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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 are series of professionally managed, open-end
management investment companies each organized as a Massachusetts business trust
(each a 'Trust'). These Funds are designed for investors generally seeking high
current income exempt from federal income tax and, in some cases, certain state
and local personal income taxes. PaineWebber California Tax-Free Income Fund and
PaineWebber National Tax-Free Income Fund are series of PaineWebber Mutual Fund
Trust. California Tax-Free Income Fund invests primarily in investment grade
bonds issued by the State of California, its municipalities and public
authorities. National Tax-Free Income Fund invests primarily in investment grade
bonds issued by various states, municipalities and public authorities.
PaineWebber Municipal High Income Fund and PaineWebber New York Tax-Free Income
Fund are series of PaineWebber Municipal Series. Municipal High Income Fund
invests primarily in medium grade and high yield, high risk lower grade bonds
issued by various states, municipalities and public authorities. New York
Tax-Free Income Fund invests primarily in investment grade bonds issued by the
State of New York, its municipalities and public authorities.
The investment adviser, administrator and distributor for each Fund is
Mitchell Hutchins Asset Management Inc. ('Mitchell Hutchins'), a wholly owned
asset management subsidiary of PaineWebber Incorporated ('PaineWebber'). As
distributor, Mitchell Hutchins has appointed PaineWebber 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, 1998. 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, 1998.
INVESTMENT POLICIES AND RESTRICTIONS
The following supplements the information contained in the Prospectus
concerning the Funds' investment policies and limitations. Except as otherwise
indicated in the Prospectus or the Statement of Additional Information, there
are no policy limitations on a Fund's ability to use the investments or
techniques discussed in these documents.
YIELD FACTORS AND RATINGS. The yield of a municipal security depends on a
variety of factors, including general municipal and fixed-income security market
conditions, the financial condition of the issuer, the size of the particular
offering, the maturity, credit quality and rating of the issue and expectations
regarding changes in tax rates. Each Fund may invest in municipal securities
with a broad range of maturities, based on Mitchell Hutchins' judgment of
current and future market conditions as well as other factors, such as the
Fund's liquidity needs. Generally, the longer the maturity of a municipal
security, the higher the rate of interest paid and the greater the volatility.
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. Also, rating agencies may fail to make timely changes in
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credit ratings in response to subsequent events, so that an issuer's current
financial condition may be better or worse than the rating indicates. The rating
assigned to a security by a NRSRO does not reflect an assessment of the
volatility of the security's market value or of the liquidity of an investment
in the security. 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.
Opinions relating to the validity of municipal securities and to the
exemption of interest thereon from federal income tax (and, when available, from
the federal alternative minimum tax ('AMT')) 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 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.
Medium and lower grade municipal securities are frequently traded only in
markets where the number of potential purchasers and sellers, if any, is
limited. This factor may limit a Fund's ability to acquire such securities and
also may limit its ability to sell such securities at their fair value in
response to changes in the economy or the financial markets. Adverse publicity
and investor perceptions, whether or not based on fundamental analysis, may also
decrease the values and liquidity of lower rated securities, especially in
thinly traded markets.
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. No Fund
intends to invest more than 5% of its total assets in uninsured 'non-
appropriation' municipal lease obligations (defined below). There is no
percentage limitation on the Funds' ability to invest in other municipal lease
obligations.
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
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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 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.
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
AMT. See 'Dividends & 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 or other financial institutions,
the credit standing of which affects the credit quality of the obligations.
Changes in the credit quality of these institutions could cause losses to a Fund
and adversely affect its share price.
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 from a bank or a guarantee or
other liquidity support arrangement from a bank or other financial institution.
As discussed under 'Participation Interests,' to the extent that payment of an
obligation is backed by a letter of credit, guarantee or other liquidity support
that may be drawn upon demand, such payment may be subject to that institution'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, or is otherwise reset to reflect
market rates of interest. 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, 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
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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 semiannually, 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 of the
market volatility associated with inverse floaters, no Fund will invest more
than 10% of its total assets in inverse floaters.
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 can provide a Fund with a means of
increasing or maintaining the level of tax-exempt interest paid to shareholders.
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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 Funds 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 a
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 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' 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 or upon demand and at a 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 or upon demand 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.
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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 (sometimes referred to
as a 'board'). Mitchell Hutchins reviews and monitors the creditworthiness of
those institutions under each 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 board.
Each board 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 board.
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 generate taxable income. As indicated in the Prospectus, however, each
Fund is authorized to lend up to 331/3% of its total assets 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. Each Fund may
reinvest cash collateral in money market instruments or other short-term liquid
investments. 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 Fund will retain authority
to terminate any loan at any time. A Fund may pay reasonable 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 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.
Pursuant to procedures adopted by the appropriate board governing each
Fund's securities lending program, PaineWebber has been retained to serve as
lending agent for each Fund. Each board also has authorized the payment of fees
(including fees calculated as a percentage of invested cash collateral) to
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PaineWebber for these services. Each board periodically reviews all portfolio
securities loan transactions for which PaineWebber acted as lending agent.
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 Other Strategies Using Derivative Instruments,' 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.' 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.
For any fixed income security with interest payments occurring prior to the
payment of principal, duration is always less than maturity. For example,
depending upon its coupon and the level of market yields, a Treasury note with a
remaining maturity of five years might have a duration of 4.5 years. For
mortgage-backed and other securities that are subject to prepayments, put or
call features or adjustable coupons, the difference between the remaining stated
maturity and the duration is likely to be much greater.
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 incorporate the economic life of a
security into the determination of its duration and, therefore, its interest
rate exposure.
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.
During the early 1990's, California experienced significant financial
difficulties, which reduced its credit standing, but the State's finances have
improved since 1994. 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
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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 almost 33 million represents
over 12% of the total United States population and grew by 26% in the 1980s,
more than double the national rate. Population growth slowed to less than 1%
annually in 1994 and 1995, but rose to 1.8% in 1997. During the early 1990's,
net population growth in the State was due to births and foreign immigration,
but more recently net in-migration from elsewhere in the United States has
resumed.
Total personal income in the State, at an estimated $867 billion in 1997,
accounts for almost 13% of all personal income in the nation. Total employment
is over 14 million, the majority of which is in the service, trade and
manufacturing sectors.
From mid-1990 to late 1993, the State suffered a recession with the worst
economic, fiscal and budget conditions since the 1930s, due in significant part
to reductions in the federal military budget and base closures. 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 job growth has occurred since early 1994. Pre-recession job levels were
reached in 1996. Unemployment, while remaining higher than the national average,
has come down from its 10% recession peak to under 6% in Spring, 1998. Economic
indicators show a steady and strong recovery underway in California since the
start of 1994 particularly in export-related industries, services, electronics,
entertainment and tourism and construction. The Asian economic difficulties
starting in mid-1997 are expected to have a moderate dampening effect on the
State's economy. Any delay or reversal of the recovery may create new shortfalls
in State revenues.
Constitutional Limitations on Taxes, Other Charges and Appropriations
Limitation on Property Taxes. Certain California Municipal Obligations may
be obligations of issuers which rely in whole or in part, directly or
indirectly, on ad valorem property taxes as a source of revenue. The taxing
powers of California local governments and districts are limited by Article
XIIIA of the California Constitution, enacted by the voters in 1978 and commonly
known as 'Proposition 13.' Briefly, Article XIIIA limits to 1% of full cash
value of the rate of ad valorem property taxes on real property and generally
restricts the reassessment of property to 2% per year, except under new
construction or change of ownership (subject to a number of exemptions). Taxing
entities may, however, raise ad valorem taxes above the 1% limit to pay debt
service on voter-approved bonded indebtedness.
Under Article XIIIA, the basic 1% ad valorem tax levy is applied against
the assessed value of property as of the owner's date of acquisition (or as of
March 1, 1975, if acquired earlier), subject to certain adjustments. This system
has resulted in widely varying amounts of tax on similarly situated properties.
Several lawsuits have been filed challenging the acquisition-based assessment
system of Proposition 13, but it was upheld by the U.S. Supreme Court in 1992.
Article XIIIA prohibits local governments from raising revenues through ad
valorem taxes above the 1% limit; it also requires voters of any governmental
unit to give two-thirds approval to levy any 'special tax.' Court decisions,
however, allowed a non-voter approved levy of 'general taxes' which were not
dedicated to a specific use.
Limitations on Other Taxes, Fees and Charges. On November 5, 1996, the
voters of the State approved Proposition 218, called the 'Right to Vote on Taxes
Act.' Proposition 218 added Articles XIIIC and XIIID to the State Constitution,
which contain a number of provisions affecting the ability of local agencies to
levy and collect both existing and future taxes, assessments, fees and charges.
Article XIIIC requires that all new or increased local taxes be submitted
to the electorate before they become effective. Taxes for general governmental
purposes require a majority vote and taxes for
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specific purposes require a two-thirds vote. Further, any general purpose tax
which was imposed, extended or increased without voter approval after December
31, 1994 must be approved by a majority vote within two years.
Article XIIID contains several new provisions making it generally more
difficult for local agencies to levy and maintain 'assessments' for municipal
services and programs. Article XIIID also contains several new provisions
affecting 'fees' and 'charges', defined for purposes of Article XIIID to mean
'any levy other than an ad valorem tax, a special tax, or an assessment, imposed
by a [local government] upon a parcel or upon a person as an incident of
property ownership, including a user fee or charge for a property related
service.' All new and existing property related fees and charges must conform to
requirements prohibiting, among other things, fees and charges which generate
revenues exceeding the funds required to provide the property related service or
are used for unrelated purposes. There are new notice, hearing and protest
procedures for levying or increasing property related fees and charges, and,
except for fees or charges for sewer, water and refuse collection services (or
fees for electrical and gas service, which are not treated as 'property related'
for purposes of Article XIIID), no property related fee or charge may be imposed
or increased without majority approval by the property owners subject to the fee
or charge or, at the option of the local agency, two-thirds voter approval by
the electorate residing in the affected area.
In addition to the provisions described above, Article XIIIC removes
limitations on the initiative power in matters of local taxes, assessments, fees
and charges. Consequently, local voters could, by future initiative, repeal,
reduce or prohibit the future imposition or increase of any local tax,
assessment, fee or charge. It is unclear how this right of local initiative may
be used in cases where taxes or charges have been or will be specifically
pledged to secure debt issues.
The interpretation and application of Proposition 218 will ultimately be
determined by the courts with respect to a number of matters, and it is not
possible at this time to predict with certainty the outcome of such
determinations. Proposition 218 is generally viewed as restricting the fiscal
flexibility of local governments, and for this reason, some ratings of
California cities and counties have been, and others may be, reduced.
Appropriations Limits. The State and its local governments are subject to
an annual 'appropriations limit' imposed by Article XIIIB of the California
Constitution, enacted by the voters in 1979 and significantly amended by
Propositions 98 and 111 in 1988 and 1990, respectively. Article XIIIB prohibits
the State or any covered local government from spending 'appropriations subject
to limitation' in excess of the appropriations limit imposed. 'Appropriations
subject to limitation' are authorizations to spend 'proceeds of taxes,' which
consist of tax revenues and certain other funds, including proceeds from
regulatory licenses, user charges or other fees, to the extent that such
proceeds exceed the cost of providing the product or service, but 'proceeds of
taxes' exclude most State subventions to local governments. No limit is imposed
on appropriations of funds which are not 'proceeds of taxes,' such as reasonable
user charges or fees, and certain other non-tax funds, including bond proceeds.
Among the expenditures not included in the Article XIIIB appropriations
limit are (1) the debt service cost of bonds issued or authorized prior to
January 1, 1979, or subsequently authorized by the voters, (2) appropriations
arising from certain emergencies declared by the Governor, (3) appropriations
for certain capital outlay projects, (4) appropriations by the State of
post-1989 increases in gasoline taxes and vehicle weight fees, and (5)
appropriations made in certain cases of emergency.
The appropriations limit for each year is adjusted annually to reflect
changes in cost of living and population, and any transfers of service
responsibilities between government units. The definitions for such adjustments
were liberalized in 1990 to follow more closely growth in the State's economy.
'Excess' revenues are measured over a two year cycle. Local governments
must return any excess to taxpayers by rate reductions. The State must refund
50% of any excess, with the other 50% paid to schools and community colleges.
With more liberal annual adjustment factors since 1988, and depressed revenues
since 1990 because of the recession, few governments are currently operating
near their spending limits, but this condition may change over time. Local
governments may by voter approval exceed their spending limits for up to four
years. During fiscal year 1986-87, State receipts from proceeds of taxes
exceeded its appropriations limit by $1.1 billion, which was returned to
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taxpayers. Since that year, appropriations subject to limitation have been under
the State limit. State appropriations were $6.3 billion under the limit for
fiscal year 1997-98.
Because of the complex nature of Articles XIIIA, XIIIB, XIIIC and XIIID of
the California Constitution, the ambiguities and possible inconsistencies in
their terms, and the impossibility of predicting future appropriations or
changes in population and cost of living, and the probability of continuing
legal challenges, it is not currently possible to determine fully the impact of
these Articles on California Municipal Obligations or on the ability of the
State or local governments to pay debt service on such California Municipal
Obligations. It is not possible, at the present time, to predict the outcome of
any pending litigation with respect to the ultimate scope, impact or
constitutionality of these Articles or the impact of any such determinations
upon State agencies or local governments, or upon their ability to pay debt
service on their obligations. Further initiatives or legislative changes in laws
or the California Constitution may also affect the ability of the State or local
issuers to repay their obligations.
Obligations of the State of California
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. As of April 1,
1998, the State had outstanding approximately $18.4 billion of long-term general
obligation bonds, plus $1.3 billion of general obligation commercial paper which
is planned to be refunded by long-term bonds in the future ($600 million was so
converted on April 30, 1998), and $6.5 billion of lease-purchase debt supported
by the State General Fund. The State also had about $8.2 billion of authorized
and unissued long-term general obligation bonds and lease-purchase debt. In FY
1996-97, debt service on general obligation bonds and lease purchase debt was
approximately 5.0% of General Fund revenues.
Recent Financial Results
The principal sources of General Fund revenues in 1965-1997 were the
California personal income tax (47% of total revenues), the sales tax (34%),
bank and corporation taxes (12%), and the gross premium tax on insurance (2%).
The State maintains a Special Fund for Economic Uncertainties (the 'SFEU'),
derived from General Fund revenues, as a reserve to meet cash needs of the
General Fund, but which is required to be replenished as soon as sufficient
revenues are available. Year-end balances in the SFEU are included for financial
reporting purposes in the General Fund balance. Because of the recession and an
accumulated budget deficit, no reserve was budgeted in the SFEU from 1992-93 to
1995-96.
General. 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
Proposition 13 and other laws. The largest State program is assistance to local
public school districts. In 1988, an initiative (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%).
Starting in mid-1990, the State has faced adverse economic, fiscal, and
budget conditions. The 1990-1994 economic recession seriously affected State tax
revenues. It also caused increased expenditures for health and welfare programs.
Recent Budgets. As a result of the recession and other factors, the State
experienced substantial revenue shortfalls, and greater than anticipated social
service costs, in the early 1990's. The State accumulated and sustained a budget
deficit in the SFEU, approaching $2.8 billion at its peak at June 30, 1993. The
Legislature and Governor agreed on a number of different steps to respond to the
adverse financial conditions and produce Budget Acts in the Years 1991-92 to
1994-95, including the following (although not all of these actions were taken
in each year):
significant cuts in health and welfare program expenditures;
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transfers of program responsibilities and some funding sources from
the State to local governments, coupled with some reduction in
mandates on local government;
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;
reduction in growth of support for higher education programs, coupled
with increases in student fees;
revenue increases (particularly in the 1992-93 Fiscal Year budget),
most of which were for a short duration;
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 had requested);
and
various one-time adjustment and accounting changes (some of which
have been successfully challenged in court).
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, with revenues equaling or exceeding expenditures
starting in FY 1992-93. As a result, the accumulated budget deficit of about
$2.8 billion was eliminated by June 30, 1997, when the State showed a positive
balance of about $408 million, on a budgetary basis, in the SFEU.
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. 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. The last of these deficit notes was repaid in
April, 1996.
The 1995-96 and 1996-97 Budget Acts reflected significantly improved
financial conditions, as the State's economy recovered and tax revenues soared
above projections. Over the two years, revenues averaged about $2 billion higher
than initially estimated. Most of the additional revenues were allocated to
school funding, as required by Proposition 98, and to make up shortfalls in
federal aid for health and welfare costs and costs of illegal aliens. The
budgets for both these years showed strong increases in funding for K-14 public
education, including implementation of initiatives to reduce class sizes for
lower elementary grades to not more than 20 pupils. Higher education funding
also increased. Spending for health and welfare programs was kept in check, as
previously-implemented cuts in benefit levels were retained.
Fiscal Year 1997-98 Budget. With continued strong economic recovery and
surging tax receipts, the State entered the 1997-98 Fiscal Year in the strongest
financial position in the decade. However, in May 1997, the California Supreme
Court ruled that the State had acted illegally in 1993 and 1994 by using a
deferral of payments to the Public Employees Retirement Fund to help balance
earlier budgets. In response to this court decision, the Governor ordered an
immediate repayment to the Retirement Fund of about $1.235 billion, which was
made in late July, 1997, and substantially 'used up' the expected additional
revenues for the fiscal year. The Budget Act as signed provided for about $52.8
billion of General Fund expenditures, and assumed about $52.5 billion of
revenues.
The 1997-98 Budget Act provided another year of rapidly increasing funding
for K-14 public education. Total General Fund support was targeted to reach
$5,150 per pupil, more than 20% higher than the recession-period levels which
were in effect as late as FY 1993-94. The $1.75 billion in new funding was
budgeted to be spent on class size reduction and other initiatives, as well as
fully funding growth and cost of living increases. Support for higher education
units in the State also increased by about 6 percent. Because of the pension
payment, most other State programs were funded at levels
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consistent with prior years, and several initiatives had to be dropped. These
included additional assistance to local governments, state employee raises, and
funding of a bond bank.
Part of the 1997-98 Budget Act was completion of State welfare reform
legislation to implement the new federal law passed in 1996. The new State
program, called 'CalWORKs,' became effective January 1, 1998, and emphasizes
programs to bring aid recipients into the workforce. As required by federal law,
new time limits were placed on receipt of welfare aid. Grant levels for 1997-98
remained at the reduced, prior years' levels.
The Department of Finance released updated budget estimates in May, 1998,
which showed that revenues for the 1997-98 Fiscal Year would be $54.6 billion,
almost $2 billion higher than initial budget estimates, as a result of the
strong economy. Expenditures were expected to increase to about $53.0 billion,
resulting in a significant balance in the SFEU at June 30, 1998.
Proposed 1998-99 Fiscal Year Budget
The Governor released his proposed FY 1998-99 Budget on January 9, 1998,
and updated his revenue projections and budgetary proposals on May 13, 1998 (the
'May Revision'). The May Revision projected General Fund revenues and transfers
of $57.8 billion. Revenue losses due to tax cuts enacted in late 1997 were
expected to be offset by higher capital gains realizations. These revenue
estimates were $2.5 billion higher than the Governor had projected with the
January Budget proposal. The Governor proposed expenditures of $58.3 billion.
The Governor proposed significant additional funding for K-12 schools under
Proposition 98, as well as additional funding for higher education, with a
proposed reduction of college student fees. State and federal funds will be used
in the new CalWORKS welfare program, with projections of a fourth consecutive
year of caseload decline. The Governor proposed a large capital expenditure
program, focusing on schools and universities, but also including corrections,
environmental and general government projects. These proposals would require
approval of almost $10 billion of new general obligation bonds over the next six
years. No agreement was reached with the Legislature to place any bond measures
on the June, 1998 ballot, but negotiations will continue for bonds at the
November, 1998 election.
With the significantly increased revenue projection for both 1997-98 and
1998-99, the Governor proposed in the May Revision that the State reduce its
Vehicle License Fee (a personal property tax on the value of automobiles, the
'VLF') by 75% over five years, by which time the tax cut would be more than $3.5
billion annually. Under current law, the VLF is entirely dedicated to city and
county government, and the Governor proposed to use the State's burgeoning
General Fund to offset the loss of VLF funds to local government. All of the
Governor's proposals must be negotiated with the Legislature as part of the
annual budget process.
Although the State's strong economy is producing record revenues to the
State government, the State's budget continues to be under stress from mandated
spending on education, a rising prison population, and social needs of a growing
population with many immigrants. These factors which limit State spending growth
also put pressure on local governments. There can be no assurances that, if
economic conditions weaken, or other factors intercede, the State will not
experience budget gaps in the future.
Bond Rating
The ratings on California's long-term general obligation bonds were reduced
in the early 1990's from 'AAA' levels which had existed prior to the recession.
In 1996 and 1997, the ratings of California's general obligation bonds were
raised by the three major rating agencies, which as of June 1998 assigned
ratings of 'A+' from Standard & Poor's, 'A1' from Moody's and 'AA-' from Fitch.
There can be no assurance that such ratings will be maintained in the future. It
should be noted that the creditworthiness of obligations issued by local
California issuers may be unrelated to creditworthiness of obligations issued by
the State of California, and that there is no obligation on the part of the
State to make payment on such local obligations in the event of default.
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Legal Proceedings
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. Trial courts have entered tentative decisions or injunctions
which would overturn several parts of the State's recent budget compromises. The
matters covered by these lawsuits include reductions in welfare payments and the
use of certain cigarette tax funds for health costs. All of these cases are
subject to further proceedings and appeals, and if California eventually loses,
the final remedies may not have to be implemented in one year.
Obligations of Other Issuers
Other Issuers of California Municipal Obligations. There are a number of
State agencies, instrumentalities and political subdivisions of the State that
issue Municipal Obligations, some of which may be conduit revenue obligations
payable from payments from private borrowers. These entities are subject to
various economic risks and uncertainties, and the credit quality of the
securities issued by them may vary considerably from the credit quality of
obligations backed by the full faith and credit of the State.
State Assistance. Property tax revenues received by local governments
declined more than 50% following passage of Proposition 13. 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. Total
local assistance from the State's General Fund was budgeted at approximately 75%
of General Fund expenditures in recent years, including the effect of
implementing reductions in certain aid programs. To reduce State General Fund
support for school districts, the 1992-93 and 1993-94 Budget Acts caused local
governments to transfer $3.9 billion of property tax revenues to school
districts, representing loss of the post-Proposition 13 'bailout' aid. Local
governments have in return received greater revenues and greater flexibility to
operate health and welfare programs. While the Governor initially proposed to
grant new aid to local governments from the State's improved fiscal condition in
1997-98, the decision to repay the State pension fund eliminated these monies.
To the extent the State should be constrained by its Article XIIIB
appropriations limit, or its obligation to conform to Proposition 98, or other
fiscal considerations, the absolute level, or the rate of growth, of State
assistance to local governments may continue to be reduced. Any such reductions
in State aid could compound the serious fiscal constraints already experienced
by many local governments, particularly counties. Los Angeles County, the
largest in the State, was forced to make significant cuts in services and
personnel, particularly in the health care system, in order to balance its
budget in FY1995-96 and FY1996-97. Los Angeles County's debt was downgraded by
Moody's and S&P in the summer of 1995. Orange County, which emerged from Federal
Bankruptcy Court protection in June 1996, has significantly reduced county
services and personnel, and faces strict financial conditions following large
investment fund losses in 1994 which resulted in bankruptcy.
Counties and cities may face further budgetary pressures as a result of
changes in welfare and public assistance programs, which were enacted in August,
1997 in order to comply with the federal welfare reform law. Generally, counties
play a large role in the new system, and are given substantial flexibility to
develop and administer programs to bring aid recipients into the workforce.
Counties are also given financial incentives if either at the county or
statewide level, the 'Welfare-to-Work' programs exceed minimum targets; counties
are also subject to financial penalties for failure to meet such targets.
Counties remain responsible to provide 'general assistance' for able-bodied
indigents who are ineligible for other welfare programs. The long-term financial
impact of the new CalWORKs system on local governments is still unknown.
Legislation enacted in late 1997 provides for the State to take over
financial responsibility for funding trial courts throughout the State. This is
estimated to save counties and cities a total of over $350 million annually.
Assessment Bonds. California Municipal Obligations which are assessment
bonds may be adversely affected by a general decline in real estate values or a
slowdown in real estate sales activity. In many
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cases, such bonds are secured by land which is undeveloped at the time of
issuance but anticipated to be developed within a few years after issuance. In
the event of such reduction or slowdown, such development may not occur or may
be delayed, thereby increasing the risk of a default on the bonds. Because the
special assessments or taxes securing these bonds are not the personal liability
of the owners of the property assessed, the lien on the property is the only
security for the bonds. Moreover, in most cases the issuer of these bonds is not
required to make payments on the bonds in the event of delinquency in the
payment of assessments or taxes, except from amounts, if any, in a reserve fund
established for the bonds.
California Long Term Lease Obligations. Based on a series of court
decisions, certain long-term lease obligations, though typically payable from
the general fund of the State or a municipality, are not considered
'indebtedness' requiring voter approval. Such leases, however, are subject to
'abatement' in the event the facility being leased is unavailable for beneficial
use and occupancy by the municipality during the term of the lease. Abatement is
not a default, and there may be no remedies available to the holders of the
certificates evidencing the lease obligation in the event abatement occurs. The
most common cases of abatement are failure to complete construction of the
facility before the end of the period during which lease payments have been
capitalized and uninsured casualty losses to the facility (e.g., due to
earthquake). In the event abatement occurs with respect to a lease obligation,
lease payments may be interrupted (if all available insurance proceeds and
reserves are exhausted) and the certificates may not be paid when due.
Litigation is brought from time to time which challenges the constitutionality
of such lease arrangements.
Other Considerations
The repayment of industrial development securities secured by real property
may be affected by California laws limiting foreclosure rights of creditors.
Securities backed by health care and hospital revenues may be affected by
changes in State regulations governing cost reimbursements to health care
providers under Medi-Cal (the State's Medicaid program), including risks related
to the policy of awarding exclusive contracts to certain hospitals.
Limitations on ad valorem property taxes may particularly affect 'tax
allocation' bonds issued by California redevelopment agencies. Such bonds are
secured solely by the increase in assessed valuation of a redevelopment project
area after the start of redevelopment activity. In the event that assessed
values in the redevelopment project decline (e.g., because of a major natural
disaster such as an earthquake), the tax increment revenue may be insufficient
to make principal and interest payments on these bonds. Both Moody's and S&P
suspended ratings on California tax allocation bonds after the enactment of
Articles XIIIA and XIIIB, and only resumed such ratings on a selective basis.
Proposition 87, approved by California voters in 1988, requires that all
revenues produced by a tax rate increase go directly to the taxing entity which
increased such tax rate to repay that entity's general obligation indebtedness.
As a result, redevelopment agencies (which, typically, are the issuers of tax
allocation securities) no longer receive an increase in tax increment when taxes
on property in the project area are increased to repay voter-approved bonded
indebtedness.
The effect of these various constitutional and statutory changes upon the
ability of California municipal securities issuers to pay interest and principal
on their obligations remains unclear. Furthermore, other measures affecting the
taxing or spending authority of California or its political subdivisions may be
approved or enacted in the future. Legislation has been or may be introduced
which would modify existing taxes or other revenue-raising measures or which
either would further limit or, alternatively, would increase the abilities of
state and local governments to impose new taxes or increase existing taxes. It
is not possible, at present, to predict the extent to which any such legislation
will be enacted. Nor is it possible, at present, to determine the impact of any
such legislation on California Municipal Obligations in which the Fund may
invest future allocations of state revenues to local governments or the
abilities of state or local governments to pay the interest on, or repay the
principal of, such California Municipal Obligations.
Substantially all of California is within an active geologic region subject
to major seismic activity. Northern California in 1989 and Southern California
in 1994 experienced major earthquakes causing
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billions of dollars in damages. The federal government provided more than $13
billion in aid for both earthquakes, and neither event is expected to have any
long-term negative economic impact. Any California Municipal Obligation in the
Fund could be affected by an interruption of revenues because of damaged
facilities, or, consequently, income tax deductions for casualty losses or
property tax assessment reductions. Compensatory financial assistance could be
constrained by the inability of (i) an issuer to have obtained earthquake
insurance coverage rates; (ii) an insurer to perform on its contracts of
insurance in the event of widespread losses; or (iii) the federal or State
government to appropriate sufficient funds within their respective budget
limitations.
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 Annual Information
Statement. 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
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.
ECONOMIC FACTORS. New York is the third most populous state in the nation
and has a relatively high level of personal wealth. 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. The State's location and its
excellent air transport facilities and natural harbors have made it an important
link in international commerce. Travel and tourism constitute an important part
of the economy. Like the rest of the nation, New York has a declining proportion
of its workforce engaged in manufacturing, and an increasing proportion engaged
in service industries.
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. Economic activity in the City has experienced
periods of growth and recession and can be expected to experience periods of
growth and recession in the future. In recent years, the City has experienced
increases in employment. Real per capita personal income (i.e., per capita
personal income adjusted for the effects of inflation and the differential in
living costs) has generally experienced fewer fluctuations than employment in
the City. Although the City periodically experienced declines in real per capita
personal income between 1969 and 1981, real per capita personal income in the
City has generally increased from the mid-1980s until the present. In nearly all
of the years between 1969 and 1988 the City experienced strong increases in
retail sales. However, from 1989 to 1993, the City experienced a weak period of
retail sales. Since 1994, the City has returned to a period of growth in retail
sales. Overall, the City's economic improvement accelerated significantly, in
fiscal year 1997. Much of the increase can be traced to the performance of the
securities industry, but the City's economy also produced gains in the retail
trade sector, the hotel and tourism industry, and business services, with
private sector employment higher than previously forecasted. The City's current
Financial Plan assumes that, after strong growth in 1997-1998, moderate economic
growth will exist through calendar year 2002, with moderating job growth and
wage increases. However, there can be no assurance that the economic projections
assumed in the Financial Plan will occur or that the tax revenues projected in
the Financial Plan to be received will be received in the amounts anticipated.
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
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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. Currently the
State economy continues to expand, but growth remains somewhat slower than in
the nation. Although the State has added over 400,000 jobs since late 1992,
employment growth has been hindered during recent years by significant cutbacks
in the computer and instrument manufacturing, utility, defense and banking
industries. Government downsizing has also moderated these job gains. Personal
income increased substantially in 1992 and 1993. The State's economy entered
into the fourth year of a slow recovery in 1996. Most of the growth occurred in
the trade, construction and service industries, with business, social services
and health sectors accounting for most of the service industry growth.
The State has released information regarding the national and state
economic activity in its Annual Information Statement of the State of New York
dated June 26,1998 ('Annual Information Statement'). At the State level, the
Annual Information Statement projects continued expansion during the 1998
calendar year, with employment growth gradually slowing as the year progresses.
The financial and business service sectors are expected to continue to do well,
while employment in the manufacturing and government sectors will post only
small, if any, declines. On an average annual basis, the employment growth rate
in the State is expected to be higher than in 1997 and the unemployment rate is
expected to drop further to 6.1 percent. Personal income is expected to record
moderate gains in 1998. Wage growth in 1998 is expected to be slower than in the
previous year as the recent robust growth in bonus payments moderates.
Personal income tax collections for 1998-99 are projected to reach $21.24
billion, or $3.5 billion above the reported 1997-98 collection total. Total
business tax collections in 1998-99 are now projected to be $4.96 billion, $91
million less than received in he prior fiscal year. Receipts from user taxes and
fees are projected to total $7.14 billion, an increase of $107 million from
reported collections in the prior year. Other tax receipts are projected to
total $1.02 billion-$75 million below last year's amount. Total miscellaneous
receipts are projected to reach $1.40 billion, down almost $200 million from the
prior year. Transfers from other funds are expected to total $1.8 billion, or
$222 million less than total receipts from this category during 1997-98.
General Fund disbursements in 1998-99, including transfers to support
capital projects, debt service and other funds are estimated at $36.78 billion.
This represents an increase of $2.43 billion or 7.1 percent from 1997-98. Nearly
one-half of the growth is for educational purposes, reflecting increased support
for public schools, special education programs and the State and City university
systems. The remaining increase is primarily for Medicaid, mental hygiene, and
other health and social welfare programs, including children and family
services. The 1998-99 Financial Plan also includes funds for the current
negotiated salary increases for State employees, as well as increased transfers
for debt service. Grants to local governments is the largest category of General
Fund disbursements and includes financial assistance to local governments and
not-for-profit corporations, as well as entitlement benefits to individuals. The
1998-99 Financial Plan projects spending of $25.14 billion in this category, an
increase of $1.88 billion or 8.1 percent over the prior year. The largest annual
increases are for educational programs, Medicaid, other health and social
welfare programs, and community projects grants. The 1998-99 budget provides
$9.65 billion in support of public schools. The year-to-year increase of $769
million is comprised of partial funding for a 1998-99 school year increase of
$847 million as well as the remainder of the 1997-98 school year increase that
occurs in State fiscal year 1998-99. Spending for all other educational
programs, which includes the State and City university systems, the Tuition
Assistance Program, and handicapped programs, is estimated at $3.00 billion, an
increase of $270 million over 1997-98 levels. Medicaid costs are estimated at
$5.60 billion, an increase of $144 million from the prior year.
The 1998-99 Financial Plan projects a closing fund balance in the General
Fund of $1.42 billion. This fund balance is composed of a reserve of $761
million available for future needs, a $400 million balance in the TSRF, a $158
million in the CPF, and a balance of $100 million in the CRF, after a projected
deposit of $32 million in 1998-99.
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The economic and financial condition of the State may be affected by
various financial, social, economic and political factors. These factors can be
very complex, may vary from fiscal year to fiscal year, and are frequently the
result of actions taken not only by the State and its agencies and
instrumentalities, but also by entities, such as the federal government, that
are not under the control of the State. Because of the uncertainty and
unpredictability of these factors, their impact cannot, as a practical matter,
be included in the assumptions underlying the State's projections at this time.
As a result, there can be no assurance that the State economy will not
experience results in the current fiscal year that are worse than predicted,
with corresponding material and adverse effects on the State's projections of
receipts and disbursements.
The State Financial Plan is based upon forecasts of national and State
economic activity developed through both internal analysis and review of State
and national economic forecasts prepared by commercial forecasting services and
other public and private forecasters. Economic forecasts have frequently failed
to predict accurately the timing and magnitude of changes in the national and
the State economies, including consumer attitudes toward spending, the extent of
corporate and governmental restructuring, the condition of the financial sector,
federal fiscal and monetary policies, the level of interest rates, and the
condition of the world economy, which could have an adverse effect on the
State's projections of receipts and disbursements.
THE STATE. Owing to the factors mentioned above 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.
Total General Fund receipts in 1998-99 are projected to be $37.56 billion,
an increase of over $3 billion from the $34.55 billion recorded in 1997-98. This
total included $34.36 billion in tax receipts, $1.40 billion in miscellaneous
receipts, and $1.80 billion in transfers from other funds. However, many complex
political, social and economic forces influence the State's economy and
finances, which may in turn affect the State's Financial Plan. These forces may
affect the State unpredictably from fiscal year to fiscal year and are
influenced by governments, institutions, and organizations that are not subject
to the State's control. The State Financial Plan is also necessarily based upon
forecasts of national and State economic activity. Economic forecasts have
frequently failed to predict accurately the timing and magnitude of changes in
the national and the State economies. Because of the uncertainty and
unpredictability of changes in these factors, their impact cannot be fully
included in the assumptions underlying the State's projections.
An additional risk to the State Financial Plan arises from the potential
impact of certain litigation and of federal disallowances now pending against
the State, which could adversely affect the State's projections of receipts and
disbursements. The State Financial Plan assumes no significant litigation or
federal disallowance or other federal actions that could affect State finances,
but has significant reserves in the event of such an action.
REVENUE BASE. The State's principal revenue sources are economically
sensitive, and include the personal income tax, user taxes and fees and business
taxes. The 1998-99 Financial Plan projects General Fund receipts (including
transfers from other funds) of $37.56 billion, an increase of $34.55 billion
recorded in 1997-98. This total includes $34.36 billion in tax receipts, $1.40
billion in miscellaneous receipts, and $1.80 billion in transfers from other
funds.
The transfer of a portion of the surplus recorded in 1997-98 to 1998-99
exaggerates the 'real' growth in State receipts from year to year by depressing
reported 1997-98 figures and inflating 1998-99 projections. Conversely, the
incremental cost of tax reductions newly effective in 1998-99 and the impact of
statutes earmarking certain tax receipts to other funds work to depress apparent
growth below the underlying growth in receipts attributable to expansion of the
State's economy. On an adjusted basis, State tax revenues in the 1998-99 fiscal
year are projected to grow at approximately 7.5 percent, following an adjusted
growth of roughly nine percent in the 1997-98 fiscal year. On an adjusted basis,
State tax revenues in the 1998-99 fiscal year are projected to grow at
approximately 7.5 percent, following an adjusted growth of roughly nine percent
in the 1997-98 fiscal year.
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The Personal Income Tax is imposed on the income of individuals, estates
and trusts and is based on federal definitions of income and deductions with
certain modifications. This tax continues to account for over half of the
State's General Fund receipts base. Net personal income tax collections are
projected to reach $21.24 billion, nearly $3.5 billion above the reported
1997-98 collection total. Since 1997 represented the completion of the 20
percent income tax reduction program enacted in 1995, growth from 1997 to 1998
will be unaffected by major income tax reductions. Adding to the projected
annual growth is the net impact of the transfer of the surplus from 1997-98 to
the current year which affects reported collections by over $2.4 billion on a
year-over-year basis, as partially offset by the diversion of slightly over $700
million in income tax receipts to the STAR fund to finance the initial year of
the school tax reduction program. The STAR program was enacted in 1997 to
increase the State share of school funding and reduce residential school taxes.
Adjusted for these transactions, the growth in net income tax receipts is
roughly $1.7 billion, an increase of over 9 percent. This growth is largely a
function of over 8 percent growth in income tax liability projected for 1998 as
well as the impact of the 1997 tax year settlement on 1998-99 net collections.
User taxes and fees comprised of three quarters of the State four percent
sales and use tax (the balance, one percent, flows to support Government
Assistance Corporation ('LGAC') debt service requirements), cigarette, alcoholic
beverage container, and auto rental taxes, and a portion of the motor fuel
excise levies. Also included in this category are receipts from the motor
vehicle registration fees and alcoholic beverage license fees. A portion of the
motor fuel tax and motor vehicle registration fees and all of the highway use
tax are earmarked for dedicated transportation funds.
Receipts from user taxes and fees receipts are projected to total $7.14
billion, an increase of $107 million from reported collections in the prior
year. The sales tax component of this category accounts for all of the 1998-99
growth, as receipts from all other sources decline $100 million. The growth in
yield of the sales tax in 1998-99, after adjusting for tax law and other
changes, is projected at 4.7 percent. The yields of most of the excise taxes in
this category show a long-term declining trend, particularly cigarette and
alcoholic beverage taxes. These General Fund declines are exacerbated in 1998-99
by revenue losses from scheduled and newly enacted tax reductions, and by an
increase in earmarking of motor vehicle registration fees to the Dedicated
Highway and Bridge Trust Fund.
Business taxes include franchise taxes based generally on net income of
general business, bank and insurance corporations, as well as gross receipt
taxes on utilities and galling-based petroleum business taxes. Beginning in
1994, a 15 percent surcharge on these levies began to be phased out and, for
most taxpayers, there is no surcharge liability for taxable periods ending in
1997 and thereafter.
Total business tax collections in 1998-99 are now projected to be $4.96
billion, $91 million less than received in the prior fiscal year. The category
includes receipts from the largely income-based levies on general business
corporations, banks and insurance companies, gross receipts taxes on energy and
telecommunication service providers and a per-gallon imposition on petroleum
business. The year-over-year decline in projected receipts in this category is
largely attributable to statutory changes between the two years. These include
the first year of utility-tax rate cuts and the Power for Jobs tax reduction
program for energy providers, and he scheduled additional diversion of General
Fund petroleum business and utility tax receipts to other funds. In addition,
profit growth is also expected to slow in 1998.
Other taxes include estate, gift and real estate transfer taxes, a tax on
gains from the sale or transfer of certain real estate (this tax was repealed in
1996), a pari-mutuel tax and other minor levies. They are now projected to total
$1.02 billion-$75 million below last year's amount. Two factors account for a
significant part of the expected decline in collections from this category.
First, the effects of the elimination of the real property gains tax
collections; second, a decline in estate tax receipts, following the explosive
growth recorded in 1997-98, when receipts expanded by over 16 percent.
Miscellaneous receipts include investment income, abandoned property
receipts, medical provider assessments, minor federal grants, receipts from
public authorities, and certain other license and fee revenues. Total
miscellaneous receipts are projected to reach $1.40 billion, down almost $200
million from the prior year, reflecting the loss of non-recurring receipts in
1997-98 and the growing effects of the phase-out of the medical provider
assessments.
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Transfers from other funds to the General Fund consist primarily of tax
revenues in excess of debt service requirements, particularly the one percent
sales tax used to support payments to LGAC. Transfers from other funds are
expected to total $1.8 billion, or $222 million less than total receipts from
this category during 1997-98. Total transfers of sales taxes in excess of LGAC
debt service requirements are expected to increase by approximately $51 million,
while transfers from all other funds are expected to fall by $273 million,
primarily reflecting the absence, in 1998-99, of a one-time transfer of nearly
$200 million for retroactive reimbursement of certain social services claims
from the federal government.
STATE DEBT. General Fund disbursements in 1998-99, including transfers to
support capital projects, debt service and other funds are estimated at $36.78
billion. This represents an increase of $2.43 billion or 7.1 percent from
1997-98. Nearly one-half of the growth is for educational purposes, reflecting
increased support for public schools, special education programs and the State
and City university systems. The remaining increase is primarily for Medicaid,
mental hygiene and other health and social welfare programs, including children
and family services. The 1998-99 Financial Plan also includes funds for the
current negotiated salary increase for State employees, as well as increased
transfers for debt service.
NONRECURRING SOURCES. The Division of the Budget estimates that the
1998-99 State Financial Plan contains actions that provide nonrecurring
resources or savings totaling approximately $64 million, the largest of which is
a retroactive reimbursement of federal welfare claims.
OUTYEAR PROJECTIONS OF RECEIPTS AND DISBURSEMENTS
State law requires the Governor to propose a balanced budget each year. In
recent years, the State has closed projected budget gaps of $5.0 billion
(1995-96), $3.9 billion (1996-97), $2.3 billion (1997-98), and less than $1
billion (1998-99). The State, as a part of the 1998-99 Executive Budget
projections submitted to the Legislature in February 1998, projected a 1999-00
General Fund budget gap of approximately $1.7 billion and a 2000-01 gap of $3.7
billion. As a result of changes made in the 1998-99 enacted budget, the 1999-00
gap is now expected to be roughly $1.3 billion, or about $400 million less than
previously projected, after application of reserves created as part of the
1998-99 budget process. Such reserves would not be available against subsequent
year imbalances.
Sustained growth in the State's economy could contribute to closing
projected budget gaps over the next several years, both in terms of
higher-than-projected tax receipts and in lower-than-expected entitlement
spending. However, the State's projections in 1999-00 currently assume actions
to achieve $600 million in lower disbursements and $250 million in additional
receipts from the settlement of State claims against the tobacco industry.
Consistent with past practice, the projections do not include any costs
associated with new collective bargaining agreements after the expiration of the
current round of contracts at the end of the 1998-99 fiscal year. The State
expects that the 1999-00 Financial Plan will achieve savings from initiatives by
State agencies to deliver services more efficiently, workforce management
efforts, maximization of federal and non-General Fund spending offsets, and
other actions necessary to bring projected disbursements and receipts into
balance.
The State will formally update its outyear projections of receipts and
disbursements for the 2000-01 and 2001-02 fiscal years as a part of the 1999-00
Executive Budget process, as required by law. The revised expectations for years
2000-01 and 2001-02 will reflect the cumulative impact of tax reductions and
spending commitments enacted over the last several years as well as new 1999-00
Executive Budget recommendations. The STAR program, which dedicates a portion of
person income tax receipts to fund school tax reductions, has a significant
impact on General Fund receipts. STAR is projected to reduce personal income tax
revenues available to the General Fund by an estimated $1.3 billion in 2000-01.
Measured from the 1998-99 base, scheduled reductions to estate and gift, sales
and other taxes, reflecting tax cuts enacted in 1997-98 and 1998-99, will lower
General Fund taxes and fees by an estimated $1.8 billion in 2000-01.
Disbursement projections for the outyears currently assume additional outlays
for school aid, Medicaid, welfare reform, mental health community reinvestment,
and other multi-year spending commitments in law.
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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 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. Since January
1995, the State's workforce has been reduced by about 10 percent, and is
projected to remain at its current level of approximately 191,000 persons in
1998-99 year. The State is currently preparing for negotiations with various
unions to establish new agreements since most of the existing contracts will
expire on March 31, 1999.
On August 22, 1996, the President signed into law the Personal
Responsibility and Work Opportunity Reconciliation Act of 1996. This federal
legislation fundamentally changed the programmatic and fiscal responsibilities
for administration of welfare programs at the federal, state and local levels.
The new law abolishes the federal Aid to Families with Dependent Children
program (AFDC), and creates a new Temporary Assistance to Needy Families with
Dependent Children program (AFDC), and creates a new Temporary Assistance to
Needy Families program (TANF) funded with a fixed federal block grant to states.
The new law also imposes (with certain exceptions) a five era durational limit
on TANF recipients, requires that virtually all recipients be engaged in work or
community service activities within two years of receipt benefits, and limits
assistance provided to certain immigrants and other classes of individuals.
States are required to meet work activity participation targets for their TANF
caseload; these requirements are phased in over time. States that fail to meet
these federally mandated job participation rates, or that fail to conform with
certain other federal standards, face potential sanctions in the form of a
reduced federal block grant.
Proposed legislation that includes both provisions necessary to implement
the State's TANF plan to conform with federal law and implement the Governor's
welfare reform proposal is still pending before the Legislature. There can be no
assurances of timely enactment of certain conforming provisions required under
the federal law. Further delay increases the risk that the State could incur
fiscal penalties for failure to comply with federal law.
MEDICAID. New York pariticpates in the federal Medicaid program under a
state plan approved by the Health Care Financing Administration. The federal
government provides a substanial portion of elgible 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. General Fund payments for Medicaid are projected to be $5.60 billion, an
increase of $144 million from the prior year. After adjusting 1997-98 for the
$116 million prepayment of an additional Medicaid cycle, Medicaid spending is
projected to increase $260 million or 4.9 percent. Disbursements for all other
health and social welfare programs are projected to total $3.63 billion, an
increase of $131 million from 1997-98. This includes an increase in support for
children and families and local public health programs, offset by a decline in
welfare spending of $75 million that reflects continuing State and local efforts
to reduce welfare fraud, declining caseloads, and the impact of State and
federal welfare reform legislation.
THE STATE AUTHORITIES. The fiscal stability of the State is related in
part to the fiscal stability of its public authorities. Public authorities are
not subject to the constitutional restrictions on the incurrence
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of debt which apply to the State itself and may issue bonds and notes within the
amounts and restrictions set forth in legislative authorization. The State's
access to the public credit markets could be impaired and the market price of
its outstanding debt may be materially and adversely affected if any of its
public authorities were to default on their respective obligations, particularly
those using the financing techniques referred to as State-supported or
State-related debt.
The State has numerous public authorities with various responsibilities,
including those which finance, construct and/or operate revenue producing public
facilities. Public authority operating expenses and debt service costs are
generally paid by revenues generated by the projects financed or operated, such
as tolls charged for the use of highways, bridges or tunnels, charges for public
power, electric and gas utility services, rentals charged for housing units, and
charges for occupancy at medical care facilities. In addition, State legislation
authorizes several financing techniques for public authorities. Also there are
statutory arrangements providing for State local assistance payments otherwise
payable to localities to be made under certain circumstances to public
authorities. Although the State has no obligation to provide additional
assistance to localities whose local assistance payments have been paid to
public authorities under these arrangements, the affected localities may seek
additional State assistance if local assistance payments are diverted. Some
authorities also receive moneys from State appropriations to pay for the
operating costs of certain of their programs. The MTA receives the bulk of this
money in order to provide transit and commuter services.
Beginning in 1998, the Long Island Power Authority (LIPA) assumed
responsibility for the provision of electric utility services previously
provided by Long Island Lighting Company for Nassau, Suffolk and a portion of
Queen Counties, as part of an estimated $7 billion financing plan.
METROPOLITAN TRANSPORTATION AUTHORITY
Since 1980, the State has enacted several taxes including a surcharge on
the profits of banks, insurance corporations and general business corporations
doing business in the 12 county Metropolitan Transportation Region served by the
MTA and a special one quarter of 1 percent regional sales and use tax that
provide revenues for mass transit purposes, including assistance to the MTA.
Since 1987 State law has required that the proceeds of a one quarter of 1
percent mortgage recording tax paid on certain mortgages in the Metropolitan
Transportation Region be deposited in a special MTA fund for operating or
capital expenses. In 1993, the State dedicated a portion of certain additional
State petroleum business tax receipts to fund operating or capital assistance to
the MTA. For the 1998-99 fiscal year, State assistance to the MTA is projected
to total approximately $1.3 billion, an increase of $133 million over the
1997-98 fiscal year.
State legislation accompanying the 1996-97 adopted State budget authorized
the MTA, Triborough Bridge and Tunnel Authority and Transit Authority to issue
an aggregate of $6.5 billion in bonds to finance a portion of the $12.17 billion
MTA capital plan for the 1995 through 1999 calendar years (the '1995-99 Capital
Program'). In July 1997, the Capital Program Review Board (CPRB) approved the
1995-99 Capital Program (subsequently amended in August 1997), which supersedes
the overlapping portion of the MTA's 1992-96 Capital Program. The 1995-99
Capital Program is the fourth capital plan since the Legislature authorized
procedures for the adoption, approval and amendment of MTA capital programs and
is designed to upgrade the performance of the MTA's transportation systems by
investing in new rolling stock, maintaining replacement schedules for existing
assets and bringing the MTA system into a state of good repair. The 1995-99
Capital Program assumes the issuance of an estimated $5.2 billion in bonds under
this $6.5 billion aggregate bonding authority. The remainder of the plan is
projected to financed through assistance from the State, the federal government,
and the City of New York, and from various other revenues generated from actions
taken the MTA.
There can be no assurance that all the necessary governmental actions for
the 1995-99 Capital Program or future capital programs will be taken, that
funding sources currently identified will not be decreased or eliminated, or
that the 1995-99 Capital Program, or parts thereof, will not be delayed or
reduced. Should funding levels fall below current projections, the MTA would
have to revise its 1995-99 Capital Program accordingly. If the 1995-99 Capital
Program is delayed or reduced, ridership and Fare revenues may decline, which
could, among other things, impair the MTA's ability to meet its operating
expenses without additional assistance.
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THE CITY
The fiscal health of the State may also be affected by the fiscal health of
New York City (City), which continues to receive significant financial
assistance from the State. State aid contributes to the City's ability to
balance its budget and meet its cash requirements. The State may also be
affected by the ability of the City and certain entities issuing debt for the
benefit of the City to market their securities successfully in the public credit
markets.
The City has achieved balanced operating results for each of its fiscal
years since 1981 as measured by the GAAP standards in force at that time.
However, in the early 1970s, the City incurred substantial operating deficits,
and its financial controls, accounting practices and disclosure policies were
widely criticized. In response to the City's fiscal crisis in 1975, the State
took action to assist the City in returning to fiscal stability. Among these
actions, the State established the Municipal Assistance Corporation For The City
of New York ('MAC') to provide financing assistance for the City; the New York
State Financial Control Board (the Control Board) to oversee the City's
financial affairs; and the Office of the State Deputy Comptroller for the City
of New York (OSDC) to assist the Control Board in exercising its powers and
responsibilities. A 'control period' existed from 1975 to 1986, during which the
City was subject to certain statutorily conditions were met. State law requires
the Control Board to reimpose a control period upon the occurrence, or
'substantial likelihood and imminence' of the occurrence, of certain events,
including (but not limited to) a City operating budget deficit of more than $100
million or impaired access to the public credit markets.
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. For each of the 1981 through 1996 fiscal years, the City
achieved balanced operating results as reported in accordance with then
applicable generally accepted accounting principles ('GAAP'). The City was
required to close substantial budget gaps in recent years in order to maintain
balanced operating results. There can be no assurance that the City will
continue to maintain a balanced budget as required by State law without
additional tax or other revenue increases or additional reductions in. City
services or entitlement programs, which could adversely affect the City's
economic base.
Pursuant to the New York State Financial Emergency Act for The City of New
York (the 'Financial Emergency Act' or the 'Act'), the City prepares a four year
annual financial plan, which is reviewed and revised on a quarterly basis and
which includes the City's capital, revenue and expense projections and outlines
proposed gap closing programs for years with projected budget gaps. The City's
projections set forth in the 1999-2002 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 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 1999-2002 Financial Plan will be
realized. Due to the uncertainty existing on the federal and state levels, the
ultimate adoption of the State budget for FY 1997-98 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
FY 1997-98 Budget may therefore be significantly adversely affected upon the
final adoption of the State budget for FY 1997-98. 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 year.
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The 1999-2002 Financial Plan projects revenues and expenditures for the
1999 fiscal year balanced in accordance with GAAP, and projects gaps of $1.5
billion, $2.1 billion and $1.6 billion for the 2000, 2001 and 2002 fiscal years,
respectively.
On April 24, 1998, the City released the Financial Plan for the 1999
through 2002 fiscal years, which relates to the City and certain entities which
receive funds from the City, and which is based on the Executive Budget and
Budget Message for the City's 1999 fiscal year (the 'Executive Budget'). The
Executive Budget and Financial Plan project revenues and expenditures for the
1999 fiscal year balanced in accordance with GAAP, and project gaps of $1.5
billion, $2.1 billion and $1.6 billion for the 2000, 2001 and 2002 fiscal years,
respectively.
Changes since the June Financial Plan include: (i) an increase in projected
tax revenues of $1.3 billion, $1.1 billion, $955 million, $897 million and $1.7
billion in the 1998 through 2002 fiscal years, respectively; (ii) a reduction in
assumed State aid of $283 million in the 1998 fiscal year and of between $134
million and $142 million in each of the 1999 through 2002 fiscal years,
reflecting the adopted budget for the State's 1998 fiscal year; (iii) a delay i
the assumed collection of $350 million of projected rent payments for the City's
airports in the 1999 fiscal year to fiscal years 2000 through 2002; (iv) a
reduction in projected debt service expenditures totaling $197 million, $361
million, $204 million and $226 million in the 1998 through 2001 fiscal years,
respectively; (v)an increase in the Board of Education (the 'BOE') spending of
$266 million, $26 million, $58 million and $193 million in the 1999 through 2002
fiscal years, respectively; (vi) an increase in expenditures for the City's
proposed drug initiatives totaling $68 million in the 1998 fiscal year and of
between $167 million and $193 million in each of the 1999 through 2002 fiscal
years; (vii) other agency net spending initiatives totaling $112 million, $443
million, $281 million, $273 million and $677 million in fiscal years 1998
through 2002, respectively; and (viii) reduced pension costs of $116 million,
$168 million and $404 million in fiscal years 2000 through 2002, respectively.
The Financial Plan also sets forth gap closing actions for the 1998 through 2002
fiscal years, which include: (i) additional agency actions totaling $176
million, $595 million, $516 million, $494 million and $552 million in fiscal
years 1998 through 2002, respectively, and (ii) assumed additional Federal and
State aid of $100 million in each of fiscal years 1999 through 2002.
The 1998 Modification and the 1999-2002 Financial Plan include a proposed
discretionary transfer in the 1998 fiscal year of approximately $2.0 billion to
pay debt service due in the 1999 fiscal year, and a proposed discretionary
transfer in the 1999 fiscal year of $416 million to pay debt service due in
fiscal year 2000, included in the Budget Stabilization Plan for the 1998 and
1999 fiscal years, respectively. In addition, the Financial Plan reflects
proposed tax reduction programs totaling $237 million, $537 million, $657
million and $666 million in fiscal years 1999 through 2002, respectively,
including the elimination of the City sales tax on all clothing as of December
1, 1999, a City funded acceleration of the State funded personal income tax
reduction for the 1999 through 2001 fiscal years, the extension of current tax
reductions for owners of cooperative and condominium apartments starting in
fiscal year 2000 and a personal income tax credit for child care and for
residential holders of Subchapter S corporations, which are subject to State
legislative approval, and reduction of the commercial rent tax commencing in
fiscal year 2000.
Although the City has maintained balanced budgets in each of its last
sixteen fiscal years and is projected to achieve balanced operating results for
the 1998 fiscal year, there can be no assurance that the gap closing actions
proposed in the Financial Plan can be successfully implemented or that the City
will maintain a balanced budget in future years without additional State aid,
revenue increases or expenditure reductions. Additional tax increases and
reductions in essential City services could adversely affect the City's economic
base.
The City derives its revenues from a variety of local taxes, user charges
and miscellaneous revenues, as well as from Federal and State unrestricted and
categorical grants. State aid as a percentage of the City's revenues has
remained relatively constant over the period from 1980 to 1997, while
unrestricted Federal aid has been sharply reduced. The City projects that local
revenues will provide approximately 66.9% of total revenues in the 1998 fiscal
year while Federal aid, including categorical grants, will provide 13.2%, and
State aid, including unrestricted aid and categorical grants, will provide
19.7%.
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The City since 1981 has fully satisfied its seasonal financing needs in the
public credit markets, repaying all short term obligations within their fiscal
year of issuance. The City has issued $1.075 billion of short term obligations
in fiscal year 1998 to finance the City's projected cash flow needs for the 1998
fiscal year. The City issued $2.4 billion of short term obligations in fiscal
year 1997. Seasonal financing requirements for the 1996 fiscal year increased to
$2.4 billion from $2.2 billion and $1.75 billion in the 1995 and 1994 fiscal
years, respectively. The delay in the adoption of the State's budget in certain
past fiscal years has required the city to issue short term notes in amounts
exceeding those expected early in such fiscal years.
The City makes substantial capital expenditures to reconstruct and
rehabilitate the city's infrastructure and physical assets, including City mass
transit facilities, sewers, streets, bridges and tunnels, and to make capital
investments that will improve productivity in City operations.
The City utilizes a three tiered capital planning process consisting of the
Ten Year Capital Strategy, the Four Year Capital Plan and the current year
Capital Budget. The Ten Year Capital Strategy is a long term planning tool
designed to reflect fundamental allocation choices and basic policy objectives.
The Four Year Capital Program translates mid-range policy goals into specific
projects. The Capital Budget defines specific projects and the timing of their
initiation, design, construction and completion.
This City's projection of its capital financing need pursuant to the
Mayor's Declaration of Need and Proposed Transitional Capital Plan of June 30,
1997 indicates additional projected debt and contract liabilities of
approximately $3 billion for fiscal year 1998. To provide for the City's capital
program, State legislation was enacted which created the Finance Authority, the
debt of which is not subject to the general debt limit. Without the Finance
Authority or other legislative relief, new contractual commitments for the
City's general obligation financed capital program would have been virtually
brought to a halt during the Financial Plan period beginning early in the 1998
fiscal year. By utilizing projected Finance Authority borrowing and including
the Finance Authority's projected borrowing as part of the total debt incurring
power set forth in the following table, the City's total debt incurring power
has been increased. Even with the increase, the City may reach the limit of its
capacity to enter into new contractual commitments in fiscal year 2000.
OTHER LOCALITIES. Certain localities outside New York City have
experienced financial problems and have requested and received additional State
assistance during the last several State fiscal years. The cities of Yonkers and
Troy continue to operate under State-ordered control agencies. The potential
impact on the State of any future requests by localities for additional
oversight or financial assistance is not included in the projections of the
State's receipts and disbursements for the State's 1998-99 fiscal year.
Eighteen municipalities received extraordinary assistance during the 1996
legislative session through $50 million in special appropriations targeted for
distressed cities, and twenty-eight municipalities received more than $32
million in targeted unrestricted aid in the 1997-98 budget. Both of these
emergency aid packages were largely continued through the 1998-99 budget. The
State also dispersed an additional $21 million among all cities, towns and
villages after enacting a 3.9 percent increase in General Purpose State Aid in
1997-98 and continued this increase in 1998-99.
The 1998-99 budget includes an additional $29.4 million in unrestricted aid
targeted to 57 municipalities across the State. Other assistance for
municipalities with special needs totals more than $25.6 million. Twelve upstate
cities will receive $24.2 million in one-time assistance from a cash flow
acceleration of State aid.
Municipalities and school districts have engaged in substantial short term
and long term borrowings. In 1996, the total indebtedness of all localities in
the State other than New York City was approximately $20.0 billion. A small
portion (approximately $77.2 million) of that indebtedness represented borrowing
to finance budgetary deficits and was issued pursuant to State enabling
legislation. State law requires the Comptroller to review and make
recommendations concerning the budgets of those local government units other
than New York City authorized by State law to issue debt to finance deficits
during the period that such deficit financing is outstanding. Twenty-one
localities had outstanding indebtedness for deficit financing at the close of
their fiscal year ending in 1996.
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INVESTMENT LIMITATIONS OF THE FUNDS
FUNDAMENTAL INVESTMENT LIMITATIONS. The following fundamental investment
limitations cannot be changed for a Fund without the affirmative vote of the
lesser of (1) more than 50% of the outstanding shares of the Fund or (2) 67% or
more of the shares of the Fund 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 331/3% 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.
(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 Fund 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 AMT ('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 is AMT
exempt interest;
(c) in the case of Municipal High Income Fund, in municipal
obligations; and
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(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 limitation (8): Each state, territory and possession
of the United States (including the District of Columbia and
Puerto Rico), 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 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 are not
fundamental and may be changed by each board without shareholder approval.
Each Fund will not:
(1) 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.
(2) 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.
(3) 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.
(4) 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.
(5) purchase portfolio securities while borrowings in excess of 5% of
its total assets are outstanding.
HEDGING AND OTHER STRATEGIES USING DERIVATIVE INSTRUMENTS
GENERAL DESCRIPTION OF DERIVATIVE INSTRUMENTS. As discussed in the
Prospectus, Mitchell Hutchins may use a variety of financial instruments
('Derivative Instruments'), including certain options, futures contracts
(sometimes referred to as 'futures') and options on futures contracts, to
attempt to hedge a
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Fund's portfolio and to enhance income or realize gains. A Fund may enter into
transactions using one or more types of Derivative Instruments, under which the
full value of its portfolio is at risk. Under normal circumstances, however, a
Fund's use of those instruments will place at risk a much smaller portion of its
assets. The particular Derivative Instruments used by the Funds are 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 INDICES 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 indices 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.
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 STRATEGIES USING DERIVATIVE INSTRUMENTS. Hedging
strategies can be broadly categorized as 'short hedges' and 'long hedges.' A
short hedge is a purchase or sale of a Derivative 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 Derivative 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 Derivative Instrument
intended partially or fully to offset potential increases in the acquisition
cost of one or more investments that a Fund intends to
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acquire. Thus, in a long hedge a Fund takes a position in a Derivative
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.
Derivative 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. Derivative Instruments on indices, in contrast, generally
are used to hedge against price movements in broad market sectors in which a
Fund has invested or expects to invest. Derivative Instruments on debt
securities may be used to hedge either individual securities or broad fixed
income market sectors.
The use of Derivative Instruments is subject to applicable regulations of
the Securities and Exchange Commission ('SEC'), the several options and futures
exchanges upon which they are traded and the Commodity Futures Trading
Commission ('CFTC'). In addition, a Fund's ability to use Derivative Instruments
will be limited by tax considerations. See 'Taxes.'
In addition to the products and strategies described below, Mitchell
Hutchins may discover additional opportunities in connection with Derivative
Instruments and with hedging, income and gain strategies. These new
opportunities may become available as regulatory authorities broaden the range
of permitted transactions and as new Derivative Instruments and 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 STRATEGIES USING DERIVATIVE INSTRUMENTS. The use of
Derivative Instruments involves special considerations and risks, as described
below. Risks pertaining to particular Derivative Instruments are described in
the sections that follow.
(1) Successful use of most Derivative 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 Derivative 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 Derivative Instrument and price movements of the
investments being hedged. For example, if the value of a Derivative 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
Derivative Instruments are traded. The effectiveness of hedges using Derivative
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 Derivative Instrument. Moreover, if the price of the Derivative
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 Derivative Instruments involving obligations to third parties
(i.e., Derivative Instruments other than purchased options). If a
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Fund were unable to close out its positions in such Derivative 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 Derivative 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 counterparty to enter into a transaction
closing out the position. Therefore, there is no assurance that any position in
a Derivative Instrument can be closed out at a time and price that is favorable
to the Fund.
COVER FOR STRATEGIES USING DERIVATIVE INSTRUMENTS. Transactions using
Derivative 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 such 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 Derivative Instrument is open, unless they are
replaced with similar assets. As a result, committing a large portion of a
Fund's assets to cover positions or to 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
may serve as a long hedge, and the purchase of put options may serve 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 may serve 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
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
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between the Fund and its counterparty (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 counterparty to make or take delivery of the
underlying investment upon exercise of the option. Failure by the counterparty
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.
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 counterparty, or by a
transaction in the secondary market if any such market exists. Although a Fund
will enter into OTC options only with counterparties 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
counterparty, 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.
GUIDELINES FOR OPTIONS. A Fund's use of options is governed by the
following guidelines, which can be changed by its board without shareholder
vote:
1. A Fund may purchase a put or call option, including any straddle or
spread, 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 its 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 its 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 a Fund that are held at any time will not exceed 20% of its
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 may serve as a long hedge, and the sale of futures or the purchase of
put options thereon may serve as a short hedge. Writing covered call options on
futures contracts may serve as a limited short hedge, and writing covered put
options on futures contracts may 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's portfolio, 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's portfolio, 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, obligations of
the United States or obligations fully guaranteed as to principal and interest
by the United States, in an amount generally equal to 10% or less of the
contract value. Margin must also be
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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 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
its board 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.
31
<PAGE>
<PAGE>
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.
TRUSTEES AND OFFICERS; PRINCIPAL HOLDERS OF SECURITIES
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**; 51 Trustee and Mrs. Alexander is president, chief executive officer
President and a director of Mitchell Hutchins (since January
1995) and an executive vice president and director
of PaineWebber (since March 1984). Mrs. Alexander
is president and a director or trustee of 31
investment companies for which Mitchell Hutchins
or PaineWebber serves as investment adviser.
Richard Q. Armstrong; 63 Trustee Mr. Armstrong is chairman and principal of RQA
78 West Brother Drive Enterprises (management consulting firm) (since
Greenwich, CT 06830 April 1991 and principal occupation since March
1995). Mr. Armstrong 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). He 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, Louis
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 30
investment companies for which Mitchell Hutchins
or PaineWebber serves as investment adviser.
</TABLE>
32
<PAGE>
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ ---------------- ----------------------------------------------------
<S> <C> <C>
E. Garrett Bewkes, Jr.**; 71 Trustee and Mr. Bewkes is a director of Paine Webber Group Inc.
Chairman of the ('PW Group') (holding company of PaineWebber and
Board of Mitchell Hutchins). Prior to December 1995, he was
Trustees 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 a director of Interstate Bakeries
Corporation and NaPro BioTherapeutics, Inc. Mr.
Bewkes is a director or trustee of 31 investment
companies for which Mitchell Hutchins or
PaineWebber serves as investment adviser.
Richard R. Burt; 51 Trustee Mr. Burt is chairman of IEP Advisors, Inc.
1275 Pennsylvania Avenue, N.W. (international investments and consulting firm)
Washington, D.C. 20004 (since March 1994) and a partner of McKinsey &
Company (management consulting firm) (since 1991).
He is also a director of Archer-Daniels-Midland
Co. (agricultural commodities), Hollinger
International Co. (publishing), Homestake Mining
Corp., Powerhouse Technologies Inc. and Wierton
Steel Corp. 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 30 investment
companies for which Mitchell Hutchins or
PaineWebber serves as investment adviser.
Mary C. Farrell**; 48 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 appears 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 30 investment
companies for which Mitchell Hutchins or
PaineWebber serves as investment adviser.
</TABLE>
33
<PAGE>
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ ---------------- ----------------------------------------------------
<S> <C> <C>
Meyer Feldberg; 56 Trustee Mr. Feldberg is Dean and Professor of Management of
Columbia University the Graduate School of Business, Columbia
101 Uris Hall University. Prior to 1989, he was president of the
New York, New York 10027 Illinois Institute of Technology. Dean Feldberg is
also a director of Primedia Inc., Federated
Department Stores, Inc. and Revlon, Inc. Dean
Feldberg is a director or trustee of 30 investment
companies for which Mitchell Hutchins or
PaineWebber serves as investment adviser.
George W. Gowen; 68 Trustee Mr. Gowen is a partner in the law firm of
666 Third Avenue Dunnington, Bartholow & Miller. Prior to May 1994,
New York, New York 10017 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 30 investment companies for which
Mitchell Hutchins or PaineWebber serves as
investment adviser.
Frederic V. Malek; 61 Trustee Mr. Malek is chairman of Thayer Capital Partners
1455 Pennsylvania Avenue N.W. (merchant bank). From January 1992 to November
Suite 350 1992, he was campaign manager of Bush-Quayle '92.
Washington, D.C. 20004 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., CB Commercial
Group, Inc. (real estate services), Choice Hotels
International (hotel and hotel franchising), FPL
Group, Inc. (electric services), Integra, Inc.
(bio-medical), Manor Care, Inc. (health care) and
Northwest Airlines Inc. Mr. Malek is a director or
trustee of 30 investment companies for which
Mitchell Hutchins or PaineWebber serves as
investment adviser.
</TABLE>
34
<PAGE>
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ ---------------- ----------------------------------------------------
<S> <C> <C>
Carl W. Schafer; 62 Trustee Mr. Schafer is president of the Atlantic Foundation
66 Witherspoon Street #1100 (charitable foundation supporting mainly
Princeton, New Jersey 08542 oceanographic exploration and research). He is a
director of Base Ten Systems, Inc., Roadway
Express, Inc. (trucking), The Guardian Group of
Mutual Funds, the Harding, Loevner Funds, Evans
Systems, Inc. (motor fuels, convenience store and
diversified company), Electronic Clearing House,
Inc. (financial transactions processing), Frontier
Oil Corporation and Nutraceutix, Inc.
(biotechnology company). Prior to January 1993, he
was chairman of the Investment Advisory Committee
of the Howard Hughes Medical Institute. Mr.
Schafer is a director or trustee of 30 investment
companies for which Mitchell Hutchins or
PaineWebber serves as investment adviser.
Cynthia N. Bow; 39 Vice President Ms. Bow is a vice president and a portfolio manager
(PW Mutual Fund of Mitchell Hutchins. Ms. Bow has been with
Trust only) Mitchell Hutchins since 1982. Ms. Bow is a vice
president of three investment companies for which
Mitchell Hutchins or PaineWebber serves as
investment adviser.
Elbridge T. Gerry III; 41 Vice President Mr. Gerry is a senior vice president and a portfolio
manager of Mitchell Hutchins. Prior to January
1996, he was with J.P. Morgan Private Banking
where he was responsible for managing municipal
assets, including several municipal bond funds.
Mr. Gerry is a vice president of five investment
companies for which Mitchell Hutchins or
PaineWebber serves as investment adviser.
John J. Lee; 29 Vice President Mr. Lee is a vice president and a manager of the
and Assistant mutual fund finance department of Mitchell
Treasurer Hutchins. Prior to September 1997, he was an audit
manager in the financial services practice of
Ernst & Young LLP. Mr. Lee is a vice president and
assistant treasurer of 30 investment companies for
which Mitchell Hutchins or PaineWebber serves as
investment adviser.
</TABLE>
35
<PAGE>
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ ---------------- ----------------------------------------------------
<S> <C> <C>
Dennis McCauley; 51 Vice President Mr. McCauley is a managing director and chief
investment officer -- fixed income of Mitchell
Hutchins. Prior to December 1994, he was director
of fixed income investments of IBM Corporation.
Mr. McCauley is a vice president of 20 investment
companies for which Mitchell Hutchins or
PaineWebber serves as investment adviser.
Ann E. Moran; 40 Vice President Ms. Moran is a vice president and a manager of the
and Assistant mutual fund finance department of Mitchell
Treasurer Hutchins. Ms. Moran is a vice president and
assistant treasurer of 31 investment companies for
which Mitchell Hutchins or PaineWebber serves as
investment adviser.
Richard S. Murphy; 43 Vice President Mr. Murphy is a senior vice president and a
(PW Mutual Fund portfolio manager of Mitchell Hutchins. Prior to
Trust only) March 1994 Mr. Murphy was a vice president at
American International Group. Mr. Murphy is a vice
president of two investment companies for which
Mitchell Hutchins or PaineWebber serves as
investment adviser.
Dianne E. O'Donnell; 46 Vice President Ms. O'Donnell is a senior vice president and deputy
and Secretary general counsel of Mitchell Hutchins. Ms.
O'Donnell is a vice president and secretary of 30
investment companies and vice president and
assistant secretary of one investment company for
which Mitchell Hutchins or PaineWebber serves as
investment adviser.
Emil Polito; 37 Vice President Mr. Polito is a senior vice president and director
of operations and control for Mitchell Hutchins.
From March 1991 to September 1993 he was director
of the mutual funds sales support and service
center for Mitchell Hutchins and PaineWebber. Mr.
Polito is also a vice president of 31 investment
companies for which Mitchell Hutchins or
PaineWebber serves as investment adviser.
</TABLE>
36
<PAGE>
<PAGE>
<TABLE>
<CAPTION>
POSITION BUSINESS EXPERIENCE;
NAME AND ADDRESS*; AGE WITH EACH TRUST OTHER DIRECTORSHIPS
- ------------------------------ ---------------- ----------------------------------------------------
<S> <C> <C>
Victoria E. Schonfeld; 47 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 and vice president and
secretary of one investment company for which
Mitchell Hutchins or PaineWebber serves as
investment adviser.
Paul H. Schubert; 35 Vice President Mr. Schubert is a senior vice president and the
and Treasurer director of the mutual fund finance department of
Mitchell Hutchins. From August 1992 to August
1994, he was a vice president at BlackRock
Financial Management L.P. Mr. Schubert is a vice
president and treasurer of 31 investment companies
for which Mitchell Hutchins or PaineWebber serves
as investment adviser.
Barney A. Taglialatela; 37 Vice President Mr. Taglialatela is a vice president and a manager
and Assistant of the mutual fund finance department of Mitchell
Treasurer Hutchins. Prior to February 1995, he was a manager
of the mutual fund finance division of Kidder
Peabody Asset Management, Inc. Mr. Taglialatela is
a vice president of 31 investment companies for
which Mitchell Hutchins or PaineWebber serves as
investment adviser.
William W. Veronda; 52 Vice President Mr. Veronda is a senior vice president of Mitchell
(PW Municipal Hutchins. Prior to September 1995, he was a senior
Series only) vice president and general manager at Invesco
Funds Group. Mr. Veronda is vice president of one
investment company for which Mitchell Hutchins or
PaineWebber serves as investment adviser.
Keith A. Weller; 36 Vice President Mr. Weller is a first vice president and associate
and Assistant general counsel of Mitchell Hutchins. Prior to May
Secretary 1995, he was an attorney in private practice. Mr.
Weller is a vice president and assistant secretary
of 30 investment companies for which Mitchell
Hutchins or PaineWebber serves as investment
adviser.
Ian W. Williams; 41 Vice President Mr. Williams is a vice president and a manager of
and Assistant the mutual fund finance department of Mitchell
Treasurer Hutchins. Mr. Williams is a vice president of 31
investment companies for which Mitchell Hutchins
or PaineWebber serves as investment adviser.
</TABLE>
(footnotes on next page)
37
<PAGE>
<PAGE>
(footnotes from previous page)
* 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 each
Fund 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 per series
for each board meeting and each separate 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. Each chairman
of the audit and contract review committees of individual funds within the
PaineWebber fund complex receives additional compensation aggregating $15,000
annually from the relevant 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 that Trust or with other
PaineWebber funds during the fiscal year ended February 28, 1998.
COMPENSATION TABLE'D'
<TABLE>
<CAPTION>
AGGREGATE COMPENSATION AGGREGATE COMPENSATION TOTAL COMPENSATION FROM
FROM PAINEWEBBER FROM PAINEWEBBER MUTUAL THE TRUSTS AND THE FUND
NAME OF PERSON, POSITION MUNICIPAL SERIES* FUND TRUST* COMPLEX**
- ----------------------------------- ---------------------- ----------------------- -----------------------
<S> <C> <C> <C>
Richard Q. Armstrong,
Trustee.......................... $4,100 $ 4,100 $ 94,885
Richard R. Burt,
Trustee.......................... 3,800 3,800 87,085
Meyer Feldberg,
Trustee.......................... 4,100 4,100 117,853
George W. Gowen,
Trustee.......................... 4,692 4,692 101,567
Frederic V. Malek,
Trustee.......................... 4,100 4,100 95,845
Carl W. Schafer,
Trustee.......................... 4,100 4,100 94,885
</TABLE>
- ------------------
'D' Only disinterested trustees 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
28, 1998.
** Represents total compensation paid to each trustee during the calendar year
ended December 31, 1997; no fund within the fund complex has a bonus,
pension, profit sharing or retirement plan.
PRINCIPAL HOLDERS OF SECURITIES
As of May 31, 1998, the Trusts' records indicate that no shareholder owned
more than 5% of a Fund's shares.
38
<PAGE>
<PAGE>
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 the Advisory Contracts, during each of the periods indicated,
Mitchell Hutchins earned (or accrued) advisory fees in the amounts set forth
below:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED FEBRUARY 28/29
--------------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
California Tax-Free Income Fund............................. $ 776,955 $ 902,327 $1,116,442
National Tax-Free Income Fund............................... $1,634,990 $2,022,871 $2,388,482
Municipal High Income Fund.................................. $ 551,107 $ 555,499 $ 647,537
New York Tax-Free Income Fund............................... $ 264,754 $ 312,553 $ 380,993
(of which (of which
$117,350 $123,590
was waived) was waived)
</TABLE>
Prior to August 1, 1997 PaineWebber provided certain services to the Funds
not otherwise provided by PFPC Inc. ('PFPC'), the Fund's transfer agent, which
agreement is reviewed by each board annually, PaineWebber earned (or accrued)
the amounts set forth below during each of the periods indicated:
<TABLE>
<CAPTION>
FISCAL YEAR ENDED
FOR THE FIVE FEBRUARY 28/29
MONTHS ENDED --------------------
JULY 31, 1997 1997 1996
------------- ------- -------
<S> <C> <C> <C>
California Tax-Free Income Fund........................... $ 5,924 $16,293 $19,943
National Tax-Free Income Fund............................. $15,757 $43,965 $52,513
Municipal High Income Fund................................ $ 5,104 $13,436 $15,997
New York Tax-Free Income Fund............................. $ 2,077 $ 7,682 $ 9,267
(of which)
$7,682
was waived
</TABLE>
Subsequent to July 31, 1997, PFPC (not the Funds) pays PaineWebber for
certain transfer agency related services that PFPC has delegated to PaineWebber.
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 a Trust not readily identifiable as belonging to a
particular Fund are allocated between the appropriate Funds by or under the
direction of the board 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
39
<PAGE>
<PAGE>
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.
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 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 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, 1998,
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)................................................ $ 7,322.7
Global........................................................................... 3,788.7
Equity/Balanced.................................................................. 6,260.8
Fixed Income (excluding Money Market)............................................ 4,850.6
Taxable Fixed Income............................................................. 3,267.9
Tax-Free Fixed Income............................................................ 1,582.7
Money Market Funds............................................................... 28,628.3
</TABLE>
PERSONNEL TRADING POLICIES. 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 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 funds and other Mitchell Hutchins advisory clients.
DISTRIBUTION ARRANGEMENTS. Mitchell Hutchins acts as the distributor of
each class of shares of the Funds under separate distribution contracts with
each Trust (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 Fund. Shares of the Funds are
offered continuously. Under separate exclusive dealer agreements between
Mitchell Hutchins and PaineWebber, relating to each class of shares of the Funds
(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
40
<PAGE>
<PAGE>
fee, accrued daily and payable monthly, at the annual rate of 0.50% of the
average daily net assets of the Class C shares. There is no distribution plan
with respect to the Funds' Class Y shares.
Among other things, each Plan provides that (1) Mitchell Hutchins will
submit to the applicable board at least quarterly, and the board members 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 is approved at least annually, and any material amendment thereto
is approved, by the applicable board, including those board members 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 board members who are not 'interested persons' of the Trust shall be
committed to the discretion of the board members who are not interested persons
of the Trust.
In reporting amounts expended under the Plans to the board members,
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 the three classes of shares for which there are Plans. 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 28,
1998:
<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............................................. $ 299,711 $ 593,783 $136,456 $ 56,124
Class B............................................. 185,535 364,267 183,553 85,494
Class C............................................. 127,095 396,151 141,828 98,452
</TABLE>
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 28, 1998:
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........................... $ 123,927 $ 190,360 $ 70,894 $ 52,043
Amortization of commissions......................... N/A N/A N/A N/A
Printing of prospectuses and statements of
additional information............................ 1,847 3,761 400 361
Branch network costs allocated and interest
expense........................................... 562,515 1,186,550 219,232 107,351
Service fees paid to PaineWebber investment
executives........................................ 113,889 225,638 51,853 21,330
</TABLE>
41
<PAGE>
<PAGE>
CLASS B
<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............................ $19,161 $ 29,190 $ 23,888 $19,840
Amortization of commissions.......................... 52,693 102,588 52,001 24,132
Printing of prospectuses and statements of additional
information........................................ 286 538 136 119
Branch network costs allocated and interest
expense............................................ 93,032 192,916 80,505 43,617
Service fees paid to PaineWebber investment
executives......................................... 17,625 34,606 17,437 8,151
</TABLE>
CLASS C
<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............................ $17,519 $ 42,336 $ 24,538 $30,439
Amortization of commissions.......................... 32,198 100,357 35,931 25,066
Printing of prospectuses and statements of additional
information........................................ 261 815 142 198
Branch network costs allocated and interest
expense............................................ 80,100 265,571 76,574 63,223
Service fees paid to PaineWebber investment
executives......................................... 16,098 50,179 17,965 11,704
</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 the Funds' overall Flexible Pricing'sm' system of
distribution, each board 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 Funds
and attracting new investors and assets to the Funds to the benefit of each
Fund and its shareholders; (2) facilitate distribution of the Funds' shares;
and (3) maintain the competitive position of the Funds in relation to other
funds that have implemented or are seeking to implement similar distribution
arrangements.
In approving the Class A Plan, each board 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 Funds than might otherwise be the case, (3)
the advantages to the shareholders of economies of scale resulting from growth
in each Fund's assets and potential continued growth, (4) the services provided
to each 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.
In approving the Class B Plan, each board 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
42
<PAGE>
<PAGE>
firms, resulting in greater growth of each Fund than might otherwise be the
case, (4) the advantages to the shareholders of economies of scale resulting
from growth in each Fund's assets and potential continued growth, (5) the
services provided to each 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 board members 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, each board considered all the features of
the distribution system, including (1) 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, (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 each Fund than might otherwise be the
case, (4) the advantages to the shareholders of economies of scale resulting
from growth in each Fund's assets and potential continued growth, (5) the
services provided to each 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 board members 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 boards 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 boards 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 Funds 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 (or periods) 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:
CALIFORNIA TAX-FREE INCOME FUND
<TABLE>
<CAPTION>
FISCAL YEARS ENDED FEBRUARY 28/29
---------------------------------
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
Earned...................................................................... $79,848 $56,842 $57,198
Retained.................................................................... 6,304 4,798 1,224
</TABLE>
NATIONAL TAX-FREE INCOME FUND
<TABLE>
<CAPTION>
FISCAL YEARS ENDED FEBRUARY 28/29
---------------------------------
1998 1997 1996
------- -------- -------
<S> <C> <C> <C>
Earned.................................................................... $79,748 $148,485 $66,206
Retained.................................................................. 6,357 1,253 1,026
</TABLE>
43
<PAGE>
<PAGE>
MUNICIPAL HIGH INCOME FUND
<TABLE>
<CAPTION>
FISCAL YEARS ENDED FEBRUARY 28/29
---------------------------------
1998 1997 1996
-------- ------- -------
<S> <C> <C> <C>
Earned.................................................................... $121,988 $23,894 $52,683
Retained.................................................................. 7,764 1,867 964
</TABLE>
NEW YORK TAX-FREE INCOME FUND
<TABLE>
<CAPTION>
FISCAL YEARS ENDED FEBRUARY 28/29
---------------------------------
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
Earned...................................................................... $47,579 $11,290 $14,417
Retained.................................................................... 3,962 838 1,034
</TABLE>
Mitchell Hutchins earned and retained the following contingent deferred
sales charges paid upon certain redemptions of shares for the fiscal year ended
February 28, 1998:
<TABLE>
<CAPTION>
CALIFORNIA NATIONAL MUNICIPAL NEW YORK
TAX-FREE TAX-FREE HIGH TAX-FREE
INCOME FUND INCOME FUND INCOME FUND INCOME FUND
----------- ----------- -------------- -----------
<S> <C> <C> <C> <C>
Class A............................ None None None None
Class B............................ $64,883 $ 121,302 $ 87,604 $25,199
Class C............................ 1,006 2,014 1,442 1,278
</TABLE>
PORTFOLIO TRANSACTIONS
Subject to policies established by each board, 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 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
44
<PAGE>
<PAGE>
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 board 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.
During the periods indicated, the portfolio turnover rates for each Fund
were as set forth below:
<TABLE>
<CAPTION>
PORTFOLIO TURNOVER RATES FOR THE
YEARS ENDED FEBRUARY 28
------------------------------------
1998 1997
---------------- ----------------
<S> <C> <C>
California Tax-Free Income Fund........................... 107% 73%
National Tax-Free Income Fund............................. 79% 81%
Municipal High Income Fund................................ 22% 64%
New York Tax-Free Income Fund............................. 34% 40%
</TABLE>
45
<PAGE>
<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 tables 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;
(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); or
(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.
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 that 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
46
<PAGE>
<PAGE>
valued in the same way as they would be valued for purposes of computing the
Fund's net asset value. Any such redemption in kind will be made with readily
marketable securities, to the extent available. 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 New York Stock
Exchange ('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 both high and 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 Fund shares concurrent with withdrawals are ordinarily
disadvantageous to shareholders because of tax liabilities and, for Class A
shares, initial sales charges. On or about the 20th of a month for monthly,
quarterly, semi-annual or annual plans, PaineWebber will arrange for redemption
by a Fund of sufficient Fund shares to provide the withdrawal payment specified
by participants in the Funds' 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, with the tax consequences described under
'Dividends & Taxes' in the Prospectus. If periodic withdrawals continually
exceed reinvested dividends and other distributions, a shareholder's investment
may be correspondingly reduced. A shareholder may change the amount of the
systematic withdrawal or terminate participation in the systematic withdrawal
plan at any time without charge or penalty by written instructions with
signatures guaranteed to PaineWebber or PFPC ('Transfer Agent').
Instructions to participate in the plan, change the withdrawal amount or
terminate participation in the plan will not be effective until five 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 Class A shares of a Fund may reinstate their
account 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
47
<PAGE>
<PAGE>
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
under 'Dividends & Taxes' in the Prospectus.
PAINEWEBBER RMA RESOURCE ACCUMULATION PLAN'sm';
PAINEWEBBER RESOURCE MANAGEMENT ACCOUNT'r' (RMA'r')
Shares of the PaineWebber mutual funds (each a 'PW Fund' and, collectively,
the 'PW Funds') are available for purchase by customers of PaineWebber and its
correspondent firms who maintain Resource Management Accounts ('RMA
Accountholders') through the RMA Resource Accumulation Plan ('Accumulation
Plan'). The Accumulation 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 Accumulation 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 Accumulation 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 Accumulation 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 Accumulation Plan. Information about
mutual fund positions and outstanding instructions under the Accumulation Plan
are noted on the RMA accountholder's account statement. Instructions under the
Accumulation Plan may be changed at anytime, but may take up to two weeks to
become effective.
The terms of the Accumulation Plan or an RMA accountholder's participation
in the Accumulation 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 Accumulation Plan.
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 both high
and 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
Accumulation 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:
monthly Premier account statements that itemize all account activity,
including investment transactions, checking activity and Gold
MasterCard'r' transactions during the period, and provide unrealized and
realized gain and loss estimates for most securities held in the account;
48
<PAGE>
<PAGE>
comprehensive preliminary 9-month and year-end summary statements that
provide information on account activity for use in tax planning and tax
return preparation;
automatic 'sweep' of uninvested cash into the RMA accountholder's choice
of the six RMA money market funds -- RMA Money Market Portfolio, RMA U.S.
Government Portfolio, RMA Tax-Free Fund, RMA California 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;
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;
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;
24-hour access to account information through toll-free numbers, and more
detailed personal assistance during business hours from the RMA Service
Center;
expanded account protection to $100 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
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.
CONVERSION OF CLASS B SHARES
Class B shares of each Fund will automatically convert to Class A shares of
that Fund, based on the relative net asset values per share of the two 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 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 the 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. For
purposes of conversion to Class A shares, 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 shares, a pro rata portion of the Class B shares in the sub-account
also converts to Class A shares. The portion will be determined by the ratio
that the shareholder's Class B shares converting to Class A shares bears to the
shareholder's total Class B shares not acquired through dividends and other
distributions.
The availability of the conversion feature is subject to the continuing
availability of an opinion of counsel to the effect 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 ('Code') and that the
conversion of shares does not constitute a taxable event. If the conversion
feature ceased to be available, the Class B shares 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 this condition 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
49
<PAGE>
<PAGE>
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, Martin
Luther King, Jr. Day, Presidents' Day, Good Friday, Memorial Day, Independence
Day, Labor Day, Thanksgiving Day and Christmas Day.
Securities that are listed on exchanges normally are valued at the last
sale price on the day the securities are being valued or, lacking any sales on
such day, at the last available bid price. In cases where securities are traded
on more than one exchange, the securities are generally valued on the exchange
considered by Mitchell Hutchins as the primary market. Securities traded in the
OTC market and listed on the Nasdaq Stock Market ('Nasdaq') normally are valued
at the last available sale price on the Nasdaq at 4:00 p.m., Eastern time; other
OTC securities normally are valued at the last bid price available prior to
valuation.
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 applicable board determines that this does not represent fair value. All
other assets are valued at fair value as determined in good faith by or under
the direction of each board.
PERFORMANCE INFORMATION
The Funds' 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 each 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.
50
<PAGE>
<PAGE>
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 each class of the
Funds' shares outstanding for the periods indicated. No Class Y shares were
outstanding for the periods indicated for New York Tax-Free Income Fund. All
returns for periods of more than one year are expressed as an average annual
return.
<TABLE>
<CAPTION>
CALIFORNIA TAX-FREE NATIONAL TAX-FREE
INCOME FUND INCOME FUND
------------------------------------------- -------------------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS A CLASS B CLASS C CLASS Y
------- ------- ------- ------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
One year ended
February 28, 1998:
Standardized
Return*.......... 4.93% 3.33% 7.96% N/A 5.11% 3.62% 8.17% 9.87%
Non-Standardized
Return........... 9.26 8.33 8.71 N/A 9.48 8.62 8.92 9.87
Five years ended
February 28, 1998:
Standardized
Return*.......... 4.31 4.03 4.63 N/A 4.56 4.30 4.88 N/A
Non-Standardized
Return........... 5.17 4.35 4.63 N/A 5.41 4.64 4.88 N/A
Ten years or since
inception** to
February 28, 1998:
Standardized
Return*.......... 6.50 6.06 5.47 (0.34) 6.77 6.34 5.67 6.81
Non-Standardized
Return........... 6.94 6.06 5.47 (0.34) 7.21 6.34 5.67 6.81
<CAPTION>
MUNICIPAL HIGH NEW YORK TAX-FREE
INCOME FUND INCOME FUND
------------------------------------------ -------------------------------
CLASS A CLASS B CLASS C CLASS Y CLASS A CLASS B CLASS C
------- ------- ------- ------- ------- ------- -------
<S> <C> <C> <C> <C> <C> <C> <C>
One year ended
February 28, 1998:
Standardized
Return*.......... 6.65 % 5.23% 9.76% N/A 5.02% 3.65% 8.07%
Non-Standardized
Return........... 11.06 10.23 10.51 N/A 9.36 8.65 8.82
Five years ended
February 28, 1998:
Standardized
Return*.......... 5.35 5.10 5.69 N/A 4.81 4.58 5.16
Non-Standardized
Return........... 6.22 5.42 5.69 N/A 5.68 4.91 5.16
Ten years or since
inception** to
February 28, 1998:
Standardized
Return*.......... 7.96 7.25 6.39 (0.09) 7.27 6.90 6.03
Non-Standardized
Return........... 8.37 7.25 6.39 (0.09) 7.73 6.90 6.03
</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.
Class Y shares do not impose an initial or contingent deferred sales charge;
therefore, Non-Standardized Return is identical to Standardized Return.
** The inception dates for the classes of shares are as follows:
<TABLE>
<CAPTION>
CLASS A CLASS B CLASS C CLASS Y
--------- --------------- --------- ------------------
<S> <C> <C> <C> <C>
California Tax-Free Income Fund....... 9/16/85 7/1/91 7/2/92 2/5/98
National Tax-Free Income Fund......... 12/3/84 7/1/91 7/2/92 11/3/95
Municipal High Income Fund............ 6/23/87 7/1/91 7/2/92 2/5/98
New York Tax-Free Income Fund......... 9/23/88 7/1/91 7/2/92 N/A
</TABLE>
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 semiannual 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, Class C shares and Class Y shares) at the end of the Period.
Yield quotations are calculated according to the following formula:
51
<PAGE>
<PAGE>
<TABLE>
<S> <C>
YIELD = 2 [(a-b)'pp'6-1]
---
cd
</TABLE>
<TABLE>
<S> <C> <C>
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.
</TABLE>
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. 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 28, 1998:
<TABLE>
<CAPTION>
CLASS A CLASS B CLASS C CLASS Y
------- ------- ------- -------
<S> <C> <C> <C> <C>
California Tax-Free Income Fund................................. 4.20% 3.62% 3.87% N/A
National Tax-Free Income Fund................................... 4.32 3.68 3.97 4.77%
Municipal High Income Fund...................................... 4.64 4.05 4.34 N/A
New York Tax-Free Income Fund................................... 4.33 3.75 4.01 N/A
</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:
<TABLE>
<S> <C> <C>
TAX EQUIVALENT YIELD = ( E )+ t
-------
l - p
</TABLE>
<TABLE>
<S> <C> <C>
E = tax-exempt yield of a Class of shares
p = stated income tax rate
t = taxable yield of a Class of shares
</TABLE>
The tax-equivalent yield of California Tax-Free Income Fund assumes a
45.22% combined effective California and federal tax rate. The tax-equivalent
yield of New York Tax-Free Income Fund assumes a 46.43% 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 28, 1998:
<TABLE>
<CAPTION>
CLASS A CLASS B CLASS C CLASS Y
------- ------- ------- -------
<S> <C> <C> <C> <C>
California Tax-Free Income Fund................................... 7.67% 6.61% 7.06% N/A
National Tax-Free Income Fund..................................... 7.15 6.09 6.57 7.90%
Municipal High Income Fund........................................ 7.68 6.71 7.19 N/A
New York Tax-Free Income Fund..................................... 8.08 7.00 7.49 N/A
</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
52
<PAGE>
<PAGE>
('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 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 the 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'r' Money
Markets. In comparing a 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 a 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.
TAXES
FEDERAL TAXES. To continue to qualify for treatment as a regulated
investment company ('RIC') under the 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 Code and its
investment company taxable income (consisting generally of taxable net
investment income and 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) 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 (3) 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.
If a Fund failed to qualify for treatment as a RIC for any taxable year, it
would be taxed as an ordinary corporation on its taxable income for that year
(even if that income was distributed to its shareholders) and all distributions
out of its earnings and profits (including distributions attributable to
tax-exempt interest income) would be taxable to its shareholders, as dividends
(that is, ordinary income).
53
<PAGE>
<PAGE>
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 would
be tax-exempt to the extent described in the Prospectus; they would only be
included in the calculation of whether a recipient's income exceeded 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.
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 its 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 almost exclusively in debt
securities and Derivative Instruments and receives no dividend income;
accordingly, no (or only a negligible) portion of the dividends or other
distributions paid by any Fund will be 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 amount, character and timing of recognition of the
gains and losses a Fund realizes in connection therewith. Gains from 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.
If a Fund has an 'appreciated financial position' -- generally, an interest
(including an interest through an option, futures contract or short sale) with
respect to any stock, debt instrument (other than 'straight debt') or
partnership interest the fair market value of which exceeds its adjusted
basis -- and enters into a 'constructive sale' of the same or substantially
similar property, the Fund will be treated as having made an actual sale
thereof, with the result that gain will be recognized at that time. A
constructive sale generally consists of a short sale, an offsetting notional
principal contract or futures
54
<PAGE>
<PAGE>
contract entered into by a Fund or a related person with respect to the same or
substantially similar property. In addition, if the appreciated financial
position is itself a short sale or such a contract, acquisition of the
underlying property or substantially similar property will be deemed a
constructive sale.
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 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 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 provisions of the 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 and
City 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 Code and satisfies certain requirements, among others, 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. Distributions to individual shareholders by the
Fund which represents long-term capital gains for federal income tax
55
<PAGE>
<PAGE>
purposes will be treated as long-term capital gains for New York State and City
personal income tax purposes. (Certain undistributed capital gains of the Fund
that are treated as (taxable) long-term capital gains in the hands of
shareholders will be treated as long-term capital gains for New York State and
City personal income taxes.)
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 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 in general 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 (and certain other expenses relating
thereto) generally will not be deductible for New York State and City 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 Fund is subject to the corporation franchise (income) tax measured by
the entire net income base, the minimum taxable income base or the fixed dollar
minimum, whichever is greater. 'Entire net income' of the Fund is federal
'investment company taxable income' with certain modifications. In addition, the
Fund is permitted to deduct dividends paid to its shareholders in determining
its federal taxable income.
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 1997 federal individual income tax rates. For
example, a couple with taxable income of $90,000 in 1997, or a single individual
with taxable income of $55,000 in 1997, whose investments earned a 6% tax-free
yield, would have had to earn approximately an 8.33% taxable yield to receive
the same benefit.
TABLE I. 1997 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 - 24.7 $ 0 - 41.2 15.00% 4.71% 5.88% 7.06% 8.24% 9.41%
24.7 - 59.8 41.2 - 99.6 28.00 5.56 6.94 8.33 9.72 11.11
59.8 - 124.7 99.6 - 151.8 31.00 5.80 7.25 8.70 10.14 11.59
124.7 - 271.1 151.8 - 271.1 36.00 6.25 7.81 9.38 10.94 12.50
Over $271.1 Over $271.1 39.60 6.62 8.28 9.93 11.59 13.25
</TABLE>
- ------------
* See note following Table III.
56
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TAX-FREE INCOME VS. TAXABLE INCOME-CALIFORNIA TAX-FREE INCOME FUND. Table
II below illustrates approximate equivalent taxable and tax-free yields at the
1997 federal individual and 1997 California personal income tax rates. For
example, a California couple with taxable income of $90,000 in 1997, or a single
California individual with taxable income of $55,000 in 1997, whose investments
earned a 6% tax-free yield, would have had to earn approximately a 9.19% taxable
yield to receive the same benefit.
TABLE II. 1997 FEDERAL AND CALIFORNIA TAXABLE VS. TAX-FREE YIELDS*
<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>
$ 18.4 - 24.7 $ 36.7 - 41.2 20.10% 5.01% 6.26% 7.51% 8.76% 10.01%
24.7 - 25.5 41.2 - 51.0 32.32 5.91 7.39 8.87 10.34 11.82
25.5 - 32.2 51.0 - 64.4 33.76 6.04 7.55 9.06 10.57 12.08
32.2 - 59.8 64.4 - 99.6 34.70 6.13 7.66 9.19 10.72 12.25
59.8 - 124.7 99.6 - 151.8 37.42 6.39 7.99 9.59 11.19 12.78
124.7 - 271.1 151.8 - 271.1 41.95 6.89 8.61 10.34 12.06 13.78
Over $271.1 Over $271.1 45.22 7.30 9.13 10.95 12.78 14.60
</TABLE>
- ------------
* 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
1997 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
1997, whose investments earned a 4% tax-free yield, would have had to earn
approximately a 6.26% 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 1997 would have had to earn approximately a 5.96% 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 1997, who lives
in New York City and whose investments earn a 4% tax-free yield, would have had
to earn approximately a 6.26% taxable yield to receive the same benefit. A
single individual with taxable income of $55,000 in 1997, who lives in New York
State outside of New York City, would have had to earn approximately a 5.96%
taxable yield to realize a 4% tax-free yield.
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<PAGE>
TABLE III. 1997 FEDERAL AND NEW YORK TAXABLE VS. TAX-FREE YIELDS*
<TABLE>
<CAPTION>
COMBINED A TAX-FREE YIELD OF
TAXABLE INCOME (000'S) FEDERAL/ ---------------------------------------------
- ------------------------------------------ NYS/NYC 4.00% 5.00% 6.00% 7.00% 8.00%
SINGLE JOINT TAX ----- ----- ----- ----- -----
RETURN RETURN BRACKET IS EQUAL TO A TAXABLE YIELD OF APPROXIMATELY:
- --------------------- ---------------- ------- ---------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
$ 0 - 24.7 $ 0 - 41.2 24.55% 5.30% 6.63% 7.95% 9.28% 10.60%
24.7 - 50.0 41.2 - 90.0 36.10 6.26 7.82 9.39 10.95 12.52
50.0 - 59.8 90.0 - 99.6 36.14 6.26 7.83 9.40 10.96 12.53
59.8 - 124.7 99.6 - 151.8 38.80 6.54 8.17 9.80 11.44 13.07
124.7 - 271.1 151.8 - 271.1 43.24 7.05 8.81 10.57 12.33 14.09
Over $271.1 Over $271.1 46.43 7.47 9.33 11.20 13.07 14.93
</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 - 24.7 $ 0 - 41.2 20.82% 5.05% 6.31% 7.58% 8.84% 10.10%
24.7 - 59.8 41.2 - 99.6 32.93 5.96 7.46 8.95 10.44 11.93
59.8 - 124.7 99.6 - 151.8 35.73 6.22 7.78 9.34 10.89 12.45
124.7 - 271.1 151.8 - 271.1 40.38 6.71 8.39 10.06 11.74 13.42
Over $271.1 Over $271.1 43.74 7.11 8.89 10.66 12.44 14.22
</TABLE>
- ------------
* Certain simplifying assumptions have been made. The amount of 'Taxable
Income' is the net amount subject to federal income tax after deductions and
exemptions, assuming that all income is ordinary income. Any particular
taxpayer's effective tax rate may differ. 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
AMT, limitations on federal or state itemized deductions, the phase out of
personal exemptions, the taxability of social security or railroad retirement
benefits 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).
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 SAI; such rates might change after that date.
OTHER INFORMATION
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, each Trust's 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. Each 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
58
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<PAGE>
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 and
Class C shares bear higher transfer agency fees per shareholder account than
those borne by Class A or Class Y 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. 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.
COUNSEL. The law firm of Kirkpatrick & Lockhart LLP, 1800 Massachusetts
Avenue, N.W., Washington, D.C., 20036-1800 serves as counsel to the Funds.
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 28, 1998 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.
59
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<PAGE>
<PAGE>
[This page intentionally left blank]
<PAGE>
<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 Other Strategies Using Derivative Instruments.................................................. 26
Trustees and Officers; Principal Holders of Securities..................................................... 32
Investment Advisory and Distribution Arrangements.......................................................... 39
Portfolio Transactions..................................................................................... 44
Reduced Sales Charges, Additional Exchange and Redemption Information and Other Services................... 46
Conversion of Class B Shares............................................................................... 49
Valuation of Shares........................................................................................ 49
Performance Information.................................................................................... 50
Taxes...................................................................................................... 53
Other Information.......................................................................................... 58
Financial Statements....................................................................................... 59
</TABLE>
'c'1998 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, 1998
- -----------------------------------
PAINEWEBBER
STATEMENT OF DIFFERENCES
The trademark symbol shall be expressed as.................................'tm'
The service mark symbol shall be expressed as..............................'sm'
The dagger symbol shall be expressed as....................................`D'
The copyright symbol shall be expressed as.................................'c'
Characters normally expressed as superscript shall be preceded by..........'pp'
