PAINEWEBBER NATIONAL TAX-FREE INCOME FUND
PAINEWEBBER MUNICIPAL HIGH INCOME FUND
PAINEWEBBER CALIFORNIA TAX-FREE 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 a "Trust"). PaineWebber National
Tax-Free Income Fund and PaineWebber California Tax-Free Income Fund are
diversified series of PaineWebber Mutual Fund Trust. PaineWebber Municipal High
Income Fund and PaineWebber New York Tax-Free Income Fund are non-diversified
series of PaineWebber Municipal Series.
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 for the funds, Mitchell Hutchins has appointed PaineWebber to serve
as the exclusive dealer for the sale of fund shares.
Portions of each fund's Annual Report to Shareholders are incorporated
by reference into this Statement of Additional Information ("SAI"). The Annual
Report accompanies this SAI. You may obtain an additional copy of a fund's
Annual Report by calling toll-free 1-800-647-1568.
This SAI is not a prospectus and should be read only in conjunction
with the funds' current Prospectus, dated June 30, 1999. A copy of the
Prospectus may be obtained by calling any PaineWebber Financial Advisor or
correspondent firm or by calling toll-free 1-800-647-1568. This SAI is dated
June 30, 1999.
TABLE OF CONTENTS
PAGE
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The Funds and Their Investment Policies...................................... 2
The Funds' Investments, Related Risks and Limitations........................ 3
Strategies Using Derivative Instruments...................................... 30
Organization of Trusts; Trustees and Officers and Principal Holders of
Securities............................................................... 36
Investment Advisory and Distribution Arrangements............................ 42
Portfolio Transactions....................................................... 48
Reduced Sales Charges, Additional Exchange and Redemption Information
and Other Services........................................................... 50
Conversion of Class B Shares................................................. 54
Valuation of Shares.......................................................... 55
Performance Information...................................................... 55
Taxes........................................................................ 60
Other Information............................................................ 66
Financial Statements......................................................... 67
Appendix.....................................................................A-1
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THE FUNDS AND THEIR INVESTMENT POLICIES
No fund's investment objective may be changed without shareholder
approval. Except where noted, the other investment policies of each fund may be
changed by its board without shareholder approval. As with other mutual funds,
there is no assurance that a fund will achieve its investment objective.
NATIONAL TAX-FREE INCOME FUND'S investment objective is to achieve high
current income exempt from federal income tax, consistent with the preservation
of capital and liquidity within the fund's quality standards. The fund seeks to
invest substantially all of its net assets in municipal bonds. Except under
unusual market conditions, the fund invests at least 80% of its net assets in
municipal bonds that pay interest that is not an item of tax preference for
purposes of the federal alternative minimum tax ("AMT exempt interest").
National Tax-Free Income Fund normally invests at least 65% of its
total assets in investment grade municipal bonds. The fund may invest up to 35%
of its total assets in municipal bonds that are not investment grade. The fund
may not invest more than 10% of its total assets in inverse floaters and may not
invest more than 5% of its total assets in uninsured "non-appropriation"
municipal lease obligations. There is no percentage limitation on the fund's
ability to invest in other municipal lease obligations.
National Tax-Free Income Fund may invest up to 10% of its net assets in
illiquid securities. The fund may purchase securities on a when-issued or
delayed delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33-1/3% of its
total assets. The fund may also borrow for temporary or emergency purposes, but
not in excess of 10% of its total assets.
MUNICIPAL HIGH INCOME FUND'S investment objective is to provide high
current income exempt from federal income tax. The fund normally invests at
least 80% of its assets in municipal bonds and may invest without limit in
municipal bonds that are below investment grade. The fund also may invest
without limit in municipal bonds that pay interest that is not AMT exempt
interest.
Municipal High Income Fund normally invests at least 65% of its total
assets, and seeks to invest substantially all of its assets, in medium grade and
high yield lower grade municipal bonds. The fund may not invest more than 10% of
its total assets in inverse floaters and may not invest more than 5% of its
total assets in uninsured "non-appropriation" municipal lease obligations. There
is no percentage limitation on the fund's ability to invest in other municipal
lease obligations.
Municipal High Income Fund may invest up to 10% of its net assets in
illiquid securities. The fund may purchase securities on a when-issued or
delayed delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33-1/3% of its
total assets. The fund may also borrow for temporary or emergency purposes, but
not in excess of 10% of its total assets.
CALIFORNIA TAX-FREE INCOME FUND'S investment objective is high current
income exempt from federal income tax and California personal income tax,
consistent with the preservation of capital and liquidity within the fund's
quality standards. The fund seeks to invest substantially all of its net assets
in municipal bonds that pay interest that is exempt from those taxes
("California Obligations"). The fund normally invests at least 80% of its net
assets in California Obligations that pay AMT exempt interest.
California Tax-Free Income Fund normally invests at least 65% of its
total assets in investment grade municipal bonds. The fund may invest up to 35%
of its total assets in municipal bonds that are not investment grade. The fund
may not invest more than 10% of its total assets in inverse floaters and may not
invest more than 5% of its total assets in uninsured "non-appropriation"
municipal lease obligations. There is no percentage limitation on the fund's
ability to invest in other municipal lease obligations.
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California Tax-Free Income Fund may invest up to 10% of its net assets
in illiquid securities. The fund may purchase securities on a when-issued or
delayed delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33-1/3% of its
total assets. The fund may also borrow for temporary or emergency purposes, but
not in excess of 10% of its total assets.
NEW YORK TAX-FREE INCOME FUND'S investment objective is to provide high
current income exempt from federal income tax and New York State and New York
City personal income taxes. The fund seeks to invest substantially all of its
net assets in municipal bonds issued by the State of New York, its
municipalities and public authorities or by other issuers that pay interest that
is exempt from those taxes ("New York Obligations"). Except under unusual market
conditions, the fund invests at least 80% of its net assets in New York
Obligations that pay AMT exempt interest.
New York Tax-Free Income Fund normally invests at least 65% of its
total assets in investment grade municipal bonds. The fund may invest up to 35%
of its total assets in municipal bonds that are not investment grade. The fund
may not invest more than 10% of its total assets in inverse floaters and may not
invest more than 5% of its total assets in uninsured "non-appropriation"
municipal lease obligations. There is no percentage limitation on the fund's
ability to invest in other municipal lease obligations.
New York Tax-Free Income Fund may invest up to 10% of its net assets in
illiquid securities. The fund may purchase securities on a when-issued or
delayed delivery basis. The fund may lend its portfolio securities to qualified
broker-dealers or institutional investors in an amount up to 33-1/3% of its
total assets. The fund may also borrow for temporary or emergency purposes, but
not in excess of 10% of its total assets.
THE FUNDS' INVESTMENTS, RELATED RISKS AND LIMITATIONS
The following supplements the information contained in the Prospectus
and above concerning the funds' investments, related risks and limitations.
Except as otherwise indicated in the Prospectus or the SAI, the funds have
established no policy limitations on their ability to use the investments or
techniques discussed in these documents.
TYPES OF MUNICIPAL BONDS. Each fund may invest in a variety of
municipal bonds, as described below:
MUNICIPAL BONDS. Municipal bonds are municipal obligations that are
issued by states, municipalities, public authorities or other issuers and 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. Municipal bonds also include "moral
obligation" bonds, which are normally issued by special purpose authorities. For
these bonds, a government unit is regarded as morally obligated to support
payment of the debt service, which is usually subject to annual budget
appropriations. Various types of municipal bonds are described in the following
sections.
MUNICIPAL LEASE OBLIGATIONS. Municipal bonds include municipal lease
obligations, such as leases, installment purchase contracts and conditional
sales contracts, and certificates of participation therein. Municipal lease
obligations are issued by state and local governments and authorities to
purchase land or various types of equipment or facilities and may be subject to
annual budget appropriations. The funds generally invest in municipal lease
obligations through certificates of participation.
Although municipal lease obligations do not constitute general
obligations of the municipality for which its 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
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subject to partial or full abatement if, because of material damage or
destruction of the leased property, there is substantial interference with the
lessee's use or occupancy of such property. This "abatement risk" may be reduced
by the existence of insurance covering the leased property, the maintenance by
the lessee of reserve funds or the provision of credit enhancements such as
letters of credit.
Certain municipal lease obligations contain "non-appropriation"
clauses, which provide that the municipality has no obligation to make lease or
installment purchase payments in future years unless money is appropriated for
such purpose on a yearly basis. Some municipal lease obligations of this type
are insured as to timely payment of principal and interest, even in the event of
a failure by the municipality to appropriate sufficient funds to make payments
under the lease. However, in the case of an uninsured municipal lease
obligation, a fund's ability to recover under the lease in the event of a
non-appropriation or default will be 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 considered 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 "Taxes"
below. Each fund may invest more than 25% of its net assets in IDBs and PABs.
FLOATING RATE AND VARIABLE RATE OBLIGATIONS. Floating rate and variable
rate obligations are municipal bonds that bear interest at rates that are not
fixed, but that vary with changes in specified market rates or indices. 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. 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 a 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.
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 instruments
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
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amount of the fund's participation interest plus accrued interest. Generally, a
fund expects to exercise the demand under the letters of credit or other
guarantees (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 bonds
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 exercisable at intervals ranging from
bi-weekly to semi-annually, and the interest rate on the bonds is typically
reset at the end of the applicable interval in an attempt to cause the bonds to
have a market value that approximates their par value. The tender option
generally would not be exercisable in the event of a default on, or significant
downgrading of, the underlying municipal bonds. 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 that 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. Municipal
bonds include tax-exempt commercial paper and short-term municipal notes, such
as 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 bonds on which the
rate of interest varies inversely with interest rates on other municipal bonds
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 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 bond 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.
MORTGAGE SUBSIDY BONDS. The funds also may purchase mortgage subsidy
bonds that are normally issued by special purpose public authorities. In some
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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 bonds 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.
YIELD FACTORS AND CREDIT RATINGS; NON-INVESTMENT GRADE BONDS. The yield
of a municipal bond 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 bonds 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 bond, 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 agencies ("rating agencies") are private services
that provide ratings of the credit quality of bonds and certain other
securities, including municipal bonds. A description of the ratings assigned to
municipal bonds by Moody's and S&P is included in the Appendix to this SAI.
Credit ratings attempt to evaluate the safety of principal and interest
payments, but they do not evaluate the volatility of a bond's value or its
liquidity and do not guarantee the performance of the issuer. Rating agencies
may fail to make timely changes in credit ratings in response to subsequent
events, so that an issuer's current financial condition may be better or worse
than the rating indicates. There is a risk that rating agencies may downgrade a
bond's rating. Subsequent to a bond's purchase by a fund, it may cease to be
rated or its rating may be reduced below the minimum rating required for
purchase by the fund. 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 bonds with the same maturity, interest rate and rating may have
different market prices.
Opinions relating to the validity of municipal bonds and to the
exemption of interest thereon from federal income tax and (when available) from
the federal alternative minimum tax, 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 reviews the proceedings relating to the issuance of
municipal bonds or the basis for such opinions. An issuer's obligations under
its municipal bonds are subject to the 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 bonds held by a fund
or 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 bonds may be materially and adversely affected.
Investment grade securities are rated in one of the four highest rating
categories or one of the two highest short-term rating categories by a rating
agency, such as Moody's or S&P, or, if unrated, are determined to be of
comparable quality by Mitchell Hutchins. Medium grade municipal securities are
investment grade and are rated A, Baa or MIG-2 by Moody's or A, BBB or SP-2 by
S&P, have received an equivalent rating from another rating agency or are
determined by Mitchell Hutchins to be of comparable quality. Moody's considers
bonds rated Baa (its lowest investment grade rating) to have speculative
characteristics. This means that changes in economic conditions or other
circumstances are more likely to lead to a weakened capacity to make principal
and interest payments than is the case for higher rated bonds.
High yield municipal bonds (commonly known as municipal "junk bonds")
are non-investment grade bonds. This means they are rated Ba or lower by
Moody's, BB or lower by S&P, comparably rated by another rating agency or
determined by Mitchell Hutchins to be of comparable quality. The high yield
municipal bonds in which the funds may invest may
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o be rated Ba, B or MIG-3 by Moody's or BB, B or SP-3 by S&P,
o have an equivalent rating from another rating agency, or
o if unrated, are determined by Mitchell Hutchins to be of comparable
quality.
A fund's investments in non-investment grade municipal bonds entail
greater risk than its investments in higher rated bonds. Non-investment grade
municipal bonds are considered predominantly speculative with respect to the
issuer's ability to pay interest and repay principal and may involve significant
risk exposure to adverse conditions. Non-investment grade municipal bonds
generally offer a higher current yield than that available for investment grade
issues and may be less sensitive to interest rate changes; however, they involve
higher risks, in that they are more sensitive to adverse changes market
conditions. During periods of economic downturn or rising interest rates, their
issuers may experience financial stress that could adversely affect their
ability to make payments of interest and principal and increase the possibility
of default.
The market for non-investment grade municipal bonds generally is
thinner and less active than that for higher quality securities, which may limit
a fund's ability to sell these bonds at fair value in response to changes in the
economy or financial markets. Adverse publicity and investor perceptions,
whether or not based on fundamental analysis, may also decrease the values and
liquidity of non-investment grade municipal bonds, especially in a thinly traded
market.
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. Each fund may acquire such
commitments 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 municipal bonds 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 bonds. 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.
ILLIQUID SECURITIES. The term "illiquid securities" for purposes of the
Prospectus and SAI means securities that cannot be disposed of within seven days
in the ordinary course of business at approximately the amount at which a fund
has valued the securities and includes, among other things, purchased
over-the-counter options, 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 each fund's board. The assets used as cover for over-the-counter
options written by a fund will be considered illiquid unless the
over-the-counter options are sold to qualified dealers who agree that the fund
may repurchase any over-the-counter options they write at a maximum price to be
calculated by a formula set forth in the option agreements. The cover for an
over-the-counter option written subject to this procedure would be considered
illiquid only to the extent that the maximum repurchase price under the formula
exceeds the intrinsic value of the option. To the extent a fund invests in
illiquid securities, it may not be able to readily liquidate such investments
and may have to sell other investments if necessary to raise cash to meet its
obligations. The lack of a liquid secondary market for illiquid securities may
make it more difficult for a fund to assign a value to those securities for
purposes of valuing its portfolio and calculating its net asset value.
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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 bids 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 the applicable 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.
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 or other obligations from a bank or securities
dealer (or its affiliate) and simultaneously commits to resell them to the
counterparty 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 obligations. A fund maintains custody of the underlying obligations
prior to their repurchase, either through its regular custodian or through a
special "tri-party" custodian or sub-custodian that maintains separate accounts
for both the fund and its counterparty. Thus, the obligation of the counterparty
to pay the repurchase price on the date agreed to or upon demand is, in effect,
secured by such obligations. Repurchase agreements carry certain risks not
associated with direct investments in securities, including a possible decline
in the market value of the underlying obligations. If their value becomes less
than the repurchase price, plus any agreed-upon additional amount, the
counterparty 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 obligations and the price that was paid by a fund upon
acquisition is accrued as interest and included in its net investment income.
Repurchase agreements involving obligations other than U.S. government
securities (such as commercial paper and corporate bonds) may be subject to
special risks and may not have the benefit of certain protections in the event
of the counterparty's insolvency. If the seller or guarantor becomes insolvent,
the fund may suffer delays, costs and possible losses in connection with the
disposition of collateral. Each fund intends to enter into repurchase agreements
only with counterparties in transactions believed by Mitchell Hutchins to
present minimum credit risks.
WHEN-ISSUED AND DELAYED DELIVERY SECURITIES. Each fund may purchase
securities on a "when-issued" basis or may purchase or sell securities for
delayed delivery, I.E., for issuance or delivery to or by the fund later than
the normal settlement date for such securities at a stated price and yield. A
fund generally would not pay for such securities or start earning interest on
them until they are received. However, when a fund undertakes a when-issued or
delayed delivery obligation, it immediately assumes the risks of ownership,
including the risks of price fluctuation. Failure of the issuer to deliver a
security purchased by a fund on a when-issued or delayed delivery basis may
result in the fund's incurring or missing an opportunity to make an alternative
investment. Depending on market conditions, a fund's when-issued and delayed
delivery purchase commitments could cause its net asset value per share to be
more volatile, because such securities may increase the amount by which the
fund's total assets, including the value of when-issued and delayed delivery
securities held by that fund, exceeds its net assets.
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
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on a when-issued or delayed delivery basis, its custodian segregates assets to
cover the amount of the commitment. See "The Funds' Investments, Related Risks
and Limitations--Segregated Accounts." A fund may sell the right to acquire the
security prior to delivery if Mitchell Hutchins deems it advantageous to do so,
which may result in a gain or loss to the fund.
DURATION. Duration is a measure of the expected life of a debt security
on a present value basis. Duration incorporates the debt security's yield,
coupon interest payments, final maturity and call features into one measure and
is one of the fundamental tools used by Mitchell Hutchins in portfolio selection
and yield curve positioning for a fund's bond investments. Duration 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.
Duration takes the length of the time intervals between the present
time and the time that the interest and principal payments are scheduled or, in
the case of a callable debt security, expected to be made, and weights them by
the present values of the cash to be received at each future point in time. For
any debt security with interest payments occurring prior to the payment of
principal, duration is always less than maturity. For example, depending on 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.
Duration allows Mitchell Hutchins to make certain predictions as to the
effect that changes in the level of interest rates will have on the value of a
fund's portfolio of debt securities. For example, when the level of interest
rates increases by 1%, a debt security having a positive duration of three years
generally will decrease by approximately 3%. Thus, if Mitchell Hutchins
calculates the duration of a fund's portfolio of debt securities as three years,
it normally would expect the portfolio to change in value by approximately 3%
for every 1% change in the level of interest rates. However, various factors,
such as changes in anticipated prepayment rates, qualitative considerations and
market supply and demand, can cause particular securities to respond somewhat
differently to changes in interest rates than indicated in the above example.
Moreover, in the case of mortgage-backed and other complex securities, duration
calculations are estimates and are not precise. This is particularly true during
periods of market volatility. Accordingly, the net asset value of a fund's
portfolio of debt securities may vary in relation to interest rates by a greater
or lesser percentage than indicated by the above example.
Futures, options and options on futures have durations that, in
general, are closely related to the duration of the securities that underlie
them. Holding long futures or call option positions will lengthen portfolio
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. Another example where the interest rate exposure is not properly
captured by the standard duration calculation is the case of mortgage-backed
securities. The stated final maturity of such securities is generally 30 years,
but current prepayment rates are critical in determining the securities'
interest rate exposure. In these and other similar situations, Mitchell Hutchins
will use more sophisticated analytical techniques that incorporate the economic
life of a security into the determination of its duration and, therefore, its
interest rate exposure.
LENDING OF PORTFOLIO SECURITIES. Each fund is authorized to lend its
portfolio securities to broker-dealers or institutional investors that Mitchell
Hutchins deems qualified. Lending securities enables a fund to earn additional
income, but could result in a loss or delay in recovering these securities. The
borrower of a fund's portfolio securities must maintain acceptable collateral
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with that fund's custodian in an amount, marked to market daily, 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 any cash collateral in money market
investments 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 of its loans at any
time. Each fund may pay reasonable fees in connection with a loan and may pay
the borrower or placing broker a negotiated portion of the interest earned on
the reinvestment of cash held as collateral. A fund will receive amounts
equivalent to any dividends, interest or other distributions on the securities
loaned. Each fund will regain record ownership of loaned securities to exercise
beneficial rights, such as voting and subscription rights, when regaining such
rights is considered to be in the fund's interest.
Pursuant to procedures adopted by the boards governing each fund's
securities lending program, PaineWebber has been retained to serve as lending
agent for each fund. The boards also have authorized the payment of fees
(including fees calculated as a percentage of invested cash collateral) to
PaineWebber for these services. Each board periodically reviews all portfolio
securities loan transactions for which PaineWebber acted as lending agent.
PaineWebber also has been approved as a borrower under each fund's securities
lending program.
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, it will
maintain with an approved custodian in a segregated account cash or 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
"Strategies Using Derivative Instruments," segregated accounts may also be
required in connection with certain transactions involving options or futures.
TEMPORARY AND DEFENSIVE INVESTMENTS; MONEY MARKET INVESTMENTS. When
Mitchell Hutchins believes that unusual circumstances warrant a defensive
posture and that there are not enough suitable municipal bonds available, each
fund may temporarily and without percentage limit hold cash and invest in money
market instruments that pay taxable interest, including repurchase agreements.
If a fund holds cash, the cash would not earn income and would reduce the fund's
yield. In addition, for temporary defensive purposes, each of California
Tax-Free Income Fund, National Tax-Free Income Fund and New York Tax-Free Income
Fund may invest more than 20% of its net assets in municipal obligations that
pay interest that is exempt from federal income tax but is subject to California
personal income tax (in the case of California Tax-Free Income Fund), New York
State and New York City personal income taxes (in the case of New York Tax-Free
Income Fund) or is not AMT exempt interest.
SPECIAL CONSIDERATIONS RELATING TO CALIFORNIA MUNICIPAL SECURITIES
The following information provides only a brief summary of the complex
factors affecting the financial situation in California (the "State") and is
derived from sources that are generally available to investors and is believed
to be accurate. It is based in part on information obtained from various State
and local agencies in California. It should be noted that the creditworthiness
of obligations issued by local California issuers may be unrelated to the
creditworthiness of obligations issued by the State of California, and there is
no obligation on the part of the State to make payment on local government
obligations in the event of default or financial difficulty.
GENERAL
During the early 1990's, California experienced significant financial
difficulties, which reduced its credit standing, but the State's finances have
improved significantly since 1994, with ratings increases since 1996. 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 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.
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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 34 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 1996 and 1.6% in 1997. During the
early 1990's, net population growth in the State was due to births and foreign
immigration, but in recent years, in-migration from the other states has
increased.
Total personal income in the State, at an estimated $902 billion in
1998, accounts for almost 13% of all personal income in the nation. Total
employment is over 15 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. Construction,
manufacturing (especially aerospace), and financial services, among others, were
all severely affected, particularly in Southern California. Employment levels
stabilized by late 1993 and 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 1999. Economic indicators show a
steady and strong recovery underway in California since the start of 1994
particularly in high technology manufacturing and services, including computer
software, electronic manufacturing and motion picture/television production, and
other services, entertainment and tourism, and both residential and commercial
construction. International economic problems starting in 1997 had some
moderating impact on California's economy, but negative impacts, such as a sharp
drop in exports to Asia which have hurt the manufacturing and agricultural
sectors, have apparently been offset by increased exports to Latin American and
other nations, and a greater strength in services, computer software and
construction. Current forecasts predict continued strong growth of the State's
economy in 1999, with a slowdown predicted in 2000 and beyond. 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 upon 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. The acquisition-based assessment system of Proposition 13 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."
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 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 was
required to be approved by a majority vote within two years.
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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
in the early 1990s 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. State appropriations were $6.8 billion under the limit for fiscal
year 1998-99.
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
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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 May 1,
1999, the State had outstanding approximately $19.7 billion of long-term general
obligation bonds, plus $246 million of general obligation commercial paper which
will be refunded by long-term bonds in the future, and $6.6 billion of
lease-purchase debt supported by the State General Fund. The State also had
about $15.3 billion of authorized and unissued long-term general obligation
bonds and lease-purchase debt. In FY 1997-98, debt service on general obligation
bonds and lease purchase debt was approximately 4.4% of General Fund revenues.
RECENT FINANCIAL RESULTS
The principal sources of General Fund revenues in 1997-1998 were the
California personal income tax (51% of total revenues), the sales tax (32%),
bank and corporation taxes (11%), 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%).
RECENT BUDGETS. As a result of the severe economic recession from
1990-94 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 budget reserve, 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
(although not all of these actions were taken in each year):
o significant cuts in health and welfare program expenditures;
o transfers of program responsibilities and some funding sources from
the State to local governments, coupled with some reduction in
mandates on local government;
o transfer of about $3.6 billion in annual local property tax revenues
from cities, counties, redevelopment agencies and some other
districts to local school districts, thereby reducing State funding
for schools;
o reduction in growth of support for higher education programs,
coupled with increases in student fees;
o revenue increases (particularly in the 1992-93 Fiscal Year budget),
most of which were for a short duration;
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o increased reliance on aid from the federal government to offset the
costs of incarcerating, educating and providing health and welfare
services to undocumented aliens (although these efforts have
produced much less federal aid than the State Administration had
requested); and
o various one-time adjustments and accounting changes (some of which
have been challenged in court and reversed).
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. For a two-month period in the summer of 1992,
pending adoption of the annual Budget Act, the State was forced to issue
registered warrants (IOUs) to some of its suppliers, employees and other
creditors. The last of these deficit notes was repaid in April, 1996.
The State's financial condition improved markedly during the 1995-96,
1996-97 and 1997-98 fiscal years, with a combination of better than expected
revenues, slowdown in growth of social welfare programs, and continued spending
restraint based on the actions taken in earlier years. The State's cash position
also improved, and no external deficit borrowing has occurred over the end of
these three fiscal years.
The economy grew strongly during these fiscal years, and as a result,
the General Fund took in substantially greater tax revenues (around $2.2 billion
in 1995-96, $1.6 billion in 1996-97 and $2.1 billion in 1997-98) than were
initially planned when the budgets were enacted. These additional funds were
largely directed to school spending as mandated by Proposition 98, and to make
up shortfalls from reduced federal health and welfare aid in 1995-96 and
1996-97. The accumulated budget deficit from the recession years was finally
eliminated. The Department of Finance estimates that the State's budget reserve
(the SFEU) totaled about $400 million as of June 30, 1997 and $1.8 billion at
June 30, 1998.
FY 1997-98 BUDGET. 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 then-expected additional General Fund revenues
for the fiscal year. The 1997-98 Budget Act provided another year of rapidly
increasing funding for K-14 public education. 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 consistent with prior years, and
several initiatives had to be dropped. The final results for FY 1997-98 showed
General Fund revenues and transfers of $54.7 billion and expenditures of $53.3
billion.
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 are placed on receipt of welfare aid.
FY 1998-99 BUDGET. The FY 1998-99 Budget Act was signed on August 21,
1998. After giving effect to line-item vetoes made by the Governor, the Budget
plan resulted in spending of about $57.3 billion for the General Fund and $14.7
billion for Special Funds. The Budget Act assumed General Fund revenues and
transfers in FY 1998-99 of $57.0 billion. After enactment of the Budget Act, the
Legislature passed a number of additional fiscal bills, which resulted in a net
increase of expenditures of about $250 million, but the Administration also
raised its estimate of revenues from the 1997-98 fiscal year. In total, the
Administration projected in September, 1998 that the balance in the SFEU at June
30, 1999 would be about $1.2 billion.
As has been the case in the last several years, spending on K-12
education increased significantly, by a total of $2.2 billion, with projected
per-pupil spending of $5,695, more than one-third higher than the per-pupil
spending during the last recession year of 1993-94.
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Funding to support higher education was also increased significantly
(15% for the University of California and 14% for the California State
University system). The Budget included some increases in health and welfare
programs, including the first increase in the monthly welfare grant since levels
were cut during the recession.
One of the most important elements of the 1998-99 Budget Act was
agreement on substantial tax cuts. The largest of these is a phased-in cut in
the Vehicle License Fee (an annual tax on the value of cars registered in the
State, the "VLF"). Starting in 1999, the VLF is reduced by 25%. Under current
law, VLF funds are automatically transferred to cities and counties, so the new
legislation provides for the General Fund to make up the reductions. If State
General Fund revenues continue to grow above certain targeted levels in future
years, the cut could reach as much as 67.5% by the year 2003. The initial 25%
VLF cut will be offset by about $500 million in General Fund money in FY
1998-99, and $1 billion for future years. Other tax cuts in FY 1998-99 include
an increase in the dependent credit exemption for personal income tax filers,
restoration of a renter's tax credit for taxpayers, and a variety of business
tax relief measures. The total cost of these tax cuts is estimated at $1.4
billion for FY 1998-99.
The Administration released new projections for the balance of FY
1998-99 on May 14, 1999 as part of the May Revision of the Governor's Proposed
Budget for 1999-2000 (the "May Revision"). The May Revision revealed that the
State's economy was much stronger in late 1998 and into 1999 than the
Administration had thought when it made its first FY 1999-2000 Budget Proposal
in January 1999. As a result, the May Revision updates 1998-99 General Fund
revenues to be $57.9 billion, almost $1 billion above the original FY 1998-99
estimates, and over $1.6 billion above the Administration's January estimate.
Most of the increase is from personal income taxes, reflecting stronger wage
employment than previously estimated, and extraordinary growth in capital gain
realizations resulting from the stock market's rise. The May Revision projects
the SFEU will have a balance of almost $1.9 billion at June 30, 1999.
Although, as noted, the Administration projects a budget reserve in the
SFEU of about $1.9 billion on June 30, 1999, the General Fund fund balance on
that date also reflects $1.0 billion of "loans" which the General Fund made to
local schools in the recession years, representing cash outlays above the
mandatory minimum funding level. Settlement of litigation over these
transactions in July 1996 calls for repayment of these loans over the period
ending in 2001-02, about equally split between outlays from the General Fund and
from schools' entitlements. The 1998-99 Budget Act contained a $300 million
appropriation from the General Fund toward this settlement
PROPOSED FY 1999-2000 BUDGET. The newly elected Governor, Gray Davis,
released his proposed FY 1999-00 Budget in January 1999. It projected somewhat
lower General Fund revenues than in earlier projections, due to slower economic
growth which was expected in late 1998, but totaling an estimated $60.3 billion.
The May Revision has sharply increased the revenue estimates, by over $2.7
billion, to a total of almost $63.0 billion, which would represent a 9% increase
above FY 1998-99. Again, the greatest increase is expected in personal income
taxes (about 10% year-over-year increase), with more moderate increases in sales
taxes (6%) and corporate taxes (3%).
The January Governor's Budget proposed $60.5 billion of expenditures in
FY 1999-00, with a $400 million SFEU reserve. The proposal contained some
education funding initiatives and certain limited initiatives in other areas,
but was overall relatively limited by the expectation of smaller revenue gains.
In the May Revision, the Governor has proposed several additional initiatives to
respond to the over $4.3 billion of new revenues over the two years. These
include over $1.2 billion more for K-12 education (much of which is mandated by
Proposition 98), over $1 billion of infrastructure spending, increases for
higher education, public safety, health and welfare and many other programs, but
only a small increase in funding to local governments. Total proposed General
Fund spending for FY 1999-00 in the May Revision is $63.2 billion.
The Governor also proposed to increase the SFEU to about $1 billion by
June 30, 2000, and also proposed to "set aside" over $650 million to pay for
future employee pay increases, possible litigation costs, and a possible future
VLF tax cut based on the current law. If these moneys are not spent for these
purposes, they would increase the SFEU reserve. The final FY 1999-00 Budget must
still be agreed on between the Governor and the Legislature, and it may contain
different provisions than the Governor's proposals described above.
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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. After 1996, the three major rating agencies raised their ratings of
California's general obligation bonds, which as of February 1999 were assigned
ratings of "A+" from Standard & Poor's, "Aa3" from Moody's and "AA-" from Fitch
IBCA.
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.
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 recently 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.
YEAR 2000 PREPARATIONS
The State and local governments, along with all other public and
private institutions in the nation, face a major challenge to ensure that their
computer systems, including microchips embedded into existing machinery, will
not fail prior to or at the January 1, 2000 date which may not be recognized
properly by software utilizing only two digits to identify a year. The new State
Administration has placed a very high priority on "Year 2000" remediation and
contingency planning. The State has a Department of Information Technology
("DOIT") which coordinates activities, provides technical assistance to State
agencies and local governments, and reports on the status of remediation efforts
by over 100 State departments and agencies.
DOIT has reported that, as of early 1999, 372 of 564 "mission critical"
systems in State government had been remediated (although final testing was
still going on in some cases). Of the balance, 54 were being retired and 138
were in process. DOIT does not report on all State agencies. In addition to
hardware and software changes, agencies are preparing business contingency plans
in case of computer problems at 1/1/2000, and are actively coordinating with
outside agencies, vendors, contractors and others with whom computer data is
shared. The State Treasurer and State Controller, responsible for State fiscal
controls and debt service payments, have reported they were fully remediated by
December 31, 1998 and are spending the 1999 year in testing and confirmation of
their systems.
The State has expended and plans to spend many hundreds of millions of
dollars on Year 2000 projects of all sorts, and has set aside several tens of
millions of dollars in contingency funds to support late-coming needs. There is
no survey of local government costs, or the overall status of their activities.
It is likely that larger government agencies are better prepared at this time
than smaller ones. Both the State and local governments are preparing emergency
plans for Year 2000 computer difficulties similar to their normal planning for
natural emergencies, such as floods or earthquakes.
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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. However, except for agreement in 1997 on a
new program for the State to substantially take over funding for local trial
courts (saving cities and counties some $400 million annually), there has been
no large-scale reversal of the property tax shift to help local government.
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. 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.
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 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
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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. Although
litigation is brought from time to time which challenges the constitutionality
of such lease arrangements, the California Supreme Court issued a ruling in
August, 1998 which reconfirmed the legality of these financing methods.
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 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
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"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 SAI. 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 and late 1990s 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 continued
strongly into fiscal year 1999. 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 1998-1999,
moderate economic growth will exist through calendar year 2003, 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. Additionally, the securities industry is more important to
the New York economy than the national economy, potentially amplifying the
impact of downturn. In 1997, the finance, insurance and real estate sector
accounted for 19.5 percent of nonfarm labor and proprietors' income statewide,
compared to 8.5 percent nationwide.
During the calendar years 1984 through 1991, the State's rate of
economic expansion was somewhat slower than that of the nation as a whole. In
the 1990-1991 national recession, the economy of the Northeast region in general
and the State in particular was more heavily damaged than that of the rest of
the nation and has been slower to recover.
Although the national economy began to expand in 1991, the State
economy remained in recession until 1993, when employment growth resumed.
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 seventh year of growth in 1999.
The seasonally adjusted unemployment rate in New York was 5.5 percent
in December 1998 (compared to 6.1 percent one year earlier). From December 1997
to December 1998, the number of nonfarm jobs increased by 140,800 or 1.7
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percent, and the number of private sector jobs increased by 142,900 or 2.1
percent. Year-to-year growth was especially strong in motion pictures (+13.3
percent), construction (+7.1 percent), business services (+6.3 percent), and
engineering and management services (+6.3 percent). Employment also increased in
construction, retail trade, finance, insurance and real estate, wholesale trade,
and transportation and utilities. Employment declined in government and
manufacturing.
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 (the "Annual Information Statement'). At the State level,
the Annual Information Statement projects continued expansion during the 1999
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 decline slightly from 1998. Personal income is
expected to record moderate gains in 1999. Wage growth in 1999 is expected to be
slower than in the previous year as the recent robust growth in bonus payments
moderates.
Personal income tax collections for 1999-2000 are projected to reach
$22.83 billion, or $2.65 billion above the reported 1998-99 collection total.
This increase is due in part to refund reserve transactions which serve to shift
receipts of $1.77 billion into 1999-2000 from the year earlier. Collections also
benefit from the estimated increase in income tax liability of 13.5 percent in
1998 and 5.3 percent in 1999. The large increases in liability in recent years
have been supported by the continued surge in taxable capital gains
realizations, activity related at least partially to changes in federal tax
treatment of such income. The State expects the growth in capital gains income
to plateau in 1999. Growth in 1999-2000 personal income tax receipts is
partially offset by the diversion of such receipts into the School Tax Relief
Fund, which finances the STAR tax reduction program. For 1999-2000, $1.22
billion will be deposited into this fund, an increase of $638 billion.
Business tax receipts are expected to total $4.53 billion in 1999-2000,
$267 million below the 1998-99 estimated result, caused by tax reductions
already scheduled in law and slower growth in the underlying tax base. Receipts
from user taxes and fees are projected to total $7.16 billion, a decrease of $72
million from the current year, reflecting the incremental effects of
already-enacted tax reductions and the diversion of $30 million of additional
motor vehicle registration fees to the Dedicated Highway and Bridge Trust Fund.
Other tax receipts are projected to total $980 million, $119 million below
1998-99. Total miscellaneous receipts are projected to reach $1.24 billion, down
almost $292 million from 1998-99.
General Fund disbursements in 1999-2000, including transfers to support
capital projects, debt service and other funds are estimated at $37.10 billion.
This represents an increase of $482 million from 1998-99. Grants to local
governments constitute approximately 67 percent of all General Fund spending,
and include financial assistance to local governments and not-for-profit
corporations, as well as entitlement benefits to individuals. The 1999-2000
Financial Plan projects spending of $24.81 billion in this category, a decrease
of $87 million over the prior year.
The 1999-2000 Financial Plan projects a closing fund balance in the
General Fund of $2.36 billion. This fund balance is composed of a reserve of
$1.79 billion of a proposed tax reduction reserve, $473 million balance in the
Tax Stabilization Reserve Fund, and $100 million in the Contingency Reserve
Fund. The entire $226 million balance in the Community Projects Fund is expected
to be used in 1999-2000.
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
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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.
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 over 3 billion
from the $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.
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 (the School Tax Relief Program)
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 are comprised of three quarters of the State four
percent sales and use tax (the balance, one percent, flows to support Local
Government Assistance Corporation ("LGAC") debt service requirements),
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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 declined $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 the 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.
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 1998-1999, of a one-time transfer of nearly
$200 million for retroactive reimbursement of certain social services claims
from the federal government. The Local Government Assistance Tax fund is
projected to receive $1.93 billion in receipts from the dedicated one-cent
statewide sales tax in 1999-2000. Debt service and associated costs on the
completed $4.7 billion LGAC program are projected at $340 billion, which results
in the transfer of excess sales taxes to the General Fund in the amount of $1.59
billion.
STATE DEBT. The State's 1998-99 borrowing plan projects issuances of
$331 million in general obligation bonds (including $154 million for purposes of
redeeming outstanding BANs) and $154 million in general obligation commercial
paper. The State has issued $179 million in Certificates of Participation to
finance equipment purchases during 1998-99. Borrowings by public authorities
pursuant to lease-purchase and contractual-obligation financings for capital
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programs of the State are projected to total approximately $2.85 billion,
including costs of issuance in 1998-99.
NONRECURRING SOURCES. The Division of the Budget estimates that the
1999-2000 State Financial Plan contains actions that provide nonrecurring
resources or savings totaling approximately $33 million, less than one-tenth of
one percent of General Fund disbursements.
OUTYEAR PROJECTIONS OF RECEIPTS AND DISBURSEMENTS. The 1999-2000
Executive Budget projects General Fund disbursements of $38.19 billion in
2000-01 and $39.97 billion in 2001-02.
State law requires the Governor to propose a balanced budget each year.
In recent years, the State has closed projected budget gaps of $3.9 billion
(1996-97), $2.3 billion (1997-98) and less than $1 billion (1998-99). The State,
as a part of the 1999-2000 Executive Budget projections submitted to the
Legislature in January 1999 (as well as a revised Financial Plan in February and
May 1999), projects a 1999-2000 General Fund budget gap of approximately $1.14
billion in 2000-01 and $2.07 billion in 2001-02. A tentative labor agreement was
reached in early 1999 (discussed below), and if the agreement is applied to the
entire Executive Branch workforce, the State estimates that the budget gaps
would increase by $275 million in 2000-01 and $475 million in 2001-02. The
budget gaps are projected after making the use of $589 million in 2000-01 and
$1.2 billion in 2001-02 from the 1998-99 tax reduction reserve.
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. The State does not expect that past rates of growth will be sustained.
The State's projections in 1999-2000 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 The State expects that
the 1999-2000 Financial Plan will achieve savings from initiatives by State
agencies to deliver services more efficiently, unspecified annual spending
efficiencies, 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 STAR program, which dedicates a portion of personal 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.
YEAR 2000 COMPLIANCE. New York State is currently addressing Year 2000
("Y2K") data processing compliance issues. As of March 31, 1999, the State had
completed 80 percent of overall compliance efforts on the high-priority systems;
208 systems are now Year 2000 compliant. Compliance testing is expected to be
completed by the end of calendar year 1999.
While the State is taking what it believes to be appropriate action to
address Year 2000 compliance, there can be no guarantee that all of the State's
systems and equipment will be Year 2000 compliant and that there will not be an
adverse impact upon State operations or finances as a result. Since Year 2000
compliance by outside parties is beyond the State's control to remediate, the
failure of outside parties to achieve Year 2000 compliance could have an adverse
impact on State operations or finances as well.
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. Many of the labor contracts expire in the spring of 1999.
In early 1999, the State reached a tentative agreement with the Civil
Service Employees Association (CSEA) on a new four-year labor contract. If this
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agreement is ratified by CSEA and approved by the Legislature, and the terms of
that contract applied to the entire Executive Branch workforce, the State
estimates that the budget gaps would increase by $275 million in 2000-01 and
$475 million in 2001-02.
The New York State and Local Retirement Systems (the Systems) provide
coverage for public employees of the State and its localities (except employees
of New York City and teachers, who are covered by separate plans). Net assets
available for benefits of the systems have increased from $58.05 million in
March, 1993 to $106.32 million in March, 1998. Under the funding method used by
the Systems, according to DOB, the net assets, plus future actuarially
determined contributions, are expected to be sufficient to pay for the
anticipated benefits of current members, retirees and beneficiaries.
Since January 1995, the State's workforce has been reduced by about 10
percent, and is projected to remain at approximately 191,000 persons in 1998-99.
PUBLIC ASSISTANCE. Spending on welfare is projected in the 1999-2000
fiscal year at $1.49 billion, a decline of 2.7 percent from the prior year.
Since 1994-95, State spending on welfare has fallen by more than 25 percent,
driven by significant welfare changes initiated at the Federal and State levels
and a large, steady decline in the number of people receiving benefits. The
State does not forecast further significant reductions in this spending
category.
Federal law enacted in 1996 abolished the federal Aid to Families with
Dependent Children program (AFDC) and created a new Temporary Assistance to
Needy Families with Dependent Children program (TANF) funded with a fixed
federal block grant to states. The law also imposes (with certain exceptions) a
five-year durational limit on TANF recipients, requires that virtually all
recipients be engaged in work or community service activities within two years
of receiving benefits, and limits assistance provided to certain immigrants and
other classes of individuals.
Local assistance spending by the State for Children and Families
Services is projected at $864 million in 1999-2000, a reduction of 4.7 percent
from the year earlier. The decline in General Fund spending is offset by higher
spending on child care and child welfare services from federal TANF funds.
MEDICAID. New York participates in the federal Medicaid program under a
state plan approved by the Health Care Financing Administration. The federal
government provides a substantial portion of eligible program costs, with the
remainder shared by the State and its counties (including the City). Basic
program eligibility and benefits are determined by federal guidelines, but the
State provides a number of optional benefits and expanded eligibility. Program
costs have increased substantially in recent years, and account for a rising
share of the State budget. Federal law requires that the State adopt
reimbursement rates for hospitals and nursing homes that are reasonable and
adequate to meet the costs that must be incurred by efficiently and economically
operated facilities in providing patient care, a standard that has led to past
litigation by hospitals and nursing homes seeking higher reimbursement from the
State. Medicaid is the second largest program, after grants to local
governments, in the General Fund. Payments for Medicaid are projected to be
$5.50 billion in 1999-2000, a decrease of $87 million, or 1.6 percent, from the
prior year.
THE STATE AUTHORITIES. The fiscal stability of the State is related in
part to the fiscal stability of its public authorities. Public authorities refer
to public benefit corporations, created pursuant to State law, other than local
authorities. Public authorities are not subject to the constitutional
restrictions on the incurrence of debt which apply to the State itself and may
issue bonds and notes within the amounts 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. As of December 31, 1997,
there were 17 public authorities with outstanding debt of $100 million or more,
and the aggregate outstanding debt, including refunding bonds, of all State
public authorities was $84 billion, only a portion of which constitutes
State-supported or State-related debt.
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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
Queens 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 be financed through
assistance from the State, the federal government, and the City of New York, and
from various other revenues generated from actions taken by the MTA.
There can be no assurance that all the necessary governmental actions
for 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.
THE CITY OF NEW YORK. The fiscal health of the State may also be
affected by the fiscal health of New York City (the "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.
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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 imposed conditions. 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 1998 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 1999-2003 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 1999-2003 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 1999-2000 may result in substantial
reductions in projected expenditures for social spending programs. Cost
containment assumptions contained in the 1999-2003 Financial Plan and the City
FY 1999-2000 Budget may therefore be significantly adversely affected upon the
final adoption of the State budget for FY 1999-2000. Furthermore, actions taken
in recent fiscal years to avert deficits may have reduced the City's flexibility
in responding to future budgetary imbalances, and have deferred certain
expenditures to later fiscal years.
On January 29, 1999, the City released the Financial Plan for fiscal
years 2000-2003. It projects total revenues in FY 1999 of $35.60 billion, of
which federal categorical grants provide $4.2 billion and State categorical
grants provide $6.7 billion. The City's Financial Plan projects that
expenditures will grow to $38.94 billion in FY 2003. While the Financial Plan
projects revenues and expenditures for the 1999 fiscal year balanced in
accordance with GAAP, it projects budget gaps of $738 million, $1.91 billion,
$2.04 billion and $1.54 billion in the 2000, 2001, 2002 and 2003 fiscal years,
respectively.
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
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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.
On May 27, 1999, Governor George E. Pataki signed into law the
legislation eliminating the New York City commuter tax, which is imposed on
wages earned by all New York State non-city residents. The legislation signed by
the Governor would repeal the commuter tax beginning July 1, 1999. This tax cut
is estimated to cost the City approximately $250-$360 million annually. The
elimination of the commuter tax is currently in litigation.
The 1999-2003 Financial Plan includes a proposed discretionary transfer
in the 1999 fiscal year of approximately $1.57 billion to pay debt service due
in fiscal year 2000, included in the Budget Stabilization Plan for the 1999
fiscal years. In addition, the Financial Plan reflects actual and proposed tax
reduction programs totaling $338 million, $410 million, $461 million and $473
million in fiscal years 2000 through 2003.
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 reports that
local revenues provided approximately 58.3% of total revenues in FY 1997-98 of
$34.9 billion, while federal and State aid, including unrestricted aid and
categorical grants, provided 33.5% in the same year.
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 issued $1.075 billion of short term
obligations in fiscal year 1998 to finance the City's projected cash flow needs
for that year. In previous years, the City's short term obligations have been
$2.4 billion, $2.4 billion, $2.2 billion, and $1.75 billion in fiscal years
1997, 1996, 1995 and 1994, 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.
The City is nearing the constitutionally-permissible limit on its
general obligation debt. Under the State constitution, the City may not contract
indebtedness in an amount greater than 10 percent of the average full value of
taxable real estate in the City for the most recent five years. To provide for
the City's capital program, State legislation was enacted in 1997 which created
the Transitional Finance Authority ("TFA"), the debt of which is not subject to
the general debt limit. Without TFA 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 TFA borrowing and
including TFA's projected borrowing as part of the total debt incurring power,
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. As of July 1,
1998, the City's outstanding general obligation debt totaled $27.1 billion., and
as of July 1, 1998, the City's net general obligation debt limit was $28.9
billion. As of July 1, 1998, the remaining City and TFA debt incurring power
totaled $3.9 billion. Despite this additional financing mechanism, the City
projected that, if no further action was taken, it would reach its debt limit in
City fiscal year 1999-2000. Issuance of tobacco settlement bonds may accelerate
income of $2.5 billion, but the City estimates that it would still reach its
constitutional indebtedness limit in fiscal year 2002.
In June 1997, the constitutionality of TFA was challenged in court,
but the challenge was dismissed at the trial level, appellate level, and before
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the New York Court of Appeals in 1998. Future developments concerning the City
or entities issuing debt for the benefit of the City, and public discussion of
such developments, as well as prevailing market conditions and securities credit
ratings, may affect the ability or cost to sell securities issued by the City or
such entities and may also effect the market for their outstanding securities.
In addition to general obligation debt, the City has other long-term
obligations, including capital leases and bond transactions of public benefit
corporations that are components of the City or whose debt is guaranteed by the
City.
The City is the largest municipal debt issuer in the nation, and has
more than doubled its debt load since the end of FY 1988, in large measure to
rehabilitate its extensive, aging physical plant. The City's Financial Plan
projects $22.3 billion of long-term borrowings for the period of FY 1999 through
FY 2003 to support the City's current capital plan. The City's Preliminary
Ten-Year Capital Strategy dated January 1999 has identified $48 billion in
additional capital expenditures over the next ten years. Additionally, a report
of the City Comptroller indicates the Preliminary Ten-Year Capital Strategy
significantly underestimates the actual capital needs of the City for
reconstructing and rehabilitating the City's infrastructure and physical assets.
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 City of Troy
continues to operate under a State-ordered control agency. The City of Yonkers
satisfied the statutory conditions for ending the supervision of its finances by
a State-ordered control board, whose powers lapsed December 31, 1998. 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.
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. These emergency aid
packages have largely continued through the 1998-99 budget, and the State is
examining methods for recalculating the distribution of State aid.
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.
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.
Like the State, local governments must respond to changing political,
economic and financial influences over which they have little or no control.
Such changes may adversely affect the financial condition of certain local
governments. For example, the federal government may reduce (or in some cases
eliminate) federal funding of some local programs which, in turn, may require
local governments to fund these expenditures from their own resources. It is
also possible that the State, New York City, or any of their respective public
authorities may suffer serious financial difficulties that could jeopardize
local access to the public credit markets, which may adversely affect the
marketability of notes and bonds issued by localities within the State.
Localities may also face unanticipated problems resulting from certain pending
litigation, judicial decisions and long-range economic trends. Other large-scale
potential problems, such as declining urban populations, increasing
expenditures, and the loss of skilled manufacturing jobs, may also adversely
affect localities and necessitate State assistance.
INVESTMENT LIMITATIONS OF THE FUNDS
FUNDAMENTAL LIMITATIONS. The following fundamental investment
limitations cannot be changed for a fund without the affirmative vote of the
lesser of (a) more than 50% of the outstanding shares of the fund or (b) 67% or
more of the shares of the fund present at a shareholders' meeting if more than
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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 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, as amended ("Investment Company Act") and then
not in excess of 33 1/3% of the fund's total assets (including the amount of the
senior securities issued but reduced by any liabilities not constituting senior
securities) at the time of the issuance or borrowing, except that the fund may
borrow up to an additional 5% of its total assets (not including the amount
borrowed) for temporary or emergency purposes.
(3) make loans, except through loans of portfolio securities or through
repurchase agreements, provided that for purposes of this restriction, the
acquisition of bonds, debentures, other debt securities or instruments, or
participations or other interests therein and investments in government
obligations, commercial paper, certificates of deposit, bankers' acceptances or
similar instruments will not be considered the making of a loan.
(4) engage in the business of underwriting securities of other issuers,
except to the extent that the fund might be considered an underwriter under the
federal securities laws in connection with its disposition of portfolio
securities.
(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 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;
(b) in the case of Municipal High Income Fund, in municipal
obligations;
(c) 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 AMT exempt interest; and
(d) in the case of New York Tax-Free Income Fund, in debt obligations
issued by the State of New York, its municipalities and public
authorities or by other issuers if such obligations pay interest
that is exempt from federal income tax as well as New York State
and New York City personal income taxes and is AMT exempt
interest.
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In addition, National Tax-Free Income Fund and California 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
non-fundamental and may be changed by the vote of the appropriate board without
shareholder approval.
Each fund will not:
(1) invest more than 10% of its net assets in illiquid securities.
(2) purchase portfolio securities while borrowings in excess of 5% of its
total assets are outstanding.
(3) 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.
(4) 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.
(5) purchase securities of other investment companies, except to the extent
permitted by the Investment Company 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.
STRATEGIES USING DERIVATIVE INSTRUMENTS
GENERAL DESCRIPTION OF DERIVATIVE INSTRUMENTS. 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 each fund's portfolio and also
to attempt to enhance income, realize gains or manage the duration of its
portfolio. A fund may enter into transactions involving one or more types of
Derivative Instruments under which the full value of its portfolio is at risk.
Under normal circumstances, however, each fund's use of these instruments will
place at risk a much smaller portion of its assets. In particular, each fund may
use the Derivative Instruments described below.
The funds might not use any derivative instruments or strategies, and
there can be no assurance that using any strategy will succeed. If the Mitchell
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Hutchins is incorrect in its judgment on market values, interest rates or other
economic factors in using a derivative instrument or strategy, a fund may have
lower net income and a net loss on the investment.
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 or at specified times or at the expiration of the
option, depending on the type of option involved. 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 that gives its purchaser, in
return for a premium, the right to sell the underlying security at a specified
price during the option term or at specified times or at the expiration of the
option, depending on the type of option involved. The writer of the put option,
who receives the premium, has the obligation, upon exercise of the option during
the option term, to buy the underlying security at the exercise price.
OPTIONS ON DEBT SECURITIES INDICES--An index assigns relative values to
the securities included in the index and fluctuates with changes in the market
values of those securities. A securities index option operates in the same way
as a more traditional securities option, except that exercise of a securities
index option is effected with cash payment and does not involve delivery of
securities. Thus, upon exercise of a securities 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 securities index.
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 securities 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 securities 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 contracts are bilateral agreements pursuant to which one
party agrees to make, and the other party agrees to accept, delivery of a
specified type of debt security or currency 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 or currency, 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 or currency, 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 or currency, at a specified price at any time during the option term or
at specified times or at the expiration of the option, depending on the type of
option involved. 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 that 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 partially
or fully to 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, a 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, a fund might be able to close out the put
option and realize a gain to offset the decline in the value of the security.
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<PAGE>
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 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, a fund could exercise the call and thus limit its acquisition
cost to the exercise price plus the premium paid and transaction costs.
Alternatively, a fund might be able to offset the price increase by closing out
an appreciated call option and realizing a gain.
A fund may purchase and write (sell) straddles on securities or indices
of securities. A long straddle is a combination of a call and a put option
purchased on the same security or on the same futures contract, where the
exercise price of the put is equal to the exercise price of the call. A fund
might enter into a long straddle when Mitchell Hutchins believes it likely that
the prices of the securities will be more volatile during the term of the option
than the option pricing implies. A short straddle is a combination of a call and
a put written on the same security where the exercise price of the put is equal
to the exercise price of the call. A fund might enter into a short straddle when
Mitchell Hutchins believes it unlikely that the prices of the securities will be
as volatile during the term of the option as the option pricing implies.
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 stock 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.
Income strategies using Derivative Instruments may include the writing
of covered options to obtain the related option premiums. Gain strategies may
include using Derivative Instruments to increase or decrease a fund's exposure
to different asset classes without buying or selling the underlying instruments.
A fund also may use derivatives to simulate full investment by the fund while
maintaining a cash balance for fund management purposes (such as to provide
liquidity to meet anticipated shareholder sales of fund shares and for fund
operating expenses).
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
may be limited by tax considerations. See "Taxes."
In addition to the products, strategies and risks described below and
in the Prospectus, 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 for a fund to the extent that they are consistent with the fund's
investment objective and permitted by its 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 the ability
of Mitchell Hutchins to predict movements of the overall securities, interest
rate or currency exchange 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 strategy adopted will succeed.
32
<PAGE>
(2) There might be imperfect correlation, or even no correlation, between price
movements of a Derivative Instrument and price movements of the investments that
are 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 affecting the markets in which Derivative Instruments
are traded, rather than the value of the investments being hedged. 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 that 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 the fund was
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 positions 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 the 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 hedging position can be
closed out at a time and price that is favorable to a fund.
COVER FOR STRATEGIES USING DERIVATIVE INSTRUMENTS. Transactions using
Derivative Instruments, other than purchased options, expose the funds 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,
currencies 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 or call options on securities in which they invest and related
indices. The purchase of call options may serve as a long hedge, and the
purchase of put options may serve as a short hedge. A fund may also use options
to attempt to realize gains by increasing or reducing its exposure to an asset
class without purchasing or selling the underlying securities. 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. Writing covered call options
serves as a limited short hedge, because declines in the value of the hedged
investment would be offset to the extent of the premium received for writing the
option. However, if the security appreciates to a price higher than the exercise
price of the call option, it can be expected that the option will be exercised
and the affected fund will be obligated to sell the security at less than its
market value. Writing covered put options serves as a limited long hedge,
because increases 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
depreciates to a price lower than the exercise price of the put option, it can
be expected that the put option will be exercised and the fund will be obligated
to purchase the security at more than its market value. The securities or other
assets used as cover for over-the-counter options written by a fund would be
33
<PAGE>
considered illiquid to the extent described under "The Funds' Investments,
Related Risks and Limitations--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, over-the-counter options on bonds are
European-style options. This means that the option can only be exercised
immediately prior to its expiration. This is in contract to American-style
options that may be exercised at any time. There are also other types of options
that may be exercised on certain specified dates before expiration. 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 and write both exchange-traded and
over-the-counter options. However, exchange-traded or liquid over-the-counter
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 over-the-counter 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,
over-the-counter options are contracts between a fund and its counterparty
(usually a securities dealer or a bank) with no clearing organization guarantee.
Thus, when a fund purchases or writes an over-the-counter 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.
The funds' ability to establish and close out positions in
exchange-listed options depends on the existence of a liquid market. The funds
intend 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 over-the-counter options only by negotiating directly with the
counterparty, or by a transaction in the secondary market if any such market
exists. Although the funds will enter into over-the-counter options only with
counterparties that are expected to be capable of entering into closing
transactions with the funds, there is no assurance that a fund will in fact be
able to close out an over-the-counter option position at a favorable price prior
to expiration. In the event of insolvency of the counterparty, a fund might be
unable to close out an over-the-counter 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 put or call
option written by the 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.
A fund may purchase and write put and call options on indices in much
the same manner as the more traditional options discussed above, except the
index options may serve as a hedge against overall fluctuations in a securities
market (or market sector) rather than anticipated increases or decreases in the
value of a particular security.
LIMITATIONS ON THE USE OF OPTIONS. The use of options is governed by
the following guidelines, which can be changed by each fund's 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.
34
<PAGE>
(2) The aggregate value of securities underlying put options written by a
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 securities indices 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 future contracts and interest rate futures contracts.
A fund may purchase put and call options, and write covered put and call
options, on futures in which it is allowed to invest. The purchase of futures or
call options thereon can serve as a long hedge, and the sale of futures or the
purchase of put options thereon can serve as a short hedge. Writing covered call
options on futures contracts can serve as a limited short hedge, and writing
covered put options on futures contracts can serve as a limited long hedge,
using a strategy similar to that used for writing covered options on securities
or indices. In addition, a fund may purchase or sell futures contracts or
purchase options thereon to increase or reduce its exposure to an asset class
without purchasing or selling the underlying securities.
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 the fund's portfolio, the fund may
buy a futures contract or a call option thereon or sell a put option thereon.
A fund may also write put options on futures contracts while at the
same time purchasing call options on the same futures contracts in order
synthetically to create a long futures contract position. Such options would
have the same strike prices and expiration dates. A fund will engage in this
strategy only when it is more advantageous to a fund than is purchasing the
futures contract.
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 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 a fund at the termination of the transaction if all
contractual obligations have been satisfied. Under certain circumstances, such
as periods of high volatility, a 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 a 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 option thereon, it is subject to daily
variation margin calls that could be substantial in the event of adverse price
movements. If a 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.
The funds intend 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.
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<PAGE>
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. A fund would continue to be
subject to market risk with respect to the position. In addition, except in the
case of purchased options, a 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.
LIMITATIONS ON THE USE OF FUTURES AND RELATED OPTIONS. The use of
futures and related options is governed by the following guidelines, which can
be changed by a fund's 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 its net
assets.
(2) The aggregate premiums paid on all options (including options on
securities and securities indices and options on futures contracts) purchased by
each fund that are held at any time will not exceed 20% of its net assets.
(3) The aggregate margin deposits on all futures contracts and options
thereon held at any time by each fund will not exceed 5% of its total assets.
ORGANIZATION OF TRUSTS; TRUSTEES AND OFFICERS
AND PRINCIPAL HOLDERS OF SECURITIES
Mutual Fund Trust was formed on November 21, 1986 and Municipal Series
was formed on January 28, 1987 as business trusts under the laws of the
Commonwealth of Massachusetts. Each Trust has two operating series and is
governed by a board of trustees, which is authorized to establish additional
series and to issue an unlimited number of shares of beneficial interest of each
existing or future series, par value $0.001 per share. The applicable board
oversees each fund's operations.
The trustees and executive officers of each Trust, their ages, business
addresses and principal occupations during the past five years are:
<TABLE>
<CAPTION>
NAME AND ADDRESS*; AGE POSITION WITH EACH BUSINESS EXPERIENCE; OTHER DIRECTORSHIPS
- ---------------------- ------------------ ----------------------------------------
TRUST
-----
<S> <C> <C>
Margo N. Alexander**; 52 Trustee and President Mrs. Alexander is chairman (since March 1999),
chief executive officer and a director of
Mitchell Hutchins (since January 1995), and an
executive vice president and a director of
36
<PAGE>
NAME AND ADDRESS*; AGE POSITION WITH EACH BUSINESS EXPERIENCE; OTHER DIRECTORSHIPS
- ---------------------- ------------------ ----------------------------------------
TRUST
-----
PaineWebber (since March 1984). Mrs. Alexander
is president and a director or trustee of 32
investment companies for which Mitchell
Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
Richard Q. Armstrong; 64 Trustee Mr. Armstrong is chairman and principal of
R.Q.A. Enterprises R.Q.A. Enterprises (management consulting firm)
One Old Church Road (since April 1991 and principal occupation
Unit #6 since March 1995). Mr. Armstrong was chairman
Greenwich, CT 06830 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 31 investment companies for which
Mitchell Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
E. Garrett Bewkes, Jr.**; 72 Trustee and Chairman of Mr. Bewkes is a director of Paine Webber Group
the Board of Trustees Inc. ("PW Group") (holding company of PaineWebber
and Mitchell Hutchins). Prior to December 1995,
he was a consultant to PW Group. Prior to 1988,
he was chairman of the board, president and
chief executive officer of American Bakeries
Company. Mr. Bewkes is a director of Interstate
Bakeries Corporation. Mr. Bewkes is a director
or trustee of 35 investment companies for which
Mitchell Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
Richard R. Burt; 52 Trustee Mr. Burt is chairman of IEP Advisors, Inc.
1275 Pennsylvania Ave, N.W. (international investments and consulting firm)
Washington, DC 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 31 investment companies for which Mitchell
Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
37
<PAGE>
NAME AND ADDRESS*; AGE POSITION WITH EACH BUSINESS EXPERIENCE; OTHER DIRECTORSHIPS
- ---------------------- ------------------ ----------------------------------------
TRUST
-----
Mary C. Farrell**; 49 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 31 investment companies for which
Mitchell Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
Meyer Feldberg; 57 Trustee Mr. Feldberg is Dean and Professor of
Columbia University Management of the Graduate School of Business,
101 Uris Hall Columbia University. Prior to 1989, he was
New York, NY 10027 president of the 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 34 investment companies
for which Mitchell Hutchins, PaineWebber or one
of their affiliates serves as investment
adviser.
George W. Gowen; 69 Trustee Mr. Gowen is a partner in the law firm of
666 Third Avenue Dunnington, Bartholow & Miller. Prior to
New York, NY 10017 May 1994, he was a partner in the law firm of
Fryer, Ross & Gowen. Mr. Gowen is a director or
trustee of 34 investment companies for which
Mitchell Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
Frederic V. Malek; 62 Trustee Mr. Malek is chairman of Thayer Capital
1455 Pennsylvania Ave, N.W. Partners (merchant bank). From January 1992
Suite 350 to November 1992, he was campaign manager of
Washington, DC 20004 Bush-Quayle `92. From 1990 to 1992, he was vice
chairman and, from 1989 to 1990, he was
president of Northwest Airlines Inc., NWA Inc.
(holding company of Northwest Airlines Inc.)
and Wings Holdings Inc. (holding company of NWA
Inc.). Prior to 1989, he was employed by the
Marriott Corporation (hotels, restaurants,
airline catering and contract feeding), where
he most recently was an executive vice
president and president of Marriott Hotels and
Resorts. Mr. Malek is also a director of
American Management Systems, Inc. (management
consulting and computer related services),
Automatic Data Processing, Inc., CB Commercial
Group, Inc. (real estate services), Choice
Hotels International (hotel and hotel
franchising), FPL Group, Inc. (electric
services), Manor Care, Inc. (health care) and
38
<PAGE>
NAME AND ADDRESS*; AGE POSITION WITH EACH BUSINESS EXPERIENCE; OTHER DIRECTORSHIPS
- ---------------------- ------------------ ----------------------------------------
TRUST
-----
Northwest Airlines Inc. Mr. Malek is a director
or trustee of 31 investment companies for which
Mitchell Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
Carl W. Schafer; 63 Trustee Mr. Schafer is president of the Atlantic
66 Witherspoon Street, #1100 Foundation (charitable foundation supporting
Princeton, NJ 08542 mainly oceanographic exploration and research).
He is a director of Base Ten Systems, Inc.
(software), 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 31 investment companies for which Mitchell
Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
Brian M. Storms;** 44 Trustee Mr. Storms is president and chief operating
officer of Mitchell Hutchins (since March
1999). Prior to March 1999, he was president of
Prudential Investments (1996-1999). Prior to
joining Prudential, he was a managing director
at Fidelity Investments. Mr. Storms is a
director or trustee of 31 investment companies
for which Mitchell Hutchins, PaineWebber or one
of their affiliates serves as investment
adviser.
Cynthia N. Bow; 40 Vice President Ms. Bow is a vice president and a portfolio
(Mutual Fund Trust only) manager of Mitchell Hutchins. Ms. Bow has been
with Mitchell Hutchins since 1982. Ms. Bow is a
vice president of three investment companies
for which Mitchell Hutchins, PaineWebber or one
of their affiliates serves as investment
adviser.
Elbridge T. Gerry III; 42 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, PaineWebber or one of
their affiliates serves as investment adviser.
John J. Lee; 30 Vice President and Mr. Lee is a vice president and a manager of the
Assistant Treasurer mutual fund finance department of Mitchell
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 32
investment companies for which Mitchell
39
<PAGE>
NAME AND ADDRESS*; AGE POSITION WITH EACH BUSINESS EXPERIENCE; OTHER DIRECTORSHIPS
- ---------------------- ------------------ ----------------------------------------
TRUST
-----
Hutchins, PaineWebber or one of their
affiliates serves as an investment adviser.
Kevin J. Mahoney; 33 Vice President and Mr. Mahoney is a first vice president and a
Assistant Treasurer senior manager of the mutual fund finance
department of Mitchell Hutchins. From August
1996 through March 1999, he was the manager of
the mutual fund internal control group of
Salomon Smith Barney. Prior to August 1996, he
was an associate and assistant treasurer of
BlackRock Financial Management L.P. Mr. Mahoney
is a vice president and assistant treasurer of
32 investment companies for which Mitchell
Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
Dennis McCauley; 52 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 22 investment companies for which Mitchell
Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
Ann E. Moran; 41 Vice President and Ms. Moran is a vice president and a manager of
Assistant Treasurer the mutual fund finance department of Mitchell
Hutchins. Ms. Moran is a vice president and
assistant treasurer of 32 investment companies
for which Mitchell Hutchins, PaineWebber or one
of their affiliates serves as investment
adviser.
Richard S. Murphy; 44 Vice President Mr. Murphy is a senior vice president and a
(Mutual Fund Trust only) portfolio manager of Mitchell Hutchins. Mr.
Murphy has been with Mitchell Hutchins since
1994. Mr. Murphy is a vice president of two
investment companies for which Mitchell
Hutchins or PaineWebber serves as investment
adviser.
Dianne E. O'Donnell; 47 Vice President and Ms. O'Donnell is a senior vice president and
Secretary deputy general counsel of Mitchell Hutchins.
Ms. O'Donnell is a vice president and secretary
of 31 investment companies and a vice president
and assistant secretary of one investment
company for which Mitchell Hutchins,
PaineWebber or one of their affiliates serves
as investment adviser.
Emil Polito; 38 Vice President Mr. Polito is a senior vice president and
director of operations and control for Mitchell
Hutchins. Mr. Polito is a vice president of 32
investment companies for which Mitchell
Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
Victoria E. Schonfeld; 48 Vice President Ms. Schonfeld is a managing director and
general counsel of Mitchell Hutchins (since May
1994) and a senior vice president of
PaineWebber (since July 1995). Ms. Schonfeld is
40
<PAGE>
NAME AND ADDRESS*; AGE POSITION WITH EACH BUSINESS EXPERIENCE; OTHER DIRECTORSHIPS
- ---------------------- ------------------ ----------------------------------------
TRUST
-----
a vice president of 31 investment companies and
a vice president and secretary of one
investment company for which Mitchell Hutchins,
PaineWebber or one of their affiliates serves
as investment adviser.
Paul H. Schubert; 36 Vice President and Mr. Schubert is a senior vice president 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
32 investment companies for which Mitchell
Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
Barney A. Taglialatela; 38 Vice President and Mr. Taglialatela is a vice president and a
Assistant Treasurer manager of the mutual fund finance department
of Mitchell 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 and
assistant treasurer of 32 investment companies
for which Mitchell Hutchins, PaineWebber or one
of their affiliates serves as investment
adviser.
William W. Veronda; 53 Vice President Mr. Veronda is a senior vice president of
(PW Municipal Series Mitchell Hutchins. Prior to September 1995,
only) he was a senior 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; 37 Vice President and Mr. Weller is a first vice president and
Assistant Secretary associate general counsel of Mitchell Hutchins.
Prior to May 1995, he was an attorney in
private practice. Mr. Weller is a vice
president and assistant secretary of 31
investment companies for which Mitchell
Hutchins, PaineWebber or one of their
affiliates serves as investment adviser.
</TABLE>
- -------------
* Unless otherwise indicated, the business address of each listed person is
1285 Avenue of the Americas, New York, New York 10019.
** Mrs. Alexander, Mr. Bewkes, Ms. Farrell, and Mr. Storms are "interested
persons" of each fund as defined in the Investment Company 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 an additional up
to $150 per series for each board meeting and each separate meeting of a board
committee. 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
41
<PAGE>
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 the current board members who held office with the Trusts or
with other PaineWebber funds during the funds' fiscal years ended February 28,
1999.
<TABLE>
<CAPTION>
COMPENSATION TABLE+
AGGREGATE AGGREGATE
COMPENSATION FROM COMPENSATION TOTAL COMPENSATION FROM
MUTUAL FUND TRUST* FROM MUNICIPAL THE TRUSTS AND THE FUND
NAME OF PERSON, POSITION SERIES* COMPLEX**
<S> <C> <C> <C>
Richard Q. Armstrong,
Trustee................................. $ 3,620 $ 3,620 $101,372
Richard R. Burt,
Trustee................................. 3,560 3,560 101,372
Meyer Feldberg,
Trustee................................. 3,620 3,620 116,222
George W. Gowen,
Trustee................................... 4,218 4,218 108,272
Frederic V. Malek,
Trustee................................... 3,620 3,620 101,372
Carl W. Schafer,
Trustee................................... 3,620 3,620 101,372
</TABLE>
- --------------------
+ Only independent board members are compensated by the Trusts and identified
above; board members who are "interested persons," as defined by the
Investment Company Act, do not receive compensation.
* Represents fees paid to each Trustee from the Trust indicated for the fiscal
year ended February 28, 1999.
** Represents total compensation paid during the calendar year ended December
31, 1998, to each board member by 31 investment companies (33 in the case of
Messrs. Feldberg and Gowen) for which Mitchell Hutchins, PaineWebber or one
of their affiliates served as investment adviser. No fund within the
PaineWebber fund complex has a bonus, pension, profit sharing or retirement
plan.
PRINCIPAL HOLDERS OF SECURITIES
As of June 1, 1999, the funds' records showed no shareholders as owning
5% or more of any class of a fund's shares.
INVESTMENT ADVISORY AND DISTRIBUTION ARRANGEMENTS
INVESTMENT ADVISORY ARRANGEMENTS. Mitchell Hutchins acts as the
investment adviser and administrator pursuant to a separate contract (each an
"Advisory Contract") with each Trust. The Advisory Contract for Mutual Fund
Trust is dated April 21, 1988 and supplemented by a Fee Agreement dated June 30,
1992 with respect to National Tax-Free Income Fund. The Advisory Contract for
Municipal Series is dated July 1, 1989. Under the applicable Advisory Contract,
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 National
Tax-Free Income Fund and California 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.
During each of the periods indicated, Mitchell Hutchins earned (or
accrued) advisory fees in the amounts set forth below:
42
<PAGE>
<TABLE>
<CAPTION>
FISCAL YEARS ENDED FEBRUARY 28/29,
1999 1998 1997
---- ---- ----
<S> <C> <C> <C>
National Tax-Free Income Fund............... $1,522,045 $1,634,990 $2,022,871
Municipal High Income Fund.................. 632,526 551,107 555,499
California Tax-Free Income Fund............. 754,659 776,955 902,327
(of which
$200,824 was
waived)
New York Tax-Free Income Fund............... 273,412 264,754 312,553
of which (of which (of which
$112,366 was $117,350 $123,590
waived) was waived) was waived)
</TABLE>
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 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.
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:
FOR THE FIVE
MONTHS ENDED JULY FISCAL YEAR ENDED
31, 1997 FEBRUARY 28, 1997
National Tax-Free Income Fund......... $15,757 $43,965
Municipal High Income Fund............ 5,104 13,436
43
<PAGE>
California Tax-Free Income Fund....... 5,924 16,293
New York Tax-Free Income Fund......... 2,077 7,682
(of which $7,682
was waived)
Subsequent to July 31, 1997, PFPC (not the funds) pays PaineWebber for
certain transfer agency related services that PFPC has delegated to PaineWebber.
During the fiscal years ended February 28, 1998 and February 28, 1999,
the funds paid (or accrued) no fees to PaineWebber for its services as
securities lending agent.
NET ASSETS. The following table shows the approximate net assets as of
May 31, 1998, sorted by category of investment objective, of the investment
companies as to which Mitchell Hutchins serves as adviser or sub-adviser. An
investment company may fall into more than one of the categories below.
NET ASSETS
INVESTMENT CATEGORY ($MIL)
Domestic (excluding Money Market)............................ $ 8,208.7
Global...... .............................................. 4,332.3
Equity/Balanced.............................................. 7,535.0
Fixed Income (excluding Money Market)........................ 5,006.0
Taxable Fixed Income................................. 3,448.4
Tax-Free Fixed Income................................ 1,557.6
Money Market Funds........................................... 35,176.9
PERSONAL 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 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 each fund 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 each fund 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 each fund adopted by each Trust in the manner prescribed
under Rule 12b-1 under the Investment Company Act (each, respectively, a "Class
A Plan," "Class B Plan" and "Class C Plan," and 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 pays Mitchell Hutchins a distribution
fee, accrued daily and payable monthly, at the annual rate of 0.75% of the
average daily net assets of the Class B shares. Under the Class C Plan, each
fund pays Mitchell Hutchins a distribution fee, accrued daily and payable
monthly, at the annual rate of 0.50% of the average daily net assets of the
Class C shares. There is no distribution plan with respect to the funds' Class Y
shares.
44
<PAGE>
Mitchell Hutchins uses the service fees under the Plans for Class A, B
and C shares primarily to pay PaineWebber for shareholder servicing, currently
at the annual rate of 0.25% of the aggregate investment amounts maintained in
each fund by PaineWebber clients. PaineWebber then compensates its Financial
Advisors for shareholder servicing that they perform and offsets its own
expenses in servicing and maintaining shareholder accounts, including related
overhead expenses.
Mitchell Hutchins uses the distribution fees under the Class B and
Class C Plans to:
o Offset the commissions it pays to PaineWebber for selling each fund's
Class B and Class C shares, respectively.
o Offset each fund's marketing costs attributable to such classes, such as
preparation, printing and distribution of sales literature, advertising
and prospectuses to prospective investors and related overhead expenses,
such as employee salaries and bonuses.
PaineWebber compensates Financial Advisors when Class B and Class C
shares are bought by investors, as well as on an ongoing basis. Mitchell
Hutchins receives no special compensation from any of the funds or investors at
the time Class B or C shares are bought.
Mitchell Hutchins receives the proceeds of the initial sales charge
paid when Class A shares are bought and of the contingent deferred sales charge
paid upon sales of shares. These proceeds may be used to cover distribution
expenses.
The Plans and the related Distribution Contracts for Class A, Class B
and Class C shares specify that each fund must pay service and distribution fees
to Mitchell Hutchins as compensation for its activities, not as reimbursement
for specific expenses incurred. Therefore, even if Mitchell Hutchins' expenses
exceed the service or distribution fees it receives, the funds will not be
obligated to pay more than those fees. On the other hand, if Mitchell Hutchins'
expenses are less than such fees, it will retain its full fees and realize a
profit. Expenses in excess of service and distribution fees received or accrued
through the termination date of any Plan will be Mitchell Hutchins' sole
responsibility and not that of the funds. Annually, the board of each fund
reviews the Plans and Mitchell Hutchins' corresponding expenses for each class
separately from the Plans and expenses of the other classes.
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 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 that Trust.
In reporting amounts expended under the Plans to the board members,
Mitchell Hutchins allocates expenses attributable to the sale of each class of
each fund's shares to such class based on the ratio of sales of shares of such
class to the sales of all three classes of shares. The fees paid by one class of
a fund's shares will not be used to subsidize the sale of any other class of
fund shares.
The funds paid (or accrued) the following service and/or distribution
fees to Mitchell Hutchins under the Class A, Class B and Class C Plans during
the fiscal year ended February 28, 1999:
45
<PAGE>
<TABLE>
<CAPTION>
CALIFORNIA TAX- NEW YORK TAX-
NATIONAL TAX- MUNICIPAL HIGH FREE INCOME FREE INCOME
FREE FUND INCOME FUND FUND FUND
--------- ----------- ---- ----
<S> <C> <C> <C> <C>
Class A................. $ 571,447 $ 159,618 $295,776 $ 66,771
Class B................. 273,146 184,576 146,383 67,141
Class C................. 361,729 171,032 133,179 90,995
</TABLE>
Mitchell Hutchins estimates that it and its parent corporation,
PaineWebber, incurred the following shareholder service-related and
distribution-related expenses with respect to each fund during the fiscal year
ended February 28, 1999:
<TABLE>
<CAPTION>
NEW YORK
NATIONAL MUNICIPAL CALIFORNIA TAX-FREE
TAX-FREE INCOME HIGH INCOME TAX-FREE INCOME
FUND FUND INCOME FUND FUND
---- ---- ----------- ----
<S> <C> <C> <C> <C>
CLASS A
Marketing and advertising................. $ 151,230 $ 145,328 $ 142,091 $ 101,820
Amortization of commissions............... 0 0 0 0
Printing of prospectuses and statements of
additional information.................... 1,344 840 1,540 195
Branch network costs allocated and
interest expense.......................... 881,627 191,330 430,202 91,463
Service fees paid to PaineWebber Financial
Advisors.................................. 217,150 60,656 112,395 25,372
CLASS B
Marketing and advertising................. 16,886 42,019 17,575 25,452
Amortization of commissions............... 87,224 60,026 46,076 21,554
Printing of prospectuses and statements of
additional information.................... 1,344 248 191 195
Branch network costs allocated and
interest expense.......................... 114,566 55,320 59,355 25,610
Service fees paid to PaineWebber Financial
Advisors.................................. 25,949 17,536 13,907 6,378
CLASS C
Marketing and advertising................. 30,852 51,928 21,334 46,143
Amortization of commissions............... 91,638 43,328 33,739 23,052
Printing of prospectuses and statements of
additional information.................... 1,344 289 231 195
Branch network costs allocated and
interest expense.......................... 187,959 68,351 65,298 42,025
Service fees paid to PaineWebber Financial
Advisors.................................. 45,819 21,664 16,869 11,526
</TABLE>
"Marketing and advertising" includes various internal costs allocated
by Mitchell Hutchins to its efforts at distributing the funds' 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
the funds' shares, including the PaineWebber retail branch system.
46
<PAGE>
In approving each fund's overall Flexible PricingSM system of
distribution, the applicable 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 fund and attracting
new investors and assets to the fund to the benefit of the fund and its
shareholders, (2) facilitate distribution of the fund's shares and (3) maintain
the competitive position of the fund in relation to other funds that have
implemented or are seeking to implement similar distribution arrangements.
In approving the Class A Plan, 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 Financial Advisors and correspondent firms,
resulting in greater growth of the fund than might otherwise be the case, (3)
the advantages to the shareholders of economies of scale resulting from growth
in the fund's assets and potential continued growth, (4) the services provided
to the fund and its shareholders by Mitchell Hutchins, (5) the services provided
by PaineWebber pursuant to its Exclusive Dealer Agreement with Mitchell Hutchins
and (6) Mitchell Hutchins' shareholder service-related expenses and costs.
In approving the Class B Plan, the board of each fund 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 Financial Advisors 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
Financial Advisors and correspondent firms, resulting in greater growth of the
fund than might otherwise be the case, (4) the advantages to the shareholders of
economies of scale resulting from growth in the fund's assets and potential
continued growth, (5) the services provided to the fund and its shareholders by
Mitchell Hutchins, (6) the services provided by PaineWebber pursuant to its
Exclusive Dealer Agreement with Mitchell Hutchins and (7) Mitchell Hutchins'
shareholder service- and distribution-related expenses and costs. The board
members also recognized that Mitchell Hutchins' willingness to compensate
PaineWebber and its Financial Advisors, 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 Financial Advisors 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 generally do not face contingent
deferred sales charges, would prove attractive to the Financial Advisors and
correspondent firms, resulting in greater growth to the fund than might
otherwise be the case, (4) the advantages to the shareholders of economies of
scale resulting from growth in the fund's assets and potential continued growth,
(5) the services provided to the fund and its shareholders by Mitchell Hutchins,
(6) the services provided by PaineWebber pursuant to its Exclusive Dealer
Agreement with Mitchell Hutchins and (7) Mitchell Hutchins' shareholder service-
and distribution-related expenses and costs. The board members also recognized
that Mitchell Hutchins' willingness to compensate PaineWebber and its Financial
Advisors, without the concomitant receipt by Mitchell Hutchins of initial sales
charges or contingent deferred sales charges upon redemption after one year
following purchase 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
47
<PAGE>
benefits that would accrue to Mitchell Hutchins under each Plan in that Mitchell
Hutchins would receive service, distribution and advisory fees that are
calculated based upon a percentage of the average net assets of a fund, which
fees would increase if the Plan were successful and the fund attained and
maintained significant asset levels.
Under the Distribution Contract between each Trust and Mitchell
Hutchins for the Class A shares 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.
<TABLE>
<CAPTION>
FISCAL YEAR ENDED FEBRUARY 28/29,
1999 1998 1997
---- ---- ----
<S> <C> <C> <C>
NATIONAL TAX-FREE INCOME FUND
Earned....................................... $ 141,884 $ 79,748 $ 148,485
Retained..................................... 12,438 6,357 1,253
MUNICIPAL HIGH INCOME FUND
Earned....................................... 66,403 121,988 23,894
Retained..................................... 5,007 7,764 1,867
CALIFORNIA TAX-FREE INCOME FUND
Earned....................................... 105,681 79,848 56,842
Retained..................................... 8,900 6,304 4,798
NEW YORK TAX-FREE INCOME FUND
Earned....................................... 35,695 47,579 11,290
Retained..................................... 3,239 3,962 838
</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, 1999:
<TABLE>
<CAPTION>
NEW YORK
NATIONAL TAX-FREE MUNICIPAL HIGH CALIFORNIA TAX-FREE TAX-FREE
INCOME FUND INCOME FUND INCOME FUND INCOME FUND
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Class A............... $ 0 $ 0 $ 0 $ 0
Class B............... 64,892 41,309 55,841 14,680
Class C............... 2,884 5,073 2,995 2,676
</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 brokerage commission
or dealer spread), 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
over-the-counter market on a "net" basis without a stated commission through
dealers acting for their own accounts and not through 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 the time. For the last three fiscal years, the funds
have not paid any brokerage commissions.
For purchases or sales with broker-dealer firms that act as principal,
Mitchell Hutchins seeks best execution. Although Mitchell Hutchins may receive
certain research or execution services in connection with these transactions,
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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 were
attributed to the services provided by the executing dealer. Mitchell Hutchins
may engage in agency transactions in over-the-counter securities in return for
research and execution services. These transactions are entered into only
pursuant to procedures that are designed to ensure 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.
Research services and information received from brokers or dealers are
supplemental to Mitchell Hutchins' own research efforts and, when utilized, are
subject to internal analysis before being incorporated into their investment
process. Information and research services furnished by brokers or dealers
through which or with 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 brokers or dealers in
connection with other funds or accounts that either of them advises may be used
in advising the funds.
Investment decisions for a fund and for other investment accounts
managed by Mitchell Hutchins are made independently of each other in light of
differing considerations for the various accounts. However, the same investment
decision may occasionally be made for a fund and one or more of such accounts.
In such cases, simultaneous transactions are inevitable. Purchases or sales are
then averaged as to price and allocated between that fund 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 the funds are
concerned, or upon their ability to complete their entire order, in other cases
it is believed that simultaneous transactions and the ability to participate in
volume transactions will benefit the funds.
The funds will not purchase securities that are offered in
underwritings in which PaineWebber is a member of the underwriting or selling
group, except pursuant to procedures adopted by each board pursuant to Rule
10f-3 under the Investment Company Act. Among other things, these procedures
require that the spread or commission paid in connection with such a purchase be
reasonable and fair, 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 PaineWebber or any affiliate thereof not participate in or benefit from
the sale to the fund.
PORTFOLIO TURNOVER. The funds' annual portfolio turnover rates may vary
greatly from year to year, but they 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 securities in the portfolio during the year.
The funds' respective portfolio turnover rates for the fiscal years
shown were:
FISCAL YEARS ENDED FEBRUARY 28
1999 1998
---- ----
National Tax-Free Income Fund....... 43% 79%
Municipal High Income Fund.......... 26% 22%
California Tax-Free Income Fund..... 45%* 107%
New York Tax-Free Income Fund....... 44% 34%
* California Tax-Free Income Fund's portfolio turnover rate was
significantly lower for the fiscal year ended February 28, 1999
(45%) compared to the prior fiscal year ended February 28, 1998
(107%). This variation in the year-to-year portfolio turnover rate
was primarily due to more limited portfolio restructuring and less
volatile swings in the general direction of interest rates during
this most recent fiscal year compared to the prior fiscal year.
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REDUCED SALES CHARGES, ADDITIONAL EXCHANGE AND REDEMPTION
INFORMATION AND OTHER SERVICES
WAIVERS OF SALES CHARGES/CONTINGENT DEFERRED SALES CHARGES -- CLASS A
SHARES. The following additional sales charge waivers are available for Class A
shares if you:
o Purchase shares through a variable annuity offered only to qualified
plans. For investments made pursuant to this waiver, Mitchell Hutchins
may make payments out of its own resources to PaineWebber and to the
variable annuity's sponsor, adviser or distributor in a total amount
not to exceed l% of the amount invested;
o Acquire shares through an investment program that is not sponsored by
PaineWebber or its affiliates and that charges participants a fee for
program services, provided that the program sponsor has entered into a
written agreement with PaineWebber permitting the sale of shares at net
asset value to that program. For investments made pursuant to this
waiver, Mitchell Hutchins may make a payment to PaineWebber out of its
own resources in an amount not to exceed 1% of the amount invested. For
subsequent investments or exchanges made to implement a rebalancing
feature of such an investment program, the minimum subsequent
investment requirement is also waived;
o Acquire shares in connection with a reorganization pursuant to which a
fund acquires substantially all of the assets and liabilities of
another fund in exchange solely for shares of the acquiring fund; or
o Acquire shares in connection with the disposition of proceeds from the
sale of shares of Managed High Yield Plus Fund Inc. that were acquired
during that fund's initial public offering of shares and that meet
certain other conditions described in its prospectus
In addition, reduced sales charges on Class A shares are available
through the combined purchase plan or through rights of accumulation described
below. Class A share purchases of $1 million or more are not subject to an
initial sales charge; however, if a shareholder sells these shares within one
year after purchase, a contingent deferred sales charge of 1% of the offering
price or the net asset value of the shares at the time of sale by the
shareholder, whichever is less, is imposed.
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 indicated in
the tables of sales charges for Class A shares in the Prospectus. The sales
charge payable on the purchase 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;
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(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.
REINSTATEMENT PRIVILEGE -- CLASS A SHARES. Shareholders who have
redeemed Class A shares of a fund may reinstate their account without a sales
charge 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, although a loss arising out of a
redemption might not be deductible under certain circumstances. See "Taxes"
below.
WAIVERS OF CONTINGENT DEFERRED SALES CHARGES -- CLASS B SHARES. The
maximum 5% contingent deferred sales charge applies to sales of shares during
the first year after purchase. The charge generally declines by 1% annually,
reaching zero after six years. 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.
PURCHASES OF CLASS Y SHARES THROUGH THE PACE MULTI ADVISOR PROGRAM. An
investor who participates in the PACE Multi Advisor Program is eligible to
purchase Class Y shares. The PACE Multi Advisor Program is an advisory program
sponsored by PaineWebber that provides comprehensive investment services,
including investor profiling, a personalized asset allocation strategy using an
appropriate combination of funds, and a quarterly investment performance review.
Participation in the PACE Multi Advisor Program is subject to payment of an
advisory fee at the effective maximum annual rate of 1.5% of assets. Employees
of PaineWebber and its affiliates are entitled to a waiver of this fee. Please
contact your PaineWebber Financial Advisor or PaineWebber's correspondent firms
for more information concerning mutual funds that are available through the PACE
Multi Advisor Program.
PURCHASES AND SALES OF CLASS Y SHARES FOR PARTICIPANTS IN PW 401(K)
PLUS PLAN. The trustee of the PW 401(k) Plus Plan, a defined contribution plan
sponsored by PW Group, buys and sells Class Y shares of the funds to implement
the investment choices of individual plan participants with respect to their PW
401(k) Plus Plan contributions. Individual plan participants should consult the
Summary Plan Description and other plan material of the PW 401(k) Plus Plan
(collectively, "Plan Documents") for a description of the procedures and
limitations applicable to making and changing investment choices. Copies of the
Plan Documents are available from the Benefits Connection, 100 Halfday Road,
Lincolnshire, IL 60069 or by calling 1-888-PWEBBER (1-888-793-2237). As
described in the Plan Documents, the price at which Class Y shares are bought
and sold by the trustee of PW 401(k) Plus Plan might be more or less than the
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price per share at the time the participants made their investment choices.
ADDITIONAL EXCHANGE AND REDEMPTION INFORMATION. As discussed in the
Prospectus, eligible shares of the funds may be exchanged for shares of the
corresponding class of most other PaineWebber mutual funds. Class Y shares are
not eligible for exchange. Shareholders will receive at least 60 days' notice of
any termination or material modification of the exchange offer, except 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 objective, policies and
restrictions.
If conditions exist that make cash payments undesirable, each fund
reserves the right to honor any request for redemption by making payment in
whole or in part in securities chosen by the fund and valued in the same way as
they would be valued for purposes of computing the fund's net asset value. 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 fund has
elected, however, to be governed by Rule 18f-1 under the Investment Company Act,
under which it is obligated to redeem shares solely in cash up to the lesser of
$250,000 or 1% of its net asset value during any 90-day period for one
shareholder. This election is irrevocable unless the SEC permits its withdrawal.
The funds may suspend redemption privileges or postpone the date of
payment during any period (1) when the New York Stock Exchange is closed or
trading on the New York Stock Exchange is restricted as determined by the SEC,
(2) when an emergency exists, as defined by the SEC, that makes it not
reasonably practicable for a 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.
SERVICE ORGANIZATIONS. A fund may authorize service organizations, and
their agents, to accept on its behalf purchase and redemption orders that are in
"good form." A fund will be deemed to have received these purchase and
redemption orders when a service organization or its agent accepts them. Like
all customer orders, these orders will be priced based on the fund's net asset
value next computed after receipt of the order by the service organizations or
their agents. Service organizations may include retirement plan service
providers who aggregate purchase and redemption instructions received from
numerous retirement plans or plan participants.
AUTOMATIC INVESTMENT PLAN. PaineWebber offers an automatic investment
plan with a minimum initial investment of $1,000 through which a fund will
deduct $50 or more on a monthly, quarterly, semi-annual or annual basis from the
investor's bank account to invest directly in the fund. Participation in the
automatic investment plan enables an investor to use the technique of "dollar
cost averaging." When an 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 low and
high price levels.
SYSTEMATIC WITHDRAWAL PLAN. The systematic withdrawal plan allows
investors to set up monthly, quarterly (March, June, September and December),
semi-annual (June and December) or annual (December) withdrawals from their
PaineWebber Mutual Fund accounts. Minimum balances and withdrawals vary
according to the class of shares:
o Class A and Class C shares. Minimum value of fund shares is
$5,000; minimum withdrawals of $100.
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o Class B shares. Minimum value of fund shares is $20,000; minimum
monthly, quarterly, and semi-annual and annual withdrawals of
$200, $400, $600 and $800, respectively.
Withdrawals under the systematic withdrawal plan will not be subject to
a contingent deferred sales charge if the investor withdraws no more than 12% of
the value of the fund account when the investor signed up for the Plan (for
Class B shares, annually; for Class A and Class C shares, during the first year
under the Plan). Shareholders who elect to receive dividends or other
distributions in cash may not participate in this 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 the minimum values specified
above. Purchases of additional shares of a fund concurrent with withdrawals are
ordinarily disadvantageous to shareholders because of tax liabilities and, for
Class A shares, initial sales charges. On or about the 20th of a month for
monthly, quarterly, semi-annual and annual plans, PaineWebber will arrange for
redemption by the funds of sufficient fund shares to provide the withdrawal
payments specified by participants in the funds' systematic withdrawal plan. The
payments generally are mailed approximately five Business Days (defined under
"Valuation of Shares") after the redemption date. Withdrawal payments should not
be considered dividends, but redemption proceeds. 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 Inc. 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 PFPC. Shareholders may request the
forms needed to establish a systematic withdrawal plan from their PaineWebber
Financial Advisors, correspondent firms or PFPC at 1-800-647-1568.
INDIVIDUAL RETIREMENT ACCOUNTS. Self-directed IRAs are available
through PaineWebber in which purchases of PaineWebber mutual funds and other
investments may be made. Investors considering establishing an IRA should review
applicable tax laws and should consult their tax advisers.
TRANSFER OF ACCOUNTS. If investors holding shares of a fund in a
PaineWebber brokerage account transfer their brokerage accounts to another firm,
the fund shares will be moved to an account with PFPC. However, if the other
firm has entered into a selected dealer agreement with Mitchell Hutchins
relating to the fund, the shareholder may be able to hold fund shares in an
account with the other firm.
PAINEWEBBER RMA RESOURCE ACCUMULATION PLANSM;
PAINEWEBBER RESOURCE MANAGEMENT ACCOUNT(R) (RMA)(R)
Shares of PaineWebber mutual funds (each a "PW Fund" and, collectively,
the "PW Funds") are available for purchase through the RMA Resource Accumulation
Plan ("Plan") by customers of PaineWebber and its correspondent firms who
maintain Resource Management Accounts ("RMA accountholders"). The Plan allows an
RMA accountholder to continually invest in one or more of the PW Funds at
regular intervals, with payment for shares purchased automatically deducted from
the client's RMA account. The client may elect to invest at monthly or quarterly
intervals and may elect either to invest a fixed dollar amount (minimum $100 per
period) or to purchase a fixed number of shares. A client can elect to have Plan
purchases executed on the first or fifteenth day of the month. Settlement occurs
three Business Days (defined under "Valuation of Shares") after the trade date,
and the purchase price of the shares is withdrawn from the investor's RMA
account on the settlement date from the following sources and in the following
order: uninvested cash balances, balances in RMA money market funds, or margin
borrowing power, if applicable to the account.
To participate in the Plan, an investor must be an RMA accountholder,
must have made an initial purchase of the shares of each PW Fund selected for
investment under the Plan (meeting applicable minimum investment requirements)
and must complete and submit the RMA Resource Accumulation Plan Client Agreement
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and Instruction Form available from PaineWebber. The investor must have received
a current prospectus for each PW Fund selected prior to enrolling in the Plan.
Information about mutual fund positions and outstanding instructions under the
Plan are noted on the RMA accountholder's account statement. Instructions under
the Plan may be changed at any time, but may take up to two weeks to become
effective.
The terms of the Plan, or an RMA accountholder's participation in the
Plan, may be modified or terminated at any time. It is anticipated that, in the
future, shares of other PW Funds and/or mutual funds other than the PW Funds may
be offered through the Plan.
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 low
and high share prices. However, over time, dollar cost averaging generally
results in a lower average original investment cost than if an investor invested
a larger dollar amount in a mutual fund at one time.
PAINEWEBBER'S RESOURCE MANAGEMENT ACCOUNT. In order to enroll in the
Plan, an investor must have opened an RMA account with PaineWebber or one of its
correspondent firms. The RMA account is PaineWebber's comprehensive asset
management account and offers investors a number of features, including the
following:
o monthly Premier account statements that itemize all account
activity, including investment transactions, checking activity and
Gold MasterCard(Registered) transactions during the period, and
provide unrealized and realized gain and loss estimates for most
securities held in the account;
o comprehensive year-end summary statements that provide information
on account activity for use in tax planning and tax return
preparation;
o automatic "sweep" of uninvested cash into the RMA accountholder's
choice of one of the 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. AN INVESTMENT IN A
MONEY MARKET FUND IS NOT INSURED OR GUARANTEED BY THE FEDERAL
DEPOSIT INSURANCE CORPORATION OR ANY OTHER GOVERNMENT AGENCY.
ALTHOUGH A MONEY MARKET FUND SEEKS TO PRESERVE THE VALUE OF YOUR
INVESTMENT AT $1.00 PER SHARE, IT IS POSSIBLE TO LOSE MONEY BY
INVESTING IN A MONEY MARKET FUND.
o check writing, with no per-check usage charge, no minimum amount
on checks and no maximum number of checks that can be written. RMA
accountholders can code their checks to classify expenditures. All
canceled checks are returned each month;
o Gold MasterCard, with or without a line of credit, which provides
RMA accountholders with direct access to their accounts and can be
used with automatic teller machines worldwide. Purchases on the
Gold MasterCard are debited to the RMA account once monthly,
permitting accountholders to remain invested for a longer period
of time;
o free and unlimited electronic funds transfers and bill payment
service for $6 a month-- unlimited fixed and variable payments;
o 24-hour access to account information through toll-free numbers,
and more detailed personal assistance during business hours from
the RMA Service Center;
o expanded account protection up to the net equity securities
balance in the event of the liquidation of PaineWebber. This
protection does not apply to shares of PW Funds that are held
directly at PFPC and not through PaineWebber; and
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o automatic direct deposit of checks into your RMA account and
automatic withdrawals from the account.
The annual account fee for an RMA account is $85, which includes the
Gold MasterCard, with an additional fee of $40 if the investor selects an
optional line of credit with the Gold MasterCard.
CONVERSION OF CLASS B SHARES
Class B shares of a 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 (i) the date on which such Class B shares were
issued or (ii) 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
will also convert 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 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 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 will
not continue to be met.
VALUATION OF SHARES
Each fund determines its net asset value per share separately for each
class of shares, normally as of the close of regular trading (usually 4:00 p.m.,
Eastern time) on the New York Stock Exchange on each Business Day, which is
defined as each Monday through Friday when the New York Stock Exchange is open.
Prices will be calculated earlier when the New York Stock Exchange closes early
because trading has been halted for the day. Currently the New York Stock
Exchange 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 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
over-the-counter market and listed on the Nasdaq Stock Market ("Nasdaq")
normally are valued at the last available sale price on Nasdaq prior to
valuation; other over-the-counter securities 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 those
quotations adequately reflect, in the judgment of Mitchell Hutchins, the fair
value of the security. Where those 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. All other securities and other assets
are valued at fair value as determined in good faith by or under the direction
of the applicable board. It should be recognized that judgment often plays a
greater role in valuing thinly traded securities, including many lower rated
bonds, than is the case with respect to securities for which a broader range of
dealer quotations and last-sale information is available. The amortized cost
method of valuation generally is used to value debt obligations with 60 days or
less remaining until maturity, unless the applicable board determines that this
does not represent fair value.
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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:
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 at the beginning of that period.
Under the foregoing formula, the time periods used in Performance
Advertisements will be based on rolling calendar quarters, updated to the last
day of the most recent quarter prior to submission of the advertisement for
publication. Total return, or "T" in the formula above, is computed by finding
the average annual change in the value of an initial $1,000 investment over the
period. In calculating the ending redeemable value, for Class A shares, the
maximum 4.0% 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.
The funds 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"). The funds calculate Non-Standardized Return
for specified periods of time by assuming an investment of $1,000 in fund shares
and assuming the reinvestment of all dividends and other distributions. The rate
of return is determined by subtracting the initial value of the investment from
the ending value and by dividing the remainder by the initial value. Neither
initial nor contingent deferred sales charges are taken into account in
calculating Non-Standardized Return; the inclusion of those charges would reduce
the return.
Both Standardized Return and Non-Standardized Return for Class B shares
for periods of over six years reflect conversion of the Class B shares to Class
A shares at the end of the sixth year.
The following tables show performance information for each class of the
funds' shares outstanding for the periods indicated. All returns for periods of
more than one year are expressed as an average annual return.
<TABLE>
<CAPTION>
NATIONAL TAX-FREE INCOME FUND
CLASS A CLASS B CLASS C CLASS Y
------- ------- ------- -------
<S> <C> <C> <C> <C>
Year ended February 28, 1999:
Standardized Return*............... 1.09% (0.42)% 4.02% 5.49%
Non-Standardized Return............ 5.31% 4.48% 4.76% 5.49%
Five Years ended February 28, 1999:
Standardized Return*.............. 4.49% 4.23% 4.81% N/A
Non-Standardized Return........... 5.35% 4.56% 4.81% N/A
Ten Years ended February 28, 1999:
Standardized Return*.............. 6.73% N/A N/A N/A
Non-Standardized Return*.......... 7.17% N/A N/A N/A
Inception** to February 28,1999:
Standardized Return*.............. 8.09% 6.20% 5.53% 6.41%
Non-Standardized Return........... 8.41% 6.20% 5.53% 6.41%
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MUNICIPAL HIGH INCOME FUND
CLASS A CLASS B CLASS C CLASS Y
------- ------- ------- -------
Year ended February 28, 1999:
Standardized Return*................. 0.58% (1.09)% 3.51% 4.96%
Non-Standardized Return.............. 4.80% 3.87% 4.25% 4.96%
Five Years ended February 28, 1999:
Standardized Return*................. 5.16% 4.89% 5.49% N/A
Non-Standardized Return.............. 6.02% 5.22% 5.49% N/A
Ten Years ended February 28, 1999:
Standardized Return.................. 7.35% N/A N/A N/A
Non-Standardized Return.............. 7.79% N/A N/A N/A
Inception** to February 28, 1999:
Standardized Return*................. 7.69% 6.93% 6.07% 4.56%
Non-Standardized Return.............. 8.06% 6.93% 6.07% 4.56%
CALIFORNIA TAX-FREE INCOME FUND
CLASS A CLASS B CLASS C CLASS Y
------- ------- ------- -------
Year ended February 28, 1999:
Standardized Return*................. 1.71% 0.15% 4.61% 6.28%
Non-Standardized Return.............. 5.90% 5.06% 5.35% 6.28%
Five Years ended February 28, 1999:
Standardized Return*................. 4.59% 4.32% 4.92% N/A
Non-Standardized Return.............. 5.46% 4.65% 4.92% N/A
Ten Years ended February 28, 1999:
Standardized Return.................. 6.61% N/A N/A N/A
Non-Standardized Return.............. 7.05% N/A N/A N/A
Inception** to February 28, 1999:
Standardized Return*................. 7.67% 6.00% 5.45% 5.54%
Non-Standardized Return.............. 8.00% 6.00% 5.45% 5.54%
NEW YORK TAX-FREE INCOME FUND
CLASS A CLASS B CLASS C CLASS Y
------- ------- ------- -------
Year ended February 28, 1999:
Standardized Return*............... 2.02% 0.44% 5.04% N/A
Non-Standardized Return............ 6.24% 5.40% 5.78% N/A
Five Years ended February 28, 1999:
Standardized Return*............... 4.89% 4.62% 5.24% N/A
Non-Standardized Return............ 5.75% 4.95% 5.24% N/A
Ten Years ended February 28, 1999:
Standardized Return................ 7.26% N/A N/A N/A
Non-Standardized Return............ 7.70% N/A N/A N/A
Inception** to February 28, 1999:
Standardized Return*............... 7.17% 6.78% 5.99% 5.90%
Non-Standardized Return........... 7.59% 6.78% 5.99% 5.90%
</TABLE>
- --------------
* All Standardized Return figures for Class A shares reflect deduction of the
current maximum sales charge of 4.0%. All Standardized Return figures for
Class B and Class C shares reflect deduction of the applicable contingent
57
<PAGE>
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, the performance information is the same for both
standardized return and non-standardized return for the periods indicated.
** The inception date for each class of shares is as follows:
<TABLE>
<CAPTION>
CLASS A CLASS B CLASS C CLASS Y
------- ------- ------- -------
<S> <C> <C> <C> <C>
California Tax-Free Income Fund 09/16/85 07/01/91 07/02/92 02/05/98
National Tax-Free Income Fund 12/03/84 07/01/91 07/02/92 11/03/95
Municipal High Income Fund 06/23/87 07/01/91 07/02/92 02/05/98
New York Tax-Free Income Fund 09/23/88 07/01/91 07/02/92 5/21/98
</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 semi-annual compounding) of the maximum offering price per
share (in the case of Class A shares) or the net asset value per share (in the
case of Class B and Class C shares) at the end of the Period. Yield quotations
are calculated according to the following formula:
6
a-b
YIELD = 2[( --- +1) - 1]
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 a class
outstanding during the Period that were entitled to
receive dividends
d = the maximum offering price per share (in the case of
Class A shares) or the net asset value per share (in
the case of Class B and Class C shares) on the last day
of the Period.
Except as noted below, in determining interest income earned during the
Period (variable "a" in the above formula), each 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 the fund,
interest earned during the Period is then determined by totaling 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) the fund's current maximum 4.0 initial sales charge on Class A shares
is included.
The following table shows the yield for each class of shares of each
fund for the 30-day period ended February 28, 1999:
<TABLE>
<CAPTION>
NATIONAL TAX- CALIFORNIA TAX- NEW YORK
FREE INCOME MUNICIPAL HIGH FREE INCOME TAX-FREE
FUND INCOME FUND FUND INCOME FUND
---- ----------- ---- -----------
<S> <C> <C> <C> <C>
Class A............. 4.32% 4.81% 4.41% 4.11%
Class B............. 3.71% 4.24% 3.83% 3.52%
58
<PAGE>
Class C............. 3.97% 4.50% 4.09% 3.78%
Class Y............. 4.67% 5.23% 4.85% 4.53%
</TABLE>
Tax-exempt yield is calculated according to the same formula except
that the 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:
E
TAX EQUIVALENT YIELD = (------) + t
1-p
E = tax-exempt yield of a class of shares
p = stated income tax rate
t = taxable yield of a Class of shares
The tax-equivalent yield of California Tax-Free Income Fund assumes a
45.22% combined effective California and federal tax rate. The tax-equivalent
yield of New York Tax-Free Income Fund assumes a 46.10% 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, 1999:
<TABLE>
<CAPTION>
NATIONAL TAX-FREE CALIFORNIA TAX- NEW YORK
INCOME MUNICIPAL HIGH FREE INCOME TAX-FREE
FUND INCOME FUND FUND INCOME FUND
---- ----------- ---- -----------
<S> <C> <C> <C> <C>
Class A............. 7.15% 7.96% 8.05% 7.67%
Class B............. 6.14% 7.02% 6.99% 6.57%
Class C............. 6.58% 7.45% 7.47% 7.05%
Class Y............. 7.73% 8.66% 8.85% 8.47%
</TABLE>
OTHER INFORMATION. In Performance Advertisements, the funds may compare
their Standardized Return and/or their Non-Standardized Return with data
published by Lipper Inc. ("Lipper") for U.S. government funds, corporate bond
(BBB) funds and high yield funds, CDA Investment Technologies, Inc. ("CDA"),
Wiesenberger Investment Companies Service ("Wiesenberger"), Investment Company
Data, Inc. ("ICD") or Morningstar Mutual Funds ("Morningstar"), or with the
performance of recognized stock, bond and other indices, including the Municipal
Bond Buyers Indices, Lehman Bond Index, the Standard & Poor's 500 Composite
Stock Price Index ("S&P 500"), 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 these 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 the funds 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.
The funds 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 a fund investment are reinvested in
additional fund shares, any future income or capital appreciation of a fund
59
<PAGE>
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 a fund investment would increase more quickly than if dividends or other
distributions had been paid in cash.
The funds may also compare their performance with the performance of
bank certificates of deposit (CDs) as measured by the CDA Certificate of Deposit
Index, the Bank Rate Monitor National Index and the averages of yields of CDs of
major banks published by Banxquote(R) Money Markets. In comparing the funds'
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. Shares of the funds are not insured or guaranteed by the U.S.
government and returns and net asset values will fluctuate. The debt securities
held by the funds generally have longer maturities than most CDs and may reflect
interest rate fluctuations for longer term debt securities. An investment in any
fund involves greater risks than an investment in either a money market fund or
a CD.
TAXES
BACKUP WITHHOLDING. Each fund is required to withhold 31% of all
taxable dividends, capital gain distributions and redemption proceeds payable to
individuals and certain other non-corporate shareholders who do not provide the
fund or PaineWebber with a correct taxpayer identification number. Withholding
at that rate also is required from taxable dividends and capital gain
distributions payable to those shareholders who otherwise are subject to backup
withholding.
SALE OR EXCHANGE OF FUND SHARES. A shareholder's sale (redemption) of
shares may result in a taxable gain or loss, depending on whether the
shareholder receives more or less than his or her adjusted basis for the shares
(which normally includes any initial sales charge paid on Class A shares). An
exchange of any fund's shares for shares of another PaineWebber mutual fund
generally will have similar tax consequences. In addition, if a fund's shares
are bought within 30 days before or after selling other shares of the fund
(regardless of class) at a loss, all or a portion of that loss will not be
deductible and will increase the basis of the newly purchased shares.
CLASS A SHAREHOLDERS. A special tax rule applies when a shareholder
sells or exchanges Class A shares within 90 days of purchase and subsequently
acquires Class A shares of the same or another PaineWebber mutual fund without
paying a sales charge due to the 365-day reinstatement privilege or the exchange
privilege. In these cases, any gain on the sale or exchange of the original
Class A shares would be increased, or any loss would be decreased, by the amount
of the sales charge paid when those shares were bought, and that amount would
increase the basis of the PaineWebber mutual fund shares subsequently acquired.
CONVERSION OF CLASS B SHARES. A shareholder will recognize no gain or
loss as a result of a conversion from Class B shares to Class A shares.
QUALIFICATION AS A REGULATED INVESTMENT COMPANY. To continue to qualify
for treatment as a regulated investment company ("RIC") under the Internal
Revenue Code, a fund must distribute to its shareholders for each taxable year
at least 90% of the sum of its net interest income excludable from gross income
under section 103(a) of the Internal Revenue Code 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, (a) it would be taxed as
an ordinary corporation on its taxable income for that year without being able
to deduct the distributions it makes to its shareholders and (b) the
shareholders would treat all those distributions, including distributions that
60
<PAGE>
otherwise would be "exempt-interest dividends" described in the following
paragraph and distributions of net capital gain (the excess of net long-term
capital gain over net short-term capital loss), as dividends (that is, ordinary
income) to the extent of the fund's earnings and profits. In addition, the fund
could be required to recognize unrealized gains, pay substantial taxes and
interest, and make substantial distributions before requalifying for RIC
treatment.
Dividends paid by a fund will qualify as "exempt-interest dividends,"
and thus will be excludable from gross income for federal income tax purposes by
its shareholders, if the fund satisfies the requirement that, at the close of
each quarter of its taxable year, at least 50% of the value of its total assets
consists of securities the interest on which is excludable from gross income
under section 103(a); each fund intends to continue to satisfy this requirement.
The aggregate dividends designated for any year by a fund as exempt-interest
dividends may not exceed its net tax-exempt income for the year. Shareholders'
treatment of dividends from a fund under state and local income tax laws may
differ from the treatment thereof under the Internal Revenue Code. Investors
should consult their tax advisers concerning this matter.
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 above; 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. The
respective portions will be determined by the "actual earned" method, under
which the portion of any dividend that qualifies as an exempt-interest dividend
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.
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 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.
61
<PAGE>
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 identical
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
a futures contract entered into by a fund or a related person with respect to
the same or substantially identical property. In addition, if the appreciated
financial position is itself a short sale or such a contract, acquisition of the
underlying property or substantially identical property will be deemed a
constructive sale. The foregoing will not apply, however, to any transaction of
a fund during any taxable year that otherwise would be treated as a constructive
sale if the transaction is closed within 30 days after the end of that year and
the fund holds the appreciated financial position unhedged for 60 days after
that closing (I.E., at no time during that 60-day period is the fund's risk of
loss regarding that position reduced by reason of certain specified transactions
with respect to substantially identical or related property, such as having an
option to sell, being contractually obligated to sell, making a short sale, or
granting an option to buy substantially identical stock or securities).
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 that 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 Internal Revenue Code and satisfies the
requirement of California law that at least 50% of its assets at the close of
each quarter of its taxable year be invested in obligations the interest on
which is exempt from personal income taxation under the laws or Constitution of
California or the laws of the United States. Distributions from the fund which
are attributable to sources other than those described in the preceding sentence
will generally be taxable to such shareholders as ordinary income. However,
distributions by California Tax-Free Income Fund, if any, that are derived from
interest on obligations of the U.S. government may also be designated by the
fund and treated by its shareholders as exempt from California personal income
tax, provided that the foregoing 50% requirement is satisfied. Moreover, under
California legislation incorporating certain 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 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.
62
<PAGE>
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 Internal Revenue 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 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 not be subject to
the unincorporated business taxation imposed by the City solely by reason of
their ownership of shares in the fund. If a shareholder is subject to the
unincorporated business tax, income and gains distributed by the fund will be
subject to such tax except 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.
63
<PAGE>
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 1998 federal individual income tax rates. For
example, a couple with taxable income of $90,000 in 1998, or a single individual
with taxable income of $55,000 in 1998, 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>
<CAPTION>
TABLE I. 1998 FEDERAL TAXABLE VS. TAX-FREE YIELDS*
TAXABLE INCOME (000'S) A TAX-FREE YIELD OF
- -------------------------------------- ----------------------------------------------------------
FEDERAL TAX
SINGLE JOINT 4.00% 5.00% 6.00% 7.00% 8.00%
RETURN RETURN BRACKET IS EQUAL TO A TAXABLE YIELD OF APPROXIMATELY:
- ------------------ ---------------- ------------ ----------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
$ 0 - 25.4 $ 0 - 42.4 15.00% 4.71% 5.88% 7.06% 8.24% 9.41%
25.4 - 61.4 42.4 - 102.3 28.00 5.56 6.94 8.33 9.72 11.11
61.4 - 128.1 102.3 - 156.0 31.00 5.80 7.25 8.70 10.14 11.59
128.1 - 278.5 156.0 - 278.5 36.00 6.25 7.81 9.38 10.94 12.50
Over $278.5 Over $278.5 39.60 6.62 8.28 9.93 11.59 13.25
</TABLE>
- ----------------------
* See note following Table III.
TAX-FREE INCOME VS. TAXABLE INCOME-CALIFORNIA TAX-FREE INCOME FUND.
Table II below illustrates approximate equivalent taxable and tax-free yields at
the 1998 federal individual and 1998 California personal income tax rates. For
example, a California couple with taxable income of $90,000 in 1998, or a single
California individual with taxable income of $55,000 in 1998, 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>
<CAPTION>
TABLE II. 1998 FEDERAL AND CALIFORNIA TAXABLE VS. TAX-FREE YIELDS*
EFFECTIVE
TAXABLE INCOME (000'S) CALIFORNIA A TAX-FREE YIELD OF
- -------------------------------------- AND ----------------------------------------------------------
FEDERAL
SINGLE JOINT TAX 4.00% 5.00% 6.00% 7.00% 8.00%
RETURN RETURN BRACKET IS EQUAL TO A TAXABLE YIELD OF APPROXIMATELY:
- ------------------ ---------------- ------------- ----------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
$19.2 - 25.4 $38.4 - 42.4 20.10% 5.01% 6.26% 7.51% 8.76% 10.01%
25.4 - 26.6 42.4 - 53.3 32.32 5.91 7.39 8.87 10.34 11.82
26.6 - 33.7 53.3 -67.3 33.76 6.04 7.55 9.06 10.57 12.08
33.7 - 61.4 67.3 - 102.3 34.70 6.13 7.66 9.19 10.72 12.25
61.4 - 128.1 102.3 - 156.0 37.42 6.39 7.99 9.59 11.19 12.78
128.1 - 278.5 156.0 - 278.5 41.95 6.89 8.61 10.34 12.06 13.78
Over $278.5 Over $278.5 45.22 7.30 9.13 10.95 12.78 14.60
</TABLE>
- -----------------
* See note following Table III.
64
<PAGE>
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
1998 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 6.23% taxable yield to receive the same benefit. A couple who
lives in New York State outside New York City with taxable income of $90,000 in
1998 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 1998, who lives
in New York City and whose investments earn a 4% tax-free yield, would have had
to earn approximately a 6.23% taxable yield to receive the same benefit. A
single individual with a taxable income of $55,000 in 1998, 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.
<TABLE>
<CAPTION>
TABLE III. 1998 FEDERAL AND NEW YORK TAXABLE VS. TAX-FREE YIELDS*
EFFECTIVE
COMBINED
TAXABLE INCOME (000'S) FEDERAL A TAX-FREE YIELD OF
- -------------------------------------- NYS/NYCTAX ---------------------------------------------------------
SINGLE JOINT TAX 4.00% 5.00% 6.00% 7.00% 8.00%
RETURN RETURN BRACKET IS EQUAL TO A TAXABLE YIELD OF APPROXIMATELY:
- ------------------ ---------------- -------------- ---------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
$ 0 - 25.4 $ 0 - 42.4 24.10% 5.27% 6.59% 7.90% 9.22% 10.54%
25.4 - 61.4 42.4 - 102.3 35.75 6.23 7.78 9.34 10.89 12.45
61.4 - 128.1 102.3 - 156.0 38.42 6.50 8.12 9.74 11.37 12.99
128.1 - 278.5 156.0 - 278.5 42.89 7.00 8.75 10.51 12.26 14.01
Over $278.5 Over $278.5 46.10 7.42 9.28 11.13 12.99 14.84
EFFECTIVE
TAXABLE INCOME (000'S) COMBINED A TAX-FREE YIELD OF
- -------------------------------------- FEDERAL ---------------------------------------------------------
SINGLE JOINT NYS TAX 4.00% 5.00% 6.00% 7.00% 8.00%
RETURN RETURN BRACKET IS EQUAL TO A TAXABLE YIELD OF APPROXIMATELY:
- ------------------ ---------------- -------------- ---------------------------------------------------------
$ 0 - 25.4 $0 - 42.4 20.82% 5.05% 6.31% 7.58% 8.84% 10.10%
25.4 - 61.4 42.4 - 102.3 32.93 5.96 7.46 8.95 10.44 11.93
61.4 - 128.1 102.3 - 156.0 35.73 6.22 7.78 9.34 10.89 12.45
128.1 - 278.5 156.0 - 278.5 40.38 6.71 8.39 10.06 11.74 13.42
Over $278.5 Over $278.5 43.74 7.11 8.89 10.66 12.44 14.22
</TABLE>
- -----------------
* Certain simplifying assumptions have been made in the tables. 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 federal alternative minimum tax, limitations on
federal or state itemized deductions, the phase out of deductions for
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 cases of Tables II and III).
65
<PAGE>
The yields listed above 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
MASSACHUSETTS BUSINESS TRUSTS. Each Trust is an entity of the type
commonly known as a "Massachusetts business trust." Under Massachusetts law,
shareholders of a fund could, under certain circumstances, be held personally
liable for the obligations of the fund or its Trust. However, each Trust's
Declaration of Trust disclaims shareholder liability for acts or obligations of
the Trust or the fund and requires that notice of such disclaimer be given in
each note, bond, contract, instrument, certificate or undertaking made or issued
by the board members or by any officers or officer by or on behalf of the Trust
or the fund, the board members or any of them in connection with the Trust. Each
Declaration of Trust provides for indemnification from the relevant fund's
property for all losses and expenses of any shareholder held personally liable
for the obligations of the fund. Thus, the risk of a shareholder 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 would be entitled to
reimbursement from the general assets of the relevant fund. The board members
intend to conduct each fund's operations in such a way as to avoid, as far as
possible, ultimate liability of the shareholders for liabilities of the fund.
CLASSES OF SHARES. A share of each class of a fund represents an
identical interest in that fund's investment portfolio and has the same rights,
privileges and preferences. However, each class may differ with respect to sales
charges, if any, distribution and/or service fees, if any, other expenses
allocable exclusively to each class, voting rights on matters exclusively
affecting that class, and its exchange privilege, if any. The different sales
charges and other expenses applicable to the different classes of shares of the
funds will affect the performance of those classes. Each share of a fund is
entitled to participate equally in dividends, other distributions and the
proceeds of any liquidation of that fund. However, due to the differing expenses
of the classes, dividends and liquidation proceeds on Class A, B, C and Y shares
will differ.
VOTING RIGHTS. Shareholders of each fund are entitled to one vote for
each full share held and fractional votes for fractional shares held. Voting
rights are not cumulative and, as a result, the holders of more than 50% of all
the shares of a Trust may elect all of the board members of that Trust. The
shares of a fund will be voted together, except that only the shareholders of a
particular class of a fund may vote on matters affecting only that class, such
as the terms of a Rule 12b-1 Plan as it relates to the class. The shares of each
series of a Trust will be voted separately, except when an aggregate vote of all
the series of a Trust is required by law.
The funds do not hold annual meetings. Shareholders of record of no
less than two-thirds of the outstanding shares of a Trust may remove a board
member through a declaration in writing or by vote cast in person or by proxy at
a meeting called for that purpose. A meeting will be called to vote on the
removal of a board member at the written request of holders of 10% of the
outstanding shares of a Trust.
CLASS-SPECIFIC EXPENSES. Each fund may determine to allocate certain of
its expenses (in addition to service and distribution fees) to the specific
classes of its 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
66
<PAGE>
number of shareholder accounts in each class and the relative amounts of net
assets in each class.
PRIOR NAMES. Prior to November 10, 1995, the Class C shares of the
funds were called "Class D" shares.
CUSTODIAN AND RECORDKEEPING AGENT; TRANSFER AND DIVIDEND AGENT. State
Street Bank and Trust Company, located at One Heritage Drive, North Quincy,
Massachusetts 02171, serves as custodian and recordkeeping agent for each fund.
PFPC Inc., a subsidiary of PNC Bank, N.A., serves as each fund's transfer and
dividend disbursing agent. It is located at 400 Bellevue Parkway, Wilmington, DE
19809.
COMBINED PROSPECTUS. Although each fund is offering only its own
shares, it is possible that a fund might become liable for a misstatement in the
Prospectus about another fund. The board of each fund has considered this factor
in approving the use of a single, combined Prospectus.
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 PaineWebber and Mitchell
Hutchins in connection with other matters. The law firm of Orrick, Herrington &
Sutcliffe, 400 Sansome Street, San Francisco, California 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 Reports to Shareholders for their last fiscal years
ended February 28, 1999 are separate documents supplied with this SAI, and the
financial statements, accompanying notes and report of independent auditors
appearing therein are incorporated herein by this reference.
67
<PAGE>
APPENDIX
RATINGS INFORMATION
DESCRIPTION OF MOODY'S MUNICIPAL BOND RATINGS
Aaa. Bonds which are rated Aaa are judged to be of the best quality.
They carry the smallest degree of investment risk and are generally referred to
as "gilt edged." Interest payments are protected by a large or by an
exceptionally stable margin and principal is secure. While the various
protective elements are likely to change, such changes as can be visualized are
most unlikely to impair the fundamentally strong position of such issues; Aa.
Bonds which are rated Aa are judged to be of high quality by all standards.
Together with the Aaa group they comprise what are generally known as high grade
bonds. They are rated lower than the best bonds because margins of protection
may not be as large as in Aaa securities or fluctuation of protective elements
may be of greater amplitude or there may be other elements present which make
the long term risk appear somewhat larger than in Aaa securities; A. Bonds which
are rated A possess many favorable investment attributes and are to be
considered as upper-medium-grade obligations. Factors giving security to
principal and interest are considered adequate, but elements may be present
which suggest a susceptibility to impairment sometime in the future; Baa. Bonds
which are rated Baa are considered as medium-grade obligations, i.e., they are
neither highly protected nor poorly secured. Interest payment and principal
security appear adequate for the present but certain protective elements may be
lacking or may be characteristically unreliable over any great length of time.
Such bonds lack outstanding investment characteristics and in fact have
speculative characteristics as well; Ba. Bonds which are rated Ba are judged to
have speculative elements; their future cannot be considered as well-assured.
Often the protection of interest and principal payments may be very moderate and
thereby not well safeguarded during both good and bad times over the future.
Uncertainty of position characterizes bonds in this class; B. Bonds which are
rated B generally lack characteristics of the desirable investment. Assurance of
interest and principal payments or of maintenance of other terms of the contract
over any long period of time may be small; Caa. Bonds which are rated Caa are of
poor standing. Such issues may be in default or there may be present elements of
danger with respect to principal or interest; Ca. Bonds which are rated Ca
represent obligations which are speculative in a high degree. Such issues are
often in default or have other marked shortcomings; C. Bonds which are rated C
are the lowest rated class of bonds, and issues so rated can be regarded as
having extremely poor prospects of ever attaining any real investment standing.
Note: Moody's applies numerical modifiers, 1, 2 and 3 in each generic
rating classification from AA through Caa. The modifier 1 indicates that the
obligation ranks in the higher end of its generic rating category, the modifier
2 indicates a mid-range ranking, and the modifier 3 indicates a ranking in the
lower end of that generic rating category.
DESCRIPTION OF S&P MUNICIPAL DEBT RATINGS
AAA. An obligation rated AAA has the highest rating assigned by S&P.
The obligor's capacity to meet its financial commitment on the obligation is
extremely strong; AA. An obligation rated AA differs from the highest rated
obligations only in small degree. The obligor's capacity to meet its financial
commitment on the obligation is very strong; A. An obligation rated A is
somewhat more susceptible to the adverse effects of changes in circumstances and
economic conditions than obligations in higher rated categories. However, the
obligor's capacity to meet its financial commitment on the obligation is still
strong; BBB. An obligation rated BBB exhibits adequate protection parameters.
However, adverse economic conditions or changing circumstances are more likely
to lead to a weakened capacity of the obligor to meet its financial commitment
on the obligation; BB, B, CCC, CC, C, D. Obligations rated BB, B, CCC, CC and C
are regarded as having significant speculative characteristics. BB indicates the
least degree of speculation and C the highest. While such obligations will
likely have some quality and protective characteristics, these may be outweighed
by large uncertainties or major exposures to adverse conditions; BB. An
obligation rated BB is less vulnerable to nonpayment than other speculative
issues. However, it faces major ongoing uncertainties or exposure to adverse
business, financial, or economic conditions which could lead to the obligor's
inadequate capacity to meet its financial commitment on the obligation; B. An
obligation rated B is more vulnerable to nonpayment than obligations rated BB,
but the obligor currently has the capacity to meet its financial commitment on
the obligation. Adverse business, financial, or economic conditions will likely
impair the obligor's capacity or willingness to meet its financial commitment on
the obligation; CCC. An obligation rated CCC is currently vulnerable to
nonpayment and is dependent upon favorable business, financial and economic
<PAGE>
conditions for the obligor to meet its financial commitment on the obligation.
In the event of adverse business, financial, or economic conditions, the obligor
is not likely to have the capacity to meet its financial commitment on the
obligation; CC. An obligation rated CC is currently highly vulnerable to
nonpayment; C. The C rating may be used to cover a situation where a bankruptcy
petition has been filed or similar action has been taken, but payments on this
obligation are being continued; D. An obligation rated D is in payment default.
The D rating category is used when payments on an obligation are not made on the
date due even if the applicable grace period has not expired, unless S&P
believes that such payments will be made during such grace period. The D rating
also will be used upon the filing of a bankruptcy petition or the taking of a
similar action if payments on an obligation are jeopardized.
CI. The rating CI is reserved for income bonds on which no interest is
being paid.
Plus (+) or Minus (-): The ratings from "AA" to "CCC" may be modified
by the addition of a plus or minus sign to show relative standing within the
major rating categories.
DESCRIPTION OF MOODY'S RATINGS OF SHORT-TERM OBLIGATIONS
There are three categories for short-term obligations that define an investment
grade situation. These are designated Moody's Investment Grade as MIG 1 (best
quality) through MIG-3. Short-term obligations of speculative quality are
designated SG.
In the case of variable rate demand obligations (VRDOs), a two-component rating
is assigned. The first element represents an evaluation of the degree of risk
associated with scheduled principal and interest payments, and the other
represents an evaluation of the degree of risk associated with the demand
feature. The short-term rating assigned to the demand feature of a VRDO is
designated as VMIG. When either the long- or short-term aspect of a VRDO is not
rated, that piece is designated NR, e.g. Aaa/NR or NR/VMIG 1.
MIG ratings terminate at the retirement of the obligation, while a VMIG rating
expiration will be a function of each issue's specific structural or credit
features.
MIG-1/VMIG-1. This designation denotes best quality. There is present strong
protection by established cash flows, superior liquidity support or demonstrated
broad-based access to the market for refinancing. MIG-2/VMIG-2. This designation
denotes high quality. Margins of protection are ample although not so large as
in the preceding group. MIG-3/VMIG-3. This designation denotes favorable
quality. Liquidity and cash flow protection may be narrow and market access for
refinancing is likely to be less well established. SG. This designation denotes
speculative quality. Debt Instruments in this category lack margins of
protection.
DESCRIPTION OF S&P'S RATINGS OF STATE AND MUNICIPAL NOTES AND OTHER SHORT-TERM
LOANS:
A S&P note rating reflects the liquidity concerns and market access risks unique
to notes. Notes due in 3 years or less will likely receive a note rating. Notes
maturing beyond 3 years will most likely receive a long-term debt rating. The
following criteria will be used in making the assessment.
- --Amortization schedule (the larger the final maturity relative to other
maturities, the more likely it will be treated as a note).
- --Source of payment (the more dependent the issue is on the market for its
refinancing, the more likely it will be treated as a note).
SP-1. Strong capacity to pay principal and interest. Issues determined to
possess very strong characteristics are given a plus (+) designation. SP-2.
Satisfactory capacity to pay principal and interest with some vulnerability to
adverse financial and economic changes over the term of the notes. SP-3.
Speculative capacity to pay principal and interest.
A-2
<PAGE>
DESCRIPTION OF SHORT-TERM DEBT COMMERCIAL PAPER RATINGS
Moody's short-term debt ratings are opinions of the ability of issuers to repay
punctually senior debt obligations. These obligations have an original maturity
not exceeding one year, unless explicitly noted.
Moody's employs the following three designations, all judged to be investment
grade, to indicate the relative repayment ability of rated issuers:
PRIME-1. Issuers (or supporting institutions) assigned this highest
rating have a superior ability for repayment of senior short-term debt
obligations. Prime-1 repayment ability will often be evidenced by the following
characteristics: Leading market positions in well established industries; high
rates of return on funds employed; conservative capitalization structures with
moderate reliance on debt and ample asset protection; broad margins in earnings
coverage of fixed financial charges and high internal cash generation; well
established access to a range of financial markets and assured sources of
alternate liquidity.
PRIME-2. Issuers (or supporting institutions) assigned this rating have
a strong ability for repayment of senior short-term debt obligations. This will
normally be evidenced by many of the characteristics cited above, but to a
lesser degree. Earnings trends and coverage ratios, while sound, will be more
subject to variation. Capitalization characteristics, while still appropriate,
may be more affected by external conditions. Ample alternate liquidity is
maintained.
PRIME-3. Issuers (or supporting institutions) assigned this rating have
an acceptable capacity for repayment of senior short-term obligations. The
effect of industry characteristics and market composition may be more
pronounced. Variability in earnings and profitability may result in changes in
the level of debt protection measurements and may require relatively high
financial leverage.
Adequate alternate liquidity is maintained.
NOT PRIME. Issuers assigned this rating do not fall within any of the
Prime rating categories.
Commercial paper rated by S&P have the following characteristics:
A-1. A short-term obligation rated A-1 is rated in the highest category
by S&P. The obligor's capacity to meet its financial commitment on the
obligation is strong. Within this category, certain obligations are designated
with a plus sign (+). This indicates that the obligor's capacity to meet its
financial commitment on these obligations is extremely strong. A-2. A short-term
obligation rated A-2 is somewhat more susceptible to the adverse effects of
changes in circumstances and economic conditions than obligations in higher
rating categories. However, the obligor's capacity to meet its financial
commitment on the obligation is satisfactory. A-3. A short-term obligation rated
A-3 exhibits adequate protection parameters. However, adverse economic
conditions or changing circumstances are more likely to lead to a weakened
capacity of the obligor to meet its financial commitment on the obligation. B. A
short-term obligation rated B is regarded as having significant speculative
characteristics. The obligor currently has the capacity to meet its financial
commitment on the obligation; however, it faces major ongoing uncertainties
which could lead to the obligor's inadequate capacity to meet its financial
commitments on the obligation. C. A short-term obligation rated C is currently
vulnerable to nonpayment and is dependent upon favorable business, financial and
economic conditions for the obligor to meet its financial commitment on the
obligation. D. A short-term obligation rated D is in payment default. The D
rating category is used when payments on an obligation are not made on the date
due even if the applicable grace period has not expired, unless S&P believes
that such payments will be made during such grace period. The D rating also will
be used upon the filing of a bankruptcy petition or the taking of a similar
action if payments on an obligation are jeopardized.
A-3
<PAGE>
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<PAGE>
YOU SHOULD RELY ONLY ON THE
INFORMATION CONTAINED OR REFERRED TO PaineWebber
IN THE PROSPECTUS AND THIS STATEMENT National Tax-Free Income
OF ADDITIONAL INFORMATION. THE FUNDS Fund
AND THEIR DISTRIBUTOR HAVE NOT
AUTHORIZED ANYONE TO PROVIDE YOU WITH PaineWebber
INFORMATION THAT IS DIFFERENT. THE Municipal High Income Fund
PROSPECTUS AND THIS STATEMENT OF
ADDITIONAL INFORMATION IS NOT AN OFFER PaineWebber
TO SELL SHARES OF THE FUNDS IN ANY California Tax-Free Income
JURISDICTION WHERE THE FUNDS OR THEIR Fund
DISTRIBUTOR MAY NOT LAWFULLY SELL
THOSE SHARES. PaineWebber
New York Tax-Free Income
Fund
------------
-----------------------------------
Statement of Additional Information
June 30, 1999
-----------------------------------
PaineWebber
(C)1999 PaineWebber Incorporated
