Statement of Additional Information ('SAI') is not a prospectus and
should be read only in conjunction with the Funds' current Prospectus, dated
July 1, 1996. A copy of the Prospectus may be obtained by calling any
PaineWebber investment executive or correspondent firm or by calling toll-free
1-800-647-1568. This Statement of Additional Information is dated July 1, 1996.
INVESTMENT POLICIES AND RESTRICTIONS
The following supplements the information contained in the Prospectus
concerning the Funds' investment policies and limitations.
YIELD FACTORS AND RATINGS. Moody's Investors Service, Inc. ('Moody's'),
Standard & Poor's, a division of The McGraw Hill Companies, Inc. ('S&P') and
other nationally recognized statistical rating organizations ('NRSROs') are
private services that provide ratings of the credit quality of debt obligations,
including issues of municipal securities. A description of the range of ratings
assigned to municipal securities by Moody's and S&P is included in the Appendix
to the Funds' Prospectus. The Funds may use these ratings in determining whether
to purchase, sell or hold a security. It should be emphasized, however, that
ratings are general and are not absolute standards of quality. Consequently,
municipal securities with the same maturity, interest rate and rating may have
different market prices. Credit ratings attempt to evaluate the safety of
principal and interest payments and do not evaluate the risks of fluctuations in
market value. Also, rating agencies may fail to make timely changes in credit
ratings in response to subsequent events, so that an issuer's current financial
condition may be better or worse than the rating indicates. Subsequent to its
purchase by a Fund, an issue of municipal securities may cease to be rated or
its rating may be reduced below the minimum rating required for purchase by the
Fund.
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Opinions relating to the validity of municipal securities and to the
exemption of interest thereon from federal income tax (and also, when available,
from the federal alternative minimum tax) and (where applicable) California
personal income tax and New York State and New York City personal income taxes
are rendered by bond counsel to the respective issuing authorities at the time
of issuance. Neither the Funds nor Mitchell Hutchins will review the proceedings
relating to the issuance of municipal securities or the basis for such opinions.
An issuer's obligations under its municipal securities are subject to the
provisions of bankruptcy, insolvency and other laws affecting the rights and
remedies of creditors (such as the federal bankruptcy laws) and federal, state
and local laws that may be enacted that adversely affect the tax-exempt status
of interest on the municipal securities held by a Fund or of the exempt-interest
dividends received by a Fund's shareholders, extend the time for payment of
principal or interest, or both, or impose other constraints upon enforcement of
such obligations. There is also the possibility that, as a result of litigation
or other conditions, the power or ability of issuers to meet their obligations
for the payment of principal of and interest on their municipal securities may
be materially and adversely affected.
TYPES OF MUNICIPAL SECURITIES. Each Fund may invest in a variety of
municipal securities, as described below:
Municipal Bonds. Municipal bonds are debt obligations issued to obtain
funds for various public purposes that pay interest that is exempt from federal
income tax in the opinion of issuer's counsel. The two principal classifications
of municipal bonds are 'general obligation' and 'revenue' bonds. General
obligation bonds are secured by the issuer's pledge of its full faith, credit
and taxing power for the payment of principal and interest. Revenue bonds are
payable only from the revenues derived from a particular facility or class of
facilities or, in some cases, from the proceeds of a special excise tax or other
specific revenue source such as from the user of the facility being financed.
The term 'municipal bonds' also includes 'moral obligation' issues, which are
normally issued by special purpose authorities. In the case of such issues, an
express or implied 'moral obligation' of a related government unit is pledged to
the payment of the debt service, but is usually subject to annual budget
appropriations.
Municipal Lease Obligations. The term 'municipal bonds' also includes
municipal lease obligations, such as leases, installment purchase contracts and
conditional sales contracts, and certificates of participation therein.
Municipal lease obligations are issued by state and local governments and
authorities to purchase land or various types of equipment or facilities and may
be subject to annual budget appropriations. The Funds generally invest in
municipal lease obligations through certificates of participation.
Although municipal lease obligations do not constitute general obligations
of the municipality for which the municipality's taxing power is pledged, they
ordinarily are backed by the municipality's covenant to budget for, appropriate
and make the payments due under the lease obligation. The leases underlying
certain municipal lease obligations, however, provide that lease payments are
subject to partial or full abatement if, because of material damage or
destruction of the leased property, there is substantial interference with the
lessee's use or occupancy of such property. This 'abatement risk' may be reduced
by the existence of insurance covering the leased property, the maintenance by
the lessee of reserve funds or the provision of credit enhancements such as
letters of credit.
Certain municipal lease obligations contain 'non-appropriation' clauses
which provide that the municipality has no obligation to make lease or
installment purchase payments in future years unless money is appropriated for
such purpose on a yearly basis. Some municipal lease obligations of this type
are insured as to timely payment of principal and interest, even in the event of
a failure by the municipality to appropriate sufficient funds to make payments
under the lease. However, in the case of an uninsured municipal lease
obligation, a Fund's ability to recover under the lease in the event of a
non-appropriation or default will be
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limited solely to the repossession of leased property without recourse to the
general credit of the lessee, and disposition of the property in the event of
foreclosure might prove difficult. No Fund intends to invest more than 5% of its
total assets in such uninsured 'non-appropriation' municipal lease obligations.
There is no percentage limitation on the Funds' ability to invest in other
municipal lease obligations.
Industrial Development Bonds ('IDBs') and Private Activity Bonds
('PABs'). IDBs and PABs are issued by or on behalf of public authorities to
finance various privately operated facilities, such as airport or pollution
control facilities. These obligations are included within the term 'municipal
bonds' if the interest paid thereon is exempt from federal income tax in the
opinion of the bond issuer's counsel. IDBs and PABs are in most cases revenue
bonds and thus are not payable from the unrestricted revenues of the issuer. The
credit quality of IDBs and PABs is usually directly related to the credit
standing of the user of the facilities being financed. IDBs issued after August
15, 1986 generally are considered PABs, and to the extent a Fund invests in such
PABs, shareholders generally will be required to include a portion of their
exempt-interest dividends from that Fund in calculating their liability for the
alternative minimum tax ('AMT'). See 'Dividends and Taxes' in the Prospectus.
Each Fund is authorized to invest more than 25% of its net assets in IDBs and
PABs.
Floating Rate and Variable Rate Obligations. Floating rate and variable
rate obligations bear interest at rates that are not fixed, but that vary with
changes in specified market rates or indices. Accordingly, as interest rates
decrease or increase, the potential for capital appreciation or capital
depreciation is less than for fixed rate obligations. Floating rate or variable
rate obligations typically permit the holder to demand payment of principal from
the issuer or remarketing agent at par value prior to maturity and may permit
the issuer to prepay principal, plus accrued interest, at its discretion after a
specified notice period. Frequently, floating rate or variable rate obligations
and/or the demand features thereon are secured by letters of credit or other
credit support arrangements provided by banks, the credit standing of which
affects the credit quality of the obligations.
A demand feature gives the Fund the right to sell the securities to a
specified party, usually a remarketing agent, on a specified date. A demand
feature is often backed by a letter of credit or guarantee from a bank. As
discussed under 'Participation Interests,' to the extent that payment of an
obligation is backed by a bank's letter of credit or guarantee, such payment may
be subject to the bank's ability to satisfy that commitment. The interest rate
on floating rate or variable rate securities ordinarily is readjusted on the
basis of the prime rate of the bank that originated the financing or some other
index or published rate, such as the 90-day U.S. Treasury Bill rate. Generally,
these interest rate adjustments cause the market value of floating rate and
variable rate municipal securities to fluctuate less than the market value of
fixed rate obligations. Accordingly, as interest rates decrease or increase, the
potential for capital appreciation or capital depreciation is less than for
fixed rate obligations.
Participation Interests. Participation interests are interests in
municipal bonds, including IDBs and PABs, and floating and variable rate
obligations that are owned by banks. These interests carry a demand feature
permitting the holder to tender them back to the bank, which demand feature
generally is backed by an irrevocable letter of credit or guarantee of the bank.
The credit standing of such bank affects the credit quality of the participation
interests.
A participation interest gives a Fund an undivided interest in a municipal
bond owned by a bank. The Fund has the right to sell the instrument back to the
bank. Such right generally is backed by the bank's irrevocable letter of credit
or guarantee and permits the Fund to draw on the letter of credit on demand,
after specified notice, for all or any part of the principal amount of the
Fund's participation interest plus accrued interest. Generally, each Fund
intends to exercise the demand under the letters of credit or other guarantees
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only (1) upon a default under the terms of the underlying bond, (2) to maintain
the Fund's portfolio in accordance with its investment objective and policies or
(3) as needed to provide liquidity to the Fund in order to meet redemption
requests. The ability of a bank to fulfill its obligations under a letter of
credit or guarantee might be affected by possible financial difficulties of its
borrowers, adverse interest rate or economic conditions, regulatory limitations
or other factors. Mitchell Hutchins will monitor the pricing, quality and
liquidity of the participation interests held by a Fund, and the credit standing
of banks issuing letters of credit or guarantees supporting such participation
interests on the basis of published financial information reports of rating
services and bank analytical services.
Tender Option Bonds. Tender option bonds are long-term municipal
securities sold by a bank subject to a 'tender option' that gives the purchaser
the right to tender them to the bank at par plus accrued interest at designated
times (the 'tender option'). The tender option may be excercisable at intervals
ranging from bi-weekly to semi-annually, and the interest rate on the bonds is
typically reset at the end of the applicable interval in an attempt to cause the
bonds to have a market value that approximates their par value. The tender
option generally would not be exercisable in the event of a default on, or
significant downgrading of, the underlying municipal securities. Therefore, a
Fund's ability to exercise the tender option will be affected by the credit
standing of both the bank involved and the issuer of the underlying securities.
Put Bonds. A put bond is a municipal bond which gives the holder the
unconditional right to sell the bond back to the issuer or a remarketing agent
at a specified price and exercise date, which is typically well in advance of
the bond's maturity date. The obligation to purchase the bond on the exercise
date may be supported by a letter of credit or other credit support arrangement
from a bank, insurance company or other financial institution, the credit
standing of which affects the credit quality of the obligation.
If the put is a 'one time only' put, the Fund ordinarily will either sell
the bond or put the bond, depending upon the more favorable price. If the bond
has a series of puts after the first put, the bond will be held as long as, in
the judgment of Mitchell Hutchins, it is in the best interest of the Fund to do
so. There is no assurance that the issuer of a put bond acquired by a Fund will
be able to repurchase the bond upon the exercise date, if the Fund chooses to
exercise its right to put the bond back to the issuer.
Tax-Exempt Commercial Paper and Short-Term Municipal Notes. Tax-exempt
commercial paper and short-term municipal notes include tax anticipation notes,
bond anticipation notes, revenue anticipation notes and other forms of
short-term loans. Such notes are issued with a short-term maturity in
anticipation of the receipt of tax funds, the proceeds of bond placements and
other revenues.
Inverse Floaters. Each Fund may invest in municipal obligations on which
the rate of interest varies inversely with interest rates on other municipal
obligations or an index. Such obligations include components of securities on
which interest is paid in two separate parts--an auction component, which pays
interest at a market rate that is set periodically through an auction process or
other method, and a residual component, or 'inverse floater,' which pays
interest at a rate equal to the difference between the rate that the issuer
would have paid on a fixed-rate obligation at the time of issuance and the rate
paid on the auction component. The market value of an inverse floater will be
more volatile than that of a fixed-rate obligation and, like most debt
obligations, will vary inversely with changes in interest rates.
Because the interest rate paid to holders of inverse floaters is generally
determined by subtracting the interest rate paid to the holders of auction
components from a fixed amount, the interest rate paid to holders of inverse
floaters will decrease as market rates increase and increase as market rates
decrease. Moreover, the extent of the increases and decreases in the market
value of inverse floaters may be larger than comparable changes in the market
value of an equal principal amount of a fixed rate municipal obligation having
similar credit quality redemption provisions and maturity. In a declining
interest rate environment, inverse floaters
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can provide a Fund with a means of increasing or maintaining the level of
tax-exempt interest paid to shareholders. However, because of the market
volatility associated with inverse floaters, no Fund will invest more than 10%
of its total assets in inverse floaters.
Mortgage Subsidy Bonds. The Funds also may purchase mortgage subsidy bonds
that are normally issued by special purpose public authorities. In some cases
the repayment of such bonds depends upon annual legislative appropriations; in
other cases repayment is a legal obligation of the issuer and, if the issuer is
unable to meet its obligations, repayment becomes a moral commitment of a
related government unit (subject, however, to such appropriations). The types of
municipal securities identified above and in the Prospectus may include
obligations of issuers whose revenues are primarily derived from mortgage loans
on housing projects for moderate to low income families.
WHEN-ISSUED AND DELAYED DELIVERY SECURITIES. As stated in the Prospectus,
the Fund may purchase securities on a 'when-issued' or delayed delivery basis. A
security purchased on a when-issued or delayed delivery basis is recorded as an
asset on the commitment date and is subject to changes in market value,
generally based upon changes in the level of interest rates. Thus, fluctuation
in the value of the security from the time of the commitment date will affect
the Fund's net asset value. When a Fund commits to purchase securities on a
when-issued or delayed delivery basis, its custodian segregates assets to cover
the amount of the commitment. See 'Investment Policies and
Restrictions--Segregated Accounts.' The Funds purchase when-issued securities
only with the intention of taking delivery, but may sell the right to acquire
the security prior to delivery if Mitchell Hutchins deems it advantageous to do
so, which may result in capital gain or loss to a Fund.
STAND-BY COMMITMENTS. Each Fund may acquire stand-by commitments pursuant
to which a bank or other municipal bond dealer agrees to purchase securities
that are held in the Fund's portfolio or that are being purchased by the Fund,
at a price equal to (1) the acquisition cost (excluding any accrued interest
paid on acquisition), less any amortized market premium or plus any accrued
market or original issue discount, plus (2) all interest accrued on the
securities since the last interest payment date or the date the securities were
purchased by the Fund, whichever is later. Although the Funds do not currently
intend to acquire stand-by commitments with respect to municipal securities held
in their portfolios, each Fund may acquire such commitments under unusual market
conditions to facilitate portfolio liquidity.
A Fund would enter into stand-by commitments only with those banks or other
dealers that, in the opinion of Mitchell Hutchins, present minimal credit risk.
A Fund's right to exercise stand-by commitments would be unconditional and
unqualified. A stand-by commitment would not be transferable by a Fund, although
the Fund could sell the underlying securities to a third party at any time. A
Fund may pay for stand-by commitments either separately in cash or by paying a
higher price for the securities that are acquired subject to such a commitment
(thus reducing the yield to maturity otherwise available for the same
securities). The acquisition of a stand-by commitment would not ordinarily
affect the valuation or maturity of the underlying municipal securities.
Stand-by commitments acquired by a Fund would be valued at zero in determining
net asset value. Whether the Fund paid directly or indirectly for a stand-by
commitment, its cost would be treated as unrealized depreciation and would be
amortized over the period the commitment is held by the Fund.
REPURCHASE AGREEMENTS. The Funds do not intend to enter into repurchase
agreements except as a temporary measure and under unusual circumstances,
because repurchase agreements are transactions that generate taxable income.
Each Fund is, however, authorized to enter into repurchase agreements with U.S.
banks and dealers with respect to any obligation issued or guaranteed by the
U.S. government, its agencies or instrumentalities and also with respect to
commercial paper, bank certificates of deposit and bankers'
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acceptances. Repurchase agreements are transactions in which a Fund purchases
securities from a bank or recognized securities dealer and simultaneously
commits to resell the securities to the bank or dealer at an agreed-upon date
and price reflecting a market rate of interest unrelated to the coupon rate or
maturity of the purchased securities. The Fund maintains custody of the
underlying securities prior to their repurchase; thus, the obligation of the
bank or dealer to pay the repurchase price on the date agreed to is, in effect,
secured by such securities. If the value of these securities is less than the
repurchase price, plus any agreed-upon additional amount, the other party to the
agreement must provide additional collateral so that at all times the collateral
is at least equal to the repurchase price, plus any agreed-upon additional
amount. The difference between the total amount to be received upon repurchase
of the securities and the price which was paid by the Fund upon acquisition is
accrued as interest and included in the Fund's net investment income.
Repurchase agreements carry certain risks not associated with direct
investments in securities, including possible declines in the market value of
the underlying securities and delays and costs to the Fund if the other party to
a repurchase agreement becomes insolvent. Each Fund intends to enter into
repurchase agreements only with banks and dealers in transactions believed by
Mitchell Hutchins to present minimal credit risks in accordance with guidelines
established by the appropriate Trust's board of trustees. Mitchell Hutchins will
review and monitor the creditworthiness of those institutions under the board's
general supervision.
ILLIQUID SECURITIES. Each Fund may invest up to 10% of its net assets in
illiquid securities. The term 'illiquid securities' for this purpose means
securities that cannot be disposed of within seven days in the ordinary course
of business at approximately the amount at which the Fund has valued the
securities and includes, among other things, repurchase agreements maturing in
more than seven days and municipal lease obligations (including certificates of
participation) other than those Mitchell Hutchins has determined are liquid
pursuant to guidelines established by the appropriate Trust's board of trustees.
Each Trust's board of trustees has delegated the function of making
day-to-day determinations of liquidity to Mitchell Hutchins, pursuant to
guidelines approved by the board. Mitchell Hutchins takes into account a number
of factors in reaching liquidity decisions, including (1) the frequency of
trades for the security, (2) the number of dealers that make quotes for the
security, (3) the number of dealers that have undertaken to make a market in the
security, (4) the number of other potential purchasers and (5) the nature of the
security and how trading is effected (e.g., the time needed to sell the
security, how offers are solicited and the mechanics of transfer). Mitchell
Hutchins monitors the liquidity of securities in each Fund's portfolio and
reports periodically on liquidity decisions to each Trust's board of trustees.
In making determinations as to the liquidity of municipal lease
obligations, Mitchell Hutchins will distinguish between direct investments in
municipal lease obligations (or participations therein) and investments in
securities that may be supported by municipal lease obligations or certificates
of participation therein. Since these municipal lease obligation-backed
securities are based on a well-established means of securitization, Mitchell
Hutchins does not believe that investing in such securities presents the same
liquidity issues as direct investments in municipal lease obligations. The
assets used as cover for any over-the-counter ('OTC') options written by a Fund
would be considered illiquid unless the OTC options are sold to qualified
dealers who agree that the Fund may repurchase any OTC option it writes at a
maximum price to be calculated by a formula set forth in the option agreement.
The cover for an OTC option written subject to this procedure will be considered
illiquid only to the extent that the maximum repurchase price under the formula
exceeds the intrinsic value of the option.
LENDING OF PORTFOLIO SECURITIES. The Funds do not intend to lend their
portfolio securities, except under unusual circumstances, because securities
loans are transactions that generate taxable income. As indicated in the
Prospectus, however, each Fund is authorized to lend up to 33 1/3% of its
portfolio securities to
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broker-dealers or institutional investors that Mitchell Hutchins deems
qualified, but only when the borrower maintains acceptable collateral with the
Fund's custodian, marked to market daily, in an amount at least equal to the
market value of the securities loaned, plus accrued interest and dividends.
Acceptable collateral is limited to cash, U.S. government securities and
irrevocable letters of credit that meet certain guidelines established by
Mitchell Hutchins. In determining whether to lend securities to a particular
broker-dealer or institutional investor, Mitchell Hutchins will consider, and
during the period of the loan will monitor, all relevant facts and
circumstances, including the creditworthiness of the borrower. Each will retain
authority to terminate any loan at any time. A 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 money market
instruments held as collateral to the borrower or placing broker. A Fund will
receive reasonable interest on the loan or a flat fee from the borrower and
amounts equivalent to any dividends, interest or other distributions on the
securities loaned. A Fund will retain record ownership of loaned securities to
exercise beneficial rights, such as voting and subscription rights and rights to
dividends, interest or other distributions, when regaining such rights is
considered to be in the Fund's interest.
SEGREGATED ACCOUNTS. When a Fund enters into certain transactions that
involve obligations to make future payments to third parties, including the
purchase of securities on a when-issued or delayed delivery basis, the Fund will
maintain with an approved custodian in a segregated account cash or other liquid
securities, marked to market daily, in an amount at least equal to the Fund's
obligation or commitment under such transactions. As described below under
'Hedging and Related Income Strategies,' segregated accounts may also be
required in connection with certain transactions involving options or futures
contracts.
DURATION. Duration is a measure of the expected life of a fixed income
security that was developed as a more precise alternative to the concept 'term
to maturity.' Duration incorporates a bond's yield, coupon interest payments,
final maturity and call features into one measure and is one of the fundamental
tools used by Mitchell Hutchins in portfolio selection for the Funds.
Traditionally, a debt security's 'term to maturity' has been used as a proxy for
the sensitivity of the security's price to changes in interest rates (which is
the 'interest rate risk' or 'volatility' of the security). However, 'term to
maturity' measures only the time until a debt security provides for a final
payment, taking no account of the pattern of the security's payments prior to
maturity. Duration is a measure of the expected life of a fixed income security
on a present value basis. Duration takes the length of the time intervals
between the present time and the time that the interest and the principal
payments are scheduled to be made or, in the case of a callable bond, expected
to be received, and weights them by the present values of the cash to be
received at each future point in time. For any fixed income security with
interest payments occurring prior to the payment of principal, duration is
always less than maturity.
Futures, options and options on futures have durations which, in general,
are closely related to the duration of the securities which underlie them.
Holding long futures or call option positions (backed by a segregated account of
cash and cash equivalents) will lengthen a Fund's duration by approximately the
same amount as would holding an equivalent amount of the underlying securities.
Short futures or put options have durations roughly equal to the negative
duration of the securities that underlie these positions, and have the effect of
reducing portfolio duration by approximately the same amount as would selling an
equivalent amount of the underlying securities.
There are some situations in which the standard duration calculation does
not properly reflect the interest rate exposure of a security. For example,
floating and variable rate securities often have final maturities of ten or more
years; however, their interest rate exposure corresponds to the frequency of the
coupon reset. In this and other similar situations, Mitchell Hutchins will use
more sophisticated analytical techniques that
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incorporate the economic life of a security into the determination of its
duration and, therefore, its interest rate exposure.
Duration allows Mitchell Hutchins to make certain predictions as to the
effect that changes in the level of interest rates will have on the value of a
Fund's portfolio. For example, when the level of interest rates increases by 1%,
a fixed income security having a positive duration of three years generally will
decrease in value by approximately 3%. Accordingly, if Mitchell Hutchins
calculates the duration of a Fund's portfolio as being three years, it normally
would expect the portfolio to change in value by approximately 3% for every 1%
change in the level of interest rates. However, various factors, such as changes
in anticipated prepayment rates, qualitative considerations and market supply
and demand, can cause particular securities to respond somewhat differently to
changes in interest rates than indicated in the above example. This is
particularly true during periods of market volatility. Accordingly, the net
asset value of a Fund's portfolio may vary in relation to interest rates by a
greater or lesser percentage than indicated by the above example.
SPECIAL CONSIDERATIONS RELATING TO CALIFORNIA MUNICIPAL SECURITIES
The financial condition of the State of California, its public authorities
and local governments could affect the market values and marketability of, and
therefore the net asset value per share and the interest income of, a Fund, or
result in the default of existing obligations, including obligations which may
be held by the Fund. The following section provides only a brief summary of the
complex factors affecting the financial condition of California, and is based on
information obtained from the State of California, as publicly available on the
date of this Statement of Additional Information. The information contained in
such publicly available documents has not been independently verified. It should
be noted that the creditworthiness of obligations issued by local issuers may be
unrelated to the creditworthiness of California, and that there is no obligation
on the part of California to make payment on such local obligations in the event
of default in the absence of a specific guarantee or pledge provided by the
State of California.
The State of California has experienced significant financial difficulties
because of the 1990-93 recession, which reduced its credit standing. However,
since the start of 1994, California's economy has rebounded strongly, with
corresponding improvements in tax revenues. The ratings of certain related debt
of other issuers for which California has an outstanding lease purchase,
guarantee or other contractual obligation (such as for State-insured hospital
bonds) are generally linked directly to California's rating. Should the
financial condition of California deteriorate again, its credit ratings could be
further reduced, and the market value and marketability of all outstanding notes
and bonds issued by California, its public authorities or local governments
could be adversely affected.
ECONOMIC FACTORS. California's economy is the largest among the 50 states
and one of the largest in the world. The State's population of over 32 million
represents over 12% of the total United States population. While the State's
substantial population growth during the 1980s stimulated local economic growth
and diversification, it also increased demands on State services. Total personal
income in the State, at an estimated $703 billion in 1994, accounts for more
than 12% of all personal income in the nation.
From mid-1990 to late 1993, the State suffered a recession with the worst
economic, fiscal and budget conditions since the 1930s. Construction,
manufacturing (especially aerospace), and financial services, among others, were
all severely affected, particularly in Southern California. Job losses were the
worst of any post-war recession. Employment levels stabilized by late 1993 and
steady growth has occurred since the start of 1994. Pre-recession job levels are
expected to be reached in 1996. Unemployment, while remaining higher than the
national average, has come down significantly from the January 1994 peak of 10%.
Economic indicators show a steady recovery underway in California since the
start of 1994, although the residential housing sector is
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weaker than in past recoveries. However, any delay or reversal of the recovery
will exacerbate shortfalls in State revenue.
STATE DEBT. Under the California Constitution, debt service on outstanding
general obligation bonds is the second charge to the General Fund after support
of the public school system and public institutions of higher education. Total
outstanding general obligation bonds and lease purchase debt of the State
increased from $9.4 billion at June 30, 1988 to $23.8 billion at February 1,
1996. State agencies and authorities had approximately $19.1 billion of revenue
bonds and notes outstanding at December 31, 1995 for which the State General
Fund has no liability.
STATE FINANCES. Throughout the 1980's, State spending increased rapidly as
the State population and economy also grew rapidly, including increased spending
for many assistance programs to local governments, which were constrained by
Article XIIIA of the California Constitution (commonly known as 'Proposition
13') and other laws. The largest State program is assistance to local public
school districts. In 1988, an initiative (commonly known as Proposition 98) was
enacted which (subject to suspension by a two-thirds vote of the Legislature and
the Governor) guarantees local school districts and community college districts
a minimum share of State General Fund revenues (currently about 35%).
Since the start of the fiscal year ('FY') 1990-91 until FY1995-96, the
State faced adverse economic, fiscal, and budget conditions. The economic
recession seriously affected State tax revenues. It also caused increased
expenditures for health and welfare programs. The State is also facing a
structural imbalance in its budget with the largest programs supported by the
General Fund (education, health, welfare and corrections) growing at rates
significantly higher than the growth rates for the principal revenue sources of
the General Fund.
These structural concerns will continue in future years with the expected
need to increase capital and operating costs of the correctional system in
response to a 'Three Strikes' law enacted in 1994 which mandates life
imprisonment for certain felony offenders.
Recent Budgets. As a result of these factors, among others, from the late
1980's until 1992-93, the State had a period of budget imbalance, with
expenditures exceeding revenues in four out of six years, and the State
accumulated and sustained a budget deficit in the budget reserve, the Special
Fund for Economic Uncertainties ('SFEU') approaching $2.8 billion at its peak at
June 30, 1993. Starting in the 1990-91 Fiscal Year and for each year thereafter,
each budget required multibillion dollar actions to bring projected revenues and
expenditures into balance and to close large 'budget gaps' which were
identified. The Legislature and Governor eventually agreed on a number of
different steps to produce Budget Acts in the years 1991-92 to 1995-96,
including:
o significant cuts in health and welfare program expenditures;
o transfers of program responsibilities and funding from the State to local
governments, coupled with some reduction in mandates on local government;
o transfer of about $3.6 billion in annual local property tax revenues from
cities, counties, redevelopment agencies and some other districts to local
school districts, thereby reducing state funding for schools;
o reduction in growth of support for higher education programs, coupled
with increases in student fees;
o revenue increases (particularly in the 1991-92 Fiscal Year budget), most
of which were for a short duration;
o increased reliance on aid from the federal government to offset the costs
of incarcerating, educating and providing health and welfare services to
undocumented aliens (although these efforts have produced much less federal aid
than the State Administration has requested); and
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o various one-time adjustments and accounting changes.
Despite these budget actions, the effects of the recession led to large,
unanticipated deficits in the SFEU, as compared to projected positive balances.
By the start of the 1993-94 Fiscal Year, the accumulated deficit was so large
(almost $2.8 billion) that it was impractical to budget to retire it in one
year, so a two-year program was implemented, using the issuance of revenue
anticipation warrants to carry a portion of the deficit over the end of the
fiscal year. When the economy failed to recover sufficiently in 1993-94, a
second two-year plan was implemented in 1994-95, to carry the final retirement
of the deficit into 1995-96.
The combination of stringent budget actions cutting State expenditures, and
the turnaround of the economy by late 1993, finally led to the restoration of
positive financial results. While General Fund revenues and expenditures were
essentially equal in FY1992-93 (following two years of excess expenditures over
revenues), the General Fund had positive operating results in FY1993-94, 1994-95
and 1995-96, which are expected to reduce the accumulated budget deficit to less
than $100 million as of June 30, 1996.
A consequence of the accumulated budget deficits in the early 1990's,
together with other factors such as disbursement of funds to local school
districts 'borrowed' from future fiscal years and hence not shown in the annual
budget, was to significantly reduce the State's cash resources available to pay
its ongoing obligations. When the Legislature and the Governor failed to adopt a
budget for the 1992-93 Fiscal Year by July 1, 1992, which would have allowed the
State to carry out its normal annual cash flow borrowing to replenish its cash
reserves, the State Controller was forced to issue registered warrants ('IOUs')
to pay a variety of obligations representing prior years' or continuing
appropriations, and mandates from court orders.
The State's cash condition became so serious that from late spring 1992
until 1995, the State had to rely on issuance of short term notes which matured
in a subsequent fiscal year to finance its ongoing deficit, and pay current
obligations. With the repayment of the last of these deficit notes in April,
1996, the State does not plan to rely further on external borrowing across
fiscal years, but will continue its normal cash flow borrowings during a fiscal
year.
Current Budget. For the first time in four years, the State entered the
1995-96 fiscal year with strengthening revenues based on an improving economy.
The major feature of the Governor's proposed Budget, a 15% phased cut in
personal income and business taxes, was rejected by the Legislature.
The 1995-96 Budget Act was signed by the Governor on August 3, 1995, 34
days after the start of the fiscal year. The Budget Act projected General Fund
revenues and transfers of $44.1 billion, a 3.5 percent increase from the prior
year. Expenditures were budgeted at $43.4 billion, a 4 percent increase. The
Department of Finance projected that, after repaying the last of the carryover
budget deficit, there would be a positive balance of less than $30 million in
the budget reserve, the Special Fund for Economic Uncertainties, at June 30,
1996, providing no margin for adverse results during the year.
In its regular budget update in May, 1996, the Department of Finance
indicated that, with the strengthening economy, State General Fund revenues for
1995-96 would be about $46.1 billion, some $2 billion higher than originally
estimated. Because of mandated spending for public schools, the failure to
receive expected federal aid for illegal immigrants, and the failure of Congress
to enact welfare reform which the Administration had expected would reduce State
costs, expenditures for 1995-96 were also increased, to about $45.4 billion. As
a result, the Department estimated that the accumulated budget deficit would be
reduced to about $70 million as of June 30, 1996.
As a result of the improved revenues, the State's cash position has
substantially recovered. Only $2 billion of cash flow borrowing was needed
during 1995-96, and only about $3 billion is projected for 1996-97, with no
external borrowing over the end of the fiscal year.
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The Governor's proposed budget for 1996-97 projects $47.1 billion of
revenues and transfers, and $46.5 billion of expenditures, resulting in a budget
reserve at June 30, 1997 of about $500 million. A number of issues relating to
the 1996-97 budget still have to be resolved, including the Governor's tax
reduction proposals, and his proposals for further health and welfare cuts.
There can be no assurance that the State will not face budget gaps in
future years. Certain major budgetary considerations affecting the State are
outlined below.
REVENUE BASE. The recession seriously affected the State's tax revenue,
which basically mirrors general economic conditions. These revenues have
rebounded strongly as the economy has improved since 1994. The principal sources
of General Fund revenues are economically sensitive, and include the California
personal income tax (43% of total FY1994-95 revenues), the sales tax (34%), bank
and corporation taxes (13%), and the gross premium tax on insurance (3%).
Personal income tax receipts are generated disproportionately by relatively few
taxpayers (the top 4% of taxpayers paid 49% of the total tax in 1990), and
capital gains are a significant component of such collections. Auto sales and
building materials are significant components of retail sales tax collections.
Tax rates are relatively high, and may impose political and economic constraints
on the ability of the State to further increase its taxes. In November 1993, the
voters approved a constitutional amendment to permanently extend 0.5 percent of
the sales tax for local law enforcement and thus not available as General Fund
revenues.
BUDGETARY FLEXIBILITY. Article XIIIB of the California Constitution,
adopted by voter initiative, established an 'Appropriations Limit' for the State
and local governments; excess state revenues are to be divided equally between
transfers to K-14 districts and refunds to taxpayers. A taxpayer refund has not
been required since FY1986-87.
Proposition 98 established a minimum expenditure base for State aid to K-14
districts, currently requiring allocation of over 34% of General Fund revenues
to such districts.
For many years starting in the early 1980s, the State maintained the SFEU
as a budget reserve in case of unexpected changes in revenues or expenditures
during a fiscal year. Since the start of the recession in 1990, the SFEU has
been in a negative balance, as the State accumulated sizable budget deficits.
The Department of Finance projects elimination of virtually all the accumulated
budget deficits with a small negative balance (about $70 million) in the SFEU on
June 30, 1996; and a positive balance of over $500 million by June 30, 1997.
LABOR COSTS. The State government workforce is mostly unionized, subject
to the law which authorizes collective bargaining and prohibits strikes and work
slowdowns. All of the State's collective bargaining agreements expired June 30,
1995. The State has a substantial unfunded liability for future pension
benefits, and has utilized changes in its pension fund policies to reduce
current contribution requirements. If the investment assumptions used in
determining required State contributions are not sustained by actual results,
additional State contributions would be required in future years.
PUBLIC ASSISTANCE. California has the largest number of persons receiving
public assistance (Aid to Families with Dependent Children ('AFDC') and General
Relief) of any state. AFDC costs are shared among the federal government, the
State and its counties by statutory formula. Caseloads tend to rise
significantly during economic downturns, but are also significantly affected by
changing demographic and social trends which may impede the reduction of
caseloads during an economic recovery. The State has reduced AFDC payments to
meet budget pressures in recent years.
MEDI-CAL. California participates in the federal Medicaid program under a
state plan approved by the Health Care Financing Administration. The federal
government provides certain of the eligible program costs,
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with the remainder shared by the State and its counties. Basic program
eligibility and benefits are determined by federal guidelines, but the State
currently provides a number of optional benefits and expanded eligibility.
Program costs have increased substantially in recent years, and account for a
large share of the State budget. The State has cut optional Medi-Cal services in
recent years to reduce expenditures. Proposed changes in the federal
Medicare/Medicaid program may lead to major restructuring of these programs in
California. Federal law requires the State to adopt reimbursement rates for
hospitals and nursing homes that are reasonable and adequate to meet the costs
that must be incurred by efficiently and economically operated facilities in
providing patient care.
LITIGATION. The State is involved in certain legal proceedings (described
in the State's recent financial statements) that, if decided against the State,
may require the State to make significant future expenditures or may
substantially impair revenues.
STATE ASSISTANCE TO LOCALITIES. Property tax revenues received by local
governments declined more than 50% following voter approval of Proposition 13 in
1978. Subsequently, the California Legislature enacted measures to provide for
the redistribution of the State's General Fund surplus to local agencies, the
reallocation of certain State revenues to local agencies and the assumption of
certain governmental functions by the State to assist municipal issuers to raise
revenues. In response to the State's current fiscal difficulties, the State has
reduced its financial assistance to counties and cities, and adopted measures to
transfer certain governmental functions to its counties, accompanied by new
funding sources. The FY1993-94 Budget Act eliminated the remaining Proposition
13 assistance to all local government entities other than K-14 education
districts. Such actions have compounded the serious fiscal constraints already
experienced by many local governments, several of which have been compelled to
seek special assistance from the State.
CONSTITUTIONAL, LEGISLATIVE AND OTHER FACTORS. Certain California
constitutional amendments, legislative measures, executive orders,
administrative regulations and voter initiatives are introduced and/or
implemented from time to time which may result in adverse fiscal or economic
effects.
The fiscal condition of local governments in California (58 counties, 480
cities and thousands of education, utility and other special districts) has been
constrained since the enactment of 'Proposition 13' in 1978, which reduced and
limited the future growth of property taxes, and limited the ability of local
governments to impose other taxes. Counties, in particular, have had fewer
options to raise revenues than many other local government entities, and have
been required to maintain many basic public services. A 1986 initiative statute,
called 'Proposition 62,' imposed additional limits on local governments,
essentially requiring either majority or 2/3 voter approval for any tax increase
(other than property taxes). Later court decisions had struck down most of
Proposition 62, and many local governments, particularly cities, had enacted or
raised local taxes without voter approval. In September 1995, the California
Supreme Court overruled the prior cases, and upheld the constitutionality of
Proposition 62. Many aspects of this decision remain unclear (such as its impact
on charter cities, and whether it will have retroactive effect), but its future
effect will be to further limit the fiscal flexibility of many local
governments.
In the aftermath of Proposition 13, the State provided aid from the General
Fund to make up some of the loss of property tax moneys, including taking over
the principal responsibility for funding local K-12 schools and community
colleges. Under the pressure of the recent recession, the Legislature has
eliminated the remnants of this post-Proposition 13 aid, although it has also
provided additional funding sources (such as sales taxes) and reduced mandates
for local services. Nonetheless, many counties, in particular, continue to be
under severe fiscal stress. While such stress has in recent years most often
been experienced by smaller, rural counties, larger urban counties have also
been affected.
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Los Angeles County, the largest in the State, has reported severe fiscal
problems. To balance its FY1995-96 budget, the county has imposed severe cuts in
services, particularly for health care. Both Moody's and S&P have reduced Los
Angeles County's debt ratings in August 1995 (to 'A' and 'A-'), respectively.
Orange County, which recently emerged from federal Bankruptcy, has substantially
reduced services and personnel in order to live within much reduced means.
SPECIAL CONSIDERATIONS RELATING TO NEW YORK MUNICIPAL SECURITIES
The financial condition of the State of New York ('New York State' or the
'State'), its public authorities and public benefit corporations (the
'Authorities') and its local governments, particularly The City of New York (the
'City'), could affect the market values and marketability of, and therefore the
net asset value per share and the interest income of a Fund, or result in the
default of existing obligations, including obligations which may be held by the
Fund. The following section provides only a brief summary of the complex factors
affecting the financial situation in New York and is based on information
obtained from New York State, certain of its Authorities, the City and certain
other localities, as publicly available on the date of this Statement of
Additional Information. The information contained in such publicly available
documents has not been independently verified. Such information is subject to
change upon the adoption by the State Legislature of the State's final budget
for fiscal year 1996-97, which has not been enacted as of the date of this
Statement of Additional Information. Further, the adoption of a final State
budget may cause changes to the City budget for the City's fiscal year 1996-97
adopted on June 12, 1996 (the 'City FY 1996-97 Budget'), There can be no
assurance that such changes may not have adverse effects on the City's cash
flow, expenditures or revenues. It should be noted that the creditworthiness of
obligations issued by local issuers may be unrelated to the creditworthiness of
New York State, and that there is no obligation on the part of New York State to
make payment on such local obligations in the event of default in the absence of
a specific guarantee or pledge provided by New York State.
New York State and the City are each facing serious financial difficulties
and have each experienced recent declines in their credit standings. S&P and
Moody's have each assigned ratings for New York State's general obligation bonds
that are among the three lowest of those states with rated general obligation
bonds. The ratings of certain related debt of other issuers for which New York
State has an outstanding moral obligation, lease purchase, guarantee or other
contractual obligation are generally linked directly to the State's rating. S&P
and Moody's have each assigned ratings for the City's obligations that are among
the four lowest of those cities with rated general obligation bonds. Should the
financial condition of New York State, its Authorities or its local governments
deteriorate, their respective credit ratings could be further reduced, and the
market value and marketability of their outstanding notes and bonds could be
adversely affected, and their respective access to the public credit markets
jeopardized.
ECONOMIC FACTORS. New York is the third most populous state, and has a
relatively high level of personal wealth; however, the State economy has grown
more slowly than that of the nation as a whole, resulting in the gradual erosion
of its relative economic affluence (due to such factors such as relative costs
for taxes, labor and energy). The State's economy is diverse, with a
comparatively large share of the nation's finance, insurance, transportation,
communications and services employment, and a very small share of the nation's
farming and mining activity. New York has a declining proportion of its
workforce engaged in manufacturing and increasing proportion engaged in service
industries. The State, therefore, is likely to be less affected than the nation
as a whole during an economic recession concentrated in construction and
manufacturing sectors of the economy, but likely to be more affected during a
recession concentrated in the service-producing sector. The State's
manufacturing and maritime base have been seriously eroded, as illustrated by
the decline of the steel industry in the Buffalo area and of the apparel and
textile industries in the City. In addition, the City experienced substantial
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socio-economic changes, as a large segment of its population and a significant
share of corporate headquarters and other businesses relocated (many
out-of-state).
Both the State and the City experienced substantial revenue increases in
the mid-1980s attributable directly (corporate income and financial corporations
taxes) and indirectly (personal income and a variety of other taxes) to growth
in new jobs, rising profits and capital appreciation derived from the finance
sector of the City's economy. From 1977 to its 1988 peak, the finance, insurance
and real estate sectors rose 55%, to account in 1988 for 23% of total earnings
in the City and 14% statewide (compared to 7% nationwide). The finance sector's
growth was a catalyst for the New York metropolitan region's related business
and professional services, retail trade and residential and commercial real
estate markets. The then rising real estate market contributed to City revenues,
as higher property values and new construction added to collections from
property taxes, mortgage recording and transfer taxes and sales taxes on
building materials. The boom on Wall Street more than compensated for the
continued erosion of the State's (and the City's) manufacturing and maritime
base, since average wages in the finance, insurance and real estate sector and
related business and professional services were substantially higher (thereby
providing a net increase of higher incomes, taxed at even higher marginal
rates).
During the calendar years 1984 through 1991, the State's rate of economic
expansion was somewhat slower than that of the nation as a whole. In the
1990-1991 national recession, the economy of the Northeast region in general and
the State in particular was more heavily damaged than that of the rest of the
nation and has been slower to recover.
Although the national economy began to expand in 1991, the State economy
remained in recession until 1993, when employment growth resumed. Employment
growth has been hindered during recent years by significant cutbacks in the
computer and instrument manufacturing, utility and defense industries. Personal
income increased substantially in 1992 and 1993. The State's economy entered
into the third year of a slow recovery in 1995. Most of the growth occurred in
the trade, construction and service industries, with buisiness, social services
and health sectors accounting for most of the service industry growth. According
to assumptions contained in the State financial plan for FY1995-96 issued on
June 20, 1995 (the '1995-96 State Financial Plan'), employment was projected to
grow slightly during 1995, although the rate of increase was expected to be
below the rate experienced in 1994, due to cutbacks in governmental spending and
employment at all levels, as well as continued corporate downsizing. The Third
Quarterly Update to the 1995-96 State Financial Plan issued on January 30, 1996
(the 'Third Quarterly Update') contained a marginally weaker economic forecast
than that contained in the initial 1995-96 State Financial Plan, and predicts a
significant slowing of state employment growth during calendar year 1996, due to
the forecasted, slackening pace of national economic growth, industry
consolidation and shrinking governmental employment. The State financial plan
for 1996-97 (the '1996-97 State Financial Plan') contained in the proposed
Governor's Executive Budget initially presented on December 15, 1995 and amended
on March 15, 1996 (the '1996-97 Executive Budget') continues to predict a
slowing of State employment growth in the public sector during calendar year
1996, but forecasts slow growth in the private sector during the same time
period. The forecast reflects a continuation of the slower growth for the State
of New York than for the nation as a whole.
Notwithstanding the State budget for FY1995-96 which enacted significant
tax and program reductions, and the 1996-97 Executive Budget (which has not been
adopted into law) which proposes further program reductions, the State can
expect structural deficits to occur in future years. Both the 1995-96 Financial
Plan and the 1996-97 Financial Plan reflect actions or measures which provide
non-recurring resources (sometimes referred to as 'one shots') estimated to
provide approximately $1.0 billion savings in FY1995-96 and approximately $1.1
billion of savings in FY1996-97. Additionally, the three-year plan to reduce
State personal
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income taxes, as discussed below briefly, will decrease State tax receipts by an
estimated $1.7 billion in FY1996-97. Similarly, other actions taken to reduce
disbursements in the State's FY1995-96, such as reductions in the State
workforce and Medicaid and welfare expenditures, are expected to provide greater
reductions in future fiscal years. The net impact of these and other factors is
expected to produce a potential imbalance in receipts and disbursements for
State's FY1996-97 and future fiscal years. Additionally, uncertainties with
regard to both the economy and potential decisions to be made at the federal
level add further pressure on the balanced budget outlook for FY1996-97 and
beyond. For example, various proposals relating to federal tax and spending
policies may have a significant impact on the State's financial condition in
FY1996-97 and future fiscal years.
Further, there can be no assurance that the State economy will not
experience worse-than-predicted results in FY1996-97 with corresponding material
and adverse effects on the State's projections of receipts and disbursements.
Although the Third Quarter Update reflects a continued balance in the 1995-96
State Financial Plan, certain receipts collected through January 1996 varied
from the estimates contained in earlier updates to the 1995-96 State Financial
Plan. The effects of such changes in receipts is still under review,
consequently the predictive nature of such forecasts is difficult to ascertain.
In any case, as all State Financial Plans are based upon forecasts of national
and State economic activity it should be noted that many uncertainties exist in
such forecasts, including federal financial and monetary policies, the
availability of credit and the condition of the world economy. In addition, the
economic and financial condition of the State may be affected by various
financial, social, economic and political factors. These factors can be complex,
may vary from year to year and are frequently the results of actions taken not
only by the State and its agencies and instrumentalities, but also by other
entities, such as the federal government, that are not under the control of the
State.
The fiscal health of the State may also be impacted by the fiscal health of
the City. Although the City has had a balanced budget since 1981, estimates of
the City's future revenues and expenditures are subject to various
uncertainties. For example, the effects of the October 1987 stock market crash
and the 1990-92 national recession have had a disproportionately adverse impact
on the New York City metropolitan region, as private sector job losses since
1989 have offset all the prior employment gains of the 1980s. Declines in both
employment and earnings in the finance sector contributed to declines in retail
sales and real estate values. In addition, a number of widely publicized
bankruptcies among highly leveraged retailing and brokerage companies occurred.
The effects of the recession have extended to banking, insurance, business
services (such as law, accounting and advertising), publishing and
communications. Factors which may inhibit the City's economic recovery include
(i) credit restraints imposed by the weak financial condition of several major
money center banks located in the City; (ii) increases in combined State and
local tax burdens, if uncompetitive tax rates are imposed; (iii) perceived
declines in the quality of life attributable to service reductions and the
deterioration of the City's infrastructure; (iv) additional employment losses in
the City's banking sector or corporate headquarters complex due to further
corporate relocations or restructurings; or (v) increased expenditures for
public assistance and health care. The City's future economic condition will
also likely be affected by its competitive position as a world financial center
(compared to London, Tokyo, Frankfurt and competing regional U.S. centers).
Investors should note that the budget for the City FY1995-96 contained
provisions to close a projected $2.7 billion budget gap and the City FY1996-97
Budget, contain similar provisions to address a budget gap of approximately $2.6
billion. Many of such budget-gap closing initiatives may be implemented only
with the cooperation of the City's municipal unions, or the State or Federal
governments. No assurance can be given that such initiatives will be
successfully undertaken.
While the State's economy is broader-based than that of the City,
particular industries are concentrated in and have a disproportionate impact on
certain areas, such as heavy industry in Buffalo, photographic and
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optical equipment in Rochester, machinery and transportation equipment in
Syracuse and Utica-Rome, computers in Binghamton and in the Mid-Hudson Valley
and electrical equipment in the Albany-Troy-Schenectady area. Constraints on
economic growth, taxpayer resistance to proposed substantial increases in local
tax rates, and reductions in State aid in regions apart from the City have
contributed to financial difficulties for several county and other local
governments.
THE STATE. As noted above, the financial condition of the State is
affected by several factors, including the strength of the State and its
regional economies, actions of the federal government, and State actions
affecting the level of receipts and disbursements. Owing to these and other
factors, the State may, in future years, face substantial potential budget gaps
resulting from a significant disparity between tax revenues projected from a
lower recurring receipts base and the future costs of maintaining State programs
at current levels.
The State has been experiencing and continues to experience substantial
financial difficulties with General Fund (the principal operating account)
deficits incurred during FY1989-90 through FY1991-92. The State's accumulated
General Fund deficit (on a GAAP basis) grew 91% from FY1986-87 to FY1990-91, and
reached a then-record $6.265 billion (audited) by March 31, 1991. An accumulated
General Fund deficit at March 31, 1992 was restated to be $4.616 billion and at
March 31, 1993 was $2.551 billion. The State ended FY1993-94 with a negative
General Fund balance of $1.637 billion. This represented an improvement over
prior fiscal years, primarily due to an improving national and State economy
resulting in higher-than-expected receipts from personal income tax and various
business taxes and the relative success of the New York Local Government
Assistance Corporation ('LGAC'). The General Fund showed an operating surplus of
$914 million (on a GAAP basis). The State's budget for FY1994-95 was adopted on
June 8, 1994, more than two months after the beginning of the State's fiscal
year and has made all of the required quarterly revisions thereto as of the date
hereof. The State ended its FY1994-95 reporting a General Fund operating deficit
of $1.426 billion, primarily due to change in accounting methodologies used by
the State Comptroller and the use of $1.026 billion of the FY1993-94
cash-surplus to fund operating expenses in FY1994-95. These factors were offset
by net proceeds of $315 million of bonds issued by LGAC. Actual receipts
reported fell short of original projections, primarily in the categories of
business taxes. These shortfalls were offset by better than expected performance
in the remaining taxes, principally the user taxes and fees. Total expenditures
for FY1994-95 increased $2.083 billion, or 6.7% over the prior fiscal year.
On June 7, 1995, the New York State Legislature passed the final
legislation regarding the State's FY1995-96 budget, again adopting such budget
more than two months after the beginning to the State's fiscal year. Both the
enacted budget bills and the State Financial Plan for FY1995-96 included the
reductions in the actual level of spending from that which occurred in FY1994-95
and projected reductions in Medicaid and State Authority operating costs. The
FY1995-96 budget also projected an approximate increase of 3% in all
governmental funds over the amounts received in FY1994-95 and includes the
phase-in of a three-year reduction in the State's personal income tax. The
1996-97 Executive Budget projects a $3.9 billion budget gap, which it proposes
to close largely by Medicaid cost containment measures (approximately $1.0
billion), welfare reform (approximately $240 million) and restructuring of the
state healthcare delivery system (approximately $470 million). The phased
reduction of the State's personal income tax is continued in the 1996-97
Executive Budget. Although as stated above, the Governor released his 1996-97
Executive Budget on December 15, 1995 and issued amendments thereto on March 15,
1996, the New York State Legislature, as of the date of this Statement of
Additional Information, has not passed final legislation adopting a budget for
FY1996-97. There can be no assurances that the Legislature will enact the
1996-97 Executive Budget or that the actual budget for FY1996-97 adopted by the
Legislature will not differ materially from the brief description of the 1996-97
Executive Budget contained herein. Further, the actual budget adopted by the
Legislature for
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FY1996-97 may be materially adversely impacted by future changes to federal
entitlement programs either not foreseen or inaccurately forecast at the time
such budget legislation is actually enacted. The amendments made in March 1996
to the 1996-97 Executive Budget contained a contingency plan intended to address
the failure of the federal government to adopt entitlement changes which were
assumed initially in the December 1995 version of the 1996-97 Executive Budget.
Uncertainties at the federal level continue to represent significant risk to the
efficacy of any budget adopted for FY1996-97.
There can be no assurance that the State will not face budget gaps in
future years, resulting from a disparity between tax revenues projected from a
lower recurring-receipts base and the spending required to maintain State
programs at current levels. Furthermore, the State is a party to numerous
lawsuits in which an adverse decision could require extraordinary expenditures.
Certain major budgetary considerations affecting the State are outlined below.
REVENUE BASE. The State's principal revenue sources are economically
sensitive, and include the personal income tax (53% of FY1994-95 and
approximately 54% of estimated FY1995-96 General Fund tax receipts,
respectively), user taxes and fees (20% of FY1994-95 and nearly 21% of estimated
FY1995-96 General Fund tax receipts) and business taxes (15% of both FY1994-95
and estimated FY1995-96 General Fund tax receipts, respectively). Uncertainties
in taxpayer behavior as a result of actual and proposed changes in Federal tax
law also may have an adverse impact on State tax receipts. One-fourth of the 4%
State sales tax has been dedicated to pay debt service of LGAC, and has
correspondingly reduced General Fund receipts. To the extent those moneys are
not necessary for payment to LGAC, they are transferred from the LGAC Tax Fund
to the General Fund and reported as a transfer from other funds rather than as a
sales and use tax receipts. During FY1991-1992, 1992-93, 1993-94 and 1994-95,
moneys were so transferred. Capital gains are a significant component of income
tax collections. Auto sales and building materials are significant components of
retail sales tax collections. Tax rates are relatively high and may impose
political and economic constraints on the ability of the State to further
increase its taxes. In 1995, the State enacted a tax-reduction program designed
to reduce, by 20 percent over three years, receipts from the personal income
tax. The tax had remained unchanged since 1989 as a result of annual deferrals
of tax reductions originally enacted in 1987. The tax-reduction program is
estimated to reduce receipts by $515 million in FY1995-96, $2.2 billion in
FY1996-97 and to produce further significant reductions in FY1997-98. In
addition to such reductions in overall tax rates, the tax-reduction program also
includes other modifications to the tax laws which will have the effect of
lowering the amount of tax revenues to be received by the State. In the absence
of countervailing economic growth or expenditure cuts the tax cuts could make
the achievement of a balanced State budget more difficult in future years. A
significant risk to the 1996-97 State Financial Plan arises from proposed tax
legislation in the U.S. Congress. Changes to the federal tax treatment of
capital gains, if made, are likely to flow automatically to the State personal
income tax. Such changes, depending upon their precise character and timing, as
well as taxpayer response, could produce revenue loss during FY1996-97.
STATE DEBT. New York has the heaviest debt burden of any state (with
approximately $5.2 billion of general obligation, $4.7 billion of LGAC debt and
$18 billion of lease-purchase or other contractual debt outstanding as of March
31, 1995), and debt service costs absorb a large share of the State's budget. As
of March 31, 1995, the State is also obligated with respect to approximately
$7.0 billion for statutory moral obligations for nine of its Authorities and for
guarantees of $358 million of other Authority debt. Historically, the State has
had one of the largest seasonal financing requirements of any municipal issuer,
and was required each spring to borrow substantial sums in the credit markets to
finance its accumulated general fund deficit and its scheduled payments of aid
to local governments and school districts. In an effort to reduce such seasonal
borrowings, the State created LGAC as a financing vehicle to finance the State's
local assistance payments by issuing long-term debt, payable over 30 years from
a portion of the State sales tax (as discussed
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above). The State budget for FY1995-96 and the 1995-96 State Financial Plan each
proposed to utilize the remainder of authorized but yet unissued LGAC bonds. As
of June 1995, LGAC had issued bonds and notes to provide net proceeds of $4.7
billion, thus completing the LGAC program. The impact of LGAC's borrowing is
that the State was able to meet its cash flow needs in the first quarter of
FY1995-96 without relying on short-term seasonal borrowings. Neither the 1995-96
State Financial plan nor the 1994-95 State Financial Plan included a spring
borrowing, the first time in 35 years that there was no short-term borrowing.
Investors should note that the enabling legislation for LGAC contains a covenant
restricting the amount of the State's spring borrowing, which may reduce the
State's fiscal flexibility in future years.
BUDGETARY FLEXIBILITY. A significant portion of the State's General Fund
budget is accounted for by contractually required expenses (such as pension and
debt service costs) and by federally mandated programs (such as AFDC and
Medicaid). In addition, State aid for school districts comprises a major share
of the budget, and total appropriations and distribution of such aid is
especially contentious politically. Furthermore, the State's ability to respond
to unanticipated developments in the future may have been impaired since the
State has utilized a substantial range of actions of a non-recurring nature in
recent years to finance its General Fund operations, including tapping excess
monies in special funds, refinancing outstanding debt to reduce reserve fund
requirements and current (but not long-term) debt service costs, recalculating
pension fund contributions, selling State assets, reimbursing past General Fund
expenditures by the issuance of authority debt and deferring payment for
expenditures to future fiscal years. The 1995-96 State Financial Plan contains
actions of a non-recurring nature including mergers of certain authorities,
payments from the sale of certain State assets and payments associated with the
resolution of certain court cases, totalling approximately $900 million to $1
billion. The 1996-97 Executive Budget contains actions of a non-recurring nature
to the extent of approximately $1.1 billion.
LABOR COSTS. The State government workforce is mostly unionized, subject
to the Taylor Law which authorizes collective bargaining and prohibits (but has
not, historically, prevented) strikes and work slowdowns. Costs for employee
health benefits have increased substantially, and can be expected to further
increase. The State has a substantial unfunded liability for future pension
benefits, and has utilized changes in its pension fund investment return
assumptions to reduce current contribution requirements. If such investment
earnings assumptions are not sustained by actual results, additional State
contributions will be required in future years to meet the State's contractual
obligations. The State's change in actuarial method from the aggregate cost
method to a modified projected unit credit in FY1990-91 created a substantial
surplus that was amortized and applied to offset the State's contribution
through FY1993-94. This change in actuarial method was ruled unconstitutional by
the State's highest court and the State has returned to the aggregate cost
method in FY1994-95 using a four-year phase-in. Employer contributions,
including the State's, are expected to increase over the next five to ten years.
PUBLIC ASSISTANCE. New York has the second largest number of persons
receiving public assistance (AFDC and Home Relief) of any state. AFDC costs are
shared among the federal government, the State and its counties (including the
City) by statutory formula. Caseloads tend to rise significantly during economic
downturns, but have fallen only in the later stages of past economic recoveries.
MEDICAID. New York participates in the federal Medicaid program under a
state plan approved by the Health Care Financing Administration. The federal
government provides a substantial portion of eligible program costs, with the
remainder shared by the State and its counties (including the City). Basic
program eligibility and benefits are determined by federal guidelines, but the
State provides a number of optional benefits and expanded eligibility. Program
costs have increased substantially in recent years, and account for a rising
share of the State budget. Federal law requires that the State adopt
reimbursement rates for hospitals
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and nursing homes that are reasonable and adequate to meet the costs that must
be incurred by efficiently and economically operated facilities in providing
patient care, a standard that has led to past litigation by hospitals and
nursing homes seeking higher reimbursement from the State. The budget adopted
for FY1995-96 and, in particular, the 1996-97 Executive Budget includes
reductions in spending for Medicaid. Cutbacks in State spending for Medicaid may
adversely affect the financial condition of hospitals and health care
institutions that are the obligors of bonds that may be held by the Fund.
THE STATE AUTHORITIES. The State's Authorities are not subject to the
constitutional restrictions on the incurrence of debt which apply to the State
itself, and may issue bonds and notes within the amounts of, and as otherwise
restricted by, their legislative authorization. The New York State Public
Authorities Control Board approves the issuance of debt and major contracts by
10 of the Authorities. As of September 30, 1994 (the date of the latest data
available), there were 18 Authorities that had outstanding debt of $100 million
or more, the aggregate debt of which (including refunding bonds and moral
obligation, lease-purchase, contractual obligation or State-guaranteed debt)
then totaled approximately $70.3 billion. As of March 31, 1995, aggregate public
authority debt outstanding as State-supported debt was $27.9 billion and
State-related debt was $36.1 billion. In recent years, the State has provided
financial assistance through appropriations, in some cases of a recurring
nature, to certain Authorities for operating and other expenses and (from 1976
to 1987) in fulfillment of its commitments on moral obligation indebtedness or
otherwise, for debt service. The State budgeted operating assistance of
approximately $1.3 billion for the Metropolitan Transportation Authority ('MTA')
during FY1994-95 and estimated total State assistance in FY1995-96 to be
approximately $1.1 billion. This assistance is expected to continue to be
required (and may increase) in future years. Failure by the State to appropriate
necessary amounts or to take other action to permit the Authorities to meet
their obligations could adversely affect the ability of the State and the
Authorities to obtain financing in the public credit markets and the market
price of the State's outstanding bonds and notes.
The MTA, whose credit rating was recently reduced, oversees the operation
of the City's subway and bus lines by its affiliates, the New York City Transit
Authority and the Manhattan and Bronx Surface Transit Operating Authority
(collectively, the 'TA'). MTA subsidiaries operate certain commuter rail and bus
lines in the New York metropolitan area. An affiliated agency, the Triborough
Bridge and Tunnel Authority ('TBTA'), operates certain intrastate toll bridges
and tunnels. To maintain its facilities and equipment, which deteriorated
significantly in the late 1970s due to deferred maintenance, the MTA prepares a
five year capital program subject to approval by the MTA Capital Program Review
Board. In April 1993, the State Legislature authorized the funding of a portion
of a five year $9.56 billion capital plan for the MTA for 1992 through 1996.
MTA's five year capital program for 1992-96 was approved by the State Capital
Program Review Board in December 1993. There can be no assurance that all
governmental actions for the 1992-96 Capital Program will be taken, that funding
sources currently identified will not be decreased or eliminated, or that the
Capital Program will not be delayed or reduced. If the Capital Program is
delayed or reduced, ridership and fare revenues may decline, which could impair
the MTA's ability to meet its operating expenses without additional State
assistance. In addition, because fares are not sufficient to finance its mass
transit operations, the MTA has depended and will continue to depend for
operating support upon a system of State, local government and TBTA support,
and, to the extent available, Federal assistance (including loans, grants and
operating subsidies). There can be no assurance that any such assistance will
continue at any particular level or in any fixed relationship to the operating
costs and capital needs of the MTA.
THE CITY. The City has required, and continues to require significant
financial assistance from the State. The City depends on the State to enable the
City to balance its budget and meet its cash requirements. In the early 1970s,
the City incurred substantial operating deficits, and its financial controls,
accounting practices and disclosure policies were widely criticized. In 1975,
the City encountered severe financial
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difficulties and lost access to the public credit markets. The State Legislature
responded in 1975 by creating the Municipal Assistance Corporation For The City
of New York ('MAC') to provide financing assistance for the City and the
Financial Control Board to exercise certain oversight and review functions with
respect to the City's finances. The Financial Control Board's powers over the
City were suspended in June 1986, but would be reinstated (under current law) if
the City experiences certain adverse financial circumstances. At the time of the
fiscal crisis the State provided substantial financial assistance to the City,
the Federal government provided the City with direct seasonal loans and
guarantees on the City's long-term debt and the City's labor unions accepted
deferrals of wage increases and approved purchases of City bonds by the pension
funds. No assurance can be given that similar assistance would again be made
available if needed, particularly given the current budgetary constraints faced
by both the Federal and State governments.
The City provides services usually undertaken by counties, school districts
or special districts in other large urban areas, including the provision of
social services such as day care, foster care, health care, family planning,
services for the elderly and special employment services for needy individuals
and families who qualify for such assistance. State law requires the City to
allocate a large portion of its total budget to Board of Education operations,
and mandates that the City assume the local share of public assistance and
Medicaid costs. While the City has had GAAP operating surpluses in recent fiscal
years, the City has experienced growing financial difficulties, primarily
related to the impact of the recession on the local economy (reducing revenues
from most major taxes and increasing public assistance and Medicaid caseloads),
rising health care costs for City employees and for Medicaid and rising
inflation and interest rates. In response, the City implemented gap-closing
programs, which initially relied primarily on actions of a non-recurring nature,
but included substantial property tax rate increases and a personal income tax
surcharge imposed in FY1991 and selected service cutbacks. Reductions in State
aid, larger than budgeted labor settlements and increased police expenditures
added to the adverse budgetary impact of the local recession, confronting the
City with a potential $3.5 billion imbalance during FY1992 budget negotiations.
This initial budget gap was closed by adoption of a budget providing for various
tax increases and significant service reductions. Aid to nonprofit cultural
institutions in the City was significantly reduced (as was State aid to such
institutions), including certain institutions that are obligors of bonds that
may be held by a Fund.
The City's budget for FY1993-94 identified measures to close a $300 million
budget gap, which was the result of shortfalls in federal and State aid from
previously projected levels. The City achieved balanced operating results as
reported in accordance with GAAP for FY1993-94. For FY1994-95, the City adopted
a budget which halted the trend in recent years of substantial increases in
City-funded spending from one year to the next. The City budget adopted for
FY1995-96 reduces City-funded spending for the second consecutive year and the
City FY1996-97 Budget calls for reduction of City-funded spending for the third
consecutive year. Pursuant to State law, the City prepares a four-year annual
financial plan, which is reviewed and revised on a quarterly basis and includes
the City's capital, revenue and expense projections and outlines proposed budget
gap-closing programs for those years with projected budget gaps. The Mayor is
responsible for preparing the City's four-year financial plan including the
City's current financial plan for the 1997 through 2000 fiscal years (the
'1997-2000 Financial Plan'). The City's projections set forth in the 1997-2000
Financial Plan are based on various assumptions and contingencies which are
uncertain and which may not materialize. Changes in major assumptions could
significantly effect the City's ability to balance its budget and to meet its
annual cash flow and financing requirements. Such assumptions and contingencies
include the timing and pace of a regional and local economic recovery, increases
in tax revenues, employment growth, the ability to implement proposed reductions
in City personnel and other cost reduction initiatives which may require in
certain cases the cooperation of the City's municipal unions, the ability of New
York City Health and Hospitals Corporation and the Board of Education to take
actions to offset reduced revenues, the ability to complete
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revenue generating transactions, provision of State and federal aid and mandate
relief, and the impact on City revenues of proposals for federal and State
welfare reform. No assurance can be given that the assumptions used by the City
in the 1997-2000 Financial Plan will be realized. Due to the uncertainty
existing on the federal and state levels, the ultimate adoption of the State
budget for FY1996-97 may result in substantial reductions in projected
expenditures for social spending programs. Cost-containment assumptions
contained in the 1997-2000 Financial Plan and the City FY1996-97 Budget may
therefore be significantly adversely affected upon the final adoption of the
State budget for FY1996-97. Furthermore, actions taken in recent fiscal years to
avert deficits may have reduced the City's flexibility in responding to future
budgetary imbalances, and have deferred certain expenditures to later fiscal
years.
The City's original budget for FY1994-95 reflected proposed actions to
eliminate a $2.3 billion budget gap. The City submitted on July 21, 1995 a
fourth quarter modification to the City's financial plan for FY1994-95 which
projects a balanced budget in accordance with GAAP for the City's FY1994-95. On
July 11, 1995, the City submitted the 1996-1999 Financial Plan, which is based
on the City's expense and capital budgets for the City's FY1995-96 adopted on
June 14, 1995 (the '1996 City Budget'). The 1996 City Budget set forth proposed
actions by the City for FY1995-96 to close a substantial projected budget gap
(approximately $3.1 billion) resulting from lower than projected tax receipts
and other revenues and greater then projected expenditures. Proposed actions in
the 1996-1999 Financial Plan for the City's FY1995-96 included a reduction of
approximately $400 million primarily affecting public assistance and Medicaid
payments by the City, expenditure reductions in agencies totalling approximately
$1.2 billion and transitional labor savings of approximately $600 million. These
and other proposed actions were contained in the 1996-1999 Financial Plan as
well as the 1996 City Budget.
The City FY1996-97 Budget identifies a $2.6 billion budget gap which it
attempts to close by implementing a variety of actions, including an approximate
$1.2 billion reduction in City spending for a variety of services and programs,
a renewal of the 12.5% personal income tax surcharge, and the use of non-
recurring measures estimated to provide approximately $1.4 billion in one-time
savings. The City FY1996-97 Budget has been the subject of substantial criticism
questioning, among other things, the capacity of the City to generate future
revenues sufficient to meet expected expenditure increases and to provide
necessary municipal services. Such criticism has also noted the City's reliance
on non-recurring resources to close budget gaps and has charged that the City
has made no progress in achieving structural balance.
The City FY 1996-1997 Budget, like all City budgets, is subject to the
ability of the City to implement the reductions in expenditures, personal
services and personnel, which are substantial and may be difficult to implement.
For example, one of the key items contained in the 1996 City Budget is the sale
of the City's water system for approximately $2.3 billion. This plan has been
hotly contested since it was announced, has been the the focus of several
lawsuits and has been ruled illegal by the lower court and the appeals court. It
is unclear whether a final appeal will be made. Further, the City FY1996-97
Budget and the 1997-2000 Financial Plan reflect the costs of tentative
settlements with a coalition of municipal unions which together represent
approximately 2/3 of its workforce. There can be no assurance that such proposed
settlement will be ratified. In addition, certain proposals may be offset by
various State and federal legislation which could mandate levels of City funding
inconsistent with either the City FY1996-97 Budget or the 1997-2000 Financial
Plan. In addition, the 1997-2000 Financial Plan anticipates the receipt of
substantial amounts of Federal aid. Certain proposed State and federal actions
are subject to legislative, the governor's and the president's approvals, as
applicable. Both federal and State actions are uncertain. Certain legislative
proposals contemplate significant reductions in federal spending, including
proposed federal welfare reform which could result in caps on, or block grants
of, federal programs. Further, no assurance can be given that either such
actions will in fact be taken or that the projected savings will result even if
such actions are taken.
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The City derives its revenues from a variety of local taxes, user charges,
miscellaneous revenues and federal and State unrestricted and categorical
grants. The City projects that local revenues will provide approximately 68.2%
of total revenues in FY1996-97 while federal aid, including categorical grants,
will provide 11.5% in FY 1996-97 and State aid, including unrestricted aid and
categorical grants, will provide 20.3% in FY1996-97. As a proportion of total
revenues, State aid has remained relatively constant over the period from 1980
to 1995, while federal aid was sharply reduced (having provided nearly 20% of
total fiscal year 1980 revenues). The largest source of the City's revenues is
the real estate tax (approximately 21.5% of total revenues projected for
FY1996-97, at rates levied by the City council (subject to certain State
constitutional limits). The City derives the remainder of its tax revenues from
a variety of other economically sensitive local taxes (subject to authorization
by the legislature), including: a local sales and compensating use tax
(primarily dedicated to MAC debt service) imposed in addition to the State's
retail sales tax; the personal income tax on City residents and the earnings tax
on non-residents; a general corporation tax; and a financial corporation tax.
High tax burdens in the City impose political and economic constraints on the
ability of the City to increase local tax rates. The City's four-year financial
plans have been the subject of extensive public comment and criticism,
principally questioning the reasonableness of assumptions that the City will
have the capacity to generate sufficient revenues in the future to provide the
level of services contained in such City financial plans. On July 10, 1995, S&P
lowered the City's credit rating from A- to BBB+, among the lowest ratings of
any major city in the country. The rating agency cited specifically the City
budget's reliance on 'one-shot' measures to balance the budget for FY1995-96
without rectifying the underlying structural problems, its continued optimistic
projections of State and federal aid, and continued high debt levels.
The City is the largest municipal debt issuer in the nation, and has more
than doubled its debt load since the end of FY1987-88, in large measure to
rehabilitate its extensive, aging physical plant. The City's seasonal borrowing
needs increased significantly during FY1989-90 and FY1990-91, largely due to
delayed State aid payments, and totalled $2.25 billion in FY1991-92, $1.40
billion in FY1992-93, $1.75 billion in FY1993-94, $2.2 billion in FY1994-95 and
$2.4 billion in FY1995-96. The City's current capital financing program reflects
major reductions (approximately $2.13 billion) in the size of the capital
program to be implemented cumulatively through FY1998-99 which is intended to
reduce future debt service requirements. The reduced program was implemented to
meet the constraint of the forecast level of the State constitutional limits on
the City's power to incur debt. Such reductions may adversely affect the
condition of the City's aging and deteriorating infrastructure and physical
assets, such as sewers, streets, bridges and tunnels, and mass transit
facilities. Further, the City's capital financing program currently contemplates
receipt of proceeds of approximately $1 billion resulting from the sale of the
City's water system to the Water Board, and proposes to utilize a substantial
portion of such proceeds for capital project improvements. It is not certain
that such proceeds will become available for capital improvements, because, as
discussed above, the legality of the sale of the water system has been
challenged.
In November 1993, the voters approved a proposed charter whereby Staten
Island would secede from the City. Staten Island is one of five
counties/boroughs, comprising 4% of the City's population and 19% of its land
area. State law provides a complex mechanism for such secession.
OTHER LOCALITIES. Certain localities in addition to the City could have
financial problems which, if significant, could lead to requests for additional
State assistance during the State's FY1995-96 and thereafter. Fiscal
difficulties experienced by the City of Yonkers, for example, could result in
State actions to allocate State resources in amounts that cannot yet be
determined. In the recent past, the State provided substantial financial
assistance to its political subdivisions, totaling approximately 68% of General
Fund disbursements in the State's FY1992-93, 69% for FY1993-94, 70% for
FY1994-95 and estimated to account for 69% of General Fund disbursements in
FY1995-96, primarily for aid to elementary, secondary and higher education and
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Medicaid and income maintenance and local transportation programs. The
Legislature enacted substantial reductions from previously budgeted levels of
State aid since December 1990. To the extent the State is constrained by its
financial condition, State assistance to localities may be further reduced,
compounding the serious fiscal constraints already experienced by many local
governments. Localities also face anticipated and potential problems resulting
from pending litigation (including challenges to local property tax
assessments), judicial decisions and socioeconomic trends.
The total indebtedness of all localities in the State, other than New York
City, was approximately $17.7 billion as of the localities' fiscal years ending
during 1993 (the date of the latest data available). A small portion
(approximately $105 million) of this indebtedness represented borrowing to
finance budgetary deficits issued pursuant to enabling State legislation
(requiring budgetary review by the State Comptroller). Subsequently, certain
counties and other local governments have encountered significant financial
difficulties including the counties of Nassau, Suffolk, Monroe and Westchester
and the City of Buffalo. The State has imposed financial control on the City
from 1977 to 1986 and on the City of Yonkers since 1984 under an appointed
control board in response to fiscal crises encountered by such municipalities.
The Legislature imposed certain limited fiscal restraints on Nassau and Suffolk
counties, and authorized their issuance of deficit bonds to finance over several
years their respective 1992 operating deficits.
INVESTMENT LIMITATIONS OF THE FUNDS
FUNDAMENTAL LIMITATIONS. The following investment limitations cannot be
changed for the Funds without the affirmative vote of the lesser of (1) more
than 50% of the outstanding shares of the applicable Fund or (2) 67% or more of
the shares present at a shareholders' meeting if more than 50% of the
outstanding shares are represented at the meeting in person or by proxy. If a
percentage restriction is adhered to at the time of an investment or
transaction, later changes in percentage resulting from a change in values of
portfolio securities or the amount of total assets will not be considered a
violation of any of the following limitations.
Each Fund will not:
(1) purchase any security if, as a result of that purchase, 25% or
more of the Fund's total assets would be invested in securities of
issuers having their principal business activities in the same
industry, except that this limitation does not apply to securities
issued or guaranteed by the U.S. government, its agencies or
instrumentalities or to municipal securities.
(2) issue senior securities or borrow money, except as permitted under
the Investment Company Act of 1940 ('1940 Act') and then not in
excess of 33 1/3% of the Fund's total assets (including the amount
of the senior securities issued but reduced by any liabilities not
constituting senior securities) at the time of the issuance or
borrowing, except that the Fund may borrow up to an additional 5%
of its total assets (not including the amount borrowed) for
temporary or emergency purposes.
(3) make loans, except through loans of portfolio securities or
through repurchase agreements, provided that for purposes of this
restriction, the acquisition of bonds, debentures, other debt
securities or instruments, or participations or other interests
therein and investments in government obligations, commercial
paper, certificates of deposit, bankers' acceptances or similar
instruments will not be considered the making of a loan.
(4) engage in the business of underwriting securities of other
issuers, except to the extent that the Fund might be considered an
underwriter under the federal securities laws in connection with
its disposition of portfolio securities.
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(5) purchase or sell real estate, except that investments in
securities of issuers that invest in real estate and investments
in mortgage-backed securities, mortgage participations or other
instruments supported by interests in real estate are not subject
to this limitation, and except that the Fund may exercise rights
under agreements relating to such securities, including the right
to enforce security interests and to hold real estate acquired by
reason of such enforcement until that real estate can be
liquidated in an orderly manner.
(6) purchase or sell physical commodities unless acquired as a result
of owning securities or other instruments, but the Fund may
purchase, sell or enter into financial options and futures,
forward and spot currency contracts, swap transactions and other
financial contracts or derivative instruments.
(7) In addition, each of the Funds has a fundamental limitation
requiring it to invest, except for temporary defensive purposes or
under unusual market conditions, at least 80% of its net assets:
(a) in the case of California Tax-Free Income Fund, in debt
obligations issued by the State of California, its
municipalities and public authorities or by other issuers if
such obligations pay interest that is exempt from federal
income tax and California personal income tax and is not an
item of tax preference for purposes of the federal alternative
minimum tax ('AMT exempt interest');
(b) in the case of National Tax-Free Income Fund, in debt
obligations issued by states, municipalities and public
authorities and other issuers that pay interest that is exempt
from federal income tax ('municipal obligations') and that also
is AMT exempt interest;
(c) in the case of Municipal High Income Fund, in municipal
obligations; and
(d) in the case of New York Tax-Free Income Fund, in debt
obligations issued by the State of New York, its municipalities
and public authorities or by other issuers if such obligations
pay interest that is exempt from federal income tax as well as
New York State and New York City personal income taxes and is
AMT exempt interest.
In addition, California Tax-Free Income Fund and National Tax-Free Income
Fund each will not:
(8) purchase securities of any one issuer if, as a result, more than
5% of the Fund's total assets would be invested in securities of
that issuer or the Fund would own or hold more than 10% of the
outstanding voting securities of that issuer, except that up to
25% of the Fund's total assets may be invested without regard to
this limitation, and except that this limitation does not apply to
securities issued or guaranteed by the U.S. government, its
agencies and instrumentalities or to securities issued by other
investment companies.
The following interpretation applies to, but is not a part of,
fundamental restriction (8): Each state (including the District
of Columbia and Puerto Rico), territory and possession of the
United States, each political subdivision, agency,
instrumentality and authority thereof, and each multi-state
agency of which a state is a member is a separate 'issuer.' When
the assets and revenues of an agency, authority, instrumentality
or other political subdivision are separate from the government
creating the subdivision and the security is backed only by the
assets and revenues of the subdivision, such subdivision would
be deemed to be the sole issuer. Similarly, in the case of an
IDB or PAB, if that bond is backed only by the assets and
revenues of the non-governmental user, then that
non-governmental user would be deemed to be the sole issuer.
However, if the creating government or another entity guarantees
a security, then to the extent that the value of all securities
issued or guaranteed by that government or entity and owned by
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the Fund exceeds 10% of the Fund's total assets, the guarantee
would be considered a separate security and would be treated as
issued by that government or entity.
NON-FUNDAMENTAL LIMITATIONS. The following investment restrictions may be
changed by each Trust's board of trustees without shareholder approval.
Each Fund will not:
(1) purchase any security if as a result of such purchase more than 5%
of its assets would be invested in securities with respect to
which payment of interest and principal are the responsibility of
a company, including its predecessors, with less than three years'
operating history.
(2) invest more than 10% of its net assets in illiquid securities, a
term which means securities that cannot be disposed of within
seven days in the ordinary course of business at approximately the
amount at which the Fund has valued the securities and includes,
among other things, repurchase agreements maturing in more than
seven days.
(3) make investments in warrants if such investments, valued at the
lower of cost or market, exceed 5% of the value of its net assets,
which amount may include warrants that are not listed on the New
York Stock Exchange, Inc. ('NYSE') or the American Stock Exchange,
Inc. ('AMEX'), provided that such unlisted warrants, valued at the
lower of cost or market, do not exceed 2% of the Fund's net assets
and further provided that this restriction does not apply to
warrants attached to, or sold as a unit with, other securities.
(4) purchase or retain the securities of any issuer if the officers
and trustees of the Fund and the officers and directors of
Mitchell Hutchins (each owning beneficially more than 0.5% of the
outstanding securities of an issuer) own in the aggregate more
than 5% of the securities of an issuer.
(5) purchase securities on margin, except for short-term credit
necessary for clearance of portfolio transactions and except that
the Fund may make margin deposits in connection with its use of
financial options and futures, forward and spot currency
contracts, swap transactions and other financial contracts or
derivative instruments.
(6) engage in short sales of securities or maintain a short position,
except that the Fund may (a) sell short 'against the box' and (b)
maintain short positions in connection with its use of financial
options and futures, forward and spot currency contracts, swap
transactions and other financial contracts or derivative
instruments.
(7) invest in oil, gas or mineral exploration or development programs
or leases, except that investments in securities of issuers that
invest in such programs or leases and investments in asset-backed
securities supported by receivables generated from such programs
or leases are not subject to this prohibition.
(8) purchase securities of other investment companies, except to the
extent permitted by the 1940 Act and except that this limitation
does not apply to securities received or acquired as dividends,
through offers of exchange, or as a result of reorganization,
consolidation, or merger.
(9) purchase securities while borrowings in excess of 5% of its total
assets are outstanding.
(10) invest in real estate limited partnerships.
25
<PAGE>
In addition, California Tax-Free Income Fund, National Tax-Free Income Fund
and New York Tax-Free Income Fund each will not:
(11) change its investment policies to invest more than 35% of its total
assets in debt securities rated Ba or lower by Moody's or BB or lower
by S&P, comparably rated by another NRSRO or determined by Mitchell
Hutchins to be of comparable quality without giving at least 30 days'
advance notice to shareholders.
It is possible that one or more of the Funds from time to time will invest
more than 25% of its total assets in a particular segment of the municipal
securities market, such as hospital revenue bonds, housing agency bonds, IDBs,
PABs or airport bonds or in securities the interest upon which is paid from
revenues of a similar type of project. In such circumstances, economic,
business, political or other changes affecting one bond might also affect other
bonds in the same segment, thereby potentially increasing market risk.
26
<PAGE>
HEDGING AND RELATED INCOME STRATEGIES
As discussed in the Prospectus, Mitchell Hutchins may use a variety of
financial instruments ('Hedging Instruments'), including certain options,
futures contracts (sometimes referred to as 'futures') and options on futures
contracts, to attempt to hedge the Funds' portfolios or to attempt to enhance
the Funds' income. In particular, each Fund may use the Hedging Instruments
described below:
OPTIONS ON DEBT SECURITIES--A call option is a short-term contract pursuant
to which the purchaser of the option, in return for a premium, has the right to
buy the security underlying the option at a specified price at any time during
the term of the option. The writer of the call option, who receives the premium,
has the obligation, upon exercise of the option during the option term, to
deliver the underlying security against payment of the exercise price. A put
option is a similar contract which gives its purchaser, in return for a premium,
the right to sell the underlying security at a specified price during the option
term. The writer of the put option, who receives the premium, has the
obligation, upon exercise during the option term, to buy the underlying security
at the exercise price. Options on debt securities are traded primarily in the
OTC market rather than on any of the several options exchanges. At present, only
options on U.S. Treasury securities are listed for trading on any recognized
exchange.
OPTIONS ON INDEXES OF DEBT SECURITIES--An index assigns relative values to
the securities included in the index and fluctuates with changes in the market
values of such securities. Index options operate in the same way as more
traditional options except that exercises of index options are effected with
cash payments and do not involve delivery of securities. Thus, upon exercise of
an index option, the purchaser will realize and the writer will pay an amount
based on the difference between the exercise price and the closing price of the
index. Currently, options on indexes of debt securities do not exist.
MUNICIPAL BOND INDEX FUTURES CONTRACTS--A municipal bond index futures
contract is a bilateral agreement pursuant to which one party agrees to accept
and the other party agrees to make delivery of an amount of cash equal to a
specified dollar amount times the difference between the index value at the
close of trading of the contract and the price at which the futures contract is
originally struck. No physical delivery of the bonds comprising the index is
made; generally contracts are closed out prior to the expiration date of the
contract.
MUNICIPAL DEBT AND INTEREST RATE FUTURES CONTRACTS--A municipal debt or
interest rate futures contract is a bilateral agreement pursuant to which one
party agrees to accept and the other party agrees to make delivery of the
specific type of debt security called for in the contract at a specified future
time and at a specified price. Although such futures contracts by their terms
call for actual delivery or acceptance of debt securities, in most cases the
contracts are closed out before the settlement date without the making or taking
of delivery. Currently there is no public market for municipal debt futures
contracts.
OPTIONS ON FUTURES CONTRACTS--Options on futures contracts are similar to
options on securities except that an option on a futures contract gives the
purchaser the right, in return for the premium, to assume a position in a
futures contract (a long position if the option is a call and a short position
if the option is a put), rather than to purchase or sell a security, at a
specified price at any time during the option term. Upon exercise of the option,
the delivery of the futures position to the holder of the option will be
accompanied by delivery of the accumulated balance, which represents the amount
by which the market price of the futures contract exceeds, in the case of a
call, or is less than, in the case of a put, the exercise price of the option on
the future. The writer of an option, upon exercise, will assume a short position
in the case of a call, and a long position in the case of a put.
GENERAL DESCRIPTION OF HEDGING STRATEGIES. Hedging strategies can be
broadly categorized as 'short hedges' and 'long hedges.' A short hedge is a
purchase or sale of a Hedging Instrument intended to
27
<PAGE>
partially or fully offset potential declines in the value of one or more
investments held in a Fund's portfolio. Thus, in a short hedge a Fund takes a
position in a Hedging Instrument whose price is expected to move in the opposite
direction of the price of the investment being hedged. For example, a Fund might
purchase a put option on a security to hedge against a potential decline in the
value of that security. If the price of the security declined below the exercise
price of the put, the Fund could exercise the put and thus limit its loss below
the exercise price to the premium paid plus transaction costs. In the
alternative, because the value of the put option can be expected to increase as
the value of the underlying security declines, the Fund might be able to close
out the put option and realize a gain to offset the decline in the value of the
security.
Conversely, a long hedge is a purchase or sale of a Hedging Instrument
intended partially or fully to offset potential increases in the acquisition
cost of one or more investments that a Fund intends to acquire. Thus, in a long
hedge a Fund takes a position in a Hedging Instrument whose price is expected to
move in the same direction as the price of the prospective investment being
hedged. For example, a Fund might purchase a call option on a security it
intends to purchase in order to hedge against an increase in the cost of the
security. If the price of the security increased above the exercise price of the
call, the Fund could exercise the call and thus limit its acquisition cost to
the exercise price plus the premium paid and transaction costs. Alternatively,
the Fund might be able to offset the price increase by closing out an
appreciated call option and realizing a gain.
Hedging Instruments on securities generally are used to hedge against price
movements in one or more particular securities positions that a Fund owns or
intends to acquire. Hedging Instruments on debt securities may be used to hedge
either individual securities or broad fixed income market sectors.
The use of Hedging Instruments is subject to applicable regulations of the
Securities and Exchange Commission ('SEC'), the several options and futures
exchanges upon which they are traded, the Commodity Futures Trading Commission
('CFTC') and various state regulatory authorities. In addition, a Fund's ability
to use Hedging Instruments will be limited by tax considerations. See 'Taxes.'
In addition to the products and strategies described below, Mitchell
Hutchins expects to discover additional opportunities in connection with
options, futures contracts and other hedging techniques. These new opportunities
may become available as Mitchell Hutchins develops new techniques, as regulatory
authorities broaden the range of permitted transactions and as new options,
futures contracts or other techniques are developed. Mitchell Hutchins may
utilize these opportunities to the extent that they are consistent with the
Funds' investment objectives and permitted by the Funds' investment limitations
and applicable regulatory authorities. The Funds' Prospectus or SAI will be
supplemented to the extent that new products or techniques involve materially
different risks than those described below or in the Prospectus.
SPECIAL RISKS OF HEDGING STRATEGIES. The use of Hedging Instruments
involves special considerations and risks, as described below. Risks pertaining
to particular Hedging Instruments are described in the sections that follow.
(1) Successful use of most Hedging Instruments depends upon Mitchell
Hutchins' ability to predict movements of the overall securities and interest
rate markets, which requires different skills than predicting changes in the
prices of individual securities. While Mitchell Hutchins is experienced in the
use of Hedging Instruments, there can be no assurance that any particular
hedging strategy adopted will succeed.
(2) There might be imperfect correlation, or even no correlation, between
price movements of a Hedging Instrument and price movements of the investments
being hedged. For example, if the value of a Hedging Instrument used in a short
hedge increased by less than the decline in value of the hedged investment, the
hedge would not be fully successful. Such a lack of correlation might occur due
to factors unrelated to the value of the investments being hedged, such as
speculative or other pressures on the markets in which
28
<PAGE>
Hedging Instruments are traded. The effectiveness of hedges using Hedging
Instruments on indices will depend on the degree of correlation between price
movements in the index and price movements in the securities being hedged.
(3) Hedging strategies, if successful, can reduce risk of loss by wholly or
partially offsetting the negative effect of unfavorable price movements in the
investments being hedged. However, hedging strategies can also reduce
opportunity for gain by offsetting the positive effect of favorable price
movements in the hedged investments. For example, if a Fund entered into a short
hedge because Mitchell Hutchins projected a decline in the price of a security
in the Fund's portfolio, and the price of that security increased instead, the
gain from that increase might be wholly or partially offset by a decline in the
price of the Hedging Instrument. Moreover, if the price of the Hedging
Instrument declined by more than the increase in the price of the security, the
Fund could suffer a loss. In either such case, the Fund would have been in a
better position had it not hedged at all.
(4) As described below, a Fund might be required to maintain assets as
'cover,' maintain segregated accounts or make margin payments when it takes
positions in Hedging Instruments involving obligations to third parties (i.e.,
Hedging Instruments other than purchased options). If a Fund were unable to
close out its positions in such Hedging Instruments, it might be required to
continue to maintain such assets or accounts or make such payments until the
position expired or matured. These requirements might impair a Fund's ability to
sell a portfolio security or make an investment at a time when it would
otherwise be favorable to do so, or require that a Fund sell a portfolio
security at a disadvantageous time. A Fund's ability to close out a position in
a Hedging Instrument prior to expiration or maturity depends on the existence of
a liquid secondary market or, in the absence of such a market, the ability and
willingness of a contra party to enter into a transaction closing out the
position. Therefore, there is no assurance that any hedging position can be
closed out at a time and price that is favorable to the Fund.
COVER FOR HEDGING STRATEGIES. Transactions using Hedging Instruments,
other than purchased options, expose a Fund to an obligation to another party. A
Fund will not enter into any such transactions unless it owns either (1) an
offsetting ('covered') position in securities or other options or futures
contracts or (2) cash or liquid securities, with a value sufficient at all times
to cover its potential obligations to the extent not covered as provided in (1)
above. Each Fund will comply with SEC guidelines regarding cover for hedging
transactions and will, if the guidelines so require, set aside cash or liquid
securities in a segregated account with its custodian in the prescribed amount.
Assets used as cover or held in a segregated account cannot be sold while
the position in the corresponding Hedging Instrument is open, unless they are
replaced with similar assets. As a result, the commitment of a large portion of
a Fund's assets to cover or segregated accounts could impede portfolio
management or the Fund's ability to meet redemption requests or other current
obligations.
OPTIONS. The Funds may purchase put and call options, and write (sell)
covered put and call options, on debt securities. The purchase of call options
serves as a long hedge, and the purchase of put options serves as a short hedge.
Writing covered put or call options can enable a Fund to enhance income by
reason of the premiums paid by the purchasers of such options. However, if the
market price of the security underlying a covered put option declines to less
than the exercise price of the option, minus the premium received, the Fund
would expect to suffer a loss. Writing covered call options serves as a limited
short hedge, because declines in the value of the hedged investment would be
offset to the extent of the premium received for writing the option. However, if
the security appreciates to a price higher than the exercise price of the call
option, it can be expected that the option will be exercised and the Fund will
be obligated to sell the security at less than its market value. If the covered
call option is an OTC option, the securities or other assets used as
29
<PAGE>
cover would be considered illiquid to the extent described under 'Investment
Policies and Restrictions-- Illiquid Securities.'
The value of an option position will reflect, among other things, the
current market value of the underlying investment, the time remaining until
expiration, the relationship of the exercise price to the market price of the
underlying investment, the historical price volatility of the underlying
investment and general market conditions. Options normally have expiration dates
of up to nine months. Generally, OTC options on debt securities are European
style options. This means that the option is only exercisable immediately prior
to its expiration. This is in contrast to American-style options, which are
exercisable at any time prior to the expiration date of the option. Options that
expire unexercised have no value.
A Fund may effectively terminate its right or obligation under an option by
entering into a closing transaction. For example, a Fund may terminate its
obligation under a call or put option that it had written by purchasing an
identical call or put option; this is known as a closing purchase transaction.
Conversely, a Fund may terminate a position in a put or call option it had
purchased by writing an identical put or call option; this is known as a closing
sale transaction. Closing transactions permit a Fund to realize profits or limit
losses on an option position prior to its exercise or expiration.
The Funds may purchase or write both exchange-traded and OTC options.
However, exchange-traded or liquid OTC options on municipal debt securities are
not currently available. Exchange markets for options on debt securities exist
but are relatively new, and these instruments are primarily traded on the OTC
market. Exchange-traded options in the United States are issued by a clearing
organization affiliated with the exchange on which the option is listed which,
in effect, guarantees completion of every exchange-traded option transaction. In
contrast, OTC options are contracts between the Fund and its contra party
(usually a securities dealer or a bank) with no clearing organization guarantee.
Thus, when the Fund purchases or writes an OTC option, it relies on the contra
party to make or take delivery of the underlying investment upon exercise of the
option. Failure by the contra party to do so would result in the loss of any
premium paid by the Fund as well as the loss of any expected benefit of the
transaction. The Funds will enter into OTC option transactions only with contra
parties that have a net worth of at least $20 million.
A Fund's ability to establish and close out positions in exchange-listed
options depends on the existence of a liquid market. Each Fund intends to
purchase or write only those exchange-traded options for which there appears to
be a liquid secondary market. However, there can be no assurance that such a
market will exist at any particular time. Closing transactions can be made for
OTC options only by negotiating directly with the contra party, or by a
transaction in the secondary market if any such market exists. Although a Fund
will enter into OTC options only with contra parties that are expected to be
capable of entering into closing transactions with the Fund, there is no
assurance that the Fund will in fact be able to close out an OTC option position
at a favorable price prior to expiration. In the event of insolvency of the
contra party, the Fund might be unable to close out an OTC option position at
any time prior to its expiration.
If a Fund were unable to effect a closing transaction for an option it had
purchased, it would have to exercise the option to realize any profit. The
inability to enter into a closing purchase transaction for a covered call option
written by a Fund could cause material losses because the Fund would be unable
to sell the investment used as cover for the written option until the option
expires or is exercised.
In the event that options on indices of municipal and non-municipal debt
securities become available, a Fund may purchase and write put and call options
on such indices in much the same manner as the more traditional options
discussed above, except that index options may serve as a hedge against overall
fluctuations in the debt securities markets (or market sectors) rather than
anticipated increases or decreases in the value of a particular security.
30
<PAGE>
GUIDELINES FOR OPTIONS. A Fund's use of options is governed by the
following guidelines, which can be changed by each Trust's board of trustees
without shareholder vote:
1. A Fund may purchase a put or call option, including any straddles
or spreads, only if the value of its premium, when aggregated with the
premiums on all other options held by the Fund, does not exceed 5% of the
Fund's total assets.
2. The aggregate value of securities underlying put options written by
any Fund determined as of the date the put options are written will not
exceed 50% of the Fund's net assets.
3. The aggregate premiums paid on all options (including options on
securities and indices of debt securities and options on futures contracts)
purchased by the Fund that are held at any time will not exceed 20% of the
Fund's net assets.
FUTURES. The Funds may purchase and sell municipal bond index futures
contracts, municipal debt futures contracts and interest rate futures contracts.
The Funds also may purchase put and call options, and write covered put and call
options, on such futures contracts. The purchase of futures or call options
thereon can serve as a long hedge, and the sale of futures or the purchase of
put options thereon can serve as a short hedge. Writing covered call options on
futures contracts can serve as a limited short hedge, and writing covered put
options on futures contracts can serve as a limited long hedge, using a strategy
similar to that used for writing covered call options on securities or indices.
Futures strategies also can be used to manage the average duration of a
Fund's portfolio. If Mitchell Hutchins wishes to shorten the average duration of
a Fund, the Fund may sell a futures contract or a call option thereon, or
purchase a put option on that futures contract. If Mitchell Hutchins wishes to
lengthen the average duration of a Fund, the Fund may buy a futures contract or
a call option thereon, or sell a put option thereon.
No price is paid upon entering into a futures contract. Instead, at the
inception of a futures contract a Fund is required to deposit in a segregated
account with its custodian, in the name of the futures broker through whom the
transaction was effected, 'initial margin' consisting of cash, U.S. government
securities or other liquid, high-grade debt securities, in an amount generally
equal to 10% or less of the contract value. Margin must also be deposited when
writing a call option on a futures contract, in accordance with applicable
exchange rules. Unlike margin in securities transactions, initial margin on
futures contracts does not represent a borrowing, but rather is in the nature of
a performance bond or good-faith deposit that is returned to the Fund at the
termination of the transaction if all contractual obligations have been
satisfied. Under certain circumstances, such as periods of high volatility, the
Fund may be required by an exchange to increase the level of its initial margin
payment, and initial margin requirements might be increased generally in the
future by regulatory action.
Subsequent 'variation margin' payments are made to and from the futures
broker daily as the value of the futures position varies, a process known as
'marking to market.' Variation margin does not involve borrowing, but rather
represents a daily settlement of the Fund's obligations to or from a futures
broker. When a Fund purchases an option on a future, the premium paid plus
transaction costs is all that is at risk. In contrast, when a Fund purchases or
sells a futures contract or writes a call or put option thereon, it is subject
to daily variation margin calls that could be substantial in the event of
adverse price movements. If the Fund has insufficient cash to meet daily
variation margin requirements, it might need to sell securities at a time when
such sales are disadvantageous.
Holders and writers of futures positions and options on futures can enter
into offsetting closing transactions, similar to closing transactions on
options, by selling or purchasing, respectively, an instrument identical to the
instrument held or written. Positions in futures and options on futures may be
closed only on
31
<PAGE>
an exchange or board of trade that provides a secondary market. Each Fund
intends to enter into futures transactions only on exchanges or boards of trade
where there appears to be a liquid secondary market. However, there can be no
assurance that such a market will exist for a particular contract at a
particular time.
Under certain circumstances, futures exchanges may establish daily limits
on the amount that the price of a future or related option can vary from the
previous day's settlement price; once that limit is reached, no trades may be
made that day at a price beyond the limit. Daily price limits do not limit
potential losses because prices could move to the daily limit for several
consecutive days with little or no trading, thereby preventing liquidation of
unfavorable positions.
If a Fund were unable to liquidate a futures or related options position
due to the absence of a liquid secondary market or the imposition of price
limits, it could incur substantial losses. The Fund would continue to be subject
to market risk with respect to the position. In addition, except in the case of
purchased options, the Fund would continue to be required to make daily
variation margin payments and might be required to maintain the position being
hedged by the future or option or to maintain cash or securities in a segregated
account.
Certain characteristics of the futures market might increase the risk that
movements in the prices of futures contracts or related options might not
correlate perfectly with movements in the prices of the investments being
hedged. For example, all participants in the futures and related options markets
are subject to daily variation margin calls and might be compelled to liquidate
futures or related options positions whose prices are moving unfavorably to
avoid being subject to further calls. These liquidations could increase price
volatility of the instruments and distort the normal price relationship between
the futures or options and the investments being hedged. Also, because initial
margin deposit requirements in the futures market are less onerous than margin
requirements in the securities markets, there might be increased participation
by speculators in the futures markets. This participation also might cause
temporary price distortions. In addition, activities of large traders in both
the futures and securities markets involving arbitrage, 'program trading' and
other investment strategies might result in temporary price distortions.
GUIDELINES FOR FUTURES AND RELATED OPTIONS. A Fund's use of futures and
related options is governed by the following guidelines, which can be changed by
each Trust's board of trustees without shareholder vote:
1. To the extent a Fund enters into futures contracts and options on
futures positions that are not for bona fide hedging purposes (as defined
by the CFTC), the aggregate initial margin and premiums on those positions
(excluding the amount by which options are 'in-the-money') may not exceed
5% of the Fund's net assets.
2. The aggregate premiums paid on all options (including options on
securities and indices of debt securities and options on futures contracts)
purchased by any Fund that are held at any time will not exceed 20% of the
Fund's net assets.
3. The aggregate margin deposits on all futures contracts and options
thereon held at any time by the Fund will not exceed 5% of the Fund's total
assets.
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<PAGE>
TRUSTEES AND OFFICERS
The trustees and executive officers of each Trust, their ages, business
addresses and principal occupations during the past five years are:
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
Margo N. Alexander**; 49 Trustee and Mrs. Alexander is president,
President chief executive officer and
a director of Mitchell
Hutchins (since January
1995) and also an executive
vice president and a
director of PaineWebber.
Mrs. Alexander is president
and a director or trustee of
30 investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Richard Q. Armstrong; 61 Trustee Mr. Armstrong is chairman and
78 West Brother Drive principal of RQA Enterprises
Greenwich, CT 06830 (management consulting firm)
(since April 1991 and
principal occupation since
March 1995). Mr. Armstrong
is also a director of Hi Lo
Automotive, Inc. He was
chairman of the board, chief
executive officer and
co-owner of Adirondack
Beverages (producer and
distributor of soft drinks
and sparkling/still waters)
(October 1993-March 1995).
Mr. Armstrong was a partner
of The New England
Consulting Group (management
consulting firm) (December
1992-September 1993). He was
managing director of LVMH
U.S. Corporation (U.S.
subsidiary of the French
luxury goods conglomerate,
Luis Vuitton Moet Hennessey
Corporation) (1987-1991) and
chairman of its wine and
spirits subsidiary,
Schieffelin & Somerset
Company (1987-1991). Mr.
Armstrong is a director or
trustee of 29 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
E. Garrett Bewkes, Jr.**; 69 Trustee and Mr. Bewkes is a director of
Chairman of the Paine Webber Group Inc. ('PW
Board of Group') (holding company of
Trustees PaineWebber and Mitchell
Hutchins). Prior to December
1995, he was a consultant to
PW Group. Prior to 1988, he
was chairman of the board,
president and chief
executive officer of
American Bakeries Company.
Mr. Bewkes is also a
director of Interstate
Bakeries Corporation and
NaPro BioTherapeutics, Inc.
Mr. Bewkes is a director or
trustee of 30 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
</TABLE>
33
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
Richard R. Burt; 49 Trustee Mr. Burt is chairman of
1101 Connecticut Avenue, N.W. International Equity
Washington, D.C. 20036 Partners (international
investments and consulting
firm) (since March 1994) and
a partner of McKinsey &
Company (management
consulting firm) (since
1991). He is also a director
of American Publishing
Company. He was the chief
negotiator in the Strategic
Arms Reduction Talks with
the former Soviet Union
(1989-1991) and the U.S.
Ambassador to the Federal
Republic of Germany
(1985-1989). Mr. Burt is a
director or trustee of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Mary C. Farrell**; 46 Trustee Ms. Farrell is a managing
director, senior investment
strategist and member of the
Investment Policy Committee
of PaineWebber. Ms. Farrell
joined PaineWebber in 1982.
She is a member of the
Financial Women's
Association and Women's
Economic Roundtable, and is
employed as a regular
panelist on Wall $treet Week
with Louis Rukeyser. She
also serves on the Board of
Overseers of New York
University's Stern School of
Business. Ms. Farrell is a
director or trustee of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Meyer Feldberg; 54 Trustee Mr. Feldberg is Dean and
Columbia University Professor of Management of
101 Uris Hall the Graduate School of
New York, New York 10027 Business, Columbia
University. Prior to 1989,
he was president of the
Illinois Institute of
Technology. Dean Feldberg is
also a director of AMSCO
International Inc. (medical
instruments and supplies),
Federated Department Stores,
Inc. and New World
Communications Group
Incorporated. Dean Feldberg
is a director or trustee of
29 investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
George W. Gowen; 66 Trustee Mr. Gowen is a partner in the
666 Third Avenue law firm of Dunnington,
New York, New York 10017 Bartholow & Miller. Prior to
May 1994, he was a partner
in the law firm of Fryer,
Ross & Gowen. Mr. Gowen is a
director of Columbia Real
Estate Investments, Inc. Mr.
Gowen is a director or
trustee of 29 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
</TABLE>
34
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
Frederic V. Malek; 59 Trustee Mr. Malek is chairman of
901 15th Street, N.W. Thayer Capital Partners
Suite 300 (investment bank) and a
Washington, D.C. 20005 co-chairman and director of
CB Commercial Group Inc.
(real estate). From January
1992 to November 1992, he
was campaign manager of
Bush-Quayle '92. From 1990
to 1992, he was vice
chairman and, from 1989 to
1990, he was president of
Northwest Airlines Inc., NWA
Inc. (holding company of
Northwest Airlines Inc.) and
Wings Holdings Inc. (holding
company of NWA Inc.). Prior
to 1989, he was employed by
the Marriott Corporation
(hotels, restaurants,
airline catering and
contract feeding), where he
most recently was an
executive vice president and
president of Marriott Hotels
and Resorts. Mr. Malek is
also a director of American
Management Systems, Inc.
(management consulting and
computer related services),
Automatic Data Processing,
Inc., Avis, Inc. (passenger
car rental), FPL Group, Inc.
(electric services),
National Education
Corporation and Northwest
Airlines Inc. Mr. Malek is a
director or trustee of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Carl W. Schafer; 60 Trustee Mr. Schafer is president of
P.O. Box 1164 the Atlantic Foundation
Princeton, New Jersey 08542 (charitable foundation
supporting mainly
oceanographic exploration
and research). He also is a
director of Roadway Express,
Inc. (trucking), The
Guardian Group of Mutual
Funds, Evans Systems, Inc.
(a motor fuels, convenience
store and diversified
company), Hidden Lake Gold
Mines Ltd. (gold mining),
Electronic Clearing House,
Inc. (financial transactions
processing), Wainoco Oil
Corporation and Nutraceutix,
Inc. (biotechnology). Prior
to January 1993, Mr. Schafer
was chairman of the
Investment Advisory
Committee of the Howard
Hughes Medical Institute.
Mr. Schafer is a director or
trustee of 29 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
John R. Torell III; 56 Trustee Mr. Torell is chairman of
767 Fifth Avenue Torell Management, Inc.
Suite 4605 (financial advisory firm),
New York, NY 10153 chairman of Telesphere
Corporation (electronic
provider of financial
information) and a partner
of Zilkha & Company
(merchant banking and
private investment company).
</TABLE>
35
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
He is the former chairman
and chief executive officer
of Fortune Bancorp (since
1990-1991 and 1990-1994,
respectively), the former
chairman, president and
chief executive officer of
CalFed, Inc. (savings
association) (1988 to 1989)
and former president of
Manufacturers Hanover Corp.
(bank) (prior to 1988). Mr.
Torell is a director of
American Home Products
Corp., New Colt Inc.
(armament manufacturer) and
Volt Information Sciences
Inc. Mr. Torell is a
director or trustee of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Cynthia N. Bow; 37 Vice President Ms. Bow is a vice president of
(PW Mutual Fund Mitchell Hutchins. Ms. Bow
Trust only) has been with Mitchell
Hutchins since 1982. Ms. Bow
is a vice president of two
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Teresa M. Boyle; 37 Vice President Ms. Boyle is a first vice
president and
manager--advisory
administration of Mitchell
Hutchins. Prior to November
1993, she was Compliance
Manager of Hyperion Capital
Management, Inc., an
investment advisory firm.
Prior to April 1993, Ms.
Boyle was a vice president
and manager--legal
administration of Mitchell
Hutchins. Ms. Boyle is a
vice president of 30
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Elbridge T. Gerry III; 39 Vice President Mr. Gerry is a senior vice
president and a portfolio
manager of Mitchell
Hutchins. Prior to January
1996, he was with JP Morgan
Private Banking where he was
responsible for managing
municipal assets, including
several municipal bond
funds. Mr. Gerry is a vice
president of four investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
C. William Maher; 35 Vice President Mr. Maher is a first vice
and Assistant president and a senior
Treasurer manager of the mutual fund
finance division of Mitchell
Hutchins. Mr. Maher is a
vice president and assistant
treasurer of 30 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Dennis McCauley; 49 Vice President Mr. McCauley is a managing
director and chief
investment officer--fixed
income of Mitchell
</TABLE>
36
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
Hutchins. Prior to December
1994, he was director of
fixed income investments of
IBM Corporation. Mr.
McCauley is a vice president
of 19 investment companies
for which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
Ann E. Moran; 38 Vice President Ms. Moran is a vice president
and Assistant of Mitchell Hutchins. Ms.
Treasurer Moran is a vice president
and assistant treasurer of
30 investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Richard S. Murphy; 40 Vice President Mr. Murphy is a senior vice
(PW Mutual Fund president of Mitchell
Trust only) Hutchins. Prior to March
1994 Mr. Murphy was a vice
president at American
International Group.
Dianne E. O'Donnell; 44 Vice President Ms. O'Donnell is a senior vice
and Secretary president and deputy general
counsel of Mitchell
Hutchins. Ms. O'Donnell is a
vice president and secretary
of 29 investment companies
for which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
Victoria E. Schonfeld; 45 Vice President Ms. Schonfeld is a managing
director and general counsel
of Mitchell Hutchins. Prior
to May 1994, she was a
partner in the law firm of
Arnold & Porter. Ms.
Schonfeld is a vice
president of 30 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Paul H. Schubert; 33 Vice President Mr. Schubert is a first vice
and Assistant president and a senior
Treasurer manager of the mutual fund
finance division of Mitchell
Hutchins. From August 1992
to August 1994, he was a
vice president of BlackRock
Financial Management L.P.
Prior to August 1992, he was
an audit manager with Ernst
& Young LLP. Mr. Schubert is
a vice president and
assistant treasurer of 30
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Julian F. Sluyters; 35 Vice President Mr. Sluyters is a senior vice
and Treasurer president and the director
of the mutual fund finance
division of Mitchell
Hutchins. Prior to 1991, he
was an audit senior manager
with Ernst & Young LLP. Mr.
Sluyters is a vice president
and treasurer of 30
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
</TABLE>
37
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
William W. Veronda; 49 Vice President Mr. Veronda is a senior vice
(PW Municipal president of Mitchell
Series only) Hutchins. Prior to September
1995, he was a senior vice
president and general
manager at Invesco Funds
Group.
Keith A. Weller; 34 Vice President Mr. Weller is a first vice
and Assistant president and associate
Secretary general counsel of Mitchell
Hutchins. Prior to May 1995,
he was an attorney in
private practice. Mr. Weller
is a vice president and
assistant secretary of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
</TABLE>
- ------------------
* Unless otherwise indicated, the business address of each listed person is
1285 Avenue of the Americas, New York, New York 10019.
** Mrs. Alexander, Mr. Bewkes and Ms. Farrell are 'interested persons' of the
Trusts as defined in the 1940 Act by virtue of their positions with Mitchell
Hutchins, PaineWebber and/or PW Group.
Each Trust pays trustees who are not 'interested persons' of the Trust
('disinterested trustees') $1,000 annually for each series and $150 for each
board meeting and each meeting of a board committee (other than committee
meetings held on the same day as a board meeting). Each Trust presently has two
series and thus pays each such trustee $2,000 annually, plus any additional
annual amounts due for board or committee meetings. Messrs. Feldberg and Torell
each receive additional annual compensation from the PaineWebber fund complex
(including the Trusts) of $15,000 for serving as chairmen of the audit and
contract review committees of the funds. All Trustees are reimbursed for any
expenses incurred in attending meetings. Trustees and officers of the Trusts own
in the aggregate less than 1% of the shares of each Fund. Because Mitchell
Hutchins and PaineWebber perform substantially all of the services necessary for
the operation of the Trusts and the Funds, neither Trust requires any employees.
No officer, director or employee of Mitchell Hutchins or PaineWebber presently
receives any compensation from the Trusts for acting as a trustee or officer.
The table below includes certain information relating to the compensation
of each Trust's current trustees who held office with the Trust or with other
PaineWebber funds during the fiscal year ended February 29, 1996.
38
<PAGE>
COMPENSATION TABLE
<TABLE>
<CAPTION>
AGGREGATE COMPENSATION FROM AGGREGATE COMPENSATION FROM TOTAL COMPENSATION FROM THE
PAINEWEBBER MUNICIPAL PAINEWEBBER MUTUAL FUND TRUSTS AND THE FUND
NAME OF PERSON, POSITION SERIES* TRUST* COMPLEX**
- ------------------------------ --------------------------- --------------------------- ---------------------------
<S> <C> <C> <C>
Richard Q. Armstrong,
Trustee..................... N/A N/A $ 9,000
Richard R. Burt,
Trustee..................... N/A N/A 7,750
Meyer Feldberg,
Trustee..................... $6,500 $5,250 106,375
George W. Gowen,
Trustee..................... 6,500 5,250 99,750
Frederic V. Malek,
Trustee..................... 6,500 5,250 99,750
Carl W. Schafer,
Trustee..................... N/A N/A 118,175
John R. Torell, III,
Trustee..................... N/A N/A 28,125
</TABLE>
- ------------------
Only independent members of the board are compensated by the Trusts and
identified above; trustees who are 'interested persons,' as defined by the
1940 Act, do not receive compensation.
* Represents fees paid to each trustee during the fiscal year ended February
29, 1996.
** Represents total compensation paid to each trustee during the calendar year
ended December 31, 1995; no fund within the fund complex has a bonus,
pension, profit sharing or retirement plan.
INVESTMENT ADVISORY AND DISTRIBUTION ARRANGEMENTS
INVESTMENT ADVISORY ARRANGEMENTS. Mitchell Hutchins acts as the investment
adviser and administrator of California Tax-Free Income Fund and National
Tax-Free Income Fund pursuant to a contract dated April 21, 1988 with
PaineWebber Mutual Fund Trust, as supplemented by a Fee Agreement dated June 30,
1992 with respect to National Tax-Free Income Fund, and of Municipal High Income
Fund and New York Tax-Free Income Fund pursuant to a contract with PaineWebber
Municipal Series dated July 1, 1989 (each an 'Advisory Contract' and,
collectively, the 'Advisory Contracts'). Under the Advisory Contracts, each Fund
pays Mitchell Hutchins a fee, computed daily and paid monthly, at the annual
rate of 0.50% of average daily net assets in the case of California Tax-Free
Income Fund and National Tax-Free Income Fund and 0.60% of average daily net
assets in the case of Municipal High Income Fund and New York Tax-Free Income
Fund.
Pursuant to their Advisory Contract, for the fiscal years ended February
29, 1996, February 28, 1995 and February 28, 1994, California Tax-Free Income
Fund paid (or accrued) to Mitchell Hutchins the amounts of $1,116,442,
$1,340,491 and $1,662,653, respectively, and National Tax-Free Income Fund paid
(or accrued) to Mitchell Hutchins the amounts of $2,388,482, $2,891,059 and
$3,374,932, respectively. Pursuant to their Advisory Contract, for the fiscal
years ended February 29, 1996, February 28, 1995 and February 28, 1994,
Municipal High Income Fund paid (or accrued) to Mitchell Hutchins the amounts of
$647,537, $768,555 and $861,664, respectively, and New York Tax-Free Income Fund
paid (or accrued) to Mitchell Hutchins the
39
<PAGE>
amounts of $380,993, $481,509 (of which $10,398 was waived) and $557,864 (of
which $202,282 was waived), respectively.
Under a Service Agreement with each Trust that is reviewed by each Trust's
board of trustees annually, PaineWebber provides certain services to the Funds
not otherwise provided by the Fund's transfer agent. Pursuant to the Service
Agreement with PaineWebber Mutual Fund Trust, during the fiscal years ended
February 29, 1996, February 28, 1995 and February 28, 1994, California Tax-Free
Income Fund paid (or accrued) the amounts of $19,943, $24,838 and $26,755,
respectively, and National Tax-Free Income Fund paid (or accrued) the amounts of
$52,513, $64,620 and $67,293, respectively. Pursuant to the Service Agreement
with PaineWebber Municipal Series, during the fiscal years ended February 29,
1996, February 28, 1995 and February 28, 1994, Municipal High Income Fund paid
(or accrued) the amounts of $15,997, $19,534 and $19,512, respectively, and New
York Tax-Free Income Fund paid (or accrued) the amounts of $9,267, $10,747 (of
which $3,734 was waived) and $9,492 (all of which was waived), respectively.
Under the terms of the applicable Advisory Contract, each Fund bears all
expenses incurred in its operation that are not specifically assumed by Mitchell
Hutchins. General expenses of the Trust not readily identifiable as belonging to
a particular Fund are allocated between the appropriate Funds by or under the
direction of the board of trustees in such manner as the board deems fair and
equitable. Expenses borne by each Fund include the following: (1) the cost
(including brokerage commissions, if any) of securities purchased or sold by the
Fund and any losses incurred in connection therewith; (2) fees payable to and
expenses incurred on behalf of the Fund by Mitchell Hutchins; (3) organizational
expenses; (4) filing fees and expenses relating to the registration and
qualification of the Fund's shares under federal and state securities laws and
maintenance of such registrations and qualifications; (5) fees and salaries
payable to trustees who are not interested persons of the Fund or Mitchell
Hutchins; (6) all expenses incurred in connection with the trustees' services,
including travel expenses; (7) taxes (including any income or franchise taxes)
and governmental fees; (8) costs of any liability, uncollectible items of
deposit and other insurance or fidelity bonds; (9) any costs, expenses or losses
arising out of a liability of or claim for damages or other relief asserted
against the Fund for violation of any law; (10) legal, accounting and auditing
expenses, including legal fees of special counsel for the independent trustees;
(11) charges of custodians, transfer agents and other agents; (12) costs of
preparing share certificates; (13) expenses of setting in type and printing
prospectuses and supplements thereto, statements of additional information and
supplements thereto, reports and proxy materials for existing shareholders and
costs of mailing such materials to existing shareholders; (14) any extraordinary
expenses (including fees and disbursements of counsel) incurred by the Fund;
(15) fees, voluntary assessments and other expenses incurred in connection with
membership in investment company organizations; (16) costs of mailing and
tabulating proxies and costs of meetings of shareholders, the board and any
committees thereof; (17) the cost of investment company literature and other
publications provided to trustees and officers; and (18) costs of mailing,
stationery and communications equipment.
As required by state regulation, Mitchell Hutchins will reimburse a Fund if
and to the extent that the aggregate operating expenses of the Fund in any
fiscal year exceed applicable limits. Currently the most restrictive such limit
applicable to a Fund is 2.5% of the first $30 million of the Fund's average
daily net assets, 2.0% of the next $70 million of its average daily net assets
and 1.5% of its average daily net assets in excess of $100 million. Certain
expenses, such as brokerage commissions, taxes, interest, distribution fees and
extraordinary items, are excluded from this limitation. For the fiscal years
ended February 29, 1996, February 28, 1995 and February 28, 1994, PaineWebber
and Mitchell Hutchins were not required to reimburse any Fund pursuant to state
limitations.
Under each Advisory Contract, Mitchell Hutchins will not be liable for any
error of judgment or mistake of law or for any loss suffered by a Fund in
connection with the performance of the Advisory Contract, except
40
<PAGE>
a loss resulting from willful misfeasance, bad faith or gross negligence on the
part of Mitchell Hutchins in the performance of its duties or from reckless
disregard of its duties and obligations thereunder. Each Advisory Contract
terminates automatically upon its assignment and is terminable at any time
without penalty by the board of trustees or by vote of the holders of a majority
of a Fund's outstanding voting securities, on 60 days' written notice to
Mitchell Hutchins or by Mitchell Hutchins on 60 days' written notice to a Fund.
The following table shows the approximate net assets as of May 31, 1996,
sorted by category of investment objective, of the investment companies as to
which Mitchell Hutchins serves as adviser or sub-adviser. An investment company
may fall into more than one of the categories below.
<TABLE>
<CAPTION>
NET ASSETS
INVESTMENT CATEGORY ($ MIL)
- ------------------------------------------------------------ ----------
<S> <C>
Domestic (excluding Money Market)........................... $ 5,608.2
Global...................................................... 2,833.3
Equity/Balanced............................................. 3,127.4
Fixed Income (excluding Money Market)....................... 5,314.1
Taxable Fixed Income................................... 3,683.0
Tax-Free Fixed Income.................................. 1,631.1
Money Market Funds.......................................... 21,968.9
</TABLE>
Mitchell Hutchins personnel may invest in securities for their own accounts
pursuant to a code of ethics that describes the fiduciary duty owed to
shareholders of the PaineWebber mutual funds and other Mitchell Hutchins'
advisory accounts by all Mitchell Hutchins' directors, officers and employees,
establishes procedures for personal investing and restricts certain
transactions. For example, employee accounts generally must be maintained at
PaineWebber, personal trades in most securities require pre-clearance and
short-term trading and participation in initial public offerings generally are
prohibited. In addition, the code of ethics puts restrictions on the timing of
personal investing in relation to trades by PaineWebber mutual funds and other
Mitchell Hutchins advisory clients.
DISTRIBUTION ARRANGEMENTS. Mitchell Hutchins acts as the distributor of the
Class A, Class B and Class C shares of the Funds under separate distribution
contracts with each Trust dated July 7, 1993 and November 10, 1995
(collectively, 'Distribution Contracts'). Each Distribution Contract requires
Mitchell Hutchins to use its best efforts, consistent with its other businesses,
to sell shares of the applicable Funds. Shares of the Funds are offered
continuously. Under separate exclusive dealer agreements between Mitchell
Hutchins and PaineWebber dated July 7, 1993 and November 10, 1995, relating to
the Class A, Class B and Class C shares of each Fund (collectively, 'Exclusive
Dealer Agreements'), PaineWebber and its correspondent firms sell each Fund's
shares.
Under separate plans of distribution pertaining to the Class A, Class B and
Class C shares of the Funds adopted by the Trusts in the manner prescribed under
Rule 12b-1 under the 1940 Act ('Class A Plan,' 'Class B Plan' and 'Class C
Plan,' collectively, 'Plans'), each Fund pays Mitchell Hutchins a service fee,
accrued daily and payable monthly, at the annual rate of 0.25% of the average
daily net assets of each Class of shares. Under the Class B Plan, each Fund also
pays Mitchell Hutchins a distribution fee, accrued daily and payable monthly, at
the annual rate of 0.75% of the average daily net assets of the Class B shares.
Under the Class C Plan, each Fund pays Mitchell Hutchins a distribution fee,
accrued daily and payable monthly, at the annual rate of 0.50% of the average
daily net assets of the Class C shares.
Among other things, each Plan provides that (1) Mitchell Hutchins will
submit to the Trust's board of trustees at least quarterly, and the trustees
will review, reports regarding all amounts expended under the Plan and the
purposes for which such expenditures were made, (2) the Plan will continue in
effect only so long as it
41
<PAGE>
is approved at least annually, and any material amendment thereto is approved,
by the Trust's board of trustees, including those trustees who are not
'interested persons' of the Trust and who have no direct or indirect financial
interest in the operation of the Plan or any agreement related to the Plan,
acting in person at a meeting called for that purpose, (3) payments by a Fund
under the Plan shall not be materially increased without the affirmative vote of
the holders of a majority of the outstanding shares of the relevant Class of
that Fund and (4) while the Plan remains in effect, the selection and nomination
of trustees who are not 'interested persons' of the Trust shall be committed to
the discretion of the trustees who are not interested persons of the Trust.
In reporting amounts expended under the Plans to the trustees, Mitchell
Hutchins will allocate expenses attributable to the sale of each Class of Fund
shares to such Class based on the ratio of sales of the shares of such Class to
the sales of all three Classes of shares. The fees paid by one Class of Fund
shares will not be used to subsidize the sale of any other Class of Fund shares.
Under prior plans of distribution substantially similar to the Class A
Plan, each Fund paid Mitchell Hutchins a monthly distribution fee computed at
the same rate and in the same manner as the service fees under the Class A Plan.
The Funds paid (or accrued) the following fees to Mitchell Hutchins under
the Class A, Class B and Class C Plans during the fiscal year ended February 29,
1996:
<TABLE>
<CAPTION>
CALIFORNIA NATIONAL NEW YORK
TAX-FREE TAX-FREE MUNICIPAL HIGH TAX-FREE
INCOME FUND INCOME FUND INCOME FUND INCOME FUND*
----------- ----------- -------------- ------------
<S> <C> <C> <C> <C>
Class A........ $ 418,711 $ 834,162 $152,119 $ 37,418
Class B........ 305,974 558,344 249,577 117,832
Class C........ 189,044 660,528 165,883 123,058
</TABLE>
- ------------------
* During the fiscal year shown above, Mitchell Hutchins waived all or a portion
of its distribution fees. If such waivers had not been made, for the Class A,
Class B and Class C shares, the actual fees that would have been paid by the
Fund would have been $76,889, $133,770 and $145,249, respectively.
Mitchell Hutchins estimates that it and its parent corporation,
PaineWebber, incurred the following shareholder service-related and
distribution-related expenses with respect to the Funds during the fiscal year
ended February 29, 1996:
CLASS A
<TABLE>
<CAPTION>
CALIFORNIA NATIONAL NEW YORK
TAX-FREE TAX-FREE MUNICIPAL HIGH TAX-FREE
INCOME FUND INCOME FUND INCOME FUND INCOME FUND
----------- ----------- -------------- -----------
<S> <C> <C> <C> <C>
Marketing and
advertising............ $ 48,048 $ 157,015 $ 43,854 $ 11,715
Amortization of
commissions............ N/A N/A N/A N/A
Printing of prospectuses
and statements of
additional
information............ 666 2,576 290 82
Branch network costs
allocated and interest
expense................ 405,937 1,634,203 178,606 55,238
Service fees paid to
PaineWebber investment
executives............. 188,818 375,372 68,453 34,958
</TABLE>
42
<PAGE>
<TABLE>
<CAPTION>
CLASS B
CALIFORNIA NATIONAL NEW YORK
TAX-FREE TAX-FREE MUNICIPAL HIGH TAX-FREE
INCOME FUND INCOME FUND INCOME FUND INCOME FUND
----------- ----------- -------------- -----------
<S> <C> <C> <C> <C>
Marketing and
advertising............ $ 28,684 $ 15,240 $ 33,118 $ 11,450
Amortization of
commissions............ 139,632 288,252 129,143 82,077
Printing of prospectuses
and statements of
additional
information............ 393 250 218 80
Branch network costs
allocated and interest
expense................ 259,099 189,454 149,270 61,283
Service fees paid to
PaineWebber investment
executives............. 34,495 62,813 28,137 15,244
CLASS C
<CAPTION>
CALIFORNIA NATIONAL NEW YORK
TAX-FREE TAX-FREE MUNICIPAL HIGH TAX-FREE
INCOME FUND INCOME FUND INCOME FUND INCOME FUND
----------- ----------- -------------- -----------
<S> <C> <C> <C> <C>
Marketing and
advertising............ $ 32,760 $ 20,868 $ 31,303 $ 36,420
Amortization of
commissions............ 42,222 131,756 49,420 39,730
Printing of prospectuses
and statements of
additional
information............ 454 342 217 255
Branch network costs
allocated and interest
expense................ 277,148 218,133 128,010 172,066
Service fees paid to
PaineWebber investment
executives............. 28,426 99,080 24,934 22,074
</TABLE>
'Marketing and advertising' includes various internal costs allocated by
Mitchell Hutchins to its efforts at distributing Fund shares. These internal
costs encompass office rent, salaries and other overhead expenses of various
departments and areas of operations of Mitchell Hutchins. 'Branch network costs
allocated and interest expense' consist of an allocated portion of the expenses
of various PaineWebber departments involved in the distribution of each Fund's
shares, including the PaineWebber retail branch system.
In approving each Fund's overall Flexible Pricing(Service Mark) system of
distribution, the Trust's board of trustees considered several factors,
including that implementation of Flexible Pricing would (1) enable investors to
choose the purchasing option best suited to their individual situation, thereby
encouraging current shareholders to make additional investments in the Fund and
attracting new investors and assets to the Fund to the benefit of the Fund and
its shareholders; (2) facilitate distribution of the Fund's shares; and (3)
maintain the competitive position of the Fund in relation to other funds that
have implemented or are seeking to implement similar distribution arrangements.
In approving the Class A Plan for each Fund, the trustees considered all
the features of the distribution system, including (1) the conditions under
which initial sales charges would be imposed and the amount of such charges, (2)
Mitchell Hutchins' belief that the initial sales charge combined with a service
fee would be attractive to PaineWebber investment executives and correspondent
firms, resulting in greater growth of the Fund than might otherwise be the case,
(3) the advantages to the shareholders of economies of scale resulting from
growth in the Fund's assets and potential continued growth, (4) the services
provided to the Fund and its shareholders by Mitchell Hutchins, (5) the services
provided by PaineWebber pursuant to its Exclusive Dealer Agreement with Mitchell
Hutchins and (6) Mitchell Hutchins' shareholder service-related expenses and
costs.
43
<PAGE>
In approving the Class B Plan for each Fund, the trustees considered all
the features of the distribution system, including (1) the conditions under
which contingent deferred sales charges would be imposed and the amount of such
charges, (2) the advantage to investors in having no initial sales charges
deducted from Fund purchase payments and instead having the entire amount of
their purchase payments immediately invested in Fund shares, (3) Mitchell
Hutchins' belief that the ability of PaineWebber investment executives and
correspondent firms to receive sales commissions when Class B shares are sold
and continuing service fees thereafter while their customers invest their entire
purchase payments immediately in Class B shares would prove attractive to the
investment executives and correspondent firms, resulting in greater growth of
the Fund than might otherwise be the case, (4) the advantages to the
shareholders of economies of scale resulting from growth in the Fund's assets
and potential continued growth, (5) the services provided to the Fund and its
shareholders by Mitchell Hutchins, (6) the services provided by PaineWebber
pursuant to its Exclusive Dealer Agreement with Mitchell Hutchins and (7)
Mitchell Hutchins' shareholder service- and distribution-related expenses and
costs. The trustees also recognized that Mitchell Hutchins' willingness to
compensate PaineWebber and its investment executives, without the concomitant
receipt by Mitchell Hutchins of initial sales charges, was conditioned upon its
expectation of being compensated under the Class B Plan.
In approving the Class C Plan for each Fund, the trustees considered all
the features of the distribution system, including (1) the advantage to
investors in having no initial sales charges deducted from the Fund's purchase
payments and instead having the entire amount of their purchase payments
immediately invested in Fund shares, (2) the advantage to investors in being
free from contingent deferred sales charges upon redemption for shares held more
than one year and paying for distribution on an ongoing basis, (3) Mitchell
Hutchins' belief that the ability of PaineWebber investment executives and
correspondent firms to receive sales compensation for their sales of Class C
shares on an ongoing basis, along with continuing service fees, while their
customers invest their entire purchase payments immediately in Class C shares
and do not face contingent deferred sales charges, would prove attractive to the
investment executives and correspondent firms, resulting in greater growth to
the Fund than might otherwise be the case, (4) the advantages to the
shareholders of economies of scale resulting from growth in the Fund's assets
and potential continued growth, (5) the services provided to the Fund and its
shareholders by Mitchell Hutchins, (6) the services provided by PaineWebber
pursuant to its Exclusive Dealer Agreement with Mitchell Hutchins and (7)
Mitchell Hutchins' shareholder service- and distribution-related expenses and
costs. The trustees also recognized that Mitchell Hutchins' willingness to
compensate PaineWebber and its investment executives, without the concomitant
receipt by Mitchell Hutchins of initial sales charges or contingent deferred
sales charges upon redemption, was conditioned upon its expectation of being
compensated under the Class C Plan.
With respect to each Plan, the trustees considered all compensation that
Mitchell Hutchins would receive under the Plan and the Distribution Contract,
including service fees and, as applicable, initial sales charges, distribution
fees and contingent deferred sales charges. The trustees also considered the
benefits that would accrue to Mitchell Hutchins under each Plan in that Mitchell
Hutchins would receive service, distribution and advisory fees that are
calculated based upon a percentage of the average net assets of a Fund, which
fees would increase if the Plan were successful and the Fund attained and
maintained significant asset levels.
Under the Distribution Contract between each Trust and Mitchell Hutchins
for the Class A shares and similar prior distribution contracts, for the fiscal
years and the fiscal period set forth below, Mitchell Hutchins earned the
following approximate amounts of sales charges and retained the following
approximate amounts, net of concessions to PaineWebber as exclusive dealer:
44
<PAGE>
CALIFORNIA TAX-FREE INCOME FUND
<TABLE>
<CAPTION>
FOR THE FISCAL YEARS ENDED
------------------------------------
FEBRUARY 28,
FEBRUARY 29, --------------------
1996 1995 1994
------------ -------- --------
<S> <C> <C> <C>
Earned......... $ 57,198 $88,183 $322,044
Retained....... 1,224 6,470 8,324
</TABLE>
NATIONAL TAX-FREE INCOME FUND
<TABLE>
<CAPTION>
FOR THE FISCAL YEARS ENDED
------------------------------------
FEBRUARY 28,
FEBRUARY 29, --------------------
1996 1995 1994
------------ -------- --------
<S> <C> <C> <C>
Earned......... $ 66,206 $195,108 $732,825
Retained....... 1,062 14,852 47,024
</TABLE>
MUNICIPAL HIGH INCOME FUND
<TABLE>
<CAPTION>
FOR THE FISCAL YEARS ENDED
------------------------------------
FEBRUARY 28,
FEBRUARY 29, --------------------
1996 1995 1994
------------ -------- --------
<S> <C> <C> <C>
Earned......... $ 52,683 $59,937 $250,560
Retained....... 964 4,449 17,606
</TABLE>
NEW YORK TAX-FREE INCOME FUND
<TABLE>
<CAPTION>
FOR THE FISCAL YEARS ENDED
------------------------------------
FEBRUARY 28,
FEBRUARY 29, --------------------
1996 1995 1994
------------ -------- --------
<S> <C> <C> <C>
Earned......... $ 14,417 $38,348 $170,247
Retained....... 1,034 2,923 11,171
</TABLE>
Mitchell Hutchins earned and retained the following contingent deferred
sales charges paid upon certain redemptions of shares for the fiscal year ended
February 29, 1996:
<TABLE>
<CAPTION>
CALIFORNIA NATIONAL NEW YORK
TAX-FREE TAX-FREE MUNICIPAL HIGH TAX-FREE
INCOME FUND INCOME FUND INCOME FUND INCOME FUND
--------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C>
Class A........ $ 0 $ 0 $ 0 $ 0
Class B........ 194,894 389,050 111,115 86,185
Class C........ 1,345 2,485 0 0
</TABLE>
PORTFOLIO TRANSACTIONS
Subject to policies established by each Trust's board of trustees, Mitchell
Hutchins is responsible for the execution of each Fund's portfolio transactions
and the allocation of brokerage transactions. In executing portfolio
transactions, Mitchell Hutchins seeks to obtain the best net results for a Fund,
taking into account such factors as the price (including the applicable dealer
spread or brokerage commission), size of order, difficulty of execution and
operational facilities of the firm involved. Each Fund effects its portfolio
transactions with municipal bond dealers. Municipal securities are traded on the
OTC market on a 'net' basis without a stated commission through dealers acting
for their own account and not as brokers. Prices paid to dealers in principal
transactions generally include a 'spread,' which is the difference between the
prices at
45
<PAGE>
which the dealer is willing to purchase and sell a specific security at that
time. Since inception, the Funds have not paid any brokerage commissions.
For purchases or sales with broker-dealer firms which act as principal,
Mitchell Hutchins seeks best execution. Although Mitchell Hutchins may receive
certain research or execution services in connection with those transactions,
Mitchell Hutchins will not purchase securities at a higher price or sell
securities at a lower price than would otherwise be paid if no weight was
attributed to the services provided by the executing dealer. Moreover, Mitchell
Hutchins will not enter into any explicit soft dollar arrangements relating to
principal transactions and will not receive in principal transactions the types
of services which could be purchased for hard dollars. Mitchell Hutchins may
engage in agency transactions in OTC debt securities in return for research and
execution services. These transactions are entered into only in compliance with
procedures ensuring that the transaction (including commissions) is at least as
favorable as it would have been if effected directly with a market-maker that
did not provide research or execution services. These procedures include
Mitchell Hutchins' receiving multiple quotes from dealers before executing the
transactions on an agency basis.
Information and research services furnished by dealers or brokers with or
through which the Funds effect securities transactions may be used by Mitchell
Hutchins in advising other funds or accounts and, conversely, research services
furnished to Mitchell Hutchins by dealers or brokers in connection with other
funds or accounts Mitchell Hutchins advises may be used by Mitchell Hutchins in
advising the Funds. Information and research received from such brokers or
dealers will be in addition to, and not in lieu of, the services required to be
performed by Mitchell Hutchins under the Advisory Contracts.
Investment decisions for the Funds and for other investment accounts
managed by Mitchell Hutchins are made independently of each other in light of
differing considerations for the various accounts. However, the same investment
decision may occasionally be made for a Fund and one or more such accounts. In
such cases, simultaneous transactions are inevitable. Purchases or sales are
then averaged as to price and allocated between the Fund involved and such other
account(s) as to amount according to a formula deemed equitable to the Fund and
such account(s). While in some cases this practice could have a detrimental
effect upon the price or value of the security as far as a Fund is concerned, or
upon its ability to complete its entire order, in other cases it is believed
that coordination and the ability to participate in volume transactions will be
beneficial to the Fund.
No Fund will purchase securities that are offered in underwritings in which
Mitchell Hutchins or any of its affiliates is a member of the underwriting or
selling group, except pursuant to procedures adopted by each Trust's board of
trustees pursuant to Rule 10f-3 under the 1940 Act. Among other things, these
procedures require that the commission or spread paid in connection with such a
purchase be reasonable and fair, that the purchase be at not more than the
public offering price prior to the end of the first business day after the date
of the public offering and that Mitchell Hutchins or any affiliate thereof not
participate in or benefit from the sale to a Fund.
PORTFOLIO TURNOVER. Each Fund's annual portfolio turnover rate may vary
greatly from year to year, but it will not be a limiting factor when management
deems portfolio changes appropriate. The portfolio turnover rate is calculated
by dividing the lesser of a Fund's annual sales or purchases of portfolio
securities (exclusive of purchases or sales of securities whose maturities at
the time of acquisition were one year or less) by the monthly average value of
the securities in the portfolio during the year. For the fiscal years ended
February 29, 1996 and February 28, 1995, respectively, the portfolio turnover
rates for the Funds were: California Tax-Free Income Fund--32% and 11%; National
Tax-Free Income Fund--74% and 60%; Municipal High Income Fund--48% and 28%; and
New York Tax-Free Income Fund--13% and 6%.
46
<PAGE>
REDUCED SALES CHARGES, ADDITIONAL EXCHANGE AND REDEMPTION
INFORMATION AND OTHER SERVICES
COMBINED PURCHASE PRIVILEGE-CLASS A SHARES. Investors and eligible groups
of related Fund investors may combine purchases of Class A shares of the Funds
with concurrent purchases of Class A shares of any other PaineWebber mutual fund
and thus take advantage of the reduced sales charges for Class A shares
indicated in the table of sales charges in the Prospectus. The sales charge
payable on the purchase of shares of Class A shares of the Funds and Class A
shares of such other funds will be at the rates applicable to the total amount
of the combined concurrent purchases.
An 'eligible group of related Fund investors' can consist of any
combination of the following:
(a) an individual, that individual's spouse, parents and children;
(b) an individual and his or her Individual Retirement Account
('IRA');
(c) an individual (or eligible group of individuals) and any company
controlled by the individual(s) (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);
(d) an individual (or eligible group of individuals) and one or more
employee benefit plans of a company controlled by the individual(s);
(e) an individual (or eligible group of individuals) and a trust
created by the individual(s), the beneficiaries of which are the individual
and/or the individual's spouse, parents or children;
(f) an individual and a Uniform Gifts to Minors Act/Uniform Transfers
to Minors Act account created by the individual or the individual's spouse;
or
(g) 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 other employer).
(h) individual accounts related together under one registered
investment adviser having full discretion and control over the accounts.
The registered investment adviser must communicate at least quarterly
through a newsletter or investment update establishing a relationship with
all of the accounts.
RIGHTS OF ACCUMULATION-CLASS A SHARES. Reduced sales charges are available
through a right of accumulation, under which investors and eligible groups of
related Fund investors (as defined above) are permitted to purchase Class A
shares of the Funds among related accounts at the offering price applicable to
the total of (1) the dollar amount then being purchased plus (2) an amount equal
to the then-current net asset value of the purchaser's combined holdings of
Class A Fund shares and Class A shares of any other PaineWebber mutual fund. The
purchaser must provide sufficient information to permit confirmation of his or
her holdings, and the acceptance of the purchase order is subject to such
confirmation. The right of accumulation may be amended or terminated at any
time.
WAIVERS OF SALES CHARGES-CLASS B SHARES. Among other circumstances, the
contingent deferred sales charge on Class B shares is waived where a total or
partial redemption is made within one year following the death of the
shareholder. The contingent deferred sales charge waiver is available where the
decedent is either the sole shareholder or owns the shares with his or her
spouse as a joint tenant with right of survivorship. This waiver applies only to
redemption of shares held at the time of death.
Certain PaineWebber mutual funds offered shares subject to contingent
deferred sales charges before the implementation of the Flexible Pricing System
on July 1, 1991 ('CDSC Funds'). The contingent deferred sales charge is waived
with respect to redemptions of Class B shares of CDSC Funds purchased prior to
July 1, 1991 by officers, directors (trustees) or employees of the CDSC Funds,
Mitchell Hutchins or their affiliates (or their spouses and children under age
21). In addition, the contingent deferred sales charge will be reduced
47
<PAGE>
by 50% with respect to redemptions of Class B shares of CDSC Funds purchased
prior to July 1, 1991 with a net asset value at the time of purchase of at least
$1 million. If Class B shares of a CDSC Fund purchased prior to July 1, 1991 are
exchanged for Class B shares of a Fund, any waiver or reduction of the
contingent deferred sales charge that applied to the Class B shares of the CDSC
Fund will apply to the Class B shares of the Fund acquired through the exchange.
ADDITIONAL EXCHANGE AND REDEMPTION INFORMATION. As discussed in the
Prospectus, eligible shares of each Fund may be exchanged for shares of the
corresponding class of most other PaineWebber mutual funds. Shareholders will
receive at least 60 days' notice of any termination or material modification of
the exchange offer, except no notice need be given of an amendment whose only
material effect is to reduce the exchange fee, and no notice need be given if,
under extraordinary circumstances, either redemptions are suspended under the
circumstances described below or a Fund temporarily delays or ceases the sales
of its shares because it is unable to invest amounts effectively in accordance
with the Fund's investment objectives, policies and restrictions.
If conditions exist that make cash payments undesirable, each Fund reserves
the right to honor any request for redemption by making payment in whole or in
part in securities chosen by the Fund and valued in the same way as they would
be valued for purposes of computing the Fund's net asset value. If payment is
made in securities, a shareholder may incur brokerage expenses in converting
these securities into cash. Each Trust has elected, however, to be governed by
Rule 18f-1 under the 1940 Act, under which a Fund is obligated to redeem shares
solely in cash up to the lesser of $250,000 or 1% of the net asset value of the
Fund during any 90-day period for one shareholder. This election is irrevocable
unless the SEC permits its withdrawal. A Fund may suspend redemption privileges
or postpone the date of payment during any period (1) when the NYSE is closed or
trading on the NYSE is restricted as determined by the SEC, (2) when an
emergency exists, as defined by the SEC, that makes it not reasonably
practicable for the Fund to dispose of securities owned by it or fairly to
determine the value of its assets or (3) as the SEC may otherwise permit. The
redemption price may be more or less than the shareholder's cost, depending on
the market value of a Fund's portfolio at the time.
AUTOMATIC INVESTMENT PLAN. Participation in the Automatic Investment Plan
enables an investor to use the technique of 'dollar cost averaging.' When the
investor invests the same dollar amount each month under the Plan, the investor
will purchase more shares when a Fund's net asset value per share is low and
fewer shares when the net asset value per share is high. Using this technique,
an investor's average purchase price per share over any given period will be
lower than if the investor purchased a fixed number of shares on a monthly basis
during the period. Of course, investing through the automatic investment plan
does not assure a profit or protect against loss in declining markets.
Additionally, because the automatic investment plan involves continuous
investing regardless of price levels, an investor should consider his or her
financial ability to continue purchases through periods of low price levels.
SYSTEMATIC WITHDRAWAL PLAN. An investor's participation in the systematic
withdrawal plan will terminate automatically if the 'Initial Account Balance' (a
term that means the value of the Fund account at the time the investor elects to
participate in the systematic withdrawal plan) less aggregate redemptions made
other than pursuant to the systematic withdrawal plan is less than $5,000 for
Class A and Class C shareholders or $20,000 for Class B shareholders. Purchases
of additional shares of a Fund concurrent with withdrawals are ordinarily
disadvantageous to shareholders because of tax liabilities and, for Class A
shares, initial sales charges. On or about the 15th of each month for monthly
plans and on or about the 15th of the months selected for quarterly or
semi-annual plans, PaineWebber will arrange for redemption by a Fund of
sufficient shares to provide the withdrawal payment specified by participants in
the Fund's systematic withdrawal plan. The payment generally is mailed
approximately five Business Days (defined under 'Valuation of Shares') after the
redemption date. Withdrawal payments should not be considered dividends, but
redemption proceeds,
48
<PAGE>
with the tax consequences described under 'Dividends and Taxes' in the
Prospectus. If periodic withdrawals continually exceed reinvested dividends, a
shareholder's investment may be correspondingly reduced. A shareholder may
change the amount of the systematic withdrawal or terminate participation in the
plan at any time without charge or penalty by written instructions with
signatures guaranteed to PaineWebber or the Transfer Agent. Instructions to
participate in the plan, change the withdrawal amount or terminate participation
in the plan will not be effective until five business days after written
instructions with signatures guaranteed are received by the Transfer Agent.
Shareholders may request the forms needed to establish a systematic withdrawal
plan from their PaineWebber investment executives, correspondent firms or the
Transfer Agent at 1-800-647-1568.
REINSTATEMENT PRIVILEGE-CLASS A SHARES. As described in the Prospectus,
shareholders who have redeemed their Class A shares may reinstate their account
in a Fund without a sales charge. Shareholders may exercise the reinstatement
privilege by notifying the Transfer Agent of such desire and forwarding a check
for the amount to be purchased within 365 days after the date of redemption. The
reinstatement will be made at the net asset value per share next computed after
the notice of reinstatement and check are received. The amount of a purchase
under this reinstatement privilege cannot exceed the amount of the redemption
proceeds. Gain on a redemption is taxable regardless of whether the
reinstatement privilege is exercised; however, a loss arising out of a
redemption will not be deductible to the extent the redemption proceeds are
reinvested, if the reinstatement privilege is exercised within 30 days after
redemption, and an adjustment will be made to the shareholder's tax basis for
the shares acquired pursuant to the reinstatement privilege. Gain or loss on a
redemption also will be adjusted for federal income tax purposes by the amount
of any sales charge paid on Class A shares, under the circumstances and to the
extent described below under 'Taxes'.
PAINEWEBBER RMA RESOURCE ACCUMULATION PLAN(SERVICE MARK);
PAINEWEBBER RESOURCE MANAGEMENT ACCOUNT(REGISTERED) (RMA(REGISTERED))
Shares of the PaineWebber mutual funds (each a 'PW Fund' and, collectively,
the 'PW Funds') are available for purchase through the RMA Resource Accumulation
Plan ('Plan') by customers of PaineWebber and its correspondent firms who
maintain Resource Management Accounts ('RMA accountholders'). The Plan allows an
RMA accountholder to continually invest in one or more of the PW Funds at
regular intervals, with payment for shares purchased automatically deducted from
the client's RMA account. The client may elect to invest at monthly or quarterly
intervals and may elect either to invest a fixed dollar amount (minimum $100 per
period) or to purchase a fixed number of shares. A client can elect to have Plan
purchases executed on the first or fifteenth day of the month. Settlement occurs
three Business Days (defined under 'Valuation of Shares') after the trade date,
and the purchase price of the shares is withdrawn from the investor's RMA
account on the settlement date from the following sources and in the following
order: uninvested cash balances, balances in RMA money market funds, or margin
borrowing power, if applicable to the account.
To participate in the Plan, an investor must be an RMA accountholder, must
have made an initial purchase of the shares of each PW Fund selected for
investment under the Plan (meeting applicable minimum investment requirements)
and must complete and submit the RMA Resource Accumulation Plan Client Agreement
and Instruction Form available from PaineWebber. The investor must have received
a current prospectus for each PW Fund selected prior to enrolling in the Plan.
Information about mutual fund positions and outstanding instructions under the
Plan are noted on the RMA accountholder's account statement. Instructions under
the Plan may be changed at anytime, but may take up to two weeks to become
effective.
The terms of the Plan or an RMA accountholder's participation in the Plan
may be modified or terminated at any time. It is anticipated that, in the
future, shares of other PW Funds and/or mutual funds other than the PW Funds may
be offered through the Plan.
49
<PAGE>
PERIODIC INVESTING AND DOLLAR COST AVERAGING. Periodic investing in the PW
Funds or other mutual funds, whether through the Plan or otherwise, helps
investors establish and maintain a disciplined approach to accumulating assets
over time, de-emphasizing the importance of timing the market's highs and lows.
Periodic investing also permits an investor to take advantage of 'dollar cost
averaging.' By investing a fixed amount in mutual fund shares at established
intervals, an investor purchases more shares when the price is lower and fewer
shares when the price is higher, thereby increasing his or her earning
potential. Of course, dollar cost averaging does not guarantee a profit or
protect against a loss in a declining market, and an investor should consider
his or her financial ability to continue investing through periods of low share
prices. However, over time, dollar cost averaging generally results in a lower
average original investment cost than if an investor invested a larger dollar
amount in a mutual fund at one time.
PAINEWEBBER'S RESOURCE MANAGEMENT ACCOUNT. In order to enroll in the Plan,
an investor must have opened an RMA account with PaineWebber or one of its
correspondent firms. The RMA account is PaineWebber's comprehensive asset
management account and offers investors a number of features, including the
following:
o monthly Premier account statements that itemize all account activity,
including investment transactions, checking activity and Gold
MasterCard(Registered) transactions during the period, and provide
unrealized and realized gain and loss estimates for most securities held
in the account;
o comprehensive preliminary 9-month and year-end summary statements that
provide information on account activity for use in tax planning and tax
return preparation;
o automatic 'sweep' of uninvested cash into the RMA accountholder's choice
of one of the seven RMA money market funds-RMA Money Market Portfolio,
RMA U.S. Government Portfolio, RMA Tax-Free Fund, RMA California
Municipal Money Fund, RMA Connecticut Municipal Money Fund, RMA New
Jersey Municipal Money Fund and RMA New York Municipal Money Fund. Each
money market fund attempts to maintain a stable price per share of $1.00,
although there can be no assurance that it will be able to do so.
Investments in the money market funds are not insured or guaranteed by
the U.S. government;
o check writing, with no per-check usage charge, no minimum amount on
checks and no maximum number of checks that can be written. RMA
accountholders can code their checks to classify expenditures. All
canceled checks are returned each month;
o Gold MasterCard, with or without a line of credit, which provides RMA
accountholders with direct access to their accounts and can be used with
automatic teller machines worldwide. Purchases on the Gold MasterCard are
debited to the RMA account once monthly, permitting accountholders to
remain invested for a longer period of time;
o 24-hour access to account information through toll-free numbers, and more
detailed personal assistance during business hours from the RMA Service
Center;
o expanded account protection to $25 million in the event of the
liquidation of PaineWebber. This protection does not apply to shares of
the RMA money market funds or the PW Funds because those shares are held
at the transfer agent and not through PaineWebber; and
o automatic direct deposit of checks into your RMA account and automatic
withdrawals from the account.
The annual account fee for an RMA account is $85, which includes the Gold
MasterCard, with an additional fee of $40 if the investor selects an optional
line of credit with the Gold MasterCard.
50
<PAGE>
CONVERSION OF CLASS B SHARES
Class B shares of each Fund will automatically convert to Class A shares,
based on the relative net asset values of each of the Classes, as of the close
of business on the first Business Day (as defined under 'Valuation of Shares')
of the month in which the sixth anniversary of the initial issuance of such
Class B shares of the Fund occurs. For the purpose of calculating the holding
period required for conversion of Class B shares, the date of initial issuance
shall mean (1) the date on which such Class B shares were issued, or (2) for
Class B shares obtained through an exchange, or a series of exchanges, the date
on which the original Class B shares were issued. If a shareholder acquired
Class B shares of a Fund through an exchange of Class B shares of a CDSC Fund
that were acquired prior to July 1, 1991, the shareholder's holding period for
purposes of conversion is determined based on the date the CDSC Fund shares were
initially issued. For purposes of conversion to Class A, Class B shares
purchased through the reinvestment of dividends and other distributions paid in
respect of Class B shares will be held in a separate sub-account. Each time any
Class B shares in the shareholder's regular account (other than those in the
sub-account) convert to Class A, a pro rata portion of the Class B shares in the
sub-account will also convert to Class A. The portion will be determined by the
ratio that the shareholder's Class B shares converting to Class A bears to the
shareholder's total Class B shares not acquired through dividends and other
distributions.
Under normal circumstances, the net asset values per share of the two
Classes of each Fund will be the same. However, if a Fund's accrued expenses on
any Business Day were to exceed the Fund's accrued income for that Business Day,
the net asset value per share of the Class B shares could be lower than that of
the Class A shares because of the higher ongoing expenses borne by the Class B
shares. If such a divergence existed on a conversion date, a shareholder would
receive fewer Class A shares than the number of Class B shares converted,
although the dollar value would be the same. Mitchell Hutchins considers the
possibility of such an occurrence to be remote.
The availability of the conversion feature is subject to (1) the continuing
applicability of a ruling of the Internal Revenue Service that the dividends and
other distributions paid on Class A and Class B shares will not result in
'preferential dividends' under the Internal Revenue Code and (2) the continuing
availability of an opinion of counsel to the effect that the conversion of
shares does not constitute a taxable event. If the conversion feature ceased to
be available, the Class B shares of each Fund would not be converted and would
continue to be subject to the higher ongoing expenses of the Class B shares
beyond six years from the date of purchase. Mitchell Hutchins has no reason to
believe that these conditions for the availability of the conversion feature
will not continue to be met.
VALUATION OF SHARES
Each Fund determines the net asset value per share separately for each
Class of shares as of the close of regular trading (currently 4:00 p.m., Eastern
time) on the NYSE on each Business Day, which is defined as each Monday through
Friday when the NYSE is open. Currently, the NYSE is closed on the observance of
the following holidays: New Year's Day, Presidents' Day, Good Friday, Memorial
Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day.
Where market quotations are readily available, portfolio securities are
valued based upon market quotations, provided such quotations adequately
reflect, in the judgment of Mitchell Hutchins, the fair value of the security.
Where such market quotations are not readily available, securities are valued
based upon appraisals received from a pricing service using a computerized
matrix system or based upon appraisals derived from information concerning the
security or similar securities received from recognized dealers in those
securities. The amortized cost method of valuation generally is used with
respect to debt obligations with 60 days or less remaining to maturity unless
the Trust's board of trustees determines that this does not represent fair
value. All other assets will be valued at fair value as determined in good faith
by or under the direction of each Trust's board of trustees.
51
<PAGE>
PERFORMANCE INFORMATION
Each Fund's performance data quoted in advertising and other promotional
materials ('Performance Advertisements') represent past performance and are not
intended to indicate future performance. 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.
TOTAL RETURN CALCULATIONS. Average annual total return quotes
('Standardized Return') used in a Fund's Performance Advertisements are
calculated according to the following formula:
<TABLE>
<S> <C> <C>
P(1 + T)n = ERV
where: P = a hypothetical initial payment of $1,000 to purchase shares
of a specified Class
T = average annual total return of shares of that Class
n = number of years
ERV = ending redeemable value of a hypothetical $1,000 payment
made at the beginning of that period.
</TABLE>
Under the foregoing formula, the time periods used in Performance
Advertisements will be based on rolling calendar quarters, updated to the last
day of the most recent quarter prior to submission of the advertisement for
publication. Total return, or 'T' in the formula above, is computed by finding
the average annual change in the value of an initial $1,000 investment over the
period. In calculating the ending redeemable value for Class A shares, the
maximum 4% initial sales charge is deducted from the initial $1,000 payment and,
for Class B and Class C shares, the applicable contingent deferred sales charge
imposed on a redemption of Class B or Class C shares held for the period is
deducted. All dividends and other distributions are assumed to have been
reinvested at net asset value. Each Fund also may refer in Performance
Advertisements to total return performance data that are not calculated
according to the formula set forth above ('Non-Standardized Return'). A Fund
calculates Non-Standardized Return for specified periods of time by assuming an
investment of $1,000 in Fund shares and assuming the reinvestment of all
dividends and other distributions. The rate of return is determined by
subtracting the initial value of the investment from the ending value and by
dividing the remainder by the initial value. Neither initial nor contingent
deferred sales charges are taken into account in calculating Non-Standardized
Return; the inclusion of those charges would reduce the return.
Both Standardized Return and Non-Standardized Return for Class B shares for
periods of over six years will reflect conversion of the Class B shares to Class
A shares at the end of the sixth year.
The following table shows performance information for the Class A, Class B
and Class C (formerly Class D) shares of the Funds for the periods indicated.
All returns for periods of more than one year are expressed as an average annual
return.
52
<PAGE>
<TABLE>
<CAPTION>
CALIFORNIA TAX-FREE NATIONAL TAX-FREE MUNICIPAL HIGH
INCOME FUND INCOME FUND INCOME FUND
---------------------------- --------------------------- ---------------------------
CLASS A CLASS B CLASS C CLASS A CLASS B CLASS C CLASS A CLASS B CLASS C
------- ------- ------- ------- ------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
One year ended February
29, 1996:
Standardized Return*... 4.29% 2.86% 7.47% 4.39% 2.94% 7.44% 5.81% 4.36% 8.89%
Non-Standardized
Return............... 8.68% 7.86% 8.22% 8.75% 7.94% 8.19% 10.18% 9.36% 9.64%
Five years ended February
29, 1996:
Standardized Return*... 6.08% N/A N/A 6.30% N/A N/A 7.14% N/A N/A
Non-Standardized
Return............... 6.96% N/A N/A 7.18% N/A N/A 8.01% N/A N/A
Ten years or since
inception** to February
29, 1996:
Standardized Return*... 6.74% 5.75% 5.20% 6.72% 6.05% 5.36% 7.77% 6.51% 5.38%
Non-Standardized
Return............... 7.17% 6.10% 5.20% 7.16% 6.39% 5.36% 8.27% 6.85% 5.38%
<CAPTION>
NEW YORK TAX-FREE
INCOME FUND
--------------------------
CLASS A CLASS B CLASS C
------- ------- -------
<S> <<C> <C> <C>
One year ended February
29, 1996:
Standardized Return*... 5.44% 4.01% 8.42%
Non-Standardized
Return............... 9.83% 9.01% 9.17%
Five years ended February
29, 1996:
Standardized Return*... 7.20% N/A N/A
Non-Standardized
Return............... 8.08% N/A N/A
Ten years or since
inception** to February
29, 1996:
Standardized Return*... 7.37% 6.80% 5.85%
Non-Standardized
Return............... 7.96% 7.14% 5.85%
</TABLE>
- ------------------
* All Standardized Return figures for Class A shares reflect deduction of the
current maximum sales charge of 4%. All Standardized Return figures for Class
B and Class C shares reflect deduction of the applicable contingent deferred
sales charges imposed on a redemption of shares held for the period.
** The inception dates for the Class A shares of the Funds are as follows:
California Tax-Free Income Fund-- September 16, 1985; National Tax-Free
Income Fund--December 3, 1984; Municipal High Income Fund-- June 23, 1987;
and New York Tax-Free Income Fund--September 23, 1988. The inception dates
for the Class B shares and Class C shares (formerly Class D shares) of each
Fund are July 1, 1991 and July 2, 1992, respectively.
YIELD. Yields used in each Fund's Performance Advertisements are
calculated by dividing the Fund's interest income attributable to a Class of
shares for a 30-day period ('Period'), net of expenses attributable to such
Class, by the average number of shares of such Class entitled to receive
dividends during the Period and expressing the result as an annualized
percentage (assuming semi-annual compounding) of the maximum offering price per
share (in the case of Class A shares) or the net asset value per share (in the
case of Class B and Class C shares (formerly Class D shares)) at the end of the
Period. Yield quotations are calculated according to the following formula:
6
YIELD = 2 [(a - b + 1) -1]
------
( cd )
where: a = interest earned during the Period attributable to a
Class of shares
b = expenses accrued for the Period attributable to a Class of
shares (net of reimbursements)
c = the average daily number of shares of the Class
outstanding during the Period that were entitled to
receive dividends
d = the maximum offering price per share (in the case of
Class A shares) or the net asset value per share (in the
case of Class B and Class C shares) on the last day of
the Period.
Except as noted below, in determining net investment income earned during
the Period (variable '
a' in the above formula), a Fund calculates interest
earned on each debt obligation held by it during the Period by (1) computing the
obligation's yield to maturity, based on the market value of the obligation
(including actual accrued interest) on the last business day of the Period or,
if the obligation was purchased during the Period, the purchase price plus
accrued interest and (2) dividing the yield to maturity by 360 and multiplying
the resulting quotient by the market value of the obligation (including actual
accrued interest) to determine the interest income on the obligation for each
day of the period that the obligation is in the portfolio. Once interest earned
is calculated in this fashion for each debt obligation held by a Fund, interest
earned during the
53
<PAGE>
Period is then determined by totalling the interest earned on all debt
obligations. For purposes of these calculations, the maturity of an obligation
with one or more call provisions is assumed to be the next date on which the
obligation reasonably can be expected to be called or, if none, the maturity
date. With respect to Class A shares, in calculating the maximum offering price
per share at the end of the Period (variable 'd' in the above formula), a Fund's
current maximum 4% initial sales charge on Class A shares is included. The Funds
had the following yields for the 30-day period ended February 29, 1996:
<TABLE>
<CAPTION>
CLASS A CLASS B CLASS C
------- ------- -------
<S> <C> <C> <C>
California Tax-Free Income
Fund........................ 4.68% 4.13% 4.38%
National Tax-Free Income
Fund........................ 4.55 3.98 4.22
Municipal High Income Fund.... 5.54 5.02 5.26
New York Tax-Free Income
Fund........................ 4.70 4.14 4.40
</TABLE>
Tax-exempt yield is calculated according to the same formula except that
variable 'a' equals interest exempt from federal income tax earned during the
Period. This tax-exempt yield is then translated into tax-equivalent yield
according to the following formula:
TAX EQUIVALENT YIELD = ( E )
------- + t
(1 - p)
E = tax-exempt yield of a Class of shares
p = stated income tax rate
t = taxable yield of a Class of shares
The tax-equivalent yield of California Tax-Free Income Fund assumes a
46.24% combined effective California and federal tax rate. The tax-equivalent
yield of New York Tax-Free Income Fund assumes a 46.88% effective New York
State, New York City and federal tax rate. The tax-equivalent yield of each of
National Tax-Free Income Fund and Municipal High Income Fund assumes a 39.6%
effective federal tax rate.
The Funds had the following tax-equivalent yields for the 30-day period
ended February 29, 1996:
<TABLE>
<CAPTION>
CLASS A CLASS B CLASS C
------- ------- -------
<S> <C> <C> <C>
California Tax-Free Income
Fund........................ 8.71% 7.68% 8.15%
National Tax-Free Income
Fund........................ 7.53 6.57 6.99
Municipal High Income Fund.... 9.17 8.31 8.71
New York Tax-Free Income
Fund........................ 8.85 7.79 8.28
</TABLE>
OTHER INFORMATION. In Performance Advertisements, each Fund may compare
its Standardized Return and/or its Non-Standardized Return with data published
by Lipper Analytical Services, Inc. ('Lipper'), CDA Investment Technologies,
Inc. ('CDA'), Wiesenberger Investment Companies Service ('Wiesenberger'),
Investment Company Data Inc. ('ICD') or Morningstar Mutual Funds
('Morningstar'), or with the performance of recognized stock, bond and other
indexes, including (but not limited to) the Municipal Bond Buyers Indices,
Lehman Bond Index, the Standard & Poor's 500 Composite Stock Price Index, the
Dow Jones Industrial Average, Merrill Lynch Municipal Bond Indices, the Morgan
Stanley Capital International World Index, the Lehman Brothers Treasury Bond
Index, Lehman Brothers Government/Corporate Bond Index, the Salomon Brothers
World Government Bond Index and changes in the Consumer Price Index as published
by the U.S. Department of Commerce. Each Fund also may refer in
54
<PAGE>
such materials to mutual fund performance rankings and other data, such as
comparative asset, expense and fee levels, published by Lipper, CDA,
Wiesenberger, ICD or Morningstar. Performance Advertisements also may refer to
discussions of a Fund and comparative mutual fund data and ratings reported in
independent periodicals, including (but not limited to) THE WALL STREET JOURNAL,
MONEY Magazine, FORBES, BUSINESS WEEK, FINANCIAL WORLD, BARRON'S, FORTUNE, THE
NEW YORK TIMES, THE CHICAGO TRIBUNE, THE WASHINGTON POST and THE KIPLINGER
LETTERS. Comparisons in performance advertisements may be in graphic form.
Each Fund may include discussions or illustrations of the effects of
compounding in Performance Advertisements. 'Compounding' refers to the fact
that, if dividends or other distributions on an investment in a Fund are
reinvested by being paid in additional Fund shares, any future income or capital
appreciation of a Fund would increase the value, not only of the original Fund
investment, but also of the additional Fund shares received through
reinvestment. As a result, the value of the Fund investment would increase more
quickly than if dividends or other distributions had been paid in cash.
Each Fund may also compare its performance with the performance of bank
certificates of deposit (CDs) as measured by the CDA Investment Technologies,
Inc. Certificate of Deposit Index and the Bank Rate Monitor National Index and
the averages of yields of CDs of major banks published by Banxquote(Registered)
Money Markets. In comparing the Fund's performance to CD performance, investors
should keep in mind that bank CDs are insured in whole or in part by an agency
of the U.S. government and offer fixed principal and fixed or variable rates of
interest, and that bank CD yields may vary depending on the financial
institution offering the CD and prevailing interest rates. Fund shares are not
insured or guaranteed by the U.S. government and returns and net asset value
will fluctuate. The securities held by the Fund generally have longer maturities
than most CDs and may reflect interest rate fluctuations for longer term
securities. An investment in a Fund involves greater risks than an investment in
either a money market fund or a CD.
55
<PAGE>
TAXES
FEDERAL TAXES. In order to continue to qualify for treatment as a
regulated investment company ('RIC') under the Internal Revenue Code, each Fund
must distribute to its shareholders for each taxable year at least 90% of the
sum of its net interest income excludable from gross income under section 103(a)
of the Internal Revenue Code plus its investment company taxable income
(consisting generally of taxable net investment income plus net short-term
capital gain) and must meet several additional requirements. For each Fund these
requirements include the following: (1) the Fund must derive at least 90% of its
gross income each taxable year from dividends, interest, payments with respect
to securities loans and gains from the sale or other disposition of securities,
or other income (including gains from options or futures) derived with respect
to its business of investing in securities ('Income Requirement'); (2) the Fund
must derive less than 30% of its gross income each taxable year from the sale or
other disposition of securities, options or futures held for less than three
months ('Short-Short Limitation'); (3) at the close of each quarter of the
Fund's taxable year, at least 50% of the value of its total assets must be
represented by cash and cash items, U.S. government securities, securities of
other RICs and other securities that are limited, in respect of any one issuer,
to an amount that does not exceed 5% of the value of the Fund's total assets;
and (4) at the close of each quarter of the Fund's taxable year, not more than
25% of the value of its total assets may be invested in securities (other than
U.S. government securities or the securities of other RICs) of any one issuer.
Entities or persons who are 'substantial users' (or persons related to
'substantial users') of facilities financed by IDBs or PABs should consult their
tax advisers before purchasing Fund shares because, for users of certain of
these facilities, the interest on those bonds is not exempt from federal income
tax. For these purposes, 'substantial user' is defined to include a 'non-exempt
person' who regularly uses in a trade or business a part of a facility financed
from the proceeds of IDBs or PABs.
Up to 85% of social security and railroad retirement benefits may be
included in taxable income for recipients whose adjusted gross income (including
income from tax-exempt sources such as a Fund) plus 50% of their benefits
exceeds certain base amounts. Exempt-interest dividends from a Fund still are
tax-exempt to the extent described in the Prospectus; they are only included in
the calculation of whether a recipient's income exceeds the established amounts.
If Fund shares are sold at a loss after being held for six months or less,
the loss will be disallowed to the extent of any exempt-interest dividends
received on those shares and any loss not disallowed will be treated as
long-term, instead of short-term, capital loss to the extent of any capital gain
distributions received thereon. Investors also should be aware that if shares
are purchased shortly before the record date for a capital gain distribution,
the shareholder will pay full price for the shares and receive some portion of
the price back as a taxable distribution.
Special tax rules apply when a shareholder (1) disposes of Class A shares
through a redemption or exchange within 90 days of purchase and subsequently
acquires Class A shares of a PaineWebber fund without paying a sales charge due
to the 365-day reinstatement privilege or exchange privilege. See 'Reduced Sales
Charges--Reinstatement Privilege--Class A shares' above and 'Exchanges' in the
Prospectus. In these cases, any gain on the disposition of the Class A shares
would be increased, or loss decreased, by the amount of the sales charge paid
when the shares were acquired, and that amount will increase the basis of the
PaineWebber fund shares subsequently acquired. In addition, if shares of a Fund
are purchased within 30 days before or after redeeming that Fund's shares
(regardless of Class) at a loss, that loss will not be deductible to the extent
the redemption proceeds are reinvested and will increase the basis of the newly
purchased shares.
56
<PAGE>
If a Fund invests in instruments that generate taxable interest income,
under the circumstances described in the Prospectus and in the discussion of
municipal market discount bonds below, the portion of any Fund dividend
attributable to the interest earned thereon will be taxable to the Fund's
shareholders as ordinary income to the extent of the Fund's earnings and
profits, and only the remaining portion will qualify as an 'exempt-interest
dividend' (as described in the Prospectus). The respective portions will be
determined by the 'actual earned' method, under which the portion of any
dividend that qualifies as exempt-interest may vary, depending on the relative
proportions of tax-exempt and taxable interest earned during the dividend
period. Moreover, if a Fund realizes capital gain as a result of market
transactions, any distributions of the gain will be taxable to its shareholders.
Each Fund is required to withhold 31% of all taxable dividends, capital gain
distributions and redemption proceeds payable to any individuals and certain
other noncorporate shareholders who do not provide the Fund with a correct
taxpayer identification number. Each Fund also is required to withhold 31% of
all taxable dividends and capital gain distributions payable to those
shareholders who otherwise are subject to backup withholding.
Dividends and other distributions declared by a Fund in October, November
or December of any year and payable to shareholders of record on a date in any
of those months will be deemed to have been paid by the Fund and received by the
shareholders on December 31 of that year if the distributions are paid by the
Fund during the following January. Each Fund invests exclusively in debt
securities and receives no dividend income; accordingly, no portion of the
dividends or other distributions paid by any Fund is eligible for the
dividends-received deduction allowed to corporations.
Each Fund will be subject to a nondeductible 4% excise tax to the extent it
fails to distribute by the end of any calendar year substantially all of its
ordinary (taxable) income for the calendar year and capital gain net income for
the one-year period ending on October 31 of that year, plus certain other
amounts.
The use of hedging and option income strategies, such as writing (selling)
and purchasing options and futures, involves complex rules that will determine
for income tax purposes the character and timing of recognition of the gains and
losses a Fund realizes in connection therewith. Income from transactions in
options and futures derived by a Fund with respect to its business of investing
in securities will qualify as permissible income under the Income Requirement.
However, income from the disposition of options and futures will be subject to
the Short-Short Limitation if they are held for less than three months.
If a Fund satisfies certain requirements, any increase in value of a
position that is part of a 'designated hedge' will be offset by any decrease in
value (whether realized or not) of the offsetting hedging position during the
period of the hedge for purposes of determining whether the Fund satisfies the
Short-Short Limitation. Thus, only the net gain (if any) from the designated
hedge will be included in gross income for purposes of that limitation. Each
Fund will consider whether it should seek to qualify for this treatment for its
hedging transactions. To the extent a Fund does not qualify for this treatment,
it may be forced to defer the closing out of certain options and futures beyond
the time when it otherwise would be advantageous to do so, in order for the Fund
to continue to qualify as a RIC.
Each Fund may invest in municipal bonds that are purchased, generally not
on their original issue, with market discount (that is, at a price less than the
principal amount of the bond or, in the case of a bond that was issued with
original issue discount, a price less than the amount of the issue price plus
accrued original issue discount) ('municipal market discount bonds'). If a
bond's market discount is less than the product of (1) 0.25% of the redemption
price at maturity times (2) the number of complete years to maturity after the
taxpayer acquired the bond, then no market discount is considered to exist. Gain
on the disposition of a municipal market discount bond purchased by a Fund after
April 30, 1993 (other than a bond with a fixed
57
<PAGE>
maturity date within one year from its issuance) generally is treated as
ordinary (taxable) income, rather than capital gain, to the extent of the bond's
accrued market discount at the time of disposition. Market discount on such a
bond generally is accrued ratably, on a daily basis, over the period from the
acquisition date to the date of maturity. In lieu of treating the disposition
gain as above, a Fund may elect to include market discount in its gross income
currently, for each taxable year to which it is attributable.
CALIFORNIA TAXES. Individual shareholders of California Tax-Free Income
Fund who reside in California will not be subject to California personal income
tax on distributions received from the Fund to the extent such distributions are
attributable to interest on tax-exempt obligations issued by the State of
California or a California local government (or interest earned on obligations
of U.S. possessions or territories) ('exempt-interest dividends'), provided that
the Fund qualifies as a RIC under the Internal Revenue Code and satisfies the
requirement of California law that at least 50% of its assets at the close of
each quarter of its taxable year be invested in obligations the interest on
which is exempt from personal income taxation under the laws or Constitution of
California or the laws of the United States. Distributions from the Fund which
are attributable to sources other than those described in the preceding sentence
will generally be taxable to such shareholders as ordinary income. However,
distributions by California Tax-Free Income Fund, if any, that are derived from
interest on obligations of the U.S. government may also be designated by the
Fund and treated by its shareholders as exempt from California personal income
tax, provided that the foregoing 50% requirement is satisfied. Moreover, under
California legislation incorporating certain portions of the provisions of the
Internal Revenue Code applicable to RICs, amounts treated as capital gain
distributions for federal income tax purposes generally will be treated as
long-term capital gains for California personal income tax purposes. In
addition, distributions to shareholders other than exempt-interest dividends are
includable in income subject to the California alternative minimum tax.
Distributions of investment income and long-term and short-term capital
gains will not be excluded from taxable income in determining the California
corporate franchise tax for corporate shareholders. In addition, such
distributions may be includable in income subject to the California alternative
minimum tax.
Interest on indebtedness incurred by shareholders to purchase or carry
shares of California Tax-Free Income Fund will not be deductible for California
personal income tax purposes.
Shares of California Tax-Free Income Fund will not be subject to the
California property tax.
NEW YORK TAXES. Individual shareholders of New York Tax-Free Income Fund
will not be required to include in their gross income for New York State
purposes any portion of distributions received from the Fund to the extent such
distributions are directly attributable to interest earned on tax-exempt
obligations issued by New York State or any political subdivisions thereof
(including the City) or interest earned on obligations of U.S. possessions or
territories to the extent interest on such obligations is exempt from state
taxation pursuant to federal law, provided that the Fund qualifies as a RIC
under the Internal Revenue Code and satisfies the requirements that at least 50%
of its assets at the close of each quarter of its taxable year constitute
obligations which are tax-exempt for federal income tax purposes. Distributions
from the Fund which are attributable to sources other than those described in
the preceding sentence (including interest on obligations of other states and
their political subdivisions) will generally be taxable to such individual
shareholders as ordinary income. However, distributions by the Fund, if any,
that are derived from interest earned on obligations of the U.S. government may
also be designated by the Fund and treated by its shareholders as exempt from
personal income taxation for New York State and City purposes, provided that at
least 50% of the value of its total assets at the close of each quarter of its
taxable year is invested in such federal obligations. Distributions to
individual
58
<PAGE>
shareholders by the Fund which represent long-term capital gains for federal
income tax purposes will be treated as long-term capital gains for New York
State and City personal income tax purposes.
Shareholders of New York Tax-Free Income Fund that are subject to the New
York State corporation franchise tax or the City general corporation tax will be
required to include exempt-interest dividends paid by the Fund in their 'entire
net income' for purposes of such taxes and will be required to include their
shares of the Fund in their investment capital for purposes of such taxes.
Shareholders of New York Tax-Free Income Fund will not be subject to the
unincorporated business taxation imposed by the City solely by reason of their
ownership of shares in the Fund. If a shareholder is subject to the
unincorporated business tax, income and gains distributed by the Fund will be
subject to such tax except to the extent such distributions are directly
attributable to interest earned on tax-exempt obligations issued by New York
State or any political subdivision thereof (including the City).
Shares of New York Tax-Free Income Fund will not be subject to property
taxes imposed by New York State or the City.
Interest on indebtedness incurred by shareholders to purchase or carry
shares of the New York Tax-Free Income Fund generally will not be deductible for
New York State personal income tax purposes.
Interest income of New York Tax-Free Income Fund which is distributed to
shareholders will generally not be taxable to the Fund for purposes of the New
York State corporation franchise tax or the New York City general corporation
tax.
The foregoing is a general summary of certain provisions of federal,
California and New York State and City tax laws currently in effect as they
directly govern the taxation of shareholders of the Funds. These provisions are
subject to change by legislative or administrative action, and any such change
may be retroactive with respect to Fund transactions. Shareholders are advised
to consult with their own tax advisers for more detailed information concerning
tax matters.
TAX-FREE INCOME VS. TAXABLE INCOME--NATIONAL TAX-FREE INCOME FUND AND
MUNICIPAL HIGH INCOME FUND. Table I below illustrates approximate equivalent
taxable and tax-free yields at the 1995 federal individual income tax rates. For
example, a couple with taxable income of $90,000 in 1995, or single individuals
with taxable income of $55,000 in 1995, whose investments earn a 6% tax-free
yield, would have had to earn approximately an 8.70% taxable yield to receive
the same benefit.
TABLE I. 1995 FEDERAL TAXABLE VS. TAX-FREE YIELDS*
<TABLE>
<CAPTION>
A TAX-FREE YIELD OF
TAXABLE INCOME (000'S) ---------------------------------------------
- ------------------------------- 4.00% 5.00% 6.00% 7.00% 8.00%
SINGLE JOINT FEDERAL TAX ----- ----- ----- ----- -----
RETURN RETURN BRACKET IS EQUAL TO A TAXABLE YIELD OF APPROXIMATELY:
- ------------ -------------- ------------- ---------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
$ 0-- 22.1 $ 0-- 36.9 15.00% 4.71% 5.88% 7.06% 8.24% 9.41%
22.1-- 53.5 36.9-- 89.2 28.00 5.56 6.94 8.33 9.72 11.11
53.5--115.0 89.2--140.0 31.00 5.80 7.25 8.70 10.14 11.59
115.0--250.0 140.0--250.0 36.00 6.25 7.81 9.38 10.94 12.50
Over 250.0 Over 250.0 39.60 6.62 8.28 9.93 11.59 13.25
</TABLE>
- ------------------
* See note following Table III.
59
<PAGE>
TAX-FREE INCOME VS. TAXABLE INCOME--CALIFORNIA TAX-FREE INCOME FUND. Table
II below illustrates approximate equivalent taxable and tax-free yields at the
1995 individual federal and 1996 California personal income tax rates. For
example, a California couple with taxable income of $90,000, or a single
California individual with taxable income of $55,000, whose investments earn a
6% tax-free yield, would have had to earn a 9.59% taxable yield to receive the
same benefit.
TABLE II. 1995 FEDERAL AND 1996 CALIFORNIA TAXABLE VS. TAX-FREE YIELDS*
(See notes 1-4 below)
<TABLE>
<CAPTION>
EFFECTIVE A TAX-FREE YIELD OF
TAXABLE INCOME (000'S) CALIFORNIA ---------------------------------------------
--------------------------------- AND 4.00% 5.00% 6.00% 7.00% 8.00%
SINGLE JOINT FEDERAL TAX ----- ----- ----- ----- -----
RETURN RETURN BRACKET IS EQUAL TO A TAXABLE YIELD OF APPROXIMATELY:
-------------- -------------- ----------- ---------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
$ 18.1-- 23.4 $ 36.1-- 39.0 20.10% 5.01% 6.26% 7.51% 8.76% 10.01%
23.4-- 25.1 39.0-- 50.2 32.32 5.91 7.39 8.87 10.34 11.82
25.1-- 31.7 50.2-- 63.4 33.76 6.04 7.55 9.06 10.57 12.08
31.7-- 56.6 63.4-- 94.3 34.70 6.13 7.66 9.19 10.72 12.25
56.6--118.0 94.3--143.6 37.42 6.39 7.99 9.59 11.19 12.78
118.0--256.5 143.6--256.5 41.95 6.89 8.61 10.34 12.06 13.78
Over 256.5 Over 256.5 45.22 7.30 9.13 10.95 12.78 14.60
</TABLE>
1. Net amount subject to federal income tax after deductions and exemptions.
Assumes that all income is ordinary income.
2. The income ranges shown for 1996 reflect federal and California income
brackets for 1995. Inflation adjusted income brackets for 1996 are not yet
available.
3. The rates shown reflect federal and California rates for 1996 in effect as of
the date hereof. Those rates are still subject to change with retroactive
effect for 1996.
4. Excludes the impact of the phase out of personal exemptions, limitations on
itemized deductions and other credits, exclusions and adjustments which may
increase a taxpayer's marginal tax rate as well as the effect of certain
levels of income (including tax exempt income) on the taxability of social
security payments.
- ------------------
* See note following Table III.
TAX-FREE INCOME VS. TAXABLE INCOME--NEW YORK TAX-FREE INCOME FUND. Table
III below illustrates approximate equivalent taxable and tax-free yields at the
1995 federal individual, and New York State and New York City personal, income
tax rates. For example, a New York City couple with taxable income of $90,000 in
1995, whose investments earn a 4% tax-free yield, would have had to earn a 6.59%
taxable yield to receive the same benefit. A couple who lives in New York State
outside of New York City with taxable income of $90,000 in 1995 would have had
to earn a 6.27% taxable yield to realize a 4% tax-free yield.
Single taxpayers may also take advantage of high tax-free income. For
example, a single individual with taxable income of $55,000 in 1995, who lives
in New York City and whose investments earn a 4% tax-free yield, would have had
to earn a 6.59% taxable yield to receive the same benefit. A single individual
with taxable income of $55,000 in 1995, who lives in New York State outside of
New York City, would have had to earn a 6.27% taxable yield to realize a 4%
tax-free yield.
60
<PAGE>
TABLE III. 1995 FEDERAL AND NEW YORK TAXABLE VS. TAX-FREE YIELDS*
<TABLE>
<CAPTION>
A TAX-FREE YIELD OF
TAXABLE INCOME (000'S) COMBINED ---------------------------------------------
--------------------------------- FEDERAL/ 4.00% 5.00% 6.00% 7.00% 8.00%
SINGLE JOINT NYS/NYC ----- ----- ----- ----- -----
RETURN RETURN TAX BRACKET IS EQUAL TO A TAXABLE YIELD OF APPROXIMATELY:
-------------- -------------- ----------- ---------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
$ 0-- 22.1 $ 0-- 36.9 25.19% 5.35% 6.68% 8.02% 9.36% 10.69%
22.1-- 53.5 36.9-- 89.2 36.64 6.31 7.89 9.47 11.05 12.63
53.5--115.0 89.2--140.0 39.32 6.59 8.24 9.89 11.54 13.18
115.0--250.0 140.0--250.0 43.71 7.11 8.88 10.66 12.44 14.21
Over 250.0 Over 250.0 46.88 7.53 9.41 11.29 13.18 15.06
</TABLE>
<TABLE>
<CAPTION>
A TAX-FREE YIELD OF
TAXABLE INCOME (000'S) ---------------------------------------------
--------------------------------- COMBINED 4.00% 5.00% 6.00% 7.00% 8.00%
SINGLE JOINT FEDERAL/NYS ----- ----- ----- ----- -----
RETURN RETURN TAX BRACKET IS EQUAL TO A TAXABLE YIELD OF APPROXIMATELY:
-------------- -------------- ------------ ---------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
$ 0-- 22.1 $ 0-- 36.9 21.45% 5.09% 6.37% 7.64% 8.91% 10.19%
22.1-- 53.5 36.9-- 89.2 33.47 6.01 7.52 9.02 10.52 12.02
53.5--115.0 89.2--140.0 36.24 6.27 7.84 9.41 10.98 12.55
115.0--250.0 140.0--250.0 40.86 6.76 8.45 10.15 11.84 13.53
Over 250.0 Over 250.0 44.19 7.17 8.96 10.75 12.54 14.33
</TABLE>
- ------------------
*Single rate assumes no dependents; joint rate assumes two dependents. The
yields listed are for illustration only and are not necessarily representative
of a Fund's yield. Each Fund invests primarily in obligations the interest on
which is exempt from federal income tax and, in the case of California Tax-Free
Income Fund, from California personal income tax and, in the case of New York
Tax-Free Income Fund, from New York State and New York City personal income
taxes; however, some of a Fund's investments may generate taxable income.
Effective tax rates shown are those in effect on the date of this Statement of
Additional Information; such rates might change after that date. The effective
rates reflect the highest tax bracket within each range of income listed.
However, a California or New York taxpayer within the lowest income ranges
shown may fall within a lower effective tax bracket. The figures set forth
above do not reflect the federal alternative minimum tax, limitations on
federal or state itemized deductions and personal exemptions or any state or
local taxes payable on Fund distributions (other than California, New York
State and New York City personal income taxes in the case of Tables II and
III).
61
<PAGE>
OTHER INFORMATION
The names of the Trusts are PaineWebber Mutual Fund Trust and PaineWebber
Municipal Series. Prior to April 6, 1992, the name of PaineWebber Mutual Fund
Trust was PaineWebber California Tax-Free Income Fund and its sole operating
series was designated as 'Initial Series.' Prior to June 30, 1992, National
Tax-Free Income Fund was a series of a different Massachusetts business trust,
PaineWebber Managed Municipal Trust. Prior to November 10, 1995, the Funds'
Class C shares were known as 'Class D' shares.
Each Trust is an entity of the type commonly known as a 'Massachusetts
business trust.' Under Massachusetts law, shareholders could, under certain
circumstances, be held personally liable for the obligations of the Trust or a
Fund. However, the Declaration of Trust disclaims shareholder liability for the
obligations of the Trust or a Fund and requires that notice of such disclaimer
be given in each note, bond, contract, instrument, certificate or undertaking
made or issued by the Trust's trustees or by any officers or officer by or on
behalf of a Fund, the trustees or any of them in connection with the Fund. The
Declaration of Trust provides for indemnification from a Fund's property for all
losses and expenses of any Fund shareholder held personally liable for the
obligations of the Fund. Thus, the risk of a shareholder's incurring financial
loss on account of shareholder liability is limited to circumstances in which
the Fund itself would be unable to meet its obligations, a possibility that
Mitchell Hutchins believes is remote and not material. Upon payment of any
liability incurred by a shareholder solely by reason of being or having been a
shareholder, the shareholder paying such liability will be entitled to
reimbursement from the general assets of a Fund. The trustees intend to conduct
the operations of each Fund in such a way as to avoid, as far as possible,
ultimate liability of the shareholders for liabilities of the Fund.
CLASS-SPECIFIC EXPENSES. Each Fund may determine to allocate certain of
its expenses (in addition to distribution fees) to the specific classes of the
Fund's shares to which those expenses are attributable. For example, Class B
shares bear higher transfer agency fees per shareholder account than those borne
by Class A or Class C shares. The higher fee is imposed due to the higher costs
incurred by the transfer agent in tracking shares subject to a contingent
deferred sales charge because, upon redemption, the duration of the
shareholder's investment must be determined in order to determine the applicable
charge. Moreover, the tracking and calculations required by the automatic
conversion feature of the Class B shares will cause the transfer agent to incur
additional costs. Although the transfer agency fee will differ on a per account
basis as stated above, the specific extent to which the transfer agency fees
will differ between the classes as a percentage of net assets is not certain,
because the fee as a percentage of net assets will be affected by the number of
shareholder accounts in each class and the relative amounts of net assets in
each class.
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COUNSEL. The law firm of Kirkpatrick & Lockhart LLP, 1800 Massachusetts
Avenue, N.W., Washington, D.C., 20036-1800, counsel to the Funds, has passed
upon the legality of the shares offered by the Funds' Prospectus. Kirkpatrick &
Lockhart LLP also acts as counsel to Mitchell Hutchins and PaineWebber in
connection with other matters. The law firm of Orrick, Herrington & Sutcliffe,
400 Sansome Street, San Francisco, CA 94111, serves as counsel to California
Tax-Free Income Fund with respect to California law. The law firm of Orrick,
Herrington & Sutcliffe, 666 Fifth Avenue, New York, New York 10103, serves as
counsel to New York Tax-Free Income Fund with respect to New York law.
AUDITORS. Ernst & Young LLP, 787 Seventh Avenue, New York, New York 10019,
serves as independent auditors for the Funds.
FINANCIAL STATEMENTS
The Funds' Annual Report to Shareholders for the fiscal year ended February
29, 1996 is a separate document supplied with this Statement of Additional
Information and the financial statements, accompanying notes and report of
independent auditors appearing therein are incorporated by reference in this
Statement of Additional Information.
63
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[This page intentionally left blank]
64
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NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS NOT CONTAINED IN THE PROSPECTUS OR IN THIS STATEMENT OF
ADDITIONAL INFORMATION IN CONNECTION WITH THE OFFERING MADE BY THE PROSPECTUS
AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED
UPON AS HAVING BEEN AUTHORIZED BY A FUND OR ITS DISTRIBUTOR. THE PROSPECTUS AND
THIS STATEMENT OF ADDITIONAL INFORMATION DO NOT CONSTITUTE AN OFFERING BY ANY
FUND OR BY THE DISTRIBUTOR IN ANY JURISDICTION IN WHICH SUCH OFFERING MAY NOT
LAWFULLY BE MADE.
------------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Investment Policies and Restrictions........... 1
Hedging and Related Income Strategies.......... 27
Trustees and Officers.......................... 33
Investment Advisory and Distribution
Arrangements................................. 39
Portfolio Transactions......................... 45
Reduced Sales Charges, Additional Exchange and
Redemption Information and Other Services.... 47
Conversion of Class B Shares................... 51
Valuation of Shares............................ 51
Performance Information........................ 52
Taxes.......................................... 56
Other Information.............................. 62
Financial Statements........................... 63
</TABLE>
(Copyright)1996 PaineWebber Incorporated
PaineWebber California
Tax-Free Income Fund
PaineWebber National
Tax-Free Income Fund
PaineWebber Municipal
High Income Fund
PaineWebber New York
Tax-Free Income Fund
- --------------------------------------------------------------------------------
Statement of Additional Information
July 1, 1996
- --------------------------------------------------------------------------------
PAINEWEBBER
<PAGE>
PAINEWEBBER CALIFORNIA TAX-FREE INCOME FUND
PAINEWEBBER NATIONAL TAX-FREE INCOME FUND
PAINEWEBBER MUNICIPAL HIGH INCOME FUND
PAINEWEBBER NEW YORK TAX-FREE INCOME FUND
CLASS Y SHARES
1285 AVENUE OF THE AMERICAS
NEW YORK, NEW YORK 10019
STATEMENT OF ADDITIONAL INFORMATION
The four funds named above (each a 'Fund' and, collectively, 'Funds') are
series of either PaineWebber Mutual Fund Trust or PaineWebber Municipal Series
(each a 'Trust'), professionally managed mutual funds. PaineWebber California
Tax-Free Income Fund ('California Tax-Free Income Fund') seeks high current
income exempt from federal income tax and California personal income tax,
consistent with the preservation of capital and liquidity within the Fund's
quality standards. PaineWebber National Tax-Free Income Fund ('National Tax-Free
Income Fund') seeks high current income exempt from federal income tax,
consistent with the preservation of capital and liquidity within the Fund's
quality standards. PaineWebber Municipal High Income Fund ('Municipal High
Income Fund') seeks high current income exempt from federal income tax.
PaineWebber New York Tax-Free Income Fund ('New York Tax-Free Income Fund')
seeks high current income exempt from federal income tax and from New York State
and New York City personal income taxes.
The investment adviser, administrator and distributor for each Fund is
Mitchell Hutchins Asset Management Inc. ('Mitchell Hutchins'), a wholly owned
subsidiary of PaineWebber Incorporated ('PaineWebber'). As distributor for the
Funds, Mitchell Hutchins has appointed PaineWebber to serve as the exclusive
dealer for the sale of Fund shares.
This Statement of Additional Information ('SAI') is not a prospectus and
should be read only in conjunction with the Funds' current Prospectus, dated
July 1, 1996. A copy of the Prospectus may be obtained by calling any
PaineWebber investment executive or correspondent firm or by calling toll-free
1-800-647-1568. This Statement of Additional Information is dated July 1, 1996.
INVESTMENT POLICIES AND RESTRICTIONS
The following supplements the information contained in the Prospectus
concerning the Funds' investment policies and limitations.
YIELD FACTORS AND RATINGS. Moody's Investors Service, Inc. ('Moody's'),
Standard & Poor's, a division of The McGraw Hill Companies, Inc. ('S&P') and
other nationally recognized statistical rating organizations ('NRSROs') are
private services that provide ratings of the credit quality of debt obligations,
including issues of municipal securities. A description of the range of ratings
assigned to municipal securities by Moody's and S&P is included in the Appendix
to the Prospectus. The Funds may use these ratings in determining whether to
purchase, sell or hold a security. It should be emphasized, however, that
ratings are general and are not absolute standards of quality. Consequently,
municipal securities with the same maturity, interest rate and rating may have
different market prices. Credit ratings attempt to evaluate the safety of
principal and interest payments and do not evaluate the risks of fluctuations in
market value. Also, rating agencies may fail to make timely changes in credit
ratings in response to subsequent events, so that an issuer's current financial
condition may be better or worse than the rating indicates. Subsequent to its
purchase by a Fund, an issue of municipal
<PAGE>
securities may cease to be rated or its rating may be reduced below the minimum
rating required for purchase by the Fund.
Opinions relating to the validity of municipal securities and to the
exemption of interest thereon from federal income tax (and also, when available,
from the federal alternative minimum tax) and (where applicable) California
personal income tax and New York State and New York City personal income taxes
are rendered by bond counsel to the respective issuing authorities at the time
of issuance. Neither the Funds nor Mitchell Hutchins will review the proceedings
relating to the issuance of municipal securities or the basis for such opinions.
An issuer's obligations under its municipal securities are subject to the
provisions of bankruptcy, insolvency and other laws affecting the rights and
remedies of creditors (such as the federal bankruptcy laws) and federal, state
and local laws that may be enacted that adversely affect the tax-exempt status
of interest on the municipal securities held by a Fund or of the exempt-interest
dividends received by a Fund's shareholders, extend the time for payment of
principal or interest, or both, or impose other constraints upon enforcement of
such obligations. There is also the possibility that, as a result of litigation
or other conditions, the power or ability of issuers to meet their obligations
for the payment of principal of and interest on their municipal securities may
be materially and adversely affected.
TYPES OF MUNICIPAL SECURITIES. Each Fund may invest in a variety of
municipal securities, as described below:
Municipal Bonds. Municipal bonds are debt obligations issued to obtain
funds for various public purposes that pay interest that is exempt from federal
income tax in the opinion of issuer's counsel. The two principal classifications
of municipal bonds are 'general obligation' and 'revenue' bonds. General
obligation bonds are secured by the issuer's pledge of its full faith, credit
and taxing power for the payment of principal and interest. Revenue bonds are
payable only from the revenues derived from a particular facility or class of
facilities or, in some cases, from the proceeds of a special excise tax or other
specific revenue source such as from the user of the facility being financed.
The term 'municipal bonds' also includes 'moral obligation' issues, which are
normally issued by special purpose authorities. In the case of such issues, an
express or implied 'moral obligation' of a related government unit is pledged to
the payment of the debt service, but is usually subject to annual budget
appropriations.
Municipal Lease Obligations. The term 'municipal bonds' also includes
municipal lease obligations, such as leases, installment purchase contracts and
conditional sales contracts, and certificates of participation therein.
Municipal lease obligations are issued by state and local governments and
authorities to purchase land or various types of equipment or facilities and may
be subject to annual budget appropriations. The Funds generally invest in
municipal lease obligations through certificates of participation.
Although municipal lease obligations do not constitute general obligations
of the municipality for which the municipality's taxing power is pledged, they
ordinarily are backed by the municipality's covenant to budget for, appropriate
and make the payments due under the lease obligation. The leases underlying
certain municipal lease obligations, however, provide that lease payments are
subject to partial or full abatement if, because of material damage or
destruction of the leased property, there is substantial interference with the
lessee's use or occupancy of such property. This 'abatement risk' may be reduced
by the existence of insurance covering the leased property, the maintenance by
the lessee of reserve funds or the provision of credit enhancements such as
letters of credit.
Certain municipal lease obligations contain 'non-appropriation' clauses
which provide that the municipality has no obligation to make lease or
installment purchase payments in future years unless money is appropriated for
such purpose on a yearly basis. Some municipal lease obligations of this type
are insured as to timely payment of principal and interest, even in the event of
a failure by the municipality to appropriate
2
<PAGE>
sufficient funds to make payments under the lease. However, in the case of an
uninsured municipal lease obligation, a Fund's ability to recover under the
lease in the event of a non-appropriation or default will be limited solely to
the repossession of leased property without recourse to the general credit of
the lessee, and disposition of the property in the event of foreclosure might
prove difficult. No Fund intends to invest more than 5% of its total assets in
such uninsured 'non-appropriation' municipal lease obligations. There is no
percentage limitation on the Funds' ability to invest in other municipal lease
obligations.
Industrial Development Bonds ('IDBs') and Private Activity Bonds
('PABs'). IDBs and PABs are issued by or on behalf of public authorities to
finance various privately operated facilities, such as airport or pollution
control facilities. These obligations are included within the term 'municipal
bonds' if the interest paid thereon is exempt from federal income tax in the
opinion of the bond issuer's counsel. IDBs and PABs are in most cases revenue
bonds and thus are not payable from the unrestricted revenues of the issuer. The
credit quality of IDBs and PABs is usually directly related to the credit
standing of the user of the facilities being financed. IDBs issued after August
15, 1986 generally are considered PABs, and to the extent a Fund invests in such
PABs, shareholders generally will be required to include a portion of their
exempt-interest dividends from that Fund in calculating their liability for the
alternative minimum tax ('AMT'). See 'Dividends and Taxes' in the Prospectus.
Each Fund is authorized to invest more than 25% of its net assets in IDBs and
PABs.
Floating Rate and Variable Rate Obligations. Floating rate and variable
rate obligations bear interest at rates that are not fixed, but that vary with
changes in specified market rates or indices. Accordingly, as interest rates
decrease or increase, the potential for capital appreciation or capital
depreciation is less than for fixed rate obligations. Floating rate or variable
rate obligations typically permit the holder to demand payment of principal from
the issuer or remarketing agent at par value prior to maturity and may permit
the issuer to prepay principal, plus accrued interest, at its discretion after a
specified notice period. Frequently, floating rate or variable rate obligations
and/or the demand features thereon are secured by letters of credit or other
credit support arrangements provided by banks, the credit standing of which
affects the credit quality of the obligations.
A demand feature gives the Fund the right to sell the securities to a
specified party, usually a remarketing agent, on a specified date. A demand
feature is often backed by a letter of credit or guarantee from a bank. As
discussed under 'Participation Interests,' to the extent that payment of an
obligation is backed by a bank's letter of credit or guarantee, such payment may
be subject to the bank's ability to satisfy that commitment. The interest rate
on floating rate or variable rate securities ordinarily is readjusted on the
basis of the prime rate of the bank that originated the financing or some other
index or published rate, such as the 90-day U.S. Treasury Bill rate. Generally,
these interest rate adjustments cause the market value of floating rate and
variable rate municipal securities to fluctuate less than the market value of
fixed rate obligations. Accordingly, as interest rates decrease or increase, the
potential for capital appreciation or capital depreciation is less than for
fixed rate obligations.
Participation Interests. Participation interests are interests in
municipal bonds, including IDBs and PABs, and floating and variable rate
obligations that are owned by banks. These interests carry a demand feature
permitting the holder to tender them back to the bank, which demand feature
generally is backed by an irrevocable letter of credit or guarantee of the bank.
The credit standing of such bank affects the credit quality of the participation
interests.
A participation interest gives a Fund an undivided interest in a municipal
bond owned by a bank. The Fund has the right to sell the instrument back to the
bank. Such right generally is backed by the bank's irrevocable letter of credit
or guarantee and permits the Fund to draw on the letter of credit on demand,
after
3
<PAGE>
specified notice, for all or any part of the principal amount of the Fund's
participation interest plus accrued interest. Generally, each Fund intends to
exercise the demand under the letters of credit or other guarantees only (1)
upon a default under the terms of the underlying bond, (2) to maintain the
Fund's portfolio in accordance with its investment objective and policies or (3)
as needed to provide liquidity to the Fund in order to meet redemption requests.
The ability of a bank to fulfill its obligations under a letter of credit or
guarantee might be affected by possible financial difficulties of its borrowers,
adverse interest rate or economic conditions, regulatory limitations or other
factors. Mitchell Hutchins will monitor the pricing, quality and liquidity of
the participation interests held by a Fund, and the credit standing of banks
issuing letters of credit or guarantees supporting such participation interests
on the basis of published financial information reports of rating services and
bank analytical services.
Tender Option Bonds. Tender option bonds are long-term municipal
securities sold by a bank subject to a 'tender option' that gives the purchaser
the right to tender them to the bank at par plus accrued interest at designated
times (the 'tender option'). The tender option may be excercisable at intervals
ranging from bi-weekly to semi-annually, and the interest rate on the bonds is
typically reset at the end of the applicable interval in an attempt to cause the
bonds to have a market value that approximates their par value. The tender
option generally would not be exercisable in the event of a default on, or
significant downgrading of, the underlying municipal securities. Therefore, a
Fund's ability to exercise the tender option will be affected by the credit
standing of both the bank involved and the issuer of the underlying securities.
Put Bonds. A put bond is a municipal bond which gives the holder the
unconditional right to sell the bond back to the issuer or a remarketing agent
at a specified price and exercise date, which is typically well in advance of
the bond's maturity date. The obligation to purchase the bond on the exercise
date may be supported by a letter of credit or other credit support arrangement
from a bank, insurance company or other financial institution, the credit
standing of which affects the credit quality of the obligation.
If the put is a 'one time only' put, the Fund ordinarily will either sell
the bond or put the bond, depending upon the more favorable price. If the bond
has a series of puts after the first put, the bond will be held as long as, in
the judgment of Mitchell Hutchins, it is in the best interest of the Fund to do
so. There is no assurance that the issuer of a put bond acquired by a Fund will
be able to repurchase the bond upon the exercise date, if the Fund chooses to
exercise its right to put the bond back to the issuer.
Tax-Exempt Commercial Paper and Short-Term Municipal Notes. Tax-exempt
commercial paper and short-term municipal notes include tax anticipation notes,
bond anticipation notes, revenue anticipation notes and other forms of
short-term loans. Such notes are issued with a short-term maturity in
anticipation of the receipt of tax funds, the proceeds of bond placements and
other revenues.
Inverse Floaters. Each Fund may invest in municipal obligations on which
the rate of interest varies inversely with interest rates on other municipal
obligations or an index. Such obligations include components of securities on
which interest is paid in two separate parts--an auction component, which pays
interest at a market rate that is set periodically through an auction process or
other method, and a residual component, or 'inverse floater,' which pays
interest at a rate equal to the difference between the rate that the issuer
would have paid on a fixed-rate obligation at the time of issuance and the rate
paid on the auction component. The market value of an inverse floater will be
more volatile than that of a fixed-rate obligation and, like most debt
obligations, will vary inversely with changes in interest rates.
Because the interest rate paid to holders of inverse floaters is generally
determined by subtracting the interest rate paid to the holders of auction
components from a fixed amount, the interest rate paid to holders of inverse
floaters will decrease as market rates increase and increase as market rates
decrease. Moreover, the extent of the increases and decreases in the market
value of inverse floaters may be larger than comparable
4
<PAGE>
changes in the market value of an equal principal amount of a fixed rate
municipal obligation having similar credit quality redemption provisions and
maturity. In a declining interest rate environment, inverse floaters can provide
a Fund with a means of increasing or maintaining the level of tax-exempt
interest paid to shareholders. However, because of the market volatility
associated with inverse floaters, no Fund will invest more than 10% of its total
assets in inverse floaters.
Mortgage Subsidy Bonds. The Funds also may purchase mortgage subsidy bonds
that are normally issued by special purpose public authorities. In some cases
the repayment of such bonds depends upon annual legislative appropriations; in
other cases repayment is a legal obligation of the issuer and, if the issuer is
unable to meet its obligations, repayment becomes a moral commitment of a
related government unit (subject, however, to such appropriations). The types of
municipal securities identified above and in the Prospectus may include
obligations of issuers whose revenues are primarily derived from mortgage loans
on housing projects for moderate to low income families.
WHEN-ISSUED AND DELAYED DELIVERY SECURITIES. As stated in the Prospectus,
the Fund may purchase securities on a 'when-issued' or delayed delivery basis. A
security purchased on a when-issued or delayed delivery basis is recorded as an
asset on the commitment date and is subject to changes in market value,
generally based upon changes in the level of interest rates. Thus, fluctuation
in the value of the security from the time of the commitment date will affect
the Fund's net asset value. When a Fund commits to purchase securities on a
when-issued or delayed delivery basis, its custodian segregates assets to cover
the amount of the commitment. See 'Investment Policies and
Restrictions--Segregated Accounts.' The Funds purchase when-issued securities
only with the intention of taking delivery, but may sell the right to acquire
the security prior to delivery if Mitchell Hutchins deems it advantageous to do
so, which may result in capital gain or loss to a Fund.
STAND-BY COMMITMENTS. Each Fund may acquire stand-by commitments pursuant
to which a bank or other municipal bond dealer agrees to purchase securities
that are held in the Fund's portfolio or that are being purchased by the Fund,
at a price equal to (1) the acquisition cost (excluding any accrued interest
paid on acquisition), less any amortized market premium or plus any accrued
market or original issue discount, plus (2) all interest accrued on the
securities since the last interest payment date or the date the securities were
purchased by the Fund, whichever is later. Although the Funds do not currently
intend to acquire stand-by commitments with respect to municipal securities held
in their portfolios, each Fund may acquire such commitments under unusual market
conditions to facilitate portfolio liquidity.
A Fund would enter into stand-by commitments only with those banks or other
dealers that, in the opinion of Mitchell Hutchins, present minimal credit risk.
A Fund's right to exercise stand-by commitments would be unconditional and
unqualified. A stand-by commitment would not be transferable by a Fund, although
the Fund could sell the underlying securities to a third party at any time. A
Fund may pay for stand-by commitments either separately in cash or by paying a
higher price for the securities that are acquired subject to such a commitment
(thus reducing the yield to maturity otherwise available for the same
securities). The acquisition of a stand-by commitment would not ordinarily
affect the valuation or maturity of the underlying municipal securities.
Stand-by commitments acquired by a Fund would be valued at zero in determining
net asset value. Whether the Fund paid directly or indirectly for a stand-by
commitment, its cost would be treated as unrealized depreciation and would be
amortized over the period the commitment is held by the Fund.
REPURCHASE AGREEMENTS. The Funds do not intend to enter into repurchase
agreements except as a temporary measure and under unusual circumstances,
because repurchase agreements are transactions that generate taxable income.
Each Fund is, however, authorized to enter into repurchase agreements with U.S.
5
<PAGE>
banks and dealers with respect to any obligation issued or guaranteed by the
U.S. government, its agencies or instrumentalities and also with respect to
commercial paper, bank certificates of deposit and bankers' acceptances.
Repurchase agreements are transactions in which a Fund purchases securities from
a bank or recognized securities dealer and simultaneously commits to resell the
securities to the bank or dealer at an agreed-upon date and price reflecting a
market rate of interest unrelated to the coupon rate or maturity of the
purchased securities. The Fund maintains custody of the underlying securities
prior to their repurchase; thus, the obligation of the bank or dealer to pay the
repurchase price on the date agreed to is, in effect, secured by such
securities. If the value of these securities is less than the repurchase price,
plus any agreed-upon additional amount, the other party to the agreement must
provide additional collateral so that at all times the collateral is at least
equal to the repurchase price, plus any agreed-upon additional amount. The
difference between the total amount to be received upon repurchase of the
securities and the price which was paid by the Fund upon acquisition is accrued
as interest and included in the Fund's net investment income.
Repurchase agreements carry certain risks not associated with direct
investments in securities, including possible declines in the market value of
the underlying securities and delays and costs to the Fund if the other party to
a repurchase agreement becomes insolvent. Each Fund intends to enter into
repurchase agreements only with banks and dealers in transactions believed by
Mitchell Hutchins to present minimal credit risks in accordance with guidelines
established by the appropriate Trust's board of trustees. Mitchell Hutchins will
review and monitor the creditworthiness of those institutions under the board's
general supervision.
ILLIQUID SECURITIES. Each Fund may invest up to 10% of its net assets in
illiquid securities. The term 'illiquid securities' for this purpose means
securities that cannot be disposed of within seven days in the ordinary course
of business at approximately the amount at which the Fund has valued the
securities and includes, among other things, repurchase agreements maturing in
more than seven days and municipal lease obligations (including certificates of
participation) other than those Mitchell Hutchins has determined are liquid
pursuant to guidelines established by the appropriate Trust's board of trustees.
Each Trust's board of trustees has delegated the function of making
day-to-day determinations of liquidity to Mitchell Hutchins, pursuant to
guidelines approved by the board. Mitchell Hutchins takes into account a number
of factors in reaching liquidity decisions, including (1) the frequency of
trades for the security, (2) the number of dealers that make quotes for the
security, (3) the number of dealers that have undertaken to make a market in the
security, (4) the number of other potential purchasers and (5) the nature of the
security and how trading is effected (e.g., the time needed to sell the
security, how offers are solicited and the mechanics of transfer). Mitchell
Hutchins monitors the liquidity of securities in each Fund's portfolio and
reports periodically on liquidity decisions to each Trust's board of trustees.
In making determinations as to the liquidity of municipal lease
obligations, Mitchell Hutchins will distinguish between direct investments in
municipal lease obligations (or participations therein) and investments in
securities that may be supported by municipal lease obligations or certificates
of participation therein. Since these municipal lease obligation-backed
securities are based on a well-established means of securitization, Mitchell
Hutchins does not believe that investing in such securities presents the same
liquidity issues as direct investments in municipal lease obligations. The
assets used as cover for any over-the-counter ('OTC') options written by a Fund
would be considered illiquid unless the OTC options are sold to qualified
dealers who agree that the Fund may repurchase any OTC option it writes at a
maximum price to be calculated by a formula set forth in the option agreement.
The cover for an OTC option written subject to this procedure will be considered
illiquid only to the extent that the maximum repurchase price under the formula
exceeds the intrinsic value of the option.
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<PAGE>
LENDING OF PORTFOLIO SECURITIES. The Funds do not intend to lend their
portfolio securities, except under unusual circumstances, because securities
loans are transactions that generate taxable income. As indicated in the
Prospectus, however, each Fund is authorized to lend up to 33 1/3% of its
portfolio securities to broker-dealers or institutional investors that Mitchell
Hutchins deems qualified, but only when the borrower maintains acceptable
collateral with the Fund's custodian, marked to market daily, in an amount at
least equal to the market value of the securities loaned, plus accrued interest
and dividends. Acceptable collateral is limited to cash, U.S. government
securities and irrevocable letters of credit that meet certain guidelines
established by Mitchell Hutchins. In determining whether to lend securities to a
particular broker-dealer or institutional investor, Mitchell Hutchins will
consider, and during the period of the loan will monitor, all relevant facts and
circumstances, including the creditworthiness of the borrower. Each will retain
authority to terminate any loan at any time. A 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 money market
instruments held as collateral to the borrower or placing broker. A Fund will
receive reasonable interest on the loan or a flat fee from the borrower and
amounts equivalent to any dividends, interest or other distributions on the
securities loaned. A Fund will retain record ownership of loaned securities to
exercise beneficial rights, such as voting and subscription rights and rights to
dividends, interest or other distributions, when regaining such rights is
considered to be in the Fund's interest.
SEGREGATED ACCOUNTS. When a Fund enters into certain transactions that
involve obligations to make future payments to third parties, including the
purchase of securities on a when-issued or delayed delivery basis, the Fund will
maintain with an approved custodian in a segregated account cash or other liquid
securities, marked to market daily, in an amount at least equal to the Fund's
obligation or commitment under such transactions. As described below under
'Hedging and Related Income Strategies,' segregated accounts may also be
required in connection with certain transactions involving options or futures
contracts.
DURATION. Duration is a measure of the expected life of a fixed income
security that was developed as a more precise alternative to the concept 'term
to maturity.' Duration incorporates a bond's yield, coupon interest payments,
final maturity and call features into one measure and is one of the fundamental
tools used by Mitchell Hutchins in portfolio selection for the Funds.
Traditionally, a debt security's 'term to maturity' has been used as a proxy for
the sensitivity of the security's price to changes in interest rates (which is
the 'interest rate risk' or 'volatility' of the security). However 'term to
maturity' measures only the time until a debt security provides for a final
payment, taking no account of the pattern of the security's payments prior to
maturity. Duration is a measure of the expected life of a fixed income security
on a present value basis. Duration takes the length of the time intervals
between the present time and the time that the interest and the principal
payments are scheduled to be made or, in the case of a callable bond, expected
to be received, and weights them by the present values of the cash to be
received at each future point in time. For any fixed income security with
interest payments occurring prior to the payment of the principal, duration is
always less than maturity.
Futures, options and options on futures have durations which, in general,
are closely related to the duration of the securities which underlie them.
Holding long futures or call option positions (backed by a segregated account of
cash and cash equivalents) will lengthen a Fund's duration by approximately the
same amount as would holding an equivalent amount of the underlying securities.
Short futures or put options have durations roughly equal to the negative
duration of the securities that underlie these positions, and have the effect of
reducing portfolio duration by approximately the same amount as would selling an
equivalent amount of the underlying securities.
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<PAGE>
There are some situations in which the standard duration calculation does
not properly reflect the interest rate exposure of a security. For example,
floating and variable rate securities often have final maturities of ten or more
years; however, their interest rate exposure corresponds to the frequency of the
coupon reset. In these and other similar situations, Mitchell Hutchins will use
more sophisticated analytical techniques that incorporate the economic life of a
security into the determination of its duration and, therefore, its interest
rate exposure.
Duration allows Mitchell Hutchins to make certain predictions as to the
effect that changes in the level of interest rates will have on the value of a
Fund's portfolio. For example, when the level of interest rates increases by 1%,
a fixed income security having a positive duration of three years generally will
decrease in value by approximately 3%. Accordingly, if Mitchell Hutchins
calculates the duration of the Fund's portfolio as being three years, it
normally would expect the portfolio to change in value by approximately 3% for
every 1% change in the level of interest rates. However, various factors, such
as changes in anticipated prepayment rates, qualitative considerations and
market supply and demand, can cause particular securities to respond somewhat
differently to changes in interest rates than indicated in the above example.
This is particularly true during periods of market volatility. Accordingly, the
net asset value of a Fund's portfolio may vary in relation to interest rates by
a greater or lesser percentage than indicated by the above example.
SPECIAL CONSIDERATIONS RELATING TO CALIFORNIA MUNICIPAL SECURITIES
The financial condition of the State of California, its public authorities
and local governments could affect the market values and marketability of, and
therefore the net asset value per share and the interest income of, a Fund, or
result in the default of existing obligations, including obligations which may
be held by the Fund. The following section provides only a brief summary of the
complex factors affecting the financial condition of California, and is based on
information obtained from the State of California, as publicly available on the
date of this Statement of Additional Information. The information contained in
such publicly available documents has not been independently verified. It should
be noted that the creditworthiness of obligations issued by local issuers may be
unrelated to the creditworthiness of California, and that there is no obligation
on the part of California to make payment on such local obligations in the event
of default in the absence of a specific guarantee or pledge provided by the
State of California.
The State of California has experienced significant financial difficulties
because of the 1990-93 recession, which reduced its credit standing. However,
since the start of 1994, California's economy has rebounded strongly, with
corresponding improvements in tax revenues. The ratings of certain related debt
of other issuers for which California has an outstanding lease purchase,
guarantee or other contractual obligation (such as for State-insured hospital
bonds) are generally linked directly to California's rating. Should the
financial condition of California deteriorate again, its credit ratings could be
further reduced, and the market value and marketability of all outstanding notes
and bonds issued by California, its public authorities or local governments
could be adversely affected.
ECONOMIC FACTORS. California's economy is the largest among the 50 states
and one of the largest in the world. The State's population of over 32 million
represents over 12% of the total United States population. While the State's
substantial population growth during the 1980s stimulated local economic growth
and diversification, it also increased demands on State services. Total personal
income in the State, at an estimated $703 billion in 1994, accounts for more
than 12% of all personal income in the nation.
From mid-1990 to late 1993, the State suffered a recession with the worst
economic, fiscal and budget conditions since the 1930s. Construction,
manufacturing (especially aerospace), and financial services, among others, were
all severely affected, particularly in Southern California. Job losses were the
worst of any post-war
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recession. Employment levels stabilized by late 1993 and steady growth has
occurred since the start of 1994. Pre-recession job levels are expected to be
reached in 1996. Unemployment, while remaining higher than the national average,
has come down significantly from the January 1994 peak of 10%. Economic
indicators show a steady recovery underway in California since the start of
1994, although the residential housing sector is weaker than in past recoveries.
However, any delay or reversal of the recovery will exacerbate shortfalls in
State revenue.
STATE DEBT. Under the California Constitution, debt service on outstanding
general obligation bonds is the second charge to the General Fund after support
of the public school system and public institutions of higher education. Total
outstanding general obligation bonds and lease purchase debt of the State
increased from $9.4 billion at June 30, 1988 to $23.8 billion at February 1,
1996. State agencies and authorities had approximately $19.1 billion of revenue
bonds and notes outstanding at December 31, 1995 for which the State General
Fund has no liability.
STATE FINANCES. Throughout the 1980's, State spending increased rapidly as
the State population and economy also grew rapidly, including increased spending
for many assistance programs to local governments, which were constrained by
Article XIIIA of the California Constitution (commonly known as 'Proposition
13') and other laws. The largest State program is assistance to local public
school districts. In 1988, an initiative (commonly known as Proposition 98) was
enacted which (subject to suspension by a two-thirds vote of the Legislature and
the Governor) guarantees local school districts and community college districts
a minimum share of State General Fund revenues (currently about 35%).
Since the start of the fiscal year ('FY') 1990-91 until FY1995-96, the
State faced adverse economic, fiscal, and budget conditions. The economic
recession seriously affected State tax revenues. It also caused increased
expenditures for health and welfare programs. The State is also facing a
structural imbalance in its budget with the largest programs supported by the
General Fund (education, health, welfare and corrections) growing at rates
significantly higher than the growth rates for the principal revenue sources of
the General Fund.
These structural concerns will continue in future years with the expected
need to increase capital and operating costs of the correctional system in
response to a 'Three Strikes' law enacted in 1994 which mandates life
imprisonment for certain felony offenders.
Recent Budgets. As a result of these factors, among others, from the late
1980's until 1992-93, the State had a period of budget imbalance, with
expenditures exceeding revenues in four out of six years, and the State
accumulated and sustained a budget deficit in the budget reserve, the Special
Fund for Economic Uncertainties ('SFEU') approaching $2.8 billion at its peak at
June 30, 1993. Starting in the 1990-91 Fiscal Year and for each year thereafter,
each budget required multibillion dollar actions to bring projected revenues and
expenditures into balance and to close large 'budget gaps' which were
identified. The Legislature and Governor eventually agreed on a number of
different steps to produce Budget Acts in the years 1991-92 to 1995-96,
including:
o significant cuts in health and welfare program expenditures;
o transfers of program responsibilities and funding from the State to local
governments, coupled with some reduction in mandates on local government;
o transfer of about $3.6 billion in annual local property tax revenues from
cities, counties, redevelopment agencies and some other districts to local
school districts, thereby reducing state funding for schools;
o reduction in growth of support for higher education programs, coupled
with increases in student fees;
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o revenue increases (particularly in the 1991-92 Fiscal Year budget), most
of which were for a short duration;
o increased reliance on aid from the federal government to offset the costs
of incarcerating, educating and providing health and welfare services to
undocumented aliens (although these efforts have produced much less federal aid
than the State Administration has requested); and
o various one-time adjustments and accounting changes.
Despite these budget actions, the effects of the recession led to large,
unanticipated deficits in the SFEU, as compared to projected positive balances.
By the start of the 1993-94 Fiscal Year, the accumulated deficit was so large
(almost $2.8 billion) that it was impractical to budget to retire it in one
year, so a two-year program was implemented, using the issuance of revenue
anticipation warrants to carry a portion of the deficit over the end of the
fiscal year. When the economy failed to recover sufficiently in 1993-94, a
second two-year plan was implemented in 1994-95, to carry the final retirement
of the deficit into 1995-96.
The combination of stringent budget actions cutting State expenditures, and
the turnaround of the economy by late 1993, finally led to the restoration of
positive financial results. While General Fund revenues and expenditures were
essentially equal in FY 1992-93 (following two years of excess expenditures over
revenues), the General Fund had positive operating results in FY 1993-94,1994-95
and 1995-96 which are expected to reduce the accumulated budget deficit to less
than $100 million as of June 30, 1996.
A consequence of the accumulated budget deficits in the early 1990's,
together with other factors such as disbursement of funds to local school
districts 'borrowed' from future fiscal years and hence not shown in the annual
budget, was to significantly reduce the State's cash resources available to pay
its ongoing obligations. When the Legislature and the Governor failed to adopt a
budget for the 1992-93 Fiscal Year by July 1, 1992, which would have allowed the
State to carry out its normal annual cash flow borrowing to replenish its cash
reserves, the State Controller was forced to issue registered warrants ('IOUs')
to pay a variety of obligations representing prior years' or continuing
appropriations, and mandates from court orders.
The State's cash condition became so serious that from late spring 1992
until 1995, the State had to rely on issuance of short term notes which matured
in a subsequent fiscal year to finance its ongoing deficit, and pay current
obligations. With the repayment of the last of these deficit notes in April,
1996, the State does not plan to rely further on external borrowing across
fiscal years, but will continue its normal cash flow borrowings during a fiscal
year.
Current Budget. For the first time in four years, the State entered the
1995-96 fiscal year with strengthening revenues based on an improving economy.
The major feature of the Governor's proposed Budget, a 15% phased cut in
personal income and business taxes, was rejected by the Legislature.
The 1995-96 Budget Act was signed by the Governor on August 3, 1995, 34
days after the start of the fiscal year. The Budget Act projected General Fund
revenues and transfers of $44.1 billion, a 3.5 percent increase from the prior
year. Expenditures were budgeted at $43.4 billion, a 4 percent increase. The
Department of Finance projected that, after repaying the last of the carryover
budget deficit, there would be a positive balance of less than $30 million in
the budget reserve, the Special Fund for Economic Uncertainties, at June 30,
1996, providing no margin for adverse results during the year.
In its regular budget update in May, 1996, the Department of Finance
indicated that, with the strengthening economy, State General Fund revenues for
1995-96 would be about $46.1 billion, some $2 billion higher than originally
estimated. Because of mandated spending for public schools, the failure to
receive expected federal aid for illegal immigrants, and the failure of Congress
to enact welfare reform which the Administration had expected would reduce State
costs, expenditures for 1995-96 were also increased, to
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about $45.4 billion. As a result, the Department estimated that the accumulated
budget deficit would be reduced to about $70 million as of June 30, 1996.
As a result of the improved revenues, the State's cash position has
substantially recovered. Only $2 billion of cash flow borrowing was needed
during 1995-96, and only about $3 billion is projected for 1996-97, with no
external borrowing over the end of the fiscal year.
The Governor's proposed budget for 1996-97 projects $47.1 billion of
revenues and transfers, and $46.5 billion of expenditures, resulting in a budget
reserve at June 30, 1997 of about $500 million. A number of issues relating to
the 1996-97 budget still have to be resolved, including the Governor's tax
reduction proposals, and his proposals for further health and welfare cuts.
There can be no assurance that the State will not face budget gaps in
future years. Certain major budgetary considerations affecting the State are
outlined below.
REVENUE BASE. The recession seriously affected the State's tax revenue,
which basically mirrors general economic conditions. These revenues have
rebounded strongly as the economy has improved since 1994. The principal sources
of General Fund revenues are economically sensitive, and include the California
personal income tax (43% of total FY1994-95 revenues), the sales tax (34%), bank
and corporation taxes (13%), and the gross premium tax on insurance (3%).
Personal income tax receipts are generated disproportionately by relatively few
taxpayers (the top 4% of taxpayers paid 49% of the total tax in 1990), and
capital gains are a significant component of such collections. Auto sales and
building materials are significant components of retail sales tax collections.
Tax rates, are relatively high, and may impose political and economic
constraints on the ability of the State to further increase its taxes. In
November 1993, the voters approved a constitutional amendment to permanently
extend 0.5 percent of the sales tax for local law enforcement and thus not
available as General Fund revenues.
BUDGETARY FLEXIBILITY. Article XIIIB of the California Constitution,
adopted by voter initiative, established an 'Appropriations Limit' for the State
and local governments; excess state revenues are to be divided equally between
transfers to K-14 districts and refunds to taxpayers. A taxpayer refund has not
been required since FY1986-87.
Proposition 98 established a minimum expenditure base for State aid to K-14
districts, currently requiring allocation of over 34% of General Fund revenues
to such districts.
For many years starting in the early 1980s, the State maintained the SFEU
as a budget reserve in case of unexpected changes in revenues or expenditures
during a fiscal year. Since the start of the recession in 1990, the SFEU has
been in a negative balance, as the State accumulated sizable budget deficits.
The Department of Finance projects elimination of virtually all the accumulated
budget deficits with a small negative balance (about $70 million) in the SFEU on
June 30, 1996; and a positive balance of over $500 million by June 30, 1997.
LABOR COSTS. The State government workforce is mostly unionized, subject
to the law which authorizes collective bargaining and prohibits strikes and work
slowdowns. All of the State's collective bargaining agreements expired June 30,
1995. The State has a substantial unfunded liability for future pension
benefits, and has utilized changes in its pension fund policies to reduce
current contribution requirements. If the investment assumptions used in
determining required State contributions are not sustained by actual results,
additional State contributions would be required in future years.
PUBLIC ASSISTANCE. California has the largest number of persons receiving
public assistance (Aid to Families with Dependent Children ('AFDC') and General
Relief) of any state. AFDC costs are shared among the federal government, the
State and its counties by statutory formula. Caseloads tend to rise
significantly
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during economic downturns, but are also significantly affected by changing
demographic and social trends which may impede the reduction of caseloads during
an economic recovery. The State has reduced AFDC payments to meet budget
pressures in recent years.
MEDI-CAL. California participates in the federal Medicaid program under a
state plan approved by the Health Care Financing Administration. The federal
government provides certain of the eligible program costs, with the remainder
shared by the State and its counties. Basic program eligibility and benefits are
determined by federal guidelines, but the State currently provides a number of
optional benefits and expanded eligibility. Program costs have increased
substantially in recent years, and account for a large share of the State
budget. The State has cut optional Medi-Cal services in recent years to reduce
expenditures. Proposed changes in the federal Medicare/Medicaid program may lead
to major restructuring of these programs in California. Federal law requires the
State to adopt reimbursement rates for hospitals and nursing homes that are
reasonable and adequate to meet the costs that must be incurred by efficiently
and economically operated facilities in providing patient care.
LITIGATION. The State is involved in certain legal proceedings (described
in the State's recent financial statements) that, if decided against the State,
may require the State to make significant future expenditures or may
substantially impair revenues.
STATE ASSISTANCE TO LOCALITIES. Property tax revenues received by local
governments declined more than 50% following voter approval of Proposition 13 in
1978. Subsequently, the California Legislature enacted measures to provide for
the redistribution of the State's General Fund surplus to local agencies, the
reallocation of certain State revenues to local agencies and the assumption of
certain governmental functions by the State to assist municipal issuers to raise
revenues. In response to the State's current fiscal difficulties, the State has
reduced its financial assistance to counties and cities, and adopted measures to
transfer certain governmental functions to its counties, accompanied by new
funding sources. The FY1993-94 Budget Act eliminated the remaining Proposition
13 assistance to all local government entities other than K-14 education
districts. Such actions have compounded the serious fiscal constraints already
experienced by many local governments, several of which have been compelled to
seek special assistance from the State.
CONSTITUTIONAL, LEGISLATIVE AND OTHER FACTORS. Certain California
constitutional amendments, legislative measures, executive orders,
administrative regulations and voter initiatives are introduced and/or
implemented from time to time which may result in adverse fiscal or economic
effects.
The fiscal condition of local governments in California (58 counties, 480
cities and thousands of education, utility and other special districts) has been
constrained since the enactment of 'Proposition 13' in 1978, which reduced and
limited the future growth of property taxes, and limited the ability of local
governments to impose other taxes. Counties, in particular, have had fewer
options to raise revenues than many other local government entities, and have
been required to maintain many basic public services. A 1986 initiative statute,
called 'Proposition 62,' imposed additional limits on local governments,
essentially requiring either majority or 2/3 voter approval for any tax increase
(other than property taxes). Later court decisions had struck down most of
Proposition 62, and many local governments, particularly cities, had enacted or
raised local taxes without voter approval. In September 1995, the California
Supreme Court overruled the prior cases, and upheld the constitutionality of
Proposition 62. Many aspects of this decision remain unclear (such as its impact
on charter cities, and whether it will have retroactive effect), but its future
effect will be to further limit the fiscal flexibility of many local
governments.
In the aftermath of Proposition 13, the State provided aid from the General
Fund to make up some of the loss of property tax moneys, including taking over
the principal responsibility for funding local K-12 schools and community
colleges. Under the pressure of the recent recession, the Legislature has
eliminated the
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remnants of this post-Proposition 13 aid, although it has also provided
additional funding sources (such as sales taxes) and reduced mandates for local
services. Nonetheless, many counties, in particular, continue to be under severe
fiscal stress. While such stress has in recent years most often been experienced
by smaller, rural counties, larger urban counties have also been affected.
Los Angeles County, the largest in the State, has reported severe fiscal
problems. To balance its FY1995-96 budget, the county has imposed severe cuts in
services, particularly for health care. Both Moody's and S&P have reduced Los
Angeles County's debt ratings in August 1995 (to 'A' and 'A-'), respectively.
Orange County, which recently emerged from federal Bankruptcy, has substantially
reduced services and personnel in order to live within much reduced means.
SPECIAL CONSIDERATIONS RELATING TO NEW YORK MUNICIPAL SECURITIES
The financial condition of the State of New York ('New York State' or the
'State'), its public authorities and public benefit corporations (the
'Authorities') and its local governments, particularly The City of New York (the
'City'), could affect the market values and marketability of, and therefore the
net asset value per share and the interest income of a Fund, or result in the
default of existing obligations, including obligations which may be held by the
Fund. The following section provides only a brief summary of the complex factors
affecting the financial situation in New York and is based on information
obtained from New York State, certain of its Authorities, the City and certain
other localities, as publicly available on the date of this Statement of
Additional Information. The information contained in such publicly available
documents has not been independently verified. Such information is subject to
change upon the adoption by the State Legislature of the State's final budget
for fiscal year 1996-97, which has not been enacted as of the date of this
Statement of Additional Information. Further, the adoption of a final State
budget may cause changes to the City budget for the City's fiscal year 1996-97
adopted on June 12, 1996 (the 'City FY1996-97 Budget'). There can be no
assurance that such changes may not have adverse effects on the City's cash
flow, expenditures or revenues. It should be noted that the creditworthiness of
obligations issued by local issuers may be unrelated to the creditworthiness of
New York State, and that there is no obligation on the part of New York State to
make payment on such local obligations in the event of default in the absence of
a specific guarantee or pledge provided by New York State.
New York State and the City are each facing serious financial difficulties
and have each experienced recent declines in their credit standings. S&P and
Moody's have each assigned ratings for New York State's general obligation bonds
that are among the three lowest of those states with rated general obligation
bonds. The ratings of certain related debt of other issuers for which New York
State has an outstanding moral obligation, lease purchase, guarantee or other
contractual obligation are generally linked directly to the State's rating. S&P
and Moody's have each assigned ratings for the City's obligations that are among
the four lowest of those cities with rated general obligation bonds. Should the
financial condition of New York State, its Authorities or its local governments
deteriorate, their respective credit ratings could be further reduced, and the
market value and marketability of their outstanding notes and bonds could be
adversely affected, and their respective access to the public credit markets
jeopardized.
ECONOMIC FACTORS. New York is the third most populous state, and has a
relatively high level of personal wealth; however, the State economy has grown
more slowly than that of the nation as a whole, resulting in the gradual erosion
of its relative economic affluence (due to such factors such as relative costs
for taxes, labor and energy). The State's economy is diverse, with a
comparatively large share of the nation's finance, insurance, transportation,
communications and services employment, and a very small share of the nation's
farming and mining activity. New York has a declining proportion of its
workforce engaged in manufacturing and increasing proportion engaged in service
industries. The State, therefore, is likely to be less affected than the nation
as a
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whole during an economic recession concentrated in construction and
manufacturing sectors of the economy, but likely to be more affected during a
recession concentrated in the service-producing sector. The State's
manufacturing and maritime base have been seriously eroded, as illustrated by
the decline of the steel industry in the Buffalo area and of the apparel and
textile industries in the City. In addition, the City experienced substantial
socio-economic changes, as a large segment of its population and a significant
share of corporate headquarters and other businesses relocated (many
out-of-state).
Both the State and the City experienced substantial revenue increases in
the mid-1980s attributable directly (corporate income and financial corporations
taxes) and indirectly (personal income and a variety of other taxes) to growth
in new jobs, rising profits and capital appreciation derived from the finance
sector of the City's economy. From 1977 to its 1988 peak, the finance, insurance
and real estate sectors rose 55%, to account in 1988 for 23% of total earnings
in the City and 14% statewide (compared to 7% nationwide). The finance sector's
growth was a catalyst for the New York metropolitan region's related business
and professional services, retail trade and residential and commercial real
estate markets. The then rising real estate market contributed to City revenues,
as higher property values and new construction added to collections from
property taxes, mortgage recording and transfer taxes and sales taxes on
building materials. The boom on Wall Street more than compensated for the
continued erosion of the State's (and the City's) manufacturing and maritime
base, since average wages in the finance, insurance and real estate sector and
related business and professional services were substantially higher (thereby
providing a net increase of higher incomes, taxed at even higher marginal
rates).
During the calendar years 1984 through 1991, the State's rate of economic
expansion was somewhat slower than that of the nation as a whole. In the
1990-1991 national recession, the economy of the Northeast region in general and
the State in particular was more heavily damaged than that of the rest of the
nation and has been slower to recover.
Although the national economy began to expand in 1991, the State economy
remained in recession until 1993, when employment growth resumed. Employment
growth has been hindered during recent years by significant cutbacks in the
computer and instrument manufacturing, utility and defense industries. Personal
income increased substantially in 1992 and 1993. The State's economy entered
into the third year of a slow recovery in 1995. Most of the growth occurred in
the trade, construction and service industries, with buisiness, social services
and health sectors accounting for most of the service industry growth. According
to assumptions contained in the State financial plan for FY1995-96 issued on
June 20, 1995 (the '1995-96 State Financial Plan'), employment was projected to
grow slightly during 1995, although the rate of increase was expected to be
below the rate experienced in 1994, due to cutbacks in governmental spending and
employment at all levels, as well as continued corporate downsizing. The Third
Quarterly Update to the 1995-96 State Financial Plan issued on January 30, 1996
(the 'Third Quarterly Update') contained a marginally weaker economic forecast
than that contained in the initial 1995-96 State Financial Plan, and predicts a
significant slowing of state employment growth during calendar year 1996, due to
the forecasted, slackening pace of national economic growth, industry
consolidation and shrinking governmental employment. The State financial plan
for 1996-97 (the '1996-97 State Financial Plan') contained in the proposed
Governor's Executive Budget initially presented on December 15, 1995 and amended
on March 15, 1996 (the '1996-97 Executive Budget') continues to predict a
slowing of State employment growth in the public sector during calendar year
1996, but forecasts slow growth in the private sector during the same time
period. The forecast reflects a continuation of the slower growth for the State
of New York than for the nation as a whole.
Notwithstanding the State budget for FY1995-96 which enacts significant tax
and program reductions, and the 1996-97 Executive Budget (which has not been
adopted into law) which proposes further program
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reductions, the State can expect structural deficits to occur in future years.
Both the 1995-96 Financial Plan and the 1996-97 Financial Plan reflect actions
or measures which provide non-recurring resources (sometimes referred to as 'one
shots') estimated to provide approximately $1.0 billion savings in FY1995-96 and
approximately $1.1 billion of savings in FY1996-97. Additionally, the three-year
plan to reduce State personal income taxes, as discussed below briefly, will
decrease State tax receipts by an estimated $1.7 billion in FY1996-97.
Similarly, other actions taken to reduce disbursements in the State's FY1995-96,
such as reductions in the State workforce and Medicaid and welfare expenditures,
are expected to provide greater reductions in future fiscal years. The net
impact of these and other factors is expected to produce a potential imbalance
in receipts and disbursements for State's FY1996-97 and future fiscal years.
Additionally, uncertainties with regard to both the economy and potential
decisions to be made at the federal level add further pressure on the balanced
budget outlook for FY1996-97 and beyond. For example, various proposals relating
to federal tax and spending policies may have a significant impact on the
State's financial condition in FY1996-97 and future fiscal years.
Further, there can be no assurance that the State economy will not
experience worse-than-predicted results in FY1996-97 with corresponding material
and adverse effects on the State's projections of receipts and disbursements.
Although the Third Quarter Update reflects a continued balance in the 1995-96
State Financial Plan, certain receipts collected through January 1996 varied
from the estimates contained in earlier updates to the 1995-96 State Financial
Plan. The effects of such changes in receipts is still under review,
consequently the predictive nature of such forecasts is difficult to ascertain.
In any case, as all State Financial Plans are based upon forecasts of national
and State economic activity it should be noted that many uncertainties exist in
such forecasts, including federal financial and monetary policies, the
availability of credit and the condition of the world economy. In addition, the
economic and financial condition of the State may be affected by various
financial, social, economic and political factors. These factors can be complex,
may vary from year to year and are frequently the results of actions taken not
only by the State and its agencies and instrumentalities, but also by other
entities, such as the federal government, that are not under the control of the
State.
The fiscal health of the State may also be impacted by the fiscal health of
the City. Although the City has had a balanced budget since 1981, estimates of
the City's future revenues and expenditures are subject to various
uncertainties. For example, the effects of the October 1987 stock market crash
and the 1990-92 national recession have had a disproportionately adverse impact
on the New York City metropolitan region, as private sector job losses since
1989 have offset all the prior employment gains of the 1980s. Declines in both
employment and earnings in the finance sector contributed to declines in retail
sales and real estate values. In addition, a number of widely publicized
bankruptcies among highly leveraged retailing and brokerage companies occurred.
The effects of the recession have extended to banking, insurance, business
services (such as law, accounting and advertising), publishing and
communications. Factors which may inhibit the City's economic recovery include
(i) credit restraints imposed by the weak financial condition of several major
money center banks located in the City; (ii) increases in combined State and
local tax burdens, if uncompetitive tax rates are imposed; (iii) perceived
declines in the quality of life attributable to service reductions and the
deterioration of the City's infrastructure; (iv) additional employment losses in
the City's banking sector or corporate headquarters complex due to further
corporate relocations or restructurings; or (v) increased expenditures for
public assistance and health care. The City's future economic condition will
also likely be affected by its competitive position as a world financial center
(compared to London, Tokyo, Frankfurt and competing regional U.S. centers).
Investors should note that the budget for the City FY1995-96 contained
provisions to close a projected $2.7 billion budget gap, and the City FY1996-97
Budget contains similar provisions to address a budget gap of approximately $2.6
billion. Many of such budget-gap closing initiatives
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may be implemented only with the cooperation of the City's municipal unions, or
the State or Federal governments. No assurance can be given that such
initiatives will be successfully undertaken.
While the State's economy is broader-based than that of the City,
particular industries are concentrated in and have a disproportionate impact on
certain areas, such as heavy industry in Buffalo, photographic and optical
equipment in Rochester, machinery and transportation equipment in Syracuse and
Utica-Rome, computers in Binghamton and in the Mid-Hudson Valley and electrical
equipment in the Albany-Troy-Schenectady area. Constraints on economic growth,
taxpayer resistance to proposed substantial increases in local tax rates, and
reductions in State aid in regions apart from the City have contributed to
financial difficulties for several county and other local governments.
THE STATE. As noted above, the financial condition of the State is
affected by several factors, including the strength of the State and its
regional economies, actions of the federal government, and State actions
affecting the level of receipts and disbursements. Owing to these and other
factors, the State may, in future years, face substantial potential budget gaps
resulting from a significant disparity between tax revenues projected from a
lower recurring receipts base and the future costs of maintaining State programs
at current levels.
The State has been experiencing and continues to experience substantial
financial difficulties with General Fund (the principal operating account)
deficits incurred during FY1989-90 through FY1991-92. The State's accumulated
General Fund deficit (on a GAAP basis) grew 91% from FY1986-87 to FY1990-91, and
reached a then-record $6.265 billion (audited) by March 31, 1991. An accumulated
General Fund deficit at March 31, 1992 was restated to be $4.616 billion and at
March 31, 1993 was $2.551 billion. The State ended FY1993-94 with a negative
General Fund balance of $1.637 billion. This represented an improvement over
prior fiscal years, primarily due to an improving national and State economy
resulting in higher-than-expected receipts from personal income tax and various
business taxes and the relative success of the New York Local Government
Assistance Corporation ('LGAC'). The General Fund showed an operating surplus of
$914 million (on a GAAP basis). The State's budget for FY1994-95 was adopted on
June 8, 1994, more than two months after the beginning of the State's fiscal
year and has made all of the required quarterly revisions thereto as of the date
hereof. The State ended its FY1994-95 reporting a General Fund operating deficit
of $1.426 billion, primarily due to change in accounting methodologies used by
the State Comptroller and the use of $1.026 billion of the FY1993-94
cash-surplus to fund operating expenses in FY1994-95. These factors were offset
by net proceeds of $315 million of bonds issued by LGAC. Actual receipts
reported fell short of original projections, primarily in the categories of
business taxes. These shortfalls were offset by better than expected performance
in the remaining taxes, principally the user taxes and fees. Total expenditures
for FY1994-95 increased $2.083 billion, or 6.7% over the prior fiscal year.
On June 7, 1995, the New York State Legislature passed the final
legislation regarding the State's FY1995-96 budget, again adopting such budget
more than two months after the beginning of the State's fiscal year. Both the
enacted budget bills and the State Financial Plan for FY1995-96 included the
reductions in the actual level of spending from that which occurred in FY1994-95
and projected reductions in Medicaid and State Authority operating costs. The
FY1995-96 budget also projected an approximate increase of 3% in all
governmental funds over the amounts received in FY1994-95 and includes the
phase-in of a three-year reduction in the State's personal income tax. The
'1996-97 Executive Budget' projects a $3.9 billion budget gap, which it proposes
to close largely by Medicaid cost containment measures (approximately $1.0
billion), welfare reform (approximately $240 million) and restructuring of the
state healthcare delivery system (approximately $470 million). The phased
reduction of the State's personal income tax is continued in the 1996-97
Executive Budget. Although as stated above, the Governor released his 1996-97
Executive Budget on
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December 15, 1995 and issued amendments thereto on March 15, 1996, the New York
State Legislature, as of the date of this Statement of Additional Information,
has not passed final legislation adopting a budget for FY1996-97. There can be
no assurances that the Legislature will enact the 1996-97 Executive Budget or
that the actual budget for FY1996-97 adopted by the Legislature will not differ
materially from the brief description of the 1996-97 Executive Budget contained
herein. Further, the actual budget adopted by the Legislature for FY1996-97 may
be materially adversely impacted by future changes to federal entitlement
programs either not foreseen or inaccurately forecast at the time such budget
legislation is actually enacted. The amendments made in March 1996 to the
1996-97 Executive Budget contained a contingency plan intended to address the
failure of the federal government to adopt entitlement changes which were
assumed initially in the December 1995 version of the 1996-97 Executive Budget.
Uncertainties at the federal level continue to represent significant risk to the
efficacy of any budget adopted for FY1996-97.
There can be no assurance that the State will not face budget gaps in
future years, resulting from a disparity between tax revenues projected from a
lower recurring-receipts base and the spending required to maintain State
programs at current levels. Furthermore, the State is a party to numerous
lawsuits in which an adverse decision could require extraordinary expenditures.
Certain major budgetary considerations affecting the State are outlined below.
REVENUE BASE. The State's principal revenue sources are economically
sensitive, and include the personal income tax (53% of FY1994-95 and
approximately 54% of estimated FY1995-96 General Fund tax receipts,
respectively), user taxes and fees (20% of FY1994-95 and nearly 21% of estimated
FY1995-96 General Fund tax receipts) and business taxes (15% of both FY1994-95
and estimated FY1995-96 General Fund tax receipts, respectively). Uncertainties
in taxpayer behavior as a result of actual and proposed changes in Federal tax
law also may have an adverse impact on State tax receipts. One-fourth of the 4%
State sales tax has been dedicated to pay debt service of LGAC, and has
correspondingly reduced General Fund receipts. To the extent those moneys are
not necessary for payment to LGAC, they are transferred from the LGAC Tax Fund
to the General Fund and reported as a transfer from other funds rather than as a
sales and use tax receipts. During FY1991-1992, 1992-93, 1993-94 and 1994-95,
moneys were so transferred. Capital gains are a significant component of income
tax collections. Auto sales and building materials are significant components of
retail sales tax collections. Tax rates are relatively high and may impose
political and economic constraints on the ability of the State to further
increase its taxes. In 1995, the State enacted a tax-reduction program designed
to reduce, by 20 percent over three years, receipts from the personal income
tax. The tax had remained unchanged since 1989 as a result of annual deferrals
of tax reductions originally enacted in 1987. The tax-reduction program is
estimated to reduce receipts by $515 million in FY1995-96, $2.2 billion in
FY1996-97 and to produce further significant reductions in FY1997-98. In
addition to such reductions in overall tax rates, the tax-reduction program also
includes other modifications to the tax laws which will have the effect of
lowering the amount of tax revenues to be received by the State. In the absence
of countervailing economic growth or expenditure cuts the tax cuts could make
the achievement of a balanced State budget more difficult in future years. A
significant risk to the 1996-97 State Financial Plan arises from proposed tax
legislation in the U.S. Congress. Changes to the federal tax treatment of
capital gains, if made, are likely to flow automatically to the State personal
income tax. Such changes, depending upon their precise character and timing, as
well as taxpayer response, could produce revenue loss during FY1996-97.
STATE DEBT. New York has the heaviest debt burden of any state (with
approximately $5.2 billion of general obligation, $4.7 billion of LGAC debt and
$18 billion of lease-purchase or other contractual debt outstanding as of March
31, 1995), and debt service costs absorb a large share of the State's budget. As
of March 31, 1995, the State is also obligated with respect to approximately
$7.0 billion for statutory moral obligations for nine of its Authorities and for
guarantees of $358 million of other Authority debt. Historically,
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the State has had one of the largest seasonal financing requirements of any
municipal issuer, and was required each spring to borrow substantial sums in the
credit markets to finance its accumulated general fund deficit and its scheduled
payments of aid to local governments and school districts. In an effort to
reduce such seasonal borrowings, the State created LGAC as a financing vehicle
to finance the State's local assistance payments by issuing long-term debt,
payable over 30 years from a portion of the State sales tax (as discussed
above). The State budget for FY1995-96 and the 1995-96 State Financial Plan each
proposed to utilize the remainder of authorized but yet unissued LGAC bonds. As
of June 1995, LGAC had issued bonds and notes to provide net proceeds of $4.7
billion, thus completing the LGAC program. The impact of LGAC's borrowing is
that the State was able to meet its cash flow needs in the first quarter of
FY1995-96 without relying on short-term seasonal borrowings. Neither the 1995-96
State Financial plan nor the 1994-95 State Financial Plan included a spring
borrowing, the first time in 35 years that there was no short-term borrowing.
Investors should note that the enabling legislation for LGAC contains a covenant
restricting the amount of the State's spring borrowing, which may reduce the
State's fiscal flexibility in future years.
BUDGETARY FLEXIBILITY. A significant portion of the State's General Fund
budget is accounted for by contractually required expenses (such as pension and
debt service costs) and by federally mandated programs (such as AFDC and
Medicaid). In addition, State aid for school districts comprises a major share
of the budget, and total appropriations and distribution of such aid is
especially contentious politically. Furthermore, the State's ability to respond
to unanticipated developments in the future may have been impaired since the
State has utilized a substantial range of actions of a non-recurring nature in
recent years to finance its General Fund operations, including tapping excess
monies in special funds, refinancing outstanding debt to reduce reserve fund
requirements and current (but not long-term) debt service costs, recalculating
pension fund contributions, selling State assets, reimbursing past General Fund
expenditures by the issuance of authority debt and deferring payment for
expenditures to future fiscal years. The 1995-96 State Financial Plan contains
actions of a non-recurring nature including mergers of certain authorities,
payments from the sale of certain State assets and payments associated with the
resolution of certain court cases, totalling approximately $900 million to $1
billion. The 1996-97 Executive Budget, however, contains actions of a
non-recurring nature to the extent of approximately $1.1 billion.
LABOR COSTS. The State government workforce is mostly unionized, subject
to the Taylor Law which authorizes collective bargaining and prohibits (but has
not, historically, prevented) strikes and work slowdowns. Costs for employee
health benefits have increased substantially, and can be expected to further
increase. The State has a substantial unfunded liability for future pension
benefits, and has utilized changes in its pension fund investment return
assumptions to reduce current contribution requirements. If such investment
earnings assumptions are not sustained by actual results, additional State
contributions will be required in future years to meet the State's contractual
obligations. The State's change in actuarial method from the aggregate cost
method to a modified projected unit credit in FY1990-91 created a substantial
surplus that was amortized and applied to offset the State's contribution
through FY1993-94. This change in actuarial method was ruled unconstitutional by
the State's highest court and the State has returned to the aggregate cost
method in FY1994-95 using a four-year phase-in. Employer contributions,
including the State's, are expected to increase over the next five to ten years.
PUBLIC ASSISTANCE. New York has the second largest number of persons
receiving public assistance (AFDC and Home Relief) of any state. AFDC costs are
shared among the federal government, the State and its counties (including the
City) by statutory formula. Caseloads tend to rise significantly during economic
downturns, but have fallen only in the later stages of past economic recoveries.
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MEDICAID. New York participates in the federal Medicaid program under a
state plan approved by the Health Care Financing Administration. The federal
government provides a substantial portion of eligible program costs, with the
remainder shared by the State and its counties (including the City). Basic
program eligibility and benefits are determined by federal guidelines, but the
State provides a number of optional benefits and expanded eligibility. Program
costs have increased substantially in recent years, and account for a rising
share of the State budget. Federal law requires that the State adopt
reimbursement rates for hospitals and nursing homes that are reasonable and
adequate to meet the costs that must be incurred by efficiently and economically
operated facilities in providing patient care, a standard that has led to past
litigation by hospitals and nursing homes seeking higher reimbursement from the
State. The budget adopted for FY1995-96 and, in particular, the 1996-97
Executive Budget includes reductions in spending for Medicaid. Cutbacks in State
spending for Medicaid may adversely affect the financial condition of hospitals
and health care institutions that are the obligors of bonds that may be held by
the Fund.
THE STATE AUTHORITIES. The State's Authorities are not subject to the
constitutional restrictions on the incurrence of debt which apply to the State
itself, and may issue bonds and notes within the amounts of, and as otherwise
restricted by, their legislative authorization. The New York State Public
Authorities Control Board approves the issuance of debt and major contracts by
10 of the Authorities. As of September 30, 1994 (the date of the latest data
available), there were 18 Authorities that had outstanding debt of $100 million
or more, the aggregate debt of which (including refunding bonds and moral
obligation, lease-purchase, contractual obligation or State-guaranteed debt)
then totaled approximately $70.3 billion. As of March 31, 1995, aggregate public
authority debt outstanding as State-supported debt was $27.9 billion and
State-related debt was $36.1 billion. In recent years, the State has provided
financial assistance through appropriations, in some cases of a recurring
nature, to certain Authorities for operating and other expenses and (from 1976
to 1987) in fulfillment of its commitments on moral obligation indebtedness or
otherwise, for debt service. The State budgeted operating assistance of
approximately $1.3 billion for the Metropolitan Transportation Authority ('MTA')
during FY1994-95 and estimated total State assistance in FY1995-96 to be
approximately $1.1 billion. This assistance is expected to continue to be
required (and may increase) in future years. Failure by the State to appropriate
necessary amounts or to take other action to permit the Authorities to meet
their obligations could adversely affect the ability of the State and the
Authorities to obtain financing in the public credit markets and the market
price of the State's outstanding bonds and notes.
The MTA, whose credit rating was recently reduced, oversees the operation
of the City's subway and bus lines by its affiliates, the New York City Transit
Authority and the Manhattan and Bronx Surface Transit Operating Authority
(collectively, the 'TA'). MTA subsidiaries operate certain commuter rail and bus
lines in the New York metropolitan area. An affiliated agency, the Triborough
Bridge and Tunnel Authority ('TBTA'), operates certain intrastate toll bridges
and tunnels. To maintain its facilities and equipment, which deteriorated
significantly in the late 1970s due to deferred maintenance, the MTA prepares a
five year capital program subject to approval by the MTA Capital Program Review
Board. In April 1993, the State Legislature authorized the funding of a portion
of a five year $9.56 billion capital plan for the MTA for 1992 through 1996.
MTA's five year capital program for 1992-96 was approved by the State Capital
Program Review Board in December 1993. There can be no assurance that all
governmental actions for the 1992-96 Capital Program will be taken, that funding
sources currently identified will not be decreased or eliminated, or that the
Capital Program will not be delayed or reduced. If the Capital Program is
delayed or reduced, ridership and fare revenues may decline, which could impair
the MTA's ability to meet its operating expenses without additional State
assistance. In addition, because fares are not sufficient to finance its mass
transit operations, the MTA has depended and will continue to depend for
operating support upon a system of State, local government and TBTA support,
and, to the extent available, Federal assistance (including loans, grants and
operating
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subsidies). There can be no assurance that any such assistance will continue at
any particular level or in any fixed relationship to the operating costs and
capital needs of the MTA.
THE CITY. The City has required, and continues to require significant
financial assistance from the State. The City depends on the State to enable the
City to balance its budget and meet its cash requirements. In the early 1970s,
the City incurred substantial operating deficits, and its financial controls,
accounting practices and disclosure policies were widely criticized. In 1975,
the City encountered severe financial difficulties and lost access to the public
credit markets. The State Legislature responded in 1975 by creating the
Municipal Assistance Corporation For The City of New York ('MAC') to provide
financing assistance for the City and the Financial Control Board to exercise
certain oversight and review functions with respect to the City's finances. The
Financial Control Board's powers over the City were suspended in June 1986, but
would be reinstated (under current law) if the City experiences certain adverse
financial circumstances. At the time of the fiscal crisis the State provided
substantial financial assistance to the City, the Federal government provided
the City with direct seasonal loans and guarantees on the City's long-term debt
and the City's labor unions accepted deferrals of wage increases and approved
purchases of City bonds by the pension funds. No assurance can be given that
similar assistance would again be made available if needed, particularly given
the current budgetary constraints faced by both the Federal and State
governments.
The City provides services usually undertaken by counties, school districts
or special districts in other large urban areas, including the provision of
social services such as day care, foster care, health care, family planning,
services for the elderly and special employment services for needy individuals
and families who qualify for such assistance. State law requires the City to
allocate a large portion of its total budget to Board of Education operations,
and mandates that the City assume the local share of public assistance and
Medicaid costs. While the City has had GAAP operating surpluses in recent fiscal
years, the City has experienced growing financial difficulties, primarily
related to the impact of the recession on the local economy (reducing revenues
from most major taxes and increasing public assistance and Medicaid caseloads),
rising health care costs for City employees and for Medicaid and rising
inflation and interest rates. In response, the City implemented gap-closing
programs, which initially relied primarily on actions of a non-recurring nature,
but included substantial property tax rate increases and a personal income tax
surcharge imposed in FY1991 and selected service cutbacks. Reductions in State
aid, larger than budgeted labor settlements and increased police expenditures
added to the adverse budgetary impact of the local recession, confronting the
City with a potential $3.5 billion imbalance during FY1992 budget negotiations.
This initial budget gap was closed by adoption of a budget providing for various
tax increases and significant service reductions. Aid to nonprofit cultural
institutions in the City was significantly reduced (as was State aid to such
institutions), including certain institutions that are obligors of bonds that
may be held by a Fund.
The City's budget for FY1993-94 identified measures to close a $300 million
budget gap, which was the result of shortfalls in federal and State aid from
previously projected levels. The City achieved balanced operating results as
reported in accordance with GAAP for FY1993-94. For FY1994-95, the City adopted
a budget which halted the trend in recent years of substantial increases in
City-funded spending from one year to the next. The City budget adopted for
FY1995-96 reduces City-funded spending for the second consecutive year and the
City FY1996-97 Budget calls for reduction of City-funded spending for the third
consecutive year. Pursuant to State law, the City prepares a four-year annual
financial plan, which is reviewed and revised on a quarterly basis and includes
the City's capital, revenue and expense projections and outlines proposed budget
gap-closing programs for those years with projected budget gaps. The Mayor is
responsible for preparing the City's four-year financial plan including the
City's current financial plan for the 1997 through 2000 fiscal years (the
'1997-2000 Financial Plan'). The City's projections set forth in the 1996-1999
Financial Plan are based on various assumptions and contingencies which are
uncertain and which may not materialize.
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Changes in major assumptions could significantly effect the City's ability to
balance its budget and to meet its annual cash flow and financing requirements.
Such assumptions and contingencies include the timing and pace of a regional and
local economic recovery, increases in tax revenues, employment growth, the
ability to implement proposed reductions in City personnel and other cost
reduction initiatives which may require in certain cases the cooperation of the
City's municipal unions, the ability of New York City Health and Hospitals
Corporation and the Board of Education to take actions to offset reduced
revenues, the ability to complete revenue generating transactions, provision of
State and federal aid and mandate relief, and the impact on City revenues of
proposals for federal and State welfare reform. No assurance can be given that
the assumptions used by the City in the 1997-2000 Financial Plan will be
realized. Due to the uncertainty existing on the federal and state levels, the
ultimate adoption of the State budget for FY1996-97 may result in substantial
reductions in projected expenditures for social spending programs.
Cost-containment assumptions contained in the 1997-2000 Financial Plan and the
City FY1996-97 Budget may therefore be significantly adversely affected upon the
final adoption of the State budget for FY1996-97. Furthermore, actions taken in
recent fiscal years to avert deficits may have reduced the City's flexibility in
responding to future budgetary imbalances, and have deferred certain
expenditures to later fiscal years.
The City's original budget for FY1994-95 reflected proposed actions to
eliminate a $2.3 billion budget gap. The City submitted on July 21, 1995 a
fourth quarter modification to the City's financial plan for FY1994-95 which
projects a balanced budget in accordance with GAAP for the City's FY1994-95. On
July 11, 1995, the City submitted the 1996-1999 Financial Plan, which is based
on the City's expense and capital budgets for the City's FY1995-96 adopted on
June 14, 1995 (the '1996 City Budget'). The 1996 City Budget set forth proposed
actions by the City for FY1995-96 to close a substantial projected budget gap
(approximately $3.1 billion) resulting from lower than projected tax receipts
and other revenues and greater then projected expenditures. Proposed actions in
the 1996-1999 Financial Plan for the City's FY1995-96 included a reduction of
approximately $400 million primarily affecting public assistance and Medicaid
payments by the City, expenditure reductions in agencies totalling approximately
$1.2 billion and transitional labor savings of approximately $600 million. These
and other proposed actions were contained in the 1996-1999 Financial Plan as
well as the 1996 City Budget.
The City FY1996-97 Budget identifies a $2.6 billion budget gap which it
attempts to close by implementing a variety of actions, including an approximate
$1.2 billion reduction in City spending for a variety of services and programs,
a renewal of the 12.5% personal income tax surcharge and the use of non-
recurring measures estimated to provide approximately $1.4 billion in one-time
savings. The FY1996-97 Budget has been the subject of substantial criticism
questioning, among other things, the capacity of the City to generate future
revenues sufficient to meet expected expenditure increases and to provide
necessary municipal services. Such criticism has also noted the City's reliance
on non-recurring resources to close budget gaps and has charged that the City
has made no progress in achieving structural balance.
The City FY1996-97 Budget, like all City budgets, is subject to the ability
of the City to implement the reductions in expenditures, personal services and
personnel, which are substantial and may be difficult to implement. For example,
one of the key items contained in the 1996 City Budget is the sale of the City's
water system for approximately $2.3 billion. This plan has been hotly contested
since it was announced, has been the focus of several lawsuits and has been
ruled illegal by the lower court and the appeals court. It is unclear whether a
final appeal will be made. Further, the City FY1996-97 Budget and the 1997-2000
Financial Plan reflect the costs of tentative settlements with a coalition of
municipal unions which together represent approximately 2/3 of its workforce.
There can be no assurance that such proposed settlement will be ratified. In
addition, certain proposals may be offset by various State and federal
legislation which could mandate levels of City funding inconsistent with either
the City FY1996-97 Budget or the 1997-2000 Financial Plan. In
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addition, the 1997-2000 Financial Plan anticipates the receipt of substantial
amounts of Federal aid. Certain proposed State and federal actions are subject
to legislative, the governor's and the president's approvals, as applicable.
Both federal and State actions are uncertain. Certain legislative proposals
contemplate significant reductions in federal spending, including proposed
federal welfare reform which could result in caps on, or block grants of,
federal programs. Further, no assurance can be given that either such actions
will in fact be taken or that the projected savings will result even if such
actions are taken.
The City derives its revenues from a variety of local taxes, user charges,
miscellaneous revenues and federal and State unrestricted and categorical
grants. The City projects that local revenues will provide approximately 68.2%
of total revenues in FY1996-97 while federal aid, including categorical grants,
will provide 11.5% in FY1996-97 and State aid, including unrestricted aid and
categorical grants, will provide 20.3% in FY1996-97. As a proportion of total
revenues, State aid has remained relatively constant over the period from 1980
to 1995, while federal aid was sharply reduced (having provided nearly 20% of
total fiscal year 1980 revenues). The largest source of the City's revenues is
the real estate tax (approximately 21.5% of total revenues projected for
FY1996-97, at rates levied by the City council (subject to certain State
constitutional limits). The City derives the remainder of its tax revenues from
a variety of other economically sensitive local taxes (subject to authorization
by the legislature), including: a local sales and compensating use tax
(primarily dedicated to MAC debt service) imposed in addition to the State's
retail sales tax; the personal income tax on City residents and the earnings tax
on non-residents; a general corporation tax; and a financial corporation tax.
High tax burdens in the City impose political and economic constraints on the
ability of the City to increase local tax rates. The City's four-year financial
plans have been the subject of extensive public comment and criticism,
principally questioning the reasonableness of assumptions that the City will
have the capacity to generate sufficient revenues in the future to provide the
level of services contained in such City financial plans. On July 10, 1995, S&P
lowered the City's credit rating from A- to BBB+, among the lowest ratings of
any major city in the country. The rating agency cited specifically the City
budget's reliance on 'one-shot' measures to balance the budget for FY1995-96
without rectifying the underlying structural problems, its continued optimistic
projections of State and federal aid, and continued high debt levels.
The City is the largest municipal debt issuer in the nation, and has more
than doubled its debt load since the end of FY1987-88, in large measure to
rehabilitate its extensive, aging physical plant. The City's seasonal borrowing
needs increased significantly during FY1989-90 and FY1990-91, largely due to
delayed State aid payments, and totalled $2.25 billion in FY1991-92, $1.40
billion in FY1992-93, $1.75 billion in FY1993-94, $2.2 billion in FY1994-95 and
$2.4 billion in FY1995-96. The City's current capital financing program reflects
major reductions (approximately $2.13 billion) in the size of the capital
program to be implemented cumulatively through FY1998-99 which is intended to
reduce future debt service requirements. The reduced program was implemented to
meet the constraint of the forecast level of the State constitutional limits on
the City's power to incur debt. Such reductions may adversely affect the
condition of the City's aging and deteriorating infrastructure and physical
assets, such as sewers, streets, bridges and tunnels, and mass transit
facilities. Further, the City's capital financing program currently contemplates
receipt of proceeds of approximately $1 billion resulting from the sale of the
City's water system to the Water Board, and proposes to utilize a substantial
portion of such proceeds for capital project improvements. It is not certain
that such proceeds will become available for capital improvements, because, as
discussed above, the legality of the sale of the water system has been
challenged.
In November 1993, the voters approved a proposed charter whereby Staten
Island would secede from the City. Staten Island is one of five
counties/boroughs, comprising 4% of the City's population and 19% of its land
area. State law provides a complex mechanism for such secession.
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OTHER LOCALITIES. Certain localities in addition to the City could have
financial problems which, if significant, could lead to requests for additional
State assistance during the State's FY1995-96 and thereafter. Fiscal
difficulties experienced by the City of Yonkers, for example, could result in
State actions to allocate State resources in amounts that cannot yet be
determined. In the recent past, the State provided substantial financial
assistance to its political subdivisions, totaling approximately 68% of General
Fund disbursements in the State's FY1992-93, 69% for FY1993-94, 70% for
FY1994-95 and estimated to account for 69% of General Fund disbursements in
FY1995-96, primarily for aid to elementary, secondary and higher education and
Medicaid and income maintenance and local transportation programs. The
Legislature enacted substantial reductions from previously budgeted levels of
State aid since December 1990. To the extent the State is constrained by its
financial condition, State assistance to localities may be further reduced,
compounding the serious fiscal constraints already experienced by many local
governments. Localities also face anticipated and potential problems resulting
from pending litigation (including challenges to local property tax
assessments), judicial decisions and socioeconomic trends.
The total indebtedness of all localities in the State, other than New York
City, was approximately $17.7 billion as of the localities' fiscal years ending
during 1993 (the date of the latest data available). A small portion
(approximately $105 million) of this indebtedness represented borrowing to
finance budgetary deficits issued pursuant to enabling State legislation
(requiring budgetary review by the State Comptroller). Subsequently, certain
counties and other local governments have encountered significant financial
difficulties including the counties of Nassau, Suffolk, Monroe and Westchester
and the City of Buffalo. The State has imposed financial control on the City
from 1977 to 1986 and on the City of Yonkers since 1984 under an appointed
control board in response to fiscal crises encountered by such municipalities.
The Legislature imposed certain limited fiscal restraints on Nassau and Suffolk
counties, and authorized their issuance of deficit bonds to finance over several
years their respective 1992 operating deficits.
INVESTMENT LIMITATIONS OF THE FUNDS
FUNDAMENTAL LIMITATIONS. The following investment limitations cannot be
changed for the Funds without the affirmative vote of the lesser of (1) more
than 50% of the outstanding shares of the applicable Fund or (2) 67% or more of
the shares present at a shareholders' meeting if more than 50% of the
outstanding shares are represented at the meeting in person or by proxy. If a
percentage restriction is adhered to at the time of an investment or
transaction, later changes in percentage resulting from a change in values of
portfolio securities or the amount of total assets will not be considered a
violation of any of the following limitations.
Each Fund will not:
(1) purchase any security if, as a result of that purchase, 25% or
more of the Fund's total assets would be invested in securities of
issuers having their principal business activities in the same
industry, except that this limitation does not apply to securities
issued or guaranteed by the U.S. government, its agencies or
instrumentalities or to municipal securities.
(2) issue senior securities or borrow money, except as permitted under
the Investment Company Act of 1940 ('1940 Act') and then not in
excess of 33 1/3% of the Fund's total assets (including the amount
of the senior securities issued but reduced by any liabilities not
constituting senior securities) at the time of the issuance or
borrowing, except that the Fund may borrow up to an additional 5%
of its total assets (not including the amount borrowed) for
temporary or emergency purposes.
(3) make loans, except through loans of portfolio securities or
through repurchase agreements, provided that for purposes of this
restriction, the acquisition of bonds, debentures, other debt
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securities or instruments, or participations or other interests
therein and investments in government obligations, commercial
paper, certificates of deposit, bankers' acceptances or similar
instruments will not be considered the making of a loan.
(4) engage in the business of underwriting securities of other
issuers, except to the extent that the Fund might be considered an
underwriter under the federal securities laws in connection with
its disposition of portfolio securities.
(5) purchase or sell real estate, except that investments in
securities of issuers that invest in real estate and investments
in mortgage-backed securities, mortgage participations or other
instruments supported by interests in real estate are not subject
to this limitation, and except that the Fund may exercise rights
under agreements relating to such securities, including the right
to enforce security interests and to hold real estate acquired by
reason of such enforcement until that real estate can be
liquidated in an orderly manner.
(6) purchase or sell physical commodities unless acquired as a result
of owning securities or other instruments, but the Fund may
purchase, sell or enter into financial options and futures,
forward and spot currency contracts, swap transactions and other
financial contracts or derivative instruments.
(7) In addition, each of the Funds has a fundamental limitation
requiring it to invest, except for temporary defensive purposes or
under unusual market conditions, at least 80% of its net assets:
(a) in the case of California Tax-Free Income Fund, in debt
obligations issued by the State of California, its
municipalities and public authorities or by other issuers if
such obligations pay interest that is exempt from federal
income tax and California personal income tax and is not an
item of tax preference for purposes of the federal alternative
minimum tax ('AMT exempt interest');
(b) in the case of National Tax-Free Income Fund, in debt
obligations issued by states, municipalities and public
authorities and other issuers that pay interest that is exempt
from federal income tax ('municipal obligations') and that also
is AMT exempt interest;
(c) in the case of Municipal High Income Fund, in municipal
obligations; and
(d) in the case of New York Tax-Free Income Fund, in debt
obligations issued by the State of New York, its municipalities
and public authorities or by other issuers if such obligations
pay interest that is exempt from federal income tax as well as
New York State and New York City personal income taxes and is
AMT exempt interest.
In addition, California Tax-Free Income Fund and National Tax-Free Income
Fund each will not:
(8) purchase securities of any one issuer if, as a result, more than
5% of the Fund's total assets would be invested in securities of
that issuer or the Fund would own or hold more than 10% of the
outstanding voting securities of that issuer, except that up to
25% of the Fund's total assets may be invested without regard to
this limitation, and except that this limitation does not apply to
securities issued or guaranteed by the U.S. government, its
agencies and instrumentalities or to securities issued by other
investment companies.
The following interpretation applies to, but is not a part of,
fundamental restriction (8): Each state (including the District
of Columbia and Puerto Rico), territory and possession of the
United States, each political subdivision, agency,
instrumentality and authority thereof, and each multi-state
agency of which a state is a member is a separate 'issuer.' When
the assets and
24
<PAGE>
revenues of an agency, authority, instrumentality or other
political subdivision are separate from the government creating
the subdivision and the security is backed only by the assets
and revenues of the subdivision, such subdivision would be
deemed to be the sole issuer. Similarly, in the case of an IDB
or PAB, if that bond is backed only by the assets and revenues
of the non-governmental user, then that non-governmental user
would be deemed to be the sole issuer. However, if the creating
government or another entity guarantees a security, then to the
extent that the value of all securities issued or guaranteed by
that government or entity and owned by the Fund exceeds 10% of
the Fund's total assets, the guarantee would be considered a
separate security and would be treated as issued by that
government or entity.
NON-FUNDAMENTAL LIMITATIONS. The following investment restrictions may be
changed by each Trust's board of trustees without shareholder approval.
Each Fund will not:
(1) purchase any security if as a result of such purchase more than 5%
of its assets would be invested in securities with respect to
which payment of interest and principal are the responsibility of
a company, including its predecessors, with less than three years'
operating history.
(2) invest more than 10% of its net assets in illiquid securities, a
term which means securities that cannot be disposed of within
seven days in the ordinary course of business at approximately the
amount at which the Fund has valued the securities and includes,
among other things, repurchase agreements maturing in more than
seven days.
(3) make investments in warrants if such investments, valued at the
lower of cost or market, exceed 5% of the value of its net assets,
which amount may include warrants that are not listed on the New
York Stock Exchange, Inc. ('NYSE') or the American Stock Exchange,
Inc. ('AMEX'), provided that such unlisted warrants, valued at the
lower of cost or market, do not exceed 2% of the Fund's net assets
and further provided that this restriction does not apply to
warrants attached to, or sold as a unit with, other securities.
(4) purchase or retain the securities of any issuer if the officers
and trustees of the Fund and the officers and directors of
Mitchell Hutchins (each owning beneficially more than 0.5% of the
outstanding securities of an issuer) own in the aggregate more
than 5% of the securities of an issuer.
(5) purchase securities on margin, except for short-term credit
necessary for clearance of portfolio transactions and except that
the Fund may make margin deposits in connection with its use of
financial options and futures, forward and spot currency
contracts, swap transactions and other financial contracts or
derivative instruments.
(6) engage in short sales of securities or maintain a short position,
except that the Fund may (a) sell short 'against the box' and (b)
maintain short positions in connection with its use of financial
options and futures, forward and spot currency contracts, swap
transactions and other financial contracts or derivative
instruments.
(7) invest in oil, gas or mineral exploration or development programs
or leases, except that investments in securities of issuers that
invest in such programs or leases and investments in asset-backed
securities supported by receivables generated from such programs
or leases are not subject to this prohibition.
25
<PAGE>
(8) purchase securities of other investment companies, except to the
extent permitted by the 1940 Act and except that this limitation
does not apply to securities received or acquired as dividends,
through offers of exchange, or as a result of reorganization,
consolidation, or merger.
(9) purchase securities while borrowings in excess of 5% of its total
assets are outstanding.
(10) invest in real estate limited partnerships.
In addition, California Tax-Free Income Fund, National Tax-Free Income Fund
and New York Tax-Free Income Fund each will not:
(11) change its investment policies to invest more than 35% of its
total assets in debt securities rated Ba or lower by Moody's or
BB or lower by S&P, comparably rated by another NRSRO or
determined by Mitchell Hutchins to be of comparable quality
without giving at least 30 days' advance notice to shareholders.
It is possible that one or more of the Funds from time to time will invest
more than 25% of its total assets in a particular segment of the municipal
securities market, such as hospital revenue bonds, housing agency bonds, IDBs,
PABs or airport bonds or in securities the interest upon which is paid from
revenues of a similar type of project. In such circumstances, economic,
business, political or other changes affecting one bond might also affect other
bonds in the same segment, thereby potentially increasing market risk.
26
<PAGE>
HEDGING AND RELATED INCOME STRATEGIES
As discussed in the Prospectus, Mitchell Hutchins may use a variety of
financial instruments ('Hedging Instruments'), including certain options,
futures contracts (sometimes referred to as 'futures') and options on futures
contracts, to attempt to hedge the Funds' portfolios or to attempt to enhance
the Funds' income. In particular, each Fund may use the Hedging Instruments
described below:
OPTIONS ON DEBT SECURITIES--A call option is a short-term contract pursuant
to which the purchaser of the option, in return for a premium, has the right to
buy the security underlying the option at a specified price at any time during
the term of the option. The writer of the call option, who receives the premium,
has the obligation, upon exercise of the option during the option term, to
deliver the underlying security against payment of the exercise price. A put
option is a similar contract which gives its purchaser, in return for a premium,
the right to sell the underlying security at a specified price during the option
term. The writer of the put option, who receives the premium, has the
obligation, upon exercise during the option term, to buy the underlying security
at the exercise price. Options on debt securities are traded primarily in the
OTC market rather than on any of the several options exchanges. At present, only
options on U.S. Treasury securities are listed for trading on any recognized
exchange.
OPTIONS ON INDEXES OF DEBT SECURITIES--An index assigns relative values to
the securities included in the index and fluctuates with changes in the market
values of such securities. Index options operate in the same way as more
traditional options except that exercises of index options are effected with
cash payments and do not involve delivery of securities. Thus, upon exercise of
an index option, the purchaser will realize and the writer will pay an amount
based on the difference between the exercise price and the closing price of the
index. Currently, options on indexes of debt securities do not exist.
MUNICIPAL BOND INDEX FUTURES CONTRACTS--A municipal bond index futures
contract is a bilateral agreement pursuant to which one party agrees to accept
and the other party agrees to make delivery of an amount of cash equal to a
specified dollar amount times the difference between the index value at the
close of trading of the contract and the price at which the futures contract is
originally struck. No physical delivery of the bonds comprising the index is
made; generally contracts are closed out prior to the expiration date of the
contract.
MUNICIPAL DEBT AND INTEREST RATE FUTURES CONTRACTS--A municipal debt or
interest rate futures contract is a bilateral agreement pursuant to which one
party agrees to accept and the other party agrees to make delivery of the
specific type of debt security called for in the contract at a specified future
time and at a specified price. Although such futures contracts by their terms
call for actual delivery or acceptance of debt securities, in most cases the
contracts are closed out before the settlement date without the making or taking
of delivery. Currently there is no public market for municipal debt futures
contracts.
OPTIONS ON FUTURES CONTRACTS--Options on futures contracts are similar to
options on securities except that an option on a futures contract gives the
purchaser the right, in return for the premium, to assume a position in a
futures contract (a long position if the option is a call and a short position
if the option is a put), rather than to purchase or sell a security, at a
specified price at any time during the option term. Upon exercise of the option,
the delivery of the futures position to the holder of the option will be
accompanied by delivery of the accumulated balance, which represents the amount
by which the market price of the futures contract exceeds, in the case of a
call, or is less than, in the case of a put, the exercise price of the option on
the future. The writer of an option, upon exercise, will assume a short position
in the case of a call, and a long position in the case of a put.
27
<PAGE>
GENERAL DESCRIPTION OF HEDGING STRATEGIES. Hedging strategies can be
broadly categorized as 'short hedges' and 'long hedges.' A short hedge is a
purchase or sale of a Hedging Instrument intended to partially or fully offset
potential declines in the value of one or more investments held in a Fund's
portfolio. Thus, in a short hedge a Fund takes a position in a Hedging
Instrument whose price is expected to move in the opposite direction of the
price of the investment being hedged. For example, a Fund might purchase a put
option on a security to hedge against a potential decline in the value of that
security. If the price of the security declined below the exercise price of the
put, the Fund could exercise the put and thus limit its loss below the exercise
price to the premium paid plus transaction costs. In the alternative, because
the value of the put option can be expected to increase as the value of the
underlying security declines, the Fund might be able to close out the put option
and realize a gain to offset the decline in the value of the security.
Conversely, a long hedge is a purchase or sale of a Hedging Instrument
intended partially or fully to offset potential increases in the acquisition
cost of one or more investments that a Fund intends to acquire. Thus, in a long
hedge a Fund takes a position in a Hedging Instrument whose price is expected to
move in the same direction as the price of the prospective investment being
hedged. For example, a Fund might purchase a call option on a security it
intends to purchase in order to hedge against an increase in the cost of the
security. If the price of the security increased above the exercise price of the
call, the Fund could exercise the call and thus limit its acquisition cost to
the exercise price plus the premium paid and transaction costs. Alternatively,
the Fund might be able to offset the price increase by closing out an
appreciated call option and realizing a gain.
Hedging Instruments on securities generally are used to hedge against price
movements in one or more particular securities positions that a Fund owns or
intends to acquire. Hedging Instruments on debt securities may be used to hedge
either individual securities or broad fixed income market sectors.
The use of Hedging Instruments is subject to applicable regulations of the
Securities and Exchange Commission ('SEC'), the several options and futures
exchanges upon which they are traded, the Commodity Futures Trading Commission
('CFTC') and various state regulatory authorities. In addition, a Fund's ability
to use Hedging Instruments will be limited by tax considerations. See 'Taxes.'
In addition to the products, strategies and risks described below, Mitchell
Hutchins expects to discover additional opportunities in connection with
options, futures contracts and other hedging techniques. These new opportunities
may become available as Mitchell Hutchins develops new techniques, as regulatory
authorities broaden the range of permitted transactions and as new options,
futures contracts or other techniques are developed. Mitchell Hutchins may
utilize these opportunities to the extent that they are consistent with the
Funds' investment objectives and permitted by the Funds' investment limitations
and applicable regulatory authorities. The Funds' Prospectus or SAI will be
supplemented to the extent that new products or techniques involve materially
different risks than those described below or in the Prospectus.
SPECIAL RISKS OF HEDGING STRATEGIES. The use of Hedging Instruments
involves special considerations and risks, as described below. Risks pertaining
to particular Hedging Instruments are described in the sections that follow.
(1) Successful use of most Hedging Instruments depends upon Mitchell
Hutchins' ability to predict movements of the overall securities and interest
rate markets, which requires different skills than predicting changes in the
prices of individual securities. While Mitchell Hutchins is experienced in the
use of Hedging Instruments, there can be no assurance that any particular
hedging strategy adopted will succeed.
(2) There might be imperfect correlation, or even no correlation, between
price movements of a Hedging Instrument and price movements of the investments
being hedged. For example, if the value of a Hedging Instrument used in a short
hedge increased by less than the decline in value of the hedged investment, the
28
<PAGE>
hedge would not be fully successful. Such a lack of correlation might occur due
to factors unrelated to the value of the investments being hedged, such as
speculative or other pressures on the markets in which Hedging Instruments are
traded. The effectiveness of hedges using Hedging Instruments on indices will
depend on the degree of correlation between price movements in the index and
price movements in the securities being hedged.
(3) Hedging strategies, if successful, can reduce risk of loss by wholly or
partially offsetting the negative effect of unfavorable price movements in the
investments being hedged. However, hedging strategies can also reduce
opportunity for gain by offsetting the positive effect of favorable price
movements in the hedged investments. For example, if a Fund entered into a short
hedge because Mitchell Hutchins projected a decline in the price of a security
in the Fund's portfolio, and the price of that security increased instead, the
gain from that increase might be wholly or partially offset by a decline in the
price of the Hedging Instrument. Moreover, if the price of the Hedging
Instrument declined by more than the increase in the price of the security, the
Fund could suffer a loss. In either such case, the Fund would have been in a
better position had it not hedged at all.
(4) As described below, a Fund might be required to maintain assets as
'cover,' maintain segregated accounts or make margin payments when it takes
positions in Hedging Instruments involving obligations to third parties (i.e.,
Hedging Instruments other than purchased options). If a Fund were unable to
close out its positions in such Hedging Instruments, it might be required to
continue to maintain such assets or accounts or make such payments until the
position expired or matured. These requirements might impair a Fund's ability to
sell a portfolio security or make an investment at a time when it would
otherwise be favorable to do so, or require that a Fund sell a portfolio
security at a disadvantageous time. A Fund's ability to close out a position in
a Hedging Instrument prior to expiration or maturity depends on the existence of
a liquid secondary market or, in the absence of such a market, the ability and
willingness of a contra party to enter into a transaction closing out the
position. Therefore, there is no assurance that any hedging position can be
closed out at a time and price that is favorable to the Fund.
COVER FOR HEDGING STRATEGIES. Transactions using Hedging Instruments,
other than purchased options, expose a Fund to an obligation to another party. A
Fund will not enter into any such transactions unless it owns either (1) an
offsetting ('covered') position in securities or other options or futures
contracts or (2) cash or liquid securities, with a value sufficient at all times
to cover its potential obligations to the extent not covered as provided in (1)
above. Each Fund will comply with SEC guidelines regarding cover for hedging
transactions and will, if the guidelines so require, set aside cash or liquid
securities in a segregated account with its custodian in the prescribed amount.
Assets used as cover or held in a segregated account cannot be sold while
the position in the corresponding Hedging Instrument is open, unless they are
replaced with similar assets. As a result, the commitment of a large portion of
a Fund's assets to cover or segregated accounts could impede portfolio
management or the Fund's ability to meet redemption requests or other current
obligations.
OPTIONS. The Funds may purchase put and call options, and write (sell)
covered put and call options, on debt securities. The purchase of call options
serves as a long hedge, and the purchase of put options serves as a short hedge.
Writing covered put or call options can enable a Fund to enhance income by
reason of the premiums paid by the purchasers of such options. However, if the
market price of the security underlying a covered put option declines to less
than the exercise price of the option, minus the premium received, the Fund
would expect to suffer a loss. Writing covered call options serves as a limited
short hedge, because declines in the value of the hedged investment would be
offset to the extent of the premium received for writing the option. However, if
the security appreciates to a price higher than the exercise price of the call
29
<PAGE>
option, it can be expected that the option will be exercised and the Fund will
be obligated to sell the security at less than its market value. If the covered
call option is an OTC option, the securities or other assets used as cover would
be considered illiquid to the extent described under 'Investment Policies and
Restrictions-- Illiquid Securities.'
The value of an option position will reflect, among other things, the
current market value of the underlying investment, the time remaining until
expiration, the relationship of the exercise price to the market price of the
underlying investment, the historical price volatility of the underlying
investment and general market conditions. Options normally have expiration dates
of up to nine months. Generally, OTC options on debt securities are European
style options. This means that the option is only exercisable immediately prior
to its expiration. This is in contrast to American-style options, which are
exercisable at any time prior to the expiration date of the option. Options that
expire unexercised have no value.
A Fund may effectively terminate its right or obligation under an option by
entering into a closing transaction. For example, a Fund may terminate its
obligation under a call or put option that it had written by purchasing an
identical call or put option; this is known as a closing purchase transaction.
Conversely, a Fund may terminate a position in a put or call option it had
purchased by writing an identical put or call option; this is known as a closing
sale transaction. Closing transactions permit a Fund to realize profits or limit
losses on an option position prior to its exercise or expiration.
The Funds may purchase or write both exchange-traded and OTC options.
However, exchange-traded or liquid OTC options on municipal debt securities are
not currently available. Exchange markets for options on debt securities exist
but are relatively new, and these instruments are primarily traded on the OTC
market. Exchange-traded options in the United States are issued by a clearing
organization affiliated with the exchange on which the option is listed which,
in effect, guarantees completion of every exchange-traded option transaction. In
contrast, OTC options are contracts between the Fund and its contra party
(usually a securities dealer or a bank) with no clearing organization guarantee.
Thus, when the Fund purchases or writes an OTC option, it relies on the contra
party to make or take delivery of the underlying investment upon exercise of the
option. Failure by the contra party to do so would result in the loss of any
premium paid by the Fund as well as the loss of any expected benefit of the
transaction. The Funds will enter into OTC option transactions only with contra
parties that have a net worth of at least $20 million.
A Fund's ability to establish and close out positions in exchange-listed
options depends on the existence of a liquid market. Each Fund intends to
purchase or write only those exchange-traded options for which there appears to
be a liquid secondary market. However, there can be no assurance that such a
market will exist at any particular time. Closing transactions can be made for
OTC options only by negotiating directly with the contra party, or by a
transaction in the secondary market if any such market exists. Although a Fund
will enter into OTC options only with contra parties that are expected to be
capable of entering into closing transactions with the Fund, there is no
assurance that the Fund will in fact be able to close out an OTC option position
at a favorable price prior to expiration. In the event of insolvency of the
contra party, the Fund might be unable to close out an OTC option position at
any time prior to its expiration.
If a Fund were unable to effect a closing transaction for an option it had
purchased, it would have to exercise the option to realize any profit. The
inability to enter into a closing purchase transaction for a covered call option
written by a Fund could cause material losses because the Fund would be unable
to sell the investment used as cover for the written option until the option
expires or is exercised.
In the event that options on indices of municipal and non-municipal debt
securities become available, a Fund may purchase and write put and call options
on such indices in much the same manner as the more traditional options
discussed above, except that index options may serve as a hedge against overall
fluctuations
30
<PAGE>
in the debt securities markets (or market sectors) rather than anticipated
increases or decreases in the value of a particular security.
GUIDELINES FOR OPTIONS. A Fund's use of options is governed by the
following guidelines, which can be changed by each Trust's board of trustees
without shareholder vote:
1. A Fund may purchase a put or call option, including any straddles
or spreads, only if the value of its premium, when aggregated with the
premiums on all other options held by the Fund, does not exceed 5% of the
Fund's total assets.
2. The aggregate value of securities underlying put options written by
any Fund determined as of the date the put options are written will not
exceed 50% of the Fund's net assets.
3. The aggregate premiums paid on all options (including options on
securities and indices of debt securities and options on futures contracts)
purchased by the Fund that are held at any time will not exceed 20% of the
Fund's net assets.
FUTURES. The Funds may purchase and sell municipal bond index futures
contracts, municipal debt futures contracts and interest rate futures contracts.
The Funds also may purchase put and call options, and write covered put and call
options, on such futures contracts. The purchase of futures or call options
thereon can serve as a long hedge, and the sale of futures or the purchase of
put options thereon can serve as a short hedge. Writing covered call options on
futures contracts can serve as a limited short hedge, and writing covered put
options on futures contracts can serve as a limited long hedge, using a strategy
similar to that used for writing covered call options on securities or indices.
Futures strategies also can be used to manage the average duration of a
Fund's portfolio. If Mitchell Hutchins wishes to shorten the average duration of
a Fund, the Fund may sell a futures contract or a call option thereon, or
purchase a put option on that futures contract. If Mitchell Hutchins wishes to
lengthen the average duration of a Fund, the Fund may buy a futures contract or
a call option thereon, or sell a put option thereon.
No price is paid upon entering into a futures contract. Instead, at the
inception of a futures contract a Fund is required to deposit in a segregated
account with its custodian, in the name of the futures broker through whom the
transaction was effected, 'initial margin' consisting of cash, U.S. government
securities or other liquid, high-grade debt securities, in an amount generally
equal to 10% or less of the contract value. Margin must also be deposited when
writing a call option on a futures contract, in accordance with applicable
exchange rules. Unlike margin in securities transactions, initial margin on
futures contracts does not represent a borrowing, but rather is in the nature of
a performance bond or good-faith deposit that is returned to the Fund at the
termination of the transaction if all contractual obligations have been
satisfied. Under certain circumstances, such as periods of high volatility, the
Fund may be required by an exchange to increase the level of its initial margin
payment, and initial margin requirements might be increased generally in the
future by regulatory action.
Subsequent 'variation margin' payments are made to and from the futures
broker daily as the value of the futures position varies, a process known as
'marking to market.' Variation margin does not involve borrowing, but rather
represents a daily settlement of the Fund's obligations to or from a futures
broker. When a Fund purchases an option on a future, the premium paid plus
transaction costs is all that is at risk. In contrast, when a Fund purchases or
sells a futures contract or writes a call or put option thereon, it is subject
to daily variation margin calls that could be substantial in the event of
adverse price movements. If the Fund has insufficient cash to meet daily
variation margin requirements, it might need to sell securities at a time when
such sales are disadvantageous.
31
<PAGE>
Holders and writers of futures positions and options on futures can enter
into offsetting closing transactions, similar to closing transactions on
options, by selling or purchasing, respectively, an instrument identical to the
instrument held or written. Positions in futures and options on futures may be
closed only on an exchange or board of trade that provides a secondary market.
Each Fund intends to enter into futures transactions only on exchanges or boards
of trade where there appears to be a liquid secondary market. However, there can
be no assurance that such a market will exist for a particular contract at a
particular time.
Under certain circumstances, futures exchanges may establish daily limits
on the amount that the price of a future or related option can vary from the
previous day's settlement price; once that limit is reached, no trades may be
made that day at a price beyond the limit. Daily price limits do not limit
potential losses because prices could move to the daily limit for several
consecutive days with little or no trading, thereby preventing liquidation of
unfavorable positions.
If a Fund were unable to liquidate a futures or related options position
due to the absence of a liquid secondary market or the imposition of price
limits, it could incur substantial losses. The Fund would continue to be subject
to market risk with respect to the position. In addition, except in the case of
purchased options, the Fund would continue to be required to make daily
variation margin payments and might be required to maintain the position being
hedged by the future or option or to maintain cash or securities in a segregated
account.
Certain characteristics of the futures market might increase the risk that
movements in the prices of futures contracts or related options might not
correlate perfectly with movements in the prices of the investments being
hedged. For example, all participants in the futures and related options markets
are subject to daily variation margin calls and might be compelled to liquidate
futures or related options positions whose prices are moving unfavorably to
avoid being subject to further calls. These liquidations could increase price
volatility of the instruments and distort the normal price relationship between
the futures or options and the investments being hedged. Also, because initial
margin deposit requirements in the futures market are less onerous than margin
requirements in the securities markets, there might be increased participation
by speculators in the futures markets. This participation also might cause
temporary price distortions. In addition, activities of large traders in both
the futures and securities markets involving arbitrage, 'program trading' and
other investment strategies might result in temporary price distortions.
GUIDELINES FOR FUTURES AND RELATED OPTIONS. A Fund's use of futures and
related options is governed by the following guidelines, which can be changed by
each Trust's board of trustees without shareholder vote:
1. To the extent a Fund enters into futures contracts and options on
futures positions that are not for bona fide hedging purposes (as defined
by the CFTC), the aggregate initial margin and premiums on those positions
(excluding the amount by which options are 'in-the-money') may not exceed
5% of the Fund's net assets.
2. The aggregate premiums paid on all options (including options on
securities and indices of debt securities and options on futures contracts)
purchased by any Fund that are held at any time will not exceed 20% of the
Fund's net assets.
3. The aggregate margin deposits on all futures contracts and options
thereon held at any time by the Fund will not exceed 5% of the Fund's total
assets.
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<PAGE>
TRUSTEES AND OFFICERS
The trustees and executive officers of each Trust, their ages, business
addresses and principal occupations during the past five years are:
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
Margo N. Alexander**; 49 Trustee and Mrs. Alexander is president,
President chief executive officer and
a director of Mitchell
Hutchins (since January
1995) and also an executive
vice president and a
director of PaineWebber.
Mrs. Alexander is president
and a director or trustee of
30 investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Richard Q. Armstrong; 61 Trustee Mr. Armstrong is chairman and
78 West Brother Drive principal of RQA Enterprises
Greenwich, CT 06830 (management consulting firm)
(since April 1991 and
principal occupation since
March 1995). Mr. Armstrong
is also a director of Hi Lo
Automotive, Inc. He was
chairman of the board, chief
executive officer and
co-owner of Adirondack
Beverages (producer and
distributor of soft drinks
and sparkling/still waters)
(October 1993-March 1995).
Mr. Armstrong was a partner
of The New England
Consulting Group (management
consulting firm) (December
1992- September 1993). He
was managing director of
LVMH U.S. Corporation (U.S.
subsidiary of the French
luxury goods conglomerate,
Luis Vuitton Moet Hennessey
Corporation) (1987-1991) and
chairman of its wine and
spirits subsidiary,
Schieffelin & Somerset
Company (1987-1991). Mr.
Armstrong is a director or
trustee of 29 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
E. Garrett Bewkes, Jr.**; 69 Trustee and Mr. Bewkes is a director of
Chairman of the Paine Webber Group Inc. ('PW
Board of Group') (holding company of
Trustees PaineWebber and Mitchell
Hutchins). Prior to December
1995, he was a consultant to
PW Group. Prior to 1988, he
was chairman of the board,
president and chief
executive officer of
American Bakeries Company.
Mr. Bewkes is also a
director of Interstate
Bakeries Corporation and
NaPro BioTherapeutics, Inc.
Mr. Bewkes is a director or
trustee of 30 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
</TABLE>
33
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
Richard R. Burt; 49 Trustee Mr. Burt is chairman of
1101 Connecticut Avenue, N.W. International Equity
Washington, D.C. 20036 Partners (international
investments and consulting
firm) (since March 1994) and
a partner of McKinsey &
Company (management
consulting firm) (since
1991). He is also a director
of American Publishing
Company. He was the chief
negotiator in the Strategic
Arms Reduction Talks with
the former Soviet Union
(1989-1991) and the U.S.
Ambassador to the Federal
Republic of Germany
(1985-1989). Mr. Burt is a
director or trustee of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Mary C. Farrell**; 46 Trustee Ms. Farrell is a managing
director, senior investment
strategist and member of the
Investment Policy Committee
of PaineWebber. Ms. Farrell
joined PaineWebber in 1982.
She is a member of the
Financial Women's
Association and Women's
Economic Roundtable, and is
employed as a regular
panelist on Wall $treet Week
with Louis Rukeyser. She
also serves on the Board of
Overseers of New York
University's Stern School of
Business. Ms. Farrell is a
director or trustee of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Meyer Feldberg; 54 Trustee Mr. Feldberg is Dean and
Columbia University Professor of Management of
101 Uris Hall the Graduate School of
New York, New York 10027 Business, Columbia
University. Prior to 1989,
he was president of the
Illinois Institute of
Technology. Dean Feldberg is
also a director of AMSCO
International Inc. (medical
instruments and supplies),
Federated Department Stores,
Inc. and New World
Communications Group
Incorporated. Dean Feldberg
is a director or trustee of
29 investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
George W. Gowen; 66 Trustee Mr. Gowen is a partner in the
666 Third Avenue law firm of Dunnington,
New York, New York 10017 Bartholow & Miller. Prior to
May 1994, he was a partner
in the law firm of Fryer,
Ross & Gowen. Mr. Gowen is a
director of Columbia Real
Estate Investments, Inc. Mr.
Gowen is a director or
trustee of 29 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
</TABLE>
34
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
Frederic V. Malek; 59 Trustee Mr. Malek is chairman of
901 15th Street, N.W. Thayer Capital Partners
Suite 300 (investment bank) and a
Washington, D.C. 20005 co-chairman and director of
CB Commercial Group Inc.
(real estate). From January
1992 to November 1992, he
was campaign manager of
Bush-Quayle '92. From 1990
to 1992, he was vice
chairman and, from 1989 to
1990, he was president of
Northwest Airlines Inc., NWA
Inc. (holding company of
Northwest Airlines Inc.) and
Wings Holdings Inc. (holding
company of NWA Inc.). Prior
to 1989, he was employed by
the Marriott Corporation
(hotels, restaurants,
airline catering and
contract feeding), where he
most recently was an
executive vice president and
president of Marriott Hotels
and Resorts. Mr. Malek is
also a director of American
Management Systems, Inc.,
(mangement consulting and
computer related services),
Automatic Data Processing,
Inc., Avis, Inc., (passenger
car rental), FPL Group,
Inc., (electric services),
National Education
Corporation and Northwest
Airlines Inc. Mr. Malek is a
director or trustee of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Carl W. Schafer; 60 Trustee Mr. Schafer is president of
P.O. Box 1164 the Atlantic Foundation
Princeton, New Jersey 08542 (charitable foundation
supporting mainly
oceanographic exploration
and research). He also is a
director of Roadway Express,
Inc. (trucking), The
Guardian Group of Mutual
Funds, Evans Systems, Inc.
(a motor fuels, convenience
store and diversified
company), Hidden Lake Gold
Mines Ltd. (gold mining),
Electronic Clearing House,
Inc. (financial transactions
processing), Wainoco Oil
Corporation and Nutraceutix,
Inc. (biotechnology). Prior
to January 1993, Mr. Schafer
was chairman of the
Investment Advisory
Committee of the Howard
Hughes Medical Institute.
Mr. Schafer is a director or
trustee of 29 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
John R. Torell III; 56 Trustee Mr. Torell is chairman of
767 Fifth Avenue Torell Management, Inc.
Suite 4605 (financial advisory firm),
New York, NY 10153 chairman of Telesphere
Corporation (electronic
provider of financial
information) and a partner
of Zilkha & Company
(merchant banking and
private investment company).
</TABLE>
35
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
He is the former chairman
and chief executive officer
of Fortune Bancorp
(1990-1991 and 1990-1994,
respectively), the former
chairman, president and
chief executive officer of
CalFed, Inc. (savings
association) (1988 to 1989)
and former president of
Manufacturers Hanover Corp.
(bank) (prior to 1988). Mr.
Torell is a director of
American Home Products
Corp., New Colt Inc.
(armament manufacturer) and
Volt Information Sciences
Inc. Mr. Torell is a
director or trustee of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Cynthia N. Bow; 37 Vice President Ms. Bow is a vice president of
(PW Mutual Fund Mitchell Hutchins. Ms. Bow
Trust only) has been with Mitchell
Hutchins since 1982. Ms. Bow
is a vice president of two
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Teresa M. Boyle; 37 Vice President Ms. Boyle is a first vice
president and
manager--advisory
administration of Mitchell
Hutchins. Prior to November
1993, she was Compliance
Manager of Hyperion Capital
Management, Inc., an
investment advisory firm.
Prior to April 1993, Ms.
Boyle was a vice president
and manager--legal
administration of Mitchell
Hutchins. Ms. Boyle is a
vice president of 30
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Elbridge T. Gerry III; 39 Vice President Mr. Gerry is a senior vice
president and a portfolio
manger of Mitchell Hutchins.
Prior to January 1996, he
was with JP Morgan Private
Banking where he was
responsible for managing
municipal assets, including
several municipal bond
funds. Mr. Gerry is a vice
president of four investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
C. William Maher; 35 Vice President Mr. Maher is a first vice
and Assistant president and a senior
Treasurer manager of the mutual fund
finance division of Mitchell
Hutchins. Mr. Maher is a
vice president and assistant
treasurer of 30 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Dennis McCauley; 49 Vice President Mr. McCauley is a managing
director and chief
investment officer--fixed
income of Mitchell
</TABLE>
36
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
Hutchins. Prior to December
1994, he was director of
fixed income investments of
IBM Corporation. Mr.
McCauley is a vice president
of 19 investment companies
for which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
Ann E. Moran; 38 Vice President Ms. Moran is a vice president
and Assistant of Mitchell Hutchins. Ms.
Treasurer Moran is a vice president
and assistant treasurer of
30 investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Richard S. Murphy; 40 Vice President Mr. Murphy is a senior vice
(PW Mutual Fund president of Mitchell
Trust only) Hutchins. Prior to March
1994 Mr. Murphy was a vice
president at American
International Group.
Dianne E. O'Donnell; 44 Vice President Ms. O'Donnell is a senior vice
and Secretary president and deputy general
counsel of Mitchell
Hutchins. Ms. O'Donnell is a
vice president and secretary
of 29 investment companies
for which Mitchell Hutchins
or PaineWebber serves as
investment adviser.
Victoria E. Schonfeld; 45 Vice President Ms. Schonfeld is a managing
director and general counsel
of Mitchell Hutchins. Prior
to May 1994, she was a
partner in the law firm of
Arnold & Porter. Ms.
Schonfeld is a vice
president of 30 investment
companies for which Mitchell
Hutchins or PaineWebber
serves as investment
adviser.
Paul H. Schubert; 33 Vice President Mr. Schubert is a first vice
and Assistant president and a senior
Treasurer manager of the mutual fund
finance division of Mitchell
Hutchins. From August 1992
to August 1994, he was a
vice president of BlackRock
Financial Management L.P.
Prior to August 1992, he was
an audit manager with Ernst
& Young LLP. Mr. Schubert is
a vice president and
assistant treasurer of 30
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
Julian F. Sluyters; 35 Vice President Mr. Sluyters is a senior vice
and Treasurer president and the director
of the mutual fund finance
division of Mitchell
Hutchins. Prior to 1991, he
was an audit senior manager
with Ernst & Young LLP. Mr.
Sluyters is a vice president
and treasurer of 30
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
</TABLE>
37
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ --------------- ------------------------------
<S> <C> <C>
William W. Veronda; 49 Vice President Mr. Veronda is a senior vice
(PW Municipal president of Mitchell
Series only) Hutchins. Prior to September
1995, he was a senior vice
president and general
manager at Invesco Funds
Group.
Keith A. Weller, 34 Vice President Mr. Weller is a first vice
and Assistant president and associate
Secretary general counsel of Mitchell
Hutchins. Prior to May 1995,
he was an attorney in
private practice. Mr. Weller
is a vice president and
assistant secretary of 29
investment companies for
which Mitchell Hutchins or
PaineWebber serves as
investment adviser.
</TABLE>
- ------------------
* Unless otherwise indicated, the business address of each listed person is
1285 Avenue of the Americas, New York, New York 10019.
** Mrs. Alexander, Mr. Bewkes and Ms. Farrell are 'interested persons' of the
Trusts as defined in the 1940 Act by virtue of their positions with Mitchell
Hutchins, PaineWebber and/or PW Group.
Each Trust pays trustees who are not 'interested persons' of the Trust
('disinterested trustees') $1,000 annually for each series and $150 for each
board meeting and each meeting of a board committee (other than committee
meetings held on the same day as a board meeting). Each Trust presently has two
series and thus pays each such trustee $2,000 annually, plus any additional
annual amounts due for board or committee meetings. Messrs. Feldberg and Torell
each receive additional annual compensation from the PaineWebber fund complex
(including the Trusts) of $15,000 for serving as chairmen of the audit and
contract review committees of the funds. All Trustees are reimbursed for any
expenses incurred in attending meetings. Trustees and officers of the Trusts own
in the aggregate less than 1% of the shares of each Fund. Because Mitchell
Hutchins and PaineWebber perform substantially all of the services necessary for
the operation of the Trusts and the Funds, neither Trust requires any employees.
No officer, director or employee of Mitchell Hutchins or PaineWebber presently
receives any compensation from the Trusts for acting as a trustee or officer.
The table below includes certain information relating to the compensation
of each Trust's current trustees who held office with the Trust or with other
PaineWebber funds during the fiscal year ended February 29, 1996.
38
<PAGE>
COMPENSATION TABLE
<TABLE>
<CAPTION>
AGGREGATE COMPENSATION FROM AGGREGATE COMPENSATION FROM TOTAL COMPENSATION FROM THE
PAINEWEBBER MUNICIPAL PAINEWEBBER MUTUAL FUND TRUSTS AND THE FUND
NAME OF PERSON, POSITION SERIES* TRUST* COMPLEX**
- ------------------------------ --------------------------- --------------------------- ---------------------------
<S> <C> <C> <C>
Richard Q. Armstrong,
Trustee..................... N/A N/A $ 9,000
Richard R. Burt,
Trustee..................... N/A N/A 7,750
Meyer Feldberg,
Trustee..................... $6,500 $5,250 106,375
George W. Gowen,
Trustee..................... 6,500 5,250 99,750
Frederic V. Malek,
Trustee..................... 6,500 5,250 99,750
Carl W. Schafer,
Trustee..................... N/A N/A 118,175
John R. Torell, III,
Trustee..................... N/A N/A 28,125
</TABLE>
- ------------------
Only independent members of the board are compensated by the Trusts and
identified above; trustees who are 'interested persons,' as defined by the
1940 Act, do not receive compensation.
* Represents fees paid to each trustee during the fiscal year ended February
29, 1996.
** Represents total compensation paid to each trustee during the calendar year
ended December 31, 1995; no fund within the fund complex has a bonus,
pension, profit sharing or retirement plan.
INVESTMENT ADVISORY AND DISTRIBUTION ARRANGEMENTS
INVESTMENT ADVISORY ARRANGEMENTS. Mitchell Hutchins acts as the investment
adviser and administrator of California Tax-Free Income Fund and National
Tax-Free Income Fund pursuant to a contract dated April 21, 1988 with
PaineWebber Mutual Fund Trust, as supplemented by a Fee Agreement dated June 30,
1992 with respect to National Tax-Free Income Fund, and of Municipal High Income
Fund and New York Tax-Free Income Fund pursuant to a contract with PaineWebber
Municipal Series dated July 1, 1989 (each an 'Advisory Contract' and,
collectively, the 'Advisory Contracts'). Under the Advisory Contracts, each Fund
pays Mitchell Hutchins a fee, computed daily and paid monthly, at the annual
rate of 0.50% of the Fund's average daily net assets in the case of California
Tax-Free Income Fund and National Tax-Free Income Fund and 0.60% of average
daily net assets in the case of Municipal High Income Fund and New York Tax-Free
Income Fund.
Pursuant to their Advisory Contract for the fiscal years ended February 29,
1996, February 28, 1995 and February 28, 1994, California Tax-Free Income Fund
paid (or accrued) to Mitchell Hutchins the amounts of $1,116,442, $1,340,491 and
$1,662,653, respectively, and National Tax-Free Income Fund paid (or accrued) to
Mitchell Hutchins the amounts of $2,388,482, $2,891,059 and $3,374,932,
respectively. Pursuant to their Advisory Contract, for the fiscal years ended
February 29, 1996, February 28, 1995 and February 28, 1994, Municipal High
Income Fund paid (or accrued) to Mitchell Hutchins the amounts of $647,537,
$768,555 and $861,664, respectively, and New York Tax-Free Income Fund paid (or
accrued) to Mitchell Hutchins the
39
<PAGE>
amounts of $380,993, $481,509 (of which $10,398 was waived) and $557,864 (of
which $202,282 was waived), respectively.
Under a Service Agreement with each Trust that is reviewed by each Trust's
board of trustees annually, PaineWebber provides certain services to the Funds
not otherwise provided by the Fund's transfer agent. Pursuant to the Service
Agreement with PaineWebber Mutual Fund Trust, during the fiscal years ended
February 29, 1996, February 28, 1995 and February 28, 1994, California Tax-Free
Income Fund paid (or accrued) the amounts of $19,943, $24,838 and $26,755,
respectively, and National Tax-Free Income Fund paid (or accrued) the amounts of
$52,513, $64,620 and $67,293, respectively. Pursuant to the Service Agreement
with PaineWebber Municipal Series, during the fiscal years ended February 29,
1996, February 28, 1995 and February 28, 1994, Municipal High Income Fund paid
(or accrued) the amounts of $15,997, $19,534 and $19,512, respectively, and New
York Tax-Free Income Fund paid (or accrued) the amounts of $9,267, $10,747 (of
which $3,734 was waived) and $9,492 (all of which was waived), respectively.
Under the terms of the applicable Advisory Contract, each Fund bears all
expenses incurred in its operation that are not specifically assumed by Mitchell
Hutchins. General expenses of the Trust not readily identifiable as belonging to
a particular Fund are allocated between the appropriate Funds by or under the
direction of the board of trustees in such manner as the board deems fair and
equitable. Expenses borne by each Fund include the following: (1) the cost
(including brokerage commissions, if any) of securities purchased or sold by the
Fund and any losses incurred in connection therewith; (2) fees payable to and
expenses incurred on behalf of the Fund by Mitchell Hutchins; (3) organizational
expenses; (4) filing fees and expenses relating to the registration and
qualification of the Fund's shares under federal and state securities laws and
maintenance of such registrations and qualifications; (5) fees and salaries
payable to trustees who are not interested persons of the Fund or Mitchell
Hutchins; (6) all expenses incurred in connection with the trustees' services,
including travel expenses; (7) taxes (including any income or franchise taxes)
and governmental fees; (8) costs of any liability, uncollectible items of
deposit and other insurance or fidelity bonds; (9) any costs, expenses or losses
arising out of a liability of or claim for damages or other relief asserted
against the Fund for violation of any law; (10) legal, accounting and auditing
expenses, including legal fees of special counsel for the independent trustees;
(11) charges of custodians, transfer agents and other agents; (12) costs of
preparing share certificates; (13) expenses of setting in type and printing
prospectuses and supplements thereto, statements of additional information and
supplements thereto, reports and proxy materials for existing shareholders and
costs of mailing such materials to existing shareholders; (14) any extraordinary
expenses (including fees and disbursements of counsel) incurred by the Fund;
(15) fees, voluntary assessments and other expenses incurred in connection with
membership in investment company organizations; (16) costs of mailing and
tabulating proxies and costs of meetings of shareholders, the board and any
committees thereof; (17) the cost of investment company literature and other
publications provided to trustees and officers; and (18) costs of mailing,
stationery and communications equipment.
As required by state regulation, Mitchell Hutchins will reimburse a Fund if
and to the extent that the aggregate operating expenses of the Fund in any
fiscal year exceed applicable limits. Currently the most restrictive such limit
applicable to a Fund is 2.5% of the first $30 million of the Fund's average
daily net assets, 2.0% of the next $70 million of its average daily net assets
and 1.5% of its average daily net assets in excess of $100 million. Certain
expenses, such as brokerage commissions, taxes, interest, distribution fees and
extraordinary items, are excluded from this limitation. For the fiscal years
ended February 29, 1996, February 28, 1995 and February 28, 1994, PaineWebber
and Mitchell Hutchins were not required to reimburse any Fund pursuant to state
limitations.
Under each Advisory Contract, Mitchell Hutchins will not be liable for any
error of judgment or mistake of law or for any loss suffered by a Fund in
connection with the performance of the Advisory Contract, except
40
<PAGE>
a loss resulting from willful misfeasance, bad faith or gross negligence on the
part of Mitchell Hutchins in the performance of its duties or from reckless
disregard of its duties and obligations thereunder. Each Advisory Contract
terminates automatically upon its assignment and is terminable at any time
without penalty by the board of trustees or by vote of the holders of a majority
of a Fund's outstanding voting securities, on 60 days' written notice to
Mitchell Hutchins or by Mitchell Hutchins on 60 days' written notice to a Fund.
The following table shows the approximate net assets as of May 31, 1996,
sorted by category of investment objective, of the investment companies as to
which Mitchell Hutchins serves as adviser or sub-adviser. An investment company
may fall into more than one of the categories below.
<TABLE>
<CAPTION>
NET ASSETS
INVESTMENT CATEGORY ($ MIL)
- ------------------------------------------------------------ ----------
<S> <C>
Domestic (excluding Money Market)........................... $ 5,608.2
Global...................................................... 2,833.3
Equity/Balanced............................................. 3,127.4
Fixed Income (excluding Money Market)....................... 5,314.1
Taxable Fixed Income................................... 3,683.0
Tax-Free Fixed Income.................................. 1,631.1
Money Market Funds.......................................... 21,968.9
</TABLE>
Mitchell Hutchins personnel may invest in securities for their own accounts
pursuant to a code of ethics that describes the fiduciary duty owed to
shareholders of the PaineWebber mutual funds and other Mitchell Hutchins'
advisory accounts by all Mitchell Hutchins' directors, officers and employees,
establishes procedures for personal investing and restricts certain
transactions. For example, employee accounts generally must be maintained at
PaineWebber, personal trades in most securities require pre-clearance and
short-term trading and participation in initial public offerings generally are
prohibited. In addition, the code of ethics puts restrictions on the timing of
personal investing in relation to trades by PaineWebber mutual funds and other
Mitchell Hutchins advisory clients.
DISTRIBUTION ARRANGEMENTS. Mitchell Hutchins acts as the distributor of the
Class Y shares of each Fund under separate distribution contracts with each
Trust that require Mitchell Hutchins to use its best efforts, consistent with
its other business, to sell shares of the Funds. Class Y shares of the Funds are
offered continuously. Under exclusive dealer agreements between Mitchell
Hutchins and PaineWebber, PaineWebber and its correspondent firms sell each
Fund's Class Y shares.
PORTFOLIO TRANSACTIONS
Subject to policies established by each Trust's board of trustees, Mitchell
Hutchins is responsible for the execution of each Fund's portfolio transactions
and the allocation of brokerage transactions. In executing portfolio
transactions, Mitchell Hutchins seeks to obtain the best net results for a Fund,
taking into account such factors as the price (including the applicable dealer
spread or brokerage commission), size of order, difficulty of execution and
operational facilities of the firm involved. Each Fund effects its portfolio
transactions with municipal bond dealers. Municipal securities are traded on the
OTC market on a 'net' basis without a stated commission through dealers acting
for their own account and not as brokers. Prices paid to dealers in principal
transactions generally include a 'spread,' which is the difference between the
prices at which the dealer is willing to purchase and sell a specific security
at that time. Since inception, the Funds have not paid any brokerage
commissions.
For purchases or sales with broker-dealer firms which act as principal,
Mitchell Hutchins seeks best execution. Although Mitchell Hutchins may receive
certain research or execution services in connection with
41
<PAGE>
those transactions, Mitchell Hutchins will not purchase securities at a higher
price or sell securities at a lower price than would otherwise be paid if no
weight was attributed to the services provided by the executing dealer.
Moreover, Mitchell Hutchins will not enter into any explicit soft dollar
arrangements relating to principal transactions and will not receive in
principal transactions the types of services which could be purchased for hard
dollars. Mitchell Hutchins may engage in agency transactions in OTC debt
securities in return for research and execution services. These transactions are
entered into only in compliance with procedures ensuring that the transaction
(including commissions) is at least as favorable as it would have been if
effected directly with a market-maker that did not provide research or execution
services. These procedures include Mitchell Hutchins receiving multiple quotes
from dealers before executing the transactions on an agency basis.
Information and research services furnished by dealers or brokers with or
through which the Funds effect securities transactions may be used by Mitchell
Hutchins in advising other funds or accounts and, conversely, research services
furnished to Mitchell Hutchins by dealers or brokers in connection with other
funds or accounts Mitchell Hutchins advises may be used by Mitchell Hutchins in
advising the Funds. Information and research received from such brokers or
dealers will be in addition to, and not in lieu of, the services required to be
performed by Mitchell Hutchins under the Advisory Contracts.
Investment decisions for the Funds and for other investment accounts
managed by Mitchell Hutchins are made independently of each other in light of
differing considerations for the various accounts. However, the same investment
decision may occasionally be made for a Fund and one or more such accounts. In
such cases, simultaneous transactions are inevitable. Purchases or sales are
then averaged as to price and allocated between the Fund involved and such other
account(s) as to amount according to a formula deemed equitable to the Fund and
such account(s). While in some cases this practice could have a detrimental
effect upon the price or value of the security as far as a Fund is concerned, or
upon its ability to complete its entire order, in other cases it is believed
that coordination and the ability to participate in volume transactions will be
beneficial to the Fund.
No Fund will purchase securities that are offered in underwritings in which
Mitchell Hutchins or any of its affiliates is a member of the underwriting or
selling group, except pursuant to procedures adopted by each Trust's board of
trustees pursuant to Rule 10f-3 under the 1940 Act. Among other things, these
procedures require that the commission or spread paid in connection with such a
purchase be reasonable and fair, that the purchase be at not more than the
public offering price prior to the end of the first business day after the date
of the public offering and that Mitchell Hutchins or any affiliate thereof not
participate in or benefit from the sale to a Fund.
PORTFOLIO TURNOVER. Each Fund's annual portfolio turnover rate may vary
greatly from year to year, but it will not be a limiting factor when management
deems portfolio changes appropriate. The portfolio turnover rate is calculated
by dividing the lesser of a Fund's annual sales or purchases of portfolio
securities (exclusive of purchases or sales of securities whose maturities at
the time of acquisition were one year or less) by the monthly average value of
the securities in the portfolio during the year. For the fiscal years ended
February 29, 1996 and February 28, 1995, respectively, the portfolio turnover
rates for the Funds were: California Tax-Free Income Fund--32% and 11%; National
Tax-Free Income Fund--74% and 60%; Municipal High Income Fund--48% and 28%; and
New York Tax-Free Income Fund--13% and 6%.
42
<PAGE>
VALUATION OF SHARES
Each Fund determines the net asset value per share separately for each
Class of shares as of the close of regular trading (currently 4:00 p.m., Eastern
time) on the NYSE on each business day, which is defined as each Monday through
Friday when the NYSE is open. Currently, the NYSE is closed on the observance of
the following holidays: New Year's Day, Presidents' Day, Good Friday, Memorial
Day, Independence Day, Labor Day, Thanksgiving Day and Christmas Day.
Where market quotations are readily available, portfolio securities are
valued based upon market quotations, provided such quotations adequately
reflect, in the judgment of Mitchell Hutchins, the fair value of the security.
Where such market quotations are not readily available, securities are valued
based upon appraisals received from a pricing service using a computerized
matrix system or based upon appraisals derived from information concerning the
security or similar securities received from recognized dealers in those
securities. The amortized cost method of valuation generally is used with
respect to debt obligations with 60 days or less remaining to maturity unless
the Trust's board of trustees determines that this does not represent fair
value. All other assets will be valued at fair value as determined in good faith
by or under the direction of each Trust's board of trustees.
PERFORMANCE INFORMATION
Each Fund's performance data quoted in advertising and other promotional
materials ('Performance Advertisements') represent past performance and are not
intended to indicate future performance. 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.
TOTAL RETURN CALCULATIONS. Average annual total return quotes
('Standardized Return') used in a Fund's Performance Advertisements are
calculated according to the following formula:
P(1 + T)n = ERV
where: P = a hypothetical initial payment of $1,000 to purchase shares
of a specified Class
T = average annual total return of shares of that Class
n = number of years
ERV = ending redeemable value of a hypothetical $1,000 payment
made at the beginning of that period.
Under the foregoing formula, the time periods used in Performance
Advertisements will be based on rolling calendar quarters, updated to the last
day of the most recent quarter prior to submission of the advertisement for
publication. Total return, or 'T' in the formula above, is computed by finding
the average annual change in the value of an initial $1,000 investment over the
period. All dividends and other distributions are assumed to have been
reinvested at net asset value. Each Fund also may refer in Performance
Advertisements to total return performance data that are not calculated
according to the formula set forth above ('Non-Standardized Return'). A Fund
calculates Non-Standardized Return for specified periods of time by assuming an
investment of $1,000 in Fund shares and assuming the reinvestment of all
dividends and other distributions. The rate of return is determined by
subtracting the initial value of the investment from the ending value and by
dividing the remainder by the initial value.
The following table shows performance information for the Class Y shares of
National Tax-Free Income Fund for the period indicated. As of February 29, 1996,
California Tax-Free Income Fund, Municipal High
43
<PAGE>
Income Fund, and New York Tax-Free Income Fund had no outstanding Class Y
shares, so no performance information is presented for those Funds.
NATIONAL TAX-FREE
INCOME FUND
-----------------
CLASS Y
-----------------
Since inception* to February 29, 1996:
Standardized Return**.......................... 1.70%
Non-Standardized Return........................ 1.70%
- ------------------
* The inception date for the Class Y shares of National Tax-Free Income Fund
was November 3, 1995.
** Class Y shares do not impose an initial or contingent deferred sales charge;
therefore, Non-Standardized Return is identical to Standardized Return.
YIELD. Yields used in each Fund's Performance Advertisements are
calculated by dividing the Fund's interest income attributable to a Class of
shares for a 30-day period ('Period'), net of expenses attributable to such
Class, by the average number of shares of such Class entitled to receive
dividends during the Period and expressing the result as an annualized
percentage (assuming semi-annual compounding) of the net asset value per share
at the end of the Period. Yield quotations are calculated according to the
following formula:
6
YIELD = 2 [( a - b + 1) -1]
-----
( cd )
where: a = interest earned during the Period attributable to a Class of
shares
b = expenses accrued for the Period attributable to a Class of
shares (net of reimbursements)
c = the average daily number of shares of the Class outstanding
during the Period that were entitled to receive dividends
d = the net asset value per share on the last day of the Period.
Except as noted below, in determining net investment income earned during
the Period (variable 'a' in the above formula), a Fund calculates interest
earned on each debt obligation held by it during the Period by (1) computing the
obligation's yield to maturity, based on the market value of the obligation
(including actual accrued interest) on the last business day of the Period or,
if the obligation was purchased during the Period, the purchase price plus
accrued interest and (2) dividing the yield to maturity by 360 and multiplying
the resulting quotient by the market value of the obligation (including actual
accrued interest) to determine the interest income on the obligation for each
day of the period that the obligation is in the portfolio. Once interest earned
is calculated in this fashion for each debt obligation held by a Fund, interest
earned during the Period is then determined by totalling the interest earned on
all debt obligations. For purposes of these calculations, the maturity of an
obligation with one or more call provisions is assumed to be the next date on
which the obligation reasonably can be expected to be called or, if none, the
maturity date. National Tax-Free Income Fund had the following yield for the
30-day period ended February 29, 1996:
CLASS Y
-------
National Tax-Free Income Fund........................ 5.02%
44
<PAGE>
Tax-exempt yield is calculated according to the same formula except that
variable 'a' equals interest exempt from federal income tax earned during the
Period. This tax-exempt yield is then translated into tax-equivalent yield
according to the following formula:
TAX EQUIVALENT YIELD = ( E )
----- + t
(1 - p)
E = tax-exempt yield of a Class of shares
p = stated income tax rate
t = taxable yield of a Class of shares
The tax-equivalent yield of National Tax-Free Income Fund assumes a 39.6%
effective federal tax rate.
National Tax-Free Income Fund had the following tax-equivalent yield for
the 30-day period ended February 29, 1996:
CLASS Y
-------
National Tax-Free Income Fund........................ 8.31%
OTHER INFORMATION. In Performance Advertisements, each Fund may compare
its Standardized Return and/or its Non-Standardized Return with data published
by Lipper Analytical Services, Inc. ('Lipper'), CDA Investment Technologies,
Inc. ('CDA'), Wiesenberger Investment Companies Service ('Wiesenberger'),
Investment Company Data Inc. ('ICD') or Morningstar Mutual Funds
('Morningstar'), or with the performance of recognized stock, bond and other
indexes, including (but not limited to) the Municipal Bond Buyers Indices,
Lehman Bond Index, the Standard & Poor's 500 Composite Stock Price Index, the
Dow Jones Industrial Average, Merrill Lynch Municipal Bond Indices, the Morgan
Stanley Capital International World Index, the Lehman Brothers Treasury Bond
Index, Lehman Brothers Government/Corporate Bond Index, the Salomon Brothers
World Government Bond Index and changes in the Consumer Price Index as published
by the U.S. Department of Commerce. Each Fund also may refer in such materials
to mutual fund performance rankings and other data, such as comparative asset,
expense and fee levels, published by Lipper, CDA, Wiesenberger, ICD or
Morningstar. Performance Advertisements also may refer to discussions of a Fund
and comparative mutual fund data and ratings reported in independent
periodicals, including (but not limited to) THE WALL STREET JOURNAL, MONEY
Magazine, FORBES, BUSINESS WEEK, FINANCIAL WORLD, BARRON'S, FORTUNE, THE NEW
YORK TIMES, THE CHICAGO TRIBUNE, THE WASHINGTON POST and THE KIPLINGER LETTERS.
Comparisons in performance advertisements may be in graphic form.
Each Fund may include discussions or illustrations of the effects of
compounding in Performance Advertisements. 'Compounding' refers to the fact
that, if dividends or other distributions on an investment in a Fund are
reinvested by being paid in additional Fund shares, any future income or capital
appreciation of a Fund would increase the value, not only of the original Fund
investment, but also of the additional Fund shares received through
reinvestment. As a result, the value of the Fund investment would increase more
quickly than if dividends or other distributions had been paid in cash.
Each Fund may also compare its performance with the performance of bank
certificates of deposit (CDs) as measured by the CDA Investment Technologies,
Inc. Certificate of Deposit Index and the Bank Rate Monitor National Index and
the averages of yields of CDs of major banks published by Banxquote(Registered)
Money Markets. In comparing the Fund's performance to CD performance, investors
should keep in mind that bank CDs are insured in whole or in part by an agency
of the U.S. government and offer fixed principal and fixed or variable rates of
interest, and that bank CD yields may vary depending on the financial
institution offering the CD and prevailing interest rates. Fund shares are not
insured or guaranteed by the U.S. government and returns and net asset value
will fluctuate. The securities held by the Fund generally have longer maturities
than most CDs and may reflect interest rate fluctuations for longer term
securities. An investment in a Fund involves greater risks than an investment in
either a money market fund or a CD.
45
<PAGE>
TAXES
FEDERAL TAXES. In order to continue to qualify for treatment as a
regulated investment company ('RIC') under the Internal Revenue Code, each Fund
must distribute to its shareholders for each taxable year at least 90% of the
sum of its net interest income excludable from gross income under section 103(a)
of the Internal Revenue Code plus its investment company taxable income
(consisting generally of taxable net investment income plus net short-term
capital gain) and must meet several additional requirements. For each Fund these
requirements include the following: (1) the Fund must derive at least 90% of its
gross income each taxable year from dividends, interest, payments with respect
to securities loans and gains from the sale or other disposition of securities,
or other income (including gains from options or futures) derived with respect
to its business of investing in securities ('Income Requirement'); (2) the Fund
must derive less than 30% of its gross income each taxable year from the sale or
other disposition of securities, options or futures held for less than three
months ('Short-Short Limitation'); (3) at the close of each quarter of the
Fund's taxable year, at least 50% of the value of its total assets must be
represented by cash and cash items, U.S. government securities, securities of
other RICs and other securities that are limited, in respect of any one issuer,
to an amount that does not exceed 5% of the value of the Fund's total assets;
and (4) at the close of each quarter of the Fund's taxable year, not more than
25% of the value of its total assets may be invested in securities (other than
U.S. government securities or the securities of other RICs) of any one issuer.
Entities or persons who are 'substantial users' (or persons related to
'substantial users') of facilities financed by IDBs or PABs should consult their
tax advisers before purchasing Fund shares because, for users of certain of
these facilities, the interest on those bonds is not exempt from federal income
tax. For these purposes, 'substantial user' is defined to include a 'non-exempt
person' who regularly uses in a trade or business a part of a facility financed
from the proceeds of IDBs or PABs.
Up to 85% of social security and railroad retirement benefits may be
included in taxable income for recipients whose adjusted gross income (including
income from tax-exempt sources such as a Fund) plus 50% of their benefits
exceeds certain base amounts. Exempt-interest dividends from a Fund still are
tax-exempt to the extent described in the Prospectus; they are only included in
the calculation of whether a recipient's income exceeds the established amounts.
If Fund shares are sold at a loss after being held for six months or less,
the loss will be disallowed to the extent of any exempt-interest dividends
received on those shares and any loss not disallowed will be treated as
long-term, instead of short-term, capital loss to the extent of any capital gain
distributions received thereon. Investors also should be aware that if shares
are purchased shortly before the record date for a capital gain distribution,
the shareholder will pay full price for the shares and receive some portion of
the price back as a taxable distribution. In addition, if shares of a Fund are
purchased within 30 days before or after redeeming that Fund's shares
(regardless of Class) at a loss, that loss will not be deductible to the extent
the redemption proceeds are reinvested and will increase the basis of the newly
purchased shares.
If a Fund invests in instruments that generate taxable interest income,
under the circumstances described in the Prospectus and in the discussion of
municipal market discount bonds below, the portion of any Fund dividend
attributable to the interest earned thereon will be taxable to the Fund's
shareholders as ordinary income to the extent of the Fund's earnings and
profits, and only the remaining portion will qualify as an 'exempt-interest
dividend' (as described in the Prospectus). The respective portions will be
determined by the 'actual earned' method, under which the portion of any
dividend that qualifies as exempt-interest may vary, depending on the relative
proportions of tax-exempt and taxable interest earned during the dividend
period. Moreover, if a Fund realizes capital gain as a result of market
transactions, any distributions of the gain
46
<PAGE>
will be taxable to its shareholders. Each Fund is required to withhold 31% of
all taxable dividends, capital gain distributions and redemption proceeds
payable to any individuals and certain other noncorporate shareholders who do
not provide the Fund with a correct taxpayer identification number. Each Fund
also is required to withhold 31% of all taxable dividends and capital gain
distributions payable to those shareholders who otherwise are subject to backup
withholding.
Dividends and other distributions declared by a Fund in October, November
or December of any year and payable to shareholders of record on a date in any
of those months will be deemed to have been paid by the Fund and received by the
shareholders on December 31 of that year if the distributions are paid by the
Fund during the following January. Each Fund invests exclusively in debt
securities and receives no dividend income; accordingly, no portion of the
dividends or other distributions paid by any Fund is eligible for the
dividends-received deduction allowed to corporations.
Each Fund will be subject to a nondeductible 4% excise tax to the extent it
fails to distribute by the end of any calendar year substantially all of its
ordinary (taxable) income for the calendar year and capital gain net income for
the one-year period ending on October 31 of that year, plus certain other
amounts.
The use of hedging and option income strategies, such as writing (selling)
and purchasing options and futures, involves complex rules that will determine
for income tax purposes the character and timing of recognition of the gains and
losses a Fund realizes in connection therewith. Income from transactions in
options and futures derived by a Fund with respect to its business of investing
in securities will qualify as permissible income under the Income Requirement.
However, income from the disposition of options and futures will be subject to
the Short-Short Limitation if they are held for less than three months.
If a Fund satisfies certain requirements, any increase in value of a
position that is part of a 'designated hedge' will be offset by any decrease in
value (whether realized or not) of the offsetting hedging position during the
period of the hedge for purposes of determining whether the Fund satisfies the
Short-Short Limitation. Thus, only the net gain (if any) from the designated
hedge will be included in gross income for purposes of that limitation. Each
Fund will consider whether it should seek to qualify for this treatment for its
hedging transactions. To the extent a Fund does not qualify for this treatment,
it may be forced to defer the closing out of certain options and futures beyond
the time when it otherwise would be advantageous to do so, in order for the Fund
to continue to qualify as a RIC.
Each Fund may invest in municipal bonds that are purchased, generally not
on their original issue, with market discount (that is, at a price less than the
principal amount of the bond or, in the case of a bond that was issued with
original issue discount, a price less than the amount of the issue price plus
accrued original issue discount) ('municipal market discount bonds'). If a
bond's market discount is less than the product of (1) 0.25% of the redemption
price at maturity times (2) the number of complete years to maturity after the
taxpayer acquired the bond, then no market discount is considered to exist. Gain
on the disposition of a municipal market discount bond purchased by a Fund after
April 30, 1993 (other than a bond with a fixed maturity date within one year
from its issuance) generally is treated as ordinary (taxable) income, rather
than capital gain, to the extent of the bond's accrued market discount at the
time of disposition. Market discount on such a bond generally is accrued
ratably, on a daily basis, over the period from the acquisition date to the date
of maturity. In lieu of treating the disposition gain as above, a Fund may elect
to include market discount in its gross income currently, for each taxable year
to which it is attributable.
CALIFORNIA TAXES. Individual shareholders of California Tax-Free Income
Fund who reside in California will not be subject to California personal income
tax on distributions received from the Fund to the extent such distributions are
attributable to interest on tax-exempt obligations issued by the State of
California
47
<PAGE>
or a California local government (or interest earned on obligations of U.S.
possessions or territories) ('exempt-interest dividends'), provided that the
Fund qualifies as a RIC under the Internal Revenue Code and satisfies the
requirement of California law that at least 50% of its assets at the close of
each quarter of its taxable year be invested in obligations the interest on
which is exempt from personal income taxation under the laws or Constitution of
California or the laws of the United States. Distributions from the Fund which
are attributable to sources other than those described in the preceding sentence
will generally be taxable to such shareholders as ordinary income. However,
distributions by California Tax-Free Income Fund, if any, that are derived from
interest on obligations of the U.S. government may also be designated by the
Fund and treated by its shareholders as exempt from California personal income
tax, provided that the foregoing 50% requirement is satisfied. Moreover, under
California legislation incorporating certain portions of the provisions of the
Internal Revenue Code applicable to RICs, amounts treated as capital gain
distributions for federal income tax purposes generally will be treated as
long-term capital gains for California personal income tax purposes. In
addition, distributions to shareholders other than exempt-interest dividends are
includable in income subject to the California alternative minimum tax.
Distributions of investment income and long-term and short-term capital
gains will not be excluded from taxable income in determining the California
corporate franchise tax for corporate shareholders. In addition, such
distributions may be includable in income subject to the California alternative
minimum tax.
Interest on indebtedness incurred by shareholders to purchase or carry
shares of California Tax-Free Income Fund will not be deductible for California
personal income tax purposes.
Shares of California Tax-Free Income Fund will not be subject to the
California property tax.
NEW YORK TAXES. Individual shareholders of New York Tax-Free Income Fund
will not be required to include in their gross income for New York State
purposes any portion of distributions received from the Fund to the extent such
distributions are directly attributable to interest earned on tax-exempt
obligations issued by New York State or any political subdivisions thereof
(including the City) or interest earned on obligations of U.S. possessions or
territories to the extent interest on such obligations is exempt from state
taxation pursuant to federal law, provided that the Fund qualifies as a RIC
under the Internal Revenue Code and satisfies the requirements that at least 50%
of its assets at the close of each quarter of its taxable year constitute
obligations which are tax-exempt for federal income tax purposes. Distributions
from the Fund which are attributable to sources other than those described in
the preceding sentence (including interest on obligations of other states and
their political subdivisions) will generally be taxable to such individual
shareholders as ordinary income. However, distributions by the Fund, if any,
that are derived from interest earned on obligations of the U.S. government may
also be designated by the Fund and treated by its shareholders as exempt from
personal income taxation for New York State and City purposes, provided that at
least 50% of the value of its total assets at the close of each quarter of its
taxable year is invested in such federal obligations. Distributions to
individual shareholders by the Fund which represent long-term capital gains for
federal income tax purposes will be treated as long-term capital gains for New
York State and City personal income tax purposes.
Shareholders of New York Tax-Free Income Fund that are subject to the New
York State corporation franchise tax or the City general corporation tax will be
required to include exempt-interest dividends paid by the Fund in their 'entire
net income' for purposes of such taxes and will be required to include their
shares of the Fund in their investment capital for purposes of such taxes.
Shareholders of New York Tax-Free Income Fund will not be subject to the
unincorporated business taxation imposed by the City solely by reason of their
ownership of shares in the Fund. If a shareholder is subject to the
unincorporated business tax, income and gains distributed by the Fund will be
subject to such
48
<PAGE>
tax except to the extent such distributions are directly attributable to
interest earned on tax-exempt obligations issued by New York State or any
political subdivision thereof (including the City).
Shares of New York Tax-Free Income Fund will not be subject to property
taxes imposed by New York State or the City.
Interest on indebtedness incurred by shareholders to purchase or carry
shares of the New York Tax-Free Income Fund generally will not be deductible for
New York State personal income tax purposes.
Interest income of New York Tax-Free Income Fund which is distributed to
shareholders will generally not be taxable to the Fund for purposes of the New
York State corporation franchise tax or the New York City general corporation
tax.
The foregoing is a general summary of certain provisions of federal,
California and New York State and City tax laws currently in effect as they
directly govern the taxation of shareholders of the Funds. These provisions are
subject to change by legislative or administrative action, and any such change
may be retroactive with respect to Fund transactions. Shareholders are advised
to consult with their own tax advisers for more detailed information concerning
tax matters.
TAX-FREE INCOME VS. TAXABLE INCOME--NATIONAL TAX-FREE INCOME FUND AND
MUNICIPAL HIGH INCOME FUND. Table I below illustrates approximate equivalent
taxable and tax-free yields at the 1995 federal individual income tax rates. For
example, a couple with taxable income of $90,000 in 1995, or single individuals
with taxable income of $55,000 in 1995, whose investments earn a 6% tax-free
yield, would have had to earn approximately an 8.70% taxable yield to receive
the same benefit.
TABLE I. 1995 FEDERAL TAXABLE VS. TAX-FREE YIELDS*
<TABLE>
<CAPTION>
A TAX-FREE YIELD OF
TAXABLE INCOME (000'S) ---------------------------------------------
- -------------------------------- 4.00% 5.00% 6.00% 7.00% 8.00%
SINGLE JOINT FEDERAL TAX ----- ----- ----- ----- -----
RETURN RETURN BRACKET IS EQUAL TO A TAXABLE YIELD OF APPROXIMATELY:
- -------------- -------------- ----------- ---------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
$ 0-- 22.1 $ 0-- 36.9 15.00% 4.71% 5.88% 7.06% 8.24% 9.41%
22.1-- 53.5 36.9-- 89.2 28.00 5.56 6.94 8.33 9.72 11.11
53.5--115.0 89.2--140.0 31.00 5.80 7.25 8.70 10.14 11.59
115.0--250.0 140.0--250.0 36.00 6.25 7.81 9.38 10.94 12.50
Over 250.0 Over 250.0 39.60 6.62 8.28 9.93 11.59 13.25
</TABLE>
- ------------------
* See note following Table III.
TAX-FREE INCOME VS. TAXABLE INCOME--CALIFORNIA TAX-FREE INCOME FUND. Table
II below illustrates approximate equivalent taxable and tax-free yields at the
1995 individual federal and 1996 California personal income tax rates. For
example, a California couple with taxable income of $90,000, or a single
California individual with taxable income of $55,000, whose investments earn a
6% tax-free yield, would have had to earn a 9.59% taxable yield to receive the
same benefit.
49
<PAGE>
TABLE II. 1995 FEDERAL AND 1996 CALIFORNIA TAXABLE VS. TAX-FREE YIELDS*
(See notes 1-4 below)
<TABLE>
<CAPTION>
EFFECTIVE A TAX-FREE YIELD OF
TAXABLE INCOME (000'S) CALIFORNIA ---------------------------------------------
- --------------------------------- AND 4.00% 5.00% 6.00% 7.00% 8.00%
SINGLE JOINT FEDERAL TAX ----- ----- ----- ----- -----
RETURN RETURN BRACKET IS EQUAL TO A TAXABLE YIELD OF APPROXIMATELY:
- -------------- -------------- ----------- ---------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
$ 18.1-- 23.4 $ 36.1-- 39.0 20.10% 5.01% 6.26% 7.51% 8.76% 10.01%
25.1-- 31.7 50.2-- 63.4 33.76 6.04 7.55 9.06 10.57 12.08
31.7-- 56.6 63.4-- 94.3 34.70 6.13 7.66 9.19 10.72 12.25
56.6--118.0 94.3--143.6 37.42 6.39 7.99 9.59 11.19 12.78
118.0--256.5 143.6--256.5 41.95 6.89 8.61 10.34 12.06 13.78
Over 256.5 Over 256.5 45.22 7.30 9.13 10.95 12.78 14.60
</TABLE>
1. Net amount subject to federal income tax after deductions and exemptions.
Assumes that all income is ordinary income.
2. The income ranges shown for 1996 reflect federal and California income
brackets for 1995. Inflation adjusted income brackets for 1996 are not yet
available.
3. The rates shown reflect federal and California rates for 1996 in effect as of
the date hereof. Those rates are still subject to change with retroactive
effect for 1996.
4. Excludes the impact of the phase out of personal exemptions, limitations on
itemized deductions and other credits, exclusions and adjustments which may
increase a taxpayer's marginal tax rate as well as the effect of certain
levels of income (including tax exempt income) on the taxability of social
security payments.
- ------------------
* See note following Table III.
TAX-FREE INCOME VS. TAXABLE INCOME--NEW YORK TAX-FREE INCOME FUND. Table
III below illustrates approximate equivalent taxable and tax-free yields at the
1995 federal individual, and New York State and New York City personal, income
tax rates. For example, a New York City couple with taxable income of $90,000 in
1995, whose investments earn a 4% tax-free yield, would have had to earn a 6.59%
taxable yield to receive the same benefit. A couple who lives in New York State
outside of New York City with taxable income of $90,000 in 1995 would have had
to earn a 6.27% taxable yield to realize a 4% tax-free yield.
Single taxpayers may also take advantage of high tax-free income. For
example, a single individual with taxable income of $55,000 in 1995, who lives
in New York City and whose investments earn a 4% tax-free yield, would have had
to earn a 6.59% taxable yield to receive the same benefit. A single individual
with taxable income of $55,000 in 1995, who lives in New York State outside of
New York City, would have to earn a 6.27% taxable yield to realize a 4% tax-free
yield.
50
<PAGE>
TABLE III. 1995 FEDERAL AND NEW YORK TAXABLE VS. TAX-FREE YIELDS*
<TABLE>
<CAPTION>
A TAX-FREE YIELD OF
TAXABLE INCOME (000'S) COMBINED ---------------------------------------------
- --------------------------------- FEDERAL/ 4.00% 5.00% 6.00% 7.00% 8.00%
SINGLE JOINT NYS/NYC ----- ----- ----- ----- -----
RETURN RETURN TAX BRACKET IS EQUAL TO A TAXABLE YIELD OF APPROXIMATELY:
- -------------- -------------- ----------- ---------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
$ 0-- 22.1 $ 0-- 36.9 25.19% 5.35% 6.68% 8.02% 9.36% 10.69%
22.1-- 53.5 36.9-- 89.2 36.64 6.31 7.89 9.47 11.05 12.63
53.5--115.0 89.2--140.0 39.32 6.59 8.24 9.89 11.54 13.18
115.0--250.0 140.0--250.0 43.71 7.11 8.88 10.66 12.44 14.21
Over 250.0 Over 250.0 46.88 7.53 9.41 11.29 13.18 15.06
</TABLE>
<TABLE>
<CAPTION>
A TAX-FREE YIELD OF
TAXABLE INCOME (000'S) ---------------------------------------------
- --------------------------------- COMBINED 4.00% 5.00% 6.00% 7.00% 8.00%
SINGLE JOINT FEDERAL/NYS ----- ----- ----- ----- -----
RETURN RETURN TAX BRACKET IS EQUAL TO A TAXABLE YIELD OF APPROXIMATELY:
- -------------- -------------- ------------ ---------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
$ 0-- 22.1 $ 0-- 36.9 21.45% 5.09% 6.37% 7.64% 8.91% 10.19%
22.1-- 53.5 36.9-- 89.2 33.47 6.01 7.52 9.02 10.52 12.02
53.5--115.0 89.2--140.0 36.24 6.27 7.84 9.41 10.98 12.55
115.0--250.0 140.0--250.0 40.86 6.76 8.45 10.15 11.84 13.53
Over 250.0 Over 250.0 44.19 7.17 8.96 10.75 12.54 14.33
</TABLE>
- ------------------
*Single rate assumes no dependents; joint rate assumes two dependents. The
yields listed are for illustration only and are not necessarily representative
of a Fund's yield. Each Fund invests primarily in obligations the interest on
which is exempt from federal income tax and, in the case of California Tax-Free
Income Fund, from California personal income tax and, in the case of New York
Tax-Free Income Fund, from New York State and New York City personal income
taxes; however, some of a Fund's investments may generate taxable income.
Effective tax rates shown are those in effect on the date of this Statement of
Additional Information; such rates might change after that date. The effective
rates reflect the highest tax bracket within each range of income listed.
However, a California or New York taxpayer within the lowest income ranges
shown may fall within a lower effective tax bracket. The figures set forth
above do not reflect the federal alternative minimum tax, limitations on
federal or state itemized deductions and personal exemptions or any state or
local taxes payable on Fund distributions (other than California, New York
State and New York City personal income taxes in the case of Tables II and
III).
51
<PAGE>
OTHER INFORMATION
The names of the Trusts are PaineWebber Mutual Fund Trust and PaineWebber
Municipal Series. Prior to April 6, 1992, the name of PaineWebber Mutual Fund
Trust was PaineWebber California Tax-Free Income Fund and its sole operating
series was designated as 'Initial Series.' Prior to June 30, 1992, National
Tax-Free Income Fund was a series of a different Massachusetts business trust,
PaineWebber Managed Municipal Trust.
Each Trust is an entity of the type commonly known as a 'Massachusetts
business trust.' Under Massachusetts law, shareholders could, under certain
circumstances, be held personally liable for the obligations of the Trust or a
Fund. However, the Declaration of Trust disclaims shareholder liability for the
obligations of the Trust or a Fund and requires that notice of such disclaimer
be given in each note, bond, contract, instrument, certificate or undertaking
made or issued by the Trust's trustees or by any officers or officer by or on
behalf of a Fund, the trustees or any of them in connection with the Fund. The
Declaration of Trust provides for indemnification from a Fund's property for all
losses and expenses of any Fund shareholder held personally liable for the
obligations of the Fund. Thus, the risk of a shareholder's incurring financial
loss on account of shareholder liability is limited to circumstances in which
the Fund itself would be unable to meet its obligations, a possibility that
Mitchell Hutchins believes is remote and not material. Upon payment of any
liability incurred by a shareholder solely by reason of being or having been a
shareholder, the shareholder paying such liability will be entitled to
reimbursement from the general assets of a Fund. The trustees intend to conduct
the operations of each Fund in such a way as to avoid, as far as possible,
ultimate liability of the shareholders for liabilities of the Fund.
CLASS-SPECIFIC EXPENSES. Each Fund may determine to allocate certain of
its expenses to the specific classes of the Fund's shares to which those
expenses are attributable.
COUNSEL. The law firm of Kirkpatrick & Lockhart LLP, 1800 Massachusetts
Avenue, N.W., Washington, D.C., 20036-1800, counsel to the Funds, has passed
upon the legality of the shares offered by the Funds' Prospectus. Kirkpatrick &
Lockhart LLP also acts as counsel to Mitchell Hutchins and PaineWebber in
connection with other matters. The law firm of Orrick, Herrington & Sutcliffe,
400 Sansome Street, San Francisco, CA 94111, serves as counsel to California
Tax-Free Income Fund with respect to California law. The law firm of Orrick,
Herrington & Sutcliffe, 666 Fifth Avenue, New York, New York 10103, serves as
counsel to New York Tax-Free Income Fund with respect to New York law.
AUDITORS. Ernst & Young LLP, 787 Seventh Avenue, New York, New York 10019,
serves as independent auditors for the Funds.
FINANCIAL STATEMENTS
The Funds' Annual Report to Shareholders for the fiscal year ended February
29, 1996 is a separate document supplied with this Statement of Additional
Information and the financial statements, accompanying notes and report of
independent auditors appearing therein are incorporated by reference in this
Statement of Additional Information.
52
<PAGE>
[This page intentionally left blank]
53
<PAGE>
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS NOT CONTAINED IN THE PROSPECTUS OR IN THIS STATEMENT OF
ADDITIONAL INFORMATION IN CONNECTION WITH THE OFFERING MADE BY THE PROSPECTUS
AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED
UPON AS HAVING BEEN AUTHORIZED BY A FUND OR ITS DISTRIBUTOR. THE PROSPECTUS AND
THIS STATEMENT OF ADDITIONAL INFORMATION DO NOT CONSTITUTE AN OFFERING BY ANY
FUND OR BY THE DISTRIBUTOR IN ANY JURISDICTION IN WHICH SUCH OFFERING MAY NOT
LAWFULLY BE MADE.
------------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Investment Policies and Restrictions...... 1
Hedging and Related Income Strategies..... 27
Trustees and Officers..................... 33
Investment Advisory and Distribution
Arrangements............................ 39
Portfolio Transactions.................... 41
Valuation of Shares....................... 43
Performance Information................... 43
Taxes..................................... 46
Other Information......................... 52
Financial Statements...................... 52
</TABLE>
(Copyright)1996 PaineWebber Incorporated
PaineWebber California
Tax-Free Income Fund
PaineWebber National
Tax-Free Income Fund
PaineWebber Municipal
High Income Fund
PaineWebber New York
Tax-Free Income Fund
Class Y Shares
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Statement of Additional Information
July 1, 1996
- --------------------------------------------------------------------------------
PAINEWEBBER
